America's
economy:
Getting
worried downtown. Whether or not it's an official recession, America's economy
will feel grim
IN RECENT years,
it has rarely paid to be pessimistic about America's economy. Time and again,
worried analysts (including The Economist) have given warning of trouble as
debt-laden and spendthrift consumers are forced to rein in their spending.
So far, that
trouble has been avoided. The housing market peaked early in 2006. Since then
home-building has plunged, dragging overall growth down slightly. But the
economy has remained far from recession. Consumers barely blinked: their spending
has risen at an annual rate of 3% in real terms since the beginning of 2006,
about the same pace as at the peak of the housing boom in 2004 and 2005.
At the same
time, rapid growth in emerging markets coupled with a tumbling dollar has
provided the American economy with a new bulwark, one that strengthened even
as financial markets seized up over the summer. Exports soared at an annual
rate of 16% in the third quarter. Thanks partly to strong export growth, revised
GDP figures due on November 29th are likely to show that America's output
grew at an annual rate of around 5% between July and September. Never mind
recession: that is well above the economy's sustainable pace of growth.
But the good
news may be about to come to an end. The housing downturn has entered a second,
more dangerous, phase: one in which the construction rout deepens, price declines
accelerate and the wealth effect of falling prices begins to change consumers'
behaviour. The pain will be intensified by a sharp credit crunch, the scale
of which is only just becoming clear. And, in the short term, it will be exacerbated
by a spike in oil prices—up by 25% since August—that is extreme,
even by the standards of recent years. The result is likely to be America's
first consumer-led downturn in close to two decades.
Home is where
the rot starts
The biggest
source of gloom is housing. Despite almost two years of plunging construction,
the collapse of the property bubble is far from finished—and its impact
on broader consumer behaviour has barely begun. So far, the housing recession
has been a builders' bust. Housing starts are down by 47% from their peak
and residential building now accounts for 4.4% of GDP, down from a record
of 6.3% in 2005. That is a big drop, but not yet unusually long or deep by
historical standards. Nouriel Roubini and Christian Menegatti, of Roubini
Global Economics, point out that the seven other housing recessions since
1960 lasted an average of 32 months and saw housing starts fall by 51%.
Judging by the
large number of unsold homes and the pace at which buyers are cancelling contracts
(around 50% according to some homebuilders), it is clear that builders have
further to cut back. Richard Berner, of Morgan Stanley, expects a further
25% decline, taking the pace of housing starts in 2008 to below 1m, the slowest
since records began in 1959.
A builders'
bust will not, by itself, drag the economy into recession. Most post-war construction
busts have been followed by recession, but only because they were triggered
by tighter monetary policy to head off inflation. The housing busts were a
symptom of a forthcoming recession rather than the cause. This time, the source
of trouble lies with the bursting of the housing bubble itself.
Since 1997,
house prices have more than doubled in real terms. That increase has coloured
America's economy in ways that go far beyond the construction boom. In particular,
rising house prices provide consumers with the collateral they need for a
huge increase in borrowing.
Up to their
necks
Relative to
their incomes, consumers have been taking on more debt for decades, as America's
increasingly sophisticated financial system allows more people more access
to credit. But the pace of indebtedness has accelerated dramatically. The
ratio of household debt to disposable income is now above 130%. Earlier this
decade it was 100%; in the early 1990s it was 80% (see chart 1).
That credit expansion was made possible by rising house prices. Now they are
falling, credit conditions are tightening. Both shifts are just beginning.
According to the S&P/Case-Shiller index, arguably America's most accurate
national measure, house prices have fallen by around 5% in nominal terms since
their peak, or 8% once inflation is taken into account. That is a tiny drop
compared with the past decade's rise (see chart 2).
Nor, judging
by the pipeline of unsold homes, is it enough of a drop to bring demand in
line with supply. Unlike shares, whose prices change quickly, house prices
are often “sticky” as homeowners are loth to acknowledge their houses
are now worth less. But the coming months are likely to see a sharp jump in
the supply of homes for sale under distressed conditions. More than 2m subprime
borrowers face markedly higher mortgage payments over the next 18 months as
their interest rates are adjusted to new levels. Many will be forced into
foreclosure.
