bizzXceleration: Performance, Value and Profit

READINGS

Our Economic Dilemma Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy. The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992. If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months. But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end. In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy. The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months. But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied. The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment. 

Our Economic Dilemma Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy. The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992. If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character.

The Sense Of An Ending  “The Sense of an Ending: Studies in the Theory of Fiction” is the title of Frank Kermode’s work of literary criticism. I’d like to borrow that title to frame today’s discussion of where the economy is now. There’s a tug of war going on between those who say we’re in recession and those who say we’re not. There are vested interests on both sides. People in positions of great authority say, “We’re not,” because they don’t wish to be blamed for recession or risk the chance of initiating a self-fulfilling prophecy. Critics of the higher-ups say, “We are,” because they routinely disagree with the higher-ups and believe the higher-ups rarely get it right. Three statistics that gauge the strength of output and production illustrate this point: Capacity Utilization, the Purchasing Managers’ Index and Job Growth. To Recap: None of these data by themselves point to recession, nor do all combined irrevocably confirm recession. But the gradual erosion is clear, so that a continuation of the trend points to a reduction in activity. Isn’t that what a turning point is all about? There seems to be a sense of an ending.

Understanding What Recessions Are One of the misunderstandings about recessions is what actually happens in the real world. A recession is where economic growth stops, and you are left with flat to contracting sales. Note that economic activity does not grind to a halt -- the year-over-year growth rate merely slips into the negative. This is often misstated, in some variation of "Gee, how it can it be a recession -- I was out shopping and the stores were pretty crowded." Whenever you see that, the speaker is either technically misunderstanding what a recession is -- or alternatively, is painfully long and hoping for the best. Of course, Growth may falter, not total economic activity. With the $13 trillion US economy, economic activity certainly won't fall to zero dollars.

Housing Cycle in Vicious Circle Housing is caught in a loop where one problem creates behaviors that make it worse. For example, falling home prices give borrowers incentive to walk away from mortgages. The trick for policy makers is to break the negative-feedback cycle. Economists have a term to describe what it means when things keep going from bad to worse: negative-feedback loop. One day's problems create a broad set of behaviors that only make the problems worse. Consider housing. As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop. Housing turmoil, in turn, causes consumers to pull back, hurting the broader economy, which puts more downward pressure on home prices. Banks, worried about mortgages going bad, tighten lending standards, shutting some new buyers out of the market and further depressing home prices. Negative-feedback loops can be pernicious when an economy depends heavily on borrowed money. Housing Starts in U.S. Near Lowest Since 1991 as Slump Enters Third Year