This author spent the weekend in New Orleans at the Annual Meetings of the American Economic Association (AEA). At a session on the subprime mess moderated by David Wessel of the Wall Street Journal I was a panelist together with Paul Krugman, Bob Shiller and Larry White, a housing expert at NYU/Stern; a crowd of over 400 listeners followed the two hour debate and asked probing questions.

The mood at the panel was gloomy. Bob Shiller spoke of the subprime meltdown, of how households are still deluding themselves – in polls – that home prices will keep on rising for the next decade while they have already fallen by 10% in real terms and need to fall by a cumulative 30% before they bottom out (a loss of home values of about $6 trillion); he also argued that the probability of an economy wide recession is now about 75%.

Larry White discussed how housing has been subsidized for a long time in the US via a plethora of subsidies and tax incentives; we thus invest way too much into the housing capital stock and not enough into more productive real capital; thus, the subprime mess is in part a reflection of this subsidization of housing. He also discussed the conflicts of interest of rating agencies and the lack of competition in the rating business. He also referred to the problems in the securitization food chain as due to information asymmetries, adverse selection and moral hazard.

I discussed in plainer terms these distortions in the securitization food chain: lender know less than borrowers about their ability to pay and lenders who do not hold the credit risk as they originate and distribute it know more about the quality of the mortgages than the final investors holding RMBs and CDOs (info asymmetries); those who are willing to take risky mortgages that may balloon and reset at higher rates may want to strategically default (adverse selection); and those in the securitization food chain (mortgage brokers, mortgage originators, mortgage appraisers, managers of CDOs, credit rating agencies) who are now not holding the credit risk but only earning a fee are subject to conflicts of interest when shoving such products to the final investors (moral hazard). This is the worst housing recession in US history and an economy-wide recession is now unavoidable and it will be a severe recession rather than a mild recession; and there is now a risk of a systemic financial crisis. This is a crisis of insolvency, not just illiquidity; it is a problem of unmeasurable uncertainty (on the size of the losses and who is holding the toxic waste) rather than priceable risk; and liquidity risk is now severe and not manageable as we have a shadow financial system where non-bank institutions (SIVs, conduits, money market funds, hedge funds, investment banks, etc.) borrow short/liquid and invest in long/illiquid assets; so they are subject to a severe liquidity/rollover risk but they don’t have access to the lender of last resort support of the central bank in the case of a liquidity run.

Paul Krugman also summarized the subprime debacle – an “unmitigated disaster” in his words – but he was more cautious and sanguine on whether this housing meltdown and the large financial losses will lead to a recession. In his view the fall in residential investment – as a share of GDP – has been compensated by a comparable increase in the share of exports in GDP (thanks to a weaker dollar); also so far consumption has held up rather than faltering. So maybe a recession will be avoided event if the ugly December employment figures made him a little more cautious about whether a recession can be avoided. So paradoxically Krugman was the most cautious in his assessment of an economy wide recession.

A lot of interesting points and nuances were added in the question and answer session after the initial presentation by the panelist. But there was an overall consensus – subject to the above caveats - that home prices may have to fall 20 to 30% before they bottom out and that the risks of an economy wide recession are high and rising.

The gloomy and pessimistic mood about the likelihood of an economy wide recession was shared by many other economists at these AEA meetings. As reported by Market Watch:

Economists say 2008 will be a year to forgetAnalysts at American Economic Association now see recession as a givenNEW ORLEANS (MarketWatch) -- Gathered in this city struggling to regain its footing after Hurricane Katrina, a group of leading economists said the U.S. is getting hit by another damaging storm: the global credit crunch.

Many analysts gathered at the American Economic Association's two-day annual meeting spoke of a recession as almost a given but differed over how severe it will be. "The recession is likely to be a serious one," said Dean Baker, co-director of the Center for Economic and Policy Research. He estimated losses in prime mortgages will be two to three times the $160-$200 billion hit seen in the subprime sector. This, he said, will lead to large losses at banks and difficulty for Fannie Mae and Freddie Mac.

