Bracing for a Recession

By Justin Fox

It's the day after Thanksgiving at Aventura Mall, north of Miami, and David Weinberg is worrying about the economy. "People are underestimating the downturn in the housing market in Florida and are spending based on home equity," says the accountant from nearby Pembroke Pines, Fla. "We have not seen the worst of it yet." In light of these looming troubles, Weinberg, at the mall with his wife and two young kids, says he'd like to rein in spending this holiday season. "But," he adds, "I'm not always in control."

Meet the American consumer of late 2007. Sure, he's worried. Apart from a brief blip after Hurricane Katrina in 2005, the University of Michigan's much watched Index of Consumer Sentiment hasn't been this low since 1992. But buying stuff is what we Americans do. The last outright decline in consumer spending came in 1991, and that was shallow and short-lived. Most indications are that this year's Christmas shopping season will be, if not exactly a blowout, better than the last one.

Short-term retail optimism brings no cheer, though, to the economy's wise men, who talk mainly of an imminent downturn. "The odds now favor a U.S. recession," writes former Treasury Secretary Larry Summers in a newspaper column. "I'd put the number at about a 75% chance," says investing guru Jack Bogle on TV. "We are becoming more certain that the recession is either here or no more than two quarters away," warns Merrill Lynch economist David Rosenberg in a note to clients.

Talk is cheap, and economists and laymen alike have a strikingly poor record of predicting recessions. But there are good reasons to be concerned that the economy is weakening. They involve struggling banks, the collapsing housing market, the volatile stock market, oil prices, the weak dollar and lots of nervous investors in far-off lands. All of which relate back to the financial condition of the people swarming the nation's malls.

Since the early 1980s, with the exception of that brief downturn during the recession of 1990-91, consumer spending in the U.S. has risen every quarter. Over that period, our pocketbooks have come to commandeer an ever greater portion of the economy, from 62% of gross domestic product (GDP) in 1981 to 70% now. Spending by U.S. consumers accounts for 19% of global economic activity.

This activity has been increasingly fueled by debt. In 1983 household debt equaled 55% of income in the U.S.; now it's above 114% (and above 136% of after-tax disposable income). The middle class--households earning roughly between $20,000 and $100,000 annually--had a debt-to-income ratio of 141% in 2004, according to New York University (NYU) economist Edward Wolff. And he figures it's even higher today. In the third quarter of 2005, the national savings rate (personal income minus spending) went negative for the first time since the Great Depression, and it has bounced back only slightly since.

It's not necessarily a bad thing to borrow money, and it's hard to say what the right debt ratio or savings rate might be. But Americans can't keep running up bigger and bigger debts forever. At some point we have to pay them back or default.

Worrywarts have been saying such things since the mid-1980s without much to show for it. But something changed after 2001, when what had been a long and in retrospect moderate rise in indebtedness exploded into a spectacular binge in mortgage and home-equity lending. It started with super-low interest rates that kept consumer spending rising even as the tech boom of the late 1990s collapsed. But before long, the mortgage boom took on a life of its own, with ever bigger and weirder loans handed out to people who would be able to pay them back only if they won the lottery or the price of their house kept rising.

Hyman Minsky, an academic economist who died in relative obscurity in 1996 but is now the talk of Wall Street, had a colorful phrase to describe such people: "Ponzi borrowers," he called them, after the early 20th century pyramid-scheme perpetrator Charles Ponzi. Minsky argued that once banks got so sloppy that they handed out Ponzi loans, a financial crisis was inevitable.

Sure enough, house prices stopped rising in 2006, and now banks and brokerages are taking huge write-downs tied to the mortgage-backed instruments that kept the Ponzi-loan machine oiled. Economists are furiously debating whether we're on the brink of a full-fledged "Minsky moment," in which lending shrinks sharply across the board. Nouriel Roubini, an NYU economist and a widely read forecaster, got a lot of attention in November by professing to see risk of "generalized meltdown of the financial system of a severity and magnitude like we have never observed before." That sounds bad. But even if the damage is restricted to U.S. mortgage markets, a $2 trillion reduction in the supply of loans could still result, estimates Goldman Sachs economist Jan Hatzius.

That's about 14% of GDP, more than enough to bring on a recession--semiofficially defined by the National Bureau of Economic Research as "a significant decline in economic activity spread across the economy, lasting more than a few months." Will it, though? The equation must factor in global demand for U.S. exports, the path of the dollar, the price of oil and other influences that make it more or less impossible to solve. What seems clear is that the borrow-and-spend era has come to an end, or at the very least a prolonged pause.

*Dollars spent per hour by American consumers in the third quarter of 2007

With reporting by With Reporting by Siobhan Morrissey / Miami