A guru is not going far out on a limb these days when he declares that the sky is falling. Real estate is in its worst funk since the Great Depression, and even the homebuilders are hard-pressed to say when things might turn around. The scare story of the week concerned a freeze on withdrawals from a Florida investment pool that manages cash accounts for state school districts and local governments. A nasty run on this fund, called the Local Government Investment Pool, drew down capital to $14 billion from a recent high of $27 billion. Similar pools exist in many other states, so it’s crucial that Florida gets it right in its efforts to restore confidence. The episode followed on the heels of another tectonic tremor in Ohio, where a judge ruled that Deutsche Bank, with its huge portfolio of mortgage derivatives, could not foreclose on a bunch of Cleveland homeowners because Deutsche was unable to show clear title to the properties .

With ominous developments like these starting to crop up all the time, and bond markets around the world growing more skittish by the day due to their interconnectedness with the U.S. subprime mortgage market, it’s easy to understand why pundits have been waxing bold to say the End Is Near. Indeed, they have asserted not merely that a recession has begun despite its evident invisibility to most economists, but that it will lead us into a Second Great Depression. Unfortunately, we find little room to disagree.

But suppose we’re wrong and the real estate market in particular is about to come bounding back. Would inveterate permabears like ourselves even be able to recognize the signs of a healthy reversal? A fair question, and it is one I have debated over the years with a pen-pal, Fred Hapgood, whom I first met as a student at Atlantic City High School. Just out of Harvard, he taught there briefly enroute to bigger and better things. A visit to his Web site, where he sells freelance articles that he has written on an amazing variety of topics, quickly persuades that Fred possesses a first-rate mind. Not surprisingly, he has always held me to a high standard of proof. In fact, he was dismissive of my deflation thesis from the get-go, and one of the articles offered for sale at his Web site even deigns to imagine ‘The Upside of Deflation.’

Hardcore Optimism

But as the threat of economic collapse has become a realistic possibility, if not a likelihood in the eyes of hardcore optimists like Fred, he has recently become somewhat more attentive to our discussion, if not to say less patronizing. I sent him an excerpt yesterday from David Rosenberg’s latest gloomy report. The Merrill Lynch economist asserts that we have already begun the ‘hard landing’ that so many of his over-educated colleagues would insist even now is extremely unlikely. Fred replied as follows: ‘I’m not interested in what [your] random collections of experts have to say. I am 65 and I have seen [doomsday predictions] go down in flames all my life. I am interested in you and in particular whether you can imagine a falsifiable situation — a situation that you personally would take seriously — for the Chicken Little scenario.’

And what would falsify my prediction of a deflationary collapse? Fred and I have settled on a statistic that I believe we can trust: bankruptcy filings. Specifically, if at any time over the next five years personal bankruptcies fall for six months, I will concede to Fred that my understanding of the economy is no better than the next guy’s – or, as Fred puts it, my ‘access to the inner workings of the economy’ will have shown itself to be ‘no more privileged than anybody else’s.’ He notes the following: ‘I am under the impression that we have defined such a test ‘ six straight months of falling personal bankruptcies.  If that happens then we are agreed that both us will consider the proposition cited above disproved.  If I’m wrong, if upon reflection you don’t consider that a fair test, let me know and we will work on it.’ A little wiggle room that, unfortunately, I doubt will be needed.

And now the government is hoping to raise the price of real estate by artificially pushing down mortgage rates. Does anyone actually think this is the best way to use what remains of America’s dwindling capital? Not that such a hair-brained scheme could possibly succeed. NASA might just as well try to launch a trash can into orbit by stuffing it with cherry bombs. One reason the plan must fail is that no amount of mortgage stimulus could possibly counteract the huge asset deflation that has already occurred worldwide. Our colleague Bill Buckler of The Privateer recently put the number at $52 trillion dollars, including $38 trillion in stock-market losses. That’s nearly 80% of global GDP, but we think it greatly underestimates the actual amount of deflation, since many assets have yet to be marked to market. New York City, for instance. Real estate there is virtually certain to collapse because the top tier of income earners have become unemployable. Can the U.S. Treasury keep thousands of condos that once sold for $5 million to $25 million from falling by 50% or more? We think not.

The Government’s intention is to use the “clout” of Fannie and Freddie, such as it is, to “encourage” banks to lend at rates as low as 4.5 percent - more than a full point below current market rates. Question: What would you do with the extra money if you could refinance your home right now at 4.5 percent? Pay down debt, right? You might even answer Paulson’s prayers by blowing it on a Chevy Tahoe. Whatever the answer, unless the saved money is invested in productive capital, it has no chance of increasing the nation’s wealth. And yet, that is the Big Lie the Government is now attempting to sell us �’ that by misdirecting yet more investment dollars toward the housing sector, we’ll somehow be better off in the end.

Here is another reason why the plan cannot succeed: Real estate’s fatal problem lies at the margin. Perhaps 25% of American homeowners are underwater on their mortgages, and they are the ones who are going to drag the rest of the market down. This is what triggered the subprime crisis. In fact, most subprime mortgage were not in trouble, but the relative handful that were, undermined the entire market. So what does that imply for the Government’s whacky scheme to suppress mortgage rates? Well, if the money is going to help those who are in the worst shape, it would have to go to homeowners who are underwater – i.e., those who could not qualify for refinancing. Policymakers apparently are hoping that helping homeowners who are in good shape will pull up the home values of those who are underwater. This is a very risky bet, for the reasons cited above. It would probably be cheaper in the end for the Treasury (i.e., taxpayers) to mail out checks to every homeowner for 20% of the amount of their mortgages. (If you’d like to have Rick’s commentary delivered free to your e-mail box each day, click here.)