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The U.S. economy is now almost certainly in the early stages of a long and deep recession. No, not a Great Depression. Economic policymaking has come a long way since the 1930s, and we now know how to avoid the worst mistakes. Nevertheless, we’re facing something akin to the severe recession of the early 1980s, when unemployment crossed 10%, rather than the relatively short, shallow recessions of the early 1990s and 2000s.
The root cause of the recession is the $4 trillion decline in the value of U.S. homes, which may well total $8 trillion before prices hit bottom. Econometric evidence suggests that for every $1 decline in housing prices, homeowners cut back spending by about 6 cents. Using this formula, a $6 trillion drop in prices translates into a $360 billion annual decline in consumption—just under three percentage points of gross domestic product.
Earlier this decade, the same economic logic pushed the economy into a recession in the aftermath of the stock-market crash. The wealth impact then was on the same order of magnitude of what we’re seeing today with housing, but homes are much more widely owned than stock is and the average homeowner spends a higher share of income than wealthy stockholders do. In the end, the "wealth effect" from the housing bubble will likely end up twice as large as the 2001 stock bubble.
And, as is all too obvious looking back, we escaped the worst fallout from the stock market collapse precisely because the housing bubble stepped in to fill the void. In the current circumstances, no obvious replacement bubble waits on the horizon.
Thomas Hobbes said that life was "nasty, brutish, and short." Get ready for nasty, brutish, and long.
A common refrain these days is that the U.S. economy is going down the route of Japan, doomed to a decade of stagnation. The short answer for those asking the question: not if Ben Bernanke and Hank Paulson have any say.
The U.S. faces both short-term and long-term challenges. In the short term, a functioning economy needs functioning capital markets. After more than a year of increasingly severe credit-market crises, the U.S. economy is almost certainly entering a full-blown recession. However, recessions don’t last forever, especially when there is aggressive countervailing policy action. After addressing the crisis with piecemeal measures, Bernanke and Paulson have adopted a proactive $1 trillion-plus program of support to the banking industry, the short-term lending market, and the mortgage market.
As a close student of both the Great Depression and the "lost decade" in Japan, Bernanke knows that an extended period of stagnation requires both a major shock and a failure of policymakers to act decisively. It took Japan a decade to adopt the aggressive asset-buying policy that the Fed started this spring.
By the middle of next year, the U.S. economy should start crawling its way out of the recession, and a new set of challenges will loom. U.S. consumer spending has grown faster than income for much of the past two decades, and much of this spending has leaked overseas in the form of imports. In the decade ahead, there will be a rebalancing of the U.S. economy with slower consumption growth, but also fewer imports. The economy also will face the challenge of slower growth in the labor force as the outsize Baby Boom generation retirees. This does not mean stagnation, just slower growth, as in other low-population-growth countries.
Turning Japanese? I really don’t think so.
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