An Economy on the Brink

How could Americans not be in a grumpy, even fearful, mood? Every day they are faced with news of plummeting house prices and a collapse in home construction (which created a third of all new jobs in the past few years). A growing credit crunch is closing the spigot of loans so necessary to the health of Main Street. Bank failures are becoming more common. Then there's the rapid decline of the U.S. auto industry—not unrelated to rising oil prices, which are also curtailing the dream of the suburban lifestyle. And millions of Americans are starting to fear losing their jobs—and the family healthcare that goes with them. The American imagination is haunted by the Great Depression of the '30s.

What's more, we don't have confidence in our political leaders—despite the bipartisan passage of the very necessary, if flawed, housing support bill. Polls put the president's approval at about 30 percent and Congress at half that. In one recent survey, only 6 percent viewed the economy positively, while 84 percent of us think we are headed in the wrong direction.

Crisis? We are in the first nationwide housing crash since the 1930s, and no one yet knows where it will end. House prices, the strategic fault line, have plummeted for most of the 68 percent of American families who own one. They are falling at an accelerating rate, while inventories of unsold and foreclosed homes are rising. This has created a spiral where lower prices force mortgage foreclosures (now running at 2.5 million a year), which in turn reduce prices further as foreclosed homes are put on the resale market. Only when this huge inventory is cleared from the market and prices start to rise will we know where the bottom was.

With 10 million mortgages exceeding the value of the homes, that could take a long time. If the futures market is correct in predicting an overall price drop of 30 percent, the value of housing assets will shrink by over $6 trillion, which could permanently lower household spending by about $300 billion a year. The losses to the financial system are horrific. Just a few weeks ago, a major mortgage lender in California failed—the third-largest bank collapse in American history. Banks are struggling to cope with borrowers who are defaulting in droves on mortgages, consumer debt, credit cards, student loans, home equity loans, car loans—you name it. The banks are left without the cash to make enough new loans, robbing the economy of the necessary lubricant to keep businesses expanding. Even worse, the banks still don't know the ultimate extent of their losses on many of the complex new credit securities.

But there are two pieces of good news. We are more resilient today than in the 1930s, and we've learned a thing or two. The economy grew at a stronger-than-expected pace for the first half of the year, in part because of exports. Everyone knows that food and fuel prices are soaring—taking about $2,000 of after-tax money from the spendable income of the average family—but there is a silver lining. Because workers are not able to demand higher wages, greater labor unit costs have not hit the entire economy, so core inflation has remained at about 2.4 percent, even though "headline inflation," which includes food and fuel, has gone up more dramatically.

Perhaps the best news, though, is that the Federal Reserve, led by Chairman Ben Bernanke, whose academic specialization fortuitously was the study of the Depression, understands what it takes to prevent the kind of systemic financial collapse that occurred then. The Fed has reduced the cost of federal funds, recognizing that the inflation in commodity prices is primarily caused by increased global demand, which doesn't respond to federal monetary policy.

The Fed wisely has chosen to focus more on preventing a dramatically deeper recession by lowering interest rates—rather than raising them to combat inflation. The Fed is right not to tighten monetary policy in the midst of a financial crisis. That was one of the many mistakes in the Great Depression. Raising interest rates would pose an excessive risk while the downward momentum in home prices shows no signs of abating.

The fate of the U.S. economy now hangs in the balance. On one side of the high wire is an inflation risk that can beget a wage-price spiral that would in turn induce a powerful contraction by the Fed. On the other side is an economy getting weaker, provoking bank and housing defaults that put further downward pressure on growth. So far, public policy has properly focused on maintaining a functioning credit system and cushioning the home-price crash.