[Pen-l] Why It’s Worse Than You Think

[Louis Proyect <lnp3@xxxxxxxxx>]

http://www.newsweek.com/id/140553

Why It’s Worse Than You Think

For months, economic Pollyannas have looked beyond the dismal headlines 
and promised a quick recovery in the second half. They're dead wrong.
Daniel Gross

The forgettable first half of 2008 is stumbling to a close. On Friday, 
the Labor Department reported that American employers axed 49,000 jobs 
in May, the fifth straight month of job losses—an event that signals a 
recession sure as the glittery ball dropping on Times Square augurs a 
New Year. The report, which inspired a 394-point decline in the Dow 
Jones Industrial Average Friday, was the latest in a run of bad news. 
Auto sales, the largest retailing sector in the U.S., were off 10.7 
percent in May from the year before. And housing? Ugh. Nationwide, 
according to the Case-Shiller Index, home prices in the first quarter 
fell 14 percent.

Yet hope springs eternal that the second half will be better than the 
first. Economists polled by the Federal Reserve Bank of Philadelphia in 
May believe the economy will grow at an annual rate of 1.7 percent and 
1.8 percent in the third and fourth quarters, respectively. Lawrence 
Yun, chief economist at the National Association of Realtors, tells 
NEWSWEEK that "home sales and prices in most of the country will improve 
during the second half of 2008." (Yun is the Little Orphan Annie of 
forecasters. He's always sure the sun will come out tomorrow.) Last 
month, Treasury Secretary Henry Paulson said, "We expect to see a faster 
pace of economic growth before the end of the year."

The cause for optimism: the U.S. has called in the economic cavalry, 
which has responded in textbook fashion. The Federal Reserve has 
aggressively cut interest rates, bringing the Federal Funds rate down 
from 5.25 percent last September to 2 percent. Earlier this spring, 
Congress and President Bush, in a rare moment of bipartisan accord, 
passed a stimulus package, which will shove nearly $100 billion into the 
pockets of American consumers by mid-July.

But this downturn is likely to last longer than the eight-month-long 
recession of 2001. While the U.S. financial system processes popped 
stock bubbles quickly, it has always taken longer to hack through the 
overhang of bad debt. The head winds that drove the economy into this 
dead calm— a housing and credit crisis, and rising energy and food 
prices—have strengthened rather than let up in recent months. To 
aggravate matters, the twin crises that dominate the financial news—a 
credit crunch and the global commodity boom—are blunting the stimulus 
efforts. As a result, the consumer-driven economy may not bounce back as 
rapidly as it did in the fraught months after 9/11.

As it seeks to regain its footing in the second half, the U.S. economy 
faces two significant obstacles, neither of which was evident in 2001. 
The first is entirely homegrown: the self-inflicted wounds of the 
promiscuous extension and abuse of credit in the housing and financial 
sectors. The second is a global phenomenon that has comparatively little 
to do with American behavior: rampant inflation in commodities such as 
oil, food, and steel. These trends have conspired to inflict genuine 
economic pain and deflate consumer confidence. The Conference Board's 
Consumer Confidence Index in May slumped to a 16-year low.

While the treatment of the current malaise has been essentially 
identical to the reaction to the 2001 slump—aggressive Federal Reserve 
rate cuts and tax rebates—the symptoms are quite different. In 2001, an 
implosion in the technology sector and a slump in business investment 
pushed the economy over the edge. Even though some 3 million jobs were 
shed between 2001 and 2003, consumers soldiered on through the downturn. 
"We had a massive reduction in both long- and short-term interest rates, 
which set off the housing and consumption boom," says Ian Morris, chief 
U.S. economist at HSBC. (Remember zero-percent car loans?) This time, 
it's the opposite. While businesses—especially those that export—are 
holding up, the economy is being dragged down by the cement shoes of a 
freaked-out consumer and a punk housing market.

The difficulties today start—as they began last year—with housing and 
housing-related credit. Last Thursday, the Mortgage Bankers Association 
quarterly report showed that the percentage of mortgage borrowers behind 
on their payments—6.35 percent—was the highest since the MBA began 
tracking the number in 1979. It's not just subprime. In the first 
quarter of 2008, 36 percent of all foreclosures initiated were on prime 
adjustable-rate mortgages in California. Mark Zandi, chief economist of 
Moody's Economy.com, says the decline in home prices has slashed $2.5 
trillion from household wealth, or about $25,000 per homeowner. The fall 
has also removed an important source of support for consumer spending, 
as Americans who grew accustomed to borrowing against rising home equity 
to finance car purchases or vacations now find themselves bereft. Banks 
are extricating themselves from the home-equity-line-of-credit business 
in the same way college students get themselves out of relationships 
gone bad: abruptly. Judi Froning, a second-grade teacher in San Diego, 
was surprised last week when she received a letter from Chase informing 
her that it was terminating her untapped HELOC. "In the light of 
declining home values, they said they are stopping, effective May 31, 
any draw on my line of credit," she says.

