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A New Economic Order
Why the Downturn Had to Happen

By Neil Irwin
Washington Post Staff Writer
Friday, March 14, 2008

Retail sales plummeting. The dollar at a new low against other world currencies. A 60 percent jump in U.S. home foreclosures. A major investment fund going kaput.

This is what a reordering of the world economy looks like in real time.

Don't think of yesterday's economic news as discrete events. They are small pieces of a much bigger reversal in a series of imbalances that made Americans feel richer than they were and created unsustainable distortions in the world economy that are now righting themselves.

Americans are consuming less, and their houses and other assets are becoming less valuable. Painful as they may be, in the long run, both trends must happen to restore sustainable growth. But in the short run, they are wrenching changes that are probably causing a recession.

The weaker U.S. economy, combined with low interest rates due to Federal Reserve rate cuts, has made traders around the world less inclined to buy dollars. Thus, the value of a dollar fell below 100 yen yesterday for the first time since 1995, and slumped to a new low against the euro. Unpleasant as that is for people planning European vacations, it should help cushion the blow to the economy by making U.S. exporters more competitive.

On the way up, a worldwide boom of cheap credit fueled consumer spending, kept the U.S. economy strong and artificially boosted the prices of real estate and other assets. Now the reverse is happening. Lenders made too much money available, taking on too much risk for too-low interest rates. The pullback is reflected in yesterday's other big business news, the default of Carlyle Capital, a fund operated by District-based private-equity giant Carlyle Group.

The Carlyle fund had increased its returns by borrowing money from banks to buy securities backed by mortgages. When the value of those securities fell and lenders demanded more collateral, lenders took control of the fund and began dumping its assets into a market that was already swimming in such securities.

Simultaneously, the lessening availability of credit is causing consumers to spend less. That causes lenders to be more cautious, making the credit problems more severe. It is what leaders of the Federal Reserve call an "adverse feedback loop."

There was clear evidence yesterday that Americans are spending less. The Commerce Department reported that retail sales fell 0.6 percent in February, a sign that consumers are bringing their spending more in line with what they can afford after a decade of spending beyond their means. Auto dealers and restaurants took the biggest hits, as people delayed purchases of new cars and saved money by eating in.

This pullback by consumers and reduction in credit availability are behind the increase in home foreclosures that RealtyTrac announced yesterday. The 60 percent jump reflects the fact that U.S. assets are becoming less valuable, making consumers poorer. With home prices down 8.9 percent in the past year (according to the Case-Schiller index), the dollar lower and stock prices down, we aren't as rich as we thought we were.

"The distress we are seeing in the credit markets, the pullback in consumer spending, the retreat in the dollar -- these are really all part of the same story," said David A. Rosenberg, chief economist at Merrill Lynch. "We had a dramatic overextension of credit and consumption growth for a long time."

In economics textbooks, such a rejiggering of economic forces happens in a nice straight line. In practice, it happens haltingly, with world markets on edge, day after day. Days like yesterday, full of jangled nerves and creeping panic.

Washington policymakers are trying to keep this adjustment of the world economy as orderly as possible, trying to prevent the economic undertow from hurting too many Americans.

In a survey released yesterday by the Wall Street Journal, 71 percent of economists said they thought the economy was in recession.

The Bush administration and the Federal Reserve stress that they're not trying to prevent fundamental adjustments. Home prices need to come in line with fundamentals, as do spending and savings rates. Credit needs to become available at prices commensurate with risk.

"It's by no means all bad that the U.S. is slowing down," said Adam S. Posen, a senior fellow at the Peterson Institute for International Economics. "Because at some point we've got to repay all the debt we have accumulated."

So policymakers have adopted strategies that don't stand in the way of that repricing. For example, this week the Fed agreed to let Wall Street firms obtain up to $200 billion worth of ultra-safe Treasury bonds in exchange for spurned mortgage debt, an effort to bring stability to that market. But it has refused to buy those mortgage assets outright, which would prop up their price.

The Bush administration has supported various proposals to make it easier for people to refinance into government-insured mortgages and has enacted a stimulus program to bolster consumer spending in the second half of the year by sending tax-rebate checks to 130 million Americans. But it has vehemently resisted proposals through which the government would buy mortgage debt.

"I've never seen a government be able to circumvent the business cycle in a capitalist economy, but at the same time, the government is going to pull out all the stops to minimize the instability," Rosenberg said. "The grim reality is that recessions are a part of life. It's like surgery. You don't feel good as you get out of the operating room, but inevitably there's a healing process and things get better."

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