With summer narcolepsy beginning to infuse Wall Street like embalming ether, we’ll turn our attention once again to the far more interesting topic of the housing bubble. The bubble surely exists, no matter what anyone says to the contrary, but one wonders whether its inevitable collapse is being delayed by anticipation itself. Anyone not from Mars will have noticed by now that the mainstream press has been devoting more and more ink to the subject. Just last week, USA Today splashed its money page with a feature on how owners of high-priced real estate can “cash out” before the crash. And the staid Economist, rarely given to sensationalism, believes “the whole world economy is at risk…the biggest increase in wealth in history was largely an illusion.”  

True enough, as any economist who hasn’t forgotten what he learned in college could tell you. But one suspects that it could take a while, and some genuinely hard times, for the illusion to lose its power over an American middle class with so many material blessings to count. For the time being, though, with mortgage rates down near 5.5%, and 0% balance-transfer offers arriving in the mail regularly, it seems unlikely that the economy is going to run out of gas in a mere month or two. To be sure, we have probably seen a peak in discretionary spending, as well as in GDP growth. However, the real damage will come when consumers drastically curtail buying out of fear the economy is sinking. Not right now, though. With money still relatively loose, and the dollar’s buying power waxing in global markets, the economy-chilling kind of fear will probably remain in remission at least till autumn.  

Regardless, we shouldn’t allow ourselves to fall sway to the illusion that the Fed has tight control of credit markets, much less of the U.S. economy. The following note, from an astute reader, explains why Alan Greenspan’s worst nightmare may soon come to pass:

“From a practical stand point the ‘conundrum’ facing the Fed is simply that the bond markets are increasingly less likely to pay homage to Fed pronouncements or rate movements.  Monetary policy has always relied on a voluntary subjugation of primal market urges. Banks are under no regulatory requirement to abide by Fed wishes on overnight lending rates, etc. And the bond market is essentially outside of the Fed’s mandate.  By extension, however, the banks have traditionally followed the Fed’s advice and, further, the bond markets have then acted accordingly.  In the new world of non-bank lending, the participants increasingly are ignoring the Fed moves and pronouncements. That is the conundrum.  So, do we expand the feds mandate or let the process takes its natural course of rendering the Fed irrelevant? 

“The Fed has traditionally followed the bond market with its monetary policy when it saw that it was on the losing end of the rate game.  So, in that sense, regardless of regulatory mandates, the relationship between the government-mandated monetary policies and the private monetary actualization of them – that is, between the Federal Reserve banks and their members – has always been symbiotic.  More importantly, so has the relationship between short rates controlled by the Fed and member banks, and long rates determined by bond-market participants.  This symbiotic relationship is in the process of breaking down as the Fed and the banks have a shrinking percentage of the direct-loan business.  In other words, the bond market and private markets of all asset classes by extension are increasingly willing to ignore the Fed.”

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Debt Burden

I've asserted here before that the mechanism by which deflation will tighten its grip on the economy is an increase in the real burden of debt. This implies that even if mortgage rates were to remain under 6%, they would crush debtors in times when asset values and wages were falling. Neither is occurring now, but as you can see in the charts below, from Bronson Capital Markets Research, the household debt service ratio has been moving streadily higher since 1994 -- even without the inclusion of several hundred billion dollars of security margin debt..  

(Click on chart to enlarge)