Corporate America to the Rescue?

The Daily Reckoning PRESENTS: The Good Doctor is back – and still wondering why our friends at the Fed seem to think that the U.S. economy is “sound” – even though all the signs seem to be saying otherwise. Read on…


With some consternation, we have been reading that Fed officials think the U.S. economy is a lot sounder today than it was at the end of 2000 and in early 2001, when the Fed abruptly reversed course and began a string of rapid interest rate cuts. One can only wonder about its reasoning. What we see is a doubling of the U.S. trade deficit, the complete collapse of personal and national saving and an unprecedented borrowing deluge that created the most anemic GDP growth in the whole postwar period.

During the five years 1995-2000, nonfinancial debt growth by 32.4% went together with 22.2% real GDP growth. In the following five years 2000-05, nonfinancial debt grew by 47.3% and real GDP by 13.4%. There has been an atrocious deterioration in the relationship between debt growth and economic growth.

In his speech on the Economic Outlook on Nov. 28, Chairman Ben S. Bernanke said:

“A reasonable projection is that economic growth will be modestly below trend in the near term but that, over the course of the coming year, it will return to a rate that is roughly in line with the growth rate of the economy’s underlying productive capacity.

“This scenario envisions that consumer spending – supported by rising incomes and the recent decline in energy prices – will continue to grow near its trend rate, and that the drag on the economy from the motor vehicle and housing sectors will gradually diminish.”

To everybody’s surprise, Mr. Bernanke indicated he was more afraid of inflation than of an economic slowdown. What, actually, would happen if he expressed some fears about an economic slowdown? He would unleash an undesirable torrent of speculation anticipating the coming rate cuts. It is one of the many bad ideas of Mr. Greenspan that central banks should foreshadow to the public their next policy moves. It only plays into the hands of speculators.

While admitting that “the correction in the housing market could turn out to be more severe and widespread than seems most likely at present,” Mr. Bernanke added:

“Economic growth could rebound more vigorously than now expected. The solid rate of job growth, the decline in the unemployment rate and the healthy pace of capital investment could be signals that underlying fundamentals are stronger than generally recognized. Moreover, to date, there is little evidence that the weakness in housing markets is spilling over more broadly to consumer spending or aggregate employment. If these trends continue, growth in real activity might return to a pace that could intensify upward pressures on resource allocation.”

Pondering the U.S. economy’s performance in 2007 ultimately boils down to two main questions: first, whether the housing downturn will seriously hurt consumer spending;  and second, whether capital spending by Corporate America will promptly come to the rescue when consumer spending slows.

In our view, the first eventuality is highly probable, and the second is highly improbable. The first of the two assumptions is simply commanded by the recognition that the housing bubble over the last few years has been the economy’s main driving motor, against pronounced weakness in business capital investment. Sharply rising house prices provided the collateral, which enabled private households to embark on their greatest borrowing-and-spending binge of all time.

Those “wealth effects” from house price inflation, manifestly, played the key role in fueling the soaring home equity withdrawals. But the thing to see now is that to stop this easy credit source, it is enough for house prices to flatten. In fact, the curb to this borrowing-and-spending binge has started with a vengeance.

The fact is that private households have drastically curbed their mortgage borrowing. It amounted to $672.7 billion in the third quarter 2006, sharply down from $1,223.6 billion in the same quarter of last year. That is, consumer borrowing almost halved. It amazes us how little attention this fact finds.

It means that the most important credit source for spending in the economy is rapidly drying up, even though money and credit remain, in general, as loose as ever. It is drying up because the decisive lever of this borrowing binge, rising house prices, has broken down; most importantly, this lever is not under the control of the Federal Reserve.

A sharp decline or even cessation of such borrowing essentially indicates an impending sharp retrenchment in consumer spending. Mortgage equity withdrawal peaked at an annual rate of about $730 billion, or 8.1% of GDP, in the third quarter 2005. One year later, in the third quarter 2006, it was sharply down to $214 billion.

This, too, represents a pretty steep decline. Yet it seems to have had little effect on consumer spending, which rose 3.9% in 2004, 3.5% in 2005 and 2.9% in the third quarter of 2006. For the bullish consensus, this is instant proof of its prior assumption that the downturn in the housing market will not spill over more broadly to consumer spending or aggregate employment. The truth is that consumer spending has been squarely hit.

But to realize this, it is necessary to look at total spending by the consumer on consumption and residential investment. The latter was down 11.1% in the second quarter and 18% in the third quarter 2006, both at annual rate. Combined, the two components of consumer spending in the third quarter had slowed to an annual rate of 2%, the slowest growth rate since the past recession, against a 3.8% increase in 2005.

