Friday, August 10, 2007

Not Just Sub-Prime

A common argument among those with a more bullish view of the U.S. economy -i.e. there wont be any recession- is that while the subprime sector may be a mess, it isn't big enough to drag down the whole economy. Subprime credit losses are perhaps only $100 billion. A big number to be sure, but considering the $13.7 trillion size of the U.S. economy, not big enough to cause a recession.

But even setting aside the fact that subprime credit losses may be even bigger than that, it misses the point entirely. The point is that the problem of the bursted housing bubble is not just a subprime problem. Subprime borrowers and lenders are of course hit hardest as their finances were almost by definition most fragile from the start. In any financial crisis, those with the most fragile finances are hit the hardest.

But the bursted housing bubble is causing ripple effect that damages others too.The decline in house prices causes residential investments to continue to decline. The decline in house prices (and increaseingly stock prices too) also creates a negative wealth effect that will make all home owners -not just those with subprime mortgages- cut back on consumer spending.

Meanwhile, weak demand, falling profits, falling stock prices and higher risk premiums on corporate bonds will make corporations less willing to invest.

All of which adds up to a recession.


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