Housing Bubble Continues To Lose Air

If you've been holding your breath waiting for the housing market to rebound, you should exhale. The air continues to go out of the market as well.

After a 15% drop in May, housing starts fell another 5% in June, according to the Commerce Department. Housing starts are now at their lowest level in eight months and 76% below their 2006 peak.

Despite record-low mortgage rates, demand for housing remains low. For months, the housing market had been on government life support, buoyed by the federal tax credit. Now that the credit has expired, the market has fallen.

With an abundance of inventory available due to foreclosures and short sales, it's no surprise that housing starts are declining. Builders are putting on the breaks. Inventories of unsold new homes stand at 40-year lows.

That's because we are mired in the worst housing downturn since World War II.

However, the market simply isn't going to bounce back to its previous highs. Unemployment is too high to support a renewed demand for housing, and consumer credit has been decimated. A whopping 35% of Americans have credit scores too low to even qualify for a loan.

Home builders are fully aware of this ugly reality and they are very discouraged. The builder sentiment index fell back to a 15-month low in July on the heels of a large drop in June.

In the past decade, housing demand was artificially inflated due to a massive increase in the monetary base — which increased bank lending — and an equally massive cut in the federal funds rate to the lowest level in more than 40 years. Both of these schemes were initiated by the Federal Reserve.

This combination created a false prosperity, which ultimately fueled a false demand.

The deflation of the housing bubble is an ongoing process, and the air will continue flowing out of that bubble for the foreseeable future.

Trade Imbalance Sucking Money, Jobs Out of US

The US trade deficit widened to $115 billion in the first quarter, or 3% of US GDP, according to theBureau of Economic Analysis. That amounted to over a billion dollars a day.

It was the third consecutive quarterly increase. And yet this negative trend continued in May, as the trade deficit reached an 18-month high.

Typically the trade gap is blamed on oil imports. However, oil imports sank 9.1 percent to $27.6 billion as both the price and the volume of oil shipments declined.

The trade deficit continues to widen even though exports rose 17% in the first quarter. The problem is that imports continue outpace exports. This means an awful lot of money is flowing out of the United States.

The concurrent flow of imports into the US is displacing American jobs. We're buying all these foreign goods instead of making them here at home.

The trade gap creates a drag on GDP. If we could export more, we would increase GDP.

When the economy tanked in 2009, both imports and exports declined, yet the trade imbalance was more than halved. The trade deficit hadn't been that small in a decade. Now, as exports are significantly trailing imports once again, the trade imbalance has re-expanded.

Such an imbalance is simply unsustainable.

In June, Treasury Secretary Tim Geithner warned that other countries can’t rely on US consumers to propel the global economy. Given the state of US unemployment, plus consumer spending and confidence levels, that seems like a reasonable conclusion.

The reason our economy melted down in the first place was because it was built on a bubble of debt. American consumers simply cannot continue taking on ever more debt while serving as the world's primary consumer.

Our unemployment problem will lead to further imbalance.

America needs to produce more, export more, and save more. For more than a quarter-century, we did exactly the opposite. And that's exactly what we need China to do now; import more and spend more.

Our trade gap with the China is the largest of any individual country, reaching $22.3 billion in May.

Although China, Germany, Japan and the US — like all other countries — would love to be net exporters with trade surpluses, not every nation can fit that profile. Someone has to buy.

For a long, long time, that has been the US. The problem for the US is that we don't export nearly enough to continue paying for all those foreign goods.

Exports represent nearly half of Germany's GDP, 30% of Great Britain's, 28% of China's and just over 10% of US's, according to Fred Hochberg, president of the Export-Import Bank of the United States.

That's not just bad for the US; it's bad for all those nations who want — rather need — us to buy their goods. Without US exports, where will the money for all this commerce come from?

As noted, the current situation is simply unsustainable.

Bad Credit Scores Affecting More Than 1/3 of Americans

New figures show that 25.5 percent of consumers — nearly 43.4 million people — have a credit score of 599 or below, marking them as high risks for lenders.

According to John Ulzheimer, the President of Credit Education at Credit.com, even in the loose credit years of the previous decade — when almost anyone was extended credit — a 600 credit score was still considered sub-prime.

The key dividing line between prime and sub-prime is a score of 650. When the number of people whose credit score is below 650 are added up, they total 70 million people, or 35 percent of consumers. These are the people considered to be at an elevated credit risk.

