Wednesday, August 22, 2007

Economic Doom

I've been warning for years now that the U.S. economy is on the verge of a major recession, and that the longer we continue without seeing a correction, the worse it will be. I've been saying this since about the time it became clear that our recovery from the recession caused by the 2001 stock market correction [and the malaise experienced in the immediate aftermath of the 9/11 attacks] would be led by an inflation of housing asset prices and a continuation of the egregiously irresponsible "twin" deficits, i.e. the U.S. government budget deficit and the U.S. trade deficit. This, it seemed to me, was the inevitable outcome of American imperial overreach in its so-called Global War On Terror long after the end of the Cold War.

Admittedly, I thought sanity could not fail to emerge and the recession would arrive sooner. I predicted more than once that it would probably be here by this time already. I was surprised and dismayed when my predictions failed, because I had always delivered them with the contingency that a downturn was impossible to avoid in the long run, and the only real question was when the downturn would arrive.

I suppose I was too hopeful that we might avoid a hard landing by taking less painful preventative steps before it was too late. Serves me right for overestimating the competence of American financial managers.

Now, it appears that a hard landing may be unavoidable. Here's the [reliably bearish] economist Nouriel Roubini delivering a technical explanation of this bad news:
The Fed finally acknowledged today the risk of a serious US economic slowdown given the current financial and credit markets turmoil. [...]

The statement was very clear in signaling an easing bias and a policy cut ahead: “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth forward." The statement also pointed that "the downside risks to growth have increased appreciably". And it clearly signaled that the FOMC is "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

[...] For the first time in over a year the Fed is now implicitly admitting that they underestimated the downside growth risk: until now the official Fed view was that the housing recession was contained and bottoming out and not spilling over to other sectors of the economy; and that the sub-prime problems were also a niche and contained problem. The sudden shift to a strong easing bias suggests that the Fed miscalculated until now the damage to the economy and to financial markets of the housing recession and its real and financial spillovers.
While you're glugging down that bit of dismal analysis, be sure to check out Brad Setser on the topic of WTF is really going on here:
John Cassidy is right. The leading US export to China is high-quality housing debt.

The toxic waste generally went elsewhere – thought there are now hints that China (perhaps the state banks) may have bought a few triple AAA rated CDOs composed of the tranches of subprime-mortgage backed securities. We just don’t quite know much of this ended in China -- or where the rest went. Elsewhere in Asia? Europe? US hedge funds? US money market funds?

But we do know that China provided – through its purchase of Agency bonds and other mortgage-backed securities – an awful lot of credit to American households over the past two years.

Consider the period from the end of June 2005 to the end of June 2006.

During that period, the US sold – according to the BEA -- $48b of goods to China.

That total was dwarfed by the $83.5b of Agencies and $22.5b of long-term corporate bonds that China bought. “Corporate” debt includes mortgage-backed securities that do not have an Agency guarantee – and China is widely thought to have been a big buyer of these securities. Combine Chinese Agency and corporate bond purchases together, and it is not all together out of the question that China bought $100b of US housing debt between mid-2005 and mid-2006. Most of this was the still-good stuff, not subprime.
Be sure to check out his pretty graphs. They show some revealing trends in the Chinese posture, and none of them are particularly healthy for anybody's sense of rugged individualism and economic freedom.

Here's how Mr. Setser concludes:
In some deep sense, this whole system is nuts.

China is a poor country. It is buying this debt on terms that almost guarantee enormous financial losses for Chinese taxpayers simply from the RMB's appreciation against the dollar.

Plus, Chinese demand for safe assets – and the resulting low-yields on those assets – also helped to induce a lot of the excesses that are now clogging up the arteries of the US financial system. At the same time, if China stopped buying -- especially now, when the private market is clogged up -- US financial markets would really seize up.

The US is in a position where it has no realistic alternative to ongoing financing from China -- at least in the short-run. In the long-run, though, I continue to believe that the scale of China's dependence on the US to provide financial assets that will retain their value and the United States dependence on credit from China is unhealthy for both parties.
It's often said: When you owe the bank ten thousand dollars and you can't pay, it's a big problem for you; when you owe the bank ten million dollars and you can't pay, it's a big problem for the bank.

Alas, when you owe the bank ten trillion dollars and you can't pay, it's a big problem for everybody.

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