Seven Questions: Martin Feldstein on the “R” Word

MARTIN OESER/AFP/Getty ImagesGround control to Major Tom: Is it time to strap our helmets on and prepare for a hard landing?

Foreign Policy: Everyone is anxiously discussing the possibility that the U.S. economy is in a recession or that it will be soon. You wrote in December that the probability of a recession in 2008 has now reached 50 percent. Where do you stand now?

Martin Feldstein: Well, I think its higher. The negative evidence continues to accumulate, so I think theres a greater than 50 percent chance that we are in recession now. It is not a sure thing, and it depends on what happens in both monetary and fiscal policy, but at this point theres unfortunately a better than even chance that we will see the economy contract.

FP: And how bad do you think it could get?

MF: It could get worse than the typical recession because the usual channels for turning something like this around through monetary policy are going to be less effective now due to the problems of the credit markets. The housing decline is really very serious this time. You put those two together, and I think we could end up with something thats deeper and longer than has traditionally been true. But it depends on the Fed, the White House, and Congress doing something to either prevent or dampen the magnitude of a downturn.

FP: Federal Reserve Chairman Ben Bernanke has come under a lot of fire for being slow to understand the scale of the subprime mortgage crisis. Even as late as May 2007, he said that he thought the effect of the troubles in the subprime sector on the broader housing market will likely be limited. Do you think hes been fairly criticized for missing the boat?

MF: Well, he wasnt the only one who didnt see the magnitude of this or who came to it late. Remember, even as recently as December, the survey of private-sector forecasters done by the Wall Street Journal predicted an average growth rate of 2 percent from the end of 2007 to the end of 2008. And the average of these forecasters probability of a decline was something like 40 percent, up from 25 percent in the early summer or late spring. So, the Fed wasnt very different from where the private forecasters were in underestimating the magnitude of what was happening both in the subprime market and more generally in the financial markets.

Bernankes speech on the 11th certainly indicates that hes now made this his No. 1 priority. And when he came out subsequently and said the Fed needs help, that we need to have a large fiscal stimulus as well, that is an indication of how concerned he is about the inability of monetary policy alone to deal with what could be a very serious problem.

FP: Oil prices are still hovering in the $90 to $100 per barrel range, and yet everyones still talking about subprime mortgages. If I had told you a year ago that oil prices would hit the $100 mark, wouldnt you have thought that was enough to trigger a recession all on its own?

MF: In the post-World War II period, recessions have been preceded by a combination of increased oil prices and high interest rates. And we certainly got a dose of both of those this time. The Fed raised the federal funds rate from 1percent to 6 percent, and oil prices tripled. So yes, I would have been worried that that combination alone, driven by the high oil prices, could have turned us down. In fact, I wrote a piece in the Wall Street Journal a couple of years ago, asking: Why did the jump in oil prices (that we had then observedfrom roughly $20 to $60 a barrel) not push the economy into recession? And I answered that by saying: because there was this surge in home-equity borrowing that allowed individuals to increase their consumption faster than their incomes. I concluded by saying that if energy prices continue to increase, we cannot count on that kind of offset from higher consumer spending financed by mortgage borrowing.

FP: U.S. President George W. Bush has proposed a roughly $140 billion stimulus package that centers on one-time tax rebates. But George Mason University economist Russell Roberts says the very idea of an economic stimulus package is like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. As he put it, If you can make the economy grow, why wait for bad times? So, is the idea of a stimulus package just political theater, or do you expect it to really help?

MF: I do expect it to help, but let me be clear about why its not like moving water from one end of the pool to the other, or more accurately, why it is not a way of making the economy grow under all circumstances. If the economy is fully employed and growing at a normal pace, 3.5 percent, with unemployment under 5 percent and no expectation of a downturn, then aggregate demand is not the problem. Then, the only way to get the economy to grow more is to have more investment in capital equipment, people working harder, more innovation, and so on. And you cant do that by simply giving money back to taxpayers to spend more. So, the spend more approach to increasing economic activity is not about long-term growth. What its about is offsetting the risk of an economic downturn.

FP: So, how do you think a U.S. economic slowdown would affect booming Asian economies such as India and China? Do you think these emerging-market economies could really pick up the slack, as some people have suggested, if U.S. demand slows? Or are they so tied to the United States that an ebb tide for the U.S. economy would lower all boats?

MF: I dont think that India and China are going to be adversely affected by a slowdown in the United States, if it occurs. Now, thats different from having them pick up the slack, to use your phrase, and provide aggregate demand for the rest of the world. I think those two ideas get confused sometimes when people talk about decoupling. India does not depend on exports to the United States. Similarly, I think the direct impact on [U.S.] imports from China would not be that large. China exports a lot, but its net exports (when you net through how much it imports in order to reexport) are not so much a driving force in their economy, and they have other ways of picking up the slack domestically. In fact, theyve been worried about the fact that their economy has been growing too fast, and theyve been looking for ways to dampen it. If their exports slow down, they will shift toward more domestic spending. Thats a very good thing for the Chinese economy and may make for a structural change that will reduce the future trade imbalance between China and the United States. So, I dont think the Chinese should be that worried about a U.S. recession.

FP: I think its fair to say that most Americans would be worse off as a result of a U.S. economic slowdown. But who would you say are the likely winners from a U.S. recession?

MF: (Laughs.) Thats a tricky question. Likely winners from a U.S. recession um (pause). There are not many winners in a situation where income is falling and sales are falling and profits are falling and so on. So, the winners, if there are winners, are going to be financial investors who have seen this recession coming and who have in effect bet financially on an economic downturntheyve sold stock short.

Martin Feldstein is professor of economics at Harvard University and president and CEO of the National Bureau of Economic Research. He was chairman of the Council of Economic Advisers under U.S. President Ronald Reagan.