Robin Chavalier

IN RECENT years, it has rarely paid to be pessimistic about America's economy. Time and again, worried analysts (including The Economist) have given warning of trouble as debt-laden and spendthrift consumers are forced to rein in their spending.

So far, that trouble has been avoided. The housing market peaked early in 2006. Since then home-building has plunged, dragging overall growth down slightly. But the economy has remained far from recession. Consumers barely blinked: their spending has risen at an annual rate of 3% in real terms since the beginning of 2006, about the same pace as at the peak of the housing boom in 2004 and 2005.

At the same time, rapid growth in emerging markets coupled with a tumbling dollar has provided the American economy with a new bulwark, one that strengthened even as financial markets seized up over the summer. Exports soared at an annual rate of 16% in the third quarter. Thanks partly to strong export growth, revised GDP figures due on November 29th are likely to show that America's output grew at an annual rate of around 5% between July and September. Never mind recession: that is well above the economy's sustainable pace of growth.

But the good news may be about to come to an end. The housing downturn has entered a second, more dangerous, phase: one in which the construction rout deepens, price declines accelerate and the wealth effect of falling prices begins to change consumers' behaviour. The pain will be intensified by a sharp credit crunch, the scale of which is only just becoming clear. And, in the short term, it will be exacerbated by a spike in oil prices—up by 25% since August—that is extreme, even by the standards of recent years. The result is likely to be America's first consumer-led downturn in close to two decades.

Home is where the rot starts

The biggest source of gloom is housing. Despite almost two years of plunging construction, the collapse of the property bubble is far from finished—and its impact on broader consumer behaviour has barely begun. So far, the housing recession has been a builders' bust. Housing starts are down by 47% from their peak and residential building now accounts for 4.4% of GDP, down from a record of 6.3% in 2005. That is a big drop, but not yet unusually long or deep by historical standards. Nouriel Roubini and Christian Menegatti, of Roubini Global Economics, point out that the seven other housing recessions since 1960 lasted an average of 32 months and saw housing starts fall by 51%.

Judging by the large number of unsold homes and the pace at which buyers are cancelling contracts (around 50% according to some homebuilders), it is clear that builders have further to cut back. Richard Berner, of Morgan Stanley, expects a further 25% decline, taking the pace of housing starts in 2008 to below 1m, the slowest since records began in 1959.

A builders' bust will not, by itself, drag the economy into recession. Most post-war construction busts have been followed by recession, but only because they were triggered by tighter monetary policy to head off inflation. The housing busts were a symptom of a forthcoming recession rather than the cause. This time, the source of trouble lies with the bursting of the housing bubble itself.

Since 1997, house prices have more than doubled in real terms. That increase has coloured America's economy in ways that go far beyond the construction boom. In particular, rising house prices provide consumers with the collateral they need for a huge increase in borrowing.

Up to their necks

Relative to their incomes, consumers have been taking on more debt for decades, as America's increasingly sophisticated financial system allows more people more access to credit. But the pace of indebtedness has accelerated dramatically. The ratio of household debt to disposable income is now above 130%. Earlier this decade it was 100%; in the early 1990s it was 80% (see chart 1).

That credit expansion was made possible by rising house prices. Now they are falling, credit conditions are tightening. Both shifts are just beginning. According to the S&P/Case-Shiller index, arguably America's most accurate national measure, house prices have fallen by around 5% in nominal terms since their peak, or 8% once inflation is taken into account. That is a tiny drop compared with the past decade's rise (see chart 2).

Nor, judging by the pipeline of unsold homes, is it enough of a drop to bring demand in line with supply. Unlike shares, whose prices change quickly, house prices are often “sticky” as homeowners are loth to acknowledge their houses are now worth less. But the coming months are likely to see a sharp jump in the supply of homes for sale under distressed conditions. More than 2m subprime borrowers face markedly higher mortgage payments over the next 18 months as their interest rates are adjusted to new levels. Many will be forced into foreclosure.

This constellation will drive house prices down. Most Wall Street seers expect a drop of around 10% in nominal terms over the next year or so, but price declines of 15% or even 20% are no longer regarded as outlandish. Economists differ on how, and by how much, falling house prices will affect consumers' spending. But empirical studies suggest that changes in house prices have a bigger effect on consumer spending in countries, like America, where credit markets are deepest.

