Wednesday, February 20, 2008
the nature of the recession
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. ...
... [T]hese 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.
the upshot is that feldstein is calling this nascent recession a different animal than any we've seen in a long time. it isn't just that the fed, having not started the bust, can now not stop it -- rate cuts will have some effect. it's that housing is a critical rate-sensitive transmission by which low policy rates can be converted into real economic activity -- and it is broken and will stay that way for some years under a mountain in liquidating inventory. and that banks, the engines of ordinary credit creation, are already capital impaired and staring down the prospect of further writedowns yet unwritten -- significant lending expansion short of recapitalization is very unlikely. and that the shadow banking system is broken, in what prudent bear's doug noland calls the breakdown of wall street alchemy -- the credit bubble was made possible by a securitization boom that will not be repeated. even after the credit market paralysis that dominates the current state of affairs passes, these things will continue to be true.
all these things combine to paint a highly deflationary picture -- a realization that is slowly gaining traction -- with potential catastrophic episodes interleaved.