How to Identify a Bubble
The Daily Reckoning PRESENTS : All asset bubbles and bubble economies have their highly visible and also compelling trademark in exploding credit.
In the old days, central bankers were always mindful of the necessary balance between available domestic savings and credit expansion. For them an early indicator of a developing imbalance between the two aggregates was a deteriorating trade balance, responding typically long before prices.
It is, as a matter of fact, the central axiom of the Austrian school of economics that the movements in the price level can be a misleading guide to monetary policy. What crucially matters is the inflation of credit, exerting a much deeper and fundamental influence on the whole economy through distortions and dislocations in its whole demand and output structure.
From a policy perspective, to stress the key point, the decisive evil thing is the credit expansion that exceeds available domestic savings. That is the regular, cardinal culprit behind all dangerous economic and financial imbalances, and also behind all inflations. What the Greenspan Federal Reserve refuses to accept is that their beloved wealth-creation reflects incredibly dangerous inflation in the asset markets.
Asset Bubbles: Outrageous Credit Inflation
Putting it differently, in a balanced economy, credit expansion is fully matched by available domestic savings. This used to belong to the elementary knowledge of economists. Mr. Greenspan shocked us with his public remark that an asset bubble can only be recognized after it has burst. Outrageous credit inflation was the infallible and most spectacular hallmark of America’s equity bubble in the late 1990s. But instead of feeding into the price indexes of goods and services, which continued to fall, it fed into soaring imports and soaring stock prices.
To repeat: All asset bubbles and bubble economies have their highly visible and also compelling trademark in exploding credit. The distinction between the two is important. An asset bubble simply reflects a rise in asset prices out of proportion to underlying yields. A bubble economy is an economy where soaring asset prices fuel a borrowing/spending binge that may be concentrated in real estate, business fixed investment or consumption.
At year’s end, during the discussion about the U.S. economy, it has been repeatedly mentioned that interest rates are at their lowest in 45 years. It made us curious about differences in the underlying conditions in the two periods.
Comparing the two eras was a most interesting exercise.
The common feature between them is low inflation rates. But in every other respect, the comparison reveals radically different economic and financial universes, and also radically different causes for the record-low rates.
Asset Bubbles: Comparing 1959 and 2004
In 1959, the private sector’s total net savings amounted to $44 billion, of which personal saving accounted for $26.5 billion and business saving (undistributed profits) for $17.5 billion. With the government sector in surplus by $21 billion, the three components added up to net national savings of $61.1 billion, or 12% of GDP.
Imagine: In 1959, the business saving rate net of depreciation – undistributed profits, in other words – was 3.4% of GDP. Compared to today’s GDP, that would amount to undistributed profits of around well over $350 billion.
And today? The reality during the third quarter in the case of the nonfinancial sector was $49 billion in the negative. American businesses are dissaving, and so, of course, is the government sector with the soaring federal deficits. According to National Income and Product Accounts statistics, private households are running a savings surplus, but looking at the rampant housing and mortgage refinancing bubble and considering that saving represents in essence unspent income, we wonder how that surplus comes about.
All in all, it seems a fair guess that today’s America has gotten rid of any savings.
Asset Bubbles: The Credit Growth Difference
If the difference in savings between the two periods is ludicrous, the difference between credit growth defies description. In 1959, total net borrowing in the United States increased by $56.8 billion, perfectly in line with available net national savings of $61.1 billion. For perspective, nominal GDP increased by $39.5 billion to $507.4 billion.
Now to the credit horrors of the present. Keep in mind: Net national savings are at best close to zero, if not negative. Nonfinancial borrowings ballooned in 2002 by $1,374.6 billion, of which $771.8 billion was on account of the consumer. For perspective, this was about seven times the simultaneous GDP growth of $364 billion.
We have drawn this comparison between the two periods not just by impulse. We think it is most important to realize the incredible difference that exists between today’s financial conditions in the United States and those of the past.
In the late 1950s, America’s record-low interest rates were clearly and soundly founded in high domestic savings and moderate credit growth. Today’s record-low interest rates are just as clearly founded in unprecedented monetary looseness accommodating unprecedented financial leverage.
The relevant issue, however, is not the bubble as such, but what happens in its wake to the real economy and the financial system. In general, policymakers have become fearful of asset bubbles.
