Thursday, November 1, 2007

It's Still the Economy, Stupid

In Washington, the big worry for presidential hopefuls is who benefits most from an election-year recession

Jimmy Carter still blames the fierce squeeze on household incomes in 1979 for his loss of the White House to Ronald Reagan in 1980.

In the New Statesman, Alex Brummer writes:

Almost every town of any size in the United States, from the towers of New York through the Great Plains to the burning shoreline of California, has a Merrill Lynch office on the corner. The "retail" stockbroker is an understated but ever-present feature of the American landscape. So imagine the shock to the system when Americans woke up recently to find that this blue-blooded symbol of US capitalism had miscalculated so badly that it was being forced to declare an $8bn loss and reveal that its very existence as an independent financial house was threatened.

US consumers and households are becoming more used to surprises. The earthquake that began in America's trailer parks, where over-enthusiastic "realtors" - the equivalent of our sharp-suited estate agents - persuaded people to buy into the dream of home ownership, irrespective of their incomes, has spread further and wider than anyone could ever have anticipated. It has rocked financial markets around the world, sent America's housing market (along with cars, one of the two great pillars of US growth) grinding to a halt and propelled the construction industry into premature depression.

All attention is focused on the Federal Reserve, America's central bank. Like an outfielder in the World Series, it is seeking to catch the ball and throw it to base to save the game. It is rapidly reducing interest rates and pumping cash into the wholesale money markets, where banks lend to each other, in the hope that it can prevent the real economy of growth and jobs crashing to the ground.

Running the Federal Reserve, in the run up to an American election campaign, is a tricky business as the chairman, the bearded former Princeton academic Ben Bernanke, is learning. Jimmy Carter still blames the fierce squeeze on household incomes in 1979 for his loss of the White House to Ronald Reagan in 1980. George Bush Snr holds a grudge against his fellow Republican Alan Greenspan, the former Fed chairman, for keeping interest rates too high in 1992 and handing the election to Democrat Bill Clinton.

Now, once again, the White House and the economy are hanging in the balance at the same time. As the first tests of strength in Iowa and New Hampshire loom into view at the turn of the year, the big question is can the US avoid an election year recession? The candidates will be monitoring events closely. There will be no presidential or vice-presidential incumbent in the White House to take the blame for economic failure in 2008. But economic uncertainty has almost always favoured the opposition down the decades, dating back to Franklin D Roosevelt's election during the Great Depression.

Failure to halt the economic slide between now and November next year potentially could sound the death knell for the hopes of any Republican nominee (Iraq notwithstanding). This would be true even if it turns out to be the present frontrunner, the social and economic liberal, Rudolph Giuliani.

Commercial turbulence could be the ace in the hole for Democratic frontrunner Hillary Clinton, who in some polls is a commanding 33 percentage points ahead of her nearest competitor, Barack Obama. In large conservative swaths of the country, the Clinton name is still surrounded with dark suspicion and salacious gossip. Yet in the area of economic competence, the Clinton family reputation is unsullied. Bill Clinton's 1992 election slogan - "It is the economy, stupid" - was not just an empty gesture.

As Greenspan recalls in his memoir, The Age of Turbulence, Bill Clinton understood the need to keep budgets close to balance if long-term interest rates were to be kept low and stability and growth maintained.

An endorsement from Greenspan is as good as it gets and Hillary must count on some of the Bill glow reflecting on her in hard economic times.


So how bad is it going to be for the American economy? Clearly, the crisis in the housing market will be key. The ridiculous lending practices of the past few years, particularly in fast-growth southern and western states, is now reaping a bitter harvest. Payments on an estimated 5 per cent of all mortgages and 15 per cent of sub-prime mortgages (the low quality loans to people who can barely afford them) are already delinquent. Whereas in Britain foreclosure and repossession is a relatively calm and careful process, in the US it can be brutal, with the bailiffs ruthlessly seizing assets. RealTrac, which monitors this process, reckons that up to 1.5 million homes will go through the process this year. In parts of the US, notably Florida and the counties east of Los Angeles, the market is already being flooded with repossessed properties. This surplus means that new housebuilding is grinding to a halt as prices in parts of the country plummet. In its just published World Economic Outlook report, the International Monetary Fund notes that "the correction in the US housing sector has now been underway for two years and has been a major drag on activity". It calculates that thus far it has wiped 1 per cent off American growth and reckons that there is much more to come. As well as the direct impact on construction, residential homes are key to consumption. When house prices are stable and rising, the consumer feels more confident and better off - the "wealth effect". Take that away and consumer confidence tumbles.

But in this crisis there is an extra dimension. Because of the way rotten mortgages were packaged up as securities, spread around the financial system and sold on to investors by intermediaries - such as Merrill Lynch - the housing crisis has triggered a credit squeeze. In a country as dependent on borrowing as the US this has a dramatic impact, with the car market among the sectors already affected. Surveys are showing plunging factory output. The IMF warns that against the background of a "more general deterioration in the labour-market conditions or a sustained drop in the stock market, risks of recession have increased".

The better news about an American recession in the present decade, should it occur, is that it will possibly have less of an impact on our own economy and the rest of the world than in the past. One of the key debates currently taking place in Washington and Wall Street is the question of how far the US economy has become "decoupled" from the rest of the world. The theory is that with some 50 per cent of global production now in the emerging market economies, such as China, India and Brazil, the world is far less dependent on the US to keep it growing.

This analysis carefully skirts around the issue of the American consumer who, on some measures, still accounts for up to 17 per cent of worldwide spending. If US households close up shop then the factories that supply them will also suffer.

Credit chaos

This is not all. No country is more dependent on imported oil than the United States. In recent weeks the market price of oil has escalated, reaching $90 a barrel, raising the price of petrol at US pumps and heating fuel prices as the US readies itself for a heavy winter. Higher oil prices act as a tax on the consumer limiting budgets for other products, raising the cost of production for industry and slowing the wheels of commerce. Add to all this uncertainty the weakness of the dollar, the chaos in credit markets and nervousness on Wall Street and you have all the ingredients for financial meltdown.

President George W Bush and his treasury secretary may worry about all of this but they have precious little time and room to manoeuvre. They could seek, for instance, to persuade the Chinese to lower the value of their currency, the renminbi, which would ease pressure on the dollar. They can also take a tougher approach to spending bills sent to them by Congress, in the hope that this will help ease long-term interest rates and constipation in the money markets.

But the real power to change things rests not at the White House, at this late stage of an eight-year presidency, but a few blocks away at the grand headquarters of the Federal Reserve. The present incumbent has already shown an awareness of the potential problems by cutting interest rates sharply by a half point and offering banks all the credit they need to keep the economy moving. Bernanke, thought to have Republican sympathies, will not want to be accused of aiding and abetting a recession in the run-up to next year's presidential election. Nor will he want to take a risk with inflation at a time when commodity prices, led by oil, wheat and steel, are surging globally.

Yet in his hands - like those of his august predecessors Paul Volcker and Greenspan - lies not just the fate of the US and global economies, but potentially the outcome of the 2008 presidential election.

US economy crisis in numbers:

$1.43 value of dollar against the euro on 26 October - an all-time low

4.7% unemployment rate, the highest in over a year

1.5 million number of families who may lose their homes as a result of the crisis

23.3% drop in house sales compared to last year - sales hit a record low

6% average drop in house prices over the past six months, the worst housing slump in 16 years

$2.3bn quarterly loss at Merrill Lynch, the biggest loss in its 93-year history

93% drop in quarterly profits at Bank of America's corporate and investment banking division