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Running Head: A Looming Recession

 A Looming Recession

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We are now almost five and a half into the current economic expansion. A slow start in 2002 was followed by three years of strong gains in real economic activity and a substantial decline in unemployment. Initially, monetary policy was very accommodative as the Federal Open Market Committee used on providing support for the recovery and avoiding an unwelcome disinflation. From early 2003 to early 2006, real gross domestic product (GDP) rose at an annual rate of 3-1/2 percent, well above consensus estimates of its underlying sustainable rate, and the unemployment rate declined to 4-3/4 percent.

Since the spring of 2006, however, the expansion of the U.S. economy appears to have been undergoing a transition to a more moderate and sustainable pace. Although such a transition will no doubt be marked by some bumps in the road, it represents a desired macroeconomic rebalancing that over the longer run can help ensure sustained non-inflationary growth. One of the fundamental factors underlying the deceleration in real activity is the lagged effect of the Federal Open Market Committee 's removal of monetary policy accommodation between June 2004 and June 2006. Another source of the rebalancing is the substantial correction in housing markets that has been under way since last spring as the unrealistic expectations about home price appreciation that fueled the extended boom in homebuilding have been unwinding.

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Looking ahead, the most likely outcome for the coming quarters is a continued moderate rate of economic expansion accompanied by some easing of pressures on resources. With inflation expectations contained, it is to expect such an economic environment to foster a gradual slowing over time in the rate of core consumer price inflation. However, the actual path for economic activity and inflation could, at times, be uneven; and as is the case for all forecasts, it involves a number of risks and uncertainties on both the downside and the upside.

Turning first to the prospects for economic activity, two particular areas have emerged recently that have heightened uncertainty about the near-term outlook. The first area is housing: Where do we stand in the housing adjustment, and what effect will recent developments in subprime lending have on that adjustment? The second area is business investment: How should we interpret the incoming data showing that business spending on equipment and software has been weak this year?

Regarding the housing adjustment, new single-family homes were started at an average annual rate of a bit under 1.2 million units in the first three months of this year, a pace roughly one-third below the unsustainable peak in new construction reached in mid-2005. At the beginning of the year, the ongoing cutbacks in starts of new homes, together with a lowered but fairly steady pace of home sales, were beginning to reduce the elevated backlog of new homes for sale. However, a further weakening in sales of new homes in January and February reversed some of the progress in reducing those inventories. As a result, cutbacks in new residential construction may well persist for a while.

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More recently, developments in the subprime mortgage market have raised some additional concern about near term prospects for the housing sector. The sharp rise in delinquencies on variable-interest-rate loans to subprime borrowers and the exit of a number of subprime lenders from the market have led to tighter terms and standards on such loans. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal. Variable interest rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely. Banks and thrift institutions that hold mortgages are well capitalized, and exposures of individual banks to possible subprime losses do

The unwillingness of businesses to invest might be due to concerns about the prospects for long-term productivity growth and the expected rate of return on capital investment. Moreover, businesses may be anticipating a more pronounced deceleration in sales than would be consistent with the moderate expansion that I am expecting. Respondents to the Blue Chip Economic Indicators survey suggest that the recent reluctance to invest reflects greater uncertainty about the outlook for sales and earnings. If so, the continuation of a moderate economic expansion is likely over time to restore confidence and lead to a firming in business investment.

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Not all of the recent news on business spending has been to the downside, however. Demand for high-tech equipment appears to have picked up early this year after leveling off in the final quarter of 2006. Demand for computers, which was likely boosted by the introduction of the Windows Vista operating system, seems to be advancing at a healthy pace. Technological innovations – such as circuitry that boosts computer performance and lowers energy consumption – appear to be generating demand to upgrade equipment in data centers. In addition, major U.S. cable companies are forecasting a step-up in capital spending, and telecommunications carriers are planning a further expansion of fiber-optic networks.

Although questions related to the prospects for housing and business spending appear to have widened the range of uncertainty about the near-term outlook, developments in other areas appear to support a continued moderate rate of economic expansion. Monthly gains in employment, while down some from last year's pace, remain solid; the average monthly increase in nonfarm payrolls over the first three months of this year was about 150,000, compared with about 190,000 in 2006. To date, job cutbacks have been centered in industries related to residential construction and manufacturing, with no indication – either from the monthly labor market reports or the weekly unemployment insurance data – of widening weakness.

