Prepare for a Depression

NEW YORK (CNNMoney.com) -- The sputtering U.S. economy has gotten

everyone from the financial markets to the Federal Reserve to Congress

in a panic.

But here's a disheartening message for those already worried about

economic growth -- it could get much worse.

Most economists who believe a recession is already here or at least

near are looking for a relatively short and mild downturn, perhaps

lasting only two or three quarters.

But many of those same economists say they also can envision a worst-

case scenario where spending by consumers and businesses falls off

sharply, unemployment heads higher than normal during a typical

recession and housing and credit market problems worsen.

"I can easily imagine [the economy] going into a free fall," said Dean

Baker, the chief economist for the Center for Economic and Policy

Research. "The danger is that housing prices continue to tumble and

accelerate, people's ability to pull out equity will evaporate, and

you'll see a serious downturn in consumption."

We talked to three more leading economists to find out their biggest

economic fears. Here's what they had to say.

Greenback blues David Wyss, chief economist with Standard & Poor's,

said that among his biggest concerns is that overseas investors could

pull back on investing in the dollar and other U.S. assets.

That could cause an even greater sense of fear among U.S. consumers

and businesses, as stock prices fall and bond yields rise, which in

turn would lift mortgage rates and be a bigger drag on the already

battered housing market.

"Americans could just get scared by a barrage of bad news," Wyss said.

"The stock market could continue going down because of foreigners

pulling money out, and between that and home values going through the

floor, it could lead to a real pullback of spending, particularly by

Baby Boomers who are getting close to retirement."

Wyss said he's also concerned that oil prices could shoot higher, even

if a recession cuts into global demand. He said supply disruptions in

the Middle East could send oil prices up to $150 a barrel and help

deepen any recession.

Wyss said that in his worst case scenario, the unemployment rate would

climb to 7.5 percent by early 2009, up from its current level of 5

percent.

He also believes gross domestic product, the broad measure of the

nation's economic activity, could wind up as much as 2 percent lower

at the end of 2008 than it was at the end of 2007. That would be the

biggest downturn since 1982. Many of those forecasting a recession

this year are expecting GDP to show a slight gain by the end of the

year.

House of pain. Edward McKelvey, senior economist at Goldman Sachs,

agreed with Wyss that, in a worst case scenario, GDP could fall 2

percent this year..

His biggest fear is that home prices could fall much further in the

coming months. In fact, Goldman and economists at Merrill Lynch have

both predicted that home values could fall another 15 percent, on top

of the 10 percent drop from earlier peaks that has already taken

place.

McKelvey said further declines could cause much deeper problems for

consumers and credit markets.

"One of the most likely candidates would be credit markets acting more

violently than we thought, a tightening of the supply of credit to

businesses and households," he said when asked what could bring about

his worst case outlook.

"You could also see a more substantial response by businesses to the

downturn through layoffs, cuts in their spending and business plans,"

he added.

Bank woes just beginning. Paul Kasriel, chief economist at Northern

Trust, said he thinks there's a good chance that the economic pullback

will be much steeper than now widely assumed. This weak forecast is

based on his belief that the billions in dollars of writedowns already

reported by Merrill Lynch (MER, Fortune 500), Citigroup (C, Fortune

500), JP Morgan Chase (JPM, Fortune 500), Bank of America (BAC,

Fortune 500) and other big banks are just the beginning of the problem

in the financial sector.

Kasriel said that if banks have to report more losses due to bad bets

on subprime mortgages, they will be unwilling, or unable, to make

large loans to businesses and consumers.

So even if the Fed keeps cutting interest rates, the impact of the

cuts may be "less potent" than rate cuts in previous recessions since

consumers and businesses may not be able to borrow enough to keep

spending. That could make this recession more like the one in 1991-92

than the relatively short and mild recession of 2001.

"Historically, and not surprisingly, recessions accompanied by

declines in consumer spending tend to be more severe. And people are

going to be constrained from spending by the declines in housing,"

Kasriel said.

He added that state and local governments might have to cut back

spending as a result of declining tax revenue. And that would be

another sizable blow to the overall economy.

"People forget about state and local government spending, but it

represents 11 percent of GDP," Kasriel said.