A Tightening Farce
The Daily Reckoning PRESENTS: Wall Street and investors can only be so optimistic, due to an almost universal expectation that the Federal Reserve has definitely stopped its rate hikes. This, essentially, assumes that further rate hikes were the greatest imminent risk to the economy and the markets – bonds, stocks and housing. The Good Doctor explores…
A TIGHTENING FARCE
There is total detachment from the bad news that is pouring out of the economy. For several years, the booming housing market has made the difference between recession and recovery for the U.S. economy. Zooming house valuations provided private households with the collateral that allowed them to replace the missing income growth with a borrowing binge.
But as the housing market is sagging, this major source of higher consumer spending is plainly drying up, and most obviously and importantly, income growth is by no means catching up.
In 2005, real disposable incomes of private households in the United States increased $93.8 billion, or 1.2%, while their debts grew $1,208.6 billion, or 11.7%. Total consumer spending on goods, services and new housing accounted for 92% of real GDP growth.
The U.S. economy’s recovery from the recession in 2001 has been its slowest in the whole postwar period, and in addition, it has been of a most unusual pattern. Real GDP rose by 11.7% over the four years to 2005. Within this aggregate, residential building soared by 35.6%. Consumption gained 13.4% and government spending 10%. The big laggard in domestic spending was business nonresidential investment, up only 3.6%. Net exports year for year were increasingly negative.
Most economic data have softened, with the downtrend accelerating. In the face of this fact, it could not be doubted that Mr. Ben Bernanke and most others in the Federal Reserve were anxious to stop their rate hikes. In question was only whether they would dare to do so in view of the high and rising inflation rates. They dared. They even disappointed those who had predicted the combination of a declared “pause” with hawkish remarks about fighting inflation.
In its statement, the Fed conceded:
“Readings on core inflation have been elevated in recent months, and the high levels of resource allocation and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative of monetary actions and other factors restraining aggregate demand.”
When the Bureau of Labor Statistics (BLS) reported on Aug. 16 that the CPI in July had seasonally adjusted, advancing 0.4%, following a 2% rise in June, both the bond and stock markets responded with strong rallies. What, apparently, had made it so exciting in the eyes of the consensus was the fact that these bad figures had remained in line with distinctly unoptimistic predictions. Never mind that during the first seven months of 2006 the CPI has risen at a 4.8% seasonally adjusted annual rate, compared with an increase of 3.4% for all of 2005.
It is, of course, perfectly true that monetary tightening impacts the economy and its inflation rates with a pretty long delay. The trouble in the U.S. case is that there never was any monetary tightening. There were many small rate hikes, and the Greenspan Fed had probably hoped that the higher costs of borrowing would exert some restraint on credit demand. But it has not happened. It was a vain hope.
The fact is that the credit expansion has sharply accelerated during these two years of rate hikes instead of decelerating. During 2004, when the Fed started its rate hike cycle, total credit, financial and nonfinancial, expanded by $2,800.8 billion. In the first quarter of 2006, it expanded at an annual rate of $4,392.8 billion.
Over the two years of so-called monetary tightening, the flow of new credit has effectively accelerated by 56%. In 2005, credit growth was $3,335.9 billion. Over the whole period of rate hikes, it had steadily accelerated from quarter to quarter. Borrowers and lenders, apparently, simply adjusted to the higher rates, trusting that there would never be serious tightening.
True monetary tightening would have to show first of all in declining “excess reserves” of banks relative to their reserve requirements. These have remained at an elevated level during the rate-hike years of 2004-05.
In 1991, when the Fed tightened, credit expansion slowed sharply from $866.9 billion in the prior year to $620.1 billion. A sharp slowdown in credit expansion in 2000 to $1,605 billion also happened, from $2,044.7 billion the year before. Yet this still represented very strong credit growth in comparison with the years until 1997.
Like all central banks, the Federal Reserve has two levers at its disposal to stimulate or to retard credit and money creation. The big lever is its open market operations, buying or selling government bonds, thereby increasing the banking system’s liquid reserves. The little lever consists of altering its short-term interest rate, the federal funds rate, thereby influencing the costs of credit.
