Fallout from the Credit Crunch

For years economists and policy makers have worried about the fragility of the U.S. economy, and particularly about the unsustainability of the U.S. housing boom, but when the shock finally occurred, everyone – central banks, commercial banks, hedge funds, private investors – appears to have been unprepared. The big surprise was the nature of the shock: suddenly banks stopped lending to one another, except on punitive terms. Liquidity dried up, threatening the existence of otherwise well-functioning banks and businesses. The crisis of confidence jumped across U.S. borders with ease, as the recent run on Northern Rock has shown. How will this financial turbulence affect the world economy?

Economists obviously don’t have perfect foresight; so I won’t try to anticipate the future. But economists can do what doctors do after the outbreak of a contagious disease: they can tell you how the disease might spread, so that you are prepared. This is my purpose – not to make a forecast, but to warn of possible dangers ahead.

Investors tend to imagine that the world will continue to be approximately like it is now. Before the U.S. Federal Reserve reduced the benchmark interest rate by one-half percentage point on Tuesday, September 18, financial markets were in despair; afterwards they were euphoric. Such myopia is dangerous. So far, economic activity – production, employment, consumption, investment and trade – have remained largely unaffected by the credit crunch. Many seem to believe this will continue. Equally dangerous.

If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent U.S. home foreclosures, nor will it eliminate the glut of unsold homes. If U.S. house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending, and the fall in demand will aggravate the rise in unemployment, hurt the U.S. stock market, and thus lead to a further fall in spending.

Meanwhile, it is worth keeping in mind that the U.S. is not the only country where house prices have risen much faster, on average, than national incomes. On the contrary, house prices in Australia, Britain, Denmark, France, Ireland, Spain, and Sweden have all increased faster, over the past ten years, than in the U.S. Of course the U.S. is a special case on account of its subprime mortgage lending towards the end of its housing boom. There, mortgage lenders with poor credit records could buy houses at virtually interest-free for a few years, before the rates were adjusted steeply upwards. But the danger of international contagion remains. The U.S. housing slump may well lead investors in Europe to reassess the value of their properties. If that happens, then consumption spending is likely to fall in the countries above, leading to weaker labor markets there.

This would happen at a time when the Chinese economy has overheated and will need to slow down, and when the Japanese economy is stagnating. There are no further countries that could take up the slack, serving as a “motor” for the world economy, as the U.S. has done for so long.

In short, a recession in the U.S. is possible and this recession could spread to other countries, primarily through loss of confidence within financial markets and house price contagion. Germany, needless to say, need not worry about a housing slump, since its housing market has already been in a state of slump for over a decade. But that does not mean that Germany is immune from the dangers of the current financial turbulence. The German economy is heavily dependent on its exports, and these would clearly suffer if world economic activity declined. Furthermore, as we have seen, the fallout from the U.S. credit crunch can affect the balance sheets of German banks.

Of course these dangers may not materialize, just as contagious diseases need not spread. It is useful, however, to know where the dangers lie.

Even if times ahead are troubled, the long run is likely to look much more settled. In the short run, a housing slump could well make private investors and central banks outside the U.S. less eager to hold dollars. A survey by the U.S. Treasury Department last year indicates that about third foreign-held U.S. corporate debt consisted by asset-backed securities and about half of that was mortgage-related. Petro-dollars held in the Middle East and Russia are particularly mobile. Once foreign money leaves the U.S., the dollar would fall. In the longer run, U.S. exports would rise, shrinking the huge U.S. trade deficit. Moreover, recession in the U.S. would lead to lower imports, further reducing the trade deficit. At the same time, China may well let the yuan rise against the dollar, leading to a rise in its domestic spending relative to its exports. Once U.S. consumers spend less and Chinese consumers spend more, the large global imbalances, which have cast a shadow on the world economy for the past decade, would begin to disappear.

5 Responses to "Fallout from the Credit Crunch"

  1. Nouriel Roubini   October 14, 2007 at 10:54 pm

    Dennis, you do not seem to believe that Europe can decouple from a US hard landing: for some countries the transmission would come from the bursting of their housing bubbles; for others – Germany – via trade links and dependence on exports; and for all via confidence effects and financial contagion channels. But housing bubbles in Europe – especially in the UK, Ireland and Spain – can burst – and are starting to burst – regardless of the US hard landing. So we do not really need a US hard landing – or contagion – to have a downturn in housing in some parts of Europe. Daniel Gros – who will soon blog here – has stressed the role and risks coming from many housing bubbles throughout the EU.

  2. Anonymous   October 15, 2007 at 6:43 am

    Which countries in Europe are more at risk of a bursting of their housing booms? Certainly Spain, UK and Portugal where are already cracks in their housing and mortgage markets. But housing was very bubbly also in Italy, France, Portugal, Netherlands, Greece. And among recent EU members – and member wannabes – you see serious housing froth – if not bubble – in the Baltic states (Estonia, Lithuania, Latvia), Turkey, Hungary and some other Central European countries. So housing bubble could easily burst in a variety of european economies.

  3. Anonymous   October 15, 2007 at 6:58 am

    Can the EU decouple from the US? Highly unlikely given trade links, the soaring euro, financial contagion, a variety of financial links, and the limited room for fiscal and monetary policy easing.
    The FT – that until recently seemed to support the decoupling view – has also taken a more cautious approach in a weekend editorial “Hard to decouple from the US train”. See:
    http://www.ft.com/cms/s/0/c6c7681c-78f0-11dc-aaf2-0000779fd2ac.html?nclick_check=1

  4. Guest   October 15, 2007 at 2:21 pm

    Dr. Snower, What do you make of the super-conduit bailout of SIVs announced today? Does it make sense? Does it create moral hazard or not? Will it be successful in stemming the liquidity crunch?

  5. Gian Luca Clementi   October 17, 2007 at 4:53 pm

    The following paragraph of your post makes really no sense to me.

    If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent U.S. home foreclosures, nor will it eliminate the glut of unsold homes. If U.S. house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending, and the fall in demand will aggravate the rise in unemployment, hurt the U.S. stock market, and thus lead to a further fall in spending.

    1) Long-term interest rates in the US have essentially not reacted in any way to all monetary policy decisions of the last 2 years.
    2) In the US there is no credit crunch whatsoever. The fact that the market stopped financing mortgage companies has nothing to do with what the Fed did.
    3) Unemployment? What unemployment? In the US the unemployment has been at 4.5% for months now. And the slump in job creation of August turned out to be measurement error.