Prepare to Suffer

October 16, 2008

John Schmitt
BusinessWeek, October 16, 2008

See article on original website

The U.S. economy is now almost certainly in the early stages of a long and deep recession. No, not a Great Depression. Economic policymaking has come a long way since the 1930s, and we now know how to avoid the worst mistakes. Nevertheless, we’re facing something akin to the severe recession of the early 1980s, when unemployment crossed 10%, rather than the relatively short, shallow recessions of the early 1990s and 2000s.

The root cause of the recession is the $4 trillion decline in the value of U.S. homes, which may well total $8 trillion before prices hit bottom. Econometric evidence suggests that for every $1 decline in housing prices, homeowners cut back spending by about 6 cents. Using this formula, a $6 trillion drop in prices translates into a $360 billion annual decline in consumption—just under three percentage points of gross domestic product.

Earlier this decade, the same economic logic pushed the economy into a recession in the aftermath of the stock-market crash. The wealth impact then was on the same order of magnitude of what we’re seeing today with housing, but homes are much more widely owned than stock is and the average homeowner spends a higher share of income than wealthy stockholders do. In the end, the “wealth effect” from the housing bubble will likely end up twice as large as the 2001 stock bubble.

And, as is all too obvious looking back, we escaped the worst fallout from the stock market collapse precisely because the housing bubble stepped in to fill the void. In the current circumstances, no obvious replacement bubble waits on the horizon.

Thomas Hobbes said that life was “nasty, brutish, and short.” Get ready for nasty, brutish, and long.

John Schmitt is a Senior Economist at the Center for Economic and Policy Research (CEPR). He has worked as a consultant for national and international organizations including the American Center for International Labor Solidarity, the Global Policy Network, the International Labor Organization, the United Nations Economic Commission for Latin America.

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