Recession Now Seems Unavoidable

As credit conditions tighten even more and consumers finally buckle, the newest dismal omen is a retrenchment by business. Still, the downturn is unlikely to be severe

The stunning rejection by the U.S. House of Representatives of the $700 billion financial stability package was more than just a blow to the markets. It also added to the growing near-term problems of the economy. As Congress readied Plan B, the credit markets remained dysfunctional, confidence in the financial system remained low, and banks in the U.S. and Europe were dropping like autumn leaves. Even once final legislation is in place, restoring trust will take time. But while lawmakers may eventually save the financial system, it's probably too late to keep the economy out of an official recession.

The economy showed resilience in the first half, but by midyear it had become much more wobbly, even before the upheaval that began in mid-September. Tighter credit, due to tougher lending standards at banks and intense aversion to risk in the credit markets, was a major reason. Through the second quarter, net borrowing by households and businesses had plunged 64% since the market turmoil began last year, with household borrowing down 76% and business loans off 57%. Recent events mean this historic shrinkage will worsen, further depressing economic activity.

Partly reflecting that squeeze, August data show that the vital signs of both consumers and businesses have weakened sharply. Now, amid all that has erupted in recent weeks, credit markets have tightened even further, most likely squeezing out of the economy what life remained. Manufacturing activity plummeted in September, according to the Institute for Supply Management, suggesting the economy's illness is starting to spread in the classic recession manner.

Consumers, who had been bearing up under soaring energy prices, job losses, sagging wage growth, and shrinking wealth, are finally buckling. Their spending, adjusted for inflation, went nowhere in August after declining in both June and July, despite more than $100 billion in tax rebates. Third-quarter spending is set to post a sizable drop of around 2% annually, the first quarterly decline since 1991.

Lower gas prices cannot compensate for more fundamental problems: Labor market weakness is intensifying as businesses cut back, and household wealth is evaporating. Based on the third-quarter close in stock prices, plus further declines expected in home prices, the value of household assets has plunged some $4.5 trillion over the past year, already exceeding the drop during the tech bust in 2000. That loss will spur consumers to save more of their incomes and spend less.

And there's a new and ominous development in the outlook. Signs of retrenchment by businesses are appearing. Cutbacks there would hit the economy two ways: declines in capital spending and even greater job losses, which would intensify the stress on consumers. Of late, companies have adjusted to weak U.S. demand with the help of strong exports, and they have made cutbacks in output that have reduced inventories. Now, U.S. demand is fading faster, overseas economies are stumbling toward their own recessions, and profit margins are shrinking. On top of that, corporate finance is coming under heavy pressure from new tightening in the credit markets.

Businesses may have begun to pull back on capital spending even before the latest market upheaval. Capital goods orders and shipments fell in August, and July bookings were revised down sharply. Third-quarter shipments, after considering inflation, are well below their second-quarter level. Outlays for construction dropped in both July and August. Those were the first declines this year, perhaps marking the beginning of an expected pullback resulting from the tightness in commercial mortgage lending.

A congressional rescue plan for the credit markets would make it unlikely that any recession would be severe. Businesses have already cut inventories and payrolls, and housing has been falling for two years. Oil prices and inflation are coming down, and interest rates are low. The problem is: Too much damage has already been done.

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