Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Sunday, January 28, 2007

Housing Led Recession May Eventually Lead to Rebalancing

I believe global economies will eventually rebalance, although the timing and manner of this rebalancing remain in question. As I see it, at least four unsustainable efforts have been prolonging and compounding the problems that go along with the global economic imbalances:

1. The financial markets are still heavily manipulated by banking institutions that have an interest in keeping the dollar strong relative to the yen. This prevents prices from adjusting to cut substantially into American consumption.

2. Foreign investors and institutions remain willing to absorb around a trillion dollars per year in new US debt.

3. Rapid money supply growth is generating enough economic growth and operating earnings to keep many heavily indebted enterprises afloat.

4. The rapid growth of derivatives markets and the hedge fund world has enabled the creation of tremendous amounts of imaginary, paper profits, that will some day disappear, along with many of the companies participating in the massive fraud.

As there seems to be no let up in the pace of these actions from foreign and domestic perpetrators, it is becoming more likely that the system itself may have to break down before economies will be allowed to rebalance. If that is the case, then the housing sector seems likely to be the first major domino that would lead to a global rebalancing, given its prominent place in the economy.

The Janaury Market Observations post over at Contrary Investor does a good job of trotting out the charts that show what has happened in past housing booms. This one has been larger than any in the past 50 years and the resulting bust is likely to be longer and deeper. Here's just one chart lifted from that site:

To that work, I'll add a few things. Here's a chart, showing how private contstruction spending has already turned down:

Residential construction spending is going to get much worse. Order backlog for most builders entering 2007 is less than 60% of what it was going into 2006. Orders are down, cancellations are up and they are sitting on a growing number of finished, unsold homes:
Starts are down, but not nearly as far down as they'll be a year from now. The bottoms of past housing cycles typcially came during economic recessions. Those recessions often started out with a slowdown in residential construction. We can expect housing to put a substantial drag on GDP growth for the next several quarters.

Additionally, much recent consumer spending has been related to the wealth effect and equity extraction that has been made possible by the recent housing boom. As the housing market slows and prices begin to fall, it should but a significant damper on consumer spending. It will be interesting to see the latest impact on these numbers in the GDP report next week.

One important thing that makes this bubble worse than past bubbles is the extent to which publicly traded builders are now responsible for a much larger portion of new home construction. As with many publicly traded companies, corporate executives ran many of the builders in a way that maximized short term and personal gains while creating massive systemic risk for shareholders and the economy. Meanwhile, Wall St. provided funding far beyond what regional banks loaned out in past cycles. Even as the market was cooling, the large, publicly traded builders were rushing to open new developments. Collectively they borrowed billions of dollars in 2006 to build homes that they were having trouble selling, and housing vacancies piled ever higher. Consequently, vacant homes for sale entered this slowdown at about 1.5% of the total housing stock, while the past slowdowns examined by contrary investor began with less than 1% of housing stock listed as vacant for sale.

It is my expectation that this housing bust will be much greater than any of the past busts, with the economic fallout leading to a pronounced slowdown in the consumption of imported goods.

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