America is the only country in the world where asset bubbles have become the panacea of monetary policy.
for the Daily Reckoning
january 7, 2004
P.S. A few days after the release of the much vaunted 3rd quarter GDP data, Treasury Secretary John Snow gave an enthusiastic address to the Economic Club in Washington. He said, "It seems clear that we have entered a new phase of economic expansion…This is not a fleeting glimmer – there is real muscle behind the growth trend."
The fact is that multiple one-off stimuli were converging on the U.S. economy – the housing bubble, the mortgage refinancing bubble, tax cuts, auto sales promotions and the rallying stock market.
The main drivers, measured in real terms, were personal consumption, business investment in computers, residential building and purchases of autos both by consumers and businesses.
But on closer look, the GDP growth in the third quarter had one overwhelming source, and that was consumer spending on two counts: consumption and homebuilding, accounting together for 76.3% of the recorded overall GDP growth.
Editor’s note: Dr. Kurt Richebächer’s articles appear regularly in The Wall Street Journal, the U.S. edition of The Fleet Street Letter and other respected financial publications. France’s Le Figaro magazine did a feature story on him as "the man who predicted the Asian crisis."
Dr. Richebächer is currently doing quite well in showing readers of his letter how to profit from Greenspan’s mistakes.
What will happen in 2004? We won’t even try to tell you. The best we can do is try to figure out what OUGHT to happen.
And even then, we are appalled by our own arrogance. We cannot know what the gods intend. All we can do is try to make out – dimly – the right and wrong of it. As we mentioned yesterday, then…at least we can deserve what we get.
We begin today’s remarks with a disturbing question: why ought an American earn 10 times as much as a Chinese laborer? Does he work that much harder? Is he so much smarter? Does he have some unseen virtue blessed by the gods with extra spending power?
He earns more only because his parents and grandparents and great grandparents worked hard…saved their money…built machines and factories…accumulated wealth and know- how…and avoided blowing themselves up in wars, hyper- inflation, revolution, and socialist delusions.
But now he squanders his savings…mortgages his children’ s future…and willingly participates in extravagant mass hallucinations (we will borrow and spend until we all get rich…we will build an American-style democracy in ancient Nineveh…our kind friends the Chinese will pay our bills…) Ought such a man prosper?
The remarkable thing, says a report from the Rocky Mountain News, is that despite the furious pace of home refinancing, other forms of consumer debt did not go down. You will remember, dear reader, that no less of an authority than Alan Greenspan (and, if there is less of an authority, we can’t think of whom he might be) told us what a great thing mortgage debt was. It allowed homeowners, he explained, to switch from expensive credit card debt to less expensive mortgage debt. With their balance sheets thus reinforced, they could add another few pounds of spending…without the whole thing giving way.
Well, the Fed chief was as wrong about this as he was about everything else. While the average household added to its mortgage debt, it added to its other debts, too. Credit card debt per household has grown to $7,000. Leaving out mortgages, consumer debt has doubled in the last 10 years…to $18,700 per household. Millions of families live ‘paycheck to paycheck,’ says the news item, with no provision for risk.
Of course, these families see no risk to provide for. As long as the money keeps flowing, they ask no questions. How can a nation with a half-trillion dollar government deficit add expensive new programs – such as providing patent medicines to old Americans…and new roads to young Iraqis? How can a country with a falling currency continue to attract foreign investment? How can a people who save less than 2% of their income build the machinery, the systems, the technology needed to compete in the modern, globalized economy? The questions never seem to occur to anyone.
Reckless spending, massive deficits, collective fantasies – if this continues, warns Paul Krugman in the New York Times, the U.S. will soon be regarded as a Third World nation. It has happened before. At the beginning of the 20th century, Argentina had living standards nearly equal to those in Europe and America. Then came the mass delusions of socialism, Peronism, paper moneyism, and debt. Hyper inflation and recession wasted Argentina’s economy…to the point where it sunk down to near-Third World levels.
Here at the Daily Reckoning, this does not scare us. We like Third World countries. The weather is often good. And the cost of living is usually low. But we doubt that many Americans will welcome a drop in their wages, or a decline in their living standards. And even as a Third World country, the winter weather is not likely to improve.
Here’s Addison with more news:
Addison Wiggin in the City of Light…
– Sunday was cold and rainy in Paris; a perfect day to stroll through the red-light district near place Clichy and hit up the art-house documentary: Derrida.
