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Recession hinges on coping with credit crisis

/ Source: Business Week

No, it's not just you — the U.S. economy really is bewildering. The government says gross domestic product expanded at an annual rate of nearly 4 percent in the third quarter, the fastest pace in a year and a half. The stock market is still up by 4 percent for this year, despite a sharp 3 percent drop on Nov. 7. On the other hand, growth in consumer borrowing slowed unexpectedly in September. Some economists argue that the U.S. is teetering on the brink of a recession, if it isn't in one already.

Oil has exploded to nearly $100 a barrel, gold is near an all-time high, and the cost of food is soaring. It seems like high prices are breaking out all over, right? Yet the core rate of inflation is less than 2 percent a year, according to one widely followed measure. Confusion reigns right on up to the Federal Reserve, whose interest ratesetters are openly disagreeing about whether more cuts are needed.

Step back a little, though, and the situation becomes clearer. What we're observing, in all its bizarreness, is the ancient paradox of what happens when an irresistible force meets an immovable object. The irresistible force in this case is the U.S. economy, which has managed to expand through all kinds of adversity for more than 15 years, aside from one brief recession in 2001. The immovable object is a wall of debt that accumulated during several years of profligate lending and now can't be paid back. The risk has increased for a generalized credit crunch that puts both borrowers and lenders in dire straits.

So, either the U.S. economy will overcome the debt crisis and keep growing, or it won't. It's that simple — and that important, with millions of indebted homeowners struggling to stay above water, the stock market seesawing uncertainly, and just a year to go before the next President is elected.

The big picture
You can't know for sure how all of this will turn out, of course. But by focusing on the big picture rather than the minutiae, you can at least know the key questions to ask and the crucial indicators meriting your attention. These range from widely followed measures like the rate of home sales and the monthly survey of household jobholding to obscure ones like the risk premium on loans between banks.

What makes the economy even more unpredictable than usual is that the main threat to growth, a credit crunch, emanates from deep within the financial system. That's not something economists understand well, especially given the complexity of today's high-powered and globally interconnected financial markets.

The closest analogy is the credit crunch in the early 1990s, when bad commercial real estate loans damaged the banking system. Lending to businesses virtually stopped, and Citicorp nearly went bust. At the time, economists disagreed about how badly the bank problems would hurt the U.S. In fact, such worries played a role in the 1992 Presidential election, when Bill Clinton's campaign made famous the slogan: "It's the economy, stupid." But after government statisticians finished revising their data years later, the growth rate at
the time of the 1992 vote actually turned out to be well above 4 percent.

So which will it be this time — strong growth or a plunge off the edge? The first place to look is the housing market, where the lending excesses were most extreme. Don't focus on falling home prices. Instead, watch for whether the pace of sales picks up in response to price declines. It's good news for the economy if more houses get sold. Sales of new homes mean more work for carpenters and plumbers. Even sales of existing homes generate jobs for real estate agents, closing attorneys, furniture salespeople, and others. It's bad news if prices and sales fall in tandem because it could mean potential buyers are fearful of even bigger price declines. In fact, that's exactly what seems to be happening. The September sales pace for existing homes was down 19 percent from a year earlier, even though the median price was off 4 percent. Goldman, Sachs & Co. economists said on Nov. 7 that California, the epicenter of the subprime earthquake, "seems to be sliding into recession," and Florida and Nevada are probably already in one.

A boost from abroad
Bad as it is, the outright depression in housing can't kill the economy as long as job growth is healthy. That's the second thing to watch, and so far, so good. The U.S. added a respectable 166,000 payroll jobs in October, according to the Labor Dept.'s preliminary estimate. The engine of growth is the service sector, including health care and social services. The weak dollar is helping export-related jobs. The tech sector is strong, too, buoyed by good global economic growth. And on Nov. 7, the government reported a surprisingly strong 4.9 percent annualized growth in workers' output per hour — meaning employers can afford to raise wages without causing inflation.

Watch out, though, for hidden weakness. While employers reported more jobs in October, a separate government survey of households showed a 250,000 decline in the number of people who said they had jobs. Some economists argue the household survey is more accurate at economic turning points such as this. Pointing to that survey and other data, economic consultant Jack W. Lavery contends the U.S. has entered a recession that will continue "through at least the first half of 2008."

