Martin Feldstein on the Economy, Credit Markets and Economic Risk

February 21, 2008
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Martin Feldstein, stepping down from heading up the National Bureau of Economic Research since 1977, has piece in the Wall Street Journal that is rather pessimistic about the economic outlook. More tellingly he thinks the recession, if it occurs (and like me, he suspects it has already begun) will be more difficult to stimulate our way out of:

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

Read the whole thing, but it mirrors much of what we have been saying. Here is Martin on the Charlie Rose show where he stresses that it is not just a subprime issue, that all kinds of assets were not priced appropriately, and frankly still are not:

Hat Tip: Barry Ritholtz

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