Readers deserve a fair chance to decide between the persistent optimism of these columns, and the more numerous and far gloomier forecasts. So let me lay out and consider the worst-case scenario. I report, you decide.
The economy is not merely slowing, it is heading toward recession. New home sales are 34 percent below year-earlier levels, as homes move from builder to buyer at the slowest pace in 13 years. The market for existing homes is no better: sales are down 23 percent, and the inventory of unsold homes has is rising.
House prices are down about 10 percent, and are headed lower at an accelerating pace. Worse still, nonresidential construction, until now holding its own, “is likely to decelerate sharply,” says Fed Chairman Ben Bernanke.
Nor is any relief in sight. The Fed has cut its short-term rate by 2.25 percentage points since September, to 3 percent. But rates on the standard 30-year fixed rate mortgage are stuck at around 6.8 percent, almost exactly where they were at the height of the credit crunch last autumn.
And any hope that the government would intervene directly was dashed when Treasury Secretary Henry Paulson announced that he sees no reason for “the American taxpayer to be stepping in with more taxpayer dollars,” and Congress rejected legislation that would have allowed bankruptcy judges to reset mortgage terms.
Given that houses are most Americans’ largest asset, it is little wonder that consumer confidence is at its lowest level in five years, and that consumer spending has slowed. More important, falling house prices, rising mortgage (and credit card) defaults, and other negative developments in the credit markets are shriveling bank balance sheets, making it more difficult for them to lend to even credit-worthy customers, and forcing them to demand more collateral, higher interest rates, more proof of credit-worthiness.
Tighter credit, combined with plummeting consumer confidence, causes the blood to run cold in the nation’s boardrooms. Investment spending declines, and with it job creation. Unemployment rises, consumer confidence and spending drop even more, foreclosures increase, credit tightens even more, and America settles into a long period of substandard growth, or actual decline.
Meanwhile, the number of people waiting for the next shoe to drop in credit markets is rising. When Credit Suisse can go from an “all’s well” to discovery of a $2.85 billion loss in a few days, investors can be forgiven for wondering what’s out there.
There’s an old saying that you can’t make chicken salad out of chicken droppings, and investors have discovered that applies to the complicated debt packages that were supposed to elevate the quality of dicey loans by bundling them with other dicey loans. You can’t make a triple-A credit instrument out of lots of loans that are unlikely to be repaid.
All of this leads to pressure on the Fed to cut rates even more, which Bernanke is hinting he will indeed do. But further loosening, especially when the fiscal stimulus is about to hit the economy, threatens to increase already substantial inflationary pressures. The Consumer Price Index is up by more than 4 percent in each of the past three months. Oil is at over $100-per-barrel, and food prices are soaring.
Adding fuel to the inflationary fire is the falling dollar. Every drop in the value of the U.S. currency makes imports more expensive. And now there is a new problem: Prices of once-cheap Chinese goods are rising as China’s manufacturers pass on rising wages.
Faced with the risk of a recession, Bernanke has decided that inflation is the lesser evil. Which has brought a furious response from Carnegie Mellon professor Allan Meltzer, America’s leading student of the Fed and its history.
Writing in the Wall Street Journal, Meltzer excoriates the Fed for its “unseemly and dangerous response to pressures from Wall Street,” where bankers are hoping that lower interest rates will drive up the prices of shares and bonds, not to mention houses.
Meltzer’s points out that even the Fed is predicting that the economy will grow more rapidly in the second half of this year, bringing the overall 2008 rate to between 1.3 percent and 2 percent. It expects unemployment to rise to 5.3 percent, up from current levels, but still below the postwar average.
So, nervous readers, hold off on the Prozac, at least until this summer, when we might just find out that lower interest rates and the stimulus package provide that bridge over troubled economic waters that will ease your mind.
Examiner columnist Irwin Stelzer is a senior fellow and director of The Hudson’s Institute’s Center for Economic Policy.
