Three reasons why the US faces recession in 2008

Presidential election years are not usually recessionary, but several factors are colliding in a perfect storm that could make 2008 a very dark year indeed for the US economy.

Presidential election years usually are not recessionary but next year will be an exception. Several economic factors are colliding in an almost perfect storm to markedly slow the general economy and the stock market.

More ripples from the subprime mortgage fiasco

The most important signal flashing recession is, of course, the subprime mortgage fiasco. After years of monetary inflation on the part of the Federal Reserve, individuals and families with poor credit were suckered into low-down-payment/low-interest adjustable mortgages that simply cannot be maintained or repaid under current conditions.

Their incentive is to sell the property quickly before their equity evaporates or the financial institution repossesses it. Yet the massive oversupply of homes and condos for sale has pushed prices down at a record clip and made additional foreclosures even more likely. Next year, unfortunately, will be the Year of the Auction.

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The financial institutions have also been punished well sort of. Various institutions including hedge funds that hold these poorly performing debt obligations have been forced (by accounting rules) to 'write down' the value of these assets, take huge paper losses in the bargain, and pull in their financial horns.

Thus, any near-term recovery in housing must now fight a record supply availability, falling prices, higher insurance costs and restricted credit a near-term impossibility in my view.

Moreover, the slowdown in residential and commercial construction will send secondary ripple effects throughout the economy. Laid-off construction workers don't spend money. Construction and home furnishing suppliers sell less output and make fewer investments. Even local governments will be pinched by declining property-tax assessments and fewer developer fees. Things are likely to get worse before they get any better.

Sky-high crude oil is near-term recession risk

The second major factor indicating a near-term recession is the sky-high price of crude oil and refined product. Pushed upward by world-wide speculative Middle East war fears and increases in demand (especially from China), increasing energy prices act as an inflationary 'tax' on domestic production and consumption throughout the market economy.

Higher costs of production will lower profits; higher prices will reduce some consumption. The only good news here is that any substantial economic slowdown in 2008 will eventually moderate the price of oil and other commodity prices as well.

Dollar devaluation is real wild card

The third factor in the current recession scenario and the real wild card is the continuing decline in the value of the dollar in international money markets caused by our Iraq blunder and the Federal Reservegenerated oversupply of dollars. Some economists would argue that a devalued dollar is good for US exports, and thus positive for the economy as a whole. I disagree for three reasons.

First, the bulk of crude oil purchases takes place in dollars; a falling dollar translates into still higher crude oil prices. Second, the US dollar is the major reserve currency of the international monetary system and dollar-paying investments (such as US Treasury bills and bonds) are held in massive amounts by foreign banks and governments. Dollar devaluation makes these investments less attractive and any disinvestment in these areas would sharply drive bond prices down and increase interest rates.

The third reason why dollar devaluation makes recession more likely is that it effectively prevents the Federal Reserve from pushing US interest rates much lower. Any additional Fed easing (inflation) would be seen as a signal of even further future dollar devaluation and even higher dollar prices for oil.

Unfortunately, we will not be able to 'inflate' our way out of this recession this time. We will simply have to take our lumps and let market forces liquidate the bulk of the malinvestments caused by the unprecedented Greenspan money bubble. This liquidation process will not be pretty but it is necessary to restore a sustainable economic recovery in the years ahead.

By Dominick Armentano for the Mises Institute