Make the Desert Bloom

Here’s a bold new idea. If people are the real source of all wealth, shouldn’t it be possible to create a currency backed by human capital alone?

Right now, the entire housing market rests on that oh-so precarious of assets, trust.

And whether it’s a housing market, a currency, or an investment phenomenon, once the trust is gone, it’s amazing how quickly the asset values follow.

Let me explain…

On my recent travels, I was introduced to a man called Stephen Belgin. Belgin is one of the most insightful and brilliant financial minds I’ve come across. Currently, he is working in partnership with a man named Bernard Lietaer on a book called "Of Human Wealth: Beyond Greed and Scarcity." Litaer was one of the architects of the Euro currency and a well-known thinker on the future of money.

The problem with the current monetary order, Stephen explained, is that it doesn’t help meet development needs in the many poor places of the world. Most of the world’s communities can’t raise money for infrastructure through a bond offering and there isn’t enough wealth to use as collateral for borrowing capital.

So how do you create wealth and opportunity in places that are not plentiful in capital or natural resources? Stephen is working on an idea called "complimentary currencies." Notice that’s it’s complimentary not alternative. He has in mind mediums of exchange that work alongside fiat money and are backed, not by the full faith and credit of a government or future tax revenues, or gold, or land, but human capital.

GSEs: Hernando de Soto

"Hmm," I frowned. I asked Stephen what he thought of Hernando de Soto. I met De Soto in Paris last year and listened to his speech about the developing world. His main point is that land is the greatest form of unused capital in the world. By creating clear title to land and extending it to individuals – private ownership – you unlock the natural resources of both human beings and an economy.

It’s a pretty compelling argument, I thought. I like it because of the idea of stewardship…that an owner is likely to be the best caretaker of his most valuable asset, his property. Owners make the desert bloom. It’s only on publicly owned land, with no ownership and therefore no accountability, that you see huge mismanagement of natural resources.

Steven nodded, but said I had put the question to him the way most of the world would. This didn’t offend my pride. But it did make me wonder. How can any economic transaction be based on anything other than a medium of exchange whose value is agreed upon by both parties? Granted, that medium could be arbitrary…a seashell, oxen, or an ounce of gold. But doesn’t it have to be a real thing that has the attributes of a good medium of exchange?

Steven nodded again, but less amused I think. He asked what the real source of all wealth is. "People," I said. To use Thomas Sowell’s phrase, people are the ultimate resource.

Stephen agreed with that and asked me to imagine a world where the basis of the currency is the faith we have in each other as human beings, as wealth producers. What kind of great societies could we produce if we abandoned the mental trap of scarcity thinking and unleashed human capital on the world?

GSEs: Currencies that Work Locally

It’s a provocative question. And what I like about it is that Stephen and his colleagues are trying to solve a real problem…how to create currencies that work at the local level. He said he believes in currencies that work alongside fiat money.

But I think that someday, and perhaps soon, it won’t be an academic question. It will be a practical one with some urgency. How do communities create a medium of exchange when government paper becomes worthless? That’s why it’s a question worth asking. The skeptic in me says you can’t have a currency based on belief in basic human potential.

Some human beings are bad loan risks, whether you look at it in banking terms or moral terms. It’s prudent not to trust all people because not all people are trustworthy. A man’s word may be his bond in some places, but in other places, I’d much rather have his land as collateral than his handshake.

It’s a matter of trust. And it’s also a matter of memory. You can get burned in a deal, at the micro level. And the macro level, crashes can happen. They happen all the time, in fact.

The other day a colleague sent me a note saying that a crash in the U.S. housing market was impossible because there was no such thing as the U.S. housing market. His point was a variation of a point I’ve made before. Don’t confuse the real estate market with the mortgage lending market.

Real estate prices are affected by interest rates. But they are also affected by local factors as well. Demand for housing, location, taxes…these are just some of the factors that account for the differences between real estate prices in different parts of the country. And in truth, regardless of what’s happened in the housing market, in some parts of the country real estate is still cheap.

But that doesn’t meant there won’t be a housing crash. Home prices in some parts of the country are up primarily because the Federal Reserve kept interest rates so low for so long before finally reversing course last month. The rising value of homes was as much a function of low interest rates as it was of sustainable demand for new housing.

