Apr 07 2008

Doom and gloom in the headlines as US economy teters on edge of recession…

Judging by today’s headlines, things aren’t looking too hot for the US economy:

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

19 responses so far

19 Responses to “Doom and gloom in the headlines as US economy teters on edge of recession…”

  1. kxc.024on 08 Apr 2008 at 7:12 pm

    A large part of the problem is also that a lot of Americans are now bankrupt. In an article I read a few weeks ago, around 15% more Americans are declaring bankruptcy. It's a vicious cycle because before, Americans felt safe depending on the wealth of their homes but now that the house bubble has burst, they really have nothing to depend on. To make matters worse, investment is extremely slow so AD is seriously shifting in.

    Now is probably a good time to be whipping out the powerful monetary policies that Bernanke has up his sleeves. Like David stated in his most recent blog post, Bernanke will be injecting new bills into the economy. The risk, however, is that there will be high inflation. But I guess it'll be up to him see which one's more important: getting out of the recession or battling inflation.

  2. Christina Huon 09 Apr 2008 at 1:42 am

    But a recession is not always a bad thing just as growth isn't always a good thing, right? We talked about the business cycle a while back, and this is part of the natural cycle. As we live and die, the economy expands and contracts. I think it's safe to say that almost nothing is indefinitely sustainable, growth included. This has been looming for a while now, so let it come. I mean, look at the other recessions in the United States; the nation usually comes back stronger after each recession.

  3. Jason Welkeron 09 Apr 2008 at 10:05 am

    Christina. You're right, it is inevitable, but does that make it desirable? I don't know… lots of people will lose their jobs, their houses, their savings… In the long run, the economy will recover, and probably be healthier because of its hardships (for example, I would bet that in the future not as many "sub-prime" loans will be made to people with poor credit), but in the short-run a recession means seriously hard times for lots of Americans.

  4. emilyyehon 09 Apr 2008 at 9:26 pm

    The coincidence that this year happens to be an election year, and the fact that the economy is about to officially be declared in a recession actually seems pretty funny to me. Did Wall Street fake its own seemingly bleak future in investments to support a certain candidate, and in the coming months we will see one candidate stand out with an excellent solution to resolve the problem? Or perhaps a new economist will be the next studied in our textbooks as the one whose policies saved America from another Great Depression?

    I just read an article and blogged on the British housing market- which also appears to be deflating the bubble. Will its market also force the British economy to look forward to a downturn? Should we be worried that two major developing nations face difficulties? I guess this is an interesting time to study economics =).

  5. KatherineYangon 10 Apr 2008 at 1:06 pm

    Emily's point is interesting, especially about the two major developed nations. But there are also many countries (i.e. China and India) that are rapidly climbing the ladder to being "developed" countries. What I wonder is, if China or India might replace America just as American once replaced the UK as the "top country". Every empire has its growth and its peak and then some other empire, comes up to snatch the throne, it happened in Egypt with the Egyptians and the Romans.

  6. howard linon 10 Apr 2008 at 9:08 pm

    Is resession in America desirable right now? "lots of people will lose their jobs, their houses, their savings… "(Mr. Welker) but can the people get through these hardships? and How long would the recession last? Even though yes, gradually the economy will climb back up, or perhaps even more prosperous than before…

    Also Katherine's point is very interesting. If places like China and India takes over the "title" of being the strongest countries (considering the economy factors) then this recession would last quite a long time…

  7. Margaret Liuon 10 Apr 2008 at 10:00 pm

    I don't understand all this hype about a recession! If a recession is to happen every few years inevitably, then everyone should just relax. The politicians and economists should have enough experience dealing with past recessions to be able to deal with future ones accordingly. Some may change in degree, cause, etc, but they can figure it out, I have faith.

    Come to think of it, the period of expansion really resembles the theories of a recent economist that we discussed before, Garrett Hardin. He evinced the idea that people exploit the "commons," leading to "the tragedy of the commons." This happens in periods of expansion as well, investors, businesses, individuals, all exploit the growing economy which will ultimately lead to a recession aka "the tragedy of the expansion period." Or am I thinking in circles?

  8. judychenon 10 Apr 2008 at 10:13 pm

    I think China is lucky then. As we know, China has a rapid growth rate now, therefore, more people would like to invest in China, especially housing investment. I think firms in China also expect the rate of buying houses would keep increasing even in the far future, so there's more and more houses recent years. Unfortunately, China is communist country, the build of houses could be stopeed or restricted by government and the interest rate is also determined by government, or China might face the same situation in the future like US faces now.

  9. alicesuon 11 Apr 2008 at 12:26 am

    well actually, even if China/India did surpass the U.S. and take its place as the economically strongest country, that doesn't mean that the U.S. would be in a recession permanently. are you implying that all nations not in the #1 spot are therefore in a recession? That would mean that for the entirety of the years that America has been at the top of the world, every other nation in the world has been struggling to deal with recession- obviously not true. In addition, I do agree that recession is a natural part of a business cycle. Of course its undesirable, as Mr. Welker pointed out, but at the same time it's unavoidable…

  10. Chris Seahon 11 Apr 2008 at 11:47 pm

    The U.S. cannot stay in a recession forever. The stock market hasn't exactly been rosy for the last few months but there have been days where large gains were made. Really, it's a bit alarmist. But what can be ascertained is that China's economy really is catching up (or at least, the US is really coming down) because the dollar is set to be valued against 6.9 RMB in the coming months. To think that four years ago it was around 1 USD to 8.4 RMB…

  11. Alex Goldmanon 13 Apr 2008 at 2:13 pm

    I like the question Howard poses: "can the people get through these hardships? and How long would the recession last?" As the article mentions, the weak housing market not only reduces DI but decreases investment. This seems like it would leave a huge dent in the confidence of US consumers. While ultimately it seems that there is a great lesson to be learned here, it is an expensive lesson. I imagine if someone's house was foreclosed it could take them years to get back on their feet; the same goes for an investor's confidence in the market. However, the business cycle is unpredictable – the recession might recover sooner than we expect.

