Outlook: The Myths of Recession

Kevin A. Hassett
American Enterprise Institute Senior Fellow and Director of Economic Policy Studies
Tuesday, January 22, 2008; 12:00 PM

Amid the speculation and the panic attacks, American Enterprise Institute economic policy studies director Kevin A. Hassett was online Tuesday, Jan. 22 at noon ET to bring some sanity to the discussion of whether we're heading for (or already in) a recession, how bad it might be and what the impact will be on your stocks.

The transcript follows.

Archive: Transcripts of discussions with Outlook article authors


Kevin A. Hassett: Hello everyone, thanks for coming. Today's dramatic events sure give us a lot to talk about. A Fed move between meetings is a pretty rare event, and a sign that the Fed is very concerned about the recent movement of world capital markets.


Dallas, Tex.: Can you give us economic dummies an overview of what a recession is, how it comes about, how it will affect the average Joe and what it takes to recover? A recession for dummies?

Kevin A. Hassett: A recession is a period of negative economic growth. Economists have found that it is useful to think of the economy as rotating between two states. One state, we could call it the "boom" economic growth, is random but usually is centered around a positive growth number of perhaps around 3 percent. In "busts" or "recessions," economic growth is random, but centered around perhaps negative .5 percent growth.


Washington: Are these headlines overblown, or am I not taking this seriously enough? Also, why the sudden panic and short-term "economic stimulus" packages? Wouldn't it be better to ride through the downturn and take our lumps with confidence?

Kevin A. Hassett: The subprime mess is really a terrible strain on the economy. It is also a classic morality tale, with greed, bad guys, and a big fall. That creates an environment where negative stories feed on themselves. We do not know yet whether the mess in housing will lead to a recession, but the press coverage tends to end with an implication that we will all suffer because of these terrible mistakes. The fact is, we do not know whether there will be a recession, but there is a good chance there might be. Being prudent, nervous and cautious is sensible right now. However, the world is not coming to an end.

One of the top Wall Street economists I know is Dick Berner at Morgan Stanley. He currently is saying that a recession, if we do have one, likely will be mild. If that is correct, then everyone is overreacting right now.


Bowie, Md.: What does this mean for a middle class family like ours? Higher pay at the grocery store, gas, electric, public transportation, children's tuition for college? We have used up our savings to make ends meet -- job is slow -- so what exactly does this mean for us? It will become worse than it already is? What options do we have?

Kevin A. Hassett: A typical middle class family will feel a recession, if it happens, in a number of ways. The most important of these are: The chances of losing your job go up; the chances of finding another job if you do lose your job go down.

It is a good idea when recession risks are higher to pause and have a look at your personal finances. Exercise some caution, and try to save a little and avoid big new purchases, just in case.


New York: I would love to be able to blame the Bush administration for the current economic woes. Would that be fair? Realistically, is there anything the government can do to stimulate the economy, or does it just have to run its course?

Kevin A. Hassett: They may deserve more blame at the moment than is typical, but not for the reason many have in mind. Typically, a recession in the U.S. has started because of an oil shock that drives up energy prices. In this episode, a recession, if it happens, will be caused by the meltdown in the housing sector. There were a number of regulatory failures, and swashbuckling lenders operated with indefensible practices. Financial regulators, including the Fed, are supposed to keep an eye on these things, and they clearly did not do their jobs. The tax cuts, etc., probably helped the economy slightly on net, so those could not be blamed.


Cape Cod, Mass.: What should a single person in their forties do with their 401(k) -- keep it diversified, or move it into a singularly conservative portfolio?

Kevin A. Hassett: If you look at the long history of investments, equities have had higher returns, but much more volatile returns as well. In the past few weeks, the downside of that volatility has been felt by all.

Over time, there have been more ups than downs, and sound portfolio theory suggests that equities should be a part of just about any portfolio. How big a part depends on your own appetite for risk. However, if you already have decided on a long-run strategy, it probably is not a good idea to use the latest market movements as a motivation to rebalance.

Indeed, Ibbotson did a study a while back that showed that folks tend to sell equities when times get tough, and buy again when times get better. This caused them to tend to buy high and sell low enough, essentially erasing most of the benefit of equity investing. Nobody knows what markets will do, but keeping a commitment to a long-run strategy is a prerequisite, really, to investing in equities.


Anonymous: How many more homes have to go into foreclosure to call it a recession, and how many more people have to lose their jobs?

Kevin A. Hassett: The housing sector alone cannot really cause a recession. Indeed, the good news this time around is that the housing sector already has collapsed so much that it is a tiny fraction of the economy, less than 4 percent. You can get an "F" in housing and still get an "A," so to speak.

