Crippling "Wealth"

Do inflating house prices truly enrich homeowners? Do they enrich the nation? Our short answer to both questions is a categorical no. The ugly truth is that both are impoverished. Dr. Richebächer explores…

Let us start with a quote from Friedrich von Hayek: "The means of perception employed in statistics are not the same as those employed in economic theory." American economists think far too much in statistical terms, regardless of underlying economic processes. While the statistics do, indeed, show general enrichment, in reality, there is none at all. The homeowner has zero gain in his comfort of living or income.

This perception of wealth has its true basis in nothing but the famous "greater fool theory"; that is, in the expectation that there will be a greater fool to buy the acquired house later at a higher price. Deluded by this wealth chimera, private households have run down their savings and piled up astronomic debts to be repaid with future earned income.

Where, then, are the economic benefits? The one obvious visible benefit is in the push to GDP growth from higher consumer spending, which also increases current incomes. Yes, but much of that spending on cars, furniture and houses is borrowed from the future. That is, the borrowing pulls future spending into the present, but, of course, at the expense of such spending in the future.

The Perception of Wealth: Distorting and Deforming

If you think it over, you realize that in reality, such a borrowing/spending bubble adds nothing to economic growth. It only distorts the time pattern of spending in relation to its long-term trend, as in the case of the consumer determined by the underlying rate of income growth.

The second problem is that such a bubble distorts and deforms the direction of demand and production in the economy. Consider these grossly disproportionate increases in U.S. domestic spending since 2000: consumer durables +30.8%, residential building +29.5%, nonresidential investment +5.8%, imports +23.5%, exports +5.8%.

Strikingly, all economies with housing bubbles have features in common that were, in the past, generally associated with ailing economies. These are collapsed savings; skyrocketing debts; chronic, large trade deficits; and booming residential investment, but weak business investment.

This coincidence is not accidental. The common denominator of these countries is runaway consumer spending. That is the key point. The big spending excesses in these countries are in consumption, while business fixed investment is in the doldrums. Policymakers and economists in the countries with these symptoms are the first in history to proclaim that people and nations become richer with consumer borrowing-and-spending binges.

Consumption never creates wealth. It is categorical: Capital decreases when consumer spending exceeds production. What is happening in these countries is the exact opposite of wealth. It is capital consumption in the sense that consumption absorbs a growing share of GDP at the expense of investment and the trade balance.

On the macro level, this is impoverishment. As a matter of fact, it is statistically easily verifiable. It shows in the comparison of soaring U.S. foreign indebtedness to the lagging growth of the domestic capital stock, as measured by net capital investment.

U.S. net foreign debts are increasing at an annual rate of around $700 billion, or 6% of GDP. The available data for America’s net fixed investment end in 2003; in that year, net private domestic investment amounted to $529.9 billion, or 4.8% of GDP. Of this total, residential building accounted for 3.4% of GDP and nonresidential investment for 1.4%.

Traditional economic thinking assumes that higher consumer spending stimulates businesses to increase their spending on capital investment and employment. This went badly wrong. It has not been realized that excessive consumption, taking up a rising share of GDP, has the exact opposite effect of depressing savings, investment and the trade balance through well-known crowding-out processes.

The Perception of Wealth: Not Wealth Creation, but National Impoverishment

If you think all this over, you will realize that the American economic reality on the macro level is not record wealth creation, but national impoverishment, foreboding a declining living standard. Take the borrowed import surplus away, and U.S. living standards collapse.

Among the industrialized countries, Japan and Germany are the two great exceptions that have missed the global housing bubble. Japan is still struggling with the aftermath of its building bubble in the late 1980s, while Germany is struggling with the building bubble that developed in eastern Germany in the wake of unification.

Yet speaking of a global housing bubble, we hasten to emphasize again that there is one all-important difference in such bubbles. There are countries where rising house prices have been isolated events in the price system without significant effects on the economy, and there are countries where the housing bubbles have become the dominant influence both on the economies and financial systems.

This really is the dividing line between bubble economies and nonbubble economies.

The inflating house prices in Europe have even failed to prevent a slow decline of consumer spending. Consumers maintained their high saving rates.

