The US economy is the next 9/11 (page 1 of 2)

So how weak will the US economy become? First of all one has to be concerned about the recent sharp money supply growth deceleration. The 12-months rate of growth in M2, at 3,6%, year-over-year, is at the lowest level since 1995 and the 13 week percentage change of MZM has now just turned negative.

As a result of the decline in the rate of growth of money supply, "excess money", as defined by the growth in money supply in excess of nominal GDP, has over the last 18 months also plunged. Usually, when money supply growth slows down so rapidly and when "excess money" plunges, the economy follows with a brief time lag.

The second reason, I have strong reservations about a sustainable recovery is that employment gains are still dismal and most unlikely to improve much. The problem, now, compared to previous recoveries in the US is that China in the manufacturing sector and that India for tradable services will continue to gain employment market share at the cost of US employment and also lead to a worsening of America's trade and current account deficit.

The more China gains of the US import market, the more jobs the US is losing. This trend has become particularly worrisome since year 2000. Moreover, what weak employment gains mean is that the US labor force has no bargaining power and, therefore, has declining real (inflation adjusted) incomes.

Under these conditions one has to wonder why US consumption expanded after 2001 rather rapidly. The reason for this anomaly were the tax cuts, which increased after tax personal incomes and the favorable conditions in the housing market, where negative real interest rates led to strong price gains and the refinancing boom.

Mortgages boost US consumer

Since 2001, homeowners have taken out much higher mortgage loans on their homes than the volume of mortgages required to finance new construction activity.

So whereas recently mortgage borrowings were running at an annual rate of almost $800 billion, the financing of new home construction only required mortgages of around $450 billion. In other words, homeowners extracted almost $300 billion a year from their homes, which they could then spend on consumer goods such as cars, appliances and other discretionary items.

However, it should be clear that consumption driven solely by asset inflation in residential real estate is not sustainable in the long run. One day, home prices will fail to rise, either because interest rates won't decline any more or because affordability for the new buyers who have declining real incomes will become an issue.

Possibly supplies will also exceed demand as home builders all want to take advantage of the appreciating housing markets across the country by building a large number of units in the hope to sell them later at inflated prices.

What we, therefore, find at the present time is that US inventories of new homes for sale are at a record because, in recent months, housing starts have been rising at a far higher rate than new home sales.

I concede that the recent renewed decline in interest rates could keep the housing market buoyant for some more time, but since housing prices have increased at a far higher rate than consumer prices in recent years, some kind of housing bubble is in the making and, by now, we should all know what eventually happens to bubbles!

I would also add that once home price appreciation slows down or interest rates rise - or a combination of both - refinancing activity will come to a halt.