It is most important to distinguish between the two instruments. True monetary tightening has to show inexorably in a slower credit expansion throughout the financial system. There is one sure way for a central bank to enforce this, and that is by curtailing bank reserves through selling government bonds.
The other lever at its disposal, as pointed out, is to influence credit costs. But the influence of the central bank on credit costs begins and ends with altering its short-term federal funds rate. During the past two years, the Fed has raised its federal funds rate from 1% to 5.25%. But long-term rates hardly budged. To the extent that borrowers shifted from the low short-term rate to the long-term rate, they encountered higher borrowing costs. But at the long end, interest rates rose less than the inflation rate.
Here are still a few other credit figures illustrating the Fed’s monetary tightening since mid-2004. Total bank credit expanded, annualized, by $957.0 billion in the first quarter of 2006, against $563.5 billion in 2004. For security brokers and dealers, the two numbers were $611.3 billion, against $231.9 billion; and for issuers of asset-backed securities (ABSs), they were $663.3 billion and $322.6 billion. This is monetary tightening à la Greenspan.
Monetary tightening has one purpose: to curb credit expansion fueling the excess spending in the economy and the markets. By this measure, Greenspan’s monetary tightening since 2004 has been a sheer farce. During these two years, he presided over a sharply accelerating credit boom, for which the reason is also obvious.
To equate rising short-term rates automatically with monetary tightening can, therefore, be a gross mistake. Later on, we shall explain that this is the great error of the monetarists in assessing the development in 1929 and following years. Borrowing exploded during 1927-29, despite the Fed’s rate hikes, and then literally collapsed after the stock market crash.
It can be argued that rate hikes in the past have generally worked. Yes, but the central bankers of the past never forgot to tighten bank reserves. Tighter money to them meant tighter credit, and it always showed in sharply shrinking credit figures. So it also has, in the past, in the United States. But this time, the diametric opposite has happened.
There was reserve easing. Money and credit, moreover, only became significantly more expensive at the short end. All the time, there was nothing in this to slow the housing bubble and the associated borrowing binge. Rising house prices easily offset the effect of rising short-term rates.
Does this mean that the economy can continue to grow as before? No, not at all. All excesses, if not stopped, are sure to exhaust themselves over time. That is no less true for economies than for the human body. In our view, the housing bubble is finished not because credit has become tight, but because the borrowing excesses are running against natural barriers.
One such natural barrier is the affordability of housing and the limited number of greater fools who are able and willing to pay these inflated prices. At some point, excess supply will exceed demand. We read from reliable sources that in June, sale offers of existing single-family homes were up 35%, while actual sales were down 6.5% versus a year ago. So the year-over-year “excess” supply was 42.2%.
Affordability is way down, units offered for sale are way up and price appreciation has all but stopped. It is a radical change in the market situation, which, however, has so far impacted economic activity only moderately.
Past experience with housing bubbles suggests that the first effects are in the steep fall of actual sales and in the lengthening of time until sales materialize. The markets become illiquid. Until sellers capitulate and accept lower prices, it can take a long time. In this way, apparent price stability becomes increasingly treacherous over time.
Present American folklore has it that a protracted slump in house prices is impossible. Let us say for many people it is unthinkable. And that is precisely one reason why this housing bubble could go to such unprecedented excess. The little historical knowledge we have about bursting housing bubbles is from a study published by the International Monetary Fund in its World Economic Outlook of April 2003. It presents past experience in a very different light. Here are some excerpts on decisive points:
“To qualify as a bust, a housing price contraction had to exceed 14%, compared with 37% for equities. Housing price busts were slightly less frequent than equity price crashes… Most housing price busts clustered around 1980-82 and 1989-92, while equity price busts were more evenly distributed across time.
Housing price crashes differ from equity price busts also in other three important dimensions. First, the price corrections during house price busts averaged 30%, reflecting the lower volatility of housing prices and the lower liquidity in housing markets. Second, housing price crashes lasted about four years, about 11/2 years longer than equity price busts. Third, the association between booms and busts was stronger for housing than for equity prices.”
