Against a Brick Wall
Mr. Greenspan is facing a “colossal policy dilemma” – on the one hand, he is desperately trying to keep the housing asset bubble intact; on the other, he is (or will soon be) forced to combat rising inflation. Will he succeed on either count? We fear the answer…
I doubt that Fed Chairman Alan Greenspan sleeps very well these days. Despite ultra-low short-term interest rates (negative when adjusted for inflation), highly expansionary monetary policies, a huge debt expansion, a declining savings rate, and a large and seemingly growing budget deficit, the economy and the stock market have only made very modest progress over the last 18 months.
In addition, the stock market has hardly risen over the last three months, despite near-record equity mutual inflows of $75 billion since the beginning of the year. Please also note that the inflows into equity mutual funds reached $43.8 billion in January, which isn’t far behind the record $44.5 billion and $55.6 billion inflows seen in January and February 2000, just before the U.S. stock market began to nose-dive from its bubble peak! In Europe, the recovery in stock prices has also failed to erase the substantial losses that occurred after 2000. Although the German stock market is up by more than 60% since the lows in March 2003, it is still down by 55% from its March 2000 high.
In the United States, consumption has continued to grow, driven by asset inflation in the real estate market, but how sustainable is this debt-driven asset inflation, which keeps consumption up? Bridgewater Associates recently published a report entitled “Housing Price Blowoff?” and commented, “The recent surge in prices is above and beyond anything we have seen in history, both in a level and rate of change sense.” Housing prices relative to household incomes are at their highest level ever, suggesting that affordability will soon become a problem – that is, unless interest rates continue to decline or incomes rise substantially.
Asset Inflation: More and More Debt
As I have explained before, Mr. Greenspan has managed not only to create a series of bubbles in the United States, but also on a worldwide scale. The only problem, and I suppose that this must cause Mr. Greenspan insomnia, is that more and more debt is required to sustain the housing asset inflation and keep the economy from imploding. I am very grateful to Barry Bannister of Legg Mason, who publishes excellent research on the relationship between commodity prices and equities, for sending me a figure showing the diminishing returns from each $1 of new debt in the U.S. economy since 1954.
From the 1950s to the late 1970s, $1 of additional debt generated between $0.50 and $0.70 of additional nominal GDP. However, more recently, $1 of additional debt has only managed to increase nominal GDP by around $0.20. In other words, in order to maintain its altitude, the pilot of the U.S. economic airplane needs to continuously increase the RPM of the engine.
But aside from excessive profits for the financial sector and asset inflation (more than 40% of S&P 500 earnings are derived from financial companies, which also include financing subsidiaries of industrial companies – remember how the Japanese zaitech boom came to an end after 1990), the increase in RPMs doesn’t translate into the economic airplane making much headway, but will wear and tear down the aircraft’s engine before it reaches its final destination and lead to a crash landing (over-leveraged households without any pent-up demand).
In the meantime, the external imbalances (trade and current account deficit) have grown worse, and inflation, driven by rising energy, commodity prices and health care prices, is almost certainly much higher than what the government publishes.
Back in the United States, Disneyland will increase the admission price for guests over 10 years old by $2.75 – a jump of 6%, compared to 2002, when prices were increased by $2. And The King Report reports that in New York, the NYC Taxi & Limousine Commission voted to increase fares by 25% and add a $1 night surcharge. Bill King also cites a USA-TODAY article, which has steel prices up 80% in the first quarter of 2004, plywood up 107.5% in February, and copper wiring up 80% in the last four months. He also cites the Chicago Tribune of April 1 (not a joke), which reports that cheese prices are at record highs (+87% year-on-year) and that farmers expect milk to sell next month for $18.10 per 100 lbs., compared to $10 a year ago. In the meantime, the Cook County, Illinois, tax on cigarettes increased on April 1 to $1.00 from $0.18, a 456% hike.
Asset Inflation: A Colossal Policy Dilemma
I hope our readers realize the colossal policy dilemma Mr. Greenspan is facing. On the one hand, he must keep the housing asset bubble intact by keeping interest rates artificially low, which encourages even more leverage through strong credit growth; on the other hand, inflation is picking up and may at some point force the Fed to tighten, unless it wants to take the risk of being faced with soaring prices at a later stage. After all, it is likely that rising commodity and housing prices will one day spill over into consumer price inflation and, along with better employment figures, push bond yields higher.
