U.S. Macro Outlook: Dating the Great Recession

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• Grim job losses in recent months stem from last fall's financial panic, when worried businesses slashed inventories, investment and hiring.

• As fear subsides, production and spending have stabilized, and real GDP growth is expected to resume during the current quarter.

• The recession is winding down just as February's fiscal stimulus bill reaches maximum impact; policymakers should gauge its effectiveness before deciding whether to launch another stimulus round.

• All the government's economic success to date will not bring recovery unless more is done to stem rising home foreclosures.

The Great Recession continues on. After 18 months of economic contraction, 6.5 million jobs have been lost, and the unemployment rate is approaching double digits. Many with jobs are seeing their hours cut—the length of the average workweek fell to a record low in June—and taking cuts in pay as overall wage growth stalls.

The statistics are bleak, but they largely reflect the financial panic of late last year. With the banking system crumbling and financial markets freezing, businesses couldn't obtain credit and were legitimately worried about survival. In response, they slashed costs, including inventories, investment and payrolls.

Less fear

Businesses' fear has since subsided; while firms are still cautious, they have grown more circumspect in their cutting. Inventories will soon shift to a source of growth, and orders for durable goods, a leading indicator of equipment investment, have stabilized in recent months. The job cutting has also moderated; while nearly 2.1 million jobs were lost in the first quarter, only 1.3 million disappeared in the second.

Consumers have also become less fearful. Retail, vehicle and home sales, in free fall through last Christmas, have stabilized since then. Many households remain uncomfortable with their heavy debt loads and low saving rates, but the higher-income households that account for the bulk of U.S. consumer spending have probably accomplished whatever financial changes they needed to make.

Investors, too, are much calmer. The financial crisis has receded meaningfully in the wake of the Fed's unprecedented efforts, the Troubled Asset Relief Program, and regulators' stress tests on the nation's largest banks. Stock prices are well above their March lows, and credit spreads in the bond market have narrowed significantly. Corporate bond issuance has largely returned to normal.

The direction of real GDP is even expected to turn from negative to positive in the current quarter. The academic arbiters of the business cycle at the National Bureau of Economic Research will eventually proclaim that the Great Recession ended sometime this summer.

Reaffirming stimulus

The recession is winding down just as the $787 billion fiscal stimulus passed this past February is about to provide its maximum benefit to the U.S. economy. Based on simulations of the Moody's Economy.com macro model , the stimulus will add a substantial 3.6 percentage points to real GDP growth in the third quarter, after adding 3 points in the second.

To date, the stimulus has mainly helped by forestalling bigger job and program cuts by state and local governments. Increased aid to unemployed workers is contributing to the recent firming in consumer confidence (which hit an all-time low in February, just before the stimulus took effect) and helping to stabilize retail sales. It may be hard to tell when hundreds of thousands of jobs are vanishing each month, but without the stimulus, job losses would be measurably worse. Take the 1.3 million jobs lost in the second quarter; without the stimulus, the economy would have instead lost an estimated 1.8 million jobs. Unemployment would now be 9.8%, instead of 9.5%.

The benefits of lower payroll taxes, increased checks to Social Security recipients, and more infrastructure spending have yet to be seen—but they will be, starting this summer. The housing market should also receive a boost in the next few months through the federal housing tax credit for first-time homebuyers.

Those who see the recession continuing and conclude that the stimulus is a failure are mistaken. The stimulus is performing close to expectations, at least so far. If it continues as expected, U.S. employment will shrink by approximately 750,000 jobs in the third quarter and by 400,000 in the fourth quarter, but the job losses will abate by the spring of 2010. Unemployment will rise as high as 10.5% next summer, but without the stimulus, unemployment would peak near 12.5% in early 2011.

It is, however, premature to conclude that the economy requires a third round of stimulus (following the first in 2008 and the current one). That can’t be reasonably determined until later this year, after the current program has had an opportunity to work. If by then the economy is not performing as anticipated, then another dose of temporary stimulus in 2010 may be warranted.

Questioning foreclosure policy

A long list of threats could prolong the Great Recession. Most worrisome is the still-mounting foreclosure crisis , which seems set to overwhelm the Obama administration's plan to tame it. The administration's economic policy successes, including the fiscal stimulus, will be for naught unless foreclosures decline soon.

Recent data on this score are not encouraging. First-mortgage loan defaults—the first step in the foreclosure process—could total an astonishing 4 million this year, representing nearly one in 12 first mortgages, if significantly more loans are not modified soon. Foreclosures are certain to soar later this year as moratoriums imposed by various states, by Fannie Mae and Freddie Mac, and by mortgage servicers expire.

Most homeowners in foreclosure will lose their homes. Since foreclosed property is dumped on the housing market at a steep discount, foreclosures drive down all home values and reduce the wealth of all homeowners. Some $6 trillion in homeowners' equity has been wiped out since house prices peaked three years ago. Households who find themselves suddenly less wealthy make for very nervous spenders.

Foreclosures also ratchet up the pressure on hard-pressed financial institutions that own mortgage loans and securities. Losses on all the subprime, alt-A, and jumbo loans made during the housing boom will easily top $1 trillion, nearly equal to the amount of capital underpinning the U.S. banking system. Prime borrowers are also defaulting with increasing regularity. Banks are again able to raise capital, but until these losses abate, even healthy banks will remain reluctant to extend credit, even to creditworthy borrowers.

It is vital to understand that foreclosures beget more foreclosures. As foreclosure sales drive house prices down, more homeowners are pushed under water—their homes are worth less than they owe. At last count, 15 million homeowners—about one in five of those with first mortgages—were in such a predicament, putting them at grave risk of defaulting if anything else were to go wrong in their financial lives.

The administration's plan to short-circuit this self-reinforcing negative foreclosure cycle has gotten off to a painfully slow start. The plan cleverly provides incentives to homeowners, mortgage servicers and mortgage owners to modify loans and reduce monthly payments. But it is also excessively complex, causing long delays as all parties try to figure out what it means for them before they act.

The plan is also guilty of kicking the can down the road. Lower monthly mortgage payments under the plan last for only five years, and for many homeowners deeply under water, it makes no sense to keep paying on their mortgages no matter how affordable the payment is. Why spend $5,000 fixing your roof if you are already under water by $20,000? That's why many of these homeowners will ultimately land back in foreclosure.

Great expectations

The expectation that the Great Recession will end in the next few months is predicated on the presumption that policymakers will find the political will to maintain or increase their support for the economy. The Federal Reserve may need to engage in more aggressive credit easing, Congress may need to pass another round of fiscal stimulus, and the administration will almost certainly have to significantly adjust its response to the foreclosure crisis.

Given all this, the near-term outlook will be characterized at best by a U-shaped cycle. After declining 2.7% this year, real GDP will expand a disappointing 1.3% in 2010. Growth is expected to accelerate strongly in 2011-2012, but much has to happen between now and then, and the risks remain skewed to the downside. The U-shaped outlook represents about 50% of the distribution of possible economic outcomes, but there is a 30% probability that the outlook will be measurably worse than the baseline and only a 20% probability that it will be better.