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The Dismal Science

Economists talk recession.

11:00 PM, Nov 12, 2007 • By IRWIN M. STELZER
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ADD $100 OIL to billions in bank write-offs and it should come as no surprise that the word "recession" is being heard with increased frequency. As is the view that circumstances have combined to neuter the Fed, making it powerless to use its monetary policy weapon to prevent a downturn.

It's not the write-offs so much as the inability of the chiefs of the major banks to come close to estimating the magnitude of the problem. In "Evita" Juan Peron complains that "The knives are out, would-be presidents are all about." That about describes what is going on in the board rooms of major financial institutions. Stan O'Neill might have survived at Merrill Lynch, and Charles O. (Chuck) Prince III at Citigroup, if their first public estimates of the extent of their firms' exposure to losses from subprime and related lending had been correct. Or almost correct. It turns out that original reports were massive understatements, leading the boards of these institutions to doubt that the CEOs were in control of events, and the markets to believe that enough shoes to fill Imelda Marcos' closets have yet to drop. Morgan Stanley is less exposed--estimates are in the $6 billion range, which is small by the standards of Merrill's $8 billion and Citigroup's $11 billion (going on $13 billion according to CreditSights Inc.), but enough so that CEO John Mack might just be wondering if he will be able to negotiate a golden goodbye as generous as those pocketed by O'Neill and Prince. Julian Jessup, chief international economist at Capital Economics expects to see more heads roll. "It looks like it will require a change of management for banks to come clean and admit the full scale of their losses," he said.

The path to recession thus became clearly marked. The nation's banks will sooner or later have to write down the value of these assets, perhaps to the tune of $600-$800 billion, seriously impairing their ability to lend to even credit-worthy firms and consumers. Indeed, a recent Fed survey already shows that credit availability has been reduced by a tightening of lending standards not only in home mortgage markets (including to prime borrowers), but in the consumer, industrial, and commercial real estate sectors. With credit crunched, fewer factories and office buildings will get built, fewer jobs created, fewer tills filled with credit card receipts. This will add to the downward pull already exerted by the slumping housing market, where rising inventories of unsold and repossessed houses, and falling house prices (the August drop was the largest since the 1991 property crash, and brought the drop from the July 2006 peak to 4.5 percent) will further weaken consumer confidence, already at a two-year low.

The interaction of the slumping housing market, the unsettled financial markets, and, eventually, the general economy is now clear. Alan Greenspan put it this way in a Tokyo speech, "The critical issue on the whole subprime, and by extension the whole financial system, rests very narrowly on getting rid of 200,000 to 300,000 excess [housing] units in the United States." A bit of an overstatement, perhaps, but you get his point: the housing market, which has a long way down still to go, affects the financial markets, the labor market, and the macroeconomy.

Adding to the recession-is-around-the-corner chatter is a rush by forecasters to lower their estimates of 2008 growth. Goldman Sachs economists are predicting a downward revision in the very strong jobs numbers reported two weeks ago, and expect tightening credit to slow the construction of commercial buildings, hitherto a bright spot in a darkening picture, shaving perhaps half a point off GDP growth over the next year. The manufacturing sector seems to be slowing, as is consumer spending, and inventories in shops are on the rise; retailers are expecting an unmerry Christmas.

Not to worry: Ben Bernanke and the Federal Reserve Board's monetary policy committee will ride to the rescue with still another stimulative cut in interest rates. Except that it won't. Or might not. That's where $100 oil comes in. Rising fuel prices are creating inflationary pressures as all industries that rely on oil either to move their trucks and planes, or as inputs in manufacturing petrochemical products, begin to raise prices.