This information provided by The Federal Observer, http://www.federalobserver.com
By Bill Bonner
What is happening is that trends that worked so beautifully on the upside are now slipping into reverse.
People still watch Fed policy setters as if it were a live sex show. They don't want to miss anything. But the thrill is gone. The magic no longer works.
The most important of these is the housing market. When house prices were rising, homeowners enjoyed what economists call a "positive wealth effect." Interest rates fell. Housing boomed as more and more people went to work in the industry; 20% to 40% of all new employment in the last five years was in the housing sector. As everyone's house rose in price, people felt richer and spent more money.
But now house prices have stalled...and are beginning to slip back.
From Dallas comes news that house sellers are offering incentives such as free maid service, swimming pools and appliances - whatever it takes to move stuck merchandise. The trouble is, after ten years of boom conditions, there's a lot of merchandise to move. And much of it is not really suited to buyers' interest.
For ten years, people have bought expensive condos, for instance, not because they really want a condo...but because they think it is a way to magnify the wealth effect. The more condos they own, the more effect they get.
Or, they might have decided to get more bang by putting up more bucks. A buyer signs up for a plusher, pricier house than he really needs, realizing that the wealth effect is proportional to the investment. Property, he sees, has been rising at 20% per year in many areas. Twenty percent of $1,000,000, he tells himself cannily, is more than 20% of $500,000. So he buys the million-dollar home, even though he really doesn't need it.
But now that that 20% per year froth has disappeared, homeowners no longer have an interest in more house than they need.
"Homeowners say 'downsize me,' reports Reuters. It costs money to maintain a house. Property taxes, heat, mortgage payments and maintenance are all proportional to the size of the house. With nothing to gain, people naturally want to cut out the unnecessary expense.
The positive wealth effect has gone negative. The more house you own, the more it costs you to hold onto the house...and the more you lose when house prices go down.
Meanwhile, the homeowner is also getting squeezed by higher interest rates and higher fuel bills. "Gas prices inch up to another record high," says an AP report. The national average rose to $3.03 last week.
Now our hapless consumer is in a bind. His real income is flat or falling, while his expenses are starting to rise. He has to cut back. Naturally, the first thing to go will be the house he doesn't need, which makes the negative wealth effect even more effective - and even more negative. Not just for the seller, but for everyone else. Every house sold at a discount drops the value of all equivalent housing stock - even for people who don't intend to sell. All of a sudden, none of them are as rich as they used to be. They, too, cut back their spending.
We know what the Fed will do once this trend builds up momentum: cut rates. But by then, the magic will have gone. And no matter how many passes in the air the magician makes, it will not come back. For, if the Fed really could manipulate the economy any way it chose, we need never have worried. It could have jerked the economy around like a puppet on a string. Want faster growth? Just cut rates. Want less inflation? Just raise them.
But there comes a time when financial officials can fondle rates as much as they want; they will never get the response they're looking for.
As Nouriel Roubini explains in last week's Financial Times:
"Once the housing and consumption slump starts, demand for durable goods becomes interest-rate insensitive. Indeed, the recent housing bubble has led to a glut of housing stock, consumer durables and lingering excess capital capacity in the rest of the economy. Thus, as we saw in 2000-01, the housing and consumption slump will dominate any monetary easing effort by the Fed."
The Fed can chirrup as much as it likes; lower rates simply won't reverse the negative wealth effect of a falling real estate market. Mortgage rates may go up or they may go down (the Fed only controls short rates), but people won't borrow at all if they sense they will have a hard time making the payments. This is because the old star-spangled circus magic has turned into black magic...a kind of voodoo economics curse, where the tricks all go wrong: The magician pulls a rabbit out of his hat and it bites him on the nose. He saws his pretty assistant in half and finds her actually cut into two bloody pieces. And the ace up his sleeve turns out to be an Old Maid.
It is what happened to Japan in the 1990s. Could it happen in the United States?
We don't doubt it.
[Ed. Note: As homeowners continue to get squeezed, you can bet the number of foreclosures nationwide are going to soar - as of now, the foreclosure rate is up 63% from last year. Now that it's time to pay the piper, sub-prime borrowers are finding that they can't - and these defaults will rock the lenders.
August 14, 2006
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