Signs of the next recession

JOEL GEIER, associate editor of the International Socialist Review, answers Socialist Worker’s questions about the Federal Reserve Bank’s decision to cut interest rates in mid-September.
- - - - - - - - - - - - - - - -
WHAT’S THE significance of the U.S. Federal Reserve Bank’s decision to lower interest rates?
THE FED cut interest rates dramatically at its September 18 meeting, reducing the benchmark rate that governs short-term lending between financial institutions, by 50 basis points, or half a percent. The banks then cut their prime rate for commercial loans by an equal amount. This was twice the 25-basis-point cut that was expected from the Fed.
Immediately, the stock market had its best single day in nearly five years, and stockbrokers and the media were suddenly assuring us that now that the Fed had acted, there was little possibility of recession.
But a more serious analysis reveals a different picture: first, the rate cut proves that the threat of a recession accelerated by the bursting of the housing bubble is real enough for the Fed to try to mitigate its effect; second, the economic situation has deteriorated quicker and more deeply than was expected, meaning that recession is closer to becoming a reality; and third, the various actions the Fed had taken to this point (pumping cash into the banking system and cutting its discount rate) failed to stop the downward slide, so stronger measures were necessary to prevent the crisis in the credit markets from overwhelming the real economy.
What else to read
Joel Geier is interviewed on “Warning signs for a coming recession” in the current issue of the International Socialist Review, now on sale in bookstores. Also see Petrino DiLeo’s “Housing bubble deflates” in the ISR.
Just in the last several weeks, there have been a number of signs that an already slowing economy was in steeper decline.
Obviously, the housing crisis is getting worse. This is what started the turmoil in financial markets two months ago, and the effects are ongoing. The latest statistics show that housing foreclosures in the U.S. soared 36 percent from July to August, and were more than double the number from the year before. Inventories of unsold homes are growing, prices are declining, mortgage rates are adjusting upwards, and fewer people are qualifying for new mortgages.
There’s also the jobs situation. Last month, according to government figures, the number of U.S. jobs contracted by 4,000--the first time in years that there was no job expansion. But in mid-September, the New York Times reported that there were 145,000 fewer people working in August than there were in February. So the employment picture is much worse than we were led to believe.
The dynamic of capitalist production, profits, are on a downward trend. The Economist reported, for example, that in the second quarter, profits on U.S. domestic operations--in other words, not including earnings from corporations’ international operations--were lower than the year before. This means that not just the rate of profit but also the mass of profits are falling in domestic U.S. production of goods and services.
The most immediate cause for alarm, however, was the run on the British bank Northern Rock, the first bank run in England since 1866. When Northern Rock was revealed to be in major trouble because of the international spread of the mortgage crisis, there was an old-fashioned bank panic, like out of the Great Depression of the 1930s, with depositors lining up to withdraw their money.
The depositors were accused of being irrational and told their money was perfectly safe. But deposit insurance in British banks is much weaker than in the U.S. And what’s more, Bank of England Governor Mervyn King had basically refused to do what the Fed and the central banks of other countries had done when the financial crisis loomed--pump money into the system. Instead, as the panic about Northern Rock spread, King said he would do nothing.
So it was very rational for depositors to run to the bank and try to get their money out.
Ultimately, King had to do a total flip-flop. Under pressure from Prime Minister Gordon Brown and the British government, he promised that the Bank of England would guarantee deposits at Northern Rock.
Taken altogether, these are signs that the financial and economic problems are spreading through the system internationally--much more extensively than the financial markets had prepared for.
WHAT IMPACT will the Fed’s interest rate cut have?
INTEREST RATES are one of the tools that economic policymakers have to try to influence the economy. When confronted with the threat of recession, the Fed can cut interests rates on loans it makes to major banks in the hope of pushing down interest rates throughout the economy, making it cheaper for people and businesses to borrow money, cheaper to do business and therefore counteracting the slowdown.
So the Fed’s interest rate cuts are one form of stimulus available as the economy slows down. But by themselves, interest rates can’t overcome the forces driving the economy toward recession.
This rate cut may provide some temporary relief--specifically, for the banks and other financial institutions, more than for ordinary people. And the Fed’s surprisingly large cut was a message to the markets that it would do whatever it could to try to prevent a recession.
It was trying to restore market confidence to overcome the drying up of credit in the commercial paper, mortgage, leveraged buyout and inter-bank markets. Short-term credit was made cheaper, but interest rates aren’t that high to begin with, nor were they the cause of the financial panic. Fifty basis points won’t do much to turn the situation around and stimulate new economic expansion.
To see why, take a closer look at what will change and what won’t because of this rate cut.
It’s not going to get any easier to qualify for a mortgage. The banks and mortgage companies are too worried about the number of foreclosures and bad loans already out there.
People will only be able to get a mortgage if they can put 20 percent down, prove their annual income to be about one-third the purchase price of the home, not have other major debts, etc.--what are called “conforming” mortgages, because they conform to standards under which they can be sold to the government-sponsored mortgage lender Fannie Mae.