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In addition, the incoming information on consumer spending has been consistent with a moderate pace of demand. The steady labor market has been generating income; and despite the ups and downs in energy prices, real disposable income has been trending up at about a 2-3/4 percent rate since early 2006. In addition, household credit quality remains generally favorable. As is the case for prime mortgages, delinquency rates on consumer loans are low. And despite the deceleration of house prices, the ratio of household net worth to disposable income is still elevated.

The U.S., the main engine of world economy, is facing a deceleration in economic growth on account of low household savings and a large and growing external deficit. Economic growth remains lacklustre in western Europe while the economy is making a modest recovery in Japan. China and India continue to have fast rates of economic growth, and increasingly, these two countries are setting the pace for the world economy.

In general, developing countries in East Asia, South Asia and Africa are experiencing relatively fast expansion of economic output, and several least developed countries (LDCs) are faring even better; however, economic growth has been relatively slow in Latin America. Irrespective of the moderately fast growth of output, growth of employment has been lagging, and high rates of unemployment and underemployment threaten the goal of poverty reduction in much of the third world.

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In 2000 at the turn of the century, there has appeared a thriving economic situation in the world, that has been rarely seen for many years and has gone down in history with a good record of growth.. However, the existence of unstable factors, such as the steep rise of oil price, the fluctuation of the global stock market and the plummeting of the exchange rate of the Euro, has caused people to feel anxious about the future development trend of the global economy... Nevertheless, the good momentum gained in the powerful growth and innovative development of the world economy this year forecasts that there will be a good beginning in the development of the world economy in the new century.

The worldwide strong economic growth is a salient feature of the world economic situation this year. World financial circles affirm that this year has witnessed the most forceful economic growth over the past 13 years, with the growth rate being expected to reach 4.7 percent, much higher than the 2.5 percent in 1998 and the 3.3 percent in 1999. In the next two years, the world economic growth rate is estimated to stay at around 4 percent. The growth of world trade value this year is expected to be 10 percent, the highest level since the first oil crisis occurred in the 1970s.

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The average economic growth rate of developed countries may reach 4.2 percent this year. The US economy continues to lead the tide of the world economic growth, with its economic growth rate getting close to 5.2 percent; the European economic situation is also better than in previous years, the average GDP growth rate of the 11 countries in the Euro zone is to reach 3.5 percent; the Japanese economy has extricated itself from a slump, its growth rate this year may reach1.9 percent, higher than the average growth rate in the past 10 years.

The average economic growth rate of the developing countries this year can reach 5.6 percent. The economic development in the Asian developing regions has attracted people's attention, their growth rate this year may reach 7.1 percent. Of them, China and some newly emerging industrial economies have given most prominent expressions: growth in exportation, a balanced international payment and a recovery in domestic demand. In addition, the economies in Latin America and the Middle East have begun to pick up after a speed reduction, the situation in Africa has also taken a turn for the better.

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The average economic growth rate of the transition countries may reach 4.9 percent, benefited from the oil price hike. The Russian economy has had an unexpected, strong recovery from the 1998 crisis, with the growth rate possibly reaching 6 percent.

Among the many factors that have boosted world economic growth, the growing information technological industry is playing an increasingly outstanding role. The information technological industry is becoming a leading industry in the national economy and a new economic growth point. This represents another feature in the world economic situation this year. According to experts' estimate, the current contribution rate of the information industry to the world economic growth is 18.2 percent, its ratio in the growth of the US economy is even higher, standing at one-third.

The information technological industry is currently the world economic sector experiencing fairly fast development and is creating ever-more wealth. An estimate shows that in 2000 income from e-business is to reach US$233.4 billion, the figure is estimated to increase to US$1,400 billion in 2003.

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The integration of the traditional economy and the web economy and the merger of the old and the new economy has become the present development trend of the world economy. Six world largest airlines of the United States, France and Britain announced this past April that they would jointly set up a website dealing in various aviation materials, with an annual business volume capable of reaching US$32 billion. The net economy has also taken big strides ahead in Asia.