Moreover, it should be obvious that housing and commodity inflation diminish real income gains (income gains adjusted for inflation). The economy then becomes totally dependent on housing asset inflation, which leads to more financial instability, as the asset inflation is dependent on ever more rapidly expanding debt accumulation. We should also be aware that once employment picks up, bonds will sell off and, in a benign case, cool the overheated residential real estate market, while in a more serious case it would lead to a real estate crash.
In other words, we should be aware that an expansion in the “real economy” (in this context, significant employment and capital spending increases, as opposed to an asset inflation-driven economy) would be offset by, at the very least, some momentum loss in the asset inflation-driven economy. Depending on the severity of the eventual decline of the bond market, losses on housing and financial assets could easily more than offset eventual income gains from rising employment.
In fact, we are in a rather peculiar and paradoxical situation, which can only lead to extreme financial vulnerability, because the best chance for the credit and housing asset inflation-driven economy to continue to do well is for the real economy to perform so miserably that no meaningful inflationary pressures come up. This would allow the bond market to rally further and keep the party going for some more time. (I wonder what Mr. Greenspan’s wish/dream really is: a weak economy, which keeps housing up, or a strengthening economy, which might kill the bond market?)
Asset Inflation: Stagflation
Lastly, there is the distinct possibility of “stagflation,” in which case the economy stops expanding, while inflation accelerates and pressures financial asset prices. Looking at a longer-term chart of U.S. 10-year Treasury notes, the period immediately ahead will reveal whether we are dealing with a massive head-and-shoulders top, which would have been formed between late 2002 and today.
In sum, I remain convinced that the U.S. economy is heading into a brick wall. This brick wall may come in the form of rising interest rates, as a result of diminished affordability, or because of a sudden change in liquidity preference among end users and speculators.
I must admit that I don’t know how far away the brick wall is. But bearing in mind that we have had extremely high bullish sentiment in stock markets over the last six months, near-record inflows into U.S. equity mutual funds (but near-record low cash positions), and the fact that real M2 growth has been negative since December 2003, we may be closer to hitting the wall than investors who buy the dips may realize.
for The Daily Reckoning
May 12, 2004
Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report. Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public. He also writes a regular column for Strategic Investment, from which this essay was adapted.
As Dr. Faber writes above, the U.S. economy may hit its brick wall sooner than you think. When it does – if it hasn’t already, that is – it could suddenly send asset prices tumbling…particularly home values.
“When interest rates suddenly rise,” writes Strategic Investment’s Dan Denning, “speculation in the housing market will immediately dry up. The value of your home could drop significantly. And your house could become worth less than what you owe on your mortgage…”
Let’s see if we can figure this out.
Oil rose to over $40 a barrel yesterday. Both businesses and consumers have to pay more to continue current operations. Airlines, for example, get hit hard…and fast.
Interest rates are rising, too. So borrowers will have to pay more in interest. Since just about everyone is a borrower – and since Alan Greenspan actually encouraged homeowners to take out adjustable-rate mortgages – this hits the economy as an additional cost, too.
And of course, the prices of lumber, milk, education, health care and so on are all up. Again, anyone at the margin…anyone whose expenses and income are matched…is feeling a pinch.
What can they do? Borrow more? Well, yes, but that only works when the cost of funds is lower than what they paid the last time they borrowed. Or when they have collateral that is worth more – so they can borrow more against it.
But now stocks seem to be headed down…into Phase II of the Great Bear Market – Ursa Major – the one we have been warning about.
It must be pleasant for lumpeninvestors, TV presenters and Fed governors to imagine that stocks go up forever…and that ordinary people can get something for nothing just by being “in the market.” But that’s not the way it works. Instead, stocks go up for periods of 17-20 years…then, they go down for about as long. Hardly anyone notices, but the money that stocks are quoted in is as wobbly as the people who control it.
In 1971, you’ll recall, the dollar was cut loose from gold, leaving it as an entirely ‘faith-based’ currency. Since then the number of dollars, the amount of dollar-linked credits and debts, the volume of dollar-defined obligations, derivative contracts, and liabilities has ballooned almost beyond belief. Now, it takes more than faith to believe in the dollar…it takes hard drugs.
The federal government alone has ginned up such extravagant promises and debts, they make economists laugh and accountants cry. Laurence Kotlikoff, writing in the current issue of Fortune, explains that the nation’s “fiscal gap” has risen to $51 trillion – more than the value of all the private assets in the entire country.
