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Recession's Hidden Virtues

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By Robert J. Samuelson
Wednesday, November 7, 2007

We are all waiting, it seems, for the next recession. Everyone knows that the business cycle hasn't been repealed, and so another recession is inevitable. Some indicators suggest that it might be sooner rather than later. The Conference Board's consumer confidence index has declined for three straight months. In March, 30 percent of respondents said jobs are "plentiful"; now that's only 24 percent. All this inspires much foreboding, because a recession is widely regarded as a calamity or something close to it.

Just last week, the Federal Reserve cut its key overnight interest rate for the second time since August. It now stands at 4.5 percent, down from its recent peak of 5.25 percent. Although the economy grew at a strong 3.9 percent annual rate in the third quarter, most economists regard this as an aberration. They expect slower growth or a recession, because three powerful forces are assaulting the economic expansion.

First, housing. Its collapse deepens. Economist Richard Berner of Morgan Stanley notes that sales of new and existing homes have dropped 42 percent and 30 percent, respectively, from their peaks of more than two years ago. As supplies of unsold homes grow, real estate prices continue to fall. One index finds that prices in August were down 4.4 percent nationally from a year earlier.

Second, oil prices. They're approaching $100 a barrel. Even before the latest price increases, energy costs rose to 6.2 percent of consumer spending in the second quarter; that's up from 4.5 percent in 2002, notes consultant Jack Lavery, a former chief economist of Merrill Lynch. Higher energy costs will continue to weaken purchasing power for other goods and services, he says.

Third, credit problems. As lenders and investors have suffered losses on subprime mortgages -- loans to weaker borrowers -- they've tightened lending standards for other borrowers. With the economy slowing, Diane Vazza of Standard & Poor's expects bond defaults to rise among shakier corporate borrowers, especially companies dependent on strong consumer spending (retailers, fast-food chains, entertainment firms).

Countering these powerful downward economic pressures are strong export growth (up at a 16 percent annual rate in the third quarter) and increased federal government spending (up 7 percent). The economy's fate hangs heavily on the outcome of this tug of war. Meanwhile, what's missing from all the agonizing about a possible recession is a sense of proportion.

Of course, no one likes the usual side effects of a recession: higher unemployment, weaker profits, more stress. Still, popular rhetoric exaggerates the damage. By and large, recessions are problems, not tragedies. Since World War II, there have been 10 of them, or one about every six years. On average, they've lasted 10 months (indeed, a common definition of a recession is at least two quarters of declining output). Disregarding two severe recessions -- those of 1973-75 and 1981-82 -- peak monthly unemployment has averaged 7.1 percent.

Recessions also have often-overlooked benefits. They dampen inflation. In weak markets, companies can't easily raise prices or workers' wages. Similarly, recessions punish reckless financial speculation and poor corporate investments. Bad bets don't pay off. These disciplining effects contribute to the economy's long-term strength, but it seems coldhearted to say so because the initial impact is hurtful.

Today, a U.S. recession might also reverse the upward spiral of oil prices and trigger a faster -- and healthier -- drop in home prices. As economist Berner notes, the slow decline in prices prolongs the housing slump, because it induces "would-be buyers [to] wait for more attractive deals." By making homes more affordable, a quick and sharp price drop might revive housing more rapidly.

"Moral hazard" is a phrase frequently bandied about now. Its initial meaning stems from insurance: If you overinsure someone against risk, you may encourage undesirable behavior. Example: Cheap flood insurance will spur home building along vulnerable coasts.

The Fed faces a similar problem. If it tries too hard to prevent a recession -- through easy-money policies -- investors, businesses and workers may conclude that they have nothing to fear. They may then engage in precisely the risky and inflationary behavior that makes matters worse, perversely "resulting in an even larger bubble and a larger subsequent recession," warns economist John Makin of the American Enterprise Institute.

We've been there before. In the 1960s and 1970s, the Fed followed easy-credit policies on the belief that government could end recessions and constantly keep the economy close to "full employment." The bad behavior thus encouraged was inflationary wage and price increases by firms and workers relieved of the fear of recession. The experiment boomeranged: Double-digit inflation ensued along with the savage 1973-75 and 1981-82 recessions (peak unemployment: 9 percent, 10.8 percent). The real "moral hazard" problem today is not starting down that path again.


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