Our mismanaged economy is in a bind

The LA Times reports today that

The supply of unsold U.S. homes ballooned to an 18-year high in August as demand for existing homes fell to a five-year low, according to a report by the National Assn. of Realtors. The Washington-based trade group blamed the onset of the global credit crisis last month for the drop in sales. [Snip]

Also today, a separate report indicated that home prices were falling at an increasing rate. The closely watched S&P/Case-Shiller home prices index, which tracks results in metropolitan areas and is considered a leading measure of U.S. single-family home prices, showed an annual decline of 4.5% for the 12 months ended in July, representing the biggest drop since 1991.

Remember that

GDP = Consumer spending + Investment spending + Government Expenditure

and the only one of those three which has been growing since 2000 has been consumer spending. Se we need to look at the sources of money that has allowed that consumer spending.

Since wages have not gone up in that time, Consumption (and thus the total Gross Domestic Product (GDP)) has depended on the increase in home prices (provides cash) and new home production (provides wages) to keep the economy at its already rather anemic growth level.

The drop in sales of homes and in home prices strikes at the heart of both available cash (second mortgage or sale of the house) and at employment. That's why the Federal Reserve dropped the federal funds rate by half a percentage point, to 4.75 percent last week.

The stock market, in a mass stampede based on a fantasy made from hope over reality, immediately increased sharply. Unfortunately, the dollar dropped sharply against the Euro and has dropped to match the Canadian dollar for the first time in thirty years. The price of oil by the barrel is the highest it has ever been in dollar terms, and this is not supply and demand for oil. It is a precursor of inflation since all the goods we import will get more expensive.

The Fed's reaction to inflation is to increase interest rates and slow down the economy, but that does not work when the inflation results from a drop in the dollar. So we are going to see either inflation or a slowed-down economy and there is nothing the Federal Reserve can do about it using monetary methods.

Inflation might be preferred to keep unemployment low, but it will also kick up the interest rates as lenders in anticipation of increased inflation start to increase the interest rate they charge for loaning money.

If the government can take actions that puts the credit markets back onto an even keel (and no other agency is large enough to do anything at all) and the whole problem can be limited in time, maybe it won't be severe. Whether that is even possible is beyond my limited knowledge.

However it turns out, I think 2008 is going to be an economically rocky year.