Turmoil raises fears of deep recession

0 Comments | Deseret News (Salt Lake City), Mar 22, 2008 | by Martin Crutsinger Associated Press

WASHINGTON -- It's been almost an article of faith: Any recession this year will be mild and brief.

Now the stunning meltdown of a top Wall Street investment bank and stubbornly persistent financial-market turbulence has called that into question, raising fears that severe problems in housing and the nation's bedrock financial system could cripple the economy and wallop many millions of Americans.

No less an authority than former Federal Reserve Chairman Alan Greenspan wrote this week that "the current financial crisis in the U.S. is likely to be judged as the most wrenching" since the end of World War II.

Other noted economists are also sounding alarms. Harvard professor Martin Feldstein, the former head of the National Bureau of Economic Research, said recently he believes the country is now in a recession, and it could be a severe one.

While it will be many months before the bureau's cycle-dating committee, the unofficial arbiter of when recessions begin and end, makes its own ruling, a growing number of private economists already have a downturn figured into their forecasts. They are generally calling for a mild recession that will end this summer, when the economic-stimulus checks going to 130 million households start getting spent.

But the severe credit crisis that erupted last August -- and claimed its biggest victim this past weekend with the forced sale of Bear Stearns Co. -- is raising doubts about those mild forecasts.

"Bear Stearns was a clear wake-up call. It resonates with everybody and highlights the severity of the stresses in the financial system," said Mark Zandi, chief economist at Moody's Economy.com.

What got people's attention was how quickly Bear Stearns, the nation's fifth-largest investment bank, could go from a stock- market value of about $3.5 billion when the market closed on March 14 to being sold at the bargain-basement price of about $236 million two days later.

The Federal Reserve rushed in to take unprecedented actions. It provided a $30 billion line of credit to facilitate the sale and is employing Depression-era provisions that, for the first time, are providing direct Fed loans to investment banks. Most analysts said the Fed was justified and that its efforts highlighted the severity of the dangers facing the financial system.

The turmoil produced wild swings on Wall Street this week, with the Dow Jones industrial average surging on Tuesday after the Fed aggressively cut a key interest rate, only to plunge on Wednesday on renewed worries about the economy and then to stage a 262-point gain on Thursday. Markets were closed Friday.

More turbulence is expected in coming weeks because there remains a great deal of uncertainty about how many more victims the credit crisis will claim.

The problems began last year with rising defaults on mortgages, as a housing slump intensified, but they have now spread to other parts of the credit markets, with institutions growing fearful about making other types of loans.

It is the ability to get credit that makes the financial system and the economy it supports function. When banks stop lending to other institutions that, like Bear Stearns, depend on credit to conduct their day-to-day operations, the results can be catastrophic.

"We can't afford to stagger from one day to the next without knowing what large financial institution might be the next to go down the tubes because of a lack of liquidity. That is way too dangerous a game," said Lyle Gramley, a former Fed board member who is now an economist with the Stanford Financial Group. "It is possible that we could be entering the worst recession of the post World War II period. The threat is certainly there."

Because of Bear Stearns, many analysts are raising the odds that a 2008 recession could be worse than expected.

"The potential freezing up of the financial system could have pretty negative ramifications on bank lending, which would have negative ramifications on consumer and business spending," said Nariman Behravesh, chief economist at Global Insight, a Lexington, Mass., forecasting firm. He said he had upped the chances of a worse- than-expected recession to 40 percent, up from 25 percent odds before Bear Stearns.

David Wyss, chief economist at Standard & Poor's in New York, said he now has a worst-case-scenario in which the country could endure a double-dip recession, in which the economy would briefly recover this summer, helped by the $168 billion in tax relief, only to quickly slip back into a downturn. Under this scenario, the economy's total output, as measured by the gross domestic product, would drop by 2.2 percentage points, making it the third-worst recession in the post World War II period.

The worst recession in recent decades, in terms of lost output, occurred in the 1973-75 period of oil shocks, when GDP fell by 3.1 percent, followed by the 1981-82 recession, when GDP dropped by 2.9 percent.

By contrast, in the last two recessions output fell by 1.3 percent in the 1990-91 downturn, and a tiny 0.3 percent in the 2001 recession, making that slump the mildest in the post-war period in terms of lost output. The 2001 downturn lasted just eight months.