An important theme running through the foregoing analysis is that housing price busts were associated with more severe macroeconomic developments than equity price busts. Coupled with the fact that housing price booms were more likely (than equity price booms) to be followed by busts, the implication is that housing price booms present significant risks. For this, the authors give the following reasons:
“Housing price busts have larger wealth effects on consumption than the equity price busts…
“Housing price busts were associated with stronger and faster adverse effects on the banking system than equity price busts… All major banking crises in industrial countries during the postwar period coincided with housing price busts.
“Price spillovers across asset classes matter, as evidenced by the fact that housing price busts were more likely associated with generalized asset price bear markets or even busts than equity price busts.
The authors then give a fourth reason, which was true in the past, but in which the situation in America today radically differs:
“Housing price busts were associated with tighter monetary policy than equity price busts, reflecting the fact that most housing price busts occurred during either the late 1970s or the late 1980s, when reducing inflation was an important policy objective. The disinflation increased the real burden of debt, which exposed inflation-related overinvestment and associated financial frailty.”
for The Daily Reckoning
September 13, 2006
Editor’s Note: The Good Doctor has found the only five investments you’ll need in 2006 – and one of them is a mighty hedge against the forces of dollar weakness and inevitable inflation. At the very least, it will help protect your money from the boneheaded inflationary policies and programs of the Federal Reserve – especially under Ben “Printing Press” Bernanke.
Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as “the man who predicted the Asian crisis.”
Nothing fails like success.
As recently as a half-century ago, the American stood like a colossus in a New World…young, free, healthy; and a creditor to the rest of the world, which owed him not only money…but liberty, for he had lent his muscle, his oil, his manufacturers – and even risked his life to win World War II for the Allies.
“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” asked Adam Smith.
Here at The Daily Reckoning headquarters, we too are occasionally beset with bouts of debt-free happiness. But we count on our natural gloominess to get us through.
But…what about people who have more debt than any one else…whose health suffers from too much sustenance…and whose conscience is encumbered with a bloody war made on people they didn’t even know, for a purpose no one knows? Can they expect happiness?
As to their conscience and health, we have no opinion. But as to their debt we have many.
Fallen into our hands is a report from the CIA, ranking nations in order of their current account balance. The current account, we remind readers, is like the operating statement of a business or an individual. Income must exceed outflow or your upkeep is your downfall. The difference between what comes in and what goes out, if it is positive, accumulates as though it were a profit. If it is negative, it builds up – but not necessarily, in the form of debt.
So what do we see? The country with the best position is Japan – with a current account balance of plus $165 billion. China is in the number two position, with almost as much. And here we pause to give readers a chance to gasp. China – a country run by communists – has the second best current account balance in the world. Figure that. In other words, Marxism…at least as practiced in the Middle Kingdom…has proven no bar whatever to capitalist success.
But we will move on…
Germany is the third most ‘profitable’ country in the world – with a positive current account balance of $115 billion. Then the list goes into various oil producers, watchmakers, and assorted national curiosities…such as Algeria…with – would you believe it – has an $18 billion surplus! Even tiny Hong Kong ended last year nearly $20 billion to the good.
But between Swaziland and the Comoros (which, we believe is an island nation somewhere off the coast of Africa) the figures make the kind of transformation that can only be likened, in the material world, to going from light to darkness, or in the sentient world, from life to death. That is, they go from positive to negative. The numbers which were such a comfort to Germany and such a delight to Japan become an embarrassment.
Poor Burkina Faso, perhaps the most God-forsaken hole on the surface of the whole planet, suffers a $438 million deficit and still manages to hold its head up in public.
“Hey, wait a minute,” said a friend at a dinner party recently, “Burkina Faso is not so bad. My wife and I love to go there for desert trekking. There is nothing there…no restaurants…no hotels you’d want to go to…no theatres…not much of anything. But out there in the natural world… in the desert, there is a quality that is sublime. I wish I could describe it to you…but you have to see it for yourself.”