Now one question: What does this aversion to consumer borrowing have to do with monetary and fiscal policies? What does it have to do with fundamental economic weakness? Absolutely nothing.

It has to do with a traditional cultural aversion in Europe to consumer borrowing for purposes other than building or buying a house.

And of course, it is stupid to believe that this aversion can be broken with still lower interest rates. In the first place, it robs the savers of income on their large mass of existing savings. It will shock them. The crucial difference to see is that Europeans are primarily savers, while people in Anglo-Saxon countries are primarily borrowers.

Consumption-driven bubble economies reveal themselves at first through sharply falling personal savings. Their second typical, yet spectacular, hallmark is large trade deficits.

The Perception of Wealth: When the Bubble Bursts

In the end, the main question is, of course, what happens when a housing bubble expires. As to be expected, Mr. Greenspan and the bullish consensus deny the possibility of a hard landing. A little logic says that such a landing is inevitable.

An illuminating case in this respect is the very recent experience in the Netherlands. While traditionally a country highly conservative in its finances, it developed a housing bubble in 1998-99, after years of strong economic growth. House prices and credit growth soared at double-digit rates. As homeowners cashing in on their burgeoning home equity went on a spending spree, the household savings rate plunged from 12.9% of disposable income in 1998 to 6.8% just two years later.

As the Dutch central bank raised its short-term rate from 2.5% to 4.5% from 1999-2000, house price inflation came to an abrupt halt. Household borrowing and mortgage equity withdrawal slumped sharply.

Being deprived of their "wealth effects," the Dutch people returned to saving from their current income. Within just three years, the personal savings ratio was back to 12%, driving the Dutch economy into the worst recession among the industrialized countries. The growth rate of consumer spending sagged in a straight line from 4.7% in 1999 to minus 1.2% in 2003.

We have recalled this episode to emphasize one point of greatest importance, yet one that is widely ignored. The Dutch example confirms that for consumer spending to slump in the wake of a fading housing bubble, house prices do not need to fall at all. It is sufficient that they stop rising, thereby depriving households of new wealth effects and the associated borrowing facilities.

Therefore, major housing bubbles imperatively end in a hard landing. A second major adverse influence on economic growth implicitly arises from the sudden cessation of the building boom. Yet the worst looming problem is always the potential damage to the banking system through escalating bad loans.

On Dec. 5, 1996, when Alan Greenspan made his famous remark about possible "irrational exuberance" in the stock market, he asked a rhetorical question: "How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?"

For a central banker, that is really a most astonishing question. With some knowledge in macroeconomics, bubble economies – in the sense that asset bubbles impact the economy – are most easily identifiable. Consider that last year, the United States had recorded an overall credit expansion of $2,718.6 billion, versus virtually zero national saving. As you can see, the simple clue is in the relationship between soaring credit and collapsing savings.


Kurt Richebächer
for The Daily Reckoning

June 21, 2005

P.S. As of last year, Americans were holding onto $37 trillion in debt – more than $123,000 for every man, woman and child in the United States. This amount of debt is more than three times the total number of dollars in existence anywhere – in home and business equity, checking and savings accounts, stock markets and even those held by foreign investors (66% of all dollars are held by foreign investors, by the way). If all of this debt comes due, there literally isn’t enough money on Earth to pay it.

Yet, the Fed and the mainstream analysts still talk about the American economy’s resilience, growth and recovery.

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."

This time of year, here in London, one day has barely died before another is born. It is light until 10:30 at night. Then, it is light again at five in the morning. We have not had time to rest or collect our thoughts.

That is usually a plus. When you are in love, war or a market mania the last thing you want to do is stop and think. You might decide to forget the whole thing. Why? Because they almost always lead to tears: heartbreak, death or insolvency, depending upon the affliction.

