The Tip of the Iceberg

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Dean Baker
The Guardian Unlimited, April 7, 2008

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Despite the sanguine assurances of the Federal Reserve, the US recession will be neither short nor mild.

The economists all assure us that the recession will be short and mild. Anyone who finds this reassuring should remember that almost none of these economists ever saw the recession coming. The overwhelming consensus among economists just a few months ago was that the problems in the housing market would cause somewhat slower growth, but posed little risk of a recession.

The misplaced optimism ran pretty much across the board. The Livingston Survey of 36 leading forecasters compiled in December by the Philadelphia Federal Reserve District bank showed a median forecast of 2.4% growth for 2008. The median forecast for the year-end unemployment rate was 4.9%, 0.2 percentage points below the level reported for March.

The Federal Reserve Board and the Congressional Budget Office were equally sanguine about the possibility that the collapse of a housing bubble would lead to a recession. The public should keep this track record in mind when assessing the latest round of assurances that the downturn will be short and mild. (For some reason the media rarely mentions this track record.)

Of course, even a short and mild recession will be rather painful to most people. In the last two recessions, both rather mild by post-World War II standards, unemployment rose by an average of 2.1 percentage points from the pre-recession low point. For African-Americans the increase averaged 3.0 percentage points, and for African American teens the unemployment rate rose an average of 7.9 percentage points.

Along with higher unemployment, we can expect to declines in both pension and health insurance coverage. In both of the last two recessions, 1.6% of the workforce lost health insurance coverage. As the labour market weakens, we can also expect that wage growth will also weaken. Wages are already falling behind inflation. Workers are likely to lose more ground as higher unemployment undermines their bargaining power.

But, there is little reason to accept the economists' claims that this recession will be short and mild. After all, remember last March when Federal Reserve chairman Ben Bernanke told us that he expected financial problems to be restricted to the subprime market? Last week, Bernanke told Congress that he doesn't see another Bear Stearns out there. Of course, Bernanke didn't see the last Bear Stearns out there either.

The reality is that the economy is just feeling the first waves from the storm created by the bursting of the housing bubble. The bubble created more than $8 trillion in illusory housing wealth. Thus far, close to $3tn of this wealth has disappeared, but there is much more to come. House prices are currently declining at more than a 20% rate nationwide. In some of the most inflated bubble markets, the rate of price decline exceeds 30%. At the current rate of price decline, another $3tn of housing wealth will be eliminated by the end of the year.

Homeowners will feel the brunt of this lost wealth, as tens of millions of families will find that they have much less wealth than they realised. This will force them to cut back their consumption. In many cases, homeowners will suddenly realise that they now have to save in a real big way for retirement, since most families have little wealth other than their homes. In other cases, they will be forced to cut back their consumption because they can no longer borrow against their home equity to support their consumption. Either way, we can expect sharp cutbacks in consumption over the course of the year in response to the loss of trillions of dollars of housing wealth.

The downturn in consumption, which is 70% of GDP, will be amplified by both a weakening in non-residential construction (which had been booming) and cutbacks in state and local government spending. These governments are almost experiencing budget shortfalls, in part due to collapsing property tax revenue, and are being forced to curtail spending and raise taxes.

We can also expect much more turmoil in financial markets. Homeowners are losing or abandoning homes at a record pace, since they have mortgages that now exceed the value of their houses. Banks have huge losses on these homes, the vast majority of which have not been written down on their books. The write-downs that we have seen to date are likely no more than a third of those yet to come.

Keeping the markets calm will give the banks and others facing big losses the opportunity to find suckers on whom to dump these losses. The Fed has been a willing ally in these efforts. Those of us who don't depend on the banks directly or indirectly for our paychecks have more freedom to talk about the economy as we actually see it. Thus far, our pessimistic warnings have been right and the Fed and other optimists have been proven wrong at every turn. Take your choice.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.