Imbalances and Dislocations
The Fed issued a ‘deflation scare’ to harness Wall Street’s awesome speculative firepower. The E-Z credit gushed. But if you play with fire, sooner or later, you’ll get burned…
Attempting to assess the U.S. economy’s further outlook, one should first ponder the main causes that have been thwarting a stronger and healthier recovery, even though the Fed’s monetary and fiscal policy has achieved aggressiveness without precedent in history.
For most American economists, sufficiently easy money is of infallible efficacy. The few instances in history when record-low interest rates persistently failed to work, like recently in Japan and during the 1930s in the United States, are summarily discarded with the argument that central banks failed to act fast enough.
During the whole postwar period, it has, in fact, been typical that depressed economies promptly took off once central banks eased. Yet for us, this was never proof of the efficacy of monetary policy. Since all postwar recessions had their cause in monetary tightening, it was only natural that economies promptly jump-started when central banks loosened their brakes.
Loose Money and Credit Excess: Easy Money Cannot Be the Cure
But the situation today is radically different. For the first time in the whole postwar period, the U.S. economy slumped against the backdrop of rampant money and credit growth. But if tight money or credit did not break the boom in 2000, it is hard to see how easy money can be the cure.
Identifying the true causes of the U.S. economy’s poor economic performance in recent years is certainly a most important task. During 2003, leading Fed members propagated the idea that the U.S. economy was mainly suffering from an "unwelcome fall in inflation" – according to the title of a speech by Fed Governor Ben S. Bernanke, on July 23, 2003, at the University of California, San Diego. In more detail, Bernanke said that lack of pricing power was seriously impinging upon corporate profits, which in turn had strangled business capital investment.
Considering that the U.S. economy had been booming with the most rapid money and credit growth in history, this was an absurd conclusion. But several Fed members managed to exploit the temporary deflation scare they had raised, the better to implant expectations for sharply lower long-term interest rates into the markets – with the desired effect that the financial community, with its huge speculative firepower, quickly obliged with prodigious carry trade.
What, then, brought the U.S. economy down in 2000? In short, several years of unprecedented credit excess. We realize this is unthinkable for many people, yet it is a notorious historic fact that serious depressions are always preceded by extremely loose money and extraordinary credit excess. Tight money is too easily reversible to cause a deeper crisis. Ironically, it was always low inflation rates that misled central banks to excessive credit accommodation.
The two worst cases of this kind in history are, of course, the U.S. boom-bust from 1927 to the 1930s and Japan’s boom-bust since 1987. In both cases, extraordinary asset bubbles played a key role in escalating credit excess. The third, and probably worst, case of a "bubble economy" is the United States for the past several years.
Credit excess thwarts economic growth even in the absence of monetary tightening, through effects ambiguously known in Austrian theory under different labels: structural maladjustments, distortions, and imbalances and dislocations.
Loose Money and Credit Excess: Imbalances
The imbalances most often cited are a rock-bottom national savings rate of 1% of GDP, record levels of personal indebtedness, a record current account deficit, a record-high budget deficit, a record ratio of household indebtedness and an unprecedented shortfall of employment growth and labor income generation.
But there are important other imbalances that are totally ignored. One of them is the tremendous gap that has developed in the United States between virtually stagnating production of goods and soaring demand, as measured in retail sales. While the latter have been going from record to record, manufacturing production, which should deliver most of the goods sold in the shops, has been badly lagging. The soaring difference went, of course, into the soaring trade deficit.
For more than two years, the Fed has been holding its short-term rate at 1%. That is, below inflation. But instead of spurring economic growth directly, it stimulated sharply rising prices in almost all major asset classes, which in turn stimulated spending, mainly consumer spending. Rising property values and the increasing ability and willingness of homeowners to tap accumulated housing wealth became the major pillars of support both for the economy and also – given minimal personal savings – for the asset markets.
