Thursday, October 02, 2008

U.S. Headed for Deep Recession

The U.S. is likely headed for a deep recession, the International Monetary Fund warned Thursday in a report in which it notes that the current banking crisis is the type that's most likely to lead to such a downturn, and suggesting the government's proposed bailout of the banking system is the right course of action.

Episodes of financial turmoil characterized by banking sector distress are more likely to be associated with severe and protracted downturns.

Financial stress is more likely to be followed by an economic downturn when it is preceded by a rapid expansion of credit, a run-up in house prices and heavy borrowing by households and non-financial firms. The current situation of the United States bears some resemblance to previous episodes of banking-related financial stress episodes that were followed by recessions.

Based on a comparison of the current episode of financial stress to previous episodes, there remains a substantial likelihood of a sharp downturn in the United States.

Not all episodes of financial stress lead to economic slowdowns or recessions.

However, when a slowdown or recession is preceded by financial stress, and especially when the stress is concentrated in the banking sector, typically it is substantially more severe than slowdowns or recessions not preceded by financial stress. In particular, slowdowns or recessions preceded by bank-related stress tend to involve two to three times greater cumulative output losses and tend to endure two to four times as long.

The odds that a banking-related crisis is followed by a slowdown or recession is associated with the extent to which house prices and outstanding credit have risen prior to the eruption of the crisis. Further, while greater reliance on borrowing by non-financial corporations is associated with a sharper downturn in the aftermath of financial stress, the indebtedness of households is crucial in determining whether the downturn will turn into a recession.

However, the relatively strong positions of corporate balance sheets at the onset of the crisis and the aggressive monetary easing by the U.S. Federal Reserve may provide some cushion in the U.S., while the relatively strong balance sheets of European households offer some protection against a sharp downturn there.

In the current circumstances, strong actions by policy-makers to deal with the stress and support the restoration of financial system capital seem particularly important.


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