Saturday, April 01, 2006

Time to pay the piper

Two-thirds of GDP growth is spurred by consumer spending. Over the last several years, that consumer spending has come largely from consumers borrowing on their credit cards and through home equity loans.

As long as the value of homes has risen and credit card interest rates have remained reasonable relative to borrowers’ incomes, consumer spending has continued to drive forward the economy.

But there is a downside to all this borrowing and spending. The Fed feels compelled to control inflation. And it has tried to do so by raising interest rates 15 times in the last several years. This raising of interest rates is beginning to reverse the direction of the housing market. And as the housing market experiences greater supply than demand, housing price increases have slowed. Thus the ability of consumers to borrow more money against the value of their homes has evaporated.

Moreover, with roughly a quarter of all mortgages in the adjustable rate category, consumers will find themselves paying more for their monthly mortgage payments when the mortgage rates reset over the next couple of years. The reset is likely to happen even as the value of the homes, which banks use as collateral for the mortgages. declines.

As home foreclosures continue to rise, banks are likely to sell these homes quickly to minimize their bad loan write-offs. This sudden addition to the supply of real estate is likely to create further downward pressure on real estate prices.

What will be the source of future economic growth? The answer depends on where you sit. For consumers, there will not be economic growth. Anyone working in the US automobile industry faces job and wage cuts with limited opportunities for future employment. And anyone who in the past depended on rising real estate prices to pay for healthcare, home heating and cooling, and gasoline will need to cut back.

By contrast, these are the best of times for private equity firms who have been able to use debt to finance the acquisition -- at a discount – of divisions of underperforming corporations, such as GM, spruce them up and sell them at a profit to public shareholders, corporations, or other private equity firms.

Economic history aptly demonstrates that growth based on borrowing is short-lived and has dire consequences. By contrast, economic growth based on innovation leading to an expanded supply of equity can spur new industries, create new jobs, and enable more workers to become entrepreneurs.

The current decade’s growth has been driven by borrowing. And the odds are good that we will see in the next five years many of debt’s negative consequences.


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