All Signs Point to Bubble

The Fed’s "fighting inflation"…or at least that’s what Greenspan and his cronies want you to believe. But the Good Doctor knows better – and he’s not afraid to tell it you straight.

In its Jan. 10 issue, Business Week carried an article, A Gold Medal for the Fed’s Inflation Fighters, from Glenn Hubbard, dean of Columbia Business School and former chief of the president’s Council of Economic Advisers. The key point of this article is that "by holding inflation down, the Fed has boosted the economy." We mention this article because it is highly typical of the prevailing systematic disinformation about the U.S. economy.

Given a U.S. inflation rate of 3.3% during 2004, any talk of "ridding the U.S. economy of inflation" is, first of all, grossly misplaced. Even more absurd is the further assumption that the Federal Reserve has distinguished itself as a great inflation fighter.

In actual fact, in the past few years, the Greenspan Fed has systematically and deliberately fostered parabolic credit and financial excess with the explicit purpose of inflating asset prices. What manifestly is duping most people is the fact that the bulk of the credit excess poured into asset prices and the soaring trade deficit, rather than into the CPI, as had been usual.

Bubble Economy: Its Cause and Effects

As we have repeatedly stressed, speaking of inflation requires a distinction between cause and effects. It ordinarily has one and the same cause: excessive creation of money and credit. But its impact on the economy and its price system depends entirely on the specific purposes for which the borrowed money is used. Therefore, its effects may differ immensely.

Principally, credit excess may find three different outlets: first, rising prices of goods and services; second, rising prices of financial and tangible assets; and third, a rising trade deficit.

The conventional focus is exclusively on the first outlet: that is, on the movement of consumer prices, popularly called CPI in America. Amazingly, even most experts flatly deny a causal connection between a rampant credit expansion, rising asset prices and a rising trade deficit. The rampant inflation in U.S. stock and house prices is actually hailed as "wealth creation."

Historically, consumer price inflation has, indeed, been the regular key feature of credit excess. But this pattern began to change drastically in the course of the 1980s. For the first time, protracted, exceptionally sharp increases in stock and real estate prices occurred in various countries, while price increases for goods and services remained moderate.

At first, there was little inclination to see in soaring asset prices a feature of inflation, even though all countries concerned showed a simultaneous surge in money and credit growth. It irritated many experts that this monetary explosion did not show in higher prices for goods and labor, as it had done in past booms. In the late 1980s, Japan had double-digit money, credit growth and soaring asset prices, yet virtually stable consumer and producer prices.

For years, this strange coincidence of soaring asset inflation and simultaneous moderate consumer price inflation was hailed as a sign of economic health and dynamism. It has long been one of Mr. Greenspan’s favorite arguments that this unusual coincidence proved the existence of a "new paradigm" economy.

While stock prices have recovered from their lows in 2001, in general, their gains during 2004 were very limited. Instead, a developing property bubble has gone global. Full-blown housing bubbles with double-digit annual price increases now exist in many countries, for an obvious cause. Ultra-low interest rates introduced by central banks to fight threatening recession have triggered an explosion in borrowing for house purchases in many countries.

Observing this, it must be stressed at the outset that from a macro perspective, the crucial issue is not an asset price bubble per se. The key question is whether and to what extent asset owners convert the asset appreciation into higher borrowing and spending. Asset bubbles as such constitute little more than a temporary economic nuisance.

Bubble Economy: Housing Bubbles Around the World

In France, too, where we live, house prices have soared at double-digit rates. But the key feature of a bubble economy – that is, the run of house owners for equity extraction, as in the United States and Britain – is completely missing, even though variable mortgage rates are at a historical low of 3.25%. Remarkably, nobody in France talks of "wealth creation." France certainly has a house price bubble, but it does not have a "bubble economy" in the sense that the rising house prices are used to boost consumer borrowing and spending for other purposes.

In the late 1990s, the U.S. stock market bubble went global. The same has happened in the last few years to the property price bubble. According to reports, full-blown housing bubbles currently exist in many countries around the world. As explained, their common cause is obvious: Ultra-loose monetary policy and ultra-low interest rates. In due time, sharply rising house prices added to the interest incentive.

Under these monetary conditions, it made sense to buy a house.

But to repeat, the pivotal hallmark of a "bubble economy" is that the ballooning asset prices are widely used as collateral for a general consumer borrowing and spending binge. In the United States, mortgage borrowing by households during the first half of the 1990s increased by an annual average of $168 billion. This accelerated in the decade’s second half to $296.9 billion. But after 2000, it virtually exploded to an average annual growth rate of $615 billion.

