US economy has begun to prove the bears right

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We can see more clearly than usual in the rearview mirror how the US economy is doing. Gross domestic product (GDP) in the fourth quarter of 2007 crawled up by 0.6 per cent. Those warning signals from holiday retail sales and automotive sales that we parsed painstakingly a month ago had it right. The absence of the home construction booster that had kept things humming in the mid 2000s has finally begun to take its bite. 


That construction component of the economy was down by 24 per cent in the quarter, which actually makes it quite remarkable that GDP grew at all. 

The hope among optimists that exports would take up the slack in domestic demand must have dimmed a little on the news that in this latest quarter exports grew by under four per cent. There was no repeat of the phenomenal spurt of export sales in the third quarter, which might have been an aberration. 

In a joined-up world, weak export performance would put pressure on the dollar in order to increase the competitiveness of US goods, but short-term moves in major currencies have long since been disconnected from trade balances. Capital flows and hedge fund speculations routinely overwhelm the fundamentals. Ultimately, however, if one believes that Americans, like everyone else, have to produce roughly as much as they consume, the only way to get there is to increase exports or to reduce imports. 

The ugliest way for the entire world economy would be a huge downturn in which American consumers cut back severely on their purchases. A far better solution would be for the rest of the world to consume more, including buying from the US, while the Americans ease off a bit.

Housing glut

Bears have been expecting to see advertising spending drop, as romancing the American consumer begins to look like a poor prospect. Yahoo, which derives its revenues from advertisements, just reported a drop in profits, but their revenues were still growing last year. It does not seem there has been any real cutback yet in ad spending, so Google, which keeps winning market share on the web, is still sitting pretty. If there is a steep downturn in US consumption, however, companies that rely on advertising are going to be hurt, again unless foreign markets make up the difference.

Our rearview mirror also provides confirmation home prices have been falling sharply, which was the anticipated effect of the housing glut. Recent government statistics seemed to suggest a big dip in prices occurred in December, but measurement error could have vitiated that indicator’s validity. The S&P/Case-Shiller index of house prices, generally seen as a more robust comparison of prices over time in metropolitan areas, shows a year on year drop of seven or eight per cent. 

That is much less than needed to clear the market in the view of heavyweight economists, but it is on the way. It is also unprecedented. The reason that Alan Greenspan and Ben Bernanke, past and present chairmen of the Federal Reserve, often gave for not worrying about excesses in home lending was that house prices had never dropped on a nationwide basis. So much for that theory.

Countrywide, the biggest sub-prime lender, reports that one-third of its sub-prime mortgages are delinquent. Lucky for Countrywide that Bank of America is taking them over and will inherit those headaches.


The one confounding datapoint in the past few days – and there always has to be at least one – was that durable orders rose by 5.2 per cent in December. Even washing out aircraft orders, which are so large and ‘lumpy’ that they distort comparisons, these orders were up a reasonably healthy 2.6 per cent. This is in line with the GDP report that actual business expenditure on equipment and software grew by 3.8 per cent in the last quarter. 

A big slug of orders for Boeing aircraft, many to be exported to foreign airlines, contributed to the 5.2 per cent durable orders number. The trouble with that is that there is often a long lag between orders and economic activity in aircraft, making this a poor predictor of near-term output and employment, not to mention a risk that the orders will be withdrawn if business conditions change for the worse.

Size of the stimulus

On the fiscal stimulus front, it looked for a time as if legislators were going to get something down quickly. A package of about $150bn was negotiated between the House of Representatives and the Administration, and actually voted on by the House, but the Senate was left out. So now the Senate is looking to put its stamp on the arrangements, and to add to the size of the stimulus. 

This could delay getting money into pockets, especially if the President refuses to go along with senators’ wishes to extend unemployment benefits as well as provide rebates for taxpayers and booty for businesses. Even on the fastest timetable, households would receive no checks until the middle of May, and that assumes everything goes well with the Internal Revenue Service’s antiquated systems. So there will be no relief to the economy from fiscal policy before the second half of 2008.

The Fed, as expected, cut the short-term interest rate a further half a point to 3 per cent. The Open Market Committee statement also expressed willingness to cut rates more, saying that “downside risks to growth remain” and that the committee “will act in a timely manner to address those risks.”

Listening to the Wall Street crowd, one would think the Fed faced no constraints on its interest-rate setting decisions. Yet the Fed is always supposed to balance growth against inflation. Now we have inflation running above the usual 2 per cent target that central bankers like to live with. 

Cheaper refinance
 

Core prices, excluding food and energy, rose in the final quarter of 2007 at a rate of 2.7 per cent, considerably faster than earlier in the year. Throw in food and energy and the price index is bubbling along considerably faster, to the point that it seems bound to pressure the core rate upward. The Fed’s inflation-fighting credibility is on the line. 


Who wants to hold long-term bonds and US dollars if the authorities are going to allow them to be devalued by rising price levels? It seems no coincidence the dollar weakened against the pound and euro during the last week of January: savvy holders will move elsewhere if the Fed is stampeded into shirking its responsibility for price stability.

One bright spot for those worried that nothing the Fed does can have much effect: mortgage applications are up. That does not mean the housing glut is about to be mopped up. It merely means people are able to refinance their loans at cheaper rates. 

That is one way that the Fed’s cheap money helps resuscitate the consumer: the less homeowners pay in interest, the more they have left over to splurge at shopping malls. There will be some marginal help for housing demand, too. The next wave of young prospective house buyers will have to wait for a little less time before buying, since the cost of a new mortgage will be lower. 

However, they would be daft to jump in too soon with house prices continuing to tumble. Better to rent and stay on the sidelines until house prices have bottomed. In any event, the younger cohort have to save up for a deposit in this new, saner housing finance environment. There will be no more loans at 100 per cent of the appraised value of the house. At least, such excesses will not repeat until memories of the recent scandal have faded.

That amnesia seems unlikely to develop soon, with the likes of UBS, the big Swiss banking conglomerate, confessing to yet more sub-prime embarrassments, this time to the tune of $4 billion (Dh15bn).
 
This brings UBS’s write-downs to a total of $18.4bn, which pushed them into a significant loss for the year. Apparently about half of the latest UBS write-down was related to the difficulties of the monocline insurers, discussed in my last column. 

There were more predictions that some of the bigger monoline insurers would have their credit ratings downgraded. When a guarantor of bonds proves to be too weak for its promises to be bankable, bankers are forced to revalue those bonds downwards.
 
One brokerage analyst, with Oppenheimer, has come out with an estimate the impact of the monocline insurers’ weakness will amount to as much as a $70bn write-down, mostly concentrated with Citibank, Merrill Lynch and UBS. We reach the point where 10 billion here and 10 billion there becomes too much for mere mortals to fathom.

Analysts start using words such as “chaos” about the state of big banks’ finances after the institutions claim to have cleaned up their balance sheets and then, only weeks later, come out with more bad news. It’s probably that chaos, and the fear of a financial system meltdown, that has the Federal Reserve so worried that they are putting concern about inflationary risks to the backs of their minds. 

The rest of us, since we do not print money, cannot afford to ignore that our savings are being devalued as a result of the need to rescue the banks with cheap money.

 

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