A few weeks ago I asked for readers to send me questions and said I would try and answer them while I was in Switzerland. Some of them were quite good and have given me ideas for whole newsletters but will require a lot of research. But a lot of them fell into two basic camps. This week we look at a number of questions from readers about my thoughts on the Muddle Through Economy.

One group basically asked, "John, given all the bad news [insert your favorite bearish statistic on housing, the credit crisis, inflation, doom and gloom, etc.] how can you be so optimistic and think we'll only see a modest recession and a Muddle Through Recovery? Don't you think we'll actually have a serious recession and/or a soft depression?"

The second group asks the obverse of the coin: "John, how can you see a long, slow recovery? Look at all the good things like [insert your favorite bullish statistic: low interest rates, a rising stock market, the worst of the credit crisis behind us, the stimulus checks just now getting to consumers, etc.]. Don't you think that means we will get back to a full growth economy by the end of the year?"

I've given both questions some thought as to which I should answer first. I think it makes more sense to start with the bullish question first and then go into why things are not as bad as many analysts suggest.

Clowns to the left of me, Jokers to the right
Here I am, Stuck in the Muddle Through Middle With You!

I take some comfort in being in the middle. It's when you get on the edge that you are most often wrong, but that also means you have the most people who disagree with your position. And there are a lot of people who disagree with me. But then, a lot of people disagreed when I said the subprime crisis would be serious enough to cause a recession. As to whether I am right about Muddle Through this time, we'll see. But it's where my thinking comes out.

So, let's make the case for a recession which will last at least for two if not three quarters and then a slow recovery of at least a year and half where GDP is in the range of 2% on average.

First, this recession is fundamentally a consumer recession, brought on by a bursting of the housing bubble and a credit crisis. Consumer spending is under pressure from several main areas.

First, as the housing market stalled and then began to drop, we saw a fall in housing related spending, in construction, furniture, mortgages, etc. Remember when most economists and analysts wrote last summer that there would not be a recession from the housing crisis because housing was only 5% of the economy? The rest of the economy was doing just fine, they opined. Don't worry. Be happy.

The problem is that the resulting fall in housing prices produces a negative wealth effect. I have used the following chart many times, but it is good to review it again quickly.



Notice that without mortgage equity withdrawals the US economy would have been in outright recession for two full years in 2001-2002, and would have been quite sluggish for the next two years. That is what you should expect from the bursting of a major equity market bubble and 9/11. But because the value of the US housing stock was rising and doing so rapidly, people felt comfortable borrowing against the ever-rising value of their homes. We borrowed and spent our way out of that recession. Coupled with the Bush tax cuts (a very important element!) and low Fed rates, we bounced backed rather handily.

But now, home values are falling and will likely do so for another year at the least. As Woody Brock pointed out in this week's Outside the Box, we are at the beginning of a reversion to the mean on national wealth. We are getting a reverse wealth effect. People either can't or won't borrow as much and thus we get negative stimulus from housing prices. It's likely that people are going to start saving more which, while a good thing from an individual stand point, is a drag on overall consumer spending.

Second, even though core inflation is tame, real inflation that includes the things you and I actually buy is high and rising. I drove past a gas station in La Jolla where the price of gas was over $4 a gallon. Money that is spent on gas and rising energy bills is money that cannot be spent on discretionary items. Rising food bills means that there is less money left over to buy entertainment and other modest luxury items.

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