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Wednesday, February 20, 2008

Feldstein on the Recession

by Calculated Risk on 2/20/2008 02:39:00 PM

Note that Martin Feldstein is the (edit: outgoing) President and CEO of the organzation that officially calls economic cycles in the U.S., the National Association of Economic Research (NBER)

Feldstein writes in the WSJ: Our Economic Dilemma (hat tip rtalcott)

Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun.
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 ... [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.
Professor Krugman has made this same point: Postmodern recessions
A lot of what we think we know about recession and recovery comes from the experience of the 70s and 80s. But the recessions of that era were very different from the recessions since. Each of the slumps — 1969-70, 1973-75, and the double-dip slump from 1979 to 1982 — were caused, basically, by high interest rates imposed by the Fed to control inflation. In each case housing tanked, then bounced back when interest rates were allowed to fall again.
But this time, as the Fed cuts rates, housing will probably not "bounce back" because prices are still too high, and there is a huge overhang of supply.

Feldstein notes the uncertainty about housing prices, and continues:
[M]arket participants now lack confidence in asset prices, they are unwilling to buy existing assets, thus preventing current asset owners from providing credit to new borrowers.
And until market participants regain confidence in asset price, Feldstein argues Fed policy might be ineffective:
Monetary policy may simply lack traction in the current credit environment.
It is not clear what can bring back the confidence in asset prices that is needed for credit to flow again. Some analysts suggest that confidence would return if the financial institutions declare the true market value of their assets by restating balance sheets at the depressed prices at which they could be liquidated today. But this is not a practical solution, since many complex securities are no longer trading in the market. Forcing an actual sale of these securities at fire-sale prices in order to establish market values could also create unnecessary bankruptcies that would further impede credit flows.
Feldstein seems to be solidly in the severe recession camp.