No: Beware of shock waves

[Joseph T. Burkeson, CMI]

No: Beware of shock waves

By Mark Weisbrot
Posted on Mon, Jan. 01, 2007

from burst of housing bubble

The big question for the U.S. economy now is whether we will make it through 2007 without a recession. Most of the top economic forecasters are predicting a "soft landing," which means the economy will slow but not so sharply as to cause a recession.

But almost all of these same experts failed to forecast the last recession, and they missed the stock market bubble -- the largest financial asset bubble in history. And most of them also missed the housing bubble until it began to burst. So it would not be prudent to rely solely on their forecasts at this time.

The timing of any downturn is not easy to predict. But a recession is likely, because of the enormity of the housing bubble and the impact of its collapse. Recall that our last recession in 2001 was caused by the bursting of a stock market bubble of about $7 trillion. The housing bubble is comparable in size -- about $5 trillion at peak. And the bubble wealth is much more widely distributed: most Americans still have most of their assets in housing and little or nothing in stocks.

As this housing wealth disappears, people cut spending. We have already seen an enormous drop in the amount that people borrow on their homes, from $600 billion in 2005 to about $350 billion for 2006.

It was this borrowing, enabled by soaring house prices that allowed people to borrow more against the value of their homes that fueled the U.S. economic recovery since 2001.

Housing construction and sales are also a big sector of the economy, currently about 6 percent of GDP. If that falls 30 percent to 40 percent, as it has in previous downturns, that's a drop of about 2 percent of GDP.

The recession caused by the stock market bubble bursting, which lasted only from March to November 2001, would have been a lot worse if not for the enormous demand created by the housing bubble. So what will rescue the U.S. economy from the collapse of the housing bubble?

It's not easy to imagine what that would be. Personal savings rates are already negative, a phenomenon not seen since the Great Depression. How much can consumers borrow on their credit cards?

A sustained surge of business investment is unlikely in the face of an economy that is already slowing: GDP growth was just 2 percent in the third quarter, down from 2.6 and 5.6 percent in the previous two quarters.

And there are downside risks from the global economy: foreign central banks are keeping our long-term interest rates extremely low -- below short-term rates -- by accumulating 10-year U.S. Treasury bonds.

They could lose just some of their appetite for this debt at any time and send U.S. long-term rates upward.

A decline in the dollar, which is inevitable given that we are borrowing more than 6 percent of GDP from other countries, poses similar risks -- although it will eventually help the U.S. economy by narrowing our trade deficit.

We could possibly get through the international imbalances for another year but the housing bubble collapse is already upon us, with November's housing starts down 25 percent over the past year, home sales plummeting, and home prices falling.

This is something that our political leaders and policy-makers should have warned people about, rather than encouraging the same kind of speculative excess that dominated our economy during the late 1990s stock market bubble.

Mark Weisbrot is co-director of the Center for Economic and Policy Research (www.cepr.net) and president of Just Foreign Policy (www.justforeignpolicy.org). Readers can write to him at CEPR, 1621 Connecticut Ave. NW, Suite 500, Washington, D.C. 20009-1052.