Steering into economic headwinds

Critical choices ahead

Depending on what Obama and Congress do, economists see three fiscal scenarios - and only one of them is good

By Robert Gavin
Globe Staff / January 11, 2009
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The massive economic stimulus package that Congress will soon debate could determine whether the nation finds a path to recovery or spirals into a depression that could last years, analysts say.

President-elect Barack Obama, who takes office this month, is proposing spending about $800 billion for tax cuts, state aid, and public works projects to stop a rapid economic slide. In the last two months alone, US employers have slashed 1.1 million jobs, sending the jobless rate above 7 percent for the first time in more than 15 years.

The speed of the economy's deterioration has stunned economists and led to comparisons with the Great Depression, when a financial panic dried up credit, destroyed confidence, and led to sharp declines in consumer and business spending.

Allen Sinai, chief economist at Decision Economics, a Boston financial market advisory firm, estimates the chances of a depression at 15 to 20 percent. But that, he said, "is not a trivial possibility."

The current crisis began in the US housing market, spread to Wall Street, and disrupted credit markets, creating a credit crunch. Consumer spending is contracting for the first time in nearly 20 years, and the government, primarily through the Federal Reserve, has pumped trillions of dollars into the financial system to prevent it from freezing up.

Now the Fed needs additional help in the form of government stimulus spending, analysts said. Depending on the size and shape of the Obama package, and the speed with which it's enacted, the economy could head in any direction: a depression, a recovery, or a period of anemic growth.

The worst case for the economy, as described by economists, begins with Congress dickering, delaying, and delivering a smaller stimulus package filled with special-interest spending aimed at winning votes rather than providing the most economic impact. In that case, economists said, confidence takes another hit, and the downward economic spiral continues.

Consumers pull back and cut spending, which hurts corporate profits, which leads to more layoffs, which drives consumers to cut spending more. The housing market plunges further, leading to more foreclosures, which further undermine financial and credit markets. Banks stop lending.

A destructive, downward spiral of prices gets underway. Businesses slash prices to attract buyers, who stay on the sidelines waiting for prices to fall further. Inventories build, businesses cut production, and more workers lose jobs. Consumers cut spending more, and the cycle repeats.

The downturn deepens for two more years. Employers cut 3 million jobs this year, and millions more next year. Unemployment hits double digits; 12, 13, 14 percent. Nearly 20 million Americans are out of work, compared with about 11 million today.

Such a long, deep, and sustained downturn would qualify as a depression, analysts said, although not as severe as the Great Depression, when unemployment soared to 25 percent. "It is not hard to get to a dark scenario," said Mark Zandi, chief economist at Moody's Economy .com.

On the other hand, Zandi said, "It's not hard to get to a brighter scenario." That also begins in Washington, where Congress quickly passes and Obama signs a stimulus package of $800 billion or more by early February. Tax cuts are directed at those most likely to spend, namely lower-income families, and benefits are extended or even increased for the unemployed, who are also likely to spend the money quickly.

With this spending providing an initial lift, hundreds of billions of dollars goes to states to avoid deep budget cuts and layoffs, and pay for public works projects that create jobs, putting a floor under the eroding labor market. Perhaps more important, big, bold and decisive action by the new president and Congress gives confidence to consumers and businesses that worst will soon be over.

This improved confidence combines with historically low interest rates to revive private spending. Potential home buyers, less anxious about jobs, come off the sidelines and start buying, enticed by bargain home prices and mortgage rates below 5 percent. The housing market stabilizes, and so do assets tied to housing, such as mortgage-backed securities, held by many financial institutions.

The improving housing market helps financial and credit markets rebound. Banks increase lending. Mortgage loans are made, homes are bought, and a recovery cycle is underway.

Businesses, sensing a recovery in consumer spending, position themselves for an economic rebound. Low interest rates entice firms to buy equipment and expand plants. They hold onto workers, and begin to hire more. A recovery gets underway in the second half of this year, with unemployment peaking below 8 percent.

"A big stimulus," said Christian Weller, public policy professor at the University of Massachusetts-Boston, "has the potential to be a game changer."

Most likely to happen, economists said, is that the stimulus package will merely keep the US economy in the game. The massive government spending will help stop the rapid deterioration. But if there's any economic growth in the second half of the year, it won't be much.

With anemic growth, businesses won't do any significant hiring. Unemployment will rise into 2010, peaking at about 9 percent and hovering there through the rest of next year. Many economists don't expect the jobless rate to decline significantly until 2011.

A crucial reason: Consumers still have far to go to repair household balance sheets. Households borrowed heavily in recent years against rising stock and home values, and now that these bubbles have burst, they are left with weighty debts to pay off. The net worth of US households, calculated by subtracting debts from assets, has plunged by $7 trillion, or 11 percent, over the past year, according to the Federal Reserve. That means consumers, who account for about 70 percent of US economic activity, are likely to continue to cut back.

"The whole economy has to do some belt-tightening," said Edward Leamer, director of the Anderson Forecast at the University of California at Los Angeles. "We have to prepare for the future the old fashioned way. By saving."

Robert Gavin can be reached at

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