University of Chicago professor of finance and former chief economist at the International Monetary Fund, Raghuram Rajan, said questions in the media over whether the U.S. economy will fall into recession are really only about semantics. "We are going to have very low growth in the first two quarters of the year. Whether it is negative or zero, it is going to feel like the same thing," Rajan said. But he added that it remains an "open question" whether an even more serious slowdown develops in the second half of the year. "One of the big issues is the extent to which the credit crunch initiated by the subprime crisis starts spreading and how much does it affect smaller corporations and poorly rated corporations," he said. "Do we have a bank credit crunch which starts impacting on retail credit for small and medium enterprises? There is some uncertainty."

And by now inside academia senior folks such as Marty Feldstein and Larry Summers – among many others – believe that the risks of a recession are now more than 50%. And outside of academia Morgan Stanley (Berner), Bill Gross of Pimco, John Bogle of Vanguard expect – with high likelihood - a mild recession in 2008; while Merrill Lynch (Rosenberg) and Goldman Sachs (Hatzius) are also now in the 2008 recession camp.

So, as argued before in this forum, at this point the debate is not anymore about whether we will have a soft landing or a hard landing recession; it is rather on how hard the hard landing will be, i.e. whether the upcoming recession will be mild – and lasting only a couple of quarters – or more severe and lasting several quarters. I have argued that this will be a severe recession rather than a mild one like the mild ones in 1990-91 and 2001; and that the risks of a severe systemic financial crisis are now very serious.

There is now a consensus – certainly at the AEA panel – that home price will have to fall 20% to 30% before they bottom out, most likely 30%. This is a whopping loss of home values of about $6 trillion that will have significant macro effects and financial effects. With losses this large the wealth effects on consumption – and the related collapse in home equity withdrawal – will be serious; and with losses this large over 10 million households will end up in negative home equity territory and would thus have a strong incentive to default on their mortgages as most US states treat mortgages as non-recourse loans (i.e. once you default and get foreclosed you are not liable for the difference between the amount of your mortgage and the lower value of your home). The macro and financial consequences of losses and defaults of this size are massive. The part of these $6 trillion losses that will be incurred by households having their home equity wiped out will show up in lower private consumption; while the part of these $6 trillion losses born by banks, other financial institutions and investors in the US and across the world will lead to a severe credit crunch.

And research by Goldman Sachs suggests that even a modest $200 billion of losses for banks – and related reduction in their capital – would lead to a reduction of $2 trillion in credit – a severe credit crunch – as banks create about 10 dollars of assets for each dollar of capital that they hold. This credit crunch will be much more severe if mortgage losses incurred by bank and other financial institutions are – as likely - much more than $200 billion. And certainly while SWFs have partly recapped bank capital through their equity injections this increase in capital – at about $20 billion – is a fraction of the capital losses that are being incurred by financial institutions. Thus, the credit crunch could be extremely serious. So the process of capital losses and bank reintermediation – as SIVs, conduits and other off-balance sheet vehicles are brought bank on-balance sheet – is likely to exacerbate the liquidity crunch of banks and the credit crunch of banks and other financial institutions.

So while 2007 was mediocre for the US stock market – with the S&P500 down in real terms and returning less than safe US Treasuries – 2008 will be a much worse year as the economy spins into a recession. The first three trading days of 2008 were already ominous with all the major indices sharply down Wednesday and Friday last week. But this is only the beginning of a real bearish stock market as a bear market is always associated with economic recessions.

For a more detailed and 24/7 coverage of the US and global economy and the markets see the continuous coverage on the RGE Monitor (www.rgemonitor.com). And starting on Tuesday January 8th all the readers of my Global EconoMonitor will have a chance to get a free three week trial of the full RGE Monitor. The RGE Monitor site's content is hundreds of times larger and more extensive - in coverage and topics - than those in my Global EconoMonitor; a simple 30 second registration will allow you to have access to my Global EconoMonitor as well as the full RGE Monitor. We cover, analyze and summarize 24/7 and 365 day a year the best information available on the web - news, opeds, research, analyses, discussions, blogs - on the most important global economic, financial and geopolitical issues, with the coverage being done by country, topic and markets angles and perspectives. Soon you will be able to get a free trial of the site that was ranked by The Economist as the #1 web site in economics in the world.