The Dreaded R-Word

Is the U.S. economy in a recession? If it is, how long will it last—and how much will it hurt? Six American Enterprise Institute economists offered differing assessments at a panel discussion last week, ranging from Charles W. Calomiris’s view that “severe recession risk is minimal” to Desmond Lachman’s prediction of “several quarters of negative growth going forward.” Other panelists—including former Federal Reserve monetary affairs director Vincent R. Reinhart—addressed the Fed’s role in credit markets, specifically its March bailout of Bear Stearns.

Meeting for the first time since their December 2007 panel, the AEI scholars took a fresh look at the health of the economy. In a paper discussed at the December conference, Calomiris argued that “it is too early to conclude that the U.S. banking system will find itself unable to reallocate risk in an orderly fashion, and end up having to dramatically curtail the supply of credit.” Last week he pointed to signs today that banks are reabsorbing off-balance sheet items and that their liquidity risks from asset-backed commercial paper and special investment vehicles are contained. Calomiris added that banks have sufficient access to capital markets and that “corporate balance sheets are strong.”

Kevin A. Hassett offered an analysis of whether the economy is in recession based on a statistical model he is helping to develop. In December and January, Hassett said, the economy was not in recession. The data “took a marked turn for the worse in February,” he added, although “it’s not obvious that we’re in recession yet.” Hassett also noted that the possibility of an impending recession combined with the 2008 presidential election might lead to “tax policy uncertainty” in the financial markets, which in turn might harm growth.

Lachman argued in December that a recession was imminent, and he said last week that the three “negative economic shocks” he felt were leading us toward recession had gone from bad to worse: the housing bust, the credit crunch, and rising oil prices. On housing, Lachman predicted there would be a further 20 percent drop in home prices. He described the recent sharp rise in foreclosures as “off the charts.” Not only are we in a recession, Lachman said, but “unorthodox measures are needed to stabilize the housing market.”

Calomiris and John H. Makin sparred over the housing market, disputing the usefulness of two important home price indices, Case-Shiller and OFHEO (Office of Federal Housing Enterprise Oversight). “Case-Shiller is a flawed index,” Calomiris said. He predicted that home prices would drop by no more than 10 percent, insisting that the housing crisis is regionally concentrated. Makin replied that the OFHEO index excludes the most vulnerable mortgages.

Like Calomiris, Allan H. Meltzer said that the housing crisis was localized and that defaults may be overstated. He suggested that much of the turmoil in financial markets has to do with a certain “hubris” on Wall Street that leads financial-sector workers to think, “If things are bad for me, they’ve got to be bad for everyone.”

Why is knowing the extent of the housing crisis so important to the overall economy and the credit crunch? Meltzer explained that the credit problem cannot end until home prices reach their natural equilibrium. “The beginning of the end of the housing problem will be when the expectation in the markets of the housing price stabilizes,” he said. “When [market participants] know what the housing price is going to be, they’ll be able to value the securities in their portfolio. They’ll be able to raise more capital. People will have more confidence in what their assets are.” With home prices in freefall, it is difficult to accurately value the packages of complex mortgage-backed securities, which has led to the current dearth of credit.

The housing crisis also affects the broader economy. As Makin wrote in the Wall Street Journal in September 2007, “Over the past half century, every U.S. housing downturn as sharp as the current one has translated into a U.S. recession. U.S. house prices are falling at an annual rate of nearly 4 percent—an event not seen since the Great Depression—and the downward trend is accelerating.”

At last week’s conference, Makin echoed some of Lachman’s comments when he said, “Everything looks like we went into a recession in the first quarter.” As for the Federal Reserve’s Bear Stearns bailout, Makin said that it was necessary to prevent a run on investment banks and “a near meltdown in the credit sector.” The Fed’s action was to be commended, he added, since it stabilized financial markets.

Reinhart, however, argued the opposite, saying that the Fed’s decision “to lend to Bear Stearns and extend lending to all primary dealers…was the [Fed’s] worst policy decision in a generation”—comparable in its long-term consequences to the errors of the “great contraction” of the 1930s and the “great inflation” of the 1970s. He said the Fed had overlooked other tenable options and acted out of “panic.” As a consequence, it had lost its credibility as an “honest broker” in financial crises and, more disturbing, increased the likelihood that Congress will respond with a wave of harmful new regulations.

Meltzer, who has written a history of the Fed, called for the central bank to take a longer view and to remain mindful of rising inflation expectations. He is pleased with its actions to safeguard the financial system but not with its weak-dollar policy. Indeed, Meltzer fears that the Fed is ignoring inflationary risks, much as it did in the 1970s. Part of the problem, he said, is that “most of the time, the Fed is not independent”: it gets “whipped around by the Congress.” Today, Meltzer added, Chairman Ben Bernanke is not “standing up” to Congress, and he is “also under the gun from Wall Street.”

This article was originally published on on May 8, 2008.