Rocky terrain ahead

Rocky terrain ahead
How much will the credit crunch hurt the world economy?
THE Teton mountains jut suddenly and majestically out of the Wyoming plains near Jackson Hole. The central bankers and economists gathering there this week for the symposium of the Federal Reserve Bank of Kansas City, an annual meeting of the macroeconomic elite, face a similarly breathtaking, if less beautiful, change in the global financial topography. In less time than it takes to get a good compass bearing, cheap credit and stable markets have given way to investor panic and a credit crunch.
So far the central bankers have concentrated on stemming panic by flooding financial markets with short-term liquidity, and, in the case of the Federal Reserve, by loosening the rules for, and price of, banks' borrowing from the discount window. These efforts helped stabilise the money markets last week. But many debt products, particularly asset-backed instruments, remain paralysed. Yields on ten-year Treasury bills dropped to 4.52% on August 28th while stockmarkets fell sharply, though shares bounced back the following day. Wholesale panic could quickly return, a danger that will occupy the Jackson Hole attendees.
Even if that unhappy outcome is avoided, there is much to worry about. Top of the list is gauging what effect the recent turmoil will have on the world economy.
Common sense suggests the biggest impact will be felt in America, home both to the subprime mess and the worst financial dislocations. At first sight, the economy hit the August turmoil in fine fettle. Output growth in the second quarter was strong; business spending looked perky; wage growth was solid and high petrol prices (which had dragged down consumer spending) were falling.
On closer inspection, however, the picture was less rosy. Output boomed in the second quarter thanks partly to one-off factors, such as the rebuilding of firms' stocks. Consumption growth slowed sharply over the same period, and some areas of consumer spending stayed weak into the summer. Car sales, for instance, fell to a nine-year low in July.
Most important, the economy's weakest link—the housing market—was in even worse shape than many realised. The pace of new-home construction plunged in July while the backlog of existing unsold houses rose to a 16-year high. House prices have kept falling. According to the S&P Case-Shiller index, average prices in America's ten main cities fell by 4.1% in the year to June (see chart).
A still-deepening housing bust left the economy vulnerable well before August's crunch. And that crunch has made the prospects for housing much worse. To see why, consider that the mortgage instruments that have disappeared, or become dramatically more expensive, account for more than half of all mortgages originated last year. They include subprime and Alt-A loans for the least creditworthy and ”jumbo” loans that are too big to be bought by the government-backed behemoths, Fannie Mae and Freddie Mac.
Not surprisingly, Wall Street's seers are chalking down their projections for construction and house prices. Economists at JPMorgan, for instance, now expect the pace of new-home building to fall by a further 30%, while they expect average house prices to tumble between 7.5% and 15% by the end of 2008. Jan Hatzius, an economist at Goldman Sachs, thinks that house prices could drop by between 15% and 30% over the next few years.A construction bust will continue to drag down output growth. The bigger question is what effect double-digit house-price declines would have in a country where consumer debts have soared on the back of housing wealth. Optimists take comfort from consumers' resilience so far. That may be a mistake. Some 60% of people whose recent adjustable-rate mortgages reset next year, for instance, have less than 15% equity in their homes, suggesting double-digit price drops will bring far more financial distress. Problems are already emerging in other consumer debt (credit-card defaults, for instance, are rising), and lenders are likely to get tougher. Consumer spending will be crimped as homeowners feel poorer, particularly if stockmarkets continue to slide.A simulation by economists at UBS gives a sense of the risks. Their analysis suggests that the combination of a credit shock (which they define as an increase of one percentage point in the cost of capital), coupled with drops of 10% in both share and house prices, would drag America's output growth down by 2.6 percentage points next year, in effect pushing the economy into recession. So why are most Wall Street analysts still convinced that the damage from financial distress will be limited? The main reason is that they expect the Fed to ride to the rescue with lower interest rates. Financial futures prices suggest investors expect the central bankers to cut their policy rate by 0.75%, to 4.5%, by the end of the year. But the UBS analysis shows that lower interest rates would not ease all of the pain. The model suggests that even with lower interest rates, America's growth rate could slow by more than a percentage point next year. Such simulations have their problems. But the bottom line seems clear. If America faces double-digit falls in house prices, the economy, despite looser monetary policy, looks set to be weak.
Foreign geography
The impact on the rest of the world, too, may be severe. Many expect the global economy to be robust enough to shake off American weakness. After all, America's output growth has been soft for more than a year, yet the global economy has remained strong.
Such optimism may underplay the potential channels through which the subprime mess can infect other countries. One route is financial contagion. Subprime losses are popping up from Canada to China. The broad spread of losses makes them easier to digest, but also spreads financial nervousness and risk aversion.
That risk aversion may find surprising victims. In previous financial wobbles, emerging markets often suffered most. This time rich countries, particularly in continental Europe, where some banks have been caught out by the subprime mess, may be more worried. Thanks to fat foreign-exchange reserves and current-account surpluses, many emerging economies are well placed to withstand an exodus of investors.
In Europe's rich economies, in contrast, subprime losses and investor nervousness may force banks to tighten their belts, denting the nascent growth in domestic spending. Germany's Ifo index of business sentiment fell for a third month in August, and consumer confidence has also declined. The European Central Bank, which before the crunch had signalled that it would raise interest rates on September 6th, seems to be waiting to see how the dust settles. This week Jean-Claude Trichet, the ECB's head, stressed that the bank was not “pre-committed” to an increase.
Even if direct financial contagion is contained, America's subprime crisis could spawn psychological contagion, particularly a reassessment of house prices. Although the scale of reckless lending to risky borrowers was bigger in America than anywhere else, house-price inflation has been more extreme elsewhere. Countries such as Britain and Spain are particularly vulnerable to a house-price bust.
Nor should the world economy's resilience to American weakness be exaggerated. Although America's current-account deficit has been declining, it is still almost 6% of GDP. By spending more than they produce, Americans are still a big source of demand for the rest of the world. A sharp drop in that demand would hurt.
The severity of mountainous terrain becomes clearer as you start climbing. So, too, the economic effects of the credit crunch will become more apparent over time. But as they mull over the challenges they face, the Jackson Hole attendees might take a good look at the Tetons.