Thomas Palley

Hurricane Katrina was an immense natural disaster that has already inflicted great harm and suffering. It has also wrought huge regional economic damage, the local effects of which will belong-lasting. Now, people are wondering whether Katrina could also spawn a national recession.

The Wall Street consensus seems to be that it will not, but there are robust grounds for believing that the consensus is wrong. Even before hurricane Katrina, the economy faced treacherous waters in the form of a decelerating housing price bubble and a two-year doubling of oil prices. It was also still digesting the effects of eleven successive Fed rate hikes. Katrina has compounded these problems with dangerous headwinds that are especially troubling for the U.S. auto industry. In this environment, the Fed should stop its rate hike campaign and await a clearer economic picture.

The U.S. economy is heavily dependent on consumer spending which accounts for approximately two-thirds of economic activity. The primary channel through which Katrina is likely to trigger a national recession is therefore the American consumer. Here, there are two different effects at work. The first can be termed the “wallet effect,” the second the “confidence effect.” The wallet effect operates through the impact of higher gasoline and energy prices, which make consumers poorer, thereby reducing their spending on other items. Its size will depend on how long energy prices remain at current high levels. Prior to the hurricane gasoline prices had already moved up. Hurricane Katrina has compounded this move, and still to come is the impact of higher winter heating costs.

The second channel of impact is the consumer confidence effect. The awful images of hurricane Katrina were seen on televisions all across the country. Just as the attacks of 9/11 shook consumer psychology, so too Katrina may impact it. If Katrina’s havoc has made people feel less secure and more vulnerable, consumers can be expected to increase precautionary saving and delay spending, especially on big-ticket items such as autos and appliances. In this regard, the news is not good. Last week’s University of Michigan survey of consumer confidence showed an exceptionally large decline, with the August reading falling to a thirteen year low. Side-by-side, August consumer spending fell by 2.1 percent, the largest decline in four years. And spending on autos plunged a record 12.1 percent.

The plunge in auto sales is especially worrying. The Big-3 – GM, Ford, and Chrysler – are all heavily dependent on sales of SUVs and light-trucks for their profitability, and they are also weak in the fuel-efficient vehicle product segment. At a minimum, the rise in gasoline prices is likely to temporarily dent sales of SUVs and trucks. However, a greater danger is that consumers may view higher gas prices as here to stay and permanently shift away from SUV buying. If this happens, the structural vulnerability of the U.S. auto industry will amplify the consumer wallet and confidence effects, which are already poised to hurt the industry. The global auto industry stands to be adversely impacted by rising gas prices, but the U.S. auto industry stands to be disproportionately impacted owing to its poor product positioning.

Though smaller in significance than in past decades, the auto industry remains a critical part of the U.S. economy and any downturn will spread shock waves through both the manufacturing and service sectors. Auto production still generates massive employment and income multipliers. Auto production requires steel, tires, parts, and machine tools. The industry spends massive amounts on new plant and equipment, while the transportation and distribution sectors benefits from vehicle shipments to dealers. The services sector also benefits from dealer sales activity. This adds up to a massive economic contribution. Any contraction in the industry will quickly reduce household incomes, the effect of which will get multiplied as households cut back on their spending.

A final channel, that has been little discussed, is the negative effect of higher energy prices on the international economy. This stands to lower U.S. exports. Just as high energy prices are negatively impacting the U.S. economy, so too they are negatively impacting other oil-importing economies, especially developing economies. Should these countries begin to register trade deficits and financial markets become skittish about financing them, the world economy could experience a renewal of financial instability and a broad slowdown.

To conclude, the current economic expansion is in its fifth year. From the beginning it has been a weak expansion, subject to repeated encounters with “soft spots.” Even before hurricane Katrina the economy confronted treacherous waters, to which have now been added dangerous headwinds. Prudent responsible policymaking demands that the Fed stop its rate hike campaign and move to a holding pattern until the economic picture clears.

This entry was posted on Sunday, September 18th, 2005 at 10:12 pm and is filed under U.S. Policy. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.