This constellation will drive house prices down. Most Wall Street seers expect
a drop of around 10% in nominal terms over the next year or so, but price
declines of 15% or even 20% are no longer regarded as outlandish. Economists
differ on how, and by how much, falling house prices will affect consumers'
spending. But empirical studies suggest that changes in house prices have
a bigger effect on consumer spending in countries, like America, where credit
markets are deepest.
The most recent
research implies that changes in Americans' housing wealth affects their spending
more than similar changes in their financial wealth, although the effect takes
longer to emerge. A $100 fall in financial wealth is traditionally associated
with a $3-5 decline in spending. An equivalent fall in housing wealth, it
seems, eventually reduces spending by between $4 and $9.
Given that America's
stock of residential housing is worth some $21 trillion (or almost one-third
of all household assets), a 10% drop in house prices would make a discernible
dent in consumption growth. If the spending response were at the top of economists'
estimates, for instance, consumer spending would slow by almost two percentage
points. The economists' studies, however, suggest that effect will be gradual:
falling house prices will be an ongoing drag on consumer spending, rather
than a sudden brake.
So far, this
brake has been eased by strong gains in financial wealth. Thanks to higher
stock prices, American households' overall assets have still been rising smartly.
If the stockmarket loses momentum along with the economy, the wealth effect
on consumer spending could appear quite quickly.
A wholesale
credit crunch would make matters much worse. No one is yet sure how tight
credit will get. It depends on how big the losses from the subprime-related
mess turn out to be; who holds those losses; how far banks are forced to take
troubled assets, such as those in structured investment vehicles, onto their
balance sheets; by how much they cut back lending in response; and how far
the Federal Reserve reduces short-term interest rates to compensate.
Three months
after the summer's financial turmoil first hit, the omens do not look good.
Entire markets for securitised assets are shrivelling: the asset-backed commercial-paper
market has shrunk for 13 weeks in a row and is now 30% smaller than in August.
Estimates of the eventual losses from the subprime-related debt mess continue
to rise.
Ben Bernanke,
the chairman of the Fed, recently put the losses from bad mortgage loans at
$150 billion, up sharply from the $50 billion to $100 billion he expected
early in the summer. And even that may be too low, given that some $1.3 trillion-worth
of subprime loans alone were originated between 2004 and 2006. Deutsche Bank
now estimates overall subprime-related losses at up to $400 billion, of which
$130 billion will belong to banks. Write-downs of that scale will eat into
even the best-stuffed capital cushions.
By some measures,
banks are already hunkering down. According to the Fed's most recent survey
of loan officers, a quarter of banks tightened their standards on consumer
loans (other than credit cards) in October, up from only 10% in July. Four
out of ten banks demanded higher standards on prime mortgages, up from 15%
in July. The pace at which banks are tightening their mortgage-lending standards
rivals that of the early 1990s, when the banking sector as a whole was much
weaker and less well capitalised (see chart 3). But since tighter mortgage
standards are themselves a response to the housing bust, they may overstate
the extent of an economy-wide credit crunch.
Shocked by
oil.
Many Americans,
however, will find credit harder to come by. And just as they do so, the third
blow will come: that of higher fuel costs. Although it has fallen back this
week, the benchmark price of crude oil is still above $90 per barrel, almost
25% higher than in August. This surge has not been fully reflected in American
petrol prices, largely because refineries had unusually fat margins earlier
in the year. Average petrol prices are up 33 cents per gallon (or 12%) since
mid-August. Unless crude prices fall dramatically, much dearer petrol lies
ahead. If oil stays near to $100 per barrel, some analysts are talking about
$4 per gallon by next summer.
Higher fuel
costs are the equivalent of a tax on consumers, reducing the amount of money
they can spend on other things. Jan Hatzius, of Goldman Sachs, reckons that
a rise in petrol prices of one cent reduces consumers' overall disposable
income by about $1.2 billion, and tends to drag consumer spending down by
$600m. Over the next few months, he reckons, higher fuel costs could reduce
consumer spending by 1.2% at an annual rate. Overall, this drag will be smaller
than the combination of tighter credit and falling house prices, but its impact
will be concentrated over a shorter period.
A final cause
for concern is the labour market. Low unemployment and solid wage growth have
been a big reason for consumers' resilience thus far (see chart 4). With unemployment
at 4.7% and 166,000 new jobs in October, that strength looks intact. But careful
inspection suggests that October's numbers mask a wider slowing. The pace
of net job creation has fallen from a monthly average of 189,000 in 2006 to
118,000 in the past three months. Details from the household-based employment
survey, which may be more accurate when the economy is slowing, are even darker.
