Fear Itself: U.S. Economy Suffering from 'Irrational Despondence'

December 10, 2008

The biggest problem facing the U.S. economy today is not housing or financial markets or employment, according to two of the country's leading economic analysts. It is fear.

"We are looking at record lows on confidence," says Joel L. Naroff, president of Naroff Economic Advisors. "The level of despondence is so great that in the short term it's excessively depressing consumer and business spending."

Rajnish Mehra, a leading researcher at the W. P. Carey School of Business, says, "People are scared. And as long as we are scared we are not going to get out of this."

While underscoring the danger present in today's crisis, they also offered hopeful messages that the economy does have underlying strengths, and a shift in public confidence could have the economy growing again sometime next year.

According to Naroff, the "irrational exuberance" that used to worry forecasters and policymakers has been replaced by "irrational despondence." Mehra maintains that the economy is stronger than most people believe. He cites Franklin D. Roosevelt's 1933 inaugural address: "We have nothing to fear but fear itself."

Naroff is an independent consultant who recently was named the top economic forecaster in the country by Bloomberg News. This fall he also received the Lawrence R. Klein Award, sponsored and judged by the W. P. Carey School of Business, for the most accurate economic forecast among those who participate in the renowned Blue Chip Economic Indicators survey. Mehra is director of the Edward C. Prescott Center for the Advanced Study of Economic Efficiency. The two were featured speakers at the W. P. Carey School of Business's 45th Annual Economic Forecast Luncheon, co-sponsored with JPMorganChase on December 10.

How bad is it?

Naroff accepts the recent conclusion of the National Bureau of Economic Research that the U.S. economy is indeed in a recession, which at 12 months and counting already rivals the downturns of the 1970s and 1980s.

"This is probably the most dangerous economic environment we've been in since World War II," Naroff says. "The question is, 'Can we survive without going into a depression?'"

What makes the situation so difficult today is the disarray in the financial sector, according to Naroff. "You have an economic and a financial sector crisis that makes this closer to what happened in the late 1920s than the problems of the mid-1970s, which were oil-driven and inflation-driven," he says.

On the other hand, Mehra questions whether we are in a true recession now. He cites an array of data to support his view that things are not really as bad as most people believe.

Between the first and third quarters of 2008, adjusted GDP per capita fell one percent, Mehra notes. In contrast, between 1978 and 1982, it fell 11 percent.

Similarly, corporate profits and household net worth, while down from a high of several years ago, have not fallen dramatically according to data cited by Mehra.

"My basic message is, things are bad, yes, but not quite as dire as they appear to be," Mehra says.

Long-term trends are favorable, according to Mehra. Analyzing data from the 1850s to today, Mehra points out that periods of expansion have gotten progressively longer and recessions shorter. Also, GDP per capita has been trending upward at a rate of 2 percent a year since the 1880s.

Where things went wrong

While overall economic conditions may not be all that bad, the woes of the financial sector are very real, according to Mehra. The problems of some large financial institutions have ignited a crisis of confidence in the system, he says.

"It was triggered by large losses by banks and insurance companies, and the concerns about the solvency of these institutions," Mehra says.

Banks became afraid to lend, and people lost trust in banks, according to Mehra. "Investors are panicking. Basically it's a reaction to widespread Knightian Uncertainty -- fear of the unknown," he says.

The turmoil in financial markets and loss of confidence create the potential for a long and deep economic downturn, according to Naroff. "This is the first time in the careers of any of us who are practicing economists that we can actually look out and see the potential for a depression," he says.

Search for a cure

Given the woes of the financial sector and the climate of fear gripping the nation and the world, what can be done to ease the crisis?

Mehra believes the inconsistent response of policymakers made things worse by feeding the public's fears of the unknown. "The ad hoc policy decisions -- bail out AIG but not Lehman, bail out Citi -- creates a lot of uncertainty," he says.

Naroff, on the other hand, sees policymakers finally taking the actions that will turn the economy back from the brink of depression.

"The reason why I don't think we are going to go into a depression is that we've already had a depression and we've learned the lessons from it," Naroff says.

The actions of the Federal Reserve and U.S. Treasury to bail out troubled companies, ease credit, and inject money into the system prevented the collapse of the financial system, according to Naroff.

And the Fed and Treasury also have moved to correct problems in housing, which is the industry that triggered the crisis, Naroff notes. Buying up troubled mortgages and engineering lower mortgage rates should set the stage for a rebound in housing, according to Naroff, who believes real estate has hit bottom.

"The fact that so many homes are being bought out of foreclosure, I think, is actually a good thing," says Naroff. "We're looking for the bottom in home prices. Foreclosed homes are the bottom. We don't have to search for it anymore."

Help from Washington

Naroff predicts that the Obama administration and Congress will approve a fiscal stimulus package by the end of January. The spending plan will be large and well-targeted, Naroff believes.

"There's a very clear understanding in the Obama group that they get one shot at it," he says. "By that I simply mean, if they don't do it right, we're done."

Naroff expects the stimulus plan to be heavily weighted to infrastructure projects that should improve the long-term productive capacity of the United States. "It's not like giving people money, letting them spend it, and when they're done spending, that's the end," he says.

But while public policies are important, public attitudes hold the key to resolving the current crisis, according to both Naroff and Mehra.

"We should be realistic," says Mehra. "Being realistic and being scared are two different things."

Naroff believes that sometime in 2009, people will adjust to the new reality, and growth will return. He calls it, "the Dr. Strangelove effect" after the film titled, "Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb."

"It will be 'How I learned to live with the slowdown and maybe not love it, but to react accordingly,'" he says.

Bottom Line:

  • While problems in housing and financial markets triggered the current economic crisis, widespread fear about the economy has greatly exacerbated the problem.
  • Although the economy officially is in recession, there are indications of underlying strength, including only modest declines in corporate profits, employment, and household net worth.
  • Since the mid-19th century, periods of economic expansion have grown progressively longer, while recessions have gotten shorter.
  • Actions by the Federal Reserve and Treasury to stabilize housing and financial markets could be followed by passage of a major fiscal stimulus package early next year. These actions are markedly different from the government response in the late 1920s.