U.S. at Economic Crossroads

Is it finished or will its effects be felt later on? Much will depend on the decisions on loans and on the real estate market

Almost a year from the beginning of the most serious financial crisis since the Thirties, the biggest surprise is how solid the American economy seems to be. In spite of the catastrophic news, in the first trimester of 2008, the USA GDP has grown by 1% and estimates are of 2 to 2.5 % in the second trimester: rates of growth below average but absolutely enviable for us Italians. How can this be explained?

One possibility is that the effects of the financial crisis will be felt with a delay. When the banks in difficulty want to cut credit to companies, they are not able to do it right away. They cannot cancel the existing lines of credit, they can only refuse to renew them or to open new ones. The companies, on their part, when they don’t succeed in obtaining credit, initially use their own liquidity reserves to face commitments already made. It is only with the passing of time that the effects of the credit crisis will have repercussions on investments of companies and on the consumption of families, reducing the demand for goods and services and precipitating a crisis. If it were to be so, a sad future awaits us.

The alternative hypothesis is that the real economy has become better prepared for financial crises. Before this crisis, businesses had accumulated reserve liquidity funds that allow them to continue to invest in spite of the reductions in credit. These reductions therefore are not as bad as foreseen, because the sovereign funds allow the banks to collect an enormous quantity of venture capital in a very short period, removing from them the need to cut loans to maintain the required property relationships. Thanks to the serious decline of the dollar, finally, the export sector is healthy and the negative real interest is making investment and consumption increasingly attractive. If this were the case, the worst would already have passed.

Which future awaits us? Unfortunately we find ourselves at a crossroads. Both scenarios are realistic. Which of the two will be realized depends on the course of foreclosures on real estate loans. Up until this point, the majority of the foreclosures have been concentrated among the loans most at risk – of those people caught in the illusion that real estate always appreciates. Now, however, the decline in house prices by 20% also threatens “normal” loans. The average American who in 2006 bought a house for three hundred thousand dollars with a cash advance of 5% finds himself today owning a house that is worth $240 thousand with a loan of $285 thousand. If he abandons the house and frees himself from the loan (in the United States this is possible) Mr. Smith saves $45,000 . With his gain, however comes a loss of 142,000 dollars for the bank because the abandoned houses are not maintained and are difficult to sell. Historically the loss is equal to 50% of the loan.

Whether the American economy (and following it the world economy) will enter a profound crisis or will recover itself rapidly, therefore depends on the decisions of many Mr. Smiths who find themselves in this situation. If most of these families decide to abandon house and loan, the losses to the banks will increase and the prices of houses will reduce further, triggering a downward spiral. In this case, a catastrophic scenario is assured. If on the other hand, they resist, the economy can pick up again.

Historically, the social stigma of bankruptcy and the cost (economic and psychological) of a move have dissuaded families that have found themselves with a negative net value of their house from leaving. Foreclosures occurred only when the burden of interests became unsustainable.

Today, however, the situation is different. On one hand, the strong decline in real estate values increases the temptation to declare bankruptcy. On the other hand, the problem is so widespread that such a decision could become socially acceptable, amplifying the phenomenon. To avoid such an occurrence, an intervention of the government that reduces incentives to abandon loans and houses would be useful. In theory this objective can be achieved in two ways. The banks can be incentivized to reduce the amounts of their loans. Or declarations of bankruptcy can be made costlier. In an election year, however, only the first road is plausible, because the second would be extremely unpopular. But time is pressing. Tomorrow could be too late.