Wednesday, February 06, 2008

Further Response from Mr. Lachman

Dear Joe,

I am in complete agreement with you that the Federal Reserve’s repeated past egregious mistakes have got us into our present predicament. However, I part company with you in diagnosing where we are now headed and what the appropriate policy response might be.

It would seem to me that most indicators are now clearly suggesting that a recession has already begun. Employment growth has stalled abruptly, consumption has been weak, housing remains in a deep downturn, the ISM indicators are now in recession territory, and GDP growth in the fourth quarter of 2007 was weak.

Worse still, looking forward the US economy is being hit by the following major shocks, which show little sign of abating:

(a) The housing market is in its worst slump in 60 years with housing starts down precipitously and with housing prices now falling by 8 percent. Housing prices are almost certain to fall in 2008 by at least 10 percent against the backdrop of record inventories, tightening lending conditions and the scheduled resetting of ARMs. Such a decline in home prices would wipe out another US$2 ½ trillion in household wealth and would complicate balance sheet problems in the banks.

(b) Equity prices have already declined by close to 20 percent, which has wiped out another US$2 trillion in household wealth. It is doing so at a time that the US household debt to income ratio is at a record 140 percent.

(c) The banking system is in the grip of its worst credit crunch in over 25 years as it grapples with losses on past bad lending, now widely estimated to be in the ballpark of at least US$500 billion. This week’s Quarterly Federal Reserve’s Senior Loan Officer’s Lending Survey could not have painted a bleaker picture of the banking system’s lending intentions going forward, which points to an abrupt decline ahead in bank lending.

(d) International oil prices remain stubbornly in the region of US$90 a barrel.

In my judgment, this unusual constellation of major negative forces will swamp any support that the US economy might be getting from a weaker US dollar or from the stimulatory measures to date that in any event will only come into play in the second half of the year. The question to me is not whether we are now in recession. Rather it is how severe will this recession be. It is also my view that simply letting this recession run its course without a policy response would be highly dangerous and irresponsible. For it would risk having the economy move into a vicious circle of a weakening economy worsening both the housing bust and the banks’ problems which in turn would deal a further body blow to the economy.

I guess only time will tell who of us is making the right diagnosis and I would be happy to revisit this question in 6 months time.

Best regards,


I will post a final comment on this later today.

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