The Credit Crunch Hits Main Street
A recession appears to have been underway since early this year, as evidenced in
declining employment, rising unemployment, falling industrial output, and reductions
in inflation-adjusted sales of businesses. Recent data leave little doubt that the
recession is deepening.
Auto sales have been headed down all year, and in August fell to 12.5 million at an
annual rate, the lowest level since the recession of 1990-91. Total consumer
spending was bolstered this spring by large tax rebate checks. But a decline in real
consumer outlays began in June that appears to have continued through September;
these outlays probably fell at about a 2-3/4 percent annual rate in the third quarter.
Until recently, the manufacturing sector was holding up well, but durable goods
orders fell significantly in August, and the ISM index for manufacturing plummeted in
September. These signs of weakness probably stem in part from the impact of the
global economic slowdown on U.S. exports. Perhaps a more important reason is that
businesses are cutting back further on their expenditures for new equipment. That is
suggested by the August decline in orders for nondefense capital goods other than
aircraft. Cutbacks in capital expenditures would be expected even in the absence of
the credit crunch, given weaker consumer spending. One of the more reliable
empirical relationships in macro economics is that between consumer purchases of
goods and business spending on plant and equipment.
Employment data for September perhaps provide the most convincing evidence that
the decline in overall economic activity is steepening. The loss of 159 thousand
payroll jobs last month—the ninth in a row—was the largest decline since March
2003. Losses were concentrated in cyclically sensitive areas—manufacturing,
construction, retail trade, temporary workers, and the trucking industry. The
unemployment rate remained unchanged, as the civilian labor force contracted
following a large increase in August. But there were signs of deterioration in the
unemployment numbers: unemployment rose sharply for men in the 25 to 54 year
old age bracket, the nation’s principal breadwinners; the median duration of
unemployment increased, and the proportion of the unemployed who lost their last
job, as opposed to leaving it voluntarily, also rose.
The recent intensification of the credit crunch is thus hitting the economy at a time
when it is weak and vulnerable to a negative shock. Credit markets have been
dysfunctional for more than a year; a credit noose is around the economy’s neck and
it is tightening. Available data make it difficult to know whether the tightening has
reached strangulation proportions. Complete data on the flow of credit are available
only through the second quarter; we know that the credit flow to businesses and
consumers fell 40 percent in the first quarter and 35 percent more in the second. We
know also that the volume of outstanding commercial paper fell in the week ended
October 15th for the fifth consecutive week.
A dramatic widening of spreads between risky and risk-less assets, however,
strongly suggests a much more severe freezing up of credit markets in just the past
few weeks. Anecdotal evidence does also. Anecdotes are always hard to appraise.
One never knows whether the tale of woe one hears is fifth hand and badly distorted
from the original version, or whether it is a special case rather than a more general
problem. But when the House voted down the Administration’s rescue package
earlier, it began to be bombarded by e-mails and phone calls warning that auto
dealers were unable to find credit to finance inventory purchases, that prospective
home buyers were arriving at the settlement table only to discover that their loan
was cancelled, that individuals were having their home equity lines cut off, and that
state and local governments were worried that they might be unable to roll over
their short-term debt obligations. Unless these anecdotes are a huge exaggeration,
and the extraordinary behavior of credit spreads suggests they are not, the credit
crunch has brought the real economy to the edge of the abyss.
Now that the $700 billion rescue bill has been passed, the question is: Will it work? It
has a chance, aimed as it is at the root of the problem that is clogging up the credit
markets—namely, a vast quantity of troubled mortgages on the books of financial
institutions around the globe whose value is hard to determine. It will probably be a
few weeks before the Treasury can assemble a team of financial experts,
accountants, and lawyers to put the program in operation. There will need to be
some experimentation with pricing and other procedures in reverse auctions.
Negotiations with individual financial institutions whose capital ratios have fallen to
unacceptably low levels and need immediate help to get seriously nonperforming
assets off their balance sheets may proceed slowly. So, it may be a while before any
clear evidence emergences of how well the program is working.
In the weeks just ahead, therefore, financial markets will likely remain unsettled,
and the Fed may have to continue to expand its loans to distressed borrowers to
keep liquidity problems from becoming solvency issues for financial institutions with
their backs to the wall. The bill gave the Fed a new tool to do so by permitting
payment of interest on reserve balances. This will permit the Fed to expand its
balance sheet while maintaining control over the federal funds rate, setting that rate
at the level deemed consistent with its objectives for the macroeconomy.
It would be unrealistic to expect this bill to be a panacea for the economy’s current
financial and economic problems. But, hopefully, it may be enough to encourage a
gradual thawing in credit markets that will keep the current recession from becoming
one of the longest and deepest of the postwar period.
That is what this month’s forecast assumes. GDP growth is expected to be negative
in the fourth quarter of this year as well as the first and the second quarters of next
year, and then to begin moving gradually upward during the second half of next
year. The economic news of coming months will not make for happy reading.
Employment declines will get steeper—monthly declines of 250 to 300 thousand may
be in the works. By the end of next year, the unemployment rate will probably be
close to eight percent and remain elevated before heading down again in late 2010.
When our economy in the past has experienced clear recessionary tendencies, the
Federal Reserve has come to the rescue by lowering interest rates. The Fed already
cut interest rates by 50 basis points earlier this month and an additional cut or more
is expected. These measures will be of significant help in assisting the economy to
get back on its feet only if conditions in credit markets improve. Reductions in the
funds rate help stimulate economic activity when they lower private costs of
borrowing, increase the availability of loans to consumers and businesses, and boost
the stock market. Those things probably would not happen if strains in financial
markets remain as acute as they have been recently.
In his testimony before the House Budget Committee on October 20, Federal
Reserve Chairman Ben Bernanke voiced his support for a second economic stimulus
plan, indicating that he believes that monetary policy alone won’t be sufficient to
stimulate the economy. Bernanke said that the economy will be “weak for several
quarters,” with "some risk of a protracted slowdown.” He said the fiscal stimulus
should be timely and should target areas that will help improving access to the credit
So far unprecedented coordinated actions by central banks seem to help thaw the
frozen credit markets, albeit gradually. Libor rates and commercial paper rates are
declining, but it is critical that they ease further to restore confidence and increasing