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Weekly Economic and Financial Commentary

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A Recession Looks More Likely

Mon, Sep 29 2008, 08:44 GMT
by Wachovia Research Team

Wachovia

U.S. Review

While the financial markets have garnered most of the attention this week, the economic numbers continue to come in weaker than expected. We now have a whole host of data consistent with the onset of a recession. We still expect real GDP to be slightly positive in the third quarter but the fourth quarter looks to be in negative territory, and the first quarter of 2009 may be down as well.

We update our forecast the week after the employment report. We still have about ten days to gather more data and refine our estimates. Most recent data, however, have been to the downside.

This week’s major reports included a much larger than expected jump in weekly first-time unemployment claims to 493,000, a huge 4.5 percent drop in advance orders for durable goods and shipments, and a much steeper than expected 11.5 percent drop in sales of new homes. In addition, second quarter real GDP growth was revised down by a half percentage point to a 2.8 percent annual rate. Taken together, these numbers, along with the credit crisis, set an ominous tone for the second half of the year.

The Credit Crunch is Weighing on the Economy

Political officials are debating the merits of the Treasury’s financial rescue package. Much of the objection about the program arises from the legitimate concerns about taxpayers bailing out Wall Street. Such concerns miss one vital point - the time for bailing out Wall Street has already passed. The two largest remaining investment banks converted to bank holding companies earlier this past week and several other firms have either been sold or shut down. The concern now is from keeping Wall Street’s troubles from further affecting Main Street.

The credit crunch is already having a debilitating impact on Main Street. Several retailers, restaurant chains, manufacturers, car dealers, and wholesalers have already shut their doors because they were denied access to capital. These shutdowns have resulted in significant job losses, which have pushed the unemployment rate back up to highs seen in the aftermath of the 2001 recession. Credit conditions have tightened further in recent weeks, affecting even more firms and also making it more difficult for consumers to qualify for home mortgage and automobile loans.

The impact of the credit crunch was clearly evident in recent economic reports. First-time claims for unemployment insurance have clearly accelerated since the onset of the credit crunch. While the numbers have been muddled by the recent hurricanes and the extension of unemployment insurance benefits, the recent spike is simply too much to dismiss. The Labor Department’s report on Mass Layoffs shows mass layoff announcements soaring to their highest level since Hurricane Katrina. Unlike the earlier spike, however, the most recent rise has occurred over several months and across a much broader assortment of industries.

The home sales data also show some contagion from the credit crunch. Sales of existing homes fell 2.2 percent and new home sales tumbled 11.5 percent in August, bringing sales back down to their lowest level since 1991. The weakness in home sales, particularly in light of the firmer pending home sales figures and various surveys of home buying intentions, likely signals that homebuyers are having more difficulty qualifying for home mortgages. That could spell even more trouble for sales in September and October, when the credit crunch really hits.

Advance orders for durable goods are also likely being restrained by credit conditions. With financing harder to come by, firms are hoarding capital by putting off expansion plans and scaling back hiring. This should become even more evident when the September jobs figures are reported next week.

Global Review

Financial Crises in Historical Context

As Congress debates Treasury Secretary Paulson’s plan to purchase up to $700 billion of troubled assets from the financial system, critics charge that the government should not be bailing out the private sector for its past mistakes while proponents warn of dire economic consequences if the plan is not adopted. How have other major countries fared in the past in the face of their own financial crises?

The banking system in Scandinavia blew apart in the early 1990s. Deregulation during the previous decade led to lax lending standards and under-capitalization of banking systems in those countries. However, the immediate catalyst for the crisis was the collapse of the Soviet Union that led to steep declines in Scandinavian exports. As those economies slipped into recession, loans started to go bad, which led to many bank failures. As bank lending shriveled up, Scandinavian economies slipped further into recession.

How bad did it get? The chart on the front page shows that the Finnish economy was hammered in the early 1990s. Between late 1989 and mid-1993 real GDP in Finland contracted 12 percent. (Between 1973-Q4 and 1975-Q1 U.S. GDP dropped “only” three percent, making it the deepest U.S. recession in the last forty years.) Sweden did not fare as poorly as its neighbor, but real GDP still contracted about four percent in the early 1990s. The top chart shows that the Finnish unemployment rate shot up from three percent in 1990 to 16 percent in 1993. In Sweden, the unemployment rate breached nine percent.

The bursting of land and stock market bubbles in Japan in 1990 led to extreme weakness in the Japanese banking system. As shown in the middle chart, Japanese GDP growth did not slip into negative territory on a sustained basis. However, the Japanese economy has never been the same. Between 1980 and 1990, real GDP growth averaged about four percent per annum. Since the bubbles broke, the annual growth has slipped to only 1.4 percent per annum. Moreover, the economy contracted a mild case of deflation in the late-1990s, from which it has not really escaped.

Many Asian countries experienced their own financial crises in 1997-98 that led to significant recessions in those countries. For example, real GDP in Korea contracted nine percent between late 1997 and mid-1998 (see bottom chart). The unemployment rate in Korea shot up from two percent to seven percent. Indonesia, where the banking system essentially collapsed, suffered a 13 percent decline in real GDP between 1997 and 1998.

The bottom line is that financial crises are usually associated with large hits to economic activity. In some cases, sharp recessions and significant increases in unemployment follow (e.g. Scandinavia and Korea). In other cases, sharp recessions do not occur, but the economy remains stagnant for a number of years (e.g. Japan). It is not for us to state what Congress “should” do. That is a value judgment. However, a failure to enact some package of support to the financial system, whether as proposed by Secretary Paulson or modified by Congress, would pose significant downside risks to the U.S. economy.

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Published on  Mon, Sep 29 2008, 08:54 GMT