Fools in Paradise

What do the city of Irvine, California and the Starbucks
Company have in common? Maybe nothing…or maybe both of
these prosperous entities owe a debt of gratitude to the
consumption-crazed American economy.

If not for America’s three-decades-and-counting consumption
boom, for example, Starbucks might not be selling $4 lattes
from 8,000 different locations.

And if not for the growing tendency of Americans to assume
the riskiest possible mortgages in the quest for the
largest possible homes, the average home price in Irvine
might not be bumping up against $800,000 – double the price
of four years earlier.

Unfortunately, booms that derive from debt, rather than
incomes, tend to die a grisly death…More about this
below.

"Archeological research establishes prehistoric man in the
Irvine area at least 12,000 years ago," the city of
Irvine’s Web site explains, but the first Starbucks outlet
did not arrive in this Southern California suburb until
many years later. In fact, the first Starbucks outlet did
not arrive anywhere until 1971, when the very first
location opened its doors in Seattle’s Pike Place Market.

Coincidentally, 1971 was also the year that gave birth to
the city of Irvine, California, a prosperous suburb of
Orange County.  Over the ensuing 34 years, both Starbucks
and Irvine enjoyed almost uninterrupted prosperity. Today,
both entities are priced for perfection. Starbucks shares
change hands for a lofty 48 times earnings, while Irvine’s
$792,000 average home price towers above the national
average.

The chart below tracks the remarkably similar trajectories
of median home prices in Orange County, CA, of which Irvine
is an important part, and the number of Starbucks outlets
worldwide. We are somewhat intrigued – and amused – that
these parabolic trajectories so closely resemble one
another.

Perhaps no legitimate connection exists between these two
trends. Or perhaps, Irvine and Starbucks share a more
profound connection than is readily apparent.

The former is "one of the safest, master-planned, business-
friendly communities in the country," according to its Web
site. The latter is one of the most successful master-
planned food retailers in the world, complete with a "CEO
and global strategist." Both entities reflect are an aspect
of America’s rampant consumption boom – a boom that may be
living on borrowed time, not to mention borrowed money.

If, for example, the Irvine real estate market had to rely
solely upon buyers who paid cash for their houses, or who
financed their purchases with traditional 30-year fixed-
rate mortgages, the average home price would be well below
$792,000 – at least, that would be our guess.

And if all of the nation’s non-cash home-buyers had no
choice but to finance their home purchases with 30-year
fixed-rate mortgages – instead of cash-flow friendly
innovations like interest-only mortgages – they would have
much less disposable income to dispose of in places like
Starbucks.

But American homebuyers do have a choice – many choices in
fact. And increasingly they are choosing to borrow as much
money as possible against their homes, repay as little as
possible, and use their borrowings to fund an outsized
consumption that their incomes alone could never support.

In short, Americans are choosing to borrow and spend,
rather than to save and invest.

We Americans scorn fiscal conservatism and its attendant
deprivations. Saving money is for losers. Why bother saving
money, when perpetually rising home values will do the
saving for us…without any of the unpleasant side effects
of saving, like foregoing frivolous luxuries. We Americans
have come to believe, in fact, that inflating asset values
provide a legitimate substitute for the traditional
capitalistic wealth-creation cycle: Save, invest, produce,
save…

Our growing reliance upon inflating asset values to fuel
our prosperity can be summed up as "wealth creation is a
fool’s paradise," according to Dr. Kurt Richebächer, editor
of the Richebächer Letter.

"There is, actually, a very simple rule about wealth
creation," the doctor observes, "It says capital decreases
when a nation consumes more than it produces. But capital
increases when a nation produces more than it consumes. Of
course, that is equally true for firms and private
households…

"But what is happening in the Unites States is the exact
opposite of capital accumulation," Richebächer warns.
"Instead of accumulating foreign assets, it is accumulating
foreign debts. And internally, instead of expanding its
capital stock for higher future output and income growth,
there is record accumulation of unproductive debt
collateralized by inflating asset prices."

Of course, as long as our assets continue inflating, we
fools may continue to enjoy our paradise. Besides, who
would want to do the hard work of saving and investing if
there were a "better" way? Asset-financed consumption is a
pretty cushy means of producing economic "growth." And such
growth can appear to be genuinely robust, especially if one
refrains from looking too closely at the liability side of
the balance sheet.

As Richebächer readily admits, "A paradoxical situation has
developed in the world. Countries with rock-bottom savings,
sluggish business investment and the worst trade balances
have been excelling with strong economic growth, while
countries with high savings and strong trade balances are
mired in protracted sluggish growth. The prime examples of
the first group are the United States, Britain, Australia
and New Zealand. Outstanding examples of the second group
are Japan and Germany."

But no country can match America’s, unbridled consumption.

"During the four years 2000-04, personal consumption
captured 87.1% of U.S. real GDP growth, as against a
longer-term average of 67%," Richebächer points out. "At
the same time, net national savings plunged from 5.8% to
less than 1% of GDP."

Since we do not save and invest, neither do we produce. The
nation’s manufacturing capacity been withering away year-
by-year, as the nearby chart attests.

"The important point to see from the macro perspective,"
Richebächer concludes, is that inflating assets prices have
played the key role in propelling consumption in the United
Sates to an exorbitant and patently unsustainable level."

"For the U.S. economy, huge twin deficits, excess
consumption, the demise of manufacturing, near-zero
savings, super-sized unproductive debt and poor
profitability of non-financial activity all speak of an
unstable economic recovery in the United States…The
looming danger is that relatively moderate further
increases of interest rates, short- and long-term, may
prick the highly leveraged bond bubble with ghastly
ramifications for the stock market and the housing bubble."

That’s the bad news. The good news is that the post-bubble
era might feature lower home prices in Irvine, California
and shorter lines at the neighborhood Starbucks.

Did You Notice…?
By Eric J. Fry

Vladimir Putin might be smiling to himself. Yesterday,
Russia’s debt rating – for the first time ever – topped the
debt rating of America’s largest automobile manufacturer.

Three months ago in this column, we noted that GM and
Russia both possessed an identical near-junk, BBB- debt
rating from S&P, and we presented the nearby chart to
illustrate their respective rating histories.

"What lies ahead for Russia and General Motors?" we
wondered at the time. "Which of these two marginal credits
will advance to the big leagues and which will fall even
deeper into the minors?"

Yesterday, S&P provided the answer: GM is the minor-
leaguer. Russian debt, for the record, remains in the big
leagues. We do not expect to see GM back in the majors any
time soon.

As we first observed in our column of February 11th, "GM’s
debt load is massive and growing. Its net debt outstanding
has doubled over the last four years to $244 billion. In
addition, GM’s balance sheet contains a towering pension
liability of $102.4 billion and a $67.5 billion liability
for other post-employment benefits (OPEB), primarily health
care, insurance and other benefits that the company is
committed to providing both current retirees and active
employees…Net-net, GM seems fully deserving of its ‘near
junk’ rating and seems likely to trend from bad to worse.

The adverse trends plaguing GM might simply continue, in
which case this BBB- borrower could slip into a kind of
junk-credit abyss – paying ever higher interest rates,
while struggling to satisfy ever-growing liabilities."

Once in that abyss, there is no easy way out…Just ask
Vladimir Putin.

And the Markets…