One of the defining features of this recession is the major role played by confidence—or rather, the lack of it. Fear of the future has sent consumers, businesses, and investors into retreat, to the great detriment of the economy. What will turn sentiment around? That's easy: signs that the worst of the recession has passed and that prospects for a recovery are improving. However, restoring confidence will be far more difficult than in past recessions because the economy's natural recuperative powers have been blunted by the financial crisis. This time, it's not just a question of overcoming worries about future profits and paychecks. Faith in the system itself has been shaken.
As a result, Washington policy is playing an outsize role in trying to heal the economy and restore confidence. The historic size of the commitment—trillions of dollars' worth of fiscal stimulus, monetary easing, and direct bank support—would appear to guarantee eventual success. Yet doubt remains. Ultimately, for policy action to work, it will have to break the mutually reinforcing weakness between the financial markets and the economy.
To date, there has been little progress toward ending this vicious cycle. The economy appears to be contracting this quarter about as fast as its 6.2% shrinkage in the fourth quarter, with further contraction widely expected in the second quarter. The dropoff in consumer spending has slowed, but businesses are still slashing capital spending, inventories, and hiring, as seen in the 651,000 decline in February payrolls (chart). Meanwhile, some indicators of credit market stress have worsened in recent weeks, reflecting worries about the banks.
Easily the biggest concern hanging over investors right now is the fear of bank insolvency. Citigroup's (C) improved profit outlook on Mar. 10 eased those fears, but policymakers have made little progress on the key issue of relieving banks of their toxic mortgage-related assets. Although the Treasury Dept.'s idea to form a Public-Private Investment Fund to tackle the problem is moving forward, any plan would most likely involve banks absorbing sizable losses. If the proposal turns out to be unworkable, its failure could be a big blow to investor confidence.
In areas other than banking, policy efforts are progressing faster. One of the most promising programs, say analysts, is the Term Asset-Backed Securities Loan Facility (TALF), a joint program of the Treasury and the Federal Reserve that begins on Mar. 17. The TALF is aimed at unclogging the credit markets by reviving loan securitization, or the packaging and selling of loans in the secondary market. The TALF will purchase up to $1 trillion in new asset-backed securities, which will include consumer and business loans and some securities backed by commercial and residential mortgages.
The TALF is important because about half of all credit flowing to households and businesses gets securitized. But by the end of last year, issuance of asset-backed securities had dropped to essentially zero, as the secondary market dried up. This market dysfunction is a big reason why the Fed's interest-rate cuts have been largely ineffective in easing financial conditions. Analysts believe the TALF will make a variety of consumer and business loans more readily available.
In addition to increasing the potency of the Fed's rate cuts, improving credit market functioning would also bolster the impact of the fiscal stimulus program. The first effects of that will show up as early as the second quarter, as take-home pay rises after companies adjust their tax-withholding schedules by Apr. 1. The Congressional Budget Office estimates the stimulus package will lift the level of real gross domestic product between 1.4% and 3.8% above where it would otherwise have been at yearend, depending on the size of the multiplier effects.
That's a prescription for halting the decline in GDP in the second half. And if policy efforts aimed at the financial markets and housing begin to show results, it will also be a remedy for restoring confidence in the future.