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U.S. Economy May Be Facing A New Normal

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Bloomberg News

Published: May 20, 2008

A normal U.S. economy is likely to look a lot different, and worse, after the credit crisis is over and financial markets settle down.

Companies will continue to struggle to raise cash for expansion and innovation as investors and lenders remain focused on conserving capital. Workers, too, may have less flexibility to go after new opportunities, because many will be stuck where they are - in homes worth less than the balances on their mortgages.

"Once you've made terrible, overly optimistic errors, that paralyzes you for some time," says economist Paul Samuelson, a Nobel laureate.

The bottom line: The United States may have to get used to a new definition of normal, characterized by weaker productivity gains, slower economic growth, higher unemployment and a diminished financial-services industry.

Long-term growth in the United States may drop to 2 percent or 2.5 percent a year from the 3 percent rate of the past 15 years, according to Peter Hooper, chief U.S. economist at Deutsche Bank Securities in New York and a former Federal Reserve official.

Even after markets recover, "the cost of risk capital is likely to be significantly higher than during the credit bubble," he says.

Three-quarters of the U.S. banks the Fed surveyed in April - a record portion - said the premium they were charging corporate borrowers over their own cost of funds had gone up. More than half reported tightening lending standards.

Behind the stricter terms: loans and investments made during the credit boom that went sour. Banks and financial institutions worldwide have racked up more than $340 billion in credit losses and asset writedowns since the start of 2007. David Rubenstein, chairman of the Washington-based private equity firm Carlyle Group, says there's more to come, telling reporters May 12 that "enormous losses" have yet to be recognized.

Companies face a tougher borrowing environment in the bond market, too. The spread investors charge over Treasury securities for high-yield bonds has narrowed since the height of the credit crisis in mid-March.

Still, it's well above the 495-point average since 1985 and is likely to remain higher, says John Lonski, chief economist at Moody's Investors Service in New York. He sees the spread averaging about 600 basis points next year.

As for high-yield bond issuance, Lonski forecasts a drop of more than 40 percent this year, to $80 billion.

"Next year, we'd do very well to reach $100 billion," he says. In 2006, before the credit crisis, more than $150 billion in new junk bonds were sold.

Equity capital is also harder to come by. Initial public offerings for fledgling businesses fell to the lowest level in almost five years in the first quarter, the National Venture Capital Association reported.

"There are an awful lot of firms who are having trouble fundraising, no doubt about it," says Mark Heesen, president of the Arlington, Va.-based association.

Less risk-taking can mean a less-vibrant economy, says Samuelson, 93, an emeritus professor at the Massachusetts Institute of Technology. "What you could lose are some new ideas that would otherwise get to be practical and get their chance," he says.

Workers too are feeling the fallout from the credit crisis. The share of respondents in a Bloomberg/Los Angeles Times poll who described themselves as financially secure fell to the lowest level since 1992.

The declining value of houses - the biggest asset for many Americans - has a lot to do with their pessimism.

Zoltan Pozsar, senior economist at Moody's Economy .com, says 8.5 million homeowners - roughly 11 percent - owed more on their mortgages than their homes were worth in the first quarter. He forecasts that the number of people in this predicament will rise to more than 12 million next year.

Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University in New York, says the nation is "in the grip of some structural forces that are moving the economy permanently to a lower level of economic activity, with an unemployment rate somewhere between 5 percent and 6 percent."

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