The Economy: Best- and Worst-Case Scenarios

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Stabilizing the housing market would be a confidence booster for the entire economy and the financial system. John Paulson of Paulson & Co., a $35 billion hedge fund that made a killing in 2007 betting against the U.S. subprime sector, told clients in a conference call days before the Treasury announcement that he's finally ready to make some tactical investments in financial firms that have gotten especially cheap, even though he thinks prices in the overall sector still have further to fall as foreclosures mount. His toe-dipping was first reported by the Financial Times.

If the housing market stopped sinking, or even rose, consumers might also spend more liberally, which would then boost employment and induce even more spending—the classic virtuous circle. One optimist, James W. Paulsen (not to be confused with Henry or John), chief investment officer of Minneapolis-based Wells Capital Management, notes that the 94% of the economy that's not housing or autos has grown over 5% over the past year, while the 6% consisting of housing and autos has shrunk 20%. The implication, says Paulsen: "A quicker-than-expected turnaround is possible, since it would not require a broad-based recovery, but rather only a cessation of the collapse in two industries."

Signs of health in the U.S. economy would reduce the risk of a panicky pullout by foreign investors, ensuring that inflowing capital would help finance spending by American households and businesses. In fact, the dollar rose after the Treasury announcement, adding to a gain of 10% against six major currencies since mid-July.

The Nightmare

So we're golden, right? Well, maybe not. In the vicious-circle scenario, Treasury's intervention ends up being a replay of Japan's ill-fated effort to prop up crippled banks in the 1990s. Increasing the availability of credit delays—but does not prevent—the full price decline needed to clear out the daunting overhang of nearly 4.7 million unsold existing homes as of July.

As the lender of last resort, the government throws good money after bad, first on housing and then on airlines, automakers, and other supplicants. All this against an undeniable backdrop of rising federal deficits: The Congressional Budget Office predicted this month that the federal budget deficit would remain above $400 billion annually from 2008 through 2010, up from about $160 billion in 2007.

In the nightmare scenario, the descent into quasi-socialism balloons the national debt and wrecks foreign investors' faith in the economy. That's the vision sketched out by ultra-bears like Peter Schiff, president of Euro Pacific Capital, a brokerage in Darien, Conn. Schiff is passionate on the topic: "The dollar is going to go through the floor, interest rates are going to spike up, and we're going to have a complete financial meltdown. It's going to be the worst-case scenario."

A different school of pessimists says the housing market actually does need a big adrenaline shot from the government. But they say it's unlikely to get one from either a McCain or an Obama Administration because the risk to taxpayers from a much bigger commitment to housing would be deemed too great. The only real beneficiaries of the takeover are the holders of Fannie and Freddie securities, who are bailed out of their bad investment choices, says Robert I. Kessler, CEO of Kessler Cos., a Denver investment firm. Says Kessler: "It's a great thing for the big banks. I don't see any benefit whatsoever to consumers."

Specifically, the Fan-Fred takeover does nothing to help homeowners who can't refinance a home loan because their property is assessed for less than they owe. It also may not be enough to draw in buyers, who are focused more on the risk of declining home values than on the upside of a slightly lower mortgage rate. "I've sat in open houses, and you just can't get people to make an offer," says Edward Cudahy Spalding, a real estate broker in Fort Lauderdale. "You've got to reinflate values in the housing market. I don't know how you do that."

Without more relief for homeowners and consumers, the housing-led recession is likely to deepen. In this vicious-circle scenario, the housing slump depresses consumer spending, leading to job cuts and thus forcing even more foreclosures and bigger spending reductions—in other words, the mirror image of the virtuous circle. Vulnerable sectors include finance; nonresidential construction, which tends to follow homebuilding downward with a lag; and retail, which has so far lost only a modest number of jobs nationally relative to the size of the sector.

Away from Wall Street, the mood is glum. Douglas S. Bartlett, owner of Bartlett Manufacturing, a maker of printed-circuit boards in Cary, Ill., says competition from China has forced him to cut employment nearly two-thirds since 2000, to 87. He hasn't felt any reprieve from the dollar's recent depreciation against China's currency. Says Bartlett: "Fortunately for us, there's been enough of our competitors going out of business that we're able to pick up their work." In Sacramento, restaurateur Ali Mackani was forced to shut down his fashionable Restaurant 55 Degrees shortly after Labor Day because of slower-than-expected commercial and residential development in the area, which he had been counting on to produce customers.

Today's business failures ripple across the economy, triggering more failures. And when the financial system is crippled by losses, the hoped-for V-shaped recovery can flatten out into a wide-bottomed U, says Dan North, chief economist of Euler Hermes ACI, a North American unit of Germany's Allianz Group (AZ) that insures accounts receivable. North says that because of business failures, the number of insurance claims processed by his company was up 80% in the first six months of 2008 compared with a year earlier.

Hedge Your Bets

It's easy to imagine either scenario unfolding, good or bad. And really, that's the whole point. Blind conviction has not served us well. On the one hand, the credit crunch has embarrassed optimists, like Federal Housing Finance Agency Director James B. Lockhart III, who averred on Mar. 19 that Fannie and Freddie "will continue to be safe and sound" and called the idea of a bailout "nonsense." In his new book, The Subprime Solution, Yale University economist Robert J. Shiller says regulators suffered from an "inability to believe that there could ever be a housing crisis of the proportions we are seeing today."

On the other hand, it would be equally wrong to assume the worst and get into a defensive crouch, as some investors have done. Prices of some derivative securities are so low that they seem to factor in a complete collapse of the U.S. economy. And yet investors who smell a profit opportunity in those assets are holding back because they worry their prices could go even lower before rebounding. Ricardo Caballero, a Massachusetts Institute of Technology economist, wrote in the Bank of France's Financial Stability Review in February that "in today's market, uncertainty has led every player to make decisions based on imagined worst-case scenarios."

What to do? Whether you're inclined toward the virtuous circle or the vicious one, hedge your bets. Because as the Fan/Fred takeover shows, just about anything can happen.

With Tara Kalwarski in New York.
Coy is BusinessWeek's Economics editor.