It is undisputed that the greater part of the escalating mortgage borrowing in the United States was for purposes other than house purchases. In short, it boosted consumption as a share of GDP at the expense of business investment and the trade balance. That is, it radically changed the U.S. economy’s pattern of growth – actually an unsustainable pattern of growth.

Yet America’s consensus, amongst it Mr. Greenspan and the Fed, categorically refuse to see any proof of a "bubble economy." A recently published survey article by the St. Louis Federal Reserve – Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms – made a most amazing statement in its conclusion: "We find little indication that booms were caused by excessive growth of money and credit, though 19th-century booms tended to occur during periods of monetary expansion. The view that monetary authorities can cause asset market speculation by failing to control the use of credit has been largely discarded."

To quote a commentator: "The complacency of the central banking fraternity and their academic standard-bearers is a wonder to behold."


Dr. Kurt Richebächer
for The Daily Reckoning

February 2, 2005 — London, England

Still want more from the Good Doctor? Check out his special report on the dollar’s long, slow slump. He predicts the that the dollar’s demise will continue for quite a few more years…and Dr. Richebächer is rarely wrong.

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."

We expect this year to be the year the consumer finally cracks. We will win no prizes for timing; we thought the same thing last year…and the year before.

But yesterday brought new evidence that the crack-up must be coming… soon. Some would say American consumers show signs of having cracked already.

But first, we salute Mr. Dave Brekher of Philadelphia. He must be one of the rarest of species in Christendom, a lender with reservations.

Yesterday, as the day before, investors, analysts and economists all were bullish. They were bullish on the American consumer credit economy, on its stocks, on its democracy, on its houses and on its professional sports.

But Mr. Brekher, president and co-owner of North American Federal Mortgage Co. in blue-collar Northeast Philadelphia, realizes that enthusiasm is not the same as good credit. His company has been asked to lend money to local football fans wishing to mortgage their houses so they can afford to go to the Super Bowl. "No," he said.

"If someone is that desperate, there’s always repercussions," he explained.

Yes, dear reader, there’s always repercussions.

But it is precisely "repercussions" that most Americans deny. U.S.A. Today polled a group of 58 "top economists." Hardly a single one of them saw any repercussions. The dollar can fall; there will be no repercussions, they think. Even news that America’s richest man, Bill Gates, is now, "short the dollar," along with America’s second richest man and its shrewdest and most successful investor, Warren Buffett, did nothing to change their minds. Likewise, the U.S. federal budget deficit can reach new records and the current account hit new highs – together they add up to more than $1 trillion of debt each year – with no repercussions. So, the nation can spend $300 billion in Iraq and Afghanistan (not to mention killing thousands of people) with no repercussions. Nor does it need to save money…or invest in productive new industry…or train people in engineering and science. (Maybe they’ll all deliver pizzas to one another!) Whatever they do, there will be no repercussions. Never.

Instead, the "top economists" foresaw steady growth – 3.6% in 2005. It did not bother them that the United States now requires nearly 80% of the world’s available savings in order to maintain itself at current levels of consumption, nor that Japanese and Chinese central bankers have in their vaults more than $900 billion worth of U.S. Treasury securities; they could send the U.S. into severe recession with a single word: "sell."

Apart from Mr. Brekher, no one in Philadelphia worries about repercussions:

"Eagles fans borrowing against their homes for Super Bowl trips," began a headline from the Associated Press.

It has been 24 years since Philadelphia had a team in the Super Bowl. Can you blame fans for not wanting to miss it?

"I don’t care if we have to mortgage our house, I’m going," said one Eagles fan named O’Donoghue. "Sometimes the cards are maxed out and you gotta do what you gotta do," he explained.

What O’Donoghue had to do was to take out a home equity line of credit, that is, to mortgage his house.

"If I had any equity left in my house, I probably would, too," said another football aficionada, who paid $8,686 Super Bowl package out of savings.

"I’d argue it’s a better investment than a flat screen TV," said a cooperative lender.

We would argue that it is not better a better investment, but one that is equal to a flat screen TV – at least as likely to pay off. Neither will pay much in the way of dividends; both will have repercussions.

More news, from our team at The Rude Awakening:


Tom Dyson, reporting from Baltimore…

"’Alchemists have actually found a way to manufacture gold out of lead, and at commercial prices,’ claims the archived article from January 20, 1980."