It shows very little net job growth in 2007, and an unemployment rate that
is already up by three tenths of a point from its nadir.
Add this all up and it is small wonder that consumers are feeling gloomy.
Most gauges of consumer confidence have been plunging of late. The University
of Michigan's index is at its lowest level in 15 years, leaving aside the
aftermath of Hurricane Katrina. The latest evidence suggests spending is already
weakening: core retail sales were flat in October.
Consumer spending,
at around 70% of GDP, is by far the biggest determinant of the economy's fate.
But it is not the only one. The odds of a downturn also depend on whether
other engines reinforce—or counteract—consumers' weakness.
One wild card
will be firms' investment. Corporate spending is historically volatile, often
helping to tip an economy into a formal downturn. In America's last recession,
in 2001, plunging investment was the source of trouble, as firms worked off
the investment excesses of the late 1990s. Today, corporate America is in
much stronger shape. Overall, balance sheets are healthy and profits strong.
But as Martin Barnes, of Bank Credit Analyst, points out, domestic non-financial
firms, the ones that do most capital spending, have been doing rather less
well, with profits down by 9%, compared with a year earlier, in the first
half of 2007. Corporate investment may not drag the economy down, but nor
is it likely to offer a boost.
That role belongs
elsewhere—to foreign trade. America's exports have been booming while
import growth has slowed sharply. That has narrowed America's trade deficit
and boosted output. Exports will not continue to grow at the torrid rates
seen in recent months, but with the dollar showing scant signs of a turnaround
and with emerging economies, in particular, looking remarkably resilient (see
article), exports will remain an important prop. At 12% of GDP, they are now
easily able to offset the drag from weaker construction.
Recession
or not?
Put all this
together and do you get a recession? Many analysts expect a sharply slower
economy, but not an outright recession—using the popular definition of
two consecutive quarters of falling GDP. Wall Street's seers have shaved their
projections for GDP growth in the fourth quarter of 2007 to around 1.5%. Most
of them expect a couple more similarly weak quarters thereafter. A few long-standing
bears, such as Mr Roubini, are convinced recession is inevitable. But most
forecasters reckon the odds remain below 50%.
Yet history
cautions against taking too much comfort from this. It is true that pessimists
tend to predict recessions more often than they occur, but it is equally true
that mainstream forecasters usually fail to predict those that happen. In
both 1990 and 2001, Wall Street's seers were predicting modest growth when
the economy, it turned out, was already contracting. History also shows that
America's economy can swing quickly from strong growth to contraction. During
the first three months of 1990 the economy was growing at 4.7%, but it was
in recession by July. Adjust Wall Street's forecasts for their inherent conservatism
and an outright recession seems all too plausible.
The bigger point
is that even if the economy technically avoids a recession, it will feel like
one to most Americans—because it will be led by consumers. That will
be a big change. Consumer spending has not fallen in a single quarter since
1991; it has not fallen on an annual basis since 1980. Consumers barely noticed
America's last recession—when low interest rates and high house prices
kept them spending solidly (see chart 5). Just how voters and politicians
react to a consumer downturn in an election year is worryingly uncertain.
What's more,
the squeeze on consumers will last longer than many expect because it involves
the unwinding of an asset-price bubble and attendant financial excesses. Just
as corporate spending stayed weak for years after the 2001 recession, so consumer
spending will be crimped for more than a few months. There seems little reason
to expect, as many analysts seem to, that the housing bust will be history
by the second half of 2008.
Finally, policymakers'
responses may be more muted. In 2001, the economy was cushioned by a large
fiscal boost, thanks to tax cuts and bigger spending, as well as much lower
interest rates. A big tax cut now seems extremely unlikely. At the same time,
the weak dollar and global economic strength that softened the downturn will
also complicate the central bankers' ability to respond. Based on underlying
inflation expectations, real interest rates are still above 2%. Central bankers
often push short-term real rates to zero, or even below, in a downturn, suggesting
there is plenty of room to cut, particularly since the housing glut means
lower interest rates may pack less punch. But high oil prices and a falling
dollar may preclude such an aggressive response, as Mr Bernanke worries about
rising inflation expectations. Recession or not, America faces a tricky road
ahead.
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