What's pushing the US into recession?

What's pushing the US into recession?

By - Vivek Kaul
The consumption binge is over

MUMBAI: It was half past one in the night and I was about to go to sleep when the phone rang. "Do you feel like going out for a long drive?" she asked.

"A drive at this hour? No, thanks, I'd rather sleep," I said and hung up.

Ten minutes later, the door bell rang. I knew it was her, but opened the door nonetheless.

"Good to see you awake. Now, tell me about home equity loans," she said. "I have been reading about them, but can't quite understand how they work."

Anyone else and I would have exploded. But, somehow, she always had her way with me.

"Ah, home equity loans. it's when you borrow against the value of home equity," I said yawning.

"And what is home equity?"

"It is the difference between the market value of your house and the portion of the home loan taken to buy it, which is still to be repaid. So let us say the current market value of a house is $400,000 and the home loan to be repaid is $300,000, the home equity works out $100,000. The loan you take against this $100,000 is a home equity loan. Now can I now go to sleep?"

"Hang on, hang on. How are home equity loans linked to the US economy?"

I feel anger welling up, but can't quite scream. "Pest you are," I say. "Interest rates in the US were reduced after the dotcom bubble burst. By mid-2003, they had come down to as low as 1%. And that is where they stayed for the next one year. This made borrowing very easy and people used this as an opportunity to take home loans to buy homes. Since demand far exceeded supply, this ensured that the home prices started to rise. Once home prices started to rise, people realised that they could use their increasing home equity to borrow more. And that is precisely what they did. The money borrowed against home equity could be used for all kinds of things. It could be used for home improvements, going on a luxurious holiday, financing your children's education or just going on a sho pping binge. The bottom line was that the money was being spent and once money was spent, consumption increased and the economy kept growing at a good pace," I explained.

"Hmmm, that's terribly interesting. What happened after that?" she asked. "As interest rates kept coming down, people realised that they could get a greater home equity loan and continue paying the same equated monthly instalment to repay the loan. So they kept refinancing their home equity loans. At the same time, the home prices kept going up and that meant home equity kept going up and hence more home equity loans could be taken on. And that's what precisely happened. A large amount of consumption binge in the US was financed through home equity loans. This is what helped the US companies to keep growing. At the same time, countries like China and Japan also benefited. An estimate made by Martin Feldstein, an economist at the Harvard University suggests that home equity worth $9 trillion has been withdrawn. The banks and other financial institutions which were lending the money also kept playing along because interest rates were low and hence money was cheap. And when money is cheap, there is an incentive to keep lending until the last borrower has been exhausted."

"But from what I hear, the American economy is in a lot of debt. How did they get to borrow so much money?"

"All that consumption benefited countries like China, Japan and Russia, etc. These countries earned US dollars. The dollars made their way back into the US as these countries bought financial securities issued by the US government. The US dollar is the international reserve currency and most countries till very recently liked to hold their reserves in US dollars. So, they could either let the US dollars lie in their vaults and not earn any interest, or invest in US government financial securities and hope to earn some interest. Since the demand for US government securities was very s trong, the interest rates offered on US government securities were very low. So, in effect, these countries lent to the US government at an extremely low interest rate. The government, in turn, lent to banks and the banks to consumers at lower rates. That's how the chain worked - the US consumed, other countries earned dollars and the dollars came back into the US economy."

"So is that chain about to break now?"

"Home prices in the US have been falling since the beginning of 2007. Thus, there is no more home equity to encash. So, consumers have moved on to using their credit cards to consume. Now, credit cards also cannot be used for eternity. This means, the consumption binge in the US has more or less ended. So, the consumption-based US economy is headed towards a recession. Once that happens, countries like China and Japan, which export a lot of stuff to the US, will be hit hard. Also, the US dollar's status as the international reserve currency is a little shaky these days. And a lot of countries have been quietly moving their reserves into other international currencies such as the euro. What this means is that the other countries will not be ready to lend to the US at lower interest rates as they were in the past. And that will also have an impact on US consumption."

She was nodding in agreement. The smile was loud and clear.

k_vivek@dnaindia.net