How the boom of 2006 ended (We should have seen it coming)

How the boom of 2006 ended (We should have seen it coming)
By Marshall Loeb, MarketWatch Last Update: 12:00 PM ET Oct. 9, 2005

NEW YORK (MarketWatch) — Anybody with a bit of imagination, with a feel for the future, can construct a plausible scenario. Like this:

We should have seen it coming.

We were living beyond our means, saving absolutely nothing, spending more than we were earning — like there was no tomorrow.

Most Americans were doing that. Worse, the government was doing it — piling deficit upon deficit. And at the end of 2005, the total federal debt per U.S. household was more than $450,000.

But, as it always does, profligacy caught up with us. And the economy, which had been growing at a comfortable 3 to 4% rate for many years, came crashing down last year, in 2006.

How did it happen? What was the trigger? What lessons were to be learned?

The prime cause of the recession that began in 2006 was that, as often happens, the President tried to do too much at once.

Historians know that, for example, Lyndon Johnson brought the economy to perdition in the 1960s and 1970s by not leveling with the American people about the true total cost of the Vietnam war (about $121 billion). Reason: LBJ wanted to pursue both his war and his costly Great Society domestic programs at the same time.

So, too, George Bush tried to pursue his war in Iraq (total cost: more than $200 billion by the end of 2005) and simultaneously to spend $150 billion or more to rebuild the Gulf Coast after the catastrophes of Hurricanes Katrina and Rita.

The consequence was that the federal debt surged from $7.3 trillion in fiscal 2004 to $8.2 trillion in 2006. You don’t have to be a card-carrying economist to know that such excessive demand strained the supply of goods and services. That strain, combined with increases in the price of energy, inevitably lifted prices throughout the economy. Inflation reared its ugly head.

To combat it, the Federal Reserve Board raised its discount interest rate in 2006 from 5 percent to 5.5%. As a result, mortgage rates surged, turning the housing boom into the housing bubble, and bringing back memories of the high-tech stock crash of 2000 and 2001.

When housing started down, it took away what UCLA economist Christopher Thornberg had called “this fabulous sense of wealth that homeowners are feeling.” No longer feeling house rich, consumers cut back their spending. This hit the economy particularly hard since consumer spending had been one of the main forces driving it.

With both consumer spending and consumer confidence in decline, President Bush’s popularity ratings sagged even more, undermining his major second-term initiatives, notably private Social Security accounts and total elimination of the estate tax. Wall Streeters had been counting on those two measures to raise stock prices; when they failed in Congress, the market drooped.
The Republicans went into the elections of 2006 with hefty margins: 55 to 44 in the Senate and 231 to 202 in the House. But, with U.S. troops still mired in Iraq and an unpopular Republican lame duck in the White House, the GOP suffered punishing losses. That, plus the rising budget deficits, killed any hopes for further business tax reductions.

Developments in the global economy only made matters worse for the U.S.

Because it imported far more than it exported, the U.S. switched from being the world’s largest creditor nation in 1981 to its largest debtor in 2005.

In that year, China held almost $200 billion of the U.S. debt, Japan held almost $700 billion, and even the OPEC countries held almost $50 billion.

That gave all of them tremendous power over the U.S. If they ever decided to dump some of their mountains of dollars — either for pure economic reasons or out of political pique — they could totally destabilize the U.S. economy.

Fears of just that kind of move caused foreign investors to pull part of their funds out of the U.S. investments, weakening markets here.

Meanwhile, the rapid industrialization of China, India and some other developing nations continued to drive up demand for energy, metals and other commodities, thus adding to the price that the U.S. has to pay for them in global markets. Result: more inflation.

So this is the kind of world that the U.S. faces in 2007. And we haven’t even mentioned that 32 million Americans are living in poverty and 46 million (including 10 million children) have no medical insurance. Those frightening numbers are growing.

How the nation will climb out from its problems is uncertain, but surely a solution to its economic challenges will include more saving, less spending, greater investment, more fiscal prudence.

We can see that now, just as clearly as we could have foreseen our inevitable problems back in 2005.

Reporter Sarah K. Wulfeck contributed to this article.

Marshall Loeb, former editor of Fortune, Money, and The Columbia Journalism Review, writes “Your Dollars” exclusively for MarketWatch.