Recession in 2007?

Nouriel Roubini predicts a recession in 2007. His argument in a nutshell:

First, consumer confidence is sharply down as consumers are in a foul mood…

Second, all indicators of the housing sector show not just a slowdown, not just a slump but an outright rout in the housing sector…

Third, consistent with this housing rout, lending indicators - both for housing and consumer loans - are also headed south…

Fourth, car sales are now falling in real terms…

Fifth, other business cycle indicators are also signaling weakness ahead: the Empire State business index, a leading indicator, is sharply softening; inventories are up and figures for May and June have been revised upward…

Big imbalances always trigger predictions of looming catastrophe. When budget deficits started getting huge in the 1980s economists were always predicting recession right around the corner. Ditto when the stock market boomed in the 1990s and today with the housing boom and huge trade deficit. Of course, a recession did occur at the end of the 1980s and in 2001, so the worryworts were vindicated. And there will be a recession some time in the future. But as they say, even a broken clock is right twice a day.

In the U.S. today there are two big imbalances: consumers are spending more than they are earning (i.e. the personal savings rate has been negative for the last five quarters), and the trade deficit is huge and growing (currently around $800 billion, or around 6 percent of GDP. These imbalances are not sustainable; eventually consumption will have to rise to stabilize consumers’ debt levels, and eventually our economy will have to begin to export more or import less to stabilize the U.S. debt level vis a vis the rest of the world. Some back of the envelope calculations suggest that for the personal savings rate to rise back even to its historically low level of 2000 would require a reduction of about $300 billion (just over 2% of GDP) in consumption expenditures. This same reduction in consumption expenditures would be sufficient to reduce the nation’s fraction of GDP devoted to consumption expenditures from the current level of 70% to a more historically normal level of 67 to 68%. While this amount of reduction in consumption expenditures – even if it came wholly out of imports – would eliminate less than half of the trade deficit, it would at least move the economy out of the potential crisis range.

Two questions arise: how might consumers be persuaded to reduce consumption expenditures by $300 billion, and how would the economy adjust to a $300 billion dollar reduction in consumption expenditures? The answer to the first question is, consumers will not change their behavior under persuasion; only brute force will make it happen. The most likely scenario is a decline in housing prices and the stock market, which would remove the props that have allowed consumers to live beyond their means for the last few years. The answer to the second question is, we don’t know. If $300 billion in demand suddenly appeared from other sources to compensate for the decline in consumption, the adjustment would be smooth. But no such sources of demand pop readily to mind. It’s unlikely that foreign demand for US exports will rise by that much even if the dollar depreciates in coming years, especially if other countries are seeing their export revenues fall because of a decline in US imports. There will be no help from the federal government given the current state of the budget. There’s always a chance that there’ll be a big investment boom such as that triggered by the internet in the 1990s, but that is hardly guaranteed. So at this point, the most likely effect of a large drop in consumption expenditures is a recession. That’s why Nouriel Roubini should not be the only one who’s worried about the state of the U.S. economy.