No historical reason why recent turmoil should spark a recession
The stock market, somebody once said, has accurately predicted nine of the past three recessions. In these testing times of market mayhem, that thought may sound a little like whistling to keep your spirits up. But if you ponder the historical connection between financial events such as the one the world experienced last week and life in the real economy – employment, incomes, consumer spending – you’ll find no clear link at all between the two.
It is certainly the case that, in a modern developed economy that has been cruelly starved of real economic misery for years now, financial journalists love these moments in the gloomy spotlight. They can wax lyrical about the fundamental flaws in our system and prognosticate portentously on our inevitable economic ruin. The rest of us should take the longer view.
It is true that once, a long time ago, financial panics led more or less directly to broader economic distress. In fact, in the classic credit cycle, a meltdown in financial markets was more or less a standard precursor of recession. But in the past 20 years, as that old saying about the stock market and recessions goes, there have tended to be far more financial panics than economic slumps. Take the past three great market dislocations before last week’s: the stock market crash of October 1987, the credit squeeze of August to October 1998 and the financial distress in the immediate aftermath of September 11, 2001.
The Great Crash of 1987 turned out, in economic terms, to be a Small Bump. Despite almost universal fears that we were in for a modern version of the Great Depression, the economy carried on regardless. (The stock market carried on regardless, too, by the way.) A recession did come, but not until after another ten quarters of rapid growth, and when it did it was a classic postwar boom-and-bust story – inflation took off and had to be reined back by interest-rate increases.
The 1998 panic was a more complex event, caused by a sudden turnaround in sentiment in credit and currency markets that wrong-footed a sizeable number of investors. It was described, without hyperbole, by people caught up in it as the worst freezing of the financial system in more than 50 years.
But again what followed, in economic terms, was minimal. In 1999 and 2000, in fact, the US and global economies recorded their strongest growth in a decade. A recession came, sure enough, but not for another 2½ years. The post-September 11 crunch was much shorter, but for a while it induced a similar amount of Cassandra commentary in the media. Yet its connection with the real world was so weak that it actually marked the end of a US recession, not the beginning of one.
Let me be clear: I am not saying that there is no connection between financial markets and the real economy. Banks and financial institutions are arteries of the global economy. If arteries become clogged, the potential damage can be enormous. What I am saying is that there is no inevitable connection between a financial market mess, such as the one we have now, and a necessarily unpleasant consequence for people whose only interaction with a financial institution is their monthly bank statement. A critical reason that none of these recent past events caused a real economic crisis was the policy response. In 1987 the Federal Reserve cut interest rates three times in six weeks. In 1998 the Fed cut rates three times in seven weeks. In 2001 the Fed cut rates three times in seven weeks – and further thereafter. Spot a pattern?
Timely reaction by the central bank is critical to shielding the broader economy from a crisis. We won’t know for a while yet whether the Fed’s actions so far – including last week’s discount rate cut – will prove to have been timely. But we know now that the Fed is fully alert to the dangers – and hinted last week that it is ready to cut its key federal funds rate at its next scheduled meeting on September 18, if not before.
Of course, even Fed action may not be enough this time. A key difference between now and previous crises is the level of uncertainty. No one really knows exactly where the fallout from the US mortgage crisis lies. There are worrying signs that this may be making banks and other lenders even more cautious this time and reining in lending even to creditworthy customers.
But I suspect that, given a supportive environment by the Fed, this will not last. As others have noted, the scale of the real problems in the US mortgage market, though large in nominal terms, are still only a small fraction of the total housing sector, let alone of the broader US economy. That suggests there are real opportunities out there for bold investors. And markets being what they are, I would be surprised if such investors did not seize them quickly.
Of course, it is possible to argue that the policy response to previous financial crises has adversely affected the economy in the longer term. By cutting interest rates aggressively each time, the Fed has made financial conditions too easy – on each occasion leading to an inflationary surge or a credit boom that proved unsustainable. That is a risk that a central bank has to take. But the history of the past 20 years suggests that it is a rather small one.