Resident Fellow  Desmond Lachman

Samuel Johnson famously observed that a second marriage was a triumph of hope over experience. One has to wonder whether the same might not be said of the US equity market's relative recovery, at least until last Friday's unemployment number shock, in the aftermath of the market's near death experience last March at the time of the Bear Stearns' fiasco. For despite ample international experience that long recessions normally follow the bursting of major housing market and credit market bubbles, the US equity market still seems to be telling us that it believes that, whatever recession we might have had at the start of this year, a US recovery is just over the horizon.

There are several strands to the equity market's optimism about an early V-shaped economic recovery. Among these is the highly accommodative stance of monetary policy, as exemplified by a cumulative 325 basis point cut in the Federal funds rate over the past six months. Then there is the hope that US credit markets will continue calming down as they digest the signal from the Federal Reserve following the Bear Stearns' rescue that the Fed will simply not allow the US financial system to implode. And finally there is the expectation that the economy will get real support, at least in the near term, from the tax rebate program now in full swing.

Valid as these arguments might be, they totally overlook the fact that the US economy is still being adversely impacted by the very same three negative shocks--a housing market bust, a credit crunch and an oil price shock--that caused the US economy to go into a funk in the first place. Worse still, it would appear that at least some of these adverse shocks are now intensifying.

Are US house prices at the national level now not declining at an accelerating pace and is the pace of home foreclosures not picking up in a manner that has no precedent in the past seventy years? Have not international oil prices dramatically risen to around US $140 a barrel, or more than double the level that they were a year ago? Has the recent run up in oil prices not more than offset the US government's tax rebate program and are we now not looking at an oil price shock that is frighteningly reminiscent of the 1979 oil price shock that precipitated a global economic recession? And is the US financial system not still in the throes of what Paul Volcker has referred to as the "mother of all credit crises," as vividly illustrated by the Federal Reserve's recent still very gloomy survey of bank lending intentions?

In gauging the probable future direction of the US economy, it would seem that the prospects for the US housing market hold the key. This is not merely because a continued slump in housing construction activity could subtract a full percentage point from GDP growth in 2008 as it did in 2007. Rather it is because further major declines in home prices would have a very important bearing on the health of the US financial system as well as on consumer spending activity, which constitutes around 70 percent of the US economy.

Over the past year, declining home prices have already wiped out around US$2 ½ trillion in US household wealth. They have also caused analysts to raise their estimates of the potential losses to the financial system from mortgage lending to US$500 billion. This has effectively put an end to the ability of households to use their homes as ATMs to finance their consumption spending. It is little wonder then that US consumer sentiment has plummeted to multiyear lows.

Sadly, the immediate outlook for US home prices is grim. At present an estimated excess inventory of around 1 million unsold homes is weighing heavily on the housing market. Compounding this situation of excess supply is the fact that private sector mortgage lending has all but dried up in the wake of large sub-prime mortgage losses. Worse still, a rapidly increasing rate of foreclosures is substantially adding to supply on an already glutted market. And there is every prospect that the foreclosure rate will continue to increase as declining home prices boost the number of households with negative equity in their homes to around one third of all households by the end of the year.

A very real danger of rapidly declining home prices for the US economy is that it raises the real risk of creating an adverse feedback-loop. For as declining housing prices reduce consumer wealth and add to the financial system's losses, they push the economy further into recession. Yet as the economy slides deeper into recession, it exacerbates the downward spiral in housing prices.

To be sure, policy measures have been introduced to stimulate the economy in the form of a US$170 billion tax reduction package and Federal Reserve interest rate cuts totaling 3 ¼ percentage points. However, with the very real prospect of the US economy sliding deeper into recession, one might ask whether enough has been done to cushion the economy from America's largest housing market and credit market bust since the Great Depression.

Desmond Lachman is a resident fellow at AEI.