Nearly "Checkmate" for American economy

From Mish's Global Economic Trend Analysis:
* Paul Kasriel:
U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

So when does it all end?

That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.
This is the first time I have read anything on economics blogs anywhere that comes close to my own position - that the falling US Dollar will deepen the recession and postpone any recovery. This was part of an interview on Mish's blog site in December 2006, long before the Subprime crisis hit, but over 12 months after my own "Perfect Storm" article.

* Paul L. Kasriel is the Senior Sr. V.P. and Director of Economic Research for The Northern Trust Company, 50 South LaSalle Street, Chicago, IL 60603.

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