The all-important question now, of course, is whether this ultra-loose monetary policy and the associated development of asset prices have laid the foundation for a normal, self-sustaining economic recovery.
Good luck, Dr. Greenspan.
for The Daily Reckoning
May 11, 2004
Editor’s note: 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."
Dr. Richebächer is currently warning readers to beware the wiles of Alan Greenspan – for unchecked, they can sabotage your investments.
If we have any virtue here at the Daily Reckoning, it is modesty. And even that is insincere.
We admit that our ignorance is boundless. Still, we can’t help but have a hunch…
Our hunch has been that the stock and bond markets were beginning to break down. Consumer spending, too, was about to head lower…with house prices not far behind.
The drop in asset values, we thought, would undermine the collateral that under-girds trillions in consumer and financial debt. People would be forced to sell; almost everything would fall in price.
But what do you buy when everything goes down?
We posed the question to a group of London-based fund managers, economists, strategists and investment professionals at our monthly MoneyWeek Roundtable last night.
Came the answers: The cheap. The solvent. The productive. The periphery.
And nothing at all!
"We may be coming to the end of a global economic boom…albeit it a strange one," began Pelham Smithers. "It is one accompanied by huge amounts of debt. Almost all European governments are running deficits at or beyond the level allowed by the Maastricht treaty. And in America, no one has ever seen so much debt."
And now interest rates are rising.
We know when this global growth phase will end: when interest rate increases make the debt unmanageable. Or, when the collateral that backs it up – residential housing, stocks, bonds – loses its value.
In the U.K., house prices have become an obsession. When will the property boom end? Is it already too late to buy?
The Bank of England raised rates a couple of weeks ago – to 4.25%. The gross rental yield on residential property is about the same.
"After expenses, the average property investor is probably already losing money," said James Ferguson. "He just hasn’t realized it yet."
Real estate agents say they cannot find enough houses to sell. But owners report that they can’t find buyers.
"The crash might have already begun," continued Ferguson, "and we won’t know it for months."
In stock, bond, gold and currency markets, awareness comes quicker. Yesterday, the Dow lost another 127 points, putting it below 10,000. At this level, it has been a long time since investors made any money.
Gold, too, went down…to $378, far below where we thought it had found its floor.
So, what do you buy?
"Nobody ever really made money in stocks or bonds when interest rates were rising," said Ferguson.
What does that leave?
The world is not running out of stocks, or bonds, or debt, or hunches about what will happen in the markets. But oil is in short supply. Experts believe oil production, worldwide, is topping out now – just when the Asians were starting to develop a taste for it.
"If this is a long, hot summer," Pelham observed, "stocks of oil are almost certain to be drawn down…and prices will go up."
Here’s Eric with more news:
Eric Fry, from the corner of Wall and Broad…
– Manhattan treated non-investors to an absolutely delightful day yesterday…every flowering tree and shrub in Central Park seemed to be blossoming, while swarms of laptop-pecking yuppies and stroller-pushing nannies basked in the springtime sunshine. For the minority of New Yorkers who wouldn’t know a common stock from a common stick, May 10, 2004, was a day to savor.
– Unfortunately, Manhattan was not so kind to its stock-buying citizenry yesterday. The city’s downtown stock exchanges buffeted investors from mid-morning until late afternoon. The Dow Jones Industrial Average tumbled below the psychically comforting 10,000-level for the first time this year – losing 127 points to 9,990 – while the Nasdaq Composite slumped 1.1% to 1,896. Bond prices also fell, pushing the yield on 10-year Treasury notes up to a new 22-month high of 4.79% from 4.77% on Friday.
– Gold did not escape unharmed from yesterday’s selling frenzy, but did manage to recover from its worst levels of the day. The wobbly precious metal fell to $371.30 in the morning, before recovering to $378.70 by the end of New York trading – a loss of only 40 cents. For those keeping score at home, the gold price has dropped 13% since touching a 15-year high of $433.00 on April 11th.
