AEI Economists: U.S. Economy Probably in Recession

WASHINGTON, OCTOBER 7, 2008--In the past few weeks, financial turmoil has dominated the news: Indy Mac experienced a run and was closed, Fannie Mae and Freddie Mac went into conservatorship, Lehman Brothers collapsed, Washington Mutual was absorbed by JPMorgan Chase, AIG was effectively nationalized, Morgan Stanley and Goldman Sachs became commercial banks, Wachovia was taken over, and the Dow fell below 10,000 for the first time since 2003. "The financial markets are in a state not seen since the Great Depression," Peter J. Wallison observed at a recent conference featuring five AEI economists, "but the economy as a whole is certainly not in anything like that condition." The conference was the third in a series that began in December 2007.

This dichotomy is puzzling for economic forecasters. Kevin A. Hassett's assertion that "a recession probably began in June" was generally accepted by the other panelists, but they disagreed about how long and how severe the downturn will be. Much of their uncertainty exists because "we [still] don't have a very good idea of the linkages between the real economy and the financial markets," Wallison suggested.

Charles W. Calomiris described the rosiest scenario, anticipating a "mild, but possibly protracted, recession." He based his prediction on the recent consolidation of the financial industry, observing that "most of the prior looming risk that significant financial institutions might fail has been resolved one way or another. Weak large banks are pretty much gone." Moreover, the current crisis was preceded by a "panic episode," rather than by significant loss of wealth. Consequently, Calomiris said, "so long as the current financial panic . . . subsides, which now seems quite likely in light of impending legislation, banks will acquire capital easily [and] . . . the recession probably will not be too bad." 

Other economists professed more pessimistic outlooks, citing worrying economic indicators. So far, Hassett said, the financial crisis has been "softened . . . [by the economic] health of Main Street." Unfortunately, there is now enormous drag on the economy due to rising unemployment, decreased construction spending, falling home prices, and declining consumer sentiment, Vincent R. Reinhart noted. Moreover, Desmond Lachman said, the export market, which until now has been bolstering GDP growth, has lately been struggling.

In addition to these basic economic problems, John H. Makin worried about the lack of liquidity in the financial system. "Banks will not lend to each other--that market is closed," he explained, so cash cannot flow to where it is needed. Makin also feared that the diminished desire for bank money and the increased demand for government money, or Treasury bills, may be a "sign of a run on the banking system."

Hassett pronounced that markets are "pricing in a scenario that says that the [current] way of life might fundamentally change," but he added that market prices were clearly being influenced by panic and might well be excessively pessimistic. Both he and Makin predicted that third-quarter GDP growth will be between negative 2 and 3 percent and that fourth-quarter numbers will be even worse. In the best case, Hassett said, the recession will only last thirteen to fourteen months, which is almost as long as the longest recession to date.

There was varying support for Henry Paulson's financial rescue plan among the panelists. Wallison expressed hope that it would "restore some market confidence that the banks are in fact solvent," and Reinhart was encouraged that the government had stopped misdiagnosing the crisis as a liquidity problem, which would require Federal Reserve intervention, and was instead treating it as a capital problem, which necessitates Treasury Department oversight. However, Reinhart's enthusiasm was tempered by the time-tested observation that politicians are bad at maintaining boundaries when they start to intervene, and he noted that bad policy will have a significant detrimental effect because "financial market behavior depends on the expectations of participants."

--KAREN DUBAS

For video, audio, and the presentations from this conference, visit www.aei.org/event1805/. View the first and second installments in this series.

For more AEI scholars' work on the financial crisis, visit www.aei.org/FinancialCrisis/.

For media inquiries, contact Veronique Rodman at 202.862.4870 or vrodman@aei.org

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