– Jacques Derrida, a living French philosopher, has made a name for himself in the U.S. for pioneering a philosophy called ‘deconstructionism.’ In case you’re ready to rush out and find the movie playing in a theatre near you, let me save you the trouble. Here’s the plot: A NYU student and a California film crew follow Derrida around for two weeks recording his every move. Derrida is very deft at buttering toast. Other than that, I learned very little from the film. But the theatre was warm. And empty. And the seats were comfortable…so we had a good occasion to rectify a bit of our post-holiday, post jet-lag sleep deprivation. That was nice.
– We raise the point because America’s stock market investors seem like they may have OD’d on Derrida lately. At one point in the documentary, Derrida gives the keynote speech at a banquet given in his honor by the University of California, Irvine. Some genius at Irvine collected all of Derrida’s work and archived it in the library’s basement. Derrida, in his speech, even thought the idea was stupid. "Archives are useless," we misquote him badly, "except as a monument to the ego. They tell us nothing about the past. They are only useful if someone delves into them and tries to apply them to the future."
– With archives of material documenting the aftermath of a credit-goosed bubble economy and collapse only three short years ago sitting at their finger tips [at the very least in places like the Daily Reckoning Archives found on our website], the nation’s lumps are destined to prove Derrida’s point. The Nasdaq continued its third straight day of gains yesterday. It climbed 10 points to 2,057 – the highest close for the tech-heavy index in two years. The S&P 500 tacked on a point to 1,123. The Dow gave back 5 points to close at 10,538.
– Even so, all the financial media remains agog the 50% increase in the DOW over the past year. "Equities are back, baby!" wrote one churlish reader yesterday…forgetting all the while that the economy and the stock market are merely reflecting "multiple one-off stimuli"…as the good doctor Richebächer calls tax cuts and auto sales promotions and other schemes…(below).
– "The Depression era generation is passing on and we’re losing our values," laments Howard Dvorkin in the Rocky Mountain News. Dvorkin is the president of the non-profit Consolidated Credit Counseling Services, i.e. he’s on the front lines of the coming consumer debt crisis. "Now we’ve got an entire generation that doesn’t know anything about thrift and careful spending. It’s tearing at the fabric that made this country great." The Depression era folks were the last to roll the baggage of credit collapse around with them daily like a hobo’s shopping cart. If the next generation super-consumer hasn’t learned how to save and invest from their grandparents’ first-hand experience…it’s not likely they’ll begin seeking their counsel in the archives of the era either. No…we fear they will have to learn the hard way.
– Especially since the nation’s pundits, analysts and economists are busy trying to invent new reasons why the boom is back!
– Kurt Richebächer explains: "During the third quarter of 2003," writes Dr. Richebächer, "consumer spending on goods and services increased – nonannualized – by $27 billion, comparing with a simultaneous increase in personal incomes by $22.7 billion, of which wage and salary income accounted for a miserable $7.1 billion. This source of income in the United States has virtually collapsed, reflecting the dismal performance of production and employment.
– "Normally, this would have similarly clipped consumer spending. But a kind of ‘new paradigm’ monetary policy has managed to replace the lacking traditional ‘income-driven’ consumer spending largely by ‘wealth-driven spending.’"
– "Wealth-driven spending," Richebächer continues, "is a completely new term in economics, invented in America. What it means is nevertheless crystal clear: increases in spending that are fuelled by rising asset prices, providing the collateral for higher borrowing, are now in America positively perceived as ‘wealth-creation.’
– "This new pattern of ‘wealth-driven’ consumer spending started with the long and steep rise in stock prices in the later 1990s. What truly matters, though, is not the rise in asset prices, but the borrowing and spending binge that it facilitates and unleashes. In the U.S. case, the protracted stock market boom shattered personal saving from current income. Regarding the gains in the market as a fully valid substitute, Americans stepped up their spending at the expense of such saving.
– "Wealth-driven economic growth is, of course, a better- sounding synonym for bubble-driven growth," Richebächer concludes. (More on the great reflation of 2003 from Dr. Richebächer, below…)
– The price of oil jumped to $34 yesterday. "Recall a month or so ago," surmises Chuck Butler, sitting tight on euro gains at the Everbank Trading desk, "our friends at OPEC (NOT!) were suffering huge losses from their oil contracts denominated in dollars, and that they had two choices? To get the price of oil higher, to offset the losses, or change their oil contracts to euros, right? So, it looks like the former is taking place, which should start to register on somebody’s inflation meter somewhere…My guess? Europe…" And the U.S., too, we’re tempted to add.
– The dollar fell to a record $1.28 in mid-day trading yesterday. Then currency profiteers rushed in, gobbled up the gains and drove the buck back down to $1.26. Still a tough pill for your hapless expat editors in London and Paris to swallow.
