IE 11 is not supported. For an optimal experience visit our site on another browser.

Just how bad will the economy get?

The events of the past few weeks  have rattled readers. Some are wondering: Just how bad is the economy going to get?
/ Source:

The events of the past few weeks — from the collapse of the investment house Bear Stearns to reassurances from the White House about the economy — have rattled readers. Some are wondering: Just how bad is the economy going to get?

Given the fact that we are already running a huge budget deficit, with China and Russia funding these deficits while our interest rates continue to drop making Treasury bonds much less attractive for foreign investors. And of course, let's not forget in the meantime we're sending hundreds of billions to the Middle East. All in all, I really don't see how this turns out with a happy ending for the USA. Do you?
— Richard M., Provo, Utah

You’re probably not going to like our answer on this one.

First off, we have yet to see confirmation that the economy has entered even a mild recession, let alone a severe downturn. The U.S. economy grew very weakly in the fourth quarter of last year, but it still moved ahead. Since then, we’ve seen overall losses in employment — the freshest monthly government data you can look at. The exact definition varies a bit, but generally speaking you need two quarters of negative growth to call it a recession. By definition, then, we won’t be able to confirm a recession until July at the earliest.

The recent upending of the housing and financial markets, however, is not a good sign. When lenders get spooked — and hoard their cash as they’re now doing — the flow of money through the system slows down. Eventually, the economy does, too. The Fed has been doing what it can to get money flowing again, but it remains to be seen whether it has enough plumbing tools to clear the clog of bad mortgage paper choking the financial markets. So the script is still being written. Still, we’ve had "credit crunches” before, and eventually they come to an end.

The drop in home prices may be even more worrisome. Hundreds of billions of dollars worth of home equity have evaporated, leaving some homeowners with a bigger mortgage than their house is worth. That's a big reason why consumers are gloomier than they've been in years. Something like 70 percent of our economy relies on consumer spending: if it stops, so does economic growth.

That's the bad news. But it may help to take a longer-term view. The worst economic period in my lifetime was the 1970s. When I finished college and went job hunting, unemployment was double what it is today. When my wife and I first went looking at houses, interest rates were on their way to 20 percent. Every time you got a raise, inflation ate it up – and then some. Gasoline wasn’t just expensive: it wasn’t available on some days at any price.

Since that period, the headlines have included: the run on Continental Illinois bank in 1984, the $400 billion collapse of the savings and loan industry, the Crash of '87, the housing crash and credit crunch of 90-91, the Asian currency meltdown of '98, and the dot-com crash of '01 — along with additional meltdowns in Russia, Argentina, Mexico, and Orange County, Calif. At each juncture, the papers (and later the cable channels and later still the Internet) offered up a steady supply of experts warning of the “coming collapse.” Some of them wrote books about the resulting social upheaval and the need to learn how to can your own crops and shoot a rifle.

Warning of such a collapse is a great way to generate reader traffic. But in each of the past “catastrophes,” the pessimists got it wrong — they overstated the downside risks. This is human nature. What we’re seeing is the flip side of the insanity that pushed house prices to unsustainable levels. Fear is at least as strong an emotion as greed, and that’s where we are in the cycle.

It may be that we’re headed for an economic cataclysm the likes of which I’ve never seen. I certainly hope not, but again, I could be wrong. Still, it’s impossible to say now that an economic downturn on the order of the 1970s is inevitable. There are plenty of people who will make that prediction and if, God forbid, it comes about they’ll claim they were prescient.

I disagree. Even a broken clock is right twice a day.

If the sale of treasury bonds produces the money required to cover over spending and old debt, how will the national debt every decrease when the only way to cover the maturing debt is to create more bonds/debt to cover them?
Scott, Michigan

It’s not the only way. The other way would be to take in more in taxes than we spend. At the end of the 1990s, the budget was balanced and there was even a little extra to pay down the debt. That prompted many people to say “Wait a minute, the government is taxing too much.”  So we got tax cuts, and now we’re back to running up the debt.

At the very least, the first step would be to have the federal government go back to the “pay as you go” spending rules used in the 1990s. The idea was pretty simple: don’t spend more than you take in. That means if you cut taxes, you have to cut spending by the same amount. And if you want to spend new money – whether on a war or a Medicare program to pay for prescription drugs — you have to raise taxes to pay for it.

Raising taxes to pay off the debt isn’t necessarily a great idea. In any case, with the economy faltering, now is not the time to raise taxes. In fact, if Congress and the White House could just balance the budget indefinitely, the debt as a percentage of Gross Domestic Product would gradually decline.

This would be roughly equivalent to a young person starting out with a big, interest-only student loan. As their income goes up over time, the debt shrinks relative to that income. As long as they don’t borrow more, the interest payments on the loan make up a smaller and smaller part of their budget.

The same thing is possible with the national debt. If you balanced the budget forever — and froze the debt at current levels — the debt becomes less of a problem over time as the economy grows.

The real long-term problem is the multi-trillion-dollars worth of promises made by the Social Security and Medicare programs. As us Baby Boomers retire and start consuming more government-funded health care, the burden on the budget will get bigger. As it stands now, those plans are financially unsustainable over time - unless they’re fixed.

That’s not to say they can’t be fixed, just the way the Reagan administration, with the help of a commission lead by former Fed Chairman Alan Greenspan, did in the 1980s. Just like any retirement plan, you need to make mid-course corrections along the way. With a relatively modest increase in taxes or cut in benefits – or both – those plans could be put back on a sound financial footing.

But so far, no one has been able to get Congress and the White House to agree on a fix.