Recession 2007 By Dominick T. Armentano Price of Liberty

December 11, 2006

Are we headed for an economic recession? Probably. What can we do about it? Not much.

The 5-year economic expansion initiated by tax reductions and lower interest rates has just about run its course. My guess is that the recession should begin in the first or second quarter of 2007 and run, if history is any guide, for about 18 months. Unfortunately for the Republicans, that would put the bulk of the decline well within the 2008 presidential race.

Economic expansions don't end naturally, but are short-circuited by bad economic policy. The fact remains that the Federal Reserve kept interest rates too low for far too long following the recession of 2000-2001. This easy money policy fueled an unprecedented expansion in the housing industry both in supply and in price appreciation. Absent substantial improvements in productivity and real income for households, that bank-fueled expansion was simply not sustainable, long term.

When the Federal Reserve woke up last year and finally pushed rates up modestly, the housing expansion stalled. Since then, prices for homes and condominiums in many areas have been in near free-fall. In my estimation it will take years, not months, to work off the surplus national inventory and restore normalcy to the housing market. A “soft landing” is just not in the cards.

Sales of automobiles mirror housing sales (with a time lag) for several reasons. First, most new car purchases are financed, and higher interest rates slow the demand for cars and trucks. Second, and more importantly, declines in the value of housing produce what economists call a “negative wealth effect.” This means that we are more likely to purchase a new car (or a vacation condo) when our primary home is worth, say, $300,000 rather than, say, $175,000. As the value of our home adjusts downward, we feel “poorer” (even if we never sell), and we cut back on large purchases elsewhere. We are in the early stages of that adjustment now.

Financial markets are also signaling a possible near-term recession. Long-term (5-year) interest rates are now lower than short-term rates, and this so-called “inverted yield curve” often foretells economic troubles down the road. Normally there is an interest rate premium for lending long-term: long-term rates are usually higher than money lent for less than one year. When long-term rates are lower, it implies that the demand for long-term capital and investment is soft, and that the long-term business outlook is relatively bleak.

Is there any good news? Sure. Employment is strong, and people who work spend money and save for the future. And despite the problems, housing markets are working efficiently, which means that new construction is slowing markedly and used home prices are adjusting downward to reduce the unsold inventory. Ditto in autos, where major producers have announced production cuts, and where rebates and dealer-supported financing will clear backlog.

Also, unlike other recent recessions, most of our major corporations and financial institutions appear strong, with fairly solid balance sheets. Finally, the stock market has moved briskly higher in the last 6 months, counter-balancing, to some extent, the negative wealth effect in primary housing. If I'm right about the recession, however, this upward move in stock prices will also stall.

In short, we are headed (probably) into an extended period of relatively modest economic activity. We can avoid making the slowdown worse by steering clear of tax increases and higher minimum wages. Households with high leveraged debt and cyclical employment will be hit the hardest. The rest of us should muddle through in reasonably fine fashion.

Dominick T. Armentano is professor emeritus in economics at the University of Hartford (Connecticut) and a research fellow at The Independent Institute in Oakland, Calif. He is author of Antitrust & Monopoly (Independent Institute, 1998).

Alvaro Vargas Llosa is director of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. He is widely published and has lectured on world economic and political issues including at the Mont Pelerin Society, Naumann Foundation (Germany), FAES Foundation (Spain), Brazilian Institute of Business Studies, Fundación Libertad (Argentina), CEDICE Foundation (Venezuela), Florida International University, and the Ecuadorian Chamber of Commerce. He is the author of the Independent Institute books The Che Guevara Myth and Liberty for Latin America. Full biography and recent publications.

Ivan Eland is Director of the Center on Peace & Liberty at The Independent Institute and Assistant Editor of The Independent Review. Dr. Eland is a graduate of Iowa State University and received an M.B.A. in applied economics and Ph.D. in national security policy from George Washington University. He has been Director of Defense Policy Studies at the Cato Institute, Principal Defense Analyst at the Congressional Budget Office, Evaluator-in-Charge (national security and intelligence) for the U.S. General Accounting Office, and Investigator for the House Foreign Affairs Committee. Full Biography and Recent Publications

Pierre Lemieux is an economist and co-director of the Economics and Liberty Research Group at the Université du Québec en Outaouais and a Research Fellow at The Independent Institute in Oakland, California.

Alexander Tabarrok is research director at The Independent Institute, associate professor of economics at George Mason University, editor of the Independent Institute books, Entrepreneurial Economics, The Voluntary City (with D. Beito and P. Gordon), and Changing the Guard: Private Prisons and the Control of Crime.

Robert Higgs is Senior Fellow in Political Economy at The Independent Institute, author of Against Leviathan and Crisis and Leviathan, and editor of the scholarly quarterly journal, The Independent Review. Click here for a bio on Dr. Higgs, the noted economist and historian.

William Marina is Research Fellow at the Independent Institute in Oakland, Calif., and Professor Emeritus of History at Florida Atlantic University.

David T. Beito is a Research Fellow at The Independent Institute, Associate Professor of History at the University of Alabama, and co-editor of the book, The Voluntary City: Choice, Community and Civil Society.

William Marina and David T. Beito belong to "Liberty and Power," a group blog at the History News Network.

For further articles and studies, see the Center on Peace & Liberty and OnPower.org.

Nicolas Heidorn is a public policy intern at The Independent Institute in Oakland, California.

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