THE OUTLOOK

U.S. Warning Signs Point
Toward a Deep Recession

Housing Crunch,
Squeeze on Consumers
Exceed Earlier Slumps

By JUSTIN LAHART
January 21, 2008

The U.S. has suffered recessions only twice in the past quarter century and both were short and mild. There are good reasons to fear that the looming recession, if it arrives, could be worse.

Housing is in the midst of its worst downturn since at least the 1970s. That has led to a meltdown in the mortgage market; with financial firms struggling to make sense of their losses, they are making it harder for even credit-worthy borrowers to get loans. The combination of heavy debt loads, still-high energy and food prices and a weakening job market has households tightening their belts. Consumer spending, long a bulwark of the economy, is faltering.

That sets the stage for something more severe than the 2001 recession, which spanned just eight months, says Merrill Lynch economist David Rosenberg. During that slump, in which gross domestic product declined a slight 0.4%, quarterly consumer spending slowed but never contracted — the first time that happened during a recession since the 1940s.

The eight-month recession that ended in early 1991, when a housing downturn and credit problems sapped the economy, is a better guide. From its peak to its trough, GDP shrank 1.3%, and consumer spending slipped.

Today’s housing debacle is even worse, says Mr. Rosenberg, and the financial crisis it has precipitated is far more severe.

University of Maryland economist Carmen Reinhart and Harvard University economist Kenneth Rogoff agree. They say the current crisis appears on track to be at least as bad as the five most catastrophic financial crises to hit industrialized countries since World War II.

If those past experiences are any guide, the economy is in trouble, they argue in a recent paper. Indeed, “if the United States does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more ’special’ than most optimistic theories suggest,” they write.

One reason that large crises inflict so much damage is that financial institutions have a hard time getting a handle on how bad their losses will be, and that uncertainty makes them less willing to lend. Citigroup Inc. and Merrill Lynch & Co. Inc. each reported billions of dollars in losses last week that were in addition to the billions in losses they reported in the fall. Citigroup said it was building its loan-loss reserves for auto loans and credit-card debt, in addition to mortgages, and that it was tightening credit-card lending standards.

“Part of the problem is just not knowing,” Ms. Reinhart says. “The longer the process of not knowing what the losses are takes, the longer the resolution takes.” Japan was the extreme example, she says, as the inability to appropriately gauge the losses from the 1990s real-estate and stock bubble collapse led to a “lost decade” of economic growth.

A critical difference between the U.S. and Japan is that the Federal Reserve has been cutting its target for its benchmark federal-funds rate and appears ready to cut it more deeply, whereas the Bank of Japan was still raising rates a year after Japan’s bubble began to collapse. Also, Congress and the White House are both promising a fiscal-stimulus package, with Fed Chairman Ben Bernanke pushing for a plan that would help boost spending this year.

Companies, at least those outside of the banking and housing sectors, might also take some of the sting out of a recession. Their finances are in far better shape now than they were in 2001, and credit so far is still widely available. As they repaired their balance sheets in the wake of the 2001 recession, companies were also slower to hire than in past economic expansions. That may mean they won’t be able to cut jobs as deeply, says Goldman Sachs economist Jan Hatzius.

Robert Gordon, an economist at Northwestern University in Illinois who is also a member of the National Bureau of Economic Research committee that determines (usually long after the fact) when recessions begin, is hopeful that overseas growth may continue to bolster the U.S. economy. He notes that exports, which have been growing rapidly and account for more than twice as large a share of GDP as home construction does, will continue to post strong growth, easing the pain of the housing decline.

Still, he thinks a recession is probably coming and that the challenges facing consumers, in particular, are more severe than they were in the two previous downturns. In addition to the housing troubles and mortgage-market woes, higher food and energy costs are cutting into household budgets, he says.

“While energy is not as important a part of the consumer budget as it was in the ’70s — nor is food — nevertheless, the squeeze will push out consumption in everything else,” Mr. Gordon says. “Across the board, I think we’re going to have significant ongoing pressure in inflation-adjusted retail sales.”

Robert Barbera, an economist at New York trading-services firm Investment Technology Group Inc., agrees. “Consumers will be part of this recession in a way that they weren’t in 2001,” he says.

Even if the country is in for just a mild recession, the pressure on spending, coupled with what has happened in the housing and mortgage markets, may make it feel a lot worse for most Americans than the last two downturns did.