Today’s love affair is with the U.S. Imperium…the modern American empire had turned our hearts to mush. It must be infectious; now our brains, our money and our economy have turned to mush too. Today’s war is a dull, but expensive, fight against "terror" – whoever that is. And today’s market mania is in housing. All over the world, residential real estate is HOT! Hot. Hot. Hot. So hot they have to print the listing on asbestos. So hot the sidewalks melt. As hot as the core of the sun on a summer day. As hot as Hades without a shade tree. HOTTER than HOT. Hotter than a $25 pistol in a drug war. Red hot. White hot. Red, White, and Blue Hot.

We only mention it because everyone says so. Everyone says we have a real estate bubble. In fact, The Economist tells us it is the biggest bubble in history. The stock bubble of the late ’90s increased investors’ wealth, on paper, by an amount equal to 80% of GDP. The stock bubble of ’29 added an amount equal to 55% of GDP. But the last five years of the real estate bubble have added as to Americans’ wealth as an entire year’s output; that is, 100% of GDP.

Here, too, the syndrome is catching. Easy lending, easy spending policies in the U.S. have forced the whole world to keep up. Foreign central bankers must create more and more of their own money in order to sop up U.S. dollars – which are then relent to the United States. The result is a worldwide bubble in money and credit, reflecting in rising real estate prices almost everywhere. According to The Economist, this bubble has added $30 trillion worth of wealth in the last five years. This "wealth," we caution Daily Reckoning readers in the words of the Economist, is "largely an illusion."

And so the whole world is HOT, enjoying an once-in-a-lifetime shindig on borrowed money and borrowed time. In Australia and Britain, property prices seem to be softening already. American prices won’t be too far behind.

How do we know?

Longtime Daily Reckoning sufferers know that we have a deep appreciation for ignorance. Where others see enlightenment, we see rampant stupidity. Where others see geniuses, we see blockheads. Where others see the future clearly, we see only the murk of our own thoughts and desires. We have no idea what will happen, but when others bet that something extraordinary would become even more extraordinary, we are happy to take the other side of the wager. The mean would not exist if things did not regress towards it. The days get longer and longer until today; and then they get shorter. Gradually, the days’ length regresses to a mean of 12 hours of sunshine, 12 hours of darkness. The trend does not stop there. Then, the days continue to get shorter and shorter until December 21st, when once again, they regress to the mean.

Real estate will regress to the mean just like everything else, dear reader. Prices will either fall sharply. Or they will stop rising, and fall gently against inflation. One way or another, soon or late, the real price of property will go back to where it always has been. Yale economist Robert Shiller predicts a 25% drop in residential property prices. The Economist hints at a worldwide recession when the air goes out of the real estate market. Maybe they will both be right.

But how could we have a real bubble in real estate when so many people say so? Don’t worry, dear reader. This mania is a popular mania. And the average lumpen house buyer has no clue. He has heard that he is buying in a bubble. He’s happy to do so, because he has no idea what a bubble is. "Yes, there may be a pause," he will tell you, "but property never goes down in price – not in America!"

More news, from our team at The Rude Awakening…


Eric Fry, reporting from Manhattan:

"What do Flemish Renaissance painters and exchange-traded funds have in common? Both have the capacity to create equally ‘lifelike’ deceptions."


Bill Bonner, back in the SUPER HOT real estate sector….

***"No-money-down MANIA," reads a headline in MONEY Magazine. The interesting thing in the story about the No-Money-Down gurus is the photo. The people attending are not a group of investors. They are fairly young people, lower-middle-class people by the looks of them. Our guess is that the concept of a "bubble" means nothing to them. We would also guess that they don’t have a lot of extra money to lose…and that they’ve bet their financial futures on the real estate bubble. This is very different from the punters who ran up tech stocks. They had to put up real money. But few mortgaged their houses to do it. When the bubble popped, they were poorer, but wiser.

What will happen to these people when the real estate bubble pops? They are already poor.

*** How? When? We don’t know. But we regard the collapse of the housing bubble as a near-certainty. But it is like life itself; just because an end is inevitable doesn’t mean you are eager to see it come. People go about their business, buying and selling, as if it will never come. But it certainly will.

