Recession and the U.S. Economy

January 30, 2008

Fed Up

For the past several weeks, mounting fears that the United States is falling into a recession have dominated the news. Global financial markets have been thrust into turmoil as speculation about the direction of the U.S. economy abounds. On Tuesday, January 22, 2008, the Dow plunged 464 points before rebounding slightly at the end of the day, down “just” 128 points to 11,971.19—its worst close in more than a year. Markets around the world followed suit, with Japan’s Nikkei stock exchange falling nearly 6 percent and Hong Kong’s Hang Seng index losing almost 9 percent.

That same day, Benjamin Bernanke, chairman of the U.S. Federal Reserve (the Fed), responded to the impending free fall by lowering the federal interest rate by three-quarters of a percentage point. (The Fed is a quasi-public system charged with–among other things–oversight of the nation’s central banking system and setting interest rates on money it charges commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility—“the discount window.”)

The emergency reduction—the first since the 9/11 attacks—was intended to jump-start the economy by stimulating borrowing, spurring new home construction, and encouraging consumer purchases of durable goods. The lower interest rate could also benefit some homeowners with adjustable-rate mortgages.

Some economic analysts, however, chalking up the decrease to a panicked response to a deeper crisis in the financial markets, are not convinced such actions will result in a lasting economic turnaround.

Despite initial skepticism over the efficacy of the Fed’s cut, markets strongly reacted to the adjustment. Last Wednesday, on the second-heaviest day of trading to date, the Dow industrial average posted a 2.5 percent increase, to close at 12,270.17. John B. Taylor, the Hoover Institution’s Bowen H. and Janice Arthur McCoy Senior Fellow, said the size and timing of the cuts are crucial. “The rate cut is more than what was expected, and it is coming earlier than expected,” Taylor said.

Robert E. Hall, the Hoover Institution’s Robert and Carole McNeil Hoover Senior Fellow and chairman of the National Bureau of Economic Research (NBER), adds that the jury is still out over whether or not the United States is in, or will enter, a recession soon. “Our ability to forecast these things is extremely poor,” he recently stated in an article for the Wall Street Journal. “Lots and lots of people have talked about recessions when they didn’t occur.” Yet reason for optimism, according to Hall, is thin, “At best the economy is flat right now. It stopped growing.”

Highs and Lows

Last December, Hoover senior fellow Michael J. Boskin warned that economic conditions indicate that “the risk of recession is growing.” Boskin, a former chairman of the President's Council of Economic Advisers, also noted the combination of the subprime mortgage crisis, falling home prices, and lagging sales could eventually create a serious drag on the economy. On the heels of the mortgage crisis, reports of increasing foreclosures and other loan defaults caused the stocks of some home builders and financial institutions to plummet. Recently, major banks began reporting significant drops in their profits as they took the brunt of large numbers of loans going into default. Such declines, explain some market research analysts, can create ripples that eventually negatively affect other sectors of the market.

During a recession, consumer confidence often erodes as several negative economic conditions occur simultaneously. Such conditions can include a decline in the stock market, decreases in the production of goods, an increase in unemployment, and a decrease in income. Although the effects of a recession may be obvious, knowing when one is occurring is a much trickier proposition.

Some economists and journalists define a recession as two consecutive quarters (a quarter is three months) in which the gross domestic product (GDP) decreases. The NBER expands on this simple explanation, defining a recession as a period marked by a significant decline in economic activity that is spread across the economy, lasts several months, and is characterized by a downturn in GDP, income, employment, industrial production, and wholesale-retail sales.

According to the NBER, the U.S. economy cycles through regular intervals of expansion and contraction. Typically, the economy expands for period of six to ten years, followed by a recession that lasts, on average, between six months to two years. Economists refer to the beginning of a recession as its peak and the end as its trough. Once a trough is reached, the economy expands toward another peak. The time between peaks is called a business cycle.

The Business Cycle Dating Committee (part of the NBER) measures business cycle expansions and contractions to determine whether or not a recession has occurred. Because the committee relies on a series of economic data to determine the economy’s health, recessions are usually not announced until well after they have begun. Using NBER criteria, the United States has weathered thirty-two recessions since 1854, ten of them between 1945 and 2001.

Fix It or Forget It

Regarding the current economic climate, economists and market analysts disagree over whether the United States is entering a recession, is headed for one, or will skirt an economic meltdown for the time being. The Congressional Budget Office, a federal agency providing nonpartisan economic and budgetary analysis to Congress, predicts that the Federal Reserve interest-rate cut will lessen the problems hanging over the housing and financial markets and that the nation will manage to avoid a recession.

In an effort to avoid deepening financial crises, the Bush administration and Congress presented a fiscal stimulus package worth about $145 billion last week. The plan calls for approximately 117 million people to receive “rebate” checks from the federal government: individuals filing income taxes will receive as much as $600, working couples as much as $1,200, and those with children, $300 per child. (Other elements of the package designed to stimulate the economy reportedly include tax breaks for some businesses and less-expensive loans for those interested in purchasing or refinancing higher-cost homes.)

Despite the bipartisan stimulus effort being hailed by many in Washington, in the financial markets, and in various industries, Hoover research fellow Russell Roberts is skeptical of a package that injects $145 billion into a $14-trillion economy, stating that “stimulus schemes based on giving people money have a poor track record of energizing the economy. Usually, the only thing that gets stimulated is a politician's approval rating.”

Boskin believes that the Federal Reserve—which is scheduled to meet again on January 30, 2008—“should be gradually lowering rates to combat recession risks” but warns “credit conditions will limit the stimulus.” Taylor cautions government officials to exercise prudence when responding to fluctuations in the economy and argues for a “plan that works well in different circumstances.” 

The fate of the proposed stimulus package is currently in question as Senate Democrats introduce new measures to the bill. Proposed changes include rebates for individuals who collect Social Security and an extension of unemployment benefits. The Bush administration has warned that such changes may be met with resistance, resulting in a slowdown of what was shaping up to be a short path toward congressional approval. During Monday’s State of the Union address, President Bush urged Congress to move quickly to reach an agreement. —Michelle Bussenius, Editor