How can the gap be closed? Federal income taxes could be raised 78%. Social Security could be cut by 51%. All of the government’s discretionary spending could be eliminated. This is America’s ‘menu of pain,’ he says.
So, what’ll it be?
‘None of the above’ is our guess. An honorable man pays his debts with his own money, said de Gaulle. But Americans can no longer afford honor. Faced with rising costs and bills they can’t pay, they’ll take the bounder’s way out: they’ll renege, default, inflate and write off.
In the meantime, a lot can happen – including all the things that shouldn’t.
Gold sank another $1.50 yesterday. The euro held steady at $1.18. The Dow managed a pathetic 29-point bounce.
In the short run, expect anything. China’s economy may be on the verge of blowing up. Wall Street could be ready for a crash…or a rebound. U.S. dollars are headed for destruction, but – with expenses mounting and debts to pay – people need them more than ever.
Nothing is clear. Nothing is easy. Nothing is straight. Nothing is certain. We love it!
Right Addison? Do you have more news for us?
Addison Wiggin, from St. Paul Street, Baltimore…
– John Law was an affable rogue; his life reads like that of a legend. Law’s infamy would be assured when, in 1694, he killed a man, dueling, in Bloomsbury Square in London. The next twenty years were spent on the run, gambling for a living.
– By 1720, the goldsmith’s son from Edinburgh was the richest man on the planet. At the height of John Law’s popularity and wealth, his possessions included the French central bank and the entire Louisiana Territory, which stretched from the Gulf of Mexico to the Great Lakes and from the Appalachians to the Rockies. He had it all – women besieged him, soldiers protected him, and royalty bowed to him.
– “Alas, all things get corrected,” we observed in our book, “even the reputations of men.” We were referring to John Law, but the same dictum could be applied to Alan Greenspan.
– Law’s experiment in paper money whipped early-18th Century France into a speculative frenzy. But just as the Chinese discovered in the 10th Century, Law’s scheme was undermined by inflation. His bubble collapsed, and Law was forced to flee in disgrace – he had bankrupted France. To this day, perhaps traumatized by the folly of John Law, the French are reluctant investors.
– Greenspan, now 78, has served as Chairman of the Board for 17 years. He is considered a genius for making America so prosperous…but it’s all a sham, a castle built on sand. And his reputation will reflect this, maybe sooner, maybe later, but surely. Greenspan has created a Ponzi scheme, a huge unwieldy monster, sustained by credit creation. How will it end, we wonder? What will be the catalyst?
– The bond markets are beginning to wonder, too. They haven’t offered yields this high since July 2002. Yesterday, they hesitated and drew back from resistance – the 10-year Treasury dipped 13 basis points. Will Greenspan be remembered for being behind the curve, stoking up the debt-soaked economy with inflation until he lost control?
– Markets bounced yesterday. The Dow added 0.3%, or 30 points, limping back into five figures at 10,019. The Nasdaq Composite added 1.9% to finish the day at 1,931, up 22 points. The dollar backed off an eight-month high versus the yen, settling at 113.27; versus the euro, it regained about one-third of a percent, pulling back to 1.1879 in late evening trade.
– Gold has now dropped around $50 from its recent peak. Yesterday, the barbarous relic gave away $1.60 to trade at $377 by the close of play in New York. In one of Mr. Market’s bizarre twists of obscurity, currencies and metals seem to be telegraphing a completely different message to that of the bond market.
– Yesterday’s Daily Reckoning brought up the argument that America’s debt represents a huge dollar short position, and that a sudden spike in rates would precipitate a rush for dollars. As the dollar has continued to rally, and gold to falter, we have noticed this argument popping up more and more. Could a dollar rally be the catalyst that brings the economy to its knees? The massive deflationary spiral would certainly tarnish Big Al’s reputation, especially as he has just declared, “Deflation is dead.”
– “This is the very crux of the coming deflation,” wrote Rick Ackerman in yesterday’s Daily Reckoning, “as well as the basis for a potentially sensational rise in the dollar that almost no one expects. As a mechanism to cleanse the economic system – to cleanse capitalism, if you will – the scenario has the ‘virtue’ of outfoxing not only gold bugs who trust that the dollar’s inevitable decline will make bullion far more precious, but also financial world-beaters like Warren Buffett, who perforce do not come naturally to the notion that cash may be the best asset to hold for the next several years.”
