Fortune telling II

My next stop is at Barry Ritholtz’s very thorough piece (e-mail required), filling in for John Mauldin, who’s taking some time off. Have a good time John —you too, Barry.

In his Real Estate and the Post-crash Economy, Barry underscores the importance of real estate (RE) in supporting the post 2000 crash years, and stresses the prolonged and damaging effects to the economy, as the aftermath of the recent downturn in the housing market.

His conclusion:

…we find it hard to imagine how the economy avoids a hard landing. In a
post-crash economy, that’s about the best we can hope for.

Ritholz
Barry Ritholtz, The Big Picture blog

After the year 2000 crash, the Fed injection of liquidity with the purpose of sustaining a weak economy had the unsuspected consequence of setting in motion a unique spiraling cycle:

  • Increased liquidity provoked the appreciation of most assets, oil, metals, RE, and the like,
  • which in turn allowed mortgage equity withdrawls (MEW) from RE,
  • which allowed US consumers to sustain their spending on imported goods,
  • which in turn increased emerging countries central bank reserves,
  • which forced these foreign CBs to buy US treasuries to avoid the appreciation of their currencies, or the loss of local employment (i.e. China and Japan),
  • which in turn lowered US interest rates,
  • which fueled higher RE prices,
  • which in turn further fueled construction,
  • and the continuation of this cycle by triggering further spending through MEWs.

In other words, RE is the float which helped sustain US economic growth during the last few years, providing the much needed support to the economy through jobs in construction and related activities. The Fed all along intended this real estate bridge to be a temporary measure, to help us cross the turbulent waters of the recession till the economy could stand on its own two feet. Unfortunately, the economy is still weak, mainly due to the low-wage/higher-return areas effect, where as we’ve discussed before, these profitable areas act as magnets for investments and their returns.

Image008

Mortgage Equity Withdrawl effect on GDP growth.
Source: Calculated Risk

But, a picture is worth a thousand words… and this is the incredibly
eloquent chart from Calculated Risk, which depicts the enormous
influence of the MEWs to GDP growth.

In other words, without the MEW induced consumption, GDP growth would’ve shrunk more than 2%, and more than 3% for the years 2004 and 2005 —so, (MEWs and) RE has been an extremely important support for the economy.

Barry sees a larger and more protracted contraction of the economy due to this RE price downturn, because RE is is far more entangled to our lives than the stock market, where our  participation is much smaller, hence crashes or downturns in RE have a much larger impact. In his own words:

And, it is falling. As rates have ticked up, two things have happened: equity extraction has trended downwards; it had fallen to $113.5 billion in Q3 2006. This is off by ~50% from the 2004/05 peaks. It is no surprise that GDP has trended downwards along with MEW.

And his conclusions…

Credit or blame for this economy lie mostly with the Federal Reserve. It has been 6 years since the last recession began. At this point in the business cycle, the Fed seems to be running out of maneuvering room. Unless inflation decelerates rapidly (allowing more rate cuts), or the economy somehow manages to re-accelerate without igniting more inflation, we find it hard to imagine how the economy avoids a hard landing. In a post-crash economy, that’s about the best we can hope for.