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America's Two Roads to Recession

Machiavellians believe that governments manipulate their national economies to create the illusion of economic well-being. The governments' goal is to ensure political stability. As with any set of perceptions, reality changes the public illusion. Unfortunately, the Americans have hit two reality bumps on their yellow brick road to the illusion of global well-being.

The Home Real Estate Perception is Changing

For middle class Americans, residential real estate has proven to be the only effective conservation hedge against inflation. Mortgage rates are at or below the U.S. inflation rate. Mortgage interest payments are tax deductible. American homebuyers can avoid paying taxes on their profits from the sale of private homes. In the past year, U.S. Residential Real Estate prices have risen an average of 15%. Everyone feels secure and content under this hard asset security blanket.

In the short run, debt is good for the economy, It creates buying which in turn creates jobs. Because interest payments on personal loans aren't tax deductible, American homeowners have tended to finance their debt by taking out second and third mortgages on their homes. Because single family residences are seen as excellent investments, Americans are buying second homes and going into massive debt to do so. Everyone's betting that the real estate boom will continue to appreciate and the hard asset house is an effective security blanket against personal excessive debt.

In the past couple of months, there has been a deluge of media articles arguing that the Real Estate Bubble is about to burst. These articles are telling the Emperor that he is naked. The media drumbeat is having its affect on the public's real estate perception. Real estate investors are less numerous. Homeowners are more inclined to put their houses on the market. The Demand/Supply equation is slowly moving toward over supply. This will force home prices down. Debt ridden homeowners will be under pressure to sell and the residential market will fall faster. Once an economic move starts, it tends to gain momentum until the forces that create it dissipate.

What happens when a real estate bubble bursts? The last time it happened in the States was the Commercial Real Estate collapse in the late 1970s and early 1980s in Texas and Oklahoma. The market failed because of an over supply of office space. Investors lost fortunes. The Savings and Loan Industry went into a crisis that required a trillion-dollar taxpayer bailout. It was the primary cause of the 1981-82 sixteen-month severe recession. In the 1990s, the real estate bubble burst in Japan. The result was the 1997-2001 Japanese recession.

Exploding real estate bubbles create illiquid markets. There is less money being spent on buying things. With fewer sales, businesses layoff employees. The result is a recession.

Fifty Dollar Per Barrel Oil

Since WWII, the West's stated goal has been to provide a higher standard of living for the rest of the world. This is a goal that almost everyone can support. It's the logic of foreign aid programs. Unfortunately, there aren't enough resources to ensure a Western Standard of Living for everyone, or even for the majority of people living on our little rock in space.

The scramble for the good life has created unmanageable environmental problems from the Amazon to the Yangtze. It has created mass movements of people from the countryside to the cities. The demand for resources is an underpinning cause of conflict from water issues in the Middle East to land issues in Africa. And, it's the reason that Americans are paying higher prices at the fuel pump.

A good example of increasing demand for oil is the People's Republic of China. They are now the third largest oil consumer, behind the U.S. and Japan. In recent years, China has been undergoing a process of industrialization and is one of the fastest growing economies in the world. With real gross domestic product growing at a rate of 7% a year, China requires increasing amounts of oil to sustain its economic development. Its oil consumption grows by 7.5% per year, seven times faster than the U.S. This model is repeated with lower growth numbers for countries from India to Taiwan. Without a Recession, the demand for oil will continue to grow at least at present rates into the foreseeable future.

The demand for oil exceeds the long-term oil supply. Nearly 2/3rds of the world's known oil reserves are found in 5 countries on the Persian Gulf: Saudi-Arabia (25%), the United Arab Emirates (10%), Kuwait (9%), Iran (9%) and Iraq (10%). There is little prospect of finding massive new oil reserves. Most petroleum experts believe that known oil reserves will decline from present levels. Thus, OPEC has little incentive to increase short-term production to offset sustained global demand for oil. The oil OPEC sells is unlikely to be replaced with new reserves.

Fifty-dollar oil means more than three-dollar gas prices at the pump. Farmers need oil to produce crops. The goods we purchase must be moved to stores by trucks that require diesel. Higher oil prices means a higher inflation rate. A good rule of thumb to find the real inflation rate is to take the Government's Consumer Price Index (CPI) and multiply by two. The reason is the CPI, like most Government statistics is heavily weighted to create a positive public perception of the economy. The doubled CPI gives you the approximate real inflation rate for the year. For years, the CPI has hovered around 3%/year. Most of the business and financial community assumed a six- percent real inflation rate. Currently, the U.S. Department of Labor projects a 4.5% CPI for 2005. This would mean a real inflation rate of 9%.

A fifty- percent increase in inflation means a thirty three percent reduction in buying, until the buyers get a fifty percent increase in their incomes. Reduced buying means layoffs and a Recession. So salary increases are unlikely and thus a Recession is the logical outcome of fifty-dollar oil.

The American economy drives the world economy. An American Recession means a World Recession. In my opinion, that recession will be evident within the next year or so. Be prepared for economic stress between 2006 and 2008 and probably longer. On the positive sideBusiness Management Articles, the American government will eventually regain control of the Economic Illusion and we will eventually find ourselves comfortably wrapped in an illusionary security blanket. At least until the American Illusion hits more reality bumps on the yellow brick road.

Article Tags: Real Estate Bubble, Real Inflation Rate, Real Estate, Inflation Rate, Security Blanket, Estate Bubble, Real Inflation

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He has been the Managing Director of Beowulf Investments since 1981 and is the Executive Director of the Global Village Investment Club

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