Bill Bonner, back in England:
*** From the King Report: "The dollar is in the toilet and gold is rallying on that jackass Fed Gov. Bernanke’s comments that the risk of a dollar crisis is low and it’s misleading to value the dollar only vs. the euro. The market construes the dolt’s remarks as either the Fed is signaling that it wants to keep rates low for the foreseeable future and they’re not concerned about the level of the dollar or Fed officials are clueless fools. In either case, one doesn’t want dollar exposure. These clowns need some real world business experience.
"The dollar topped in Feb 1985 but traded slightly lower until mid-Sept 1985 when it collapsed after the Plaza Accord. Stocks crashed just over two years later in mid- October 1987. But stocks in 1985 were the mirror image of the dollar. They traded slightly higher until the dollar collapse in mid-Sept and then more than doubled by August 24, 1987. As we keep harping, stocks love inflation and a collapsing currency for awhile, but later there is hell to pay. 30 months after the Feb ’85 dollar peak, stocks crashed. Or to look at it another way, 23 months after the dollar tanking commenced, stocks peaked.
"As we forecast months ago, we’d look for a stock market peak in January and then a rebound rally in March that should approach if not exceed the January high. But after that, look out.
"This view also coincides with the presidential cycle. Wall Street pundits stridently trumpeted the bullish propensity of the third year of a president’s first term, but they’ve been silent about what ensues. That’s because the following year, the election year, typically has a top in Q1, a decline into late spring, a sharp rally into the conventions, and then a severe decline that commences after the conventions."
*** "What about China?" an interviewer asked yesterday. The question surfaces almost daily. China is THE BIG STORY of the financial world. Everyone seems to want a part of it.
But what can an investor know about a Chinese company? Almost nothing. Knowing nothing, he cannot really invest. He can only speculate.
"Speaking of bubbles…" the Pirate Investor’s Brian Hunt writes, "I was thumbing through Barron’s closed-end fund section last night. The China Fund (CHN) changes hands at $44.84. Net asset value is $27.11, for a premium of 65%."
Pao Mo! Pao Mo! Pao Mo! Bubble, bubble, bubble!
*** Poor Prince Charles! Poor Britney Spears! The two hapless celebrities look out from Britain’s tabloids almost daily. Both may be lucky at cards, we conclude, because neither seems to have any luck at love. We don’t really know who Britney Spears is, but all of Britain seems concerned about her marriage. It lasted only 55 hours, we are told. "A publicity stunt," suggest the cynics.
And Charles…according to today’s papers, the prince will be forced to delay his own marriage by a new inquiry into Diana’s death. It seems Diana left a note telling no one in particular that her husband, Charles, was plotting to kill her in "an accident."
"Was she out of her mind?" asks the Daily Mail. We never met her. But we judge from the report of her speeding through the streets of Paris at 90 mph with a drunken chauffeur at the wheel that perhaps she lacked good judgment from time to time.
But we are sentimental saps here at the Daily Reckoning and we share the nausea of anyone made a little sick on love’s tempest-toss’d seas.
*** It is love that really matters, we often hear. Why then do we spend most of our time in pursuit of money? For men, and here we are merely guessing, money is like the rich plumage on peacocks. It is a handicap, of sorts, since it takes energy to drag it around…and it draws predators. Does it also draw admiring glances…and even love?
A reader reprises our comment from a previous Daily Reckoning:
"’Things mean more to women than they do to men,’" Elizabeth [my wife] volunteered. ‘Status is more important. At least for women who don’t work; they get their status from having fine things. And successful children. They have few other ways to show off."
"I am reading George Orwell’s ‘Keep the Aspidistra Flying’ (first published 1936) and what do I find on page 103 of the Penguin Classics edition?
"The only thing a woman ever wants is money; money for a house of her own and two babies and Drage furniture and an aspidistra. The only sin they can imagine is not wanting to grab money. No woman ever judges a man by anything except his income. Of course she doesn’t put it to herself like that. She says he’s such a nice man – meaning that he’s got plenty of money. And if you haven’t got money you aren’t nice. You’re dishonored, somehow. You’ve sinned. Sinned against the aspidistra."
*** Another little item from the King Report:
"Baghdad’s October murder rate is 6 murders per 100,000 people. In the U.S., the murders/100,000 rate are 17 in Los Angeles, 19 in Philadelphia, 22 in Chicago and 46 in D.C."