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Recession ahead?

December 7, 2007 | Pages 6 and 7

THE U.S. economy is on the skids and could be headed into recession--fast. That's the emerging consensus among economists and Wall Street insiders. LEE SUSTAR looks at the causes of the emerging crisis and explains why the "experts" are so worried.

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ACCORDING TO newly updated government statistics, the U.S. economy expanded at a rapid 4.9 percent annual clip in the third quarter of this year, driven in large part by a buildup in inventories across Corporate America.

Good news, you might think. But since then, the signs have all pointed to a sharp slowdown--and a recession could be in the offing, despite the recent surge of growth. "Many economists expect economic growth this quarter to come in below 1 percent, and some are forecasting a slight contraction," the Wall Street Journal noted.

"How bad is it?" wrote New York Times columnist and economist Paul Krugman. "Well, I've never seen financial insiders this spooked--not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world. This time, market players seem truly horrified--because they've suddenly realized that they don't understand the complex financial system they created."

The financial crisis is rooted in the collapse in housing, which is getting worse. New home construction is half the rate it was at during the boom years of the housing market, and home prices are declining in most major markets.

What else to read

Joel Geier is interviewed on "Warning signs for a coming recession" in a recent issue of the International Socialist Review. Socialist Worker's previous coverage of the economy is collected in an archive called "Economy in crisis."

For books that examine the recent backdrop to the latest economic developments, look for The Boom and the Bubble: The U.S. and the World Economy by Robert Brenner, and Doug Henwood's After the New Economy: The Binge and the Hangover That Won't Go Away.


Total profits for business are falling, too--down 8 percent in the third quarter compared to the same period a year earlier.

Unemployment claims, while still relatively moderate, are edging up. But workers are feeling the pinch through inflation in prices for food and fuel. "And with crude oil at $95 a barrel, pump prices could average $3.45 a gallon," Business Week noted. "At those prices, U.S. households would have to spend an additional $90 billion on costlier gasoline, leaving less income for other purchases."

The housing bust, moreover, has forced banks to raise capital reserves to offset expected losses from bad mortgage loans. This has made it much harder for small and medium businesses to obtain loans for expansion. The New York Times noted that two main sources of credit to business--conventional bank loans and short-term loans known as commercial paper--dropped from $3.3 trillion to $3 trillion between August and November, a decline of 9 percent.

"Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly," the Times noted. "Smaller declines preceded three recessions going back to 1975; at other times, such declines tended to occur in conjunction with an economic downturn."

According to Goldman Sachs economist Andrew Tilton, this credit squeeze "is a very big deal. You're basically crimping the growth of the more vulnerable companies. If they can't borrow the money, their options are much more limited. They'd have to have less ambitious hiring plans, buy less machinery and cancel projects."

For all these reasons, many economists believe U.S. economic growth is heading toward negative territory. That means a recession--the official definition of a recession is two consecutive three-month periods of negative economic growth.

Writing in the Financial Times, former Harvard University President and U.S. Treasury Secretary Lawrence Summers said, "It is now clear that only a small part of the financial distress that must be worked through has yet been faced.

"On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on sub-prime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that--if all assets were marked to market valuations--total losses in the U.S. financial sector would be several times the $50 billion or so in write-downs that have already been announced by big financial institutions.

"These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognize the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt."

Economist Nouriel Roubini made the same case more bluntly. "The evidence is now building that an ugly recession is inevitable," he told a reporter. "When the United States sneezes, the rest of the world gets the cold. And since the United States will not just sneeze, but is risking a serious case of protracted and severe pneumonia, the rest of the world should start to worry about a serious viral contagion."

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THAT CONTAGION began in the housing market, which is in its steepest decline in decades, with worse still expected to come. Mortgages on some 2 million homes are already expected to go into default in the coming year, and the figure is likely to go higher as interest rates on adjustable rate mortgages rise.

"Beyond the human tragedy," wrote Joel Geier of the International Socialist Review in a recent article, "this will add to the large inventory of unsold houses, further depressing prices, so that many mortgages will be greater than the house is worth. That, in turn, will lead more people to walk away from homes with inflated prices, producing even more forecloses and further price declines.

"And, of course, the banks are now refusing to make mortgage loans in declining or unstable markets, narrowing the pool of potential buyers. It is the mad logic of the capitalist market in crisis, spiraling downward and producing the worst housing depression since the 1930s."

