James Saft
Reuters
February 7, 2008

Job losses and a contraction in the business sector where more than 80 percent of Americans work show that the angle of descent for the U.S. economy is steepening.

Unsurprisingly, while problems are spreading to the formerly indefatigable American consumer, the old issues – falling home prices and crippled credit markets – show no signs of healing themselves or being healed from on high.

And yet, the Dow Jones industrial average is just 14 percent below its all-time closing high, an improbable combination.

The big question – can the economy possibly shake off a deflating debt bubble? – seems to have been answered.

The Institute for Supply Management’s index of the all-important services sector fell abruptly in January to 41.9, from 54.4 in December, indicating that the sector is shrinking outright.

Private-sector services account for nearly 70 percent of U.S. economic output and have been the engine of growth during the past seven years as manufacturing increasingly moved overseas.

“That was really a crunching number, a recessionlike number,” said Lex Hoogduin, chief economist at the Dutch fund manager Robeco.

Hoogduin, who takes comfort from data showing an uptick in the manufacturing sector, said the services numbers had prompted him to rate a recession at nearly an even shot, up from about a 30 percent chance before.

The ABC News/Washington Post Consumer Comfort index has just dropped to its lowest reading since November 1993, capping a monthlong decline that eerily mirrored drops before recessions in 1990 and 2001.

“They don’t ring a bell when a recession starts, but that tinkling sound seems to be getting louder,” said Kevin Logan, an economist at Dresdner Kleinwort in New York.

“Some shift is taking place in January and February that wasn’t evident in 2007.”

And it is true that businesses and consumers have suffered through a blizzard of bad news since the year began, with President George W. Bush and others calling for a stimulus plan to rescue the economy, an emergency inter-meeting rate cut by the Federal Reserve and more pain from financial markets.

Seeing this, it is very likely that consumers and businesses are doing what they classically do in a recession: deferring decisions and consumption. This can combine with what is happening in credit in a dangerously self-reinforcing way.

An increasing number of American businesses and consumers will be finding credit harder to come by. The great piggy bank called home is definitely tapped out, with declining house prices and banks’ unwillingness to extend more credit making further borrowing difficult.

Look no further for confirmation than the Fed’s January senior loan officer survey, which showed less demand for loans and less desire to make them on easy terms, both to consumers and businesses.

Banks do not want to lend both because do not have the money, having already lent and lost too much, and because they are turning downbeat about overall prospects for the people they lend to.

Banks, too, are subject to huge evolving risks, not least the crisis among bond insurance companies, that could be causing them to preserve capital even more aggressively.

So-called monoline bond insurers, which insure structured financings and municipal bonds, are at risk of downgrades from ratings agencies that could touch off yet another round of losses and write-downs by banks.

In a week of incredible stories, maybe the most amazing was that Fitch Ratings was reviewing 172,326 bond issues after putting on a negative watch the triple-A ratings of one such insurer, MBIA.

Banks own about $615 billion of structured securities insured by monolines, according to Marc Chandler of Brown Brothers Harriman. A downgrade to double-A would force a write-down of $20 billion to $25 billion, while one to a single-A rating would require $140 billion to $150 billion, according to Chandler.

Besides hitting credit, this could undermine a stock market that is already looking vulnerable at these levels if we head into recession.

If American consumers really take a close look at their finances, they may not just defer spending but cut back hard.

Paul Kasriel of Northern Trust in Chicago points out that from 1929 to 1998 U.S. households had been in deficit in only six years, including two during the Depression and several after World War II when there was finally stuff to buy with money they had been forced to save.

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