In 2005, real GDP rose $345.1 billion, or 3.2%. Private households increased their total spending by $312.2 billion, of which $264.1 billion was on consumption and $48.1 billion was on residential building. Together, the two components accounted for 91.8% of GDP growth. This spending boom compared with current income growth by just $93.8 billion, or 1.2%. Thus, less than one-third of the rise in consumer spending was funded by current income growth and more than two-thirds was derived from additional borrowing. To us, this seems an unsustainable pattern.

Considering the dramatic reversal in the housing bubble, a virtual collapse of consumer borrowing is definitely in the cards for the United States. Compensating for this big loss in spending power will require a sharp surge in employment and income growth. Some recent employment numbers have been somewhat better than expected. But they are not nearly as good as would be necessary to offset the impending further sharp decline in consumer borrowing. Importantly, there is no acceleration in comparison with last year.

The median price of a new single-family home fell 9.7% year over year in September – the largest percentage decline since December 1970. The median price of an existing single-family home fell 2.5% year over year – the largest decline in the history of the series.

How likely is it that this housing downturn will be milder than average, as the consensus assumes? A rule of thumb says that the fierceness of a downturn tends to be rather proportionate to that of the prior upturn. By any measure, this was America’s wildest housing boom. We owe the following chart to Paul Kasriel of Northern Trust. It measures the dollar volume of single-family home sales to GDP. In 2005, it reached a record high of 16.3%, almost double the median percentage of the entire series dating back to 1968.

For us, the most obvious, and also most simple, measure of spending excess is associated increases in credit and debt. Between 2000 and third quarter 2006, the mortgage debt of U.S. private households soared from $4,801.7 billion to $9,497.4 billion. In barely six years, it has, thus, almost doubled.

We have been reading with utter amazement that stronger employment and income growth will offset the negative effects of the downturn in homebuilding. By available official numbers, the housing bubble – including directly related businesses such as furniture, mortgage finance and real estate – has created about 850,000 new jobs, about 30% of total job growth. Most of these jobs are sure to disappear.


Dr. Kurt Richebacher
for The Daily Reckoning
February 1, 2007

Dr. Kurt Richebacher is the editor of The Richebacher Letter. 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.”

How do you say ‘bubble’ in Mandarin? The Shanghai exchange has gained 200% in the last 18 months. In Singapore, the stock market nearly doubled last year. And yesterday, the Dow hit a new record too.

And in Bozeman, Montana, it is a dash for trash. On Blixseth!

Mr. Tim Blixseth, whom we mentioned yesterday, is building what is easily the gaudiest cabin in the Montana woods…and perhaps the most expensive house in the whole world.

But, for making headlines, he has plenty of competition. Everything is soaring.

Oil rose to over $58. Gold shot up to $657. And Mr. Jim Wilson of Missouri won a Powerball pot of $254 million.

We were thinking of all this money this morning; it is the Age of Mammon, for sure. Which is why we have our Crash Alert flag still flying. Things don’t go up this sharply without them going down sharply, too – in a crash for example.

But don’t worry, say the experts, all this new sophistication in the financial markets (they have computers now!) makes crashes a thing of the past.

And yet, the Financial Times report from earlier this week troubled our sleep:

“‘There is now such creativity of new and very sophisticated financial instruments…that we don’t know fully where the risks are located,’ said Jean-Claude Trichet, head of the European Central Bank. ‘We are trying to understand what is going on – but it is a big, big challenge.'”

If the head of the second most powerful banking cartel in the world can’t make sense of it, what hope is there for us? We don’t know. But we have an obligation to our dear readers to try. So, for the last three days we have done nothing else…pausing only to pray and burn incense to the credit gods.

Do all these new financial instruments really reduce risk…or do they increase it? First, we have to master the peculiar dialect in which this subject is discussed. Swaps, securitized debt, alphas…you have to understand the language of the high priests before you can enter the temple. Then, when you get inside, you discover that the whole religion is nothing more than hocus-pocus.

After about 20 seconds of reflection, we realized that the answer, for once, lay not in the details, but in the generalities. The particular formula by which a specific derivative contract is constructed only affects the particular participants. But the phenomenon as a whole affects the entire world financial system. $450 trillion is a lot of money. In fact, it’s nearly 15 times world GDP. What it represents is more leverage and higher asset prices. Both make the financial world riskier.

Let’s look again at how it works. The feds make money and credit available. This reduces the cost of borrowing…and boosts up asset prices. Thereby, a man’s suburban castle rises in price, and he is able to ‘take out’ a little cash, by increasing his mortgage. This money gives him the wherewithal to buy a new car, made in Japan. The man himself is now immediately placed in a riskier position; he owes more money than he did before.

And then comes Goldman Sachs, which borrows the same money from the Japanese – at very low interest rates – and uses it to, say, finance the leveraged buyout of Equity Office Properties by the Blackstone Group. However much Equity Office Properties owed on its real estate holdings, the new owners are sure to owe more. That’s how leveraged buyouts work; the purchase is made on credit. The effect, once again, is to increase the risk in the system. If you own a commercial building in full, you can sit out a downturn in the business cycle. All that happens is that your income goes down. But if the building is leveraged, you have to pay interest on the debt. And if the interest is high enough…and your income falls low enough…you go broke.