Despite repeated claims that the damage has been contained, the banks 
that recklessly financed the housing boom—and then traded mortgage debt 
even more recklessly—are still cleaning up the mess. But it turns out 
(surprise!) the same sort of clouded judgment led banks to excesses in 
commercial lending, and in loans to private-equity firms. The battered 
financial system, which has raised tens of billions of dollars on 
onerous terms from new investors to shore up balance sheets, is still 
likely to suffer more pain from the popped credit bubble, said Bruce 
Wasserstein, the CEO of the investment bank Lazard, speaking at a New 
York breakfast. "The harm will radiate for another year." The latest 
victim: Wachovia CEO G. Thompson Kennedy, cashiered after the North 
Carolina-based bank suffered a string of losses. Next up: write-offs for 
bad credit-card and commercial realestate debt. After a serene period 
between 2004 and '07 in which the Federal Deposit Insurance Corp. went 
without a single bank failure, four have gone under so far this year. 
FDIC chairperson Sheila Bair warned of the "possibility that future 
failures could include institutions of greater size than we have seen in 
the recent past." In preparation, the agency has brought staffers out of 
retirement.

The financial system is supposed to be a tube, transmitting lower 
interest rates. Banks borrow from the Fed, and pass through lower costs 
to customers and to the markets at large. But today banks are acting 
more like dried sponges, absorbing the liquidity the Fed is providing to 
shore up their balance sheets and make up for losses, rather than 
releasing the cash into the economy. The Federal Reserve reports that in 
April, 55 percent of commercial banks said they are tightening lending 
standards on commercial loans, up from 30 percent in January. Judy 
Eisenbrand, a Moorpark, Calif., real-estate agent, notes that buyers 
also can't get loans as easily today, even in strong markets. "The 
standards are so much stricter than they were during the boom days," she 
says.

The upshot: the Fed's adrenaline isn't really circulating through the 
commercial bloodstream. According to mortgage-data firm HSH, rates on 
conforming 30-year mortgages (under $417,000) have only fallen 
marginally since the Fed began cutting rates, from 6.4 percent on Sept. 
21 to 6.17 on May 30, while jumbo loan rates haven't budged at all. 
Worse, this may be as good as it gets. Last Tuesday, Federal Reserve 
chairman Ben Bernanke indicated that the Fed may be done cutting rates. 
Why? "Inflation has remained high," Bernanke said, "largely reflecting 
continuing sharp increases in the prices of globally traded commodities."

Economists say it generally takes nine to 12 months for Federal Reserve 
interest-rate cuts to work their way into the system. By contrast, 
sending checks to consumers tends to produce quick results. Some 
retailers have reported a surge of business spurred by the tax rebates. 
But consumers are shopping for necessities, not discretionary items. 
Sales at Wal-Mart and Costco were up in May, while sales at Kohl's and 
Nordstrom were down. David Rosenberg, chief economist at Merrill Lynch, 
argues that higher food and gas prices are eating the rebate. Follow the 
math. The rebate checks will total about $120 billion. Studies suggest 
that about 40 percent of that total, or about $48 billion, will be spent 
in short order; the rest will be saved or spent later. Rosenberg reckons 
that higher energy costs—crude-oil prices are up 40 percent so far in 
2008—are draining about $30 billion out of household cash flow per 
quarter, and that food inflation, running at a 9 percent annualized 
rate, drains another $20 billion per quarter. "So instead of the 
stimulus being filtered into real economic activity, it's being diverted 
into the checkout counter at Albertson's and the gas station," he says.

Last November, retired school principal Barbara McGeary, 75, of Camp 
Hill, Pa., switched from a Toyota Rav 4 SUV to a Prius. But the savings 
she realizes are eaten by a higher food bill. "When I go to the grocery 
store, I see prices have doubled on some of the things I'm purchasing," 
she says. Last year she paid $3.99 for a container of about two dozen 
brownies. Now that they're retailing for $8.49, she bakes her own. 
McGeary and her husband are also eating at home more than ever. 
"Restaurants, of course, have had to increase their prices," she says.

While the housing and credit crisis is homegrown, the higher prices for 
high-octane gasoline and corn chips are effectively imports. 
Historically, or at least since the end of World War II, if the U.S. 
sneezed, the world caught a cold. When we used more gas, oil prices 
rose, and when we used less gas, oil prices fell. As GM vice chairman 
Bob Lutz points out, "Usually petroleum prices were the first to react 
to a severe U.S. slowdown." In the past it would have been unthinkable 
for oil to spike if Americans were cutting back.

Many factors, from a weak dollar to rising speculation, are behind the 
higher commodity prices. But at root, $4-per-gallon gasoline and 
$20-per-pound steaks are largely a function of the changing economic 
geography, and the diminished stature of the U.S. Last January, the talk 
of the World Economic Forum in Davos (aside from the locale of the 
Google party) was the prospect of "decoupling"—the notion that India and 
China could maintain their breakneck economic growth rates even if the 
U.S. pooped out. Five months later, the global economy seems to have 
decoupled faster than Jessica Simpson and John Mayer. The world is 
growing without us. "My impression is that China and India both have 
sufficient domestic demand-led growth to continue to have vibrant growth 
even if the U.S. has a sustained period of difficulty," former Treasury 
secretary Robert Rubin tells NEWSWEEK. Producers of commodities are 
enjoying the fruits of higher prices. Sorry, Tom Friedman, the world is 
no longer flat. "It is upside down," says Mohamed El-Erian, co-CEO of 
bond mutual-fund giant PIMCO. "The growing robustness of the emerging 
economies enables them to step up to the global plate at a time when the 
U.S. has to take a breather in order to put its financial house in 
order." This rampant global economic growth—more people eating better, 
more people driving, more people using electricity—is translating into 
higher prices at the Stop & Shop.

