Recession Is Likely as Pillars of Growth Continue ErosionThe plan to bail out the U.S. financial system Congress hammered out over the weekend offers a much-needed salve to ailing credit markets, but it is unlikely to prevent the economy from sliding into recession.
"There will be some benefits of this plan, but we think the economy's already gone too far to prevent enough damage," said J.P. Morgan chief economist Bruce Kasman.
Recent news on the economy has been bleak. In a sign that the housing market continues to deteriorate, sales of new homes dropped sharply last month, the Commerce Department reported last week. Another report showed sales of big-ticket items also fell in August, pointing to deterioration in the factory sector and a drop in business spending.
"The business sector has been probably the most important source of resilience through the last year," Mr. Kasman said, and as companies slash spending layoffs could worsen. His firm now says a U.S. recession began during the second half of this year.
Economists polled by Dow Jones Newswires expect that this Friday's employment report will show the economy shed 105,000 jobs in September. Meanwhile, consumer confidence is weak and weekly readings on retail sales show that shoppers are cutting back on spending.
Consumer spending is also under serious strain, and is poised to decline during the third and possibly fourth quarter of this year, which would mark the first quarterly spending drop since the 1990-91 recession. Americans are grappling with rising unemployment and higher prices on fuel and food. In the midst of a financial crisis centered on falling home prices and fractured mortgage markets, a 2001-style mortgage refinancing boom isn't in the cards.
"The plan cannot prevent a recession," said Brookings Institution senior fellow Douglas Elmendorf. "What matters for people is how long and deep any economic slowdown is."
Until this point, the government response to the crisis has been ad hoc rescues of financial institutions that didn't do enough to prevent fears in the credit market from spreading, Mr. Elmendorf said. Without a more comprehensive move from the government, credit market participants would have been absorbed with worrying over which institution was going to fail next, leading to a sharp slowdown in lending that could cause a prolonged recession. The rescue is aimed at restoring confidence to the market.
While the plan may help heal the financial markets, it may not be a direct boon to the ailing U.S. economy. The major pillars of economic growth -- consumer and business spending, government spending, and exports -- are already crumbling. Foreign demand for U.S. goods, which has helped the factory sector avoid a deeper downturn this year, is expected to dry up as the world's major economies flirt with recession and fast-growing nations like China and India lose momentum.
The bailout includes a plan for the government to facilitate loan modifications and lower the number of foreclosures next year. That could help slow the swelling inventory of unsold homes that continue to depress the housing market. But it does not resolve the more fundamental problem of home prices that, relative to rents, still appear too high.
"The housing market still has further to fall, regardless of what we do with credit-default swaps and mortgage securities," said University of California, Berkeley economist Barry Eichengreen.
Further home price declines could bring more trouble to the financial markets as more loans go sour. Even under the best circumstances, Mr. Eichengreen expects a recession that will bring the unemployment rate to 8% from the current 6.1%.
Still, the bailout could act as a defibrillator, jolting activity in financial markets back to life and hopefully preventing a deeper exacerbation of the economy's woes. It could give would-be investors a sense that they should buy now, said Wrightson ICAP economist Lou Crandall.
Under the plan, hundreds of billions of dollars-worth of mortgage-related assets that were being sold at fire-sale prices are going to be drained out of the system by the Treasury. Buyers who were on the sidelines, opportunistically waiting for undervalued securities to get even cheaper will now have to act.
"This may restart the market for these kinds of assets," Mr. Crandall said.
By: Justin Lahart and Kelly Evans
Wall Street Journal; September 29, 2008
