Saturday, October 20, 2007

It's The Economy, Stupid

I very much agree with the premise of this article ( - while Iraq, health care and taxes are the main campaign issues today, if things pan out as I fear they might, the economy and a recession may be the bigger issues in 2008. If that happens, I suspect the GOP's difficult prospects will become far worse. I have mixed emotions - I do not want economic hardship for anyone, yet a crushing defeat for the GOP may (A) get the country on a new course economically and socially and (B) flush "values voter" issues down the toilet for years to come. Both are very much needed. Here are some highlights:

I am not an economic forecaster, but anyone can dream. And if I had to guess, I would say that the chances are better than even that next year's presidential contest will be fought against the backdrop of a recession. The stock market, so far, appears to disagree. You might prefer to trust the collective wisdom of a million investors betting real money. Usually I would advocate that. But you might also ask yourself, as I am, what on earth is Wall Street thinking?

Roubini said last year that the problems in the housing market would get worse before they got better. He and only a handful of others predicted that house prices would soon fall (on a national aggregate basis) year-on-year for the first time since the Great Depression. Until recently, most economists were expecting no worse than a slowing rate of increase, and a good number recommended housing as an investment. House prices are now falling across the country as Roubini said they would, and the backlog of unsold houses (suggesting lower prices to come) is growing.

Roubini made a second prediction. He said that stresses in the housing market would feed into the broader financial system. One of the forces powering the housing boom, he pointed out, was the explosive growth in subprime mortgages. That growth, in turn, had been driven by financial innovation -- especially by the repackaging of those mortgages into securities that could be sold to investors across the wider financial market. As defaults began to rise on those poor-quality mortgages, Roubini predicted, the pain would not be confined to the victims of foreclosure or to the reckless new lenders that had granted the loans in the first place but would also extend to their backers at one or more removes in the capital market. And again, so it proved.
Were soothing words from the Fed and a tweak to interest rates all that was needed to put things right? Treasury Secretary Henry Paulson Jr. does not seem to think so. The slump in the home-building industry, in other words, is still gathering momentum. Sales of homes in Southern California, until recently one of the hottest markets in the country, fell 30 percent between August and September, and are now down 50 percent from a year ago. Only when sellers are ready, or are forced, to face their losses and let the market clear will a floor for prices be established. Wherever that floor might be, we are not there yet.
Another economist with a disturbingly good track record of calling market slumps is Yale's Robert Shiller. Long in a small minority, he foresaw the big stock market fall of 2001-02. Since then he has been sounding the alarm about house prices. According to his recent calculations, prices would need to fall by approximately 50 percent to re-establish a historically normal ratio of prices to rents. Even a far smaller decline would still be enough to push mortgage foreclosures to highs, to worsen the plight of homebuilders, to tear bigger holes in the earnings of banks and investment firms, and, most important, to severely dent consumer spending.
Everything depends on what consumers do next. Roubini thinks that they will retrench, and he is still predicting a "hard landing." It is the only aspect of his earlier forecasts that has not yet come true, and I would not bet against it. Distressed debtors and foreclosures are already on the rise and the economy is still strong. What would a downturn do to those housing market numbers, and how would they then feed back on the broader economy?

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