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From New Orleans, Negative Notes on the Economy

by Travis Pantin
Mon, 7 Jan 2008 at 11:50 PM

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A New York University professor of economics, Nouriel Roubini, reports on his blog from the annual American Economic Association meeting, held this year in New Orleans, where the outlook for 2008 was decidedly gloomy.

Mr. Roubini served on a panel about the mortgage crisis alongside well-known economists Robert Shiller, Lawrence White, and Paul Krugman. With a few caveats, Mr. Roubini writes that among the panelists "there was an overall consensus … that home prices may have to fall 20% to 30% before they bottom out and that the risks of an economy wide recession are high and rising."

Mr. Shiller, an economist at Yale University, spoke of "how households are still deluding themselves – in polls – that home prices will keep on rising for the next decade." In reality, home prices have already fallen by 10% and need to fall at least 30% before they bottom out, according to Mr. Roubini.

Striking a similarly negative note at the conference was an economics professor from the University of St. Louis, Lawrence White. Mr. Roubini says Mr. White spoke of "how housing has been subsidized for a long time in the U.S. via a plethora of subsidies and tax incentives," which make us invest too much into housing and not enough into "more productive real capital." Mr. White argued that the current subprime crisis is therefore a partial result of this subsidization of housing.

The most sanguine speaker on the panel was a Princeton University professor of economics who is a columnist for the New York Times, Paul Krugman, who characterized the subprime debacle as an "unmitigated disaster," but was less willing than his peers to say the disaster will lead to a recession.

Mr. Roubini himself offered perhaps the most ominous forecast: "This is the worst housing recession in U.S. history and an economy-wide recession is now unavoidable and it will be a severe recession rather than a mild recession," he said.

He continued: "This is a crisis of insolvency, not just illiquidity; it is a problem of immeasurable uncertainty (on the size of the losses and who is holding the toxic waste) rather than priceable risk."

According to Mr. Roubini, one of the major problems is that America now has a "shadow financial system" where nonbank institutions such as SIVs, hedge funds, and money market funds can borrow an assortment of very risky assets. These institutions do not have access to the kind of emergency funds normally provided by the central bank, which makes them especially vulnerable during economic crises and a potentially destabilizing force in America's economy.

History and Recession
An anonymous blogger at Calculated Risk compares recent data with historical data in an attempt to determine the chances of a recession. The data are mixed, but suggest we may be heading into a recession.

The blogger found that year-over-year private fixed investment in America has gone negative only 13 times since 1949, including the current period. During 10 of those times the American economy fell into a recession.

So what happened during the three similar situations when private investment fell, but the economy didn't slide into recession?

"The answer is generally the same for all three periods: a surge in defense spending," the Calculated Risk blogger writes. "The defense spending in the early '50s was due to the Korean War, in the mid '60s the Vietnam War, and in the mid '80s a general defense build-up helped offset a small decline in private investment. The mid '80s also saw a surge in MEW (mortgage equity withdrawal) that also contributed to GDP growth."

However, the year-over-year change in private investment appears to have bottomed out in early 2007, suggesting that we may have narrowly avoided a recession while still experiencing falling fixed private investment — a rare occurrence.

"Usually this means the recession is over, or at least almost over. This has given some hope to the idea that non-residential investment (along with consumer spending) would keep the economy out of recession. However, it appears that investment is about to take another turn down, both for residential and non-residential," the Calculated Risk blogger says.

The strong investment in nonresidential structures that helped us avoid a recession through the third quarter of 2007 may not hold out, he writes: "Now that commercial real estate appears to be slumping, it looks like non-residential investment will slump too — putting the economy into recession."

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