Recession watch: Krugman edition

Paul Krugman is in the bears’ camp for 2007 (thanks to Economist’s View for posting NYT Select content):

Economic Storm Signals

… Before I explain what the bond market is telling us, let’s talk about why the economy may be at a turning point. Between mid-2003 and mid-2006, economic growth in the United States was fueled mainly by a huge housing boom… That housing boom has now gone bust. But the optimists and pessimists disagree both about how bad the bust will get and about how much damage the housing slump will do to the economy…Most, though not all, of the … economic numbers that came out this week were … substantially weaker than expected. Pessimists feel vindicated by the downbeat data. Nouriel Roubini…, who has been forecasting a housing-led recession for some time, … predicts zero growth for the current quarter. Economists at Deutsche Bank say the same thing.

But that’s still a minority position; most forecasters are still telling us not to worry. So whom should you listen to? And how can you avoid believing what you want to believe?

Maybe the best answer is to look at what the financial markets say. Not the stock market, which is a notoriously bad indicator of the economy’s direction, but the bond market. (Paul Samuelson, the Nobel Prize-winning … economist, famously quipped that the stock market had predicted nine of the last five recessions).

Since last summer, when the housing bust became unmistakable, interest rates on long-term bonds have fallen sharply. They’re now yielding much less than short-term bonds. The fact that investors are willing to buy those long-term bonds anyway tells us that these investors expect interest rates to fall. And that will happen only if the economy weakens, forcing the Federal Reserve to cut rates. So bond buyers are, in effect, betting on a future economic slowdown.

How serious a slump is the bond market predicting? Pretty serious. Right now, statistical models … give roughly even odds that we’re about to experience a formal recession. And since even a slowdown that doesn’t formally qualify as a recession can lead to a sharp rise in unemployment, the odds are very good — maybe 2 to 1 — that 2007 will be a very tough year.

Luckily, we’ve got good leadership for the coming economic storm: the White House is occupied by a man who’s ideologically flexible, listens to a wide variety of views, and understands that policy has to be based on careful analysis, not gut instincts. Oh, wait.

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