The real problem is that the decline in home prices threatens the rest of the economy through two main channels.

Financial institutions become more risk-averse because of housing losses, and slow their lending to the good projects that an economy needs in order to grow.

Also, consumers get depressed by their lower housing wealth, and allow that to influence their consumption decisions. If folks are less willing to buy a car because their house prices dropped and they feel less wealthy, then that can lead to a consumption reduction that feeds the recession.


Annapolis, Md.: Hi Mr. Hassett. Thanks for taking my question. In the article, you seemed to imply that the trend toward more government involvement in the economy probably hurt recovery efforts, and that a laissez-faire approach would be best.

That may be, but the you can't downplay the psychological impact of the government doing absolutely nothing while families suffered. That is a very real issue in enduring the hardship of losing jobs during recessions. Thanks.

Kevin A. Hassett: This is a good and important point. Voters seem to need their politicians to act, and politicians clearly feel compelled to do so. That is why we almost always have a stimulus plan around the time of a recession. However, these plans do not tend to be that effective or timely. The market seemed to respond negatively to President Bush's sketch of a plan late last week, perhaps an indication that markets do not believe that the current stimulus plan will change the path of the economy very much.


Los Angeles: Can you explain how inflation is calculated? I've noticed that on a standard weekly shopping basket it cost me $100-125 for items that cost $75 one year ago.

Kevin A. Hassett: There are many different measures of inflation, but one of the most widely cited is the Consumer Price Index. It measures prices for a wide range of goods that consumers buy, and then aggregates these up to an aggregate index. It is meant to reflect a typical basket of things that people might buy, although there probably is not anybody out there who aligns perfectly with the index. When prices change for things measured by the CPI, then it adds all those up to calculate aggregate inflation.

If your bill has gone up more than the CPI indicates, it is because you consume disproportionately things that went up more in price lately.


Newport News, Va.: How does futures trading predict index movement so closely that the fed "knows" that the Dow will fall 500 points?

Kevin A. Hassett: This is a timely question. Early this morning, the futures were suggesting that the Dow would drop almost 500 points before the Fed made its announced rate cut. When the market opened it was almost down that much.

The futures markets are trading contracts on the indexes, so they essentially capture current market expectations about what the market will do today. It's liking polling a person at 9 a.m. about what they will have for dinner that day. Odds are they will give a pretty good answer.

The thing I found most interesting was that the futures markets did not appear to respond much to the rate cut. I think this is because the rate cut had two possible implications: The economy was falling off a cliff, and the Fed is panicked, or the Fed was going to save us.

At the beginning of the morning, it seemed that the first view was the dominant one, but now it seems that markets have settled down some.


Rockville, Md.: At this point, how would you rate the likelihood of stagflation?

Kevin A. Hassett: Stagflation is a terrible state where the economy does not grow very much, but has high inflation. Normally inflation tends to go up during good times and down during bad times. When it goes up during bad times, it cause serious harm, especially on middle- and lower-income individuals who disproportionately bear the risks of losing their jobs in the downturn.

Stagflation is much more likely now than it used to be because the U.S. economy is becoming less and less important with regard to the economy of the rest of the world. Today, growth in China and India can drive energy and commodity prices up, even while the U.S. economy slows. We take inflation, more and more, as a given that depends on everybody else's economy. Accordingly, when we slow, inflation need not do so as much as it used to.


Omaha, Neb.: I heard one analyst say that there is a disparity between what a nation of people should do to reverse a recession and what the individual should do to ride out the recession. Specifically, if the nation continues to spend money it will help the economy stay afloat, but the individual should save and stockpile in order to ride out the uncertainty and hard times. Do you agree with this assessment? If so, how can we "help" the economy while still keeping an eye on our individual savings and well-being?

Kevin A. Hassett: This is an excellent point, and relates really to an earlier answer. It is prudent for individuals to try to slow down their consumption and increase their savings right now, just in case a recession hits. However, if everyone does that, then it might be enough to cause a recession. If, on the other hand, everyone throws caution to the wind and consumes like crazy, then it might be enough to stave off a recession.

This is true, but it is still important than individuals remember that they are small relative to the economy, and can not have much of an effect on it on their own. Everyone should do whatever is best for them. It is not our patriotic duty to spend excessively right now.


Vienna, Va.: Mr. Hassett: In your opinion, what if any effect has the borrowing associated with conducting military operation in Iraq affected the credit crunch (in terms of the government competing with the private sector for overseas investment capitol, such as from China)? Or is the magnitude not significant? Thanks.

