Q. NBER, the group you direct, announced earlier this month that the U.S. economy began contracting a year ago, in December 2007. That means it's already the third-longest recession since World War II, following two 16-month recessions in the 1970s and 1980s. Given that many of the leading economic indicators signal more weakness ahead, just how bad is this going to get?
A. Many signals suggest that the current recession is likely to be the longest and the most severe in at least several decades. The NBER Business Cycle Dating Committee, which consists of seven economists who monitor economic indicators on an ongoing basis, identified the turning point as December 2007 - before the array of financial market shocks that have buffeted the U.S. and the world economy in 2008. The economy was in a period of declining economic activity when these shocks hit, and these shocks are virtually certain to prolong and deepen the period of economic weakness. The NBER does not make forecasts, but a number of private sector firms that do suggest that the U.S. unemployment rate, which was 6.7 percent in November, could rise to 9 percent in 2009. If those forecasts are realized, this would be the deepest recession since 1982-3, when the U.S. unemployment rate averaged more than 9.5 percent. The recession of the early 1980s was the deepest on in U.S. postwar history, and it was associated in part with the efforts by the Federal Reserve Board under Paul Volcker to wring inflationary pressures out of the U.S. economy.
Although a deep recession is a serious possibility, it is important to remember that government stimulus, implemented either through monetary policy or through fiscal policy, can have an important counter-balancing effect. The trajectory of economic activity during 2009 and 2010 is likely to depend in substantial part on the course of economic policy.
Q. Many Democrats have seized on NBER's announcement as more evidence of the need for Congress to approve a massive stimulus package - a new New Deal, of sorts. Yet presumably the U.S. would have to finance such spending with an equally massive expansion of debt. At what point do foreigners - who have dutifully loaned America trillions of dollars in recent years so that we could finance our consumption habits when times were good - say "enough's enough"? If they balk at lending us more, what then?
A. The short-run fiscal stimulus that began this year with the TARP program to rescue financial institutions, and that seems very likely to expand under the new administration in 2009, could push the measured federal budget deficit to close to one trillion dollars - about 6 percent of our GDP. While that is a dramatic change from recent years, when the federal deficit was less than $200 billion, it is not uncharted territory. The U.S. experienced similar-sized deficits for several years in the mid-1980s, and we begin this period with a lower ratio of government debt to GDP than many other large developed countries. The fact that the current financial crisis is global in nature has also led to a "flight to quality" in financial markets, and U.S. Treasury securities are viewed as the safest securities in the world. Thus at least for the moment, there does not seem to be much risk that foreign lenders will precipitously reduce their demand for U.S. government debt.
The auction of Treasury four-week notes on Dec. 9 provides some indication of the market's appetite for U.S. government securities. The Treasury securities sold at a zero interest rate - investors were prepared to lend to the federal government for four weeks in return only for a promise that they would get back their principal when the loan was due. Yields on long-term Treasury bonds are also currently low, even though market participants foresee substantial borrowing in the next few years.
One caution should be kept in mind when evaluating reports about the federal deficit, particularly the deficit connected with the TARP program to assist financial institutions. The federal government is making loans and providing subsidies to an array of firms, but it is in return collecting equity stakes or other securities issued by these firms. These claims have value, although it is difficult to judge that value today. The net cost to the federal government of rescuing financial institutions is likely to be substantially smaller than the gross cost of the loans, because the claims that the federal government now has on these firms may be sold at some future date. In some historical cases when the federal government stepped in to help troubled firms, and received an equity stake in return, the rescue operation netted a profit for the U.S. Treasury.
Q. What, if any, early signs should we be watching for to indicate that the worst has passed and the economy is rebounding?
A. I would look at the housing market. The financial crisis began with weakness in the housing market and a corresponding drop in the value of mortgages held by banks and many other financial institutions. The U.S. has been through a period of excessive leverage in which borrowing supported a wide range of investments, ranging from homes to exotic financial securities to consumer durables, and we are now witnessing a "deleveraging" in many markets. Because housing markets are very visible and construction employment is a major, but volatile, component of the aggregate employment, falling levels of housing inventory and stabilizing house prices may be "canaries in the coal mine" for stronger economic times.