No matter how many times the Fed cuts interest rates, there isn’t going to be any return to the preceding lending standards that drove the housing boom--and therefore, no return of the housing boom.
As for existing mortgage loans, interest rates for some adjustable rate mortgages--depending on how they’re set--may not rise as much as they would have. But they will rise, particularly from the low teaser introductory rates. This will cut into consumer spending and throwing more homes into foreclosure.
Interest rates for conventional fixed mortgages won’t be affected--if anything, rates on new loans will go up as a result of the Fed’s rate cut, which produced fears of inflation that sent long-term interest rates higher, including the 10-year Treasury notes on which fixed mortgage rates are based.
And if the value of the dollar continues to decline, there’s the fear that foreign borrowing--on which the U.S. economy depends, at a rate of $50 billion to $60 billion a month to pay for its balance of payments deficit--may dry up unless long-term rates become higher and more attractive to foreign lenders.
On the other hand, the banks will do much better because of the Fed’s action. Banks will pay their depositors less in interest on savings accounts or certificates of deposits, whereas the long-term loans they make will be at higher rates. The spread between the two is where a lot of their profits come from, so this will help the banks overcome some of the bad loans on their books.
The Fed rate cut will also help the banks get rid of some of the $350 billion in leveraged buyout loans that they haven’t been able to sell to investors, tying up bank funds and contributing to the credit crunch. The Fed cutting interest rates may make these higher-yielding but riskier loans, called junk bonds, more attractive to investors.
All this shows something very important. The Federal Reserve is the bank for banks. There’s a lot of talk about the Fed’s job being to hold down inflation and manage sustained economic growth. But the main job of the Fed is to protect the banks and their needs--and that’s just what it’s done.
It isn’t reported like that, of course-- just like it isn’t reported that the U. S. went to war for oil in Iraq. This is part of the ideological mystification of the functioning of American capitalism.
So the Feds’ goals with its bigger-than-normal rate cut were, first, restore some measure of confidence in the financial markets; second, allow the banks and corporations to lighten their debt load, as protection against a coming storm; and third, try to prevent more bank panics from taking place.
But even if it achieves these goals, it won’t have restored profitability or caused an expansion of jobs. At best, the Fed is relieving some of the worst pressures for a little while.
CAN INTEREST rate cuts by the Fed stop a recession from happening?
IF THE only thing needed to prevent recession were interest rate cuts by the Fed, then, of course, there would never be a recession--the Fed would step in and fix the problem.
And the funny thing is that all these free-market ideologues--who believe the invisible hand of the free market should determine all things--fully expect that the central government can step in and make everything right, when there’s trouble, by overcoming the market’s periodic tendency to busts, as if this were a centrally planned economy.
But recessions aren’t caused by interest rates. What causes recessions under capitalism, at the most basic level, is the drive toward overproduction built into the system, which lowers the capitalists’ rate of profit and causes them to hold back from investment and put the brakes on--eventually, throughout the economy. The overproduction of houses, the housing bubble and now the bust are completely characteristic of a crisis of overproduction as Karl Marx described it in the 19th century.
Sometimes, interest rates can be a signal of the problems, or a catalyst, but they don’t cause recessions, nor can cutting interest rates prevent them.
In Japan, real interest rates are less than 1 percent, and have been for many years. There has been a 15-year stagnation following the collapse of the stock market and housing bubble together in the early 1990s. Japan cut interest rates again and again, but it didn’t spark new growth. And meanwhile, housing prices are 32 percent lower than they were 10 years ago, and the banks are still sitting on bad loans.
Officially, a recession is defined as two consecutive quarters of negative growth in the gross domestic product. We haven’t come to that--negative growth--yet. But what has taken place is a slowdown in growth centered in the U.S., but now spreading to Japan and Europe, although not yet stopping the boom still underway in China, India and other emerging countries.
The Fed’s rate cut is one response, and it’s certainly only the first of many. In the last recession, there weren’t just interest rate cuts but enormous stimulus measures, including an immense tax cut for the rich and shifting the government surplus of $236 billion a year to a deficit of more than $300 billion a year.
The decline of U. S. finances means they don’t have the ability to repeat the same highly stimulating measures and will have to find different ways stimulate capitalism.
What we can say is that there’s a recession on the horizon, and it looks like it will be nastier than the two previous ones.
It will occur in an economic environment of a huge bad debt bubble whose full dimensions are only now starting to be revealed. Plus, the balance of payments deficit and government budget deficit caused by the huge cost of the wars in Iraq and Afghanistan have put the value of the dollar at risk, constraining the Fed’s ability to make deeper interest rate cuts. All this makes the situation that much more unstable.
This recession will also take place in a different political climate--amid a crisis of the dominant neoliberal model that has existed for the past two decades; an imperialist war in Iraq that’s losing; an administration that’s lost all credibility; and class inequality that has developed to grotesque proportions.
They still have cards to play. But what seems clear is that this recession will involve an attempt to make workers pay for the crisis with an even bigger cut in their living standards than occurred in the previous two recessions. And that’s a recipe for deepened social instability and class conflict.