Beware of False Hopes on the Economy

Is there light at the end of this very long tunnel of a recession? Government spokespeople, keen to encourage confidence, say there is (their metaphor is "green shoots"). Many private business people concur. Let's do a reality check.

Our recession is not of the garden variety type that occurs when businesses, having overinvested, cut back, or when the Federal Reserve hikes interest rates to slow the economy and contain inflation. This one, unusually, was triggered by an enormous financial crisis in which people could not get credit to buy things and businesses could not borrow and spend. The shadow banking system of investment banks, hedge funds, money market funds, etc., which accounted for vast chunks of credit, just broke down. The conventional banking system also sustained massive losses from securities and to this day remains exposed to other bad loans that will limit its ability to lend in the years ahead.

The unique danger in any recession induced by financial crises (according to a study of 14 such recessions by economists Carmen Reinhart and Kenneth Rogoff) is that they entail much higher unemployment—an average increase in the jobless rate of 7 percentage points, compared with an increase of 4.7 percentage points in more normal downturns—and a much longer recession, one that lasts an average of 4.8 years. On this count, we are still only halfway in the tunnel. The sequel today includes trillions of dollars of losses in the stock market and the housing market, representing the most extensive evaporation of wealth since the Great Depression. And the excessive debt or leverage remains. Household debt, for example, is at 134 percent of disposable income, so Americans are increasing their savings and paying down debt. The savings rate has gone from 1.2 percent of disposable income last year to an annualized rate of 6.9 percent today. The effect of this is that every percentage point of extra saving leads to a corresponding cut in consumption spending of roughly $60 billion to $70 billion.

Labor income is squeezed. Firms are cutting wages, benefits, and work hours—even after a massive reduction in head counts that led to a drop in wages and salaries of 4.7 percent in the 12 months that ended June 30. That's the largest decline since records began in 1960. And the stimulus monies? Households saved close to 80 percent of the tax cuts.

We've also had to face a continuing decline in home prices, the largest asset in the balance sheet of the average American family. Despite the government's inadequate attempts to reverse the trend in foreclosures, which damage the market so badly, prices have dropped an average of about 30 percent to date, and some estimates, such as one from Goldman Sachs, are that home prices will drop another 10 to 15 percent. Home foreclosures in July shot up almost 7 percent from June and were 32 percent greater than in July 2008.

A recent report by Deutsche Bank titled "Drowning in Debt" estimates that within two years, the number of homes that are underwater—that is, where the mortgage exceeds the value of the home—will rise to a depressing 48 percent of the roughly 51.6 million homes that have mortgages. This would be nearly double where they are today. It's not hard to understand why buyers aren't buying and builders have slashed residential construction by over 70 percent. Simultaneously, banks have reduced access to credit cards and home equity lines of credit for about 1 in 5 U.S. borrowers in the past six months.

The metrics show that all the drivers of the previous boom—consumers, housing, and easy credit—are in reverse gear and will stay that way as a drag on the growth of the economy even when it moves technically out of the recession.

The most important signal of any recovery is an increase in employment. We are not likely to see that soon for a number of reasons. Before hiring new workers, companies will increase the hours of temporary workers and move workers they kept from part time to full time. Had employers not been forced to reduce the workweek to slightly over 33 hours, we'd have another 3 million out of work now. Equally disturbing is that the number of people out of work 27 weeks or longer has reached a record 5 million, suggesting that job losses have been caused by structural changes in the economy that may be permanent.