Normally, just 15 percent, or 25 million people, fall into this high risk / sub-prime, category. But credit scores have worsened considerably for a much larger percentage of the population. Ulzheimer says this is the biggest shift in FICO score distribution he's ever seen since the score became widely available in 1989.

This bottom 35 percent of consumers are either denied credit outright, or they are charged exorbitant interest rates. This applies even to credit cards.

The FICO score ranges from 300 to 850, though the highest score is exceptionally rare. Scores in excess of 750 are also rare, and individuals with these scores can pretty easily attain credit and are often courted, if not aggressively pursued.

These worsening credit scores mean that more than a third of Americans won't qualify to buy a house or a car. That lessened demand will have far-reaching effects across the economy, limiting GDP growth.

It will also affect those 70 million people in the most direct sort of way.

Most Americans have gotten used to mitigating the effects of low or stagnant wages though the use of credit. And the unemployed may be entirely dependent on it.

For many of them, those days are now over.

Decreased Lending Shrinks Money Supply

Deficit Reduction Will Shrink It Further

The size of our continuing deficits and bloated debt have politicians concerned and citizens scared. The fiscal path we are on has been repeatedly characterized as "unsustainable" by economists, members of Congress, and the Federal Reserve.

The IMF warns that US gross public debt will reach 97% of GDP next year, and 110% by 2015.

Willingly, or unwillingly, change is on the horizon. The federal budget will be cut.

If the US were to cut its projected 2010 deficit in half by 2013 — as agreed to at the G-20 summit — that would be a cut of $780 billion. There is no easy way out of this. It will cause a lot of pain to a lot of people.

As the government begins paying down its debt, standards of living will decline.

With a national debt exceeding $13 trillion and other debts and obligations — such as Social Security, Medicare/Medicaid and veterans payments — reaching $99 trillion (according to the Dallas Federal Reserve), the only hope the US has to repay these debts is by inflating its currency to the point that it loses value. Fixed debts can then be paid back with devalued money.

However, events seem to have gone beyond the reach of the government and the Federal Reserve. Despite their best efforts to stimulate the economy and create at least a little inflation, the threat of deflation now seems more likely.

An unintended consequence of shrinking government spending will be shrinking the money supply, since virtually all “money” today originates as loans or debt.

However, the money supply has already been shrinking at an alarming rate.

In a May 26 article in The Financial Times titled “US Money Supply Plunges at 1930s Pace as Obama Eyes Fresh Stimulus,” Ambrose Evans-Pritchard writes:

“The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of institutional money market funds fell at a 37pc rate, the sharpest drop ever."

As Professor Tim Congdon from International Monetary Research notes, "It’s frightening. The plunge in M3 [money supply] has no precedent since the Great Depression."

This is not good for the banking system since the vast majority of the money supply is created by banks as loans (or credit). And since bank loans are now virtually the only source of new money in the economy, the interest can only come from additional debt.

Just this week, the earnings results of the three biggest US banks were announced, and they weren't encouraging.

Bank of America, the largest U.S. bank by assets, said Friday that second-quarter net interest income was $13.2 billion, down 10% from $14.7 billion in the same period last year.

J.P. Morgan Chase, the second-largest U.S. bank by assets, said net interest income was $12.8 billion in the period, down 13% from a year earlier, largely driven by lower loan balances.

And Citigroup, the No. 3 U.S. bank, reported a 13% drop in quarterly revenue. Average loans in the company's Regional Consumer Banking business fell 2% to $218 billion, partly driven by declining balances in North America.

Consumers and businesses simply aren't taking out new loans. Instead, they're still focused on reducing the massive debts they racked up during the boom of the previous decade.

In this environment, bank revenues will likely remain flat or continue to shrink. And when you combine decreased borrowing in both the private and public sectors, the money supply will also continue to shrink.

Unfortunately, the economy will continue to shrink along with it.

The pace of events is outstripping the efforts of the Treasury and the Federal Reserve. It seems that neither is able to control the shrinking money supply and, therefore, they cannot control the outcome.

Fed Downgrades Economic Forecast; Dilemma at Hand

The Federal Reserve has downgraded its forecast for economic growth in the second half of the year and into 2011.

In fact, Fed officials believe it could take five to six years before the US economy is fully recovered from the Great Recession of 2008.

The Fed foresees more years of high unemployment, very low interest rates, continued deleveraging, and the persistent threat of deflation.

With the economy showing signs of faltering, Fed officials are considering a range of options to stimulate growth. But the reality is that, in this battle, the Fed may have finally run out of bullets.

