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Chapman economist predicts ‘economic slog’

September 13, 2010

Don’t look for the “R” word to go away anytime soon, according to Vernon L. Smith, Ph.D., Nobel Prize laureate in economics at Chapman University. Dr. Smith’s expert insights into the recession have been highlighted in major news outlets recently, including an ABC documentary and in the opinion pages of the Wall Street Journal.

Dr. Smith was interviewed at length in an ABC – Four Corners documentary titled “Overdose: The Next Financial Crisis,” which examined the role of the housing bubble in the financial crisis and the continuing economic debacle.

Among his comments explaining how the bubble grew in an environment of unchecked no-down mortgage lending, Dr. Smith said, “Greed has to be balanced with a certain degree of fear. That’s what down-payment rules are all about.” The original air date was Aug. 23, but the program can be seen in its entirety on YouTube and viewer comments can be followed at the Four Corners website.

And in the Wall Street Journal, an essay by Dr. Smith and Chapman colleague Steven Gjerstad, Ph.D., a Presidential Fellow at Chapman, was featured in its Sept. 10 issue. (See full text at end of this post.) In addition, Dr. Smith weighed in with a comment in a Sept. 13 WSJ story, “Economists’ Outlook Dim.”

In that comment post, Dr. Smith said: “Buying treasuries won’t dent the negative equity of homeowners still in their homes, who are trying to save out of their $771 billion balance sheet hole. This part of our current economy is a re-run of the Great Depression, absent the bank panic. Bernanke prevented that with his purchase of $ 1 trillion plus worth of shaky bank loans. He removed the negative equity from bank balance sheets but not household balance sheets. And that is where we are stuck.”

Dr. Smith was awarded the Nobel Prize in Economic Sciences in 2002 for his groundbreaking work in experimental economics. He has joint appointments with the Argyros School of Business & Economics and the School of Law, and he is part of the Economic Science Institute at Chapman.

The full text of Drs. Gjerstad and Smith’s essay follows:

Why We’re in for a Long, Hard Economic Slog

By Steven Gjerstad and Vernon L. Smith

Our study of all the postwar recessions and the Great Depression leads to the following empirical proposition: If there is no recovery in housing expenditures, confirmed by a recovery in consumer durable goods expenditures, then there is no economic recovery.

In the Great Depression and in every recession since, recovery of residential construction has preceded recovery in every other sector, and its recovery has been far larger in percentage terms than the recovery in any other major sector.

Applied to the Great Recession, it appears that those who see signs of a recovery may be grasping at straws. What one should hope is that this time it is different from every one of the past 14 U.S. downturns, but those who believe this have the weight of past experience against them.

We looked at all the major expenditure components of Gross Domestic Product in percentage deviations from their levels in the fourth quarter of 2007, officially declared as the start of the Great Recession by the National Bureau of Economic Research.

The onset of and decline during this recession were like previous recessions, though its course has been deeper and longer. By quarter four of 2007, sales of new homes had fallen without interruption for nine straight quarters and expenditures on new residential construction had fallen for seven quarters—strong lead time signals of the looming distress. New home sales recovered briefly in 2009 but have now declined for three quarters. Residential construction expenditures have essentially been flat for five quarters. Consumer durables spending at best has stabilized, up slightly from its low in the fourth quarter of 2008.

The average increase in new residential construction in the first year following the previous 10 postwar recessions has been 26.3%. The largest increase in residential construction followed the 1981-82 recession, when it increased 75.5% as monetary policy was relaxed. In the past year, residential construction has increased 6.3%. This is the slowest rebound in residential construction in any sustained recovery from a postwar recession.

No currently debated policy will likely change this situation, as the market is saturated with foreclosed houses and homeowners suffer from $771 billion in negative equity. This fact needs to be confronted: We are almost surely in for a long slog.

Mr. Gjerstad is a presidential fellow at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics. Their review of housing and previous recessions is at www.chapman.edu/ESI/wp/Recessions_1929_2007.pdf

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