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Economic forecast: Long, bumpy ride ahead

Monday's turmoil on Wall Street makes it clear the crisis is anything but contained – and that the nation's financial system is dangerously close to the edge.

It may well pull back. But as policymakers try to guide the economy across a frayed tightrope, it is increasingly difficult to know whether the worst is behind us.

Former Federal Reserve Chairman Alan Greenspan called the unraveling financial mess a “once-in-a-century” crisis, and experts say the most likely result will be more tightening of credit and lending standards for consumers and businesses.

In the wake of the collapse of Lehman Brothers, the forced sale of Merrill Lynch and the shaky condition of American International Group, stocks on Wall Street took their steepest fall since after the Sept. 11, 2001, terrorist attacks.

But fears of a global financial collapse proved ill-founded as markets avoided panic selling, which some had feared. The Dow Jones Industrial Average – on pace for one of its worst years – closed down a whopping 504 points, or 4.4 percent, to 10,917.51. The S&P 500 fell 4.7 percent and the Nasdaq fell 3.6 percent.

At the center of the storm is a widening credit crunch that's causing lending of virtually any kind to seize up. Without lending, the economy faces peril.

“There's nothing like this in the postwar period,” said Lyle Gramley, a veteran markets watcher who was a Federal Reserve governor during a turbulent period, from 1980 to 1985. “We aren't going into the Great Depression, no question about that. But we could get into a recession that accumulates if things don't get better in financial markets. I think we have to worry a lot that this may be the turning point that puts this economy into a very significant recession.”

Policymakers and economists have a better understanding of how the financial system works now than they did during the Great Depression, where it's widely agreed that much of the damage came because of a failure to act.

Lessons from the past go a long way toward protecting the economy against present dangers. But they don't eliminate them.

“I call the economy right now the Humpty-Dumpty economy,” said Eugenio Aleman, senior economist with Wells Fargo & Co.

If federal policymakers don't act fast enough, the economy could take a plunge – in the worst-case scenario, falling into a depression. If they continue to shovel money into the financial system, the economy could fall the other way, into an extended period of sharply rising prices and little growth, Aleman says.

“So the Federal Reserve is trying to make Humpty-Dumpty walk a line on top of that wall, which is a very tough equilibrium,” Aleman said.

In refusing to bail out Lehman Brothers, the government is sending a message that the next faltering financial institution cannot expect a bailout.

That alone adds risk to credit markets, which could make home, retail and business loans more expensive and harder to secure.

“So all of a sudden the guy that needed a business loan for a new plant may not get his money because a bank decides to put a hold on it and reconsider their position,” said Kenneth Thomas, a Miami-based economist and independent bank consultant.

“The same for somebody buying a house. They think they have a good price and are ready to buy, but if they can't get the credit, there's no deal. I think what we're going to see is the credit crunch getting worse.”

Others have speculated that more banks could fail in light of the latest problems to hit the financial markets. Of particular concern are several banks owned by Lehman Brothers. Lehman Brothers Bank, based in Wilmington, Del., has deposits of nearly $12 billion, while Lehman Brothers Commercial Bank, in Salt Lake City, has nearly $3 billion in deposits.

Mixed signals

Since the housing problems began to boil over last year, the economy has continued to expand. Boosted by federal stimulus payments, the country's gross domestic product grew at a 3.3 percent annual pace in the second quarter of this year.

Many analysts call the growth evidence of the resilience of the U.S. economy.

Many economists, meanwhile, say the worst is yet to come. There are already signs of a shift, including a slowdown in automobile sales, said Edward Leamer, an economist at the University of California at Los Angeles. But rather than approaching a sharp drop, he said, the economy is most likely to be in for a prolonged period of sluggish growth.

Christian Weller, a senior fellow at the Center for American Progress, said things are bad, even if they do not yet look that way. With spiraling debt and a yawning trade deficit, and with consumers grappling with heavy mortgages and credit card bills, he said, the country is in for a long, painful repayment period.

Best-case scenario

Will policymakers take the right actions quickly enough to keep an economic catastrophe at bay?

In the best-case scenario, the drop in home prices would begin to slow in coming months and then stabilize. Builders are doing so little new construction that demand for homes could start catching up to supply. Lower home prices and lower interest rates could send buyers back into the market, gradually easing investors' fears.

Moody's Economy.com expects average home prices nationwide to drop 24 percent from their peak by next spring before leveling off, with values in states such as California, Florida, Arizona and Nevada dropping much more.

Meanwhile, companies are likely to keep cutting jobs, driving up the nation's unemployment rate, experts say.

But the government's response could come at a price. The Federal Reserve has funneled so much money to shore up banks that it could lead to higher inflation and a drop in the value of the dollar, which could cut Americans' power to buy imported oil and other products.

Still, if policymakers don't act, the potential is there for something far worse.

President Bush tried to calm the waters Monday, using a White House visit by the president of Ghana to tell the nation that his administration is working to contain Wall Street's problems.

“As policymakers, we're focused on the health of the financial system as a whole. In the short run, adjustments in the financial markets can be painful, both for the people concerned about their investments and for the employees of the affected firms,” Bush said. “In the long run, I'm confident that our capital markets are flexible and resilient, and can deal with these adjustments.”

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