Optimists say debt problems are simply too small of an iceberg to sink a ship as mighty as the $14 trillion U.S. economy. Lincoln F. Anderson, chief investment officer and chief economist for LPL Financial Services in Boston, argues that even if default rates on subprime mortgages are sky-high, losses would amount to less than 1 percent of outstanding debt. But pessimists respond that if lenders were reckless in subprime, it stands to reason that they were at least somewhat careless in other kinds of lending. "We had a period of over-easy financing that will show up across-the-board," says Avinash Persaud, chairman of London-based adviser Intelligence Capital. Adds Persaud: "I don't think we've really seen the full scale of the problem yet." To see if Persaud is right, keep an eye out for sharply rising default rates on prime mortgage loans, auto loans, credit cards, and corporate debt.

With a generalized credit crunch threatening, it's suddenly essential to search for signs of it in such arcana as interest rate spreads between risky and less risky securities. Trouble broke out in mid-August when investment banks began to report losses on mortgage-backed securities. The markets appeared to be healing in September and most of October, but they've abruptly worsened since.

Market insiders are alarmed by evidence that banks don't trust each other. The London interbank offered rate (Libor) for dollars, which is for short-term loans between big, healthy banks, usually perks along at less than one-tenth of a percent above the risk-free interest rate. But the gap widened abruptly to seven-tenths of a percent in mid-August and, after briefly narrowing, stands at around six-tenths, according to broker Tullett Prebon. Says Lena Komileva, Tullett Prebon's G7 market economist: "The crisis never went away. It just got concealed."

What's so scary about a credit crunch is that everyone — from banks to corporations to households — retrenches simultaneously, and an excess of caution kills growth. That hasn't happened yet, but there are hints we could be near a tipping point. The Federal Reserve reported on Nov. 5 that banks said they tightened lending standards in October, and equally unsettling, demand for loans from both business and consumers has decreased. Chief financial officers' gloominess is the worst since surveying began during the 2001 recession, according to Duke University's Fuqua School of Business and CFO magazine. Pessimists outnumbered optimists by about 4 to 1 in September. And consumer spending, the longtime engine of U.S. economic growth, might be flattening. The Conference Board's index of consumer confidence dropped sharply from nearly 112 in July to less than 96 in October.

The holiday selling season will provide crucial information on whether the economy has left shoppers feeling merry or harried. Several major retailers, who are among the first to detect changes in the consumer mood, began their holiday discounting in early November this year, about three weeks ahead of normal, according to Stevan Buxbaum, executive vice-president of Buxbaum Group, an Agoura Hills (Calif.) investor and consultant. Wal-Mart kicked off its Black Friday pricing on Nov. 2 with Fisher-Price NASCAR Ride-On cars for $144.72, vs. $239.99 at KB Toys. That kind of pricing smacks of desperation to some analysts. "I expect a really tough Christmas," says William B. Greiner, chief investment officer of UMB Asset Management in Kansas City, Mo.

A nervous November
So far, the subprime mess is more of a human tragedy than a stopper for the economy. It's being felt most by the lower middle class, which isn't the driving force in economic growth. The bottom 40 percent of the population by income accounts for just 21 percent of consumer expenditures. Julia L. Coronado, a senior U.S. economist at Barclays Capital, says that in terms of spending power, and taking into account stock market gains, "Consumers haven't lost any wealth at all. In fact, consumers are better off than they were a year ago."

The stock market is the economy's best-known weather vane, but it's probably the hardest to interpret. So far this year, stock prices have trended higher, signaling that investors expect corporate profits to keep rising. Lately, though, Wall Street is getting edgy. The Dow Jones industrial average shed 362 points on Nov. 1 and the same on Nov. 7. Falling stock prices can darken the economic outlook by making investors feel poorer and less willing to spend.

With major firms such as Citigroup and Merrill Lynch seemingly unable to assess the depths of their own troubles, the possibility of the economy slamming into a brick wall is palpable. The U.S. economy is one heck of an irresistible force, but the credit crunch is slowly sapping its strength. Clearly, the risk of recession is growing.