Recession watch: Baker

Dean Baker looks back to 2001 for a reality check (note: Canada, unlike the US, did not technically have a recession in 2001) about the reliability of most forecasters:

Virtually all economists missed the 2001 recession, in most cases not even predicting it until it was almost over. The main reason was that the recession did not follow the usual pattern. It was the result of the stock market crash decimating tech investment. All prior post-war recessions had been brought on by higher interest rates leading to a falloff in housing construction and new car buying.

There is a similar situation today. If the economy slides into a recession (my bet), it is because of a crash of the housing bubble. This is one that will also not follow the usual pattern. For this reason, standard forecasting methods are likely to provide bad predictions. Fortunately, we have not had many instances of national housing crashes, so we don’t have much experience on which to predict the course of a recession based on one. (Yes, housing markets are local, but we will have the simulataneous collapse of enough local markets to have a national impact, just as the rise in housing values had a national impact.)

The one thing we can say is that the recovery from a housing crash induced recession will not be as easy as a normal recovery. Youl can’t just lower interest rates and expect a boom in home construction and car buying. As I’ve note before, the Fed used the housing bubble to boost the economy out of the recession that resulted from the collapse of stock bubble. It’s not clear that it has another potential bubble out there.

3 comments

  • I think it might have been useful for Dean Baker to spell out a couple of additional points.

    First, that interest rate cuts have typically not had a big positive impact on non-residential fixed capital formation.

    Second, if U.S. spending needs a boost to offset recessionary pressures, and interest rate cuts cannot be relied upon to do much for housing construction, new car buying, or non-residential fixed capital formation, then either interest rate cuts, open mouth operations, or something else needs to weaken the U.S. dollar and stimulate net exports, or stimulative fiscal policy has to come into play.

  • “You can’t just lower interest rates and expect a boom in home construction and car buying.”
    This comment rather misses the point. The main consequence of a housing crash is a decrease in consumer spending. The most likely cause of such a crash is higher interest rates leading to stretched home owners cutting back on non-essential spending. The effect of a fall in the price of their main asset is to make them feel less wealthy and they are even less likely to spend money.
    Cutting interest rates makes property more affordable encouraging buyers back into the market pushing prices up and at the same time reduces monthly outgoings of consumers giving them more disposable income.
    I can’t see the relevance of whether there is a boom in home construction.

  • Macroeconomics 101 isn’t going to work here. There are a number of key factors that dictate interest rates:

    1) the fed may desire to lower interet rates to stimulate growth. However, this is not the Fed’s mandate. They are there to avoid excessive inflation or delation.

    2) overnight rates do little to influence long-term rates if there is high inflation – bond yields need to be above inflation in order to get investors to buy them. If the bank can’t float low interest bonds, then they cannot loan out at low rates

    3) interest rates impact the dollar value – a weak dollar is typcally propped up by setting treasury yields higher

    In the current environment, (2) and (3) are working against any chance of lower, stimulative rates.

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