The situation we're in is nowhere near stagflation—the consumer price 
index is rising at a 3 percent annual rate, compared with 13 percent in 
1979. But it's still a shock to the system. Fuel surcharges have become 
de rigueur from exterminators to personal trainers. On May 28, Dow 
Chemical announced it would increase prices 20 percent to compensate for 
higher energy prices. The realization that the U.S. no longer controls 
its economic destiny is contributing to the widespread feeling of unease 
and crisis of confidence. Economically speaking, the 1990s belonged to 
the U.S. and New York and Silicon Valley. But as this decade motors 
toward its close, it seems powered by China, and Russia, and Dubai and 
Mumbai. It's as though we're home watching reruns while everybody else 
is out partying. Worse, some of those benefiting the most from the new 
tilt on the Risk board are hostile to the U.S., like Hugo Chávez of 
Venezuela. In a recent study, Mary Egan, a partner at the Boston 
Consulting Group, found that 71 percent of those polled agreed with the 
following statement: "Because the world has changed so much, the U.S. 
economy will not be as strong as it was—or at least not for the next 
several years."

Such surveys measure sentiment, and any analyst worth his weight in 
PowerPoint presentations will tell you that sentiment doesn't always 
translate into cash activity in the marketplace. But there's one 
marketplace where sentiment—and especially consumer confidence—matters 
greatly: politics. The last time consumer confidence was this low was in 
October 1992—the month before incumbent George H.W. Bush won 37 percent 
of the popular vote, the worst performance of any incumbent in history. 
"The economy is always the biggest issue in a general presidential 
election," says Tom Mann, a senior fellow at the Brookings Institute, 
because it's a referendum on the party in power. A recent CBS News poll 
showed more people identified the economy as their leading concern (34 
percent) than identified oil prices (16 percent) and Iraq (15 percent) 
combined.

Yale economist Ray Fair has developed a formula in which particular 
economic factors can foreshadow election outcomes. Crude summary: when 
there's lots of good news on growth and inflation in a presidential 
term, it favors the incumbent party. With growth low and inflation high, 
John McCain comes out with 44 percent in November. (Before Obama-ites go 
making reservations for the Inaugural, consider that the formula 
misfired in 1992.)

All things being equal, the limping economy should favor Obama. While 
McCain has taken pains to distance himself from the Bush administration, 
he has heartily embraced the most significant component of Bush's 
economic legacy: the tax cuts. But in presidential elections, all things 
are never equal. Obama and McCain have staked out different economic 
turf. For Obama, it's middle-class tax cuts, and creating new jobs in 
environmental and tech fields; for McCain it is repealing the 
Alternative Minimum Tax, expanding free trade (a winner in an age of 
rising exports) and a summer gas holiday. But if the economy worsens 
significantly, if oil spikes to $150 per barrel and unemployment becomes 
more widespread, the campaign will likely take on a different tenor. The 
typical dialogues about taxes and spending, health care and pensions 
will assume a greater prominence. But a crisis atmosphere would require 
both candidates to come up with big-picture narratives about America's 
role in the world economy, and how the nation can re- assume financial 
leadership—something neither has yet done comprehensively.

It's not all doom and gloom. Businesses that thrive on a weak dollar are 
holding up nicely. "In fact many sectors are benefiting from strong 
growth overseas, including high-tech, capital goods, chemical and other 
raw materials, aircraft," says Nariman Behravesh, chief economist at 
Global Insight. Bob Toney, president of Ft. Lau- derdale, Fla.-based 
National Liquidators, which auctions repossessed boats and yachts, has 
doubled his staff to 78 employees to pick up around 120 boats a month. 
"Two years ago, we had 200 cases in our inventory and now we have 610," 
he says.

But it's the mainstream indicators—not countercyclical businesses—that 
will point to a recovery. For signs that tomorrow really is a day away, 
look to the thing that got us into this mess: housing. "Housing doesn't 
have to return to the bubble era. It's just that the rate of decline has 
to stop," says Lakshman Achuthan, managing director at the Economic 
Cycle Research Institute. Reductions in the level of housing inventories 
for sale will be a hopeful sign. Other tea leaves are the weekly reports 
on jobless claims, retail chain stores, and mortgage application 
activity. "This will give you an early read on potential trend shifts in 
consumption," says Ian Morris, chief U.S. economist at HSBC.

Just as sharp spikes in the price of oil and commodities have dented 
confidence, precipitous falls in the commodity markets could bolster 
consumer confidence. But that doesn't seem likely any time soon: on 
Friday, the price of a barrel of oil rose $10.75 to a record $138.54.
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