In the new century, information technology will become the commanding height of the high and new technologies. In order to seize this commanding point, various countries around the world have been vying with each other to accelerate the development of their information technology: The United States has formulated relevant policies, increased investment for research and development, its investments in commerce using information equipment and software will be more than doubled in five years; the European Union (EU) formally put forward the concept of "Network Europe" in March this year, and has planned to raise 40 billion European dollars in the next three years to be used in the construction of a Network Europe and has set down the grand goal of catching up with and overtaking the United States to become the world's largest economic entity in 10 years, Japan, ASEAN countries and India have also mapped out their respective plans for the development of information technology.

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There are also some hidden troubles behind the good world economic situation. The fluctuation of the global stock market can be regarded as a major lurking peril in the present global economy. In the 90s, dangerous situations have frequently emerged in the international financial field. This year, the rise and fall in the global stock market, particularly high-tech stocks, have aroused people's concern. Although the Nasdaq index reached its peak value of over 5,000 points in March, on December 20 it plummeted to the low of 2,400 points, with the rate of decrease exceeding 50 percent this year. This has entailed the fluctuations in the stock markets of other countries, for example, the European stock index dropped by 21 percent, that of Japan by 25 percent and that of the ROK by 51 percent. Furthermore, judged from the present situation, it is hardly possible for the global stock market to witness a rapid, big rebound.

Depressing clouds also loam large over the sky of the international swap centers, the situation of Euro is depressed. This year, people have sold large quantities of European communications and high-tech stocks as well as European dollar bonds. Under such circumstances, seven Western countries were compelled to jointly interfere in the exchange houses in September, thereafter, the European central bank also twice singly interfere in the stock market in November, but with little result. The exchange rate reached its peak value of one Euro to 0..9140 US dollar on December 21 only after people anticipated that the US economic growth rate would continue to slow down in the fourth quarter. Apparently, the future development trend of Euro will depend mainly on whether or not the economy in the Euro dollar zone can continue a strong recovery and whether the US economic growth rate can slow down.

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The dramatic rise of oil price in the international market will increase the crude oil importing countries' expenditures on imports, bring greater inflationary pressure on the developed countries and expand the crude oil importing developing countries' current account deficits, thus leading to the deterioration of the debt problem. This has brought and will continue to bring certain negative influence on world economic growth.

At the turn of the century, people can see from the experiences and lessons in the 20th century that change is eternal and that people can adapt themselves to change and bring about development only through unremitting efforts for readjustment and innovation.

In the new century, the economic globalization is developing at an accelerated rate, under the action of the new technological revolution, the internationalization of productive forces has been greatly speeded up, the international division of labor and the degree of cooperation along specialized lines has become ever higher, transnational corporations have further become the mainstays of international economic activities, global economic competition and cooperation will further strengthen.

In order to cope with the new situation, various countries around the world, particularly the majority of newly emerging market countries, have in recent years actively carried out various types of reform to support the market economy and greet the tidal wave of a new technological revolution in the hope to bring the economy onto the track of a virtuous circle through system innovation, technological innovation and management innovation, and to imbue it with the ability to resist various unforeseeable external impacts. This year, America, Europe, Japan as well as some developing countries all have worked out plans to deepen structural readjustments.

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The new economy represented by information technology constitutes a big driving force and orientation for various countries to speed up structural readjustments. The US economic change is a typical example: People can remember that in 1992 when the Internet was first opened to the general public, the US economy was still in the doldrums, and the unemployment rate even further rose. However, US enterprises, particularly the financial sector, made the maximum use of the Internet, streamlined administrative structures and solved bad debts. .

Japan's already stagnant economy, the second largest in the world, looks even more dismal this year amid a worldwide economic slowdown following the September terrorist attacks in the United States. Bad news and pessimistic outlook for the economic are popular in Japan, with dwindling GDP (gross domestic product), hiking unemployment, reduced investment, job cuts, insolvent banks, and so on.

Earlier this month, the Japanese government announced Japan's GDP shrank by 0.5 percent in the third quarter of this year, or an annualized decline of 2.2 percent, the second consecutive quarterly shrinkage following a 1.2 percent contraction in the previous quarter.

