Over a year since its start in December 2007, the U.S. economic recession shows little sign of abating. Indeed, output and employment are now declining at alarming rates and the U.S. financial system remains in a highly dysfunctional state. Worse still, one has to expect a number of other shoes to drop in 2009 that could further compound the very large loan losses now being experienced in the financial system. 

Policymakers have to expect further important strains on the financial system and on household balance sheets. Among the more important of these strains is the prospect that housing prices will decline by at least another 10 percent to 15 percent in 2009. They will do so partly under the weight of falling wage income and near record-level inventories of unsold housing. They will also be buffeted by a continued high rate of foreclosures that will be boosted by rising unemployment and by the increased number of homeowners with negative equity in their homes.    

Corporate defaults in 2009 will be on a scale not experienced in the postwar period.

Further compounding the financial sector’s problems in 2009 will be the continued bursting of the commercial property market bubble and a wave of corporate defaults. Up until 2008, the commercial property market had experienced a bubble similar to that in the housing market. However, over the past six months, the commercial market bubble has shown every sign of having burst and one has to expect that bursting to gather pace now that the economy has moved decisively into recession. 

Of even greater concern for the banks has to be the wave of corporate defaults that is now in prospect, especially in the area of private-equity sponsored leveraged buyout arrangements. The Fitch rating agency believes that corporate defaults in 2009 will be on a scale not experienced in the postwar period. It bases this belief mainly on the expected severity of the recession and on the very high interest rates at which corporations with less than an investment grade rating now have to raise money in markets. 

Notably absent from the Obama administration's early pronouncements is any clear indication of how to return the financial system to a state of normality or of how to stabilize the U.S. housing market.

The administration seems to grasp the enormity of the economic challenge confronting it and President Obama appears to be going out of his way to dampen any expectation of a speedy economic recovery. However, the almost exclusive focus of the new economic team has been on a massive public expenditure package that will have an unduly high infrastructural spending content and on temporary tax cuts that are more likely to be saved than spent. Notably absent from its early pronouncements is any clear indication of how to return the financial system to a state of normality or of how to stabilize the U.S. housing market. 

Judging by Japan’s lost decade in the 1990s, one has to wonder whether a sustainable U.S. economic recovery can be achieved without engineering the resumption of financial system lending and without putting a floor on falling home prices. One also has to wonder whether an emphasis on infrastructure spending to get the economy moving is misplaced. By its very nature, infrastructure spending will be spread out over many quarters at a time; but breaking the economy’s present downward spiral requires immediate fiscal support. 

The Obama administration needs to make serious revisions to its fiscal stimulus package with a view to providing the economy with more immediate support. It also needs to offer the country a bold new economic vision that goes beyond Keynesian-style fiscal stimulus and that addresses the serious problems in the financial and housing sectors. Any delay in providing a comprehensive economic plan could quickly dissipate the benefit of the doubt that the markets and the public are giving the new administration, which will only deepen the present economic recession. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. Go here to see his presentation on the housing market bottom.

Image by Darren Wamboldt/The Bergman Group.