The most recent research implies that changes in Americans' housing wealth affects their spending more than similar changes in their financial wealth, although the effect takes longer to emerge. A $100 fall in financial wealth is traditionally associated with a $3-5 decline in spending. An equivalent fall in housing wealth, it seems, eventually reduces spending by between $4 and $9.

Given that America's stock of residential housing is worth some $21 trillion (or almost one-third of all household assets), a 10% drop in house prices would make a discernible dent in consumption growth. If the spending response were at the top of economists' estimates, for instance, consumer spending would slow by almost two percentage points. The economists' studies, however, suggest that effect will be gradual: falling house prices will be an ongoing drag on consumer spending, rather than a sudden brake.

So far, this brake has been eased by strong gains in financial wealth. Thanks to higher stock prices, American households' overall assets have still been rising smartly. If the stockmarket loses momentum along with the economy, the wealth effect on consumer spending could appear quite quickly.

A wholesale credit crunch would make matters much worse. No one is yet sure how tight credit will get. It depends on how big the losses from the subprime-related mess turn out to be; who holds those losses; how far banks are forced to take troubled assets, such as those in structured investment vehicles, onto their balance sheets; by how much they cut back lending in response; and how far the Federal Reserve reduces short-term interest rates to compensate.

Three months after the summer's financial turmoil first hit, the omens do not look good. Entire markets for securitised assets are shrivelling: the asset-backed commercial-paper market has shrunk for 13 weeks in a row and is now 30% smaller than in August. Estimates of the eventual losses from the subprime-related debt mess continue to rise.

Ben Bernanke, the chairman of the Fed, recently put the losses from bad mortgage loans at $150 billion, up sharply from the $50 billion to $100 billion he expected early in the summer. And even that may be too low, given that some $1.3 trillion-worth of subprime loans alone were originated between 2004 and 2006. Deutsche Bank now estimates overall subprime-related losses at up to $400 billion, of which $130 billion will belong to banks. Write-downs of that scale will eat into even the best-stuffed capital cushions.

By some measures, banks are already hunkering down. According to the Fed's most recent survey of loan officers, a quarter of banks tightened their standards on consumer loans (other than credit cards) in October, up from only 10% in July. Four out of ten banks demanded higher standards on prime mortgages, up from 15% in July. The pace at which banks are tightening their mortgage-lending standards rivals that of the early 1990s, when the banking sector as a whole was much weaker and less well capitalised (see chart 3). But since tighter mortgage standards are themselves a response to the housing bust, they may overstate the extent of an economy-wide credit crunch.

Shocked by oil

Many Americans, however, will find credit harder to come by. And just as they do so, the third blow will come: that of higher fuel costs. Although it has fallen back this week, the benchmark price of crude oil is still above $90 per barrel, almost 25% higher than in August. This surge has not been fully reflected in American petrol prices, largely because refineries had unusually fat margins earlier in the year. Average petrol prices are up 33 cents per gallon (or 12%) since mid-August. Unless crude prices fall dramatically, much dearer petrol lies ahead. If oil stays near to $100 per barrel, some analysts are talking about $4 per gallon by next summer.

Higher fuel costs are the equivalent of a tax on consumers, reducing the amount of money they can spend on other things. Jan Hatzius, of Goldman Sachs, reckons that a rise in petrol prices of one cent reduces consumers' overall disposable income by about $1.2 billion, and tends to drag consumer spending down by $600m. Over the next few months, he reckons, higher fuel costs could reduce consumer spending by 1.2% at an annual rate. Overall, this drag will be smaller than the combination of tighter credit and falling house prices, but its impact will be concentrated over a shorter period.

A final cause for concern is the labour market. Low unemployment and solid wage growth have been a big reason for consumers' resilience thus far (see chart 4). With unemployment at 4.7% and 166,000 new jobs in October, that strength looks intact. But careful inspection suggests that October's numbers mask a wider slowing. The pace of net job creation has fallen from a monthly average of 189,000 in 2006 to 118,000 in the past three months. Details from the household-based employment survey, which may be more accurate when the economy is slowing, are even darker. It shows very little net job growth in 2007, and an unemployment rate that is already up by three tenths of a point from its nadir.

