June 8, 2006
The Collapse in Housing and the Coming Recession
The coming recession will be more severe than most people expect because it will come after two huge historical bubbles, i.e. the 2000 technology stock market bubble and the 2005 real estate bubble. These two speculative bubbles are interrelated, since the second bubble developed because the Greenspan Fed attempted to stop the stock market decline in 2002 and avoid a recession after 9/11, by driving short term interest rates down to 1 percent over a two-year period. This was accompanied by a decline in mortgage rates and other long-term interest rates, which stimulated investments in real estate through long-term borrowing.
Indeed, since 2002, the Fed has flooded the U.S. banking system with excess liquidity. The increase in liquidity has been phenomenal. In 2005 alone, the Fed increased liquidity by about $850 billion, printing money through various open market operations. As a consequence, the absolute level of money in the U.S. economy has been increasing at a 10 percent yearly rate, much higher than the growth in nominal GDP and nominal disposable income.
The main beneficiaries of this excess liquidity and low real short-term interest rates have been the financial markets (stocks and bonds), the market for commodities, the housing market and the consumption side of the economy. Some of this hot money has washed into financial markets abroad and helped push prices higher there also. This is why the coming financial retrenchment will be worldwide, and not reserved to the U.S. economy.
American consumers increased their mortgage debt and went on a spending spree on other goods and services, pushed by a "wealth effect" resulting from higher stock prices and the rise in the price of properties. In particular, they have refinanced their homes and taken out the increased equity to finance other spending, from restaurant and travel expenses to automobile purchases, pushing consumption growth way in excess of income growth. In 2005, the market value of owner-occupied homes, in the U.S., was evaluated at US$18 trillion. We can realize the size and growth of this real estate wealth, considering it was valued at US$8 trillion only ten years before, —and that total financial assets in the entire world is estimated to be at about US$74 trillion, with $36 trillion in equities, $18 trillion in bonds and $20 trillion in liquid assets.
Owners were helped in their rush to consume real estate wealth by new "innovative" mortgage financing by U.S. banks and credit unions, such as 'interest-only' mortgages or even with mortgages that capitalized first year interest payments. This came on top of the $10,000 worth of credit-card debt that the average American now carries. The unwinding of this mountain of mortgage debt and consumers debt will most likely spell the death of the booming housing market and of the consumer-driven growth boom. Fast increasing debt supports higher prices, but it is also true that the liquidation of debt brings about lower asset prices. It is therefore to be expected that sharply rising mortgage payments will be accompanied by rising foreclosures, and possible difficulties for mortgage lenders, and that housing prices will decline.
If housing prices start to tumble and consumer spending dips, while energy prices are still rising, the Fed may be in a quandary. On the one hand, against the background of the deterioration in the U.S. long-term fiscal situation, a huge American current account imbalance, high energy prices and with the U.S. housing boom cooling, the Bernanke Fed may hesitate between raising interest rates further to sustain the dollar and contain inflation, and declaring a pause to avoid a real estate collapse.
On the other hand, if core inflation remains above 2 percent, the Fed may have no choice but to keep tightening monetary conditions to prevent inflation from intensifying. Such tightening will most likely reverse the growth in the U.S. real estate wealth and with it, the above-trend growth in U.S. consumption spending. Mind you, the Fed has already raised its benchmark short-term interest rate target to 5 percent in 16 consecutive 25 basis-point (bp) rate increases since June 2004. Even if it were to stop its monthly rate increases for a few months, it may have to resume the increases shortly thereafter, if inflation remains elevated.
The answer to the dilemma may come from the behavior of the U.S. dollar and from capital flows. Foreign investors hold over US$6 trillion worth of U.S. financial assets and the fear of capital losses may induce them to withdraw some of these investments from the United States. A foreign capital flight from the U.S. would be bad news for the Fed, since this would prompt a sharp devaluation of the dollar, an acceleration of domestic inflation and a prolonged period of economic weakness.
A period of economic slowdown and rising inflation — in other words, stagflation could be in the cards for the coming years. — "Stagflation" is a word invented during the 1970's. The term refers to a period when rising commodity prices and previously lax monetary policy weaken the central banks' ability to control inflation through interest-rate rises, and economies start to stagnate. A nightmare for the Fed and the U.S. would be a new bout of stagflation — a combination of a stagnating economy and soaring interest rates. Just as it was bad news for the Democratic Carter administration in the late '70s, it would also be bad news for the Republican Bush Jr. administration.
Finally, let me say that if George W. Bush decides to bomb Iran, in the same reckless way he did in launching a war of aggression against Iraq, the above scenario will become a virtual certainty. Expect oil to hit US$200 a barrel and gold to rise to $2,000 an ounce, with the dollar falling and interest rates rising.
In conclusion, it is no time to go deeply into debt in this uncertain economic climate. One has to be reminded that the world economy presently stands at the end of the long 54 year Kondratieff debt-inflation cycle and at the end of the 18 year Kuznets real estate cycle. It would be prudent to take these facts into account as the trough in these cycles unfolds over the next few years.
Posted by Rodrigue Tremblay, June 8, 2006, at 11:30 am
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