  12. Hansenon 13 Apr 2008 at 6:00 pm

    To add onto Alex, we also learned that we can't really say when we are going to get out of a recession or when we've hit the trough until we're past it and look back upon it. There are obviously struggles that lay ahead, as with investment spending and market confidence. Indeed there is the business cycle, but the question now is how long this recession will last. As with the growing economies of the China, Brazil, etc., will these help us out of the recession or keep us there longer?

  13. Jessicaon 14 Apr 2008 at 12:47 am

    I guess it's safe to say that America is in, or heading to, a recession. However, I think that the recession won't last too long, as the government will try to pull the nation out of the recession. As for Hansen's question, I think the growing economy of China will prolong America's recession; a huge part of China's GDP is exports, which makes it hard for America to export goods, even though the dollar is weaker now. The weaker dollar also isn't helping the American people. To them, foreign goods are relatively more expensive than before.

  14. Howard Jingon 14 Apr 2008 at 1:54 am

    It is basically inevitable that this would happen, and the fact that the RMB is increasing in value when compared to the USD means that the US cannot depend on cheap Chinese exports to save the day.

    One the other hand, don't consumer expectations play a large role in the economy? Everybody thought that the housing market would stay strong forever so the housing market began to boom. When the housing market started collapsing, the media began to cover it, people started bailing out, and now the housing market is even worse.

    What would happen if the media started blatantly lying about the economy and falsely increased consumer expectations and thus aggregate demand? If the country were at full employment, this would only increase the price level and inflation rates would rise. But since the US is experiencing high amounts of unemployment, increased aggregate demand can only do the country good. I realize that what I am suggesting is basically illegal (and for good reason), but is it possible to somehow trick the US out of its recession using nothing but an increase in consumer expectations?

  15. Jinnyon 14 Apr 2008 at 3:11 am

    On the contrary to Jessica's views, I think that the recession this time has hit US hard and deep. This time, it would be quite difficult and long-lasting for the US economy to break through this recessionary period due to all of its current sub-prime mortgage loan problems and credit problems that are rooted deeply in the US population. Also, due to this recession in US, further impact other economies world-wide are expected since US is one of the largest importers among nations. Thus, the recession in US does not only mean hard time for Americans but also for the economies that are highly interdependent with the US economy.

  16. Claire Moonon 14 Apr 2008 at 7:08 am

    Well Christina's view point can be right in someway, but I think it is hard to think that recession is just a part of procedure of the business cycle, since recession is a huge economic problem than it sounds like. The whole country is suffering from losing jobs and the whole country is suffering from the economic slow down because of the decreased exports, increased imports (such as from China). Also, the horrible business cycle might increase by declining the consumption of households, demand for investment, and so on.

  17. Trevor Sunon 14 Apr 2008 at 6:37 pm

    I thought that the US has been in a recession for a while but now that they've admitted it I wonder what the government's response will be. Or for that matter what the presidential candidates propose. In response to Howard's comment about trying to trick US consumers….>:( no way, I don't think any of the evil corporations of America are that evil especially considering the consequences that would follow if people found out.

  18. Michael Dailyon 14 Apr 2008 at 8:09 pm

    Well it took a while for him to admit it. And yeah it's getting so bad that it will just take time to dig out of it. I mean there is only so much an economist can do to stimulate the economy. It will be interesting to see if the presidential candidates do have economic policies that can help America climb out of this hole. With the inflation of the dollar becoming very high, the U.S. is affecting other countries economies as well. Let's just hope we can turn this around quickly.

  19. Steve Latteron 25 May 2008 at 9:16 pm

    The American press, like any national media, is prone to emphasize the worse as that is a proven way to sell newspapers and get people to listen to talk shows.

    There is officially no recession in America as GDP and incomes have not receded even for one quarter. But, it is true that GDP and income growth has fallen sharply over the last two quarters to approximately .7%, on an annualized basis, versus the country's historical, annualized-growth rate of 3.5%.

    The great news is that unemployment in the United States has not been significantly affected by the economic slow down, caused primarily by turmoil in the credit and housing markets, and has remained relatively steady by moving up only modestly to 5.0% from an end of year rate of 4.8%. In short, the economy is growing, albeit slowly, and the labor markets remain solid.

    In addition, most economists are predicting an upward revision of the United States growth rate in the first quarter of this year (from .6% to .9%) when the revised GDP data comes out this coming Friday. Most economists also see growth picking up for the remainder of the year as well, suggesting that this little slow down is behind us. The US stock markets have rallied from early this year as most investors believe that the country will avert a recession.