According to minutes from the October FOMC meeting US central bank policy makers have expressed concern that a severe housing downturn poses a serious risk to the economy. In short, Fed officials have turned more pessimistic on the economy in the months ahead. This way of thinking is starting to receive support from a growing number of financial commentators.
In line with the Fed’s view most commentators see the housing slump as the likely trigger for a severe economic downturn. It is argued that with the fall in house prices consumers can no longer borrow against capital gains to support their spending. Year-on-year the S&P-Case-Shiller house price index fell by 5 per cent in August after declining by 4.4 per cent in the previous month. This was the 8th consecutive monthly decline. (The index has probably fallen in September).
The yearly rate of growth of home equity has weakened to 0.9 per cent in Q2 from 2 per cent in the previous quarter. We suspect that in Q3 home equity has actually fallen from the same quarter a year ago. Also, according to the Fed, borrowing on the back of home equity has fallen to $494 billion in Q2 from $640 billion in Q1. Since consumer spending is around 66 per cent of GDP it is argued that a weakening in consumer outlays is going to hurt the GDP rate of growth.
In addition to this consumers capacity to borrow doesn’t appear to be that good. In Q2 household debt as a percentage of disposable income stood at a record 131.6 per cent against 130.8 per cent in Q1. Also consumer credit as a percentage of disposable income remains at a lofty level. This figure stood at 24.1 per cent in September against a similar figure in the month before.
We suggest that the likely economic downturn in the months ahead is not going to be on account of sub-prime mortgages meltdown and the likely weakening in consumer outlays but on account of the boom-bust policies of the Fed. All the above mentioned factors are just the outcome of Fed’s policies. As a result of the tighter stance from June 2004 to September 2007 the bubble activities in the housing sector have been hit first. (The bubble activities that emerged on the back of loose monetary policy between December 2000 to June 2004).
The effect from a monetary policy change on various parts of the economy operates with a time lag that varies with respect to various sections of the economy. This means that sooner or later bubble activities in the various other parts of the economy are likely to exhibit difficulties. We suggest that the main threat to economic activity is that the money supply rate of growth could fall sharply or even turn negative. A factor that could contribute to this is a fall in banks’ expansion of credit.
(Note that the pool of real savings ultimately dictates the magnitude of the possible decline in bank credit expansion. See on this the article on deflation at the end of this report).
According to Bernanke losses from bad mortgage loans could be at around $150 billion. Given the fact that between 2004 and 2006 $1.3 trillion worth of sub-prime loans were originated some experts hold that losses could be at around $400 billion.
Now write-downs of this magnitude are likely to severely weaken bank capital, which will force banks to curtail the expansion of credit. And this in turn is likely to undermine the money supply rate of growth and put further pressure on various bubble activities. (Please note that this likely fall in banks credit expansion is also the result of Fed’s boom-bust policies).
A recent survey by the Federal Reserve of banks lending standards points to a visible toughening in lending criteria. The Federal Reserve survey indicates that in Q4 19.2 per cent of banks have reported that they had tightened their lending standards on business loans — in Q3 this figure stood at 7.5 per cent. In residential mortgages the percentage stood at 52 per cent against 37 per cent in Q3 and 16.4 per cent in Q1. The survey also shows that in Q4 26 per cent have tightened their standards on consumer loans against 12 per cent in the previous quarter.
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A tightening in the standard doesn’t immediately imply that lending must follow suit. Indeed latest data for the week ending November 14 shows that commercial bank lending is still holding its ground. The yearly rate of growth of lending stood at 10.5 per cent against 10.2 per cent in October. On the week though loans fell by $24.3 billion mostly on account of real estate loans, which fell on the week by $25.4 billion. Likewise business loans are still strong. The yearly rate of growth of these loans stood at a near record high of 18.3 per cent. On the week these loans increased by $5.8 billion. Consumer loans have risen by $7.8 billion on the week.
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How severe is the economic downturn going to be? Two factors are likely to dictate the severity of the downturn (1) the extent of the misallocation of resources during the previous boom, and (2) the state of the pool of real savings. We suspect that on account of the Greenspan Fed’s massive lowering of interest rates a large percentage of bubble activities out of overall activities was created. (The fed funds rate target was lowered from 6.5 per cent in December 2000 to 1 per cent by June 2003 and kept at this level until June 2004).
Remember that bubble activities cannot stand on their own feet. These activities are supported by loose monetary policies that divert real savings from wealth generating activities. This in turn means that if the cleansing process were to go all the way then a large percentage of activities are likely to come under pressure, which means a severe economic downturn could emerge. (Note that bubble activities are likely to be in every sector of the economy.
Some sectors might contain a large percentage of these activities and other sectors a lower percentage). Obviously, the Fed will try to step in to provide support to various bubble activities. We do know that the Fed doesn’t have real savings at its disposal, it can only divert real savings from wealth generating activities. So without a growing pool of real savings the Fed’s policies will not succeed in kick starting the economy.
An important factor that provides support to the American pool of real savings is the rest of the world, in particular China. So if the US overall pool of savings, which contains domestic and overseas contribution, is still expanding then the Fed’s loose policies might “revive” the economy (the Fed might be able to do the “trick” and prevent a severe economic downturn).
A possible threat to the pool of savings at the disposal of Americans is a bust of China’s economy. To restrain the sharp rises in various price indexes the Chinese central bank has visibly tightened its stance this year. For instance, several weeks ago the central bank raised commercial banks’ reserve ratios by 0.5 per cent to a record high of 13.5 per cent. This was the 9th increase in required reserves this year.
We suggest that sooner or later the persistent tightening will burst the bubble and plunge China’s economy into an economic downturn. The burst of China’s bubble activities can happen at any time. This in turn could disrupt the flow of real savings to the US. Now if we were to assume that China’s bubble activities may hold for another year then a serious economic downturn in the US and the rest of the world is likely to take place during 2009.
If the pool of real savings at the disposal of Americans is not growing (despite the rest of the world’s contribution) then this is likely to manifest itself by sudden collapses in various activities in the economy. Consequently banks’ lending will follow suit.
Dr Shostak is a former professor of economics who now works in the private sector
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