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A gigantic credit bust is about to happen in America. The prospect of that, not political or international events, is what's driving the stock market down.
As stocks plunge from their recent highs, pundits have been quick to look for catalysts. But few experts are giving enough weight to the massive debt mountain that is about to collapse with serious consequences for the U.S. economy.
Fed chairman Alan Greenspan has been able to keep the U.S. economy afloat since the stock market bubble popped in 2000 by setting interest rates low enough to unleash a tidal wave of credit to households, chiefly in the form of mortgages, home equity loans and credit-card debts.
But now, with interest rates on their way up, that flow of credit is likely to contract, causing a further rise in personal bankruptcies, a slump in house prices and a slowdown in the economy. The U.S. has of course been through credit busts before. But because of the amount of debt creation over the last 10 years, this crackup is going to be worse than any we've seen in the post-war period.
And past experience shows that it will only take a small rise in interest rates from their historic lows to trigger the crunch. In other words, watch loan growth shrink -- and house prices start dropping -- soon after the Fed starts to increase its federal funds target rate. Economists expect a hike in the federal funds rate as early as the June 29-30 meeting of the Fed's monetary policy-setting committee.
Greenspan and his lieutenants at the Fed, not to mention a large swath of Wall Street economists, go out of their way to dismiss the notion that the average U.S. borrower is over-leveraged and that financial distress is right around the corner. They are always quick to say why interest rates won't have to go up by much, citing high productivity and low inflation. But even if rates do start going up, they don't see big problems. For example, in 1994, the Fed increased its federal funds rate aggressively, taking it from 3% at the end of 1993 to 6% at the beginning of 1995. The move did cause some disruption in the bond markets and on banks' balances sheets, but it didn't tank the economy. Indeed, from 1995 to 1999 there was scorching growth.
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