With a Bang, Not a Whimper

06/20/2007 12:00 am EST

Focus:

Gary Shilling

Columnist, Forbes

A. Gary Shilling, editor of Gary Shilling’s Insight, warns that the Grand Disconnect between the real economy and the virtual world of speculation may end with disastrous consequences.

For years we’ve explored the Grand Disconnect between the virtual world of speculative finance and the real world of goods and services.

It developed first in the late 1990s with dot com stocks. After their demise, it was kept alive by massive Federal Reserve ease and huge federal fiscal stimuli. Then speculation shifted to housing and other real estate, junk bonds, the carry trade, emerging-market stocks and bonds, commodities, hedge funds, and private equity.

A highly visible and politically charged manifestation of the Grand Disconnect is the difference between the fabulous wealth it has created for investment bankers, hedge fund managers, and private equity managers and the flat or declining real incomes of those on the economic bottom. Sooner or later, the virtual and real worlds will reunite, and history suggests it’ll be via a violent breaking of the speculative bubbles. At that point, politicians will pile in to affix blame. Consider Congressional concerns over the plight of subprime mortgage borrowers as a forerunner.

We continue to believe that the bursting of the housing bubble, led by the rupture of its subprime soft underbelly, will trigger the demise of speculation that will end the Grand Disconnect, but the collapse in another speculative area, perhaps private equity, may beat housing to the punch.

Meanwhile, stocks may continue in a self-feeding bubble that is increasingly detached from economic fundamentals while Treasury bond prices are pressured by those abandoning dull old fixed-income securities for the thrill of LBO-driven equities.

Nevertheless, the housing collapse will proceed fast and intensely enough to initiate a recession late this year. In the post-World War II era, every time real GDP growth fell below the 3% long-term norm—as it has in the last four quarters—the economy was always within four quarters of a recession and usually much closer.

Fed officials may be much more concerned about a dramatic bursting of the housing bubble and other speculations than they discuss publicly. But at the same time, they may be considerably worried over the global liquidity, zeal for yield, and low market volatility that are driving these speculations and could inflate them to disastrous proportions if speculators foresaw no possible further Fed restraint.

As it is, central banks have very limited control over financial markets in a world in which derivatives with almost all the attributes of real money can be created out of thin air. The Fed, in effect, may just be sweating it out, hoping that speculation will be contained and eventually dissipate without upsetting the financial applecart.

One thing does seem clear, [however]: the longer the speculative climate remains uncorrected, the more extreme it will likely become and the more disruptive will be its eventual demise.

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