Add this all up and it is small wonder that consumers are feeling gloomy. Most gauges of consumer confidence have been plunging of late. The University of Michigan's index is at its lowest level in 15 years, leaving aside the aftermath of Hurricane Katrina. The latest evidence suggests spending is already weakening: core retail sales were flat in October.

Consumer spending, at around 70% of GDP, is by far the biggest determinant of the economy's fate. But it is not the only one. The odds of a downturn also depend on whether other engines reinforce—or counteract—consumers' weakness.

One wild card will be firms' investment. Corporate spending is historically volatile, often helping to tip an economy into a formal downturn. In America's last recession, in 2001, plunging investment was the source of trouble, as firms worked off the investment excesses of the late 1990s. Today, corporate America is in much stronger shape. Overall, balance sheets are healthy and profits strong. But as Martin Barnes, of Bank Credit Analyst, points out, domestic non-financial firms, the ones that do most capital spending, have been doing rather less well, with profits down by 9%, compared with a year earlier, in the first half of 2007. Corporate investment may not drag the economy down, but nor is it likely to offer a boost.

That role belongs elsewhere—to foreign trade. America's exports have been booming while import growth has slowed sharply. That has narrowed America's trade deficit and boosted output. Exports will not continue to grow at the torrid rates seen in recent months, but with the dollar showing scant signs of a turnaround and with emerging economies, in particular, looking remarkably resilient (see article), exports will remain an important prop. At 12% of GDP, they are now easily able to offset the drag from weaker construction.

Recession or not?

Put all this together and do you get a recession? Many analysts expect a sharply slower economy, but not an outright recession—using the popular definition of two consecutive quarters of falling GDP. Wall Street's seers have shaved their projections for GDP growth in the fourth quarter of 2007 to around 1.5%. Most of them expect a couple more similarly weak quarters thereafter. A few long-standing bears, such as Mr Roubini, are convinced recession is inevitable. But most forecasters reckon the odds remain below 50%.

Yet history cautions against taking too much comfort from this. It is true that pessimists tend to predict recessions more often than they occur, but it is equally true that mainstream forecasters usually fail to predict those that happen. In both 1990 and 2001, Wall Street's seers were predicting modest growth when the economy, it turned out, was already contracting. History also shows that America's economy can swing quickly from strong growth to contraction. During the first three months of 1990 the economy was growing at 4.7%, but it was in recession by July. Adjust Wall Street's forecasts for their inherent conservatism and an outright recession seems all too plausible.

The bigger point is that even if the economy technically avoids a recession, it will feel like one to most Americans—because it will be led by consumers. That will be a big change. Consumer spending has not fallen in a single quarter since 1991; it has not fallen on an annual basis since 1980. Consumers barely noticed America's last recession—when low interest rates and high house prices kept them spending solidly (see chart 5). Just how voters and politicians react to a consumer downturn in an election year is worryingly uncertain.

What's more, the squeeze on consumers will last longer than many expect because it involves the unwinding of an asset-price bubble and attendant financial excesses. Just as corporate spending stayed weak for years after the 2001 recession, so consumer spending will be crimped for more than a few months. There seems little reason to expect, as many analysts seem to, that the housing bust will be history by the second half of 2008.

Finally, policymakers' responses may be more muted. In 2001, the economy was cushioned by a large fiscal boost, thanks to tax cuts and bigger spending, as well as much lower interest rates. A big tax cut now seems extremely unlikely. At the same time, the weak dollar and global economic strength that softened the downturn will also complicate the central bankers' ability to respond. Based on underlying inflation expectations, real interest rates are still above 2%. Central bankers often push short-term real rates to zero, or even below, in a downturn, suggesting there is plenty of room to cut, particularly since the housing glut means lower interest rates may pack less punch. But high oil prices and a falling dollar may preclude such an aggressive response, as Mr Bernanke worries about rising inflation expectations. Recession or not, America faces a tricky road ahead.