Fears of worst US recession since WWII

There remains a great deal of uncertainty about how many more victims the credit crisis will claim.

money good 88 (photo credit: )
money good 88
(photo credit: )
It has been almost an article of faith: Any US recession this year will be mild and brief. But now the stunning meltdown of a top Wall Street investment bank and stubbornly persistent financial market turbulence has called that into question, raising fears that severe problems in housing and the US' bedrock financial system could cripple the economy and wallop many millions of Americans. No less an authority than former Federal Reserve chairman Alan Greenspan wrote this week that "the current financial crisis in the US is likely to be judged as the most wrenching" since the end of World War II. Other noted economists are also sounding alarms. Harvard professor Martin Feldstein, the former head of the National Bureau of Economic Research, said recently he believes America is now in a recession and it could be a severe one. While it will be many months before the bureau's cycle dating committee, the unofficial arbiter of when recessions begin and end, makes its own ruling, a growing number of private economists already have a downturn figured into their forecasts. They are generally calling for a mild recession that will end this summer when the economic stimulus checks going to 130 million households start getting spent. But the severe credit crisis that erupted last August - and claimed its biggest victim this past weekend with the forced sale of Bear Stearns Co. - is raising doubts about those mild forecasts. "Bear Stearns was a clear wake-up call. It resonates with everybody and highlights the severity of the stresses in the financial system," said Mark Zandi, chief economist at Moody's Economy.com. What got people's attention was how quickly Bear Stearns, the nation's fifth largest investment bank, could go from a stock market value of about $3.5 billion when the market closed on March 14 to being sold at the bargain-basement price of about $236 million two days later. The Federal Reserve rushed in to take unprecedented actions. It provided a $30b. line of credit to facilitate the sale and is employing Depression-era provisions that for the first time are providing direct Fed loans to investment banks. Most analysts said the Fed was justified and that its efforts highlighted the severity of the dangers facing the financial system. The turmoil produced wild swings on Wall Street this week with the Dow Jones industrial average surging on Tuesday after the Fed aggressively cut a key interest rate only to plunge on Wednesday on renewed worries about the economy and then to stage a 262-point gain on Thursday. Markets were closed Friday. More turbulence is expected in coming weeks because there remains a great deal of uncertainty about how many more victims the credit crisis will claim. The problems began last year with rising defaults on mortgages as a housing slump intensified, but they have now spread to other parts of the credit markets with institutions growing fearful about making other types of loans. It is the ability to get credit that makes the financial system and the economy it supports function. When banks stop lending to other institutions that, like Bear Stearns, depend on credit to conduct their day-to-day operations, the results can be catastrophic. "We can't afford to stagger from one day to the next without knowing what large financial institution might be the next to go down the tubes because of a lack of liquidity. That is way too dangerous a game," said Lyle Gramley, a former Fed board member who is now an economist with the Stanford Financial Group. "It is possible that we could be entering the worst recession of the post World War II period. The threat is certainly there." Because of Bear Stearns, many analysts are raising the odds that a 2008 recession could be worse than expected. "The potential freezing up of the financial system could have pretty negative ramifications on bank lending, which would have negative ramifications on consumer and business spending," said Nariman Behravesh, chief economist at Global Insight, a Lexington, Massachusetts, forecasting firm. He said he had upped the chances of a worse-than-expected recession to 40 percent, up from 25% odds before Bear Stearns. David Wyss, chief economist at Standard & Poor's in New York, said he now has a worst-case-scenario in which the US could endure a double-dip recession in which the economy would briefly recover this summer, helped by the $168b. in tax relief, only to quickly slip back into a downturn. Under this scenario, the economy's total output, as measured by the gross domestic product, would drop by 2.2 percentage points, making it the third worst recession in the post World War II period. The worst recession in recent decades, in terms of lost output, occurred in the 1973-75 period of oil shocks, when GDP fell by 3.1%, followed by the 1981-82 recession, when GDP dropped by 2.9%. By contrast, in the last two recessions output fell by 1.3% in the 1990-91 downturn, and a tiny 0.3% in the 2001 recession, making that slump the mildest in the post-war period in terms of lost output. The 2001 downturn lasted just eight months. Wyss's baseline forecast calls for the 2008 downturn to trim US GDP by just 0.5% and last for nine months, from last November until August. Under that forecast, unemployment, which hit a low in this expansion of 4.4% and now stands at 4.8%, will rise to around 6%, meaning 1.5 million Americans will lose their jobs. Under the worst-case forecast, unemployment jumps to 7.5%, meaning 3 million people would be tossed out of work. "There would be bigger drops in the stock market and in home prices than we are now anticipating and more people out of work," Wyss said. "There would be a lot of pain all the way around." While they are developing worst-case-scenarios, Wyss and other economists said they still believe the balance has not tipped from their more benign main forecasts. One thing that gives them hope is the expectation that Congress and the Bush administration, having acted so quickly to pass the first stimulus package, will move quickly, especially in an election year, to pass a second package if needed. Also, analysts said the Bear Stearns crisis, which has already prompted the Fed to move more aggressively, will also probably trigger a bigger response on the part of Congress and the administration in offering help to homeowners to keep them from losing their homes because of mortgage defaults. "Historically, when policy-makers have acted in a concerted and aggressive way, that signals that we are nearing the end of the crisis," said Zandi. "If that occurs this time and the financial markets stabilize in the next few months, then the economy will suffer but it won't be a prolonged and severe recession."