– Yesterday’s panic and pandemonium in the stock market did not seem to result from any one specific cause. Rather, the sell-off was caused by everything and nothing. The not-yet-successful Iraqi campaign seems to be unnerving investors as much as the way-too-successful reflation campaign waged by General Greenspan and his minions at the FOMC.
– Skyrocketing interest rates testify to Greenspan’s "success" – vanquishing deflation by cultivating inflation. But over in the stock market, where share prices are now deflating instead of inflating, investors aren’t sure whether to hoist Greenspan atop their shoulders or to tar and feather him.
– Rising interest rates may be scaring the daylights out of stock market investors, but Mr. and Mrs. Consumer aren’t flinching…the New York Times recently presented the stereotypical tale of Philo Thompson, a single 28-year old male, who, like many Americans, is "not afraid to stretch when it comes to buying a house."
– Thompson is a management consultant from Denver who recently bought a $500,000 townhouse in the suburb of North Cherry Creek. When buying his new townhouse, did Thompson lock in a fixed-interest rate on a 30-year mortgage, as Grandpa Thompson might have done? Heck no! Thompson the Younger put no money down, while borrowing 100% of the purchase monies at short-term floating rates. "[Thompson] took out a first mortgage for 80 percent of the purchase price and paid the rest by taking a home equity loan against the new house," the Times reports. "To reduce monthly payments, and to qualify for a big enough loan, he took out an adjustable-rate mortgage that requires him to make only interest payments."
– Thompson’s mortgage arrangement – called an "interest-only ARM" in the parlance of the mortgage industry – is a nifty loan, as long as rates stay low. But it is decidedly less nifty when rates go up.
– "People like Thompson could get squeezed if interest rates start to rise," the Times blandly observes. Truth be told, people like Thompson could get crushed. Yet Thompson betrays no fear. "I’m too young to be scared," he says, betting that both the value of his house and his income will keep rising. On the other hand, it is possible that both the value of his house and his income will cease rising. Indeed, it is possible – in theory – that they might both FALL.
– But let’s not lie awake at night worrying about Philo Thompson. He has girded his psyche with an ironclad philosophy of personal finance: "There is a difference between being poor and being broke," he explains. "Being broke is more of a temporary condition. Donald Trump has been broke a couple of times."
– The frightening truth of the matter is that Thompson’s fearlessness is partly justified. As a homeowner who owns none of his home, Thompson has no "skin in the game." In the event of a default, he has little to lose, other than his credit rating. The mortgage lenders – and the housing market itself – have far more at risk than the Philo Thompsons of the world.
– But the mortgage lenders have only themselves to blame for the precarious predicament in which they find themselves. The increasingly aggressive mortgage industry has admitted an increasing number of marginal borrowers to the homeowner ranks.
– "There are an incredible number of loans that get approved now that would have been way out of bounds a few years ago," Ruben Ybarra, president of the Chicagoland Home Mortgage tells the Times. "I may think a person is being allowed to borrow too much. But if the computer tells them they’re approved, what can you tell them?"
– Evidently, "the computer" has a tough time saying "No." The statistics tell the tale: household debt climbed at twice the pace of household incomes from the beginning of 2000 through 2003. During that period, Americans took on a staggering $2.3 trillion in new mortgages – an increase of 50% in just three years.
– Despite these troubling trends, Chairman Greenspan insists that rising household debt poses little problem, partly because Americans are richer – on paper – than they were at the peak of the stock market in 2000. Thanks to the runaway housing market, the collective net worth of American households is now higher than it was before the stock market bubble burst four years ago.
– Unfortunately, asset values don’t pay the bills; income (or borrowed money) does. So if borrowing costs rise faster than incomes, bad things can happen. When incomes fall short, cash-strapped folks must try to borrow more money to stay afloat. But if the would-be borrower has no equity remaining in his home and if he has also maxed out his credit cards, where does he next turn for relief? Bankruptcy court is a time-honored option.