The announcement officially confirmed that the Japanese economy has now slid into recession, the third recession in a decade. Recession is usually defined as two consecutive quarters of economic contraction.

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Fueling the latest slump, personal consumption, which had played a major role in keeping the economy from an unchecked plunge, dipped substantially in the quarter. The dwindling personal consumption, along with falling prices, point to the possibility of a dreaded deflationary spiral in which prices plunge amid a slowing economy.

The business sentiment also dumps, with the diffusion index of business sentiment among big manufacturers down to minus 38, according to the latest Tankan month report by the Bank of Japan ( BOJ). A minus reading means more firms are more pessimistic than optimistic.

The index of electronics makers and automakers, regarded as the engine of Japan's economy, hit a 27-year low of minus 63 and a record low of minus 14, respectively. Other accurate figures are certainly appalling, with industrial production down at an annual rate of 15 percent in the first half of the year, exports falling at an annual rate of nine percent over the same period while machinery order tumbling at an annual rate of 20 percent in the third quarter.

Unemployment situation was severe, with the jobless standing at a record high of 5.4 percent in October after renewing the record once again in the previous months. Japan's economic downward drift is certainly partly due to the spreading impact of the September 11 terrorist attacks and the U.S. economic recession, the first in a decade for the U.S.

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Industrial output and exports have slowed after the September 11 terrorist attacks, while the rising jobless rate and the mad- cow disease scare are dampening consumer confidence. But the root for Japan's problems lies in its own, namely, its failure to address the structural problems in the past and the lagging structural reforms, as the Organization for Economic Co- operation and Development (OECD) put it.

One of the long-standing problems came from its banking sector, which has consistently failed to deal properly with bad loans.
As of the end of September, Japan's 14 banks' outstanding bad loans totaled 20.69 trillion yen (166.8 billion U.S. dollars) under the strict disclosure standards required by the financial- system revival law. Another most worrying problem facing Japan is deflation, with prices falling close to one percent a year. Yet, Japan's policy makers seem incapable to respond to the dangers posed by prolonged deflation. The future course of the Japanese economy looks dim.

According to the UN annual report, World Economic Situation and Prospects 2007, a moderate fall in real estate prices could slow the growth of the US economy by 2.2 % in 2007. However, the same report also warns of the possibility that a more dramatic reduction in house prices in the United States of, for example, of 15%, would have deep repercussions. Such a fall, the report indicates, "would not only cut US growth to a rate below 1 percent in 2007 but would also substantially reduce world economic growth by at least one percentage point''. This possibility, which the British weekly "The Economist" has been warning about for some years now, could provoke a crisis on a grand scale, including the risk of a stock market crash.

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The picture outlined in the above quoted report, presented at the beginning of the year, was confirmed on Wednesday, March 14 with the fall in the world stock markets. The daily newspaper El País in its comments the following day, did not lend itself to optimism: "Nervousness and fear of a recession in the United States. These were the feelings that dominated investors yesterday, who issued many orders to sell, and this led to the second largest fall of the year for the IBEX 35, of 2.7% (...). Growth in mortgage payment arrears in the United States, which have risen to 4.6%, could provoke a fall in consumption and accelerate a recession".

The granting of hundreds of thousands of millions of dollars in mortgages in the United States in recent years, thanks to low interest rates, has provided a strong impetus to the building industry which in turn has led to the creation of hundreds of thousands of jobs, to the point where four out of every ten jobs created in the United States during the last ten years have been related to the real estate sector. At the same time, however, this process has led to unprecedented levels of debt for families, and a risk of defaulting on payments that, by threatening the banking system, would affect the entire economy. In a little more than a year, 36 North American banking institutions specialising in mortgages have gone bust and have disappeared from the market, a scenario that could be repeated in the Spain in an even more dramatic way.

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To appreciate the enormous danger that this sector is in, one statistic suffices: between 2000 and 2006, the value of mortgages in the United States rose from 4.8 trillion dollars to 9.5 trillion dollars.

The two major bottoms of the past were accompanied by severe financial distress. The distress was caused by factors outside of the housing market itself. This time, financial distress is beginning to be seen, but so far it has been pretty much confined to the mortgage market itself and not to other issues. But should other major credit problems emerge, a recession, in my view, is likely.

