A mid-year economic status report

Economic growth in the United States is sluggish, and there are several reasons to be pessimistic about macroeconomic performance in the balance of 2008, if not beyond.

The adjective “macroeconomic” is crucial. We should never forget that, even when major sectors of a country’s economy are experiencing hard times and macroeconomic statistics are gloomy, there are always great opportunities for entrepreneurs and investors to be found in various microeconomic niches.

Another point to understand is that markets know far more than any mere economist. Inevitably, the next bull market in stocks will be born and economic activity will improve, even while economists, with our foggy crystal balls, continue issuing dismal prognostications.

That being said, it seems to me that the piper now needs to be paid for decades of economic mistakes and that painful economic corrections and adjustments will continue for the foreseeable future.

Here are some of the economic chickens now coming home to roost:

1. The housing bubble bust may weigh on us for years. While housing prices rose from 1998 through 2005, between 1.25 percent and 3.25 percent of GDP consisted of spending financed by homeowners withdrawing equity from their houses.

This debt-financed spending splurge was painless as long as prices of houses continued to soar. However, now that home prices are deflating, home equity credit has contracted.

It was 3.125 percent of GDP in 2005, 2 percent in 2006 (the most recent year for which I have figures) but certainly far lower today.

Housing prices, on average, have fallen 15 percent from their peak already, but in spite of lower prices, the inventory of unsold new homes has continued to rise, now standing at an 11-month inventory.

The mortgage delinquency rate rose to 6.35 percent in the first quarter of this year, the foreclosure rate doubled in one year to almost 2.5 percent, and according to the Census Bureau, approximately 10 percent of houses built since 2000 remain unoccupied.

To give some historical perspective on the size of the housing bubble, residential property in the United States hovered around the same real value for the century spanning 1890 to 1990.

After 1990, however, housing prices doubled in real terms. If those prices return to anywhere near their historical average, then the 15-percent decline so far is just the beginning.

One enormous effect of the shaky housing market is that the mortgage-backed securities derivative crisis in the financial industry continues unabated. In fact, the financial crisis has gotten worse.

Investment analyst Porter Stansberry asserts that Fannie Mae and Freddie Mac, the two giant federal mortgage agencies, already have negative equity (i.e, are technically bankrupt) and that their stocks will fall to zero.

2. Decades of Congress obstructing the development of domestic energy resources has produced $4 per-gallon gasoline.

Among the casualties: Ford and General Motors may be mortally wounded, and prices of many products are rising to cover increased transportation costs.

These higher costs are likely to eat into corporate profits and lead to lower stock prices.

Thus, Americans have been put in the uncomfortable position of watching the prices of their primary assets (homes and stocks) fall while the prices of the things they need to buy (food, fuel, miscellaneous consumer products) rise.

3. The cost of the Iraq war. This isn’t a comment about the ethics or geopolitics of the war. The economic fact is that the huge spending on this war has weakened and will continue to weaken the dollar, just as previous wars had inflationary consequences.

The stock market, which tends to discount (anticipate) the future, is floundering now. Besides the economic conditions just described (none of which, alas, is amenable to a quick fix), the market may be foreshadowing political problems.

Monetary policy is paralyzed. The Fed has been checkmated. It can’t raise interest rates to defend the dollar, because higher rates would aggravate the housing decline and related financial crisis.

Nor can it lower rates to stimulate activity, thereby weakening the dollar and causing the dollar-denominated prices of oil and other essential commodities to rise.

The outlook for fiscal policy is also discouraging. The next Congress may be controlled by a veto-proof majority of radical anticapitalist redistributionists.

Neither presidential candidate has a plan to rein in the rapid growth of federal spending, which has been cannibalizing the private sector.

Both candidates pay homage to global-warming mythology and advocate imposing cap-and-trade ceilings on fossil-fuel consumption, a folly that can only raise energy prices even higher.

Neither candidate seems willing to let free markets make the painful adjustments needed to correct past mistakes.

In sum, the economic outlook for the coming months is dicey. Appropriate advice for most Americans would be Warren Buffett’s two rules of investing: 1. Don’t lose the money; and 2. pay special attention to rule #1.

[Dr. Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision & Values at Grove City (Penn.) College.]