The odds of economic meltdown

With interest rates and oil prices rising and consumers spending beyond their means, we may be headed for recession -- and worse.

By Brad DeLong

Read more: Opinion

Aug. 3, 2006 | Forecasting recessions is a fool's game. If there is enough solid economic information to make it appear highly likely that a recession is coming -- that production, employment and consumer demand will actually fall -- then it is highly likely that there already is a recession. Businesses are not stupid, and they don't have to wait for economists to tell them what they already know. By the time a gloomy forecast has been issued they've probably already noticed a drop in consumer demand and responded by firing workers and reducing production.

So: Never say that a recession is coming. Say only that a recession is here, or that there might be a recession on the way. Which, in fact, is what I'm saying today. As of the beginning of August 2006, a recession is not here, and I'm not going to violate my own rule by saying one is coming. But there is a good chance -- for the first time since 2003 -- that there might be a recession in progress six months from now.

Why? Three factors: 1) A Federal Reserve that finds itself with less inflation-fighting credibility than it thought it had; 2) upward pressure on inflation from rising energy and, perhaps, import prices; and 3) millions of middle-class homeowners who for too long have treated their houses as gigantic ATMs, using home equity loans and refinancing to generate extra spending money.

First, the Federal Reserve, now chaired by Bush appointee Ben Bernanke. The Federal Reserve sets interest rates, and when it does it tries to hit the economy's sweet spot: that point that produces maximum employment, purchasing power and growth without generating enough upward pressure on prices to produce expectations of inflation. The Federal Reserve does this by pushing interest rates up and down. Push interest rates up and businesses find it more expensive to expand capacity and production, causing them to cut back on investment spending. Push interest rates up and households' balance sheets deteriorate, causing them to cut back on consumption spending. Push interest rates down and firms find it cheaper to expand capacity and production, and so they ramp up investment spending. Push interest rates down and households find their balance sheets looking better and feel flush, expanding consumption spending.

There is one major complication: what Milton Friedman calls the "long and variable lags" in the system. Every action the Federal Reserve takes now affects production, demand and inflation roughly 15 months in the future. What the Federal Reserve has done in the past 15 months has not yet had a chance to affect the economy.

This leads to the Federal Reserve's current dilemma. The last two percentage points' worth of increases in interest rates -- increases in interest rates that will in the end make businesses cut back on investment spending and households feel pinched -- have not yet had a chance to affect the economy. Because of "long and variable lags," they are still "in the pipeline." When they emerge from the pipeline they will slow the economy further. By how much? Nobody is really sure.

In this situation it seems reasonable that the Federal Reserve should stop raising interest rates. Waiting to see what the interest-rate increases of the past couple of years will do to the economy would be a prudent strategy. Indeed, since last December the Federal Reserve has been quietly signaling that it is about to "pause," to adopt such a wait-and-see strategy. Yet so far it has not done so. Why not? One important reason is that the Federal Reserve is scared that if it pauses too soon it will convince many observers that it is not truly serious about fighting inflation -- and a central bank has a hard time fighting inflation if businesses, speculators and workers ever conclude that it is not truly serious.

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