by Jerome a Paris
Mon Nov 26th, 2007 at 10:52:58 AM EST
For close to 3 years now, I've been writing about the huge asset bubble generated by Greenspan's lax monetary policies, and about how unsustainable it was. I wrote how the real estate bubble had allowed average Americans to continue to consume despite the stagnation of their income, and how the end of these exagerated valuations would create a vicious circle of falling prices, less credit, less spending and lead to a massive recession.
Many people scoffed at me, and mocked my doomsterism. Well, I'm now officially in good company, as "serious person" Lawrence Summers, formerly the Secretary of Treasury in the later years of Clinton's presidency, joins me in a gloomy assessment of the situation today.
Wake up to the dangers of a deepening crisis
Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.
As the WSJ writes:
The Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, up from 705,000 in 2005.
The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes.
No refinancings for existing borrowers, in particular those facing interest rate rests. No out via a sale as prices go down. No house equity withdrawals... Foreclosures, lower spending, and a sector (real estate, construction and associated financial nd other services) which accounted for a disproportionate share of growth in recent years which is dead.
But that's not the worst of it. Cueing Summers again:
Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that - if all assets were marked to market valuations - total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions. These figures take no account of the likelihood that losses will spread to the credit card, auto and commercial property sectors. Nor do they recognise the large volume of financial instruments that depend for their high ratings on guarantees provided by credit insurers whose own health is now very much in doubt.
The borrowers are in for a world of pain, but so are the lenders.
This is the reason why the financial crisis has not been that visible so far: it's a debt-side crisis, not an equity side crisis. The Dow Jones is still doing fine (well, outside of banking and retail stocks), but credit markets are in full panic mode (again, not my words). Banks have taken a look at their balance sheets, really did not like what they saw and all thought at the same time "if we look this bad, when we've been relatively prudent, what does the balance sheet of our colleagues, who did all sorts of crazy things, look like?" - and stopped lending to one another, because they all did the same crazy things, encouraged by cheap credits, easily obtained credit-ratings, and goaded by one another - and supported, of course, by the fact that it looked fine for a long while, as prices increased on the back of that credit bubble.
Well, even before the shit has hit the fan, banks are realizing they are overextended, and the simple fact of tightening conditions creates a crisis - one linked to slowing credit activity, not yet to the souring of past things. If you want, we're in the situation of a car passenger when the driver brakes brutally because of a crash in front of the car: with no belt, you're hitting the windshield as the car slows brutally even before it actually hits the wreck in front...
The actual is still to come. So says Summers, again:
Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.
Everything that allowed the bubble to go up is now conspiring to bring things down. Trust is gone. Liquidity is gone. Optimism is gone. Exuberance is gone. Now's the time for prudence, depreciation of assets, cash hoarding, and enforcing contracts to the letter.
The banks are stepping on the brakes as hard as they can. Even if that means weakening one another.
Then there are the potentially adverse effects on confidence of a sharply falling dollar, rising energy costs, geopolitical uncertainties especially in the Middle East, or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort.
Oh yes, it's raining and the road is slippery.
While it's pleasant to be finally proven right by "serious people " like Summers, I'd like to note that his discourse still lacks the analysis that this whole cycle was created on purpose to enrich a happy few on the back of the US middle classes, and that it has worked brilliantly, as the income of the average American stagnated and that of the very wealthy (in the top 0.1% mostly) shot up.
While I won't venture into the hidden goals of the Bush administration in Iraq, it is clear that the macro-economic strategy of massive outsourcing to China paid on (cheap) credit was structurally bound to weaken the dollar and, at some point, increase commodity prices. Geopolitical tensions caused by the same administration only reinforced that, consciously or not.
But Summers' advice (lower Fed rates, a Keynesian boost via increased government spending of tax cuts, and public support to lending and housing markets) completely ignores that diagnosis. Cheap money is not the issue - it's the problem (there's been too much of it for too long) and it's the symptom of the underlying bias in value sharing between workers and investors. Cheap credit has hidden for years the fact the the economy was not sound, as workers saw lower wages and the rich captured an increasing share of incomes. It's that split that needs correction. It's the fact that wages cannot keep up with costs. It's the fact that too much of GDP was generated by virtual activities (selling houses to one another using Chinese money, as Krugman described it more than 2 years ago) that created a lot of paper value but had no substance - and whatever value existed was captured - and spent - by the Wall Street bankers right away.
This is a crisis of the conservative economic policies pushed to their extreme. After denying for years that this was unsustainable, I expect that they will claim that their policies did not go far enough, and that they must be pursued further to "save the economy" - more refom, more labor "flexibility", more effort in the face of globalization. This is all bunk.
Wealth capture is not weath creation. Wage increases is not inflation. Asset price increases is not growth.It's time to change economic discourse now that 30 years of increasingly unrestrained economic laissez-faire are bringing us the greatest crisis since 1929.
The diagnosis is no longer only made by doom porn lovers that supposedly want America to fail. Hopefully, the diagnosis we make will be heard a bit quicker, and will lead to real changes in economic policies.