The economic downturn that began when the U.S. housing bubble burst appears to only be getting worse.

Housing values continue to tumble, prices for oil and other commodities are soaring, banks in both the U.S. and Europe are struggling, and even industry bellwether General Electric saw its earnings plummet recently. All of which begs the question: How much worse can things really get?

According to Wharton Professor of Finance and Economics Franklin Allen, there’s a degree of disagreement about that. But Allen, whose recent research has focused on financial crises, says a major U.S. economic downturn is not out of the question. Whether or not that happens, he says, will probably depend on how bad the housing market gets. If values continue to dip, he says, real trouble awaits.

Q. Getting right to it, how bad are things right now?
A. Well, there’s a great diversity of opinion about that question. One view is that the real economy, in terms of firm earnings and those kind of things, is quite strong, and that while there are some problems in the financial sector, that we’ve put the worst of it behind us. That’s one view, at least.

Q. But I assume it’s not your view?
A. No, my own view is that this situation is somewhat unlike any situation we’ve been in for quite some time. The reason that it’s different is because housing prices are falling so significantly. That hasn’t happened here since the Great Depression. So one of the big issues now is: How much are they going to fall? If you take a somewhat simplistic approach, you can say that because prices were about 25 percent above the long-term growth rate, they will then fall about 25 percent in total. But we’re already down 15 percent and there’s another 10 percent to go. The next big issue is whether or not other things—the “feedback effect”—are going to happen because of this, such as whether we’re going into a recession, if companies start cutting jobs, what’s happening with inflation, all of those kinds of things.

Q. If we did see prices fall another 10 percent, what might happen?
A. That would cause a fair amount of pain in the banking system and we may end up seeing more bankruptcies or situations like Bear Stearns. But it shouldn’t be that bad. It will be quite painful, but not catastrophic. The real worry is what happens if we were to get the “feedback effect.” In other words, what happens if the housing prices start [creating job cuts] or other things? And if we have housing prices drop by 30 or 40 percent, there’s uncertainty as to which banks would survive and what affects that would have. I think that’s the real concern going forward—if there’s a big feedback effect, it might get much worse.

Q. Does the situation here in the U.S. today remind you of any other economic crises, either here or elsewhere?
A. My own view is that ... it’s most like what happened in Japan in the 1990s. They had a huge bubble. Prices were way above what they subsequently turned out to be. They peaked in about 1991 and then fell about 70 to 75 percent over 15 years. It took an awful long time. Growth basically stopped. Japan went from one of the highest-growth economies to one of the lowest in the developed world. … If the U.S. got to that point, it would be very painful, but we didn’t have nearly as big of a bubble. That’s what the Fed is trying to stop. They’re cutting rates to stop the feedback. People say that Japan [in the 1990s] didn’t cut rates fast enough. Well, the Fed has avoided that but now inflation is getting quite high.

Q. How does Europe look at all of this?
A. In Europe they have a very different view about what a central bank needs to do. The last few days in Europe, the discussions have been about raising rates. The head of the Bundesbank made a speech arguing that [Europe] should think about raising rates. They’re very different than us. They haven’t cut rates much since last August. So we have this big difference in rates and that’s caused the dollar to fall dramatically, especially against the euro. It wasn’t long ago that it was 85 cents, and now it’s almost halved the value of the dollar vs. the euro. That’s why oil prices are going up so much. Most of the world is not paying in dollars. But we are. The dollar price is going up dramatically and that’s likely to continue so long as we have interest rate cuts.

Q. Can you project how long it’s going to take for the U.S. economy to turn the corner?
A. You have to go back to the question of how far the housing market is going to fall, and how big the feedback effects are going to be. With the housing market, it takes a long time. A house is such a big asset for most people, so they don’t want to make the wrong decision, and they’ll just wait. It’s not clear how long it’s going to take.

Originally published May 8, 2008