Seven Questions: Martin Feldstein on the “R” Word

By Foreign Policy

Interview with Martin Feldstein*

Is the global economy headed for a rough patch? With the world’s stock markets in turmoil, FP spoke with distinguished Harvard economist Martin Feldstein on what a U.S. recession would mean for America and the world.

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 it’s higher. The negative evidence continues to accumulate, so I think there’s 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 there’s 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 that’s 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 he’s been fairly criticized for missing the boat?

MF: Well, he wasn’t the only one who didn’t 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 wasn’t 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.

Bernanke’s speech on the 11th certainly indicates that he’s 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 everyone’s still talking about subprime mortgages. If I had told you a year ago that oil prices would hit the $100 mark, wouldn’t 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 1 percent 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 observed—from 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?

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*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.