Fall in US household wealth likely to spur a long recession, by Martin Feldstein

The massive downturn in the US economy will last longer and be more damaging than previous recessions because it is driven by an unprecedented loss of household wealth. Although the fiscal stimulus package ... will give a temporary boost to activity sometime this summer, the common forecast that a sustained recovery will begin in the second half of the year will almost certainly prove to be overly optimistic....

[T]he fall in share prices and in home values has destroyed more than US$12 trillion of household wealth..., an amount equal to more than 75 percent of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about US$500 billion every year until the wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.

The decline in housing construction has added to the current shortfall in aggregate demand..., cutting annual GDP by an additional US$250 billion. ... So the US economy faces a US$750 billion shortfall of demand. ...

Although the recently enacted two-year stimulus package includes a total of US$800 billion of tax reductions and increased government spending... Most of the tax reductions will be saved by households, rather than used to finance additional spending.

Moreover, a substantial part of the spending will be spread over the following decade. ... An optimistic estimate of the direct increase in annual demand from the stimulus package is about US$300 billion in each of the next two years.

The stimulus package would thus fill less than half of the hole in GDP..., with the remaining demand shortfall of US$450 billion in each of the next two years causing serious second-round effects. ...

To be sure, an improvement in the currently dysfunctional financial system will ... help, but it is unlikely to be enough to achieve positive GDP growth.

A second fiscal stimulus package is therefore likely. However, it will need to be much better targeted at increasing demand... Similarly, the tax changes in such a stimulus package should provide incentives to increase spending by households and businesses.

Although long-term government interest rates are now very low, they are beginning to rise in response to the outlook for a sharply rising national debt. ... The resulting increase in real long-term interest rates will reduce all forms of interest-sensitive spending, adding further to the economy’s weakness.

So it is not clear what will occur to reverse the decline in GDP and end the economic downturn. Will a sharp US dollar depreciation cause exports to rise and imports to fall? Will a rapid rise in the inflation rate reduce the real value of government, household and commercial debt, leading to lower saving and more spending? Or will something else come along to turn the economy around.

Only time will tell.

http://economistsview.typepad.com/economistsview/2009/03/feldstein-long-recession-ahead.html