US economy recession

Dr Kurt Richebacher - Fri 29 Sep, 2006

...A recession and a bear market in asset prices are inevitable for the US economy...

 
 
- A recession and a bear market in asset prices are inevitable for the US economy. Recent economic data leave no doubt that both are on their way. What keeps triggering rebounds in US stocks is only the "bad news is good news" syndrome, reflecting the hope that economic weakness will stop the Fed's rate hikes.

- Nonfarm payrolls grew in the second quarter by 108,000 per month, well off the first quarter's 176,000. It was the slowest quarter in almost three years. Meanwhile, the overall economy is already feeling the effects of a slowing housing market.

US economy recession: Residential construction

- Residential construction [mostly homebuilding] contributed only 0.38 percentage points to real GDP growth during the last two quarters (Q4 2005–Q1 2006). This compares with 1.18 percentage points in the first half of 2005. Consider that construction spending has the highest multiplier effects within the US economy, generating jobs and additional spending. Retail trade and residential building together account for 75% of GDP.

- It is no secret what has mainly pulled the US economy out of its 2001 recession. The Greenspan Fed succeeded in offsetting the depressive impact of plunging stock prices and business investment on the economy by inflating house prices, which lubricated an unprecedented consumer borrowing-and-spending binge.

- For the first time in history, a central bank systematically engineered an asset and credit bubble for the explicit purpose of precipitating economic growth.

- "Asset-driven" economic growth became the conventional label for this new pattern of growth. Policymakers and quite a few others have apparently come to appreciate it as a valid alternative to the traditional income-driven economic growth. It is not. It is the road into the next asset bust.

US economy recession: Asset-driven growth

- Appearances of the last few years are deceptive. Asset-driven economic growth is a badly flawed and dangerous alternative for two reasons: First, asset prices cannot rise in perpetuity; and second, it involves exorbitant credit and debt growth, lured by the rising asset prices and excessively optimistic expectations.

- Bubble-driven growth invariably ends when asset prices stop rising. In the US case of the late 1920s and Japan's case of the late 1980s, asset prices collapsed, with huge damage to the balance sheets of banks, firms and private households.

- Of course, the fabulous asset-driven "wealth creation" kindles the readiness to stampede into debt. In the United States, debts of private households since 2000 have soared from $6,966.7 billion to $11,840.1 billion (Q1 2006). This represents an increase by $4,873.4 billion, or 70%.

- But this record debt growth is discarded as irrelevant because the net worth of private households — asset values minus outstanding debt — over the same time has surged from $42,113.5 billion to $53,830.3 billion. In other words, asset values have risen much faster than debts.

- Is this a reasonable calculation? Our categorical answer is no. Few people seem to realize that America's vast real estate "wealth" arises from imputed values. In other words, the relatively small number of houses that change hands every year establishes the value for all of the rest of the nation's houses.

- In the United States, only about 5% of all existing houses are traded every year. The other 95% simply sit there, while their theoretical values steadily rise. Americans call this wealth creation. I do not. This wealth can disappear just as easily as it first appeared. In fact, it is disappearing already.

- I have always rigorously disputed the idea that rising implied home values equal wealth creation. Even the owners of the houses gain, in reality, very little from the rise in prices. Everyone may feel richer. But they are no richer in housing comfort or anything else. If anyone would later exchange his residence for a place of the same quality, he would have to pay the same high price for which he sold.

- In reality, the homeowner gains one thing only, and that is higher collateral for higher borrowing. Reckless utilization of correspondingly higher borrowing facilities is the central feature of every bubble economy, leading to exponential debt growth. So it happened in the late 1920s in the United States, and in the late 1980s in Japan, and so it has happened again in the United States during the last few years.

US economy recession: The unbalanced bubble economy

- Assessing the US economy's prospects, the most important thing first to take into account is that what has happened over the last few years is not the garden-variety business cycle. It is a grossly overly indebted and unbalanced bubble economy, in which borrowing and indebtedness, particularly for private households, have gone to unprecedented extremes in chasing house price inflation.   

- Also, we have to recognize that once asset prices stop rising, the game is up. The potential of the post-bubble crash in asset prices largely depends on the size of the prior excesses. The other day, professor Robert J. Shiller of Yale University declared that the present housing boom in the United States "is the biggest on record."

- A bubble economy needs rising asset prices to keep it going. Once the prices of those assets, which have lubricated the decisive assets — stocks and housing in the US case — stall, let alone fall, the whole process stops and reverses with a vengeance, because the formerly ample liquidity and wealth creation go into reverse.

- With this in mind, let us take a closer look at the finances of private households, being the dominant deficit spender in the US economy, vastly exceeding that of the government. In 2005, the public sector borrowed $479.5 billion, against $1,208.7 billion borrowed by private households.

- With real disposable incomes of private households now in stagnation, any increase in consumer spending essentially depends on borrowing — mainly against rising house prices.

- But if home prices stop rising – or worse, begin falling – the consumer will stop borrowing and spending. The US economy, therefore, would begin contracting...And that would be a very rude awakening indeed.


Regards,

Dr Kurt Richebacher
for The Daily Reckoning
    

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