In the early 1980s, interest rates set record highs as Paul Volcker (late 1979) clamped down on the rate of growth of the money supply in order to end the inflation of the 1970s.

His action ended the inflation but also sent the economy into a huge recession as interest rates soared to record levels. All economic activity that relied on borrowed money suffered. Housing, business investment and auto sales, in particular suffered. Moreover, the high interest rates increased the value of dollar and exporters suffered as well.

This time, it is clear the banks will tighten their standards for mortgage lending, but there remains a lot of liquidity elsewhere in the financial system and it is unlikely that all forms of borrowing will be restricted. So if we fall into a recession at this time, the culprit is unlikely to be an inability to borrow money as it was in the early 1980s.

The housing crunch of the 1990s was related to the Savings and Loan crisis. Savings and Loan institutions had been the major source of housing finance. In the 1980s, these institutions transformed themselves with de-regulation and entered into many markets previously dominated by banks. Unfortunately, they did not have the expertise to assess risk, especially for office and commercial real estate, and they made many bad loans.

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As the Savings and Loan institutions went under, lending for construction collapsed, and the whole economy went into a mild recession.

A number of emerging markets, especially in emerging Asia, have built up reserves to protect against everything short of the Apocalypse. The reserve build-up is now undermining monetary control, as well as the soundness of their financial systems. Greater exchange rate flexibility would slow reserve build-up and allow countries to regain monetary control. Financial sector reforms so that capital is allocated more transparently and profitably would increase the returns to investment, which should not only lead to greater investment but also could reduce the need to save, allowing imported capital to fill the gap. Capital could then flow again in the desired direction.

Finally, as domestic demand in the United States slows down and until emerging market are large enough to take up the slack, Europe and Japan will have to help out. They will have to grow faster, and there are domestic imperatives for this, also. At its current growth potential, Europe simply cannot afford its welfare state, while Japan will have difficulty dealing with its fiscal problems. Structural reforms to increase competition and flexibility are essential. When call centers are helping firms around the world squeeze 24 hours into a working day, Europe cannot still be debating stretching 35 hours into a working week.

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Politicians typically deal only with the painfully immediate. Periods of foreign exchange or oil price volatility have been relatively brief, thus far, and the resulting pain muted so politicians have not been forced to focus. Even were they to do so, their choice of policies follows a simple calculus: any gain that follows elections counts for nothing, while any pain that precedes it is multiplied manyfold. Since the public will appreciate the gains from the policies we have outlined only in the medium term, it is not surprising that little has been done, thus far. But we are running out of time, and markets may not be willing to wait until after the next election. The world needs action now.

We are clearly at a turning point. The economy is flashing alternating signs of weakness and strength as it always does at a turning point. After good news, the optimists say we are out of the woods and after bad news the pessimists say more bad news is yet to come.

We are not out of the woods by any means, but we could still escape without a recession. Whether the turning point is a major downshift to slow growth or whether it marks the entry to a recession is yet to be determined. While I can’t be sure a recession is coming, we must remember that the housing sector has long tentacles. It affects the economy in many ways. There is the decline in GDP as new construction falls; there are the financial ramifications of unsound mortgages; and there is the effect on household spending of declines in the value of houses.

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David W. Smith, 1993, “Economic and Social Development in Pacific Asia (Growth Economies of Asia Series)”

The World Bank, 2002, “World Development Report 2003: Sustainable Development in a Dynamic World: Transforming Institutions, Growth, and Quality of Life (World Development Report, 2003)”

David Judge, Gerry Stoker, and Hal Wolman, 2006, “The contribution of economic freedom to world economic growth, 1980-99.: An article from: The Cato Journal”

Institute for International Economics (U. S.), C. Fred Bergsten, John Williamson, and Fred C., 2003, “Dollar Overvaluation and the World Economy (Special Reports (Institute for International Economics (U.S.)), 16.)”

Marco Neuhaus, 2006, “The Impact of FDI on Economic Growth: An Analysis for the Transition Countries of Central and Eastern Europe (Contributions to Economics)”

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