Bubble bubble toil and trouble?

UCLA's Edward Leamer sees a slowdown for the US in 2006, as the real estate party comes to an end. He sets the context well:

The discovery of the Internet set off a mad dash for the Web, and that powered the U.S. economy forward at breakneck speed from 1997 to 2000. Every business in America had to have a cool Website or advertise on one. There was a very heavy investment in equipment and software. Every person who could crawl off the street was offered a job and anyone who could whisper "yes" was given one. Equity values went into the stratosphere and dot-com workers and their friends celebrated with a wild spending spree.

Reality and reason became unwanted guests at this party in 2001, causing equity values to plummet and jobs to disappear.

But the party picked up again in 2002, when Alan Greenspan arrived with a very attractive bond market nestled on his arm, and passed out party favors inthe form of low-interest loans to compensate for the loss of equity wealth. The low loan rates, reminiscent of the 1950s, set off a mad dash for homeownership that powered the U.S. economy forward at breakneck speed from 2002 to 2005. Every American family had to have a cool house or live next to one. There was heavy investment in new homes and remodeling existing ones. Every person who could crawl off the street was offered a home loan and anyone who could whisper "yes" was given one. Home values went into the stratoshpere and homeowners and their friends celebrated with a wild spending spree.
But as the party went on, Mr. Greenspan began to grow worried over the level of debt, and reality and reason returned. In 2006, regulators, worried about delinquencies and defaults, will start to require borrowers to walk off the street (crawling is not enough anymore) and the deals that were premised on continued high rates of appreciation will go sour. Homeowners who can service their debt will cling to their optimism and refuse to sell into a softening market. This tenacity will help keep homes prices from a severe adjustment, but it will make high sales rates of existing homes a thing of the past.

But without the dot-com mania or the housing bubble to power the economy forward, things will slow down considerably in 2006. It could become really ugly really fast in the housing sector if there is a recession with sever job loss, since loss of a job is often enough to force delinquency and default. History suggests this is likely, but history is not a perfect guide.

Keynes called it the "animal spirits" of capitalism. Well, the animals have been on quite the bender these past few years. I hope the soft landing plays out, but sometimes I feel like we're partying like it's 1929 . . .

Lots of people now believe the plausibility of a housing bubble, but does it burst or just slowly deflate? The big question mark is around the overall state of the US economy. If a recession hits, fuelled by high and higher oil prices, a sharp change in the value of the US dollar as foreign investors grow leary of financing US deficits, higher interest rates from central banks, or some combination of the above, watch out.

Our fate just to the north will be determined by how this all plays out in the US. If things get ugly, the fallout will hit Canada quickly.

The tale of a stock market bubble flowing into a housing bubble also raises some questions about inflation. Central banks are dangerously obsessed with consumer price inflation, in my opinion, ready to jack up rates based on the slightest whiff of higher prices. Yet, asset prices area allowed to shoot up with barely a shrug of the shoulders.