Wednesday, March 7, 2007

Is the US economy heading into Recession?

Is the US economy set for further growth or is a recession an inevitability for an economy that has been living beyond its means for a long time?

With Alan Greenspan suggesting the US economy has a 33% chance of entering into recession it is worth considering whether this is a realistic prospect or just a controversial parting shot from the 81 year old former Chair of the Federal Reserve. Alan Greenspan is held in high regard as an economist, some even credit him with “saving the US economy”. However his track record on economic predictions is mixed. He did predict a dotcom bubble bursting, (although it was 4 years before it occurred)

Reasons why the American Economy may enter a Recession.

  1. Falling House Prices. After several years of a booming housing market. House prices are now starting to fall in most US states. Falling house prices will have a significant impact on consumer spending. As house prices fall, people can no longer remortgage to have extra capital to spend. Also falling house prices have a significant impact on consumer confidence. As housing is the biggest form of wealth it will adversely impact on the financial situation of most households. [1] America's past growth has been maintained by strong consumer spending, if this falters economic growth is likely to do the same.

  1. House Prices could have further to fall. Looking at historic house price to earnings ratios the average US house price has been overvalued for several years. For the house price to earnings ratios to return to normal, house prices may have to fall by more than 18%. [2] Note the Japanese housing market provides a recent precedent for those who don’t believe house prices can fall for a long time.

  1. Mortgage Lenders going Bust. Due to a record levels of default on sub prime mortgages, the number of mortgage lenders going out of business is at an all time high. [3] This has also changed other financial markets attitude to risk. Banks and stock markets will be much less willing to lend on dubious terms. The net effect is that investment and consumer spending will grow much slower, or even start to fall.

  1. Current Account Deficit. The US current account deficit is currently 6.5% of GDP. [4] For a long time some economists have said there is nothing to worry about. The deficit has been financed by Chinese investors willing to buy US assets, even with a relatively low interest rate. However increasingly Chinese and Asian investors are seeking to diversify out of the US dollar. The dollar is losing its “safe haven” status. Partly because of events in Iraq and Afghanistan but also because of a realisation that the US economy is not as dominant as it used to be in the past. If the Chinese start buying less US securities it will cause a further devaluation in the dollar and also require higher interest rates to attract people to buy sufficient US securities. The higher interest rates will exacerbate any fall in US consumer demand.

  1. Budget Deficit. The US has a twin deficit. As well as a balance of payments deficit. They also have a budget deficit. The effect of this is that it puts upward pressure on interest rates. Higher interest rates are required to attract investors to buy bonds and securites. Having such a large deficit also leaves the government less room for manoeuvre in terms of expansionary fiscal policy. If the US economy does start to slow down there is little scope for further tax cuts and increases in government spending.

  1. High levels of debt. High levels of debt make the US economy susceptible to increases in interest rates. Higher interest rates may be necessary because of the twin deficits and falling dollar. Even a small rise in interest rates could have a significant adverse effect on heavily indebted consumers.

  2. Falling Stock Market. By itself a falling stock market doesn't cause a recession, but it is indicative of the change in confidence and mood of the US economic situation that US share prices have fallen sharply since last week.

Reasons why the US economy may not enter recession.

  1. High Economic Growth. Economic growth is still positive and inflation is under control. Current economic statistics are generally good, despite growth being revised downward. The Fed still expects growth of 2.75% - 3% next year

  1. The Global economy is no longer dependent on US consumers. Economic growth in Asia and particularly China means that there is a growing Chinese middle class who will be increasingly willing to buy US exports in the future. It is possible the trade deficit could change over time. Especially as devaluation makes the US dollar more attractive.

[1] US house price sales fall 17%

[2] US house prices 18% overvalued

[3] US Mortgage lenders going bust

[4] US current account deficit

Other References

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