Unresolved US imbalance could mean more pain

Greg Ip says: "Economy May Face Prolonged Pain, History Suggests".

The worst of the financial pain may have passed, but the economic pain could be just starting...

The nation's financial markets have rallied since early March...

But history suggests celebration may be premature. It's common in a crisis for markets to hit bottom long before the economy does. That's because markets are forward-looking and because economic weakness is the way the underlying imbalances that produced a crisis are corrected.

Where is the imbalance in the US?

... For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards.

When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are above most estimates of sustainable levels, and household saving has barely picked up. Even if the Fed's bailout of Bear Stearns Cos. in mid-March proves the apex of the crisis, as some think, the economy could still contract as consumers adjust to lost wealth and reduced access to credit.

Ip draws a parallel with South Korea's financial crisis in the late 1990s.

Korea's economy had been bolstered for years by overinvestment by its chaebols, or industrial conglomerates...

But in early 1997, several chaebols, which had been losing competitiveness, began to experience difficulties...

Ted Truman...says the overexpansion and excessive borrowing of Korea's corporate sector in the run-up to its crisis are analogous to the overexpansion of housing and consumption in the U.S. in its crisis...

Korea's recovery began in 1999. Mr. Kim says that capital investment never fully recovered and that economic growth, while a healthy 4% to 5%, hasn't returned to the precrisis pace... Korea's lesson to the U.S., he says, is that "imbalances must be corrected." A recovery doesn't need a full resolution of those imbalances, he says, only a "convincing sign that change is taking place."

The risk for the U.S. is that weakness goes beyond the correction of housing excesses and begins to feed back into the financial system and then, again, hurts the wider economy.

... Nouriel Roubini...predicts that a wave of defaults on industrial loans, municipal bonds and consumer credit is coming, which will trigger another wave of financial-system distress.

Fed Chairman Ben Bernanke believes such feedback effects are what made the Great Depression great. Mr. Bernanke's awareness of such risks is why he cut rates last week and, despite signaling a pause, is still focused on the risks that the U.S. economy may deteriorate further.

I agree with most of what Ip says.

However, I am not sure exactly why his concluding paragraph bothered mentioning Ben Bernanke's rate cut last week. If a correction of imbalances is required for sustained recovery, and elevated house prices and low household saving reflect the imbalance in the US, then how was the rate cut supposed to help? Based on the gist of the article's argument, Bernanke's concern for the economy last week becomes understandable but not necessarily his action.

See also Ip's blog post.