For those of you that have followed my previous diaries (Greespan’s bubbles – more graphs) as well as Stirling Newberry‘s pieces, bonddad‘s “It’s the fucking economy, stupid” series, and taonow‘s “American Economic Disaster series, this should not come out as a surprise, but the Financial Times publishes yet another pessimistic article about the US economy.

Today’s installment is quite explicit: Property could fall like a house of cards

Nout Wellink, president of the Dutch central bank, last month warned that a hangover from the property boom could well exacerbate the next downturn. Both the Dutch experience and the history of housing booms suggest that this counsel deserves to be taken seriously. However, it is probably already too late for the leading Anglo-Saxon economies to escape lightly from the consequences of their property bubbles.

In the late 1990s, the Netherlands had one of the most successful economies in Europe. At the time, both Dutch house prices and household credit growth were rising at double-digit rates. As homeowners cashed in on their burgeoning home equity, the Dutch savings ratio collapsed (from more than 13 per cent of income in 1997 to less than 7 per cent three years later).

The Dutch housing market cooled after interest rates began climbing in 1999. The following year, house-price inflation came to a halt. Household credit growth slowed simultaneously – mortgage equity withdrawal fell from €10bn ($13bn) in 1999 to €5bn in 2002. This had an adverse effect on consumption. As consumer confidence dipped and unemployment climbed, the Dutch began to save more. Three years after the end of the housing boom, the economy contracted.


Contrary to popular perception it is not necessary for house prices to fall to create a serious problem for the economy at large. When house prices merely cease rising, the rate of credit growth normally slows, inducing householders to save more and spend less. At best, this produces a mild drag on the economy, as has been the case in the Netherlands. At worst, the economy undergoes a severe slowdown with soaring unemployment and a painful recession – as occurred in Japan, the UK and Scandinavia in the early 1990s.

Note this – you need perpetually increasing housing prices to support consumption when such consumption is not based on growing wages (stagnant in the US for the past 2 years) but on increasing asset prizes being monetised through equity withdrawals and mortgage refinancings on increasingly aggressive terms.

Even if prices stop increasing, you get economic pain: consumption slowdown, stagnant economic growth, with all the usual consequences: higher unemployment, bankruptcies, higher budgetary deficits as tax revenues decrease.

But it is not just borrowers who are hurt by a housing market collapse. Rising levels of bad debt inflict damage on lenders’ balance sheets. This often leads to a credit crunch and sometimes to a full-blown banking crisis. The failure of the Bank of United States in 1930, for instance, during the Great Depression, was due largely to losses on property lending. Furthermore, as over-indebted households cling tenaciously to their homes and lenders delay the politically unpopular and costly process of foreclosure, the banking system may have to deal with the aftermath of a housing crash for many years.

Remember also that houses represent the biggest share of US assets. For most people, their home is their single biggest asset; and their mortgage their single largest financial commitment. Should a serious economic crisis hit, banks will be seriously hit along with many of their clients, especially when they have provided highly leveraged financings (like the 30-year, no principal repayment, interest-only-in-the-first-few-years loans provided in some markets). And banking crises cost a lot of money in bailouts, and always have the risk of a systemic crisis (when there are bank runs or at least a massive loss of trust in the financial system). Furthermore, many of the recently invented financial instruments (like CDOs) have NEVER been tested through an economic downturn.

Government finances commonly deteriorate after housing booms end, as fiscal policy is employed aggressively to prevent the economy from slumping further. Since the end of the property bubble in the early 1990s, Japanese government debt as a percentage of gross domestic product has more than doubled and currently exceeds 160 per cent of national income.

That’s actually the worst part: housing market slowdowns have massive negative consequences for government budgets, which suffer mightily form the downturn. If you think that the budget deficit is bad, think what it will be like after that… The Bush administration has used up all reserves and spent recklessly despite benefitting from a supposedly strong economy.

It’s REALLY a house of cards. The recent apparent economic growth has been obtained by throwing massive amounts of money at an economy increasingly unable to absorb it (to invest) – that money has thus been spent, either in the total waste that the Iraqi war is, or on a growing volume of imports from China and other places. It’s not growth, it’s bingeing on plastic – and it leaves no room for manoeuver when the bad times actually come, as they will.

The end of housing bubbles in other countries has been associated with periods of prolonged economic weakness, increasing financial fragility, rising government deficits and the appearance of monetary instability.

We already have this before the end of the bubble, what will it be after?

Again, the blame goes to both Bush for his reckless budgetary policies and to Greenspan for his amazingly lax monetary policy. Call him “Bubbles” Greenspan each time you write and talk about him, because that’s the only way to put it. Stephen Roach, the markedly bearish chief efconomist of Morgan Stanley, which I quote often, has another piece this week where he wonders if there could actually be some kind of conspiracy in Greenspan’s act, in view of their obvious recklessness:

Morgan Stanley’s Global Economic Forum (25 April 2005)

I am not a believer in conspiracy theories.   But the Fed’s behavior since the late 1990s is starting to change my mind. 

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years.   From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the US central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories.  The problem is that this recasting of macro is very self-serving.  It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles.  The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

Go read the whole piece, it provides more in-depth explanations of how the Fed has dug itself deeper at every turn, by inflating a new, bigger bubble whenever the previous one threatened to burst. The housing one is likely to be the last (unless, as Sterling Newberry suggests, the Bushistas manage to raid the Social Security Trust fund for one last binge), and it will have consequences in the real world that are known, as they have been experienced many times in many countries.

I’ll let Edward Chancellor, the author of the Financial Times piece, conclude:

The head of the Dutch central bank now regrets what he calls the “artificial stimulus” provided to the economy by the housing boom. With the housing markets in the UK and the US vulnerable to rising interest rates, officials at the Federal Reserve and the Bank of England may shortly be forced to learn the same painful lesson.
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