EVENTS

Date:	Monday, July 21, 2008
Time:	2:00 PM -- 3:30 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

Recessions That Occur alongside Credit Crunches and Asset Price Bubbles Are Longer and Deeper, Study Finds

WASHINGTON, JULY 21, 2008--The current U.S. economic slowdown has brought forth familiar doomsday predictions. Former Federal Reserve chairman Alan Greenspan wrote in a recent Financial Times op-ed that "the current financial crisis in the United States is likely to be judged the most wrenching since the end of the Second World War." Resident scholar Vincent Reinhart opened an AEI conference Monday noting that his recent encounter with a book about Nostradamus may be "an omen." While humorous, Reinhart's comments reflect many dark predictions about the economy.

In the midst of these predictions, a forthcoming paper by scholars at the International Monetary Fund (IMF) looks at prior recession episodes that were tied to conditions similar to those in the United States today. IMF economist Dr. Stijn Claessens, who co-authored the paper with M. Ayhan Kose, and Marco E. Terrones, presented its findings to AEI. The paper seeks to classify recessions by their connections to other economic events to see if those events are correlated to changes in the behavior of the recession.

The authors examined data from recessions in twenty-five Organisation for Economic Cooperation and Development (OECD) countries from 1960 to present. They found that recessions that occurred alongside credit crunches and asset price bubbles were longer and deeper than other recessions. Currently, the United States is experiencing a credit crunch caused by tightened lending by banks due to defaults on many subprime loans and an asset price bubble as home prices tumble.

Dr. Claessens noted that housing prices often fall during U.S. slowdowns but that the current decline is much deeper than usual. "Residential investment is down much farther than we have seen before. This is much steeper than typically observed," said Claessens.

"To use a baseball metaphor, we are probably in the third inning of this game," said AEI resident scholar Desmond Lachman in reference to the current economic slowdown. Discussing the findings presented by Claessens, Lachman argued that the current slowdown could be long and deep. He stressed that housing prices have risen between 40 to 50 percent above their long-term trend during the price boom and he speculated that a drop in home prices of 30 to 40 percent could be realistic. Lachman also noted that the combination of a high inventory of unsold homes and rising foreclosures is flooding the market and is sure to keep home prices low.

Lachman then warned against comparing the current slowdown to a broad range of recessions as the authors have done in their paper. "These shocks are not normal shocks by historical standards. We might not compare these to the average but to once-in-a-generation events" he said. When asked about cases in which credit crunches and asset price bubbles occur simultaneously, Claessens noted that the ensuing recessions are often worse but that the rarity of this combination prevented statistical inference.

Angel Ubide, director of global economics at Tudor Investment Corporation and a former IMF economist, agreed with Lachman that the United States faces an atypical situation but stressed the resilience of market economies and other sources of strength worldwide.

"We seem to be living in a world where the rest of the world can continue to move on even if the United States slows down," said Ubide. Ubide explained that the ability of other global economies to maintain growth as the United States slows should not be lamented as a loss of American power but rather as an opportunity for the United States. He continued that under these conditions "the United States can worry about solving its own problems with less worry about their effect internationally."

While Claessens stressed that the paper does not draw causal inferences and was not designed as a predictive tool, he did point out similarities in previous policy responses. Interest rates tend to decline during a recession, as central banks pursue a more accommodative monetary policy. Yet fiscal policy responses and their effects vary widely. Lachman agreed, citing the current $150 billion stimulus package as an important but temporary buoy for the U.S. economy.

Claessens, Lachman, and Ubide all admitted some degree of uncertainty going forward. While expressing optimism, Ubide cautioned that spillovers to the global economy could lead to an international recession. Lachman noted that spillovers are already occurring in places like China, where monetary policy is tied to that in the United States through a monetary peg and large U.S. foreign reserves.

Claessens took the more restrained view that "there are signs of a slowing economy but also aggressive monetary policy. So it is not clear if it is a mid-cycle slowdown or a recession."

--ADAM PAUL

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