Bill Bonner, back in the building with the golden balls:

*** One of the major sponsors of the Super Bowl is lender, Ameriquest. Our Pittsburgh correspondent comments:

"And as to Ameriquest, don’t get me started on that bunch of thieving bastards. Okay, you got me started. Their lending practices are so aggressive as to be deplorable. They prey on a combination of peoples’ ignorance and shortsighted greed. They say things like, ‘no one holds a gun to anyone’s head to make them take out a loan.’ Yes, but… They focus on people who live at the economic margins. Working poor and lower middle class… They offer the prospect of prompt cash, but are pretty short on the financial education that a consumer ought to have before going into debt, particularly on his house.

"Ameriquest has almost single-handedly corrupted the ‘appraisal’ market nationwide, by pressuring appraisers to ‘challenge the market’ with elevated estimates of value. Then, they loan ungodly amounts against these inflated appraisals (like, 100% against an inflated estimate of value), with the borrowers’ payment-to-income ratios commonly in excess of 50%. Thus, there is no margin for error or financial setback. They tack on hefty fees up-front, to make for 110-115% loans to (inflated) value. They are brutal with their prepayment penalties, usually for the first three years of a ‘loan,’ so it is a disincentive to refinance at a lower rate. Their variable rates are geared to increase with a trajectory that makes the space shuttle look like a static display. And then they sell the paper into the secondary markets, which eliminates the ‘friendly banker’ concept if someone is having trouble with payments.

"This system is completely geared to prompt payment (‘capital discipline,’ or ‘the discipline of debt,’ are common euphemisms), and it almost never allows for partial payments after late or missed payments. There are small armies of lawyers in most major cities who do nothing but run lawsuit-mills to sue in foreclosure when people miss payments. Talk with any U.S. Bankruptcy Trustee, and ask about Ameriquest, and you will see a scowl on the Trustee’s face. That says it all."

*** We got a letter from a reader who strongly objected to the way the French hunt stags. Of course, the French have been doing this for hundreds of years. Somehow, the writer seems to hold us responsible for it. His letter, with our annotations:

"You are now officially a Great White Hunter – one who has literally ‘hound’-ed an innocent animal to its gruesome death."

[Actually, we weren’t even there…our son reported it to us.]

"Tell me, what did the poor animal do to you? Did it have the nerve to grace the landscape with its beauty? Did it attack you in a fit of animal rage? Well, one cannot have that."

[The animal did nothing to us, or we to it…]

"Ah, but now you can sit back and relax in your château by a roaring fire and regale your guests with the story of your magnificent and brave hunting prowess."

[You must be thinking about someone else…]

"I suppose you are so hungry for the approval of the French (who hate you, by the way) that you will resort to anything to try to prove you are just ‘one of them.’"

[Are you kidding? They don’t let outsiders do anything but watch…]

"Next time, I hope they choose you to be the ‘stag.’ I wonder how you will feel being tormented and tortured by a mass of blood-hungry fools – and I’m not referring to the hounds."

[Amazing how many people insist we act just like them…or they get upset about it.]

*** Another letter, another subject:

"First off, as an ex-pat Englishman trapped in the United States by a wife who hated Europe, I never cease to be amazed by the average American (including her). Perhaps it’s the school system, I don’t know, but notice that the New England Patriots are now ‘World Champions.’ Not content with the ‘World Series’ in baseball, it seems that everything that no one else plays in the world qualifies an American team for the world title. I just think that it’s a way for this country to cling on to something ‘tangible,’ albeit a fantasy, as a way of saying that America is still number one. I think that it may also be a recognition that the country is going down the pan economically and they are inventing new and daft ways to cling on to the top spot.

"Just one more reason that the rest of the world finds them an odd bunch."

*** And another:

"China in 2050! Ha…there won’t be a China…or, any other country for that matter…planet Earth is TOAST my friend…the end is soon to come…the book of Revelation in the Bible is fast approaching…get ready!!!

"The entire face of the planet will change within the next two decades. The Earth’s population will be reduced to 10-20% of its current size, following world devastation that will put us back into the Stone Age!

"However, small groups of government, military and civilians will live in underground cities that the major superpowers are now building in secret…just hope you are lucky to be one of these!

"A much smaller group will escape – in a grand deception – the planet entirely on extraterrestrial spacecraft to live on other planets in the galaxy… just hope you aren’t one of these unfortunate ones!

"I will live at the top of a mountain in a secret gold mine…outfitted with food, clothing, weapons and survival gear to last the rest of my life!"

The Daily Reckoning