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Paulson Predecessor Says U.S. Recession Likely

In Sunday’s Financial Times (UK), former U.S. Treasury Secretary Lawrence Summers said that the odds now favor a U.S. recession that will slow growth significantly on a global basis. Summers, who served with the Clinton administration and now teaches at Harvard University in addition to serving as a managing director at hedge fund D.E. Shaw Group, concluded that the U.S. economy will stall out, based on the following:

1. The U.S. housing slump marches on.

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.

2. The U.S. financial sector will be rocked— hard.

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions. These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognise the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt.

3. Credit, necessary for economic expansion, will become tougher to come by.

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.

Add the following:

Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfill its traditional role of importer of last resort.

And you have the recipe for an economic recession in the United States. Summers said:

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.