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The Conference Board Review® Article
Crossing to Safety
Gail Fosler is president and chief economist of The Conference Board. She has written an economic-forecast article for the January issue each year since 1991; this is her final installment.
The financial turmoil of 2007 has opened a new chapter on the ongoing global expansion, with a revised scenario: Rather than rapid growth, low interest rates, and a benign economic outlook, the financial world is turned upside down and the United States comes out the worse.
The direction of concern is right, but the focus is wrong. The global economy is filled with imbalances, and the United States by no means holds the monopoly. As 2008 progresses, it will become clear that emerging-market growth and the accompanying commodity cycle are unsustainable. The fall of these iconic symbols of the new twenty-first century may be much more disruptive to financial expectations and growth than the subprime crisis was in 2007. Interest rates, already low, will head lower; the U.S. dollar, at a low point, will rebound.
These events are not themselves an apocalyptic alarm bell for the global economy. Although today's heightened financial-market volatility and risk aversion are early signals that it is getting later and later in the day for this economic expansion, plenty of shoes must drop before conditions are in place for an outright recession.
It will take a number of large financial disappointments to adjust valuations and expectations to a level consistent with long-term sustainable growth. The disappointments and corresponding adjustments tend to be greatest in those sectors and geographies with the greatest concentrations of optimism.
The past year was turbulent indeed. The subprime crisis introduced the realization that the very financial technology that had promised an end to the era of risk itself had introduced new and incalculable risks that caused important short-term asset markets to cease to function. Thus, although the subprime phenomenon affected about $1.3 trillion — or 14 percent of the overall U.S. mortgage market — short-term credit markets seized up.
A relevant lesson for this discussion is not that financial innovation is not to be trusted — rather, it is that imbalances and instabilities can become evident long before their actual financial effect takes hold. In the subprime case, for example, housing activity began to weaken in the beginning of 2006 and was falling at a 10 percent annual rate in the first half of 2007 — months before markets downgraded subprime mortgages. Prices showed signs of weakness as early as May 2006.
Subprime was a tempting source of yield in a field of low-interest-rate alternatives. Although default rates are high (16 percent) by mortgage-market standards, they are reasonably predictable. Unfortunately, subprime mortgages fueled the housing bubble in 2005 and 2006, and its popping — with price declines accompanying the slide in housing activity in highly leveraged markets such as California, Nevada, Arizona, and Florida — has led to an explosion of defaults.
Thus, the most damaging ramifications of the subprime crisis have been not in the housing sector itself but, rather, in the financial system, and on bank profits, liquidity, and credit availability. Recent Federal Reserve surveys indicate that almost 20 percent of all banks have tightened credit standards. Average home prices have fallen faster than would otherwise be the case because "jumbo"mortgages are particularly hard to get, creating disproportionate stress in the high end as well as the low end of the housing market.
Were the housing-market effects to be the only impact, the subprime problems would be less serious. But the rise in defaults in this asset class has cast a shadow on a wide range of financial products that were structured with a mix of assets to create specific risk-and-return characteristics and, more to the point, on special investment vehicles that banks maintain "off-balance sheet"to hold these investments. In this uncertain environment, it is hardly unsurprising that banks are uneasy about other banks' creditworthiness. Central banks have had to add cash to the interbank market in both the United States and Europe to keep it functioning smoothly and are considering regulatory moves to maintain bank liquidity while sorting out where the bank profit and capital problems really lie.
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Return to the January/February 2008 The Conference Board Review® issue.
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