From the November 11, 2007 Sunday Times
November 12, 2007
by Irwin Stelzer
Add $100 oil to billions in bank write-offs and it should come as no surprise that the word “recession” is being heard with increasing frequency. As is the view that circumstances have combined to neuter the Federal Reserve Board, making it powerless to use its monetary-policy weapon to prevent a downturn.
It’s not the write-offs so much as the inability of the chiefs of the leading banks to come close to estimating the magnitude of the problem. Stan O’Neal might have survived at Merrill Lynch, and Charles Prince at Citigroup, if their first public estimates of their firms’ exposure to losses from sub-prime and related lending had been almost correct, rather than huge understatements that led investors to believe that enough shoes to fill Imelda Marcos’s closets have yet to drop.
The path to recession thus became clearly marked. The banks will sooner or later have to write down the value of these assets, perhaps to the tune of $600 billion (£287 billion) to $800 billion, impairing their ability to lend to even credit-worthy firms and consumers, and further tightening credit availability not only in home-mortgage markets, but in the consumer, industrial and commercial property sectors. With credit crunched, fewer factories and office buildings will get built, fewer jobs created, fewer tills filled with credit-card receipts. This will add to the downward pull already exerted by the slumping housing market, where rising inventories of unsold and repossessed properties, and falling house prices will further weaken consumer confidence, already at a two-year low.
The gloomy scenario continues. The housing market, which has a long way down still to go, is affecting, or will soon affect, the financial markets, the labour market, and the macroeconomy. So forecasters are lowering their estimates for 2008 growth. They expect tightening credit to slow the construction of commercial buildings, hitherto a bright spot in a darkening picture. Moreover, the manufacturing sector is slowing, as is consumer spending. Inventories in shops are rising.
Not to worry: Fed chairman Ben Bernanke and his monetary-policy committee will ride to the rescue with yet another stimulative cut in interest rates. Except that they might not. That’s where $100 oil comes in. Rising fuel prices are creating inflationary pressures as all industries that rely on oil to move their trucks and planes, or use it as a raw material, begin to raise prices.
At the same time, food prices are rising at an annual rate of something like 6%. Corn prices have doubled this year, in part because land is being diverted from producing products for the table to substitutes for oil; wheat prices have soared because farmers have switched from wheat to corn; milk and dairy prices are at their highest level in nominal terms since the beginning of the second world war, as rising demand in China presses on supplies reduced by the Australian drought; and Procter & Gamble has announced price increases on several products, most notably the Folgers-brand coffee that bankers and lawyers are scarfing down during their allnight hunts for some cure for their self-inflicted wounds – and some way to save their year-end bonuses from the 10%-15% cuts now being pencilled in.
Then there is the small problem of the sinking dollar, now at a 26-year low against sterling, and its decline seems to be accelerating. That has had the positive effect of stimulating American exports. But it will also make imported goods more expensive, and frighten away foreign investors who have no desire to acquire dollar-denominated assets that are sinking in value. That might turn a decline into a rout.
The European Central Bank and the Bank of England are holding interest rates steady for now, while investors expect the Fed to continue to cut rates to relieve pressures in the financial markets and give a flagging economy a bit of a boost. That is prompting investors to switch out of dollars and into higher-yielding assets in other currencies.
Had enough gloom and doom? Then consider this. The job market remains strong, not as strong as in the recent past, but strong enough to keep unemployment low. Productivity rose at the robust annual rate of 4.9% in the third quarter, causing labour costs to fall. Core inflation remains low. Personal incomes continue to rise. The economy did grow at a healthy pace in the third quarter. Most chief executives I meet expect double-digit profit growth in 2008. The World Economic Forum ranks America No 1 in competitiveness. The International Monetary Fund expects the world economy to grow at close to 5%, which bodes well for American exports. And Bernanke, while warning of downside risks, told the Joint Economic Committee last week that “most businesses appeared to enjoy good access to credit . . . the overall economy remained resilient in recent months”, and he expects growth to resume in the second half of 2008 after a “sluggish” first half, “as the effects of tighter credit and the housing correction begin to wane”.
Besides, a recession might be the least bad of the possible outcomes of our current troubles, according to John Makin, economist at the American Enterprise Institute. In his latest epistle he writes: “The cost of avoiding recession after the biggest housing bubble in American history has burst is too high. It will involve rewards to those who took excessive risks that will only result in more underpricing of risk in the future, and therefore larger bubbles and, ultimately, a more unstable economy that underperforms expectations . . . The positive economic aspect of the US housing bubble collapse is that it will lead to a recession.”
That’s why economics is called the dismal science.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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