That said, at least Burkina Faso is far from the worst on the CIA’s list. The rest of Africa follows…and then come the Banana Republics of Latin America…and finally, guess who makes the end of the line-up? Guess who has the worst current account deficits in the entire world? Guess which countries spend more than they earn – regularly and spectacularly?
Last in line are the nations of the Anglo-Saxon, English-speaking debt-based empire! New Zealand has a deficit of nearly $10 billion. Then, South Africa…and India…and Australia all have deficits too. Among the major former colonies of the British Empire, only Canada seems to have any sense. It runs a surplus. The others are all debtors. The UK itself is third from the bottom with a $57 billion negative current account balance.
For no reason we can think of, the penultimate on the list is Spain. And then comes the worst of all…the United States of America, with a current account balance of a minus $829 billion.
Add up all the deficits of the entire world and you get a figure barely half of the U.S. total.
The U.S. economy makes up a quarter of the world total…that it should have more than half of the world’s current account deficits is a spectacular success – only made possible by its great wealth and status.
And here, in yesterday’s news, comes the latest: “Record $68 billion trade deficit in July,” reports Bloomberg.
Nothing fails like success.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
“The U.S. July Trade Deficit printed at a new record of $68 Billion!!!!! That beats the old record monthly Trade Deficit, which printed at $66.5 Billion almost a year ago.”
For the rest of this story, see today’s issue of The Daily Pfennig
And more thoughts…
*** What’s up? What’s down?
Since the World Trade Towers went down, the Dow has gone up – 17%. Even the NASDAQ has gone up 9%.
But what has really gone up is gold – up 210% since 9/11/01 …and oil – up 250%.
What will be down, or up, over the next five years?
Ah, dear reader, you are toying with us. You know we don’t have any idea. It is not given to mortals to know their fate.
“Of course, I don’t know either, ” said our friend Philippe in Paris yesterday. “But I know what worries me. You look at what is happening in America. The mortgage lenders have given out money to almost anyone who can breathe…on these exotic mortgages that actually punish the borrower in the future…and we know that the borrower didn’t really know what he was getting into. So what? If the homeowners can’t make their payments, well, the lenders get what they deserve, right? No…because they’ve sold the mortgages on…they’ve been packaged as leveraged derivatives in MBOs…Mortgage Backed Obligations.
“And these mortgages have then been bought by institutional investors who try to get a little extra performance. They buy them along with junk bonds. And they don’t worry about risk anymore since people have been protected against default for so long – because interest rates have been going down. When rates are going down you can almost always refinance a loan at a better rate…so you don’t ever have to own up to the fact that you can’t really repay it. So, even insurance companies and hedge funds and retirement funds have these mortgage-backed securities.
“And do you realize that there are now some $250 TRILLION of derivatives on the loose. And one institutional investor thinks it is protected because it owns derivatives from another institution…which owns derivatives from yet another. They are all holding each other’s paper. And I wonder what will happen when the guy with the mortgage can’t make his payments. Credit has been inflating for the last 25 years. What happens when it deflates? The whole thing is going to meltdown.”
As we explained yesterday, the way to make money from investments is not by guessing right about the future, but about guessing right about the odds. Most investors tend to miscalculate. They systematically over-rate the odds that what happened in the recent past will continue to happen in the near future. What’s more, the majority of investors want to think for themselves, so long as they are thinking what everyone else is thinking. Whatever the great mass of investors believe – no matter how absurd – is what the individual investor tends to believe.
Which means that the investor who thinks a little differently has an advantage. Again, it is not that he is more likely to be right. It is just that the odds are in his favor, whether he is right or wrong. If the great mass of investors has bought into a position…almost by definition it has paid too much. Because nature does not distribute her favors according to mass demand. If the real odds that it will rain tomorrow are one in two, there is a 50% chance it will rain…it doesn’t matter how many people think the odds are two in three. The investor who bets against the majority opinion is likely to win.