This Recession Is Only Beginning

05/19/2008 12:00 am EST

Focus: MARKETS

Gary Shilling

Columnist, Forbes

Gary Shilling, editor of Gary Shilling's Insight, says the housing bust will depress spending and encourage saving, prolonging a recession and dampening any recovery.

The overleveraged, illiquid financial sector has suffered considerably for almost a year [in] the second phase of this recession. The first phase, the subprime slime, which spread to the rest of housing, precipitated those woes on Wall Street, which was unprepared.

Between the first two recessionary phases, last April and May, optimists thought the setbacks would be confined to housing. Similarly, they now believe the economy will recover in the second half, registering a mild recession in the first half at worst.

But in our view, recessionary phases 3 and 4 are on the way. The next big event is weakness in consumer spending, more so than in any previous post-World War II recession with the disappearance of home equity, the fuel for consumer spending in recent years in the absence of robust growth in wages, salaries, and other income.

Furthermore, high energy prices are sapping consumer purchasing power while layoffs mount. Falling consumer spending, which accounts for 71% of GDP, should depress the economy severely in the second half of this year. Then comes recessionary phase 4 as declining consumer outlays and general US weakness depress the exports on which many foreign countries depend.

The household sector used to be a big net saver, even after accounting for spending on residential construction. But no more, as the saving rate collapsed and mortgage borrowing leaped in recent years. With the collapse in housing activity, however, both mortgage borrowing and mortgage equity withdrawal are also plummeting.

The further collapse in house prices will take its toll on real household wealth in houses while the bear market that commenced last October will continue to damage the real stock wealth that never really recovered from the 2000-2002 nosedive. This will have consumers in very distressed condition.

Sure, US consumers will spend as long as they have borrowing power. With the collapse in home equity, many turned to credit cards and maxed them out as delinquencies leaped. Some have raided their slender 401(k)s. But consumers have no remaining assets of adequate size to spend or use for borrowing.

Our research examined the rest of household assets beyond stocks-now $11.3 trillion in market value but down from the $13-trillion peak in the first quarter of 2000-and houses-now $22.5 trillion and falling fast-and found no other assets big enough to support meaningful consumer spending. [With few] assets to fund oversized spending, US consumers will be forced into a saving spree.

If the saving rate shifts from falling a half-percentage point per year for 25 years to increasing one percentage point per annum for 10 years, that would take about 1% off GDP annual growth rates for a decade.

Given the dependence of most countries on direct or indirect exports to the US for growth, the effects of American consumer retrenchment in this recession and in the chronic saving spree that should follow will be much worse for many foreign economies than for the US.

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