Is the US heading for a Depression?

As the above chart shows the last three months of 2008 were a significant step in the wrong direction for the US economy. Official figures showing GDP shrinking at an annualised rate of 3.8%. With many economists predicting the worst US recession since WWII how big is the danger that the US economy will slip into a depression similar to the 1930s?

US recession evidence:

Consumer spending which makes up two thirds of the economy fell for the second successive quarter by 3.5%
Within this consumer spending drop there was a 22% drop in spending on durable goods such as cars and washing machines
Exports have fallen sharply by 19.7%
Residential investment fell by 23.6%
Business investment dropped 19.1% (led by a 27.8% drop in the purchases of equipment and software

The economic uncertainty in the US is clearly changing consumer behaviour, this is reflected in the rising personal savings rate amongst households which rose to 2.9% in the last quarter, more than double that of the previous quarter. Economists predicted this rate could rise as high as 5%.

The three major reasons for the rising savings rate:

Rising unemployment (could rise from 7% to 10% by the end of the year)
Restricted access to credit (the ‘credit crunch’)
Falling asset values (the fall in stock markets and house price values since the middle of 2007. This has had a negative wealth effect, and this factor alone has reduced consumption by 1%)

How bad can it get?

In the 1930s, output declined for four years, with GDP cut in half and unemployment rising to 25%. Despite the New Deal ouptut did not recover until its 1929 level until after the Second World War.

At the moment economists are predicting that the US slowdown will last around two years not the four experienced during the Great Depression.

The only thing boosting the US economy currently is government spending which rose 5.8% in the last quarter of 2008. Although Obama’s $800bn stimulus was passed last week by the House of Represntatives and is currently beinf considered by the Senate it will take time for the money to be felt by the economy. Only $170bn will be spent before October of this year, the bulk of the spending will occur in 2010 and 2011. Likewise it is unclear how many jobs will be created, President Obama aims to create 3.5m jobs but others say the job creation will be limited to between 1.2m and 3.6m.

The other great uncertainty is the financial sector. There is now $2.2trn of toxic debt worldwide according to the IMF. There is still uncertainty as to how much is still left out there. Obama still has $350bn of the $700bn bailout plan approved last year.

There is a possibilty that the US could avoid a recession that borders on depression but that outcome is far from certain.

For the full BBC article click here.