Saturday, April 12, 2008

No Time for Panic

Illustration by Brian Rea

In his recent column, The Economy of Fear, John Cassidy makes an excellent case that the U.S. is headed for an awful economic outcome. He compares the current economic situation with others caused by credit crunches over the past 150 years and does not like what he sees.

Unlike some past recessions, which were rooted in inflation problems, this one has been triggered by credit and real estate—both of which have a lot to do with how people perceive their financial well-being and, in response, how they adjust their spending. (View a tally of recent recessions and their causes.) For what is probably the first time since the 1930s, home prices are falling sharply. Nationwide, housing prices have slipped about 10 percent in the past year, and the decline is accelerating, according to the S&P Case-Shiller home-price index. As prices drop, more and more homeowners discover that they owe more than their property is worth, at which point they experience the temptation to hand the keys back to the bank or mortgage company. Jan Hatzius, an economist at Goldman Sachs, estimates that by the end of 2009 up to 15 million households could be in a position of negative equity. If Hatzius is right, the glut in houses for sale will only get larger, and prices will fall a lot further. Just how low they could go is anybody's guess, but a reading of data compiled by Yale economist Robert Shiller, which show the evolution of inflation-adjusted home values since 1890, suggests an overall drop of 30 or even 40 percent.

The situation is certainly serious, but in this analyst’s opinion not as grave as Cassidy portends. Like most U.S. analysts, Cassidy is understating the positive impact that globalization is having on world markets and how this can redound to the benefit of the U.S. And, he states that U.S. Federal Reserve Chairman Bernanke is pursuing Keynesian policies, when in fact he is taking a more nuanced approach.

First, the world economy is in far better shape than the U.S. economy, for a number of reasons:

  • China and India, the Philippines, Malaysia and Eastern European countries are reaping the benefits of the opening of global markets in manufacturing and services
  • As those economies build much-needed infrastructure and develop professional classes with strong consumer demands, they are driving up commodities prices and purchasing industrial and transportation equipment
  • Oil-rich countries are reaping the windfall profits born of the tremendous uncertainty in global supply brought about by the Iraq war

Second, the deflation in U.S. housing prices, while very significant, is also very local. Financial centers like New York, Boston and San Francisco will be the hardest hit, while more balanced economies like Chicago and St. Louis are not feeling such great impacts. A 15% drop in housing prices nationally would be an astoundingly bad result--10% is much more likely.

Third, Bernanke is taking a targeted approach (see Getting it Right on the U.S. Economy), directly absorbing risk in financial markets while reducing interest rates and constraints on lending. Opening up the supply of money by reducing federal lending rates and shifting some risk from financial institutions will only be inflationary if matched by corresponding increases in demand. In the near term the more likely scenario is that all institutions will adjust through a rocky first and second quarter, financial and housing stocks will bottom out and increased export activity will start to be felt. Lenders are already finding creative ways of absorbing some of the cost of over-financed properties, as they attempt to avoid becoming America’s (bankrupt) landlords through mass foreclosure.

In the near term, government policy should be directed, as it has been, toward averting panic in the financial markets. (This is a far cry from a bailout—investors in lending institutions are in for a very rough time.) Moreover, the U.S. should be pulling out all stops to increase trade. Pennsylvania workers, for example will feel much better about their economic situation if they can start exporting Chef Boyardee product from Milton, PA to Canada, which currently matches our high tariffs on dairy-based products.

The U.S. might also try being a little friendlier to foreign tourists and students, not to mention U.S. business travelers. Much of the hassle of air travel is a direct result of the inability of Homeland Security to distinguish one common name from another, my own being a case in point. Perhaps it is time to rebalance our approach to risk and apply a political thumb to the economic side of the scale.

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Anonymous said...

Good post Jim

I have been reading your blog with some interest.

....I sometimes forget that you're an economist and only tangentially a supply chain hack !

Yours truly,

Jim Morehouse

JP Farrell & Associates, Inc. said...

Hi Jim,

Great to hear from you. As the inventor of the term "supply chain" (and probably "extended enterprise" as well), you honor me with the designation of "hack."

It's always interesting to know who exactly is reading this stuff.


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