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Immense Problems Require Big Solutions By Dr. Scott J. Brown, Chief Economist

The U.S. economy faced a number of difficulties in 2008, and 2009 looks likely to be just as challenging.

The National Bureau of Ecnomic Research’s Business Cycle Dating Committee has pegged December 2007 as the start of the recession. For the first eight months of 2008, the recession seemed relatively mild. Indeed, gross domestic product (GDP) rose in both the first and second quarters. However, economic weakness became more severe and broader-based in September, as credit markets seized up.

The Federal Reserve responded to the crisis by cutting short-term interest rates by 100 basis points (bps) by the end of 2007, another 225 bps in the spring and yet another 175 bps by mid-December. With the target range for overnight lending between 0.25% and zero, monetary policy moves are limited. However, monetary policy can support the economy in other ways.

The Fed will turn to quantitative easing – a focus on the quantity of credit in the system, rather than on the price of credit (the interest rate). In late November, the Fed signaled that it would buy up to $100 billion in agency debt (Fannie Mae and Freddie Mac paper), up to $500 billion in mortgage-backed securities, and up to $200 billion in asset-backed securities (student loans, auto loans, credit cards loans, and small business loans). 

Predecessor Recessions
In the Great Depression, policymakers made all the wrong moves – raising taxes, hiking interest rates, putting up trade barriers and standing by while thousands of banks failed. This is not the Great Depression, but the downturn could rival the 1973-75 and 1981-82 recessions in both depth and duration.

The Treasury has moved to recapitalize the banking industry. Congressional leaders, working closely with President-elect Barack Obama, should have a massive stimulus bill ready to sign when the new president takes office later this month. This package will likely include spending on public works, middle class tax cuts and aid for the states.