Recession hinges on coping with credit crisis

updated 3:27 p.m. ET Nov. 12, 2007

No, it's not just you — the U.S. economy really is bewildering. The government says gross domestic product expanded at an annual rate of nearly 4 percent in the third quarter, the fastest pace in a year and a half. The stock market is still up by 4 percent for this year, despite a sharp 3 percent drop on Nov. 7. On the other hand, growth in consumer borrowing slowed unexpectedly in September. Some economists argue that the U.S. is teetering on the brink of a recession, if it isn't in one already.

Oil has exploded to nearly $100 a barrel, gold is near an all-time high, and the cost of food is soaring. It seems like high prices are breaking out all over, right? Yet the core rate of inflation is less than 2 percent a year, according to one widely followed measure. Confusion reigns right on up to the Federal Reserve, whose interest ratesetters are openly disagreeing about whether more cuts are needed.

Step back a little, though, and the situation becomes clearer. What we're observing, in all its bizarreness, is the ancient paradox of what happens when an irresistible force meets an immovable object. The irresistible force in this case is the U.S. economy, which has managed to expand through all kinds of adversity for more than 15 years, aside from one brief recession in 2001. The immovable object is a wall of debt that accumulated during several years of profligate lending and now can't be paid back. The risk has increased for a generalized credit crunch that puts both borrowers and lenders in dire straits.

So, either the U.S. economy will overcome the debt crisis and keep growing, or it won't. It's that simple — and that important, with millions of indebted homeowners struggling to stay above water, the stock market seesawing uncertainly, and just a year to go before the next President is elected.

The big picture
You can't know for sure how all of this will turn out, of course. But by focusing on the big picture rather than the minutiae, you can at least know the key questions to ask and the crucial indicators meriting your attention. These range from widely followed measures like the rate of home sales and the monthly survey of household jobholding to obscure ones like the risk premium on loans between banks.

What makes the economy even more unpredictable than usual is that the main threat to growth, a credit crunch, emanates from deep within the financial system. That's not something economists understand well, especially given the complexity of today's high-powered and globally interconnected financial markets.

The closest analogy is the credit crunch in the early 1990s, when bad commercial real estate loans damaged the banking system. Lending to businesses virtually stopped, and Citicorp nearly went bust. At the time, economists disagreed about how badly the bank problems would hurt the U.S. In fact, such worries played a

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role in the 1992 Presidential election, when Bill Clinton's campaign made famous the slogan: "It's the economy, stupid." But after government statisticians finished revising their data years later, the growth rate at
the time of the 1992 vote actually turned out to be well above 4 percent.

So which will it be this time — strong growth or a plunge off the edge? The first place to look is the housing market, where the lending excesses were most extreme. Don't focus on falling home prices. Instead, watch for whether the pace of sales picks up in response to price declines. It's good news for the economy if more houses get sold. Sales of new homes mean more work for carpenters and plumbers. Even sales of existing homes generate jobs for real estate agents, closing attorneys, furniture salespeople, and others. It's bad news if prices and sales fall in tandem because it could mean potential buyers are fearful of even bigger price declines. In fact, that's exactly what seems to be happening. The September sales pace for existing homes was down 19 percent from a year earlier, even though the median price was off 4 percent. Goldman, Sachs & Co. economists said on Nov. 7 that California, the epicenter of the subprime earthquake, "seems to be sliding into recession," and Florida and Nevada are probably already in one.

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