Kevin A. Hassett: If interest rates were very high right now, then one might be worried that the Iraq war, and other things that have led to deficits would have helped push us into recession. However, long- and short-term interest rates are all pretty low right now. Long-term rates are well below where they were when Bush took office. This link, therefore, is not nearly as important as the housing collapse.


Traverse City, Mich.: If the Fed lowers rates to try and mitigate the housing woes, are they taking on a substantial risk of fueling inflation later this year?

Kevin A. Hassett: This is an important point. The fact is, the hard economic data only go through November, with some important glimpses of December. It seems virtually certain that a recession did not begin in November, and likely that one did not begin in December either. So a recession likely is starting right now if it is starting at all. However, the Fed has cut interest rates a good bit, and Congress is talking about a stimulus package. Those two factors could, if they pile onto an economy that was going to muddle through anyway, cause growth to be so high that it actually increases inflationary risks.

That is likely why the Fed has seemed slow to move. The problem is, one would like to wait and see how bad it is going to get before turning the policy dials, but if one does that then the policy likely will be too late. In that world, all that one can do is try to balance the risks.


Washington: Isn't it a self-fulfilling prophecy when we start talking about a recession -- i.e. when people get worried about the economy they spend less (as you advised) and then their lower spending means slower economic growth, which makes us worry more about a recession, spend less, until voila -- recession?

Kevin A. Hassett: Sentiment certainly can feed on itself and create upward and downward spirals. This observation dates back at least to Keynes. Downward sentiment spirals end when people think that all of the bad news is on the table. Right now I think we need to go a little bit of time without having some other financial institution announce that it has much bigger losses than we expected before we can feel comfortable that this spiral has hit bottom.


Washington: Why did World War II stimulate the economy and bring us out of the Depression, but the Iraq war hasn't had a similar effect?

Kevin A. Hassett: Government spending surged during World War II, and many credit that surge with finally delivering us from the Great Depression. In the current episode, the Iraq War -- while much more costly than originally was forecast by the Bush administration -- still is not that costly relative to our ability to pay (that is, our gross domestic product). It is not big enough, thank goodness, to have large macro effects.


Princeton, N.J.: The Congressional Budget Office has computed that by 2006, the Bush tax cuts had reduced tax revenue by $1 trillion to $1.5 trillion dollars. Greg Mankiw has written about this too. How can you say the tax cuts have helped the economy? When the old rates were in effect during the Clinton years, the economy was much better.

Kevin A. Hassett: Calculating the revenue effect is not the same as establishing the effect on the economy.

I base my statement on balance on the following intuitive observation: Opponents of the Bush tax cuts conceded at the time of the debate about them that the lower tax rates might stimulate things, but argued that the higher interest rates associated with higher deficits would offset that benefit, and even overpower it. Interest rates are lower now than they were back then, so it seems hard to argue that higher interest rates squashed the positive effect of lower marginal tax rates.


Freising, Germany: What precisely is the difference between a recession and a depression?

Also, what does it typically take to get out of recession? A new political ordering, namely WWII, ended the Great Depression, but what events ended the recessions after that period?

Kevin A. Hassett: A recession is a mild depression, or a depression is a severe recession. We only have had one depression, and we can hope that it never will happen again.

One strong reason to be optimistic that we will at least avoid depression is that a whole bunch of the bad news is on the table. When Japan saw its real estate prices drop, it led to 10 years of misery, in part because financial institutions there never really put their losses on the table. Our firms are doing that now, and the painful adjustments that need to happen are happening. That is good news in the long run.


Pittsburgh: I'm planning to retire in five years; my 401(k) is currently in a balanced fund (Boston Trust Retirement Fund). Should I move my money to something stable now (U.S. Treasury Bills) or ride out the storm?

Kevin A. Hassett: It is normal to begin to move one's assets into more fixed-income securities as retirement approaches. You probably should discuss this with a financial advisor.


Ferguson, Mo.: A question born of greed. Wouldn't a meltdown period like this offer a real stock-buying opportunity? If so, when? Doesn't the market look forward six months? And if so, wouldn't the next few weeks present a real opportunity to buy "low"?

On the other hand, wild Jim Cramer thinks the Dow could plunge another 2,000. Is he as crazy as he acts?

Kevin A. Hassett: The market has tended to go up during recessions, in part because it does look ahead. Current prices clearly indicate that the market expects a recession to happen, perhaps even a bad one. It is a mistake to try to outthink the market -- it collectively is smarter than all of us. The best thing to do is to stick with your long-term strategy.


Kevin A. Hassett: Thanks everyone for all of the great questions, and have a good day.


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