Larry DeBoer
Professor of
Agricultural Economics
Purdue University

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Odds of Recession

We may have a recession in 2007 or 2008. Or we may not. Former Federal Reserve chairman Alan Greenspan made waves back in March by putting the odds of recession over the next year at one out of three. More likely than usual, but still unlikely.

But why do we need odds or probabilities? Why can't economists just give a yes or no answer to the question of recession? Will we have one or not?

One reason may be that the study of economics isn't advanced enough (or economists aren't smart enough) to provide the answer. But another reason is that recessions are caused by shocks. And shocks are, well, shocking. An unexpected event drags down the economy, and the economist looks at the ruins of his or her forecast and says, "I sure didn't expect that to happen!"

What are shocks? Asset market crashes, in stocks or real estate. Foreign exchange crises. Wars and revolutions on top of the world's oil supply in the Middle East . Terrorist attacks. Weird changes in expectations by consumers or businesses. Ill-timed government policies.

All these shocks have played a role in recessions in the past. But shocks don't always bring recession. The stock market crashed in 1987. No recession followed. The 1997-98 Asian currency crisis could have ended the 1990s expansion early. It didn't. Shocks tend to cause recessions when the economy is already weak. Or, if you like, it takes more than one shock to bring about recession.

Consider the recession in 1980. The economy was already weak. The Fed had begun increasing interest rates by the end of 1979. The revolution in Iran was pushing oil prices to record levels.

Inflation was in double digits in 1980, and President Jimmy Carter wanted to bring it down. So, he had the Federal Reserve impose "consumer credit controls" to restrict credit card borrowing by consumers. If consumers spent less, retailers would have to cut their prices. He announced the new policy in a speech in March. He scolded consumers for going into debt to try to beat inflation. That just made the problem worse, he said.

The controls weren't very tight, and economists didn't think they'd have much effect. But people quit spending. Some cut up their credit cards and sent the pieces to the White House. Perhaps consumers felt guilty about buying so much on credit, and the President's speech had tapped into that guilt.

The drop in spending pushed an already weak economy into recession, because consumers responded to a small policy change in a big way. It was a shock.

Consider the recession of 1990-91. The economy was already weak. The Fed had increased interest rates. The savings and loan crisis had led to a "credit crunch," so banks were reluctant to lend.

Then, on Aug. 2, 1990, Saddam Hussein invaded Kuwait . The first Gulf War was on. Oil prices increased for a time (they dropped again before the war ended).

Consumer confidence dropped. Consumer spending fell. Perhaps consumers remembered that oil price hikes had preceded the previous three recessions, and figured they'd better not commit to buy a car or house if a recession was coming. So, they held back on their spending. And a recession came.

What's our situation today? The economy is already weak. The Fed has increased interest rates. Oil prices have risen. Output has been growing by less than 3 percent for several quarters. And we've had our shock. The housing boom has collapsed. In many markets, home construction has dropped, home sales have slowed and real estate prices are falling.

We don't know yet how severe this shock will be. Will it lead to a credit crunch? It might. Business spending on buildings and equipment has slowed along with housing construction. Perhaps, they're having trouble borrowing money for these big investments.

Most important, though, is how consumers will react. With housing prices falling, will consumers stop spending? Will they take out fewer home equity loans? They haven't so far. Consumer spending has continued to grow.

Odds are consumers will keep spending. The housing market shouldn't have that big an effect on consumers. What if it does? That would be a shock.




Writer: Larry DeBoer
Editor: Olivia Maddox