Isn’t the economy in really bad shape?

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The latest news on inflation and unemployment seem to be pointing to a gathering storm in the U.S. economy. A lot of readers are wondering: Just how bad is this downturn going to be?

The economists say we are in a recession? I don't think so. Would you say that we are more in a "'30s-type depression"? I have never seen the country in such bad shape. Rising gas and food prices. How do we live?
Mary Ann R., Port Charlotte, Fla.

Well, Mary Ann, we’ve seen the economy in much worse shape. There’s little doubt left that we’re headed for — or in the beginnings of — an economic downturn. The housing recession that began in 2006 is one of the worst since the 1930s. It’s likely that things will get worse before they get better. But it’s impossible to say at this moment in time how bad they’ll get.

Economic forecasters and weather forecasters have a few things in common. Since no one can see into the future, both kinds of forecasters look at the forces that have created and shaped storms in the past — and then look at current data to help guide their predictions. When you see a sharp drop in the barometer, it’s a pretty good bet there’s a storm coming.

That’s where we are now — the economic barometer has just started dropping. Unfortunately, economists don’t have radar and satellite imaging to measure how big the storm is before it gets here.

There are lots of economic data out there to chew on, but the broadest measure of the economy’s strength is the gross domestic product — the total value of all the stuff we all make and services we sell each other. So a good yardstick of the damage done by a recession is the drop in GDP from start to finish.

By that measure, it’s too soon to say we're even in a recession: the last GDP data, for the last quarter of 2007, showed very weak growth of 0.6 percent — but growth nonetheless. Given the latest news on job losses in January and February, it’s likely we’ll see a negative number for the quarter that wraps up at the end of this month. (A preliminary figure will be reported in late April.) Depending on how long it takes for banks and other lenders to get through the ongoing turmoil in the credit markets, we may have more down quarters this year — and possibly even next.

That could make this the worst downturn in recent memory. The last recession — in 2001 — was pretty short and shallow by historical standards. But things would have to get a whole lot worse to put the current downturn on the list of all-time worst.

The 1980-82 recession (technically two quick, back-to-back downturns) sent the unemployment rate to 10.8 percent — more than double current levels. In the second quarter of 1980 alone, GDP fell 7.8 percent.

The worst recession since the Great Depression ran from November 1973 to March 1975 and wiped out more than 5 percent of GDP. For all of 1974, inflation averaged 12.3 percent, which meant that unless you got a fat raise that year, you had to figure out how to get by with a big drop in spending power. Inflation also destroyed savings and investment: From the start of 1973 to September 1974, the stock market, as measured by the S&P 500 index, fell by 46 percent.

But as bad as the 1970s were, that downturn didn’t come close to the economic contraction we now call the Great Depression. There’s good reason for using that superlative — and for avoiding it when describing current conditions. From August 1929 to March 1933, the economy (as measured by GDP) shrank by more than a quarter. The stock market, as measured by the Dow Jones industrial average, fell from 380.33 in August 1929 to 42.84 in June 1932. If that happened today, the stocks in your 401(k) retirement fund would be worth about 11 cents on the dollar. The Dow didn't fully recover from the '29 crash until November 1954.

It’s entirely possible we’re at the beginning of what may turn out to be a nasty recession, and we may see further drops in the stock market. There are plenty of ominous conditions, especially the recent rise in the inflation rate and the drop in the value of the dollar. Fed Chairman Ben Bernanke said recently he expects some banks will fail. On the other hand, the Fed’s aggressive interest rate cuts take time to work through the system. Many forecasters we respect maintain that the downturn will be relatively mild and over by the second half of this year.

So we’re not saying there won’t be a severe downturn; the point is that no one knows. It’s just too early to know how bad it will be. And it would have to get a whole lot worse to measure up to the biggest economic storms we’ve been through.

I know this is a ridiculous question, but I have to ask it because asking ridiculous questions is the only way I can really understand things that I just don't understand at all.

My question is about the Federal Reserve lowering interest rates: I have heard that when the Federal Reserve lowers interest rates what they are really doing is creating dollars that didn't exist before in the attempt to create the interest rate they are targeting. So here comes my ridiculous question: If that is what they are doing, then why can't interest rates go below zero? Why is it impossible that they can create so much money that we have an interest rate of -1%?
— Robert Bloomer, Durham, N.C.

One of the reasons we started writing this column was the belief that there are no ridiculous questions — only ridiculous answers. (Since then, we’ve occasionally been proven wrong.)

Yours, however, is not at all ridiculous. The question of “negative” rates comes up all the time. Your analysis of how the Fed targets rates is close: The “creation” of money comes from the Fed’s actions in the bond market. The Fed’s New York trading desk is the mechanism by which policy decisions are carried out through sales and repurchases of Treasury debt.

If the Fed buys Treasuries, it takes cash from its own account and pays the holder of the bonds (usually big “money center” banks), who then send that cash circulating throughout the economy. To raise rates, the Fed sells Treasuries, mopping up excess cash and tightening credit. There are other tools in the Fed’s arsenal, but these market actions are the most powerful and immediate. (And “money” is created by other means: Every time you use your credit card, in theory, you’re “creating” cash that wasn’t there before. That cash gets mopped up when you pay off the card, but if we all just charge more and more every month, we’re “creating” money.)

Interest rates don’t have to go to zero to produce the effect you describe: Borrowers look at the “real” cost of money when they decide whether or not to borrow.  The “real” rate is the stated rate minus inflation. That’s because inflation is burning a hole in the purchasing power of money while you’re paying it back. Since you repay with inflated dollars, you’re getting a break on the “real” cost of repayment. So If you borrow at 5 percent, and inflation is running 2 percent, you’re really only paying 3 percent in real (inflation-adjusted) dollars. So you can see that if inflation is running at nearly 4 percent, and overnight interest rates are at 3 percent, we’re actually in negative territory right now.

If the headline rate actually went to 0 percent, and inflation rose, you can see how money would get cheaper much faster. The problem is that as inflation rises, money also loses its purchasing power much faster, which destroys savings and investment. (That’s what we had in the 1970s.)

That’s the risk the Fed faces now: If it keeps rates too low, it risks losing control of inflation. Once that happens it’s extremely difficult — and painful — to get inflation back under control, as former presidents Nixon, Ford and Carter learned.

The real problem right now, however, is not the cost of money. Money is cheap enough; lenders are just too scared to lend. So they’re charging a lot more than they otherwise would. The reason they’re scared is that no one knows just how bad or widespread the damage has been from the housing/mortgage meltdown.

If you’re Bank of America and Citibank calls up and asks for a loan, you may be wondering in the back of your mind if Citibank has come clean with all the bad news about its loan losses. Accounting rules give you some leeway in rolling over bad debts. And the Fed seems happy to oblige. If these bad debts eventually blow up, you don’t want to be one of the parties on the list that is owed money.