The Economy Sucks. But Is It '92 Redux?

Clinton makes a gritty, unexpected comeback in New Hampshire. The contentious primaries pivot from a war in Iraq to economics. Business people fret about recession. What is this, 1992?

Not since James Carville helped Bill Clinton take the White House 16 years ago by reminding him "it's the economy, stupid," has the nation's economic state played such a key role in a presidential campaign. CNN's New Hampshire exit poll found that 97 percent of Democrats and 80 percent of Republicans expressed anxiety about the economy. Of course, the economy is in a worse place than it was when Hillary Clinton's husband was on the campaign trail. Today, the nation is perilously close to sliding into a recession; in '92, the economy had already started growing, though a jobless recovery doomed George H.W. Bush's re-election bid anyway. The lesson? Voters' perceptions matter more than whether the economy is technically expanding or contracting.

The news since the ball dropped this year in Times Square has been unrelentingly dour. We've learned that in December, the unemployment rate shot up from 4.7 percent to 5 percent, and the manufacturing sector unexpectedly shrank. Santa Claus left retailers lumps of coal for Christmas. Macy's, the 850-store chain that is an excellent proxy for middle-class spending, reported that same-store sales slumped 7.9 percent in December.

Just two years ago, Wall Street economists spoke of a Goldilocks economy, in which everything was just right. These days, it's the three bears. As of this week, the economists at Merrill Lynch, Morgan Stanley and Goldman Sachs are all predicting a recession for 2008. "I think it's already started," says David Rosenberg, chief economist at Merrill Lynch. "The real tipping point was the employment report."

But policymakers aren't ready to give up on the business cycle. In a recent interview with NEWSWEEK, Treasury Secretary Henry Paulson, the former Goldman Sachs chief executive officer who is the administration's designated market whisperer, stayed upbeat and on message. "Our economy, like any other, has its ups and downs," he says. "But you know, I believe our economy is going to continue to grow." What gives Paulson his optimism? "The president's pro growth policies, the fact that government revenues are coming in ahead of forecasts and that our deficit is now down to 1.2 percent of GDP."

There are bright spots, to be sure. Exports rose 13 percent in November from 2006.The farm belt is thriving, thanks to record prices for grains. Regions that produce coal, gas, oil or minerals are riding the global energy boom.

Recessions—defined as a contraction in economic activity—are notoriously hard to predict, especially since they occur so infrequently. Since 1992 the economy has contracted for just eight months, according to the National Bureau of Economic Research, the Cambridge, Mass.-based arbiter of business cycles. Recessions usually occur after a the economy hits a huge speed bump. The commercial real-estate/savings-and-loan implosion precipitated the 1990 recession. In 2001 the bursting tech bubble caused a sharp pullback in business investment.

If the economy teeters into recession this year, it will be because the hardy American consumer—who accounts for 70 percent of economic activity—has finally hit the wall. And when consumers stop spending, the companies that cater to them idle and lay off, which, in turn, leads to more reduced spending.

"Consumers were cautious in their spending at Christmas, and they're going to be cautious going forward," said Rosalind Wells, chief economist at the National Retail Federation. As a result, retailers are acting swiftly to reduce costs and cut their losses. In recent weeks, Talbots announced it would shutter all its Talbots Mens and Talbots Kids clothing stores.

At the dank CompUSA store on Eighth Avenue and 57th Street in Manhattan, a lone security guard checks the bags of the handful of shoppers buying memory cards, cell phones and televisions for 15 to 30 percent off at the store's going-out-of-business sale. "As the days go by it's slowing down a bit," says assistant manager Steve Laureano, who plans to go back to school and seek work elsewhere. The outlet is one of 103 that the chain is closing.

As you've no doubt heard, the trouble started with housing. Defaults on subprime mortgage led to a credit squeeze. After enjoying several years of growth, home prices fell an unprecedented 6.1 percent in the past year. "There's never been a time where you had a real-estate deflation as deep and prolonged as this," says David Rosenberg of Merrill Lynch.

In the most recent recession, 2001, the areas hardest hit were those that had benefited most from the technology boom —San Francisco, Boston and Austin, Texas. Today, former housing hot spots like California are functioning as cement shoes for the national economy. John Harmer, co-owner of Southland Lumber & Supply of Inglewood, Calif., says his business is off 50 percent this year. After being hit by a slowdown in sales to home-remodeling contractors, his 18-employee firm, which also supplies materials to the sets of television shows like "Boston Legal" and "Nip/Tuck," was nailed by the entertainment writers' strike. "TV is out completely," Harmer says. So far, 10,500 Hollywood workers have been laid off since the strike began, says Jack Kyser, chief economist of the Los Angeles County Economic Development Corporation.

In California, slowing economic activity is already producing one of the most unwelcome byproducts of an economic slump: declining government receipts. California Gov. Arnold Schwarzenegger last week called for steep budget cuts to close a gaping $14 billion deficit.

When the economy slows, debt of all kinds begin to go bad. Subprime loans are yesterday's news. Today's news? The souring credit of middle-class consumers. Credit-card giant Capital One Financial had to set aside $1.9 billion for bad loans in the fourth quarter, thanks to higher write-offs of auto and credit-card loans.

From Wall Street to California, eyes are turning to Washington for help. Government responses to recessions come in two forms: fiscal policy (stimulus packages) and monetary policy (lowering interest rates). As the primaries roll into economically depressed Michigan, the need for the government to stimulate the economy—through tax breaks or increased spending—has become a hot political issue. On Friday Hillary Clinton unveiled a $70 billion stimulus package, including aid for struggling homeowners and extended unemployment benefits. President George W. Bush, speaking in Chicago before he departed for the Middle East, shifted subtly from his position that the fundamentals are sound. "Recent economic indicators have become increasingly mixed," he said. Bush's upcoming State of the Union address will likely include a grab bag of tax proposals intended to jolt the economy back to life.

The Federal Reserve has already taken action by slashing rates three times since September. Chairman Ben Bernanke last Thursday said the central bank is prepared to take more dramatic action (read: more cuts) given that "the baseline outlook for real activity in 2008 has worsened." But the assumptions that a proactive Federal Reserve can bail out the economy may not pan out this time. Banks recovering from poor lending decisions are less willing to make mortgage loans today, regardless of the Fed's interest rates.

Another assumption that underlay sunny economic forecasts in the past may be crumbling, as well. Economists argued that as long as the rich are getting richer, and spending—they account for a disproportionate share of consumer purchases, after all—the economy could skate by a recession. But signs are mounting that even the holders of the American Express Gold Card are struggling. American Express last week took a $440 million charge for bad debt, reporting that more of its well-off customers were behind in card payments. Cadwalader, Wickersham & Taft, the white-shoe law firm where associate pay starts at $160,000, just laid off 35 attorneys. And big layoffs are coming at Citigroup and Merrill Lynch, two of Wall Street's biggest—and most generous—employers.

Tiffany, which notched huge sales gains throughout 2007, even as many retailers suffered, on Friday reported that same-store sales during the Christmas season unexpectedly fell 2 percent. The reason: lower sales on products that cost more than $50,000. Even for the rich, breakfast at Tiffany's these days is limited to the $1.99 special.