Many of the people who could lose their homes were given "sub-prime" mortgages--loans that carried higher adjustable interest rates because the borrowers had little or no credit history and no cash for a down payment.

The sub-prime loans were highly profitable for the brokers and bankers who made money on fees and above-average interest rates--as well as for the Wall Street investment banks that packaged these mortgages together into huge securities that could be sold to the biggest investors.

Wall Street is indifferent to the plight of millions of people losing their homes. What worries the banks is the fact that the mortgage crisis means that the mortgage-backed securities they put together are worth far less than their stated value. Big banks have been forced to confront heavy losses.

For example, HSBC, the big international London-based bank, was recently forced to own up to having $45 billion worth of these problem securities hidden away in off-the-books entities known as structured investment vehicles (SIVs), supposedly independent companies that bought the securities.

HSBC isn't alone--most big banks created SIVs. With an estimated $400 billion in assets, they made money by taking short-term loans and issuing securities based on the mortgages.

This allowed the banks' balance sheets to appear much healthier than they really were. In fact, some banks--including Citigroup, the world's largest--agreed to buy back the securities from the SIVs if they couldn't otherwise be sold. "That risk may have seemed slight when the securitization market was booming," wrote New York Times business columnist Floyd Norris. "But now the banks are being forced to buy back securities for more than they are worth."

If the banks tried to walk away from losses incurred by the SIVs, they would face multibillion-dollar lawsuits and downgrades by credit rating agencies. But simply accepting the losses would force them to raise capital reserves to repair their balance sheets--which could also cripple their operations. It was in this context that Citigroup turned to the Gulf emirate of Abu Dhabi for an emergency $7.5 billion investment.

To try to stave off a bigger crisis, Citigroup is working with the U.S. Treasury Department and other big banks to create a $100 billion superfund to buy up the assets of the SIVs. In this way, they hope to contain the losses. But whether the plan will work is by no means a certainty.

Already, the major international banks are preparing for the worst by raising the interest rates that they charge one another--known as the London Interbank Offer Rate--to over 5 percent. This comes despite efforts by the U.S. Federal Reserve and the European Central Bank to keep their own interest rates for banks much lower to ease the credit crunch.

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IF THE housing crisis is having such a major effect on the U.S. economy, it's in large part because cheap mortgage refinancing propped up consumer spending since the recession of 2001. Between 2004 and 2006, Americans took $800 billion per year out of their homes through refinancing, even as household savings rates went negative for the first time since the Great Depression of the 1930s.

During years in which wages declined or grew modestly, housing loans boosted consumption and provided an economic stimulus that could partly compensate for the loss of 3 million manufacturing jobs and a low level of business investment compared to the 1990s boom.

A few remaining cheerleaders for the Bush administration's economic policy claim that U.S. economic growth will soon be boosted by the falling value of the dollar, which will make U.S. exports more competitive. Yet business, which held off major investments during the boom, won't launch big capital spending projects on the eve of an expected recession.

"Corporations still have a good bit of production capacity that they have not tapped," observed Gretchen Morgenson of the New York Times. "The capacity utilization rate of 82.2 percent in August is well below the peak of 85 percent seen in recent booms. It is unlikely that companies will spend capital to increase production capacity if existing facilities are not being fully used."

As Paul Kasriel, an economist for Northern Trust, put it, "Business capital spending was not booming when corporate profit growth and household demand were strong. So why would it be expected to continue to grow when profit growth and household demand growth are slowing?"

In addition, the cheap dollar, while providing some relief for U.S. manufacturers, poses big risks of its own, noted Joel Geier of the International Socialist Review. "The U.S. has borrowed $2.5 trillion from the rest of the world in the last three years and is still borrowing $50-60 billion a month--which is now producing a dollar crisis as capital flows into the U.S. have fallen into negative territory ever since the mortgage crisis came to a head in August," he wrote in a recent article.

"The decline of the dollar is stoking inflationary pressures, forcing up the price of oil, gold and other commodities. Meanwhile, the endless wars in Iraq and Afghanistan contribute to the crisis by having raised arms and war spending from $299 billion in 2000 to between $700-800 billion this year. The crisis in the U.S. will be felt painfully throughout the world."

When exactly the economy could tail into recession can't be predicted. But the ingredients for a major economic crisis have clearly come into view.

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