After spending the beginning of this year talking about how to exit from its extremely loose monetary policies that injected trillions into the banking system and housing market, the Fed is now wondering what more it can do to increase demand and stimulate growth.

However, there's a disagreement at the Fed Board about exactly what is happening, and what they should do about it. There are those at the Fed who fear inflation, while others worry about deflation.

The ones who worry about deflation are starting to think the Fed should be doing more. But with interest rates already near zero, you have to wonder, what more can they do? Mortgage rates are already near all-time lows.

Last year, the Fed bought $1.7 trillion worth of mortgage bonds and Treasury debt. Perhaps they could try more of that, but how much further can they expand the Fed's balance sheet? Massive infusions of cash into the economy would have the same effect on the Fed's books. And there are disagreements among Fed officials about how effective that would be anyway.

If the Fed were to launch a new asset-purchase program, that may cause global investors to lose faith that the Fed will be able or willing to pull money out of the economy in time to prevent inflation. That would lead the investors to demand higher interest rates on long-term loans.

Investors could also come to fear that the Fed was "monetizing the debt," or printing money to fund budget deficits.

And, of course, both of these possibilities would be counterproductive.

Central banks utilize monetary policy, or the manipulation of the money supply, to control inflation. An inflated money supply in relation to the amount of goods and services in the economy eventually results in price inflation throughout the economy.

The Fed, like all central banks, prefers inflation to deflation. Yet despite all its best efforts, deflation still appears to be a threat.

Despite massive monetary stimulus, including $1 trillion in excess bank reserves, the Fed expects consumer prices to rise only about 1% this year and less than 2% per year over the next two years.

If deflation does indeed take hold, the Fed will pull out all the stops and take the most dramatic measures to thwart it. Deflation, a dangerous cycle of falling prices, could actually spur the Fed to undertake another round of massive asset purchases, despite the risks that it would entail.

The reality is that there are no good options. Every move will have undesired consequences.

Without a doubt, the next couple of quarters, and years, will be fascinating, to say the least.

Latest Indicators Spell Trouble for US Economy

The US trade deficit widened to an 18-month high in May, catching many economists by surprise. The amount of money flowing out of the United States indicates that economic growth may be slowing. That's a bad sign for an already weak US economy.

According to the Commerce Department, the overall US trade gap for goods and services rose nearly five percent to $42.3 billion in May, from $40.3 billion in April.

Notably, the deficit cannot be blamed on oil imports, which sank 9.1 percent to $27.6 billion as both the price and the volume of oil shipments declined. Consequently, sales at gas stations also fell, down 2% as pump prices also declined.

Of greatest concern, perhaps, the trade deficit with China — the largest with any individual country — widened to $22.3 billion in May, from $19.3 billion in April. It was the biggest gap since last October.

However the trade data was mixed.

Imports climbed nearly three percent to a 19-month high of $194.5 billion in May, while exports also rose 2.4 percent to a 20-month high of $152.3 billion. So the good news is that exports are climbing, but they are being outpaced by imports.

Exports add to GDP, while imports reduce it. That's why it's critical for the US to increase exports and decrease its reliance on cheap consumer imports. Simply put, a trade deficit creates a drag on the economy.

In fact, the trade deficit may result in a 1-2 point reduction in economic growth for the second quarter. The US economy grew by 2.7 percent in the first quarter, but various indicators show the expansion may slow in the second half of the year.

China has undervalued the yuan in relation to the dollar to keep its products artificially inexpensive in the US while discouraging US exports into China, There are now concerns that the growing trade gap could create a wider rift between the two nations.

This controversial currency policy, which the Chinese central bank vowed to loosen just weeks ago, is contributing to high unemployment in the US. And it undermines President Obama's goal of doubling exports within five years to increase both jobs and growth.

But China is not the only obstacle to that goal.

The European debt crisis has slowed growth in Europe and raised the value of the dollar 14 percent this year versus the euro. As with China, a stronger dollar against the euro makes US goods costlier and less competitive in Europe.

The deficit with the European Union rose 7.5 percent to $6.2 billion as imports rose 3.2 percent, outpacing a 1.9 percent rise in U.S. exports to that region.

The upside to the rise in imports is that it indicates US consumers are spending once again. But given the state of unemployment, housing, consumer debt, and the state of the overall economy in general, this is a confounding development.

Consumer spending increased in four of the first five months this year (April was flat, but not declining). In fact, consumer spending rose at a 3 percent pace in the first quarter.

However, the data is contradictory.

Retail sales fell 1.1 percent from April to May, marking the first decline since September 2009. But, on a year-over-year basis, core retail sales were up 4.5 percent from May 2009.

