George Bush and the Federal Reserve have been telling investors not to panic: the housing crisis won't touch the broader economy. But recent news has proved them wrong.
In August, layoffs surged to 79,459 from 42,897 in July, more than double what economists had predicted for the month. Nearly half of those layoffs were attributed directly to the financial industry and the mortgage crisis. Which means that George Bush and the Fed were wrong: a large number of those layoffs came from the broader economy. The housing downturn is having a wider effect than predicted.
Common sense tells us how this could happen. The housing market has been full of speculation--investors and developers buying second, third, and fourth houses to fix up and resell while housing values skyrocketed. All this purchasing, selling, and remodeling activity created jobs in the construction, service, and retail industries, and those jobs are now being lost as the bottom drops out of the housing market.
There's another, more ominous explanation for why the economy is experiencing a larger downturn than expected. The prevalence of cheap money (i.e., low interest rates and easy loan terms) that fueled the run-up in the housing market may have had a similar impact on corporate balance sheets.
Post-9/11, George Bush put forward an economic stimulus package that included tax cuts for corporations and a controversial--though not widely discussed--tax amnesty for multinational corporations that use offshore accounts to shelter their international profits from US income taxes. For a short time, multinationals could repatriate (bring back into the US) their international profits without having to pay a dime in US taxes. Bush sold this bill to Congress as a means to stimulate the job market: corporations could use this "free money" to create jobs.
Most corporations were very happy to repatriate their profits, but few used them to hire more workers. Most profits were used to fund mergers and takeovers (which often lead to job losses), capital purchases (buying machinery and equipment), and stock buy-backs. Buying back company stock was a particularly popular move, because it boosted the price of the company's stock, which made investors happy and made further mergers and acquisitions easier.
But corporations may have became hooked on this artificial means of growth. In the past couple of years, low interest rates have tempted CEOs to borrow money to continue buying back stock and to finance even more mergers and acquisitions. This has artificially driven up the stock markets. In addition, many corporations may also have run up unsustainable amounts of debt on their balance sheets.
As more and more folks succumb to mortgage defaults and declare personal bankruptcy, or decide to struggle on with their huge monthly mortgage payments, consumer spending will continue to fall. Consumer spending is the lynchpin of the US economy: without it, corporate profits suffer, without exception. Once corporate profits plunge, the companies that have fallen into the cheap money trap will have a hard time making payments on their debts. Then it'll be downsizing time, and we'll really see a lot of layoffs.
Currently, economists are predicting that there's a 50% chance that the US economy will undergo a recession next year. The odds are probably greater than that. And if many corporations have unwisely engaged in risky borrowing practices, the recession could be deep and prolonged.
At the same time, state and local governments will take a pounding as the economy worsens. Here in Washington State, our local governments rely heavily on the general sales tax. With a plunge in consumer spending, our state and city governments will be hit with deficits just when they'll need extra money to deal with a growing homeless and jobless population.
(The housing downturn is expected to reach us eventually, and maybe quite soon. The inventory of unsold houses in the Puget Sound area is growing bigger each month. Local newspapers are now reporting that Seattleites are having trouble getting mortgages because of tightening credit. The next indicator will be falling prices--coming to your neighborhood soon. After all, if San Francisco can see their housing prices sink, so can we.)
We should remember, too, that 2008 will be an election year. Voters are always quick to punish the party in power whenever the economy goes sour. In the case of the Republicans and George Bush, the punishment will be well deserved.