– Oil is winding back the clock. As Bill notes above, it hit $40.15 yesterday – the highest level since October 1990, when Iraq invaded Kuwait. Could an energy crisis cut the lights on Greenspan’s party? What about the Iraqi adventure? Could Desert Storm II fire the missile that triggers the debt bomb? Or Osama, perhaps?
– We are befuddled…and readily admit we haven’t a clue. We don’t know how the massive de-leveraging of America will occur. There are too many uncontrollable factors, notwithstanding the errors being committed at the Central Bank. The dollar might spike. The dollar might collapse. Gold might lose another $50. These are mere catalysts for the correction, because in the end, just as John Law discovered, America’s dalliance with paper money will end in fiasco.
Bill Bonner, back in Paris…
*** Well, actually, we’re not in Paris. We’re on our way to Las Vegas for a couple of speeches…and a chance to see old friends. Maybe we’ll see you there?
*** “Global rebound unraveling,” says a Financial Times headline. The money press can’t resist a mixed metaphor.
*** Fannie Mae says its equity fell $1.6 billion in the first quarter.
Want to watch the decline of America’s consumer credit empire? Just keep your eye on Fannie and Wal-Mart. Fannie lent consumers the money…Wal-Mart, the retail arm of China, Inc., helped them squander it.
*** Reading the U.S. papers, we detect widespread support for President Bush and his activist foreign policy. The prevailing sentiment in yesterday’s International Herald Tribune, for example, was one of steadfast optimism. No, things were not going as we would like, the editorialists seemed to agree, but we are sure we are doing the right thing.
Right thing? Wrong thing? We have no idea how it will turn out. But we note how reluctant the masses are to give up on an idea – even if it seems preposterous.
The idea that average investors are going to get rich by buying each others’ stocks or each others’ houses, for example, is absurd. As a group, which is to say on average, people would be not one penny richer even if the prices of all stocks and all houses doubled overnight. The stream of real earnings…or real utility…from these assets would be exactly the same. A stockholder might sell to a non-stockholder and the seller would be ahead of the game. But, on average, everyone would be the same…because now the buyer no longer has the money.
Still, people do not readily give up on stocks. On Monday, the Dow fell below 10,000. Stocks are no higher today than they were, what, 6 years ago. And now, stock prices seem to be headed down. And yet, investors hold on…they still believe…
They believe in their government, too.
Stopping in the news shop at the train station, we saw an intriguing German magazine. “The Most Catastrophic Mistakes of the Last Hundred Years,” said the cover. We do not understand German, but we got the idea from the photos. WWI. WWII. Death Camps. Etc. When it came to catastrophe, the Germans had a peculiar gift for it.
But it is a new century. Catastrophe may have emigrated. It could hold a U.S. passport now.
No one can know what will happen, but a good argument can be made that George W. Bush has made one of the most catastrophic mistakes in American history. Thousands of people have been killed in his Iraq adventure – for no apparent reason. The cost is mounting; $300 billion is the estimate we saw this morning. The integrity of America’s military has been compromised. The moral high ground of its modern ‘civilizing mission’ has been lost.
But the more damage a president does, the more the voters love him. Bush has not yet equaled America’s biggest catastrophes – Lincoln’s war between the states, or Wilson’s entry into WWI – but if he keeps going at the present pace, he might still get his mug on Mount Rushmore.
*** More on the battle of Dien Bien Phu, from the English magazine, The Spectator:
“…The battle began in earnest on 13 March 1954, and ended after a 57-day siege. When the end came – the Viets used trench warfare offensively, creeping up inch by inch, overrunning impregnable positions by flooding; they had dammed up rivers and diverted them into the valley – [Colonel Christian Marie Ferdinand de la Croix] de Castries phoned Cogny back in Hanoi. Here comes the Beau Geste moment.
“‘Raise the white flag,’ said Cogny, adding, ‘But it would be such a pity after such a gallant defense.’
“At the end, de Castries refused to raise the flag of shame. He simply ordered his men to stop firing and to lay down their arms. General Giap walked in stepping on the body of a dead Viet Minh in the process. Just before the fall, de Castries spoke on the telephone with his wife back in France. For once she was sure he was not screwing around. They said tender goodbyes. Of 15,000 defenders, 3,600 died in action, 4,400 were wounded, and out of the 9,000 prisoners more than half died from the brutal Viet treatment.”