This article appeared in the Wed. Jan. 2, 2008 issue of the Financial Times:
Whatever the inflationary risks lurking in the US economy, recession is the fear that is keeping policymakers up at night. Rightly so. The long-resilient US faces a series of blows that will cut into growth. The residential housing market is dealing with an almost unprecedented nationwide fall in prices. Meanwhile, unstable credit markets, roiled by the subprime crisis, could have a significant impact on the availability, and price, of credit.
How big will the impact be? US growth will certainly slow. But a house price correction in itself should be manageable, unless it turns into a freefall. After all, the pain so far has been concentrated among poorer, subprime borrowers, whose spending is very small in the context of the overall economy.
The trouble is, we are heading into largely uncharted territory on housing when it comes to guessing whether consumers, already heavily burdened with debt, will lose confidence. That is a significant risk. And it could feed back into credit market problems.
Banks are already building up their own liquidity and are worried about lending to each other because of the credit market crisis. Now they also have to factor in the risk of a recession. If they are bearish, they are likely to ratchet up credit standards and reduce lending somewhat to prepare for loan losses. There is the risk of a downward spiral, where such a credit contraction in itself increases recession risk.
As the property and credit markets undergo a slow and ugly repricing, it would be little surprise if the US slipped at least briefly into recession. Stronger export growth, on the back of a weak dollar and healthy demand from the rest of the world, will struggle to offset the domestic forces at work.