Over the last few weeks, several economic commentators have written about an upcoming recession – its causes and its overall effect. These writers highlight the systemic problems of the US economy, namely, that we are not creating anything. Instead, the US economy is based on asset prices that will eventually come down in price, causing a drop in consumer confidence leading to a recession.
Marshall Loeb at CBS.Marketmatch writes from the perspective of 2007, analyzing what happens in 2006:
The prime cause of the recession that began in 2006 was that, as often happens, the President tried to do too much at once.
Historians know that, for example, Lyndon Johnson brought the economy to perdition in the 1960s and 1970s by not leveling with the American people about the true total cost of the Vietnam war (about $121 billion). Reason: LBJ wanted to pursue both his war and his costly Great Society domestic programs at the same time.
So, too, George Bush tried to pursue his war in Iraq (total cost: more than $200 billion by the end of 2005) and simultaneously to spend $150 billion or more to rebuild the Gulf Coast after the catastrophes of Hurricanes Katrina and Rita.
The consequence was that the federal debt surged from $7.3 trillion in fiscal 2004 to $8.2 trillion in 2006. You don’t have to be a card-carrying economist to know that such excessive demand strained the supply of goods and services. That strain, combined with increases in the price of energy, inevitably lifted prices throughout the economy. Inflation reared its ugly head.
To combat it, the Federal Reserve Board raised its discount interest rate in 2006 from 5 percent to 5.5%. As a result, mortgage rates surged, turning the housing boom into the housing bubble, and bringing back memories of the high-tech stock crash of 2000 and 2001.
When housing started down, it took away what UCLA economist Christopher Thornberg had called “this fabulous sense of wealth that homeowners are feeling.” No longer feeling house rich, consumers cut back their spending. This hit the economy particularly hard since consumer spending had been one of the main forces driving it.
James Cramer of theStreet.com has a slightly different take:
It’s dawning on wall street that George W. Bush may be the first president since Lyndon B. Johnson who believes that we can have a guns-and-butter federal spending policy without creating a serious inflation spiral, if not outright government bankruptcy. At least LBJ, to his credit, believed that there were limits to profligacy and that taxes had to be raised. Not President Bush. He’s making Johnson look like a fiscal conservative, what with his insistence on waging a war in Iraq that’s costing $177 million a day and rebuilding New Orleans by taking on a monstrous load of federal debt.
For the longest time, because Bush is a Republican, we on Wall Street simply didn’t believe that he could be a reckless spender. We knew only two paradigms: You either spent less and cut taxes or you spent more and raised taxes. Both courses at least presumed some sacrifice at some time. Not Bush’s plan. He’s gone on both the biggest spending binge and the lowest taxation course in U.S. history, which, alas, will produce gigantic liabilities down the road. Of course, he’ll be back on the ranch by the time his successor will have to deal with his inflation and currency debasement. Our only hope that financial disaster won’t strike sooner lies with the Chinese, who actually fund our deficit by buying our Treasuries–$242 billion worth, or 12 percent of all foreign holdings. If the Chinese decide to be good communists and stop buying our bonds, the Feds will have to raise rates to attract new investors and the reaper will be at our doorstep with interest rates more akin to those of South than North America. Right now, it’s not a problem. But in a year or two or maybe less, I perceive that the government will throw a bond auction and nobody will show, including the Chinese, until rates shoot up dramatically.
Central to Loeb’s and Cramer’s theory is some event (here excessive demand from a massive increase in federal spending) causing the Federal Reserve to boost interest rates. Both note the size of combined spending associated with Iraq and Katrina rebuilding as cause. Loeb’s theory states the Massive increase in government spending simply increases macro-level demand to the point where it pulls prices up – the classic example of demand pull inflation. Cramer ties the US’ complete dependence on foreign capital, arguing Bush’s profligate spending finally causes creditors to demand increased compensation for their purchases of US debt. Either way, interest rate levels reached a tipping point where they negatively affected the housing market. This will eventually hurt the US consumer, who has financed the latest economic expansion by taking on record levels of consumer debt.
Central to both theories is an understanding that housing – and the extraction of excess value from home price appreciation – has fueled the latest expansion. A recent paper by Alan Greenspan explains the process:
Greenspan disclosed the results of a study he had done with Fed staff economist James Kennedy. The study estimated the amount of cash that homeowners have extracted from rising housing prices (those prices are up 53 percent over five years, according to government figures).
Homeowners could convert higher real-estate values into cash in three ways, reasoned Greenspan and Kennedy: (1) sell their homes and grab the surplus, deducting any amounts paid for other homes; (2) refinance their existing mortgage for a higher amount and pocket the extra money (a “cash out” refinancing), and (3) take out a home-equity loan against the higher house value.
By estimating all three sources, Greenspan and Kennedy reached annual grand totals, shown on the table below. It provides the figures both in billions of dollars and as a percentage of people’s ordinary disposable (after-tax) personal income. The housing money is extra, on top of personal income.
YEAR | MONEY | SHARE OF DISPOSABLE PERSONAL INCOME
2000 | $204 bil. | 2.8%
2001 | 262 bil. | 3.5%
2002 | 398 bil. | 5.1%
2003 | 439 bil. | 5.4%
2004 | 599 bil. | 6.9%Whoa! Consumers had a lot more to spend than ordinary income, almost $600 billion more in 2004. How much of that was actually spent (as opposed to being put into bank deposits, stocks or mutual funds) is unclear. Consumer surveys cited by Greenspan suggest perhaps two thirds, a big chunk of it on remodeling. The economy has depended heavily on all this extra cash.
Let me offer a third scenario that is perhaps just as likely: energy prices forcing the Fed to increase interest rates. Energy prices are like water; they seep into every single nook and cranny of the US economy. If you want to produce a good, you have to buy raw materials whose extraction consumes energy. To build a good you need energy to operate the plant. Then you have to ship the good with a mode of transportation that uses energy. The wholesaler who stocks the good for distribution to retailers uses energy to light his warehouse and operate his computers. The wholesaler has to ship the good to retailers – again using energy to get the goods to market. Finally, the retailer has to use energy to light his store, cool his store in the summer and heat it in the winter etc….
Over the last few years, energy prices have increased sharply. Oil has increased 50% since January starting 2005 at roughly $40/bbl, and now standing near $60/bbl. Unleaded gas has increased about 75% since January, starting near $1.00 and currently standing near $1.75. Heating oil has increased about 60% since the beginning of the year, starting at about $1.25 in January and standing near $2 in October. Natural gas has increased about over 100%, starting January at $6 and standing near $13 in October.
All three scenarios are a possibility. Or perhaps more exist that haven’t been discussed yet. Regardless:
1.) Our dependence on foreign capital to finance our standard of living,
2.) Our complete dependence on oil for energy, and
3.) The consumer’s near complete dependence on asset prices to fuel his purchasing,
are all three serious problems that may lead to more serious macro-level issues that will cause a great deal of pain.