Is the US heading for recession?

Even optimistic pundits are warning that Americans will have to start tightening their belts. And if they do, so might everyone else, says Jody Clarke.

Is the US heading for a recession?

It certainly looks possible. Former Federal Reserve chief Alan Greenspan believes there's a 50/50 chance of the US going into recession this year, and he's far from alone. A Reuters poll of 88 analysts last month put the odds of a US recession at 40%, up from 35% in November.

Even this may be overly optimistic. A recession technically defined occurs when an economy shrinks for two quarters in a row. As economic-growth data are historical, it's impossible to be sure if an economy has been in recession until well after it begins. But Bill Gross, the head of Pimco, one of the world's largest asset managers, told the FT last month: "If I had to be bold, I'd say we began a recession in December."

Are things really that bad?

Looking at the most recent data, there seems little cause for concern. Annual GDP growth rose from 3.8% in the second quarter to 4.9% in the third. However, most analysts expect the figure to plunge in the fourth quarter, to as low as 0%, says economic forecaster Global Insight. "A mild US recession is now likely, with no growth for the year ahead," said the normally upbeat Richard Berner, chief US economist for Morgan Stanley in New York, in a recent note to clients. "Financial conditions are tighter, the weakness is broadening into capital spending, and global growth is slowing."

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So what's the problem?

The housing downturn, and more to the point the impact that's having on the amount of money available for US consumers to spend. Median house prices have fallen this year for the first time since the Great Depression, squeezing ordinary Americans who have been borrowing against the value of their homes to fund their lifestyles.

According to the latest Standard & Poor's/Case-Shiller index, house prices in ten key cities fell by 6.7% in October compared with the same time last year. As subprime borrowers stopped paying off their mortgages, banks and hedge funds that took bets on these bad loans have been hammered. The resulting credit crunch has made it pricier for banks to borrow money, making them and other lenders less willing to lend to the public.

As New York University economics professor Edward Wolff points out in The Times, middle-class Americans "are not going to be able to take out additional debt. Credit-card companies and auto-loan groups are just going to start saying no." As consumer spending accounts for 70% of US GDP, any downturn here will have a huge impact.

Can recession be prevented?

The Fed has cut interest rates by a full percentage point since September to 4.25%, and many expect it to cut by another point next year. But the housing slowdown looks like it has only just begun. In 2008, home sales will drop 12% and prices 4.5%, says lender Fannie Mae.

Meanwhile, Lehman Brothers estimates that almost one million mortgage loans will default in 2008, up from 300,000 last year. "Our judgment is that it's hard to see that the slowdown we've seen in the housing sector won't spill over in a more powerful way to consumer and domestic demand broadly," says Brian Coulton of ratings agency Fitch.

Why is this such bad news for the rest of us?

Of Chinese exports, 21% head for the US, so any slowdown in US consumer spending will have a big effect on Asian economies, which many hope will prop up the world economy if America falters. "There is a view that the world is somehow decoupled from the American growth engine," Morgan Stanley's Stephen Roach told Sky News recently. "I think that view will turn out to be dead wrong." The US is a $9.5trn consumer, while China stands at just $1trn and Indian $650bn, says Roach. "It is almost impossible for the young, dynamic consumers of China and India to fill the void."

Are there any grounds for optimism?

The economy's poor state has put a smile on the face of US exporters. The weak dollar saw exports rise 19.1% in the third quarter, more than double the second quarter. As a result, the US trade deficit is now at its lowest rate in two years. Blinky Chadha of Deutsche Bank reckons jobs growth will remain strong, and with the Fed cutting rates again, he predicts "no recession in the US and a rebound in growth during the second half of 2008".

But the US cannot survive on exports alone; according to the Manufacturers' Alliance, the housing slump will mean there will be no manufacturing production growth this year, which bodes ill for jobs, particularly at a time when the financial sector laid off a greater number of people in 2007 more than 150,000 than during the dotcom bust. As Yale economist Robert Shiller warned The Times this week, "a Japan-style recession with property values declining for years is a realistic scenario'".

Why things could be even worse for the UK

When America sneezes, so the saying goes, everyone else catches a cold. But the UK may get something nastier. Last month, Dresdner Kleinwort said there is now a 50/50 chance of a UK recession in 2008. UK consumers have also been relying on a housing boom to prop up their finances, but that boom is now over. The state of the public finances is grim Liam Halligan in The Sunday Telegraph points out that borrowing is likely to hit £42bn in 2007/2008, £5bn ahead of the most recent forecasts.

The Government may find it has to raise taxes, just as consumers are feeling the pressure of falling house prices. Add rising petrol and food costs, which will make it harder for the Bank of England to cut interest rates, and the outlook is bleak.

Jody Clarke

Jody studied at the University of Limerick and she has been a senior writer for MoneyWeek for more than 15 years. Jody is experienced in interviewing, for example in her time she has dug into the lives of an ex-M15 agent and quirky business owners who have made millions. Jody’s other areas of expertise include advice on funds, stocks and house prices.