And now we find that retail sales decreased 0.5% in June, further indication that the economy is slowing. Retail sales are a critical indicator because they account for about half of total consumer spending.

Two consecutive months of declines don't paint a portrait of confident, free-spending consumers.

In fact, the consumer confidence index plummeted to 52.9 in June — the lowest level since March — from a downwardly revised 62.7 in May. That's a huge drop. A reading above 90 indicates the economy is on solid footing; above 100 signals strong growth. By this measure, we are a long way from recovery.

And, rather suddenly, consumers are saving again. Cautious Americans saved more in May than at any time since September. According to the Commerce Department, the personal savings rate in May -- the part of every paycheck that goes unspent -- rose to 4 percent, the highest amount in nearly a year.

In this environment, it is not possible for US consumers to increase both savings and spending.

So the data is quite contradictory. No matter, American consumers simply won't rescue the US economy by purchasing foreign goods.

Given the challenges facing US consumers, it's hard to envision domestic consumption — which accounts for 70 percent of GDP — leading the US into economic recovery.

And given the expanding trade gap, it's also difficult to imagine exports leading the recovery either.

So what will? Your guess is as good as mine. But the numbers don't look good.

Prepare For Tax Hikes & Budget Cuts

The world economy is reaching a point of stagnation, and perhaps contraction will follow. Consumption has dwindled. However, we live in a perpetual growth system that cannot handle this sort of pullback.

So governments around the world have jumped into the breach with absolutely massive stimulus programs designed to rekindle growth. Under the current economic model, if you're not growing, you're dying.

However, all of this government spending has led to a run-up in government debts. As we've seen in Europe, this spooks markets and can lead to a credit crisis. That can make it difficult, if not impossible, for nations to borrow money. And even if they can, the costs are prohibitive.

As a result, the G-20 nations have pledged to cut their deficits in half by 2013, and to "stabilize or reduce" their debt-to-GDP ratios by 2016.

The debt-to-GDP ratios of some of the world's largest economies — including the U.S. and U.K. — are stunning and potentially dangerous.

The U.K., the world's seventh largest economy at $2.1 trillion, is facing a massive debt burden and a depressed currency. The U.K. faces a deficit that is 12.5% of GDP (similar to Greece), and a national debt equaling 72% of GDP. But when private debt is added, things get a lot worse.

A study by the McKinsey Global Institute found that the U.K. has the world’s worst private and public debt in comparison to GDP, with a ratio of 470%. Yet, due to artificially low interest rates, the problem stands to get a lot worse as those rates inevitably rise.

In an effort to address its fiscal shortfall, the U.K. government outlined a budget intended to eliminate its structural current deficit through a combination of spending cuts, a two-year public sector pay freeze, a bank levy, and tax increases.

U.K. Chancellor of the Exchequer George Osborne announced an immediate increase in the capital-gains tax paid by higher earners from the current 18% to 28%, and the value-added tax will increase from 17.5% to 20% in January, 2011.

This is what the U.S. has to look forward to; tax hikes and budget cuts.

The U.S. is currently facing a current budget deficit that is 10% of GDP, and the 2011 deficit is projected to rise to 11% of GDP. Meanwhile, the national debt recently topped $13 trillion. The long-run projections of the Congressional Budget Office suggest that the U.S. will never again run a balanced budget. Imagine that.

If the U.S. were to cut its projected 2010 deficit in half by 2013 — as agreed to at the G-20 summit — that would be a cut of $780 billion. This will result in a lot of pain for a lot of people. There is no easy way out. It's going to hurt a lot.

However, the Obama administration recently said it will work to reduce the U.S. fiscal deficit to 3% of GDP by 2015. That would amount to a $994 million budget cut.

While these reductions are desperately needed, they will severely impact the lives of tens of millions of Americans.

Since two-thirds of the federal budget is comprised of Social Security, Medicare, payments to veterans, and interest on the national debt, cuts to these items will range from painful to impossible. The U.S. cannot — will not — default on its debt payments, so the cuts will come from the aforementioned entitlement programs.

The government will not be able to significantly reduce the debt it has recklessly run-up unless it does it on the backs of the American people. Many of them will be the most vulnerable; the elderly, the disabled, the poor and the unemployed.

The effects of budget cutting will be brutal and lasting. And it seems that day of reckoning will soon be at hand.

Undoubtedly, the bloated military budget should be — needs to be — significantly reduced. But that's a story for a future article.

To be continued....