Write to Justin Lahart at justin.lahart@wsj.com

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What a Recession Could Mean to You

By GREG IP
January 20, 2008

A recession in 2008 isn’t official yet. But with unemployment rising and stocks falling — including a 4% drop in the Dow Jones Industrial Average last week — many economists, including former Federal Reserve Chairman Alan Greenspan and former Treasury Secretary Lawrence Summers, say the U.S. is probably in a recession.

What does that mean exactly? And what does it mean for investors? Here are answers to some key questions.

Q: What is a recession?

A: Business cycles are made up of periods of economic expansion and recessions, when the economy is contracting. The generally accepted arbiter of when U.S. recessions begin and end is the “business cycle dating committee” of the 87-year old National Bureau of Economic Research, a non-profit group based in Cambridge, Mass., that is made up of 600 academic economists.

The NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months,” and usually visible in measures such as gross domestic product, employment, incomes and industrial production.

A popular rule of thumb says a recession is two consecutive quarters of shrinking GDP, although that doesn’t fit some NBER-designated recessions.

Q: Are we in a recession or about to enter one?

A: We won’t know for sure unless the NBER announces it, and that would likely be long after the fact. (It did not decide the last recession began in March of 2001 until November of that year.) So far, GDP has yet to shrink.

But there are some things that are common to most recessions that are present now: a drop in the stock market, long-term interest rates falling below the level of short-term rates, and a decline in housing activity. Goldman Sachs says the unemployment rate, averaged over three months, has always risen at least 0.3 percentage points before or during a recession, a threshold that was crossed last month.

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But there are some indicators that are not flashing recession. Employers have not trimmed employee work weeks, as they commonly do if demand for their products has tailed off. Initial claims for unemployment insurance have actually dropped so far in January.

Perhaps most important, inventories are not unusually high, which makes it less urgent for manufacturers to scale back production.

Q: If it’s a recession, how long and deep will it be?

A: According to the NBER, there have been 32 recessions since 1854, lasting an average of 17 months. Recessions have gotten shorter and less frequent since 1945, averaging just 10 months. And the two last recessions were among the shortest and mildest on record; both the 1990-1991 downturn and the 2001 recession lasted just eight months.

One reason recessions are less severe now is that traditionally a major cause of declines in GDP and employment has been manufacturers’ need to reduce excess inventories. Over time, manufacturing has shrunk as a share of GDP and manufacturers and retailers now have better control over their inventories thanks to just-in-time supply-chain management.

Recessions from 1945 to 1981 were principally caused by the Federal Reserve raising interest rates to suppress inflation, which then undermined demand for houses and cars. This time around, the Fed did not raise rates very high, and home construction has already fallen by half since the housing bubble burst in 2006. That suggests a lot of the potential damage to the economy has already been done.

Even some of the economists who do expect a recession think it will be mild. Goldman Sachs argues, for example, that employers trim their payrolls nowadays mostly through attrition rather than layoffs, which will soften the blow to incomes.

One area of concern, though, is that housing prices are declining nationwide, which hasn’t happened on a sustained basis since the 1930s. As home values decline, households may cut back on spending, and the most overstretched borrowers will likely default. Loan defaults in turn weaken the health of banks and other lenders and may lead to further restrictions in credit. This could make the recession severe.

Moreover, the fallout of the tech bust in 2001 was cushioned by the boom in housing that followed. No sector is an obvious candidate to provide the same degree of relief now.

Q: If it’s a recession, how will stocks perform?

A: Stocks usually start to fall before a recession begins, as investors sense that economic activity and thus corporate profits are about to turn down. Prices often bottom out before a recession ends, as investors sense that the excess inventories or the glut of unsold homes that led to the recession have been resolved.

The turnaround usually occurs once the Federal Reserve shifts its priority from battling inflation to supporting growth, and cuts interest rates.

Charles Reinhard, director of portfolio strategy at fund manager Neuberger Berman, compared how stocks performed in previous periods when the Fed began cutting rates. In all but one of the past 11 rate-cutting cycles (including several when a recession didn’t materialize), the Standard & Poor’s 500-stock index has risen — advancing an average 17% in the 12 months after the Fed starts to cut rates.

The exception was 2001: the S&P 500 was still down 12% 12 months after the first Fed rate reduction. Mr. Reinhard says that’s because the market started out so overvalued relative to earnings then.

Since Sept. 18, when the Fed started cutting rates, the S&P 500 is down 13%. It’s down 15% from its October peak. If pre-2001 patterns hold, that suggests the next eight months could end up being good for stocks.

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