The worst is not over

The worst is not over

For years economists and policymakers have worried about the fragility of the US economy, and particularly about the unsustainability of the US housing boom, but when the shock finally occurred, everyone—central banks, commercial banks, hedge funds, private investors—appears to have been unprepared.

Investors tend to imagine that the world will continue to be approximately like it is now. Before the US Federal Reserve reduced the benchmark interest rate by one-half percentage point on 18 September, financial markets were in despair; afterwards they were euphoric. Such myopia is dangerous. So far, economic activity—production, employment, consumption, investment and trade—have remained largely unaffected by the credit crunch. Many seem to believe this will continue. Equally dangerous.

If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent US home foreclosures, nor will it eliminate the glut of unsold homes. If US house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending.

The fall in demand will aggravate the rise in unemployment, hurt the US stock market, and thus lead to a further fall in spending.

Meanwhile, it is worth keeping in mind that the US is not the only country where house prices have risen much faster, on average, than national incomes. House prices in Australia, Britain, Denmark, France, Ireland, Spain and Sweden have all increased faster, over the past 10 years, than in the US. Of course, the US is a special case on account of its subprime mortgage lending towards the end of its housing boom.

But the danger of international contagion remains. The US housing slump may well lead investors in Europe to reassess the value of their properties. If that happens, then consumption spending is likely to fall in the countries listed above, leading to weaker labour markets.

This could happen at a time when the Chinese economy has overheated and will need to slow down, and when the Japanese economy is stagnating. There are no other countries to take up the slack, to serve as a “motor" for the world economy, as the US has done for so long.

In short, a recession in the US is possible and this recession could spread to other countries, primarily through the loss of confidence within financial markets and house price contagion.

Even if times ahead are troubled, the long run is likely to look much more settled. In the short run, a housing slump could well make private investors and central banks outside the US less eager to hold dollars. A survey by the US treasury department last year indicates that about one-third of foreign-held US corporate debt consisted of asset-backed securities and about half of that was mortgage-related. Petrodollars held in West Asia and Russia are particularly mobile. Once foreign money leaves the US, the dollar would fall. In the longer run, US exports would rise, shrinking the huge US trade deficit. Moreover, recession in the US would lead to lower imports, further reducing the trade deficit. At the same time, China may well let the yuan rise against the dollar, leading to a rise in its domestic spending relative to its exports. Once US consumers spend less and Chinese consumers spend more, the large global imbalances, which have cast a shadow on the world economy for the past decade, would begin to disappear.

Dennis J. Snower is president of the Kiel Institute of World Economics. This excerpted article is published with permission from Comment at