Housing BubbleEverytime you hear the optimists speak about a turn in the economy being just around the corner, you hear of things like the tax rebate checks, or some statistic trying to show that housing isn’t as bad as it really is, or the fact that unemployment and GDP growth aren’t as bad as they could be.

But the truth is that you still have to ask a few basic questions.

There are several strands to the market’s optimism about an early V-shaped economic recovery. Among these is the fact that, while certainly not good, the various US macroeconomic indicators, like GDP growth and employment, for the first quarter of the year were not nearly as bad as the Cassandras had led us to fear.

Valid as these arguments might be, they totally overlook the fact that the US economy is still being adversely impacted by the very same three negative shocks that caused the US economy to go into a funk in the first place. Worse still, it would appear that at least some of these adverse shocks are now intensifying.

What are those three negative shocks?

Are US house prices at the national level now not declining at an accelerating pace in a manner that has no precedent in the past seventy years?

Have not international oil prices dramatically risen to around US $125 a barrel, or approximately double the level that they were a year ago, thereby more than offsetting the US government’s tax rebate program?

And is the US financial system not still in the throes of what Paul Volcker has referred to as the “mother of all credit crises”, as vividly illustrated by the Federal Reserve’s recent still very gloomy survey of bank lending intentions?

There’s no doubting the first question. We’ve seen proof of that in all of our neighborhoods recently.

The second is a bit more convoluted and complex, but we end up noticing the end result of higher gas prices each time we make a trip to fill the tank.

And the third, is something that the Ron Paul campaign has continued to preach about for some time now. Whether you agree that the Federal Reserve should be eliminated or disagree – there’s no doubt that we’ve seen that lowering rates has NOT helped the situation.

Over the past year, declining home prices have already wiped out around US $2.5 trillion in US household wealth. They have also caused analysts to raise their estimates of the potential losses to the financial system from mortgage lending to US $500 billion. This has effectively put an end to the ability of households to use their homes as ATMs to finance their consumption spending. It is little wonder then that US consumer sentiment has plummeted to multiyear lows.

Sadly, the immediate outlook for US home prices is grim. At present an estimated excess inventory of around 1 million unsold homes is weighing heavily on the housing market. Compounding this situation of excess supply is the fact that private sector mortgage lending has all but dried up in the wake of large sub-prime mortgage losses.

Worse still, a rapidly increasing rate of foreclosures is substantially adding to supply on an already glutted market. And there is every prospect that the foreclosure rate will continue to increase as declining home prices boost the number of households with negative equity in their homes to around one third of all households by the end of the year.

To be sure, policy measures have been introduced to stimulate the economy in the form of a US$170 billion tax reduction package and Federal Reserve interest rate cuts totaling 3 1/4 percentage points. However, with the very real prospect of the US economy sliding deeper into recession, one might ask whether enough has been done to cushion the economy from America’s largest housing market and credit market bust since the Great Depression.

No matter how you slice it – this quote puts things into perspective. It’s a dog-chasing-tail scenario and for us to call things based on the change in one side of it, is anything but responsible:

“A very real danger of rapidly declining home prices for the US economy is that it raises the real risk of creating an adverse feedback-loop. For as declining housing prices reduce consumer wealth and add to the financial system’s losses, they push the economy further into recession. Yet as the economy slides deeper into recession, it exacerbates the downward spiral in housing prices.”

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