Year-on-year real investment in the housing market fell by 16.4 per cent in Q1 after a fall of 12.8 per cent in the previous quarter. This was the 4th consecutive quarterly decline. In relation to the previous year the median price of existing homes fell by 2.1 per cent in May after declining by 1.3 per cent in April. This was the 10th consecutive monthly decline.

Additionally most commentators including Bernanke are of the view that recent problems in the sub-prime mortgage market could put more downward pressure on general economic activity. Sub-prime delinquencies as per cent of total sub-prime loans stood at 13.8 per cent in Q1 against 13.3 per cent in the prior quarter. Note that there is very good visual inverse correlation between the sub-prime loan delinquency rate and the growth momentum of real GDP.

Problems in the sub-prime mortgage market are starting to manifest themselves through falls in the value of asset backed securities. The ABX index for AAA asset backed securities has fallen by 4.2 per cent on July 17 from July 6. The BBB asset backed securities index fell to 44.86 on July 19 from 67.92 on June 4 — a fall of 34 per cent.

Despite all these compelling statistics we suggest that the slump in the housing sector and its various side effects like sub-prime lending problems are not the cause of possible economic difficulties in the months ahead. Here is why.

Real economic growth compared to the rate of growth of real GDP

For most economists and Fed policy makers economic growth is assessed by means of real gross domestic product (GDP). GDP is viewed as a summation of various types of monetary outlays such as consumer outlays, government outlays and expenditure on fixed investment, which includes outlays on residential housing. To obtain final GDP the difference between the value of exports and imports is added to the various items of expenditure. To obtain so-called real GDP various items of monetary expenditure are adjusted for price changes. Obviously within the framework of GDP a weakening in fixed investment such as housing must produce a negative effect, which can also be measured.

Elsewhere this writer has shown that the whole idea of measuring real output and real economic growth is conceptually not possible. It is not possible to obtain a meaningful total by adding potatoes to tomatoes. All that so-called real GDP depicts is distorted monetary turnover, which has nothing to do with total real output. Hence, changes in real GDP are erroneously viewed as the real rate of growth of the economy. Since we are dealing here with outlays of money, obviously in order to establish where so-called GDP is heading one should pay attention to changes in money supply.

Again, note that the key-driving factor behind this so-called real economic growth is money supply. If for whatever reason outlays on housing are falling while money supply continues to expand then some other items of GDP will take over and the overall gross domestic product over time will display a rate of growth in accordance with the rate of expansion in money supply. The effect of changes in money supply on various markets operates with a variable time lag. As a result of this the effect from past changes in money supply can continue to assert its dominance notwithstanding more recent changes in the money supply.

We suggest that what we are currently observing in the housing market with all its side effects such as sub-prime mortgage delinquencies is the outcome of the Fed’s boom-bust policies. This means that sooner or later various other parts of the economy are likely to exhibit difficulties. Between December 2000 and June 2004 the Fed was pursuing an aggressive lowering of interest rates — the fed funds rate fell from 6.5 per cent to 1 per cent. As a result of this loose stance a visible increase in the growth momentum of our monetary measure AMS had taken place. Between Q3 2001 to Q4 2004 the average yearly rate of growth of AMS stood at 7.5 per cent.

This should be contrasted with the rate of growth of 2 per cent in Q2 2001 and 0.9 per cent in Q4 2000. On the back of the loose interest stance and the subsequent increase in the growth momentum of money supply various bubble activities emerged. The strengthening in real GDP manifested the emergence of these activities. The yearly rate of growth of real GDP jumped from 0.2 per cent in Q4 2001 to 4.5 per cent by Q2 2004.

Since June 2004 to present the Fed has reversed its stance. The fed funds rate target was raised from 1 per cent to 5.25 per cent currently. In response to the tighter stance the growth momentum of our monetary measure AMS has been in a visible downtrend since Q4 2004. The yearly rate of growth fell from 7.1 per cent in Q4 2004 to 1.4 per cent in Q2 2007. A tighter stance has put pressure on various bubble activities, which cannot stand on their own feet without monetary pumping.

As a result the yearly rate of growth of real GDP fell from 3.7 per cent in Q1 2006 to 1.9 per cent in Q1 2007. As the effect from a tighter stance continues to gain strength bubble activities in various sectors of the economy are expected to come under pressure. Again the likely deflation of various bubbles is on account of the Fed policies and has nothing to do with the housing sector slump.

Note: The Austrian definition of the US money supply is currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.

Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.

NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.

NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts. AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.

Dr Shostak is a former professor of economics who now works in the private sector