Another doomed phenomenon is the U.S. dollar. The American currency rose with the empire – from 1917 to 2002. But no paper money has ever endured. The dollar is now losing value faster than the Roman currency after Nero. That it will eventually be extinct is a safe bet. When it will happen is anyone’s guess. But gold is rising against the dollar and will, no doubt, continue to do so. Gold, food, houses, oil and other tangible things can only be brought into commerce at great expense in time and money. Paper dollars can be created at will. The relative abundance of the latter compared to the former makes the decline of the dollar inevitable.

And of course, the empire itself has a tomb waiting for it. As long as there are humans there will be human history. And what is human history but a record of the misadventures of the species? One empire is born; another dies. An empire is an extraordinary thing, like a market mania, a war or a love affair. All of them regress to the mean of ordinary life, where things are not HOT…HOT…HOT…but normal, common, usual…as cold, boring and peaceful as the grave.

*** A reader, writing from Ireland:

"I write to you with the intention of passing on compliments with regard to the Daily Reckoning mailout which I thoroughly enjoy reading and also with a genuine query regarding house prices in the Emerald Isle

"Due to a variety of travel and business adventures throughout my twenties I find myself at age 34 in the (slightly) unfortunate life cicumstance of living with my parents.

"This is not entirely an unusual occurrence in Dublin. I have lots of friends my age engaging in similar living arrangements. Frankly, although I love my parents very much, I would much rather be living elsewhere (as would my long suffering parents).

"I pay a nominal rent and contribute to bills and am saving for a deposit to buy a house somewhere in Dublin. As you are most likely aware, local house prices have been steadily increasing and I reckon it will be easy enough for me to acquire an ‘agreement until death’ with a local lender secured against a habitable collection of bricks tethered with mortar.

"But my question is, ‘Should I bother?’

"I am trying to resist pressure to enter the housing market as it goes against my (minimal) better financial judgment breaking many property purchasing rules:

"1. Having a deposit greater than 30% of the asking price. (I possess considerably less than that at present. The parents have offered to help but I am uncomfortable with this kind offer.)

"2. Being able to afford repayments on a loan given a two to five percent increase in interest rates, I probably couldn’t.

"3. Entering a market where the price of the artifact is expensive. Every year I have put this off house prices have increased. But I have also experienced the benefits of purchasing property in a foreign land where there was a market ‘correction’ of over 20%. I know a drop in house prices is not (as is locally called) ‘impossible.’

"Should I move out, rent and save more slowly or should I stay, save and get a three-bedroom house swapping cohabitation with my parents for cohabitation with tenants?

"Kind regards,


*** Dear Robert,

We do not give personal advice in the Daily Reckoning. And if we did you’d be a fool to take it. But we have some thoughts.

First, we note that the house bubble has blown up prices in Dublin as much or more than anywhere else. Since that is the case, you could reasonably expect to get more house for your money later rather than sooner. House prices should revert to the mean. When they get to the mean, or below, you will make a better purchase.

Second, we caution that a house is not an investment. It is a consumer item. The time to buy a house is when you want one and can afford it, just as with any other consumer item. Will it be cheaper in the future? We guess it will, but we don’t like to run our personal lives on the basis of our guesses about the markets. Instead, we ask ourselves a specific question rather than a general one: do we want to pay that amount of money for that particular house? Or would we prefer to rent the one next door? That is, you might want to convert the whole issue from macroeconomics to a matter of personal, private interest. You cannot really know what the markets will do. So you have to ask yourself the questions without regard to your macro-economic guesses.

We have noticed, for example, that while we are perfectly happy to rent an apartment, our better half feels a strong desire to buy one. It is not an economic or investment question. It is simply a matter of personal taste. In our experience, women like to feel they have the family’s feet firmly on the ground – rooted in community affairs and mortgage payments. Men might prefer a more nomadic life. What can you do? You compromise. You divide decision-making. But here we give you some confidential advice, hombre al hombre: You tell your spouse that she will make some of the decisions and you will make others. Just make sure you make the important ones. That’s the way we have done it in our household. Your editor’s wife decides where we live, where the children go to school, where we go on vacations, what we do with our time, where we invest our money and how we spend it. But your editor makes the important decisions, such as the family’s position on the European constitution and the revaluation of the yuan.

The Daily Reckoning