Bill Bonner, back in London…
*** "An honorable man," noted Charles de Gaulle, "pays his debt with his own money."
But Americans don’t have enough of their own money. How will their debts get paid? At some point, someone is going to get stiffed. We have presumed it would be the foreign lenders. The dollar will fall, we’ve predicted, wiping out trillions in debt. Gold will rise – as people seek refuge from paper currencies.
We still believe it. But we worry; it is almost too convenient. Americans borrow the world’s savings. Will they really be able to walk away from all that debt so easily? Can you and I, like Warren Buffett, avoid the worst debt contraction in human history simply by buying gold and euros? Is that how the world OUGHT to work?
"[Warren] Buffett – and millions of other investors, most particularly precious-metals bulls – could be very much mistaken in assuming that a weak or even worthless dollar cannot soar, at least for a while, for reasons wholly unrelated to its fundamental value. As a floor trader, I saw this happen time and again when the shares of a poorly run or even criminally mismanaged company went ballistic.
"Many of them – after initially falling for fundamental reasons that were widely recognized – soared 30% or 40% in mere days. The cause, almost invariably, was unrelated to the company’s fortunes; rather, it was the result of egregious, fleeting imbalances between supply and demand. The demand came from shorts who, having bet the stock would fall, were stampeded into covering their positions when the stock started moving against them. As for supply, it dried up almost completely when shareholders realized they had the bears on the ropes.
"I have seen this occur on the trading floor too many times to ignore the possibility it could happen to the dollar…Most of the world’s hundreds of trillions of dollars of debt is denominated in dollars, and this debt represents, implicitly, a massive short position against the dollar. As such, all borrowers of dollars should be praying for inflation, since it would allow them to pay back what they owe in cheapened money. They could also pray for the one other thing that might do the trick – a dramatic rise in incomes over and above the rate of inflation. Miracles do happen.
"But unless Murphy’s Law is suspended for the next ten years, we can be reasonably certain that borrowers are not going to get off quite so easily, especially since all it would take to crush them is a rise in lending rates. I’m not talking about 15% mortgages, either, or even 10%. If residential property values and incomes were to fall even slightly, a five- or six-percent mortgage would, for most homeowners, become a crushing burden.
"This is the very crux of the coming deflation 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.
"A strong dollar – one impelled by uncontrollable market forces rather than by Fed whim – seems the most likely catalyst for a deflationary collapse, albeit the one least expected. What it implies is dollar rates rising to extraordinary levels in real terms, with foreign money pouring in to take advantage. If this should come to pass, there will be a dearth of double-your-money bets, and even financial wizards like Warren Buffett will be challenged to withstand the violent, tidal shifts in asset values. For gold bugs, such a volatile period would pose a particular dilemma, since bullion’s eventual rise, though absolutely assured, would come only after the pain of deflation had caused the central bank to shovel money out the door. Meanwhile, we should not pretend to be mystified if the dollar’s supposed bear rally steepens and bullion remains leaden. A ‘worthless’ dollar may yet have the last laugh on all those who have rightfully disparaged it."
*** The credit cycle, like life itself, begins in joy and ends in sadness. Bankruptcy rates in America and Britain are near records. Correspondent Byron King, in Pittsburgh, takes us to the morgue:
"Preparing and filing a federal bankruptcy petition is a lot like performing an autopsy on a deceased economic entity. As I go over the lists of creditors, assets, collections and income statements, it drives home the point of how much even a little bit of bad business practice can cost the economy. And one can blame a lot of the cost to the economy on liberal grants of credit to non-creditworthy borrowers.
"If some credit is good to have, which I certainly think is true, more credit is not necessarily better. Too much credit can enable bad behavior and bad business practice just like cheap booze enables the alcoholic. The creditor can act as a co-dependant to a bad business risk. Too much credit can fund projects (and lifestyles) that do not merit the support, and can take an untenable situation and make it far worse…"