Economic history is a history of bubbles - and of bursts. The great disservice being done to Americans by the financial media is that they are not being offered the opportunity to learn from what is going on.



The global economy is changing, and the U.S. dollar is on the front lines of change. When we take a look at history, we see how past events have affected everything. The Black Death created a devastating labor shortage throughout Europe for decades. Christopher Columbus' voyages turned trade upside down for hundreds of years.

The Industrial Revolution moved economic power in ways that continue to affect economic balances to this day. And now we face another great shift, away from the U.S. dominance of world markets and toward new leaders - China and India.

The economic reality - a type of geography - is changing. As a consequence, real estate speculation in New York, Chicago, and Los Angeles may be replaced with more global interest in the new real estate markets - in Beijing, Shanghai, and Bombay. Who knows? We can only anticipate how changes will occur based on what we observe today. Does this mean the age of America is ending? No, it simply means that economic muscle will be flexed by someone else in the future. This is a trend. And like all trends, they are more easily viewed in historical perspective but harder to judge from their midst.

When we look at trends in dollar values, we can observe that incomes have not declined. That's great. But we also see that prices have risen faster than incomes. So with decreased buying power (caused by this disparity) we have seen a decline in income in terms of what really counts. It takes more dollars to buy the same thing (in other words, prices are higher) but incomes have not risen to meet that price inflation. That's what happens when the value of the dollar declines.

Economic history is a history of bubbles - and of bursts. The great disservice being done to Americans by the financial media is that they are not being offered the opportunity to learn from what is going on. They are losing buying power, but apart from a few painful spikes at the gas pumps, it's invisible.

In the Great Dollar Standard Era, the problem is global. While there is, of course, more to it than just the value of the U.S. dollar, here is how it works:

1. The dollar's value falls due to Fed policy, liberal credit, and artificially low interest rates. 2. Eventually, we cannot afford to buy as many foreign goods. 3. Foreign manufacturers, unable to sell at previous levels, have excess inventory, which causes an inflationary outcome. 4. Foreign governments, in an effort to counteract this inflation, blame the fallen dollar for the problem and begin moving out of U.S. instruments. 5. As debt returns to the United States, our system is unable to absorb it. This creates more severe recession at home.

The whole thing is connected. This is similar to what happened worldwide at the end of the 1920s.The worldwide depression had numerous aspects, but most notable among them were two things: a huge transfer of funds from World War I reparations, and far too much credit that went beyond the borrowers' ability to repay. All of that credit - essentially, funny money - also creates a fake demand.

We see the effects of this policy in housing as severely as anywhere. The whole mess is traced back to the origin - a Fed policy encouraging debt spending as a means to artificially create the appearance of productivity. This Fed policy has included four aspects:

1. The Fed has lent money below inflation. Fed lending rates have been far below inflation (even as measured by the consumer price index, not to mention any real inflationary measurements). In a very real sense, the Fed has lost money on these loans. When inflation is higher than the lending rate, it is a loss. Just as a business cannot stay open when it sells goods below cost, the Fed cannot continue to hold the view that it isn't real money. The point is, the money lent out at bargain rates is real credit, and that is corrupted when it is given away cheaply.

2. The low interest rates have created the mortgage bubble without any corresponding investment. It is basic: if you borrow money to invest in productivity (new plants and equipment, for example) it is a profitable use of money. But those low interest rates have gone, instead, into cheap long-term mortgages. Current homeowners have refinanced, and many first-time buyers have gotten into the market because low rates make housing affordable.

3. The mortgage bubble has inflated the housing market in an exaggerated fashion, creating the illusion of equity. All of that cheap money has created two troubling changes in housing. First is higher demand for owner-occupied housing based on the low cost of borrowed money rather than on any real market forces. Second is the resulting equity buildup from rapid expansion of market value in residential property. But it is as fake as the low interest rates. Like all pyramid schemes, the whole thing will eventually crumble under its own weight. We do not have an endless supply of new home ownership demand; quite the contrary. The baby boomers mostly own homes already, and a smaller population of people coming into home ownership age will ultimately result in an oversupply of housing stock. Once the mortgage bubble bursts, we can expect to see several consequences:

? Defaults on existing loans. As rates on variable mortgages begin to rise right up to their cap rates, we'll see many of those marginal loans go into default. Many Americans are barely able to afford the mortgage payments they are making based on low interest qualification. But as the Fed finally faces reality and allows interest rates to rise, those variable increases will kick in as well. Many existing loans will be defaulted as a result.

? Reduced market value from oversupply of housing. The oversupply in building will become obvious, but suddenly. At some point, when the bubble bursts, everyone will realize that too many homes were built too quickly, and the anticipated demand simply isn't there. The result: those skyrocketing market values will disappear.

? Abandonment of no-equity properties. The reduced market value in homes is not going to be limited to a simple supply and demand cyclical change. For investors, reduced demand and flat or falling prices may be viewed as a cyclical and natural effect. But when the supply-and-demand cycle has been manipulated through interest rate policy, we have to expect a more wrenching effect. For those who enter into the housing market when prices are inflated, the day arrives when they realize that real equity is below zero.

There remains no incentive to continue making payments, notably when lenders are raising rates and when the dollar's buying power is tumbling. In such a severe condition, marginal buyers are going to simply walk away from their properties. Why stay when there is no equity - or worse, minus equity?

? Secondary market fallout from these changes. Where does all of that mortgage debt end up? It isn't held by your local bank or savings and loan. It all gets sold to Ginnie Mae, Freddie Mac, and other mortgage pools, who then package it up and sell it on to investors, many of them from Europe and Asia. Imagine how those pools will perform when the foreclosure rate rises and when - at the same time - market values fall.A high rate of foreclosures in an overbuilt market spells disaster in the housing sector.

While a normal supply and demand cycle may last three to five years on average, this downturn could be severe, going much longer into the future.The actual length of the housing recession would depend on how decisively the Fed will be willing to act and to fix the problem.

4. The lack of investment and a flat manufacturing trend are damaging the U.S. competitive position in the world market. Imagine an economic situation in which enterprising homeowners refinanced their homes when rates fell, invested the money in small business expansion, and created an internationally competitive economic climate.

Well, this is the rosy picture the Fed hopes will eventually emerge from its monetary policies. By artificially lowering interest rates and enabling homeowners to get at their equity, the idea is that on a broad range of economic trends (housing, business investment, savings, etc.) there will be a strong growth spurt, an economic recovery that will return the United States to its leading position. But the lack of investment is doing great damage. The whole thing is credit-based, starting with the Fed losing on below-inflation loans and ending up with credit based spending but no real productivity.

It appears that Fed policy has been premised on the idea that lower interest rates bring down inflation. Yet there is no evidence of that in economic history. It has always been an effective policy to raise rates to slow down inflation, just as lead rods are moved into the radioactive core of a reactor to cool down the chain reaction.

Higher rates put a damper on spending. This has been recognized widely, so the Fed policy - based on the idea that lower rates are "good for the economy" - is baseless. In fact, it is damaging. The housing market and its mortgage bubble are most likely to be the first victims of this policy, and the most visible.

Regards,

Addison Wiggin
The Daily Reckoning

Addison Wiggin is the editorial director and publisher of The Daily Reckoning, and executive publisher of Agora Financial, a multi-million dollar financial research firm and publishing group based in Baltimore, Maryland. Mr. Wiggin is also the author, with Bill Bonner, of the New York Times Business best sellers "Financial Reckoning Day: Surviving the Soft Depression of The 21st Century" and "Empire of Debt: The Rise Of An Epic Financial Crisis". Copyright © 2007 Addison Wiggin