Sunday, August 17, 2008
In our debt-based economy, new credit is the source of new money. Without ever more money (meaning credit) to fuel ever more spending, our economy will contract. Which is why I keep a close eye on credit. The stories below tell a very different tale from the recent stock market action.
In this type of economy, nothing is more important than the continuation of ever more borrowing in ever larger amounts. If this falters for any reason, extreme financial instability would be the expected outcome, especially given the extreme degree of leverage in the financial system, which we would experience as collapsing financial institutions and rising levels of default. The three main sources of demand for new borrowing are consumers, businesses, and the government. I will examine each below, along with some other evidence to make the case that our financial crisis is not over; in fact, it has hardly begun. This means that the recent perplexing actions in the dollar and the stock market very likely represent one of the largest head-fakes of all time.
We are all familiar with the fact that US residential real estate activity is basically down 33% from its all-time peak. This represents roughly 2 million homes that will not be sold this year, compared to 2005. Among other things, this includes 2 million fewer mortgages, sales commissions, inspections, title searches, and municipal transfer fees paid. The ripple effect extends to everything from granite countertop sales, to lumber prices, to furniture. Assuming that the average house sale resulted in a net increase of borrowing of $100,000 (= the size of a new loan on a newly purchased house when compared to the old one), that results in a direct borrowing hit of 2,000,000 times $100,000, or $200 billion. Add in the ripple effects, and we are talking another few hundred billion in lost activity.
Further, Mortgage Equity Withdrawal, the practice of “extracting wealth” from a house, peaked at $682 billion in 2006, and will be lucky to break $200 billion this year, which will represent a loss of nearly $500 billion/yr from the peak and some $275 billion from last year. Taken together, residential real estate is already off some $500 billion in consumer borrowing from last year. The question lurks: What will fill in that gap? Business borrowing? Even higher levels of government borrowing?