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When Economic Tailwinds Become Headwinds

When Economic Tailwinds Become Headwinds

For the last several years U.S. economic growth has ridden the tail winds of falling interest rates and rising asset prices (particularly, residential real estate). Since the U.S. economy heavily depends on consumer spending, as these winds subside, it is in danger of hitting the “mother of all air pockets.???

Falling interest rates have enabled homeowners to reduce their monthly mortgage payments, freeing up extra income to finance other discretionary purchases, which would otherwise have been unaffordable. In addition, lower interest rates have directly reduced the cost of financing purchases of big ticket items, such as cars, appliances, and consumer electronics. On a national level, because of the extensive reliance of short-term debt by the Federal Government itself, the budget deficit is much lower than would other wise have been the case, making possible the recent tax cuts, and the consumption they have spurred.

Rising asset prices have also enabled homeowners to turn paper real estate profits into real consumption, with the burden of larger mortgage balances being eased by the availability of lower interest rates. The resulting real estate “wealth effect??? has encouraged “richer” homeowners to spend money that they might otherwise have saved, bringing future consumption into the present. Further, the ability to leverage appreciated assets at low interest rates has also allowed overly-extended borrowers to stay one step ahead of creditors.

In cannot be seriously doubted that many Americans now owe their livelihoods directly to the extra consumer spending lower interest rates and rising assts prices have financed. In fact, more than fifty percent of the profits of fortune five-hundred companies are now derived directly from financial services. When interest rates rise and housing prices fall, these tail winds will turn into formidable head winds. Higher interest rates will increase the cost of buying on credit, directly reducing consumer spending, while the proliferation of adjustable rate mortgages will reduce the share of household incomes available for discretionary purposes. In addition, higher interest rates will increase the cost of funding the growing national debt. As the annual budget deficits grow, the resulting higher taxes or reduced government spending will further undermine consumer spending.

The reverse wealth effect will also impose significant barriers to consumer spending, as households strive to repair their personal balance sheets. Falling asset prices will also sever the life lines between over-leveraged Americans and financial solvency. The resulting surge in bankruptcies and foreclosures will not only cause significant losses for Fortune 500 companies in particular, but wide-spread job losses throughout the general economy, especially in the service sector, which is so dependant on consumer borrowing and spending.

Falling corporate earnings and rising unemployment will only exacerbate a budget deficit already expanding under the stress of higher interest payments. Since a growing share of those payments flow abroad, the current account deficit will swell as well, putting added downward pressure on the dollar, while exerting additional upward pressure on consumer prices and interest rates. This self-perpetuating spiral of rising deficits, interest rates, consumer prices, and unemployment, producing falling GNP, corporate earnings, household incomes, stock and real estate prices, means that the coming economic head winds will more likely prove to be a brick wall.

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