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September 10, 2007

The US Economy: Is a Recession on the Way?
by Gerard Jackson

There have been oodles of commentary about the effects of the subprime real estate fiasco and how this will impact on the US economy. The first thing to bear in mind is that this financial disaster should be laid at the feet of the Fed. Without its loose monetary policies the credit to fund subprime mortgages on a massive scale would not have been available. Pumping masses of credit into the banking system is like pouring water into a bucket that is full. It's gotta overflow. And this is precisely what America got: an overflow of credit that went into funding a lot of dodgy loans -- and not all of them are mortgages.

Dr. Robert Shiller of Yale University and the author of Irrational Exuberance has asserted that in the next few years real estate prices across the US could plummet by 40 per cent in real dollars. I find this prediction very dubious. It is true that land and houses can suffer severe and prolonged drops in their prices. For example, good British farming land that sold for $100 an acre in 1860 was selling for $10 in 1940. This was not due to any land boom going bust but to the successful opening up of the prairies by the railways. The flow of grain and meat from this agricultural cornucopia dealt a severe blow to many European farmers. My point is that one should be very careful when dealing with real estate trends. That the market is overvalued is indisputable: that a correction could slash real estate prices across the board is something that would, in my opinion, require a significant deflation.

Readers will recall that I frequently refer to findings by the ISM (Institute of Supply Management) that keeps a very accurate check on the performance of the manufacturing sector. It is true, as several readers pointed out to me, that the index is falling though it still remains positive. The interesting thing here is that a decline in the index is usually followed by a recession. But it is at this point where we must exercise caution. In 1999 I made similar observations. However, I did not 'predict' recession, as I recall, until the manufacturing indicators were negative, leading some economic commentators to make the silly statement that the US economy was half in recession while the other half was booming, as was employment.

A similar thing happened in the in 1924, 1927 and Australia in 2001. It was clear in 1924 that the US economy was sliding into recession. The Fed saved the day by quickly expanding the money supply. Economic activity slowed again in 1926 and in the following year the Fed opened the monetary tap. In 1999 it was obvious to me that Australian manufacturing was slowing and in 2000 the slowdown became more pronounced so that by the end of the year it was generally agreed that the country was going into recession. The Reserve Bank of Australia reacted to the threat by letting the money supply rip. From January 2001 to February 2002 bank deposits rocketed by 25 per cent and M1 grew by 38 per cent.

So it is not just a case of a declining ISM index but also the response of the Fed that needs to be considered. Should the Fed decide on a significant cut to the funds rate then it is possible that manufacturing and even the residential real estate market could rebound, as happened in Australia. But this would be a case of putting of a day of economic reckoning for a more pain one down the track. The real danger to the economy would be control of both Houses and the White House by the Democrats. If they are true to their word about taxation and spending then they would sink the US economy. After all, every economy can only take so much punishment. And let us also bear in mind just how ignorant of economics and economic history Democrats -- not that they really care.

People ask me whether real estate is a good economic indicator. Not exactly, the real indicator here is new residential building. The reason for this is durability and price. These two factors make housing very sensitive to interest rates charges in the same way that durable capital goods are responsive. Houses are built on the expectation of being sold at a price that covers the cost of production. A self-evident fact. What is not self-evident is that the price of the house is the sum of the value of its discounted services. It therefore takes little to understand how interest rates would influence the building industry1. The demand for big ticket consumerables is also declining, particularly for cars. One reason would be that many of these articles are bought with borrowed money. This too could indicate recession.

I know that a number of economists are predicting an imminent recession. But I have also shown why one must be cautious about such predictions. But do not forget that it is manufacturing that first feels the cold wind of recession2 -- even when monetary policy is not particularly tight. Never underestimate the power of money!

Banks are being urged to come clean with investors. Laudable as this sentiment is it overlooks the fact that the problem is not one of devious bankers holding out on investors and ordinary depositors but of bankers -- along with the Fed, most of the economic commentariat and academia -- being completely ignorant of the nature of money, capital and interest rates. The economic commentary I've read from banks, including central banks, does not fill me with confidence.

1. Hayek considers houses to be capital goods "so far as they are non-permanent". Additionally, "we have to replace them by something if we want to keep our income stream at a given level..." (The Pure Theory of Capital, The University of Chicago Press, 1975, pp. 77-78). But the same thing can be said of cars, televisions, books, furniture. In fact, just about any household appliance. Or even works of art. Although the Mona Lisa is 500 years old and will probably survive another 500 years no one calls it -- at least as far as I know -- a capital good.

2. The exception would be a consumer-led boom. The effect on the capital structure by this type of boom would be very different from credit boom that directly fuelled industrial expansion. I should also add that it is a myth that Austrians do not -- and never have -- considered consumer booms.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2010 Gerard Jackson

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