The financial crisis comes at a time when the American economy was already highly vulnerable because of high energy prices, stagnant real incomes and persistent job losses since the start of the year. As a result, there is a high probability that the financial crisis will help tip the economy into a formal recession. The unemployment rate is virtually certain to be high than it otherwise would be because of the financial crisis. One key impact of the crisis will be on consumer spending. The natural correction to the 2004-06 phase when consumers were over consuming through equity extraction from their homes is a phase of under consumption.
A second key impact will be on consumer confidence. Worries about the value of ones life savings and even the security of one’s money market account will likely have knock on effects on consumption.
Third, the loss of financial wealth will have a negative impact on consumption. Economists typically find that for each dollar of lost financial wealth, consumption drops by 3-4 percent. This means, for example, that a sustained $100 billion loss in capitalization of the stock market would be expected to cut spending by at least $3 billion in the first year after the decline. With consumer spending representing 70% of US GDP, the net impact could be severe.
The crisis is likely to have negative effects on business activity as well. Many small businesses are heavily dependent upon bank lending for commercial and industrial loans – to add to capacity, add workers, or upgrade equipment. Such lending is already being reduced as banks tighten credit standards. Larger businesses tend to source more funding in the credit markets and will almost certainly face tougher conditions as well. They also can be expected to delay hiring and postpone investment projects if the financial crisis reduces their ability to