The high economic anxieties that most Americans felt six months ago may have faded, but count me among economists who are still very concerned. Sure, the last GDP report came in at 3.5 percent, and the next one should show comparable gains. Virtually all of those gains, however, come from the temporary stimulus and unusual inventory corrections. Once those factors run their course â€” mid-2010 for the stimulus and maybe earlier for inventories â€” a second dip down becomes very possible, and it could be even worse than the first. And the main reason we remain so vulnerable is the series of political stumbles which have left largely unchanged many of the forces that drove us off the cliff.
Just today we learned that new residential construction fell again last month, while home foreclosures continue to rise. It could hardly be otherwise: Washington still has done little to address the pressures from falling home prices colliding with rising mortgage payments, even though they were the largest single factor in the financial meltdown. We did warn that the governmentâ€™s housing plan wouldnâ€™t work: A small government benefit to encourage banks to offer better terms to strapped homeowners couldnâ€™t overcome the basic rule that anyone facing foreclosure becomes a poor credit risk, and banks donâ€™t refinance mortgages for poor credit risks. So, as jobs have continued to disappear and incomes fall, foreclosures continue to rise. We could still declare a brief moratorium on foreclosures while putting in place some measures that might actually work â€” for example, directing Fannie Mae, which we taxpayers now own, to provide better terms to strapped homeowners whose mortgages are held there.
Washington also gave financial institutions hundreds of billions of tax dollars without ever requiring them to get rid of their toxic assets and reboot credit to businesses â€” and so, they largely didnâ€™t. Now, as foreclosures continue to rise, those financial institutions face more losses from the mortgage-backed securities and their derivatives they still hold. Those losses will continue to limit the credit flows needed to keep the economy going once the stimulus fades. And that doesnâ€™t factor in the increasing pressures on financial institutions from growing problems with commercial real estate.
And by the way, oil prices are up to $80 per-barrel again and headed higher if the dollar continues to weaken. You may have forgotten, but it was the run-up in oil price in 2007 that actually triggered the recent recession, with the financial crisis coming a little later and making it so much worse. If oil prices keep on rising now, on top of weak credit flows and anemic consumer spending, and the economy heads down again, its trajectory could well be even worse this time, since it will come in the context of already weak demand and high unemployment.
This possibility brings us to Washingtonâ€™s largest failure of all â€” okay, the second largest after its astonishing incompetence dealing with the financial bubble and bust. Throughout the last expansion, Washington sat on its hands as jobs continued to disappear for two years after the 2001 recession ended, and then finally began to grow but at less than half the rates seen in the 1990s and 1980s. This political failure means that we now face double-digit unemployment for a long time, even if we manage to avoid returning to recession.
At least the administration and Congress finally are noticing the jobs problem. What we donâ€™t know is whether theyâ€™ll do anything effective to address it. They have real options here. For example, for the short-term, they can provide more money to states squeezed by falling revenues and balanced-budget requirements, so the states can keep their teachers, police and other employees working. An even better idea would be to jumpstart new job creation by exempting the first few thousand dollars of wages from payroll taxes. And they could pay for it with a small, Tobin-type tax on financial transactions.
What really scares me and some other economists, however, is the possibility of another large shock to the financial system. For example, while itâ€™s not likely, we could see a sudden collapse in the markets for securities backed by commercial mortgages. The real nightmare on Wall Street, however, is an international crisis that suddenly drives up the dollarâ€™s value. That would present terrible problems, since much of the near-record profits being reported by Goldman â€œWeâ€™re doing Godâ€™s workâ€ Sachs and others come from nearly a trillion dollars in complicated financial plays that depend on a weak dollar.
If this somehow should come to pass, Washingtonâ€™s incapacity to deal effectively with the recent crisis will create very scary scenarios. At a minimum, even President Obamaâ€™s legendary skills of persuasion wonâ€™t be enough to convince the public to bail out Wall Street a second time. Itâ€™s may not be too late, however, for the administration and the Fed to privately jawbone Wall Street to reduce this new risk exposure â€” and ours. Whether theyâ€™re willing to accept smaller bonuses, which usually come with less risk, could be a good test of whether they deserve to ever be rescued again.