Consider the aforementioned Mr. Blixseth, who is bringing more of the world’s good things to Bozeman, Montana. He is building a luxury ski chalet that he plans to sell for $155 million. What kind of a man would be able to buy it? Maybe someone who just got a wad of cash that didn’t exist before… someone who owned Equity Office Properties and just stuck it to a group of investors for $38 billion! But even buying bricks, mortar, and Italian granite countertops can be a risky proposition. The price of the house could go down. There’s a lot more risk inherent in a $155 million house than there is in one at $155,000.

But that’s not the end of it. The $155 million house can be a financial asset too – it can be used to secure a position in stocks, bonds, or private equity. And the debt used to acquire Equity Office Properties can also be traded, repackaged, sliced, diced and baked in a pie. Then, it too can be counted as an asset and placed in leveraged portfolios, passing around more risk. And as liquidity rises, people not only make more and bigger bets, but riskier ones. It is a classic bubble, where too much money chases too few decent investments. As Martin Fridson points out, the lowest-rated credits – Triple-C or below – which made up just 2% of the junk debt market in 1990, are now closer to 20%.

Still, here are the experts telling us that the financial system is actually less risky – because these fancy new products ‘disperse’ risk. Besides, they say, nothing bad has happened thus far; so, probably nothing ever will.

What do they take us for? The only reason nothing has gone wrong is…that nothing has gone wrong. We are living through the biggest credit expansion in history. When it ends, plenty will go wrong.

But will it ever come to an end? Yes, dear reader, everything does…

Which is why we keep our Crash Alert fluttering on the mast…

More news:


Eric Fry, reporting from Laguna Beach, California…

“… ‘Subprime’ refers to borrowers with relatively poor credit – i.e., borrowers who cannot qualify for a traditional ‘prime’ or ‘conforming’ mortgage…”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening


And more thoughts…

*** “Personal debt levels reach a record 140% of income,” says the Daily Telegraph, speaking of the English. In 1980, the paper explained, the level was only half as high. The Telegraph might have been speaking of almost any country in the English-speaking world. The leading financial regulator in the United Kingdom, the FSA, warned yesterday that debt levels were becoming dangerously high. Mortgage repossessions rose 65% last year. “There is a risk that consumers could be unprepared for a weaker economic environment…,” said the FSA.

What has happened in the Anglo-Saxon economies? Several things: First, the financial industry in these countries has been extraordinarily innovative and aggressive – always finding new ways to lure people into debt. Second, these economies are more closely allied with the United States and the U.S dollar. The steady loss of purchasing power in the dollar, and the threat of consumer price inflation, has led people to spend rather than save. Finally, the Anglo-Saxon culture, along with the English language, has become the imperial standard. But it is a late-stage imperial culture, dominated by a ‘get it now’ emphasis on money, status and material well-being.

*** Next week, we will have another opportunity to laugh at the rich. Christie’s and Sotheby’s will auction off some incredibly trivial paintings at incredibly high prices. A self-portrait of Andy Warhol hamming it up for a photographer is expected to bring $3 million. Another hideous portrait by Francis Bacon should sell for a similar amount. And there are also works by Gerhard Richter, Picasso, Twombly, and many others.

*** The frogs have succumbed to the spirit of the age. We’re having lunch with two hard-boiled smokers later today – will they light up despite the new ban? We’ll see. The French usually have the good sense to ignore the law; public smoking may still survive in the land of Liberte.

“C’est la merde…” said a taxi driver. “Everything is forbidden. Everything. I’m sick of it.”

Soon, we fear, people will not be allowed to smoke in private either.

But how do the health police know the world will be a better place without the smell of cigarette smoke? In the old days, a man sentenced to death would get a chance to smoke a cigarette before the firing squad shot him dead. Or, a man wheezing with a critical chest wound on the battlefield would ask his buddies for one last smoke. The U.S. army gave out cigarettes; it settled nerves. Our own father reported that he couldn’t have waged war in the Pacific islands without the help of the Philip Morris Company.

And how could you discuss Sartre or Foucault, without cigarette smoke to blot out the imbecilities of it? How could Marlene Dietrich have appeared so seductive, without a cigarette dangling in her hand? Or, Humphrey Bogart…what would he have been without smokes? Bacall might have paid no attention to him.

Thousands of people die because of tobacco, say the meddlers. True. But how many survive without it? It is never a question of whether…but only when.

Cigarettes have surely hastened millions to an early grave…but who measures the good they might have done? Who can tell, except the smokers themselves?

We have never smoked a cigarette, but we are thinking of taking it up just to find out.

The Daily Reckoning