GSEs: Full Disclosure and Transparency

And in any event, the Government sponsored enterprises aren’t exactly poster boys for full disclosure and transparency. We found out at the end of June that Freddie Mac (FRE) posted a 52% decline in profit in 2003 from 2002. I don’t care what business you’re in, a 52% decline is pretty severe.

Freddie told investors it wouldn’t report 2004 results until March of 2005. The company says it’s grappling with antiquated accounting systems. That’s a comforting thought for an entity that manages trillions in risk, and apparently isn’t managing it too well.

To what did the GSE attribute its losses, you ask? Rising interest rates and their affect on Freddie’s derivative positions. The company said, "To the extent changes in interest rates continue to be significant, our overall net income will remain volatile."

We’ve been assured that the GSEs are wizards at managing interest-rate risk. And Alan Greenspan has told us that existence of the derivatives market has allowed for the dispersion of risk throughout the system…and that it’s been a GOOD thing.

But there’s another way of looking at it. It’s that you can’t package up dozens of other people’s liabilities and sell them as assets and pretend there is no risk.

You can’t expect profits when your borrowing costs go up faster than the money you make lending at low rates.

Mortgage bond buyers beware!


Dan Denning
for The Daily Reckoning
July 29, 2004

We are stuck in the summer doldrums…locked in irons on a dead, still sea.

There is no wind to move stocks…no breeze to push along the price of gold…no air to blow away the bubble…no ventilation to take out the stale odors of the great consumer-led humbug.

The Dow is back above 10,000. The price of gold is back below $400. Barely any progress has been made in any direction all year. And now they sit with liquidity, liquidity everywhere…and not a drop of real money. Real money comes from real savings…which get used to build real factories…which pay real wages…by making real profits…by selling real things…to people with real money! Instead, Americans have credit. And equity in their houses. And delusions galore. (More below…)

But watch out. A storm could blow up at any time. This just in from Steve Sjuggerud:


"We’ve just recently entered "Super Red Light" mode on my 1-2-3 Model…something that basically never happens. But when it does, watch out!

"Over the last 30 years, we’ve only entered Super Red Light mode three times…just before the Crash of ’87, in mid- 1994, and late 1999. Two out of three of those Super Red Light calls were fantastic. If you acted immediately on those signals, you’d have beaten the ’87 crash and the 2000 crash. Wow! (In the mid-1994 signal, the market was flat.)

"Remember, in my 1-2-3 model there are three things to watch:

1) Is the market expensive? 2) Is the Fed in the way? 3) Is the market acting badly?

"If we’re ‘in the clear’ on all three of these, it’s green light mode. If one of the three is against us, it’s yellow light mode. And if two or more are against us, then it’s red light mode. It’s extremely rare when all three are against you (occurring less than 2% of the time).

"Looking at stocks now, #1 is against us… stocks are still expensive, as the P/E ratio of the overall market is above 17. A month ago, the Fed put #2 against us, by raising interest rates. And just recently, #3 has gone against us, as the fall in stock prices in the last few weeks has finally put the S&P500 Index below it’s 45-week moving average. That’s three strikes!"

And here’s the news from Eric…


Eric Fry, from the Big Rotten Apple…

– "$50 oil now seems more realistic than ever," says Kevin Kerr, editor of Outstanding Investments. Kerr, a steadfast oil bull, bases his outlook on the growing tension between the world’s delicate oil supply and an increasingly robust demand.

– The global oil supply may not be up to the demands placed upon it – like a solitary sushi chef trying to feed an NFL football team, or a lone oyster-shucker trying to provide a steady supply of Blue Points and Kumamotos to a roomful of Republicans…a quick bathroom break would create a major supply disruption.

– The oil price spiked to a new record high yesterday on word that Russian oil production is about to take a bathroom break of sorts. Crude prices jumped $1.06 to $42.90 a barrel on the New York Mercantile Exchange after OAO Yukos Oil Co., Russia’s largest oil exporter, said the Justice Ministry had ordered the company to halt production from its main Siberian unit. (Daily Reckoning readers who are unfamiliar with the Yukos saga should know that the Russian government has been trying to recoup a few billion dollars of back taxes from the delinquent oil company.)

– The Yukos news pushed crude futures to a record high of $43.05, before closing at $42.90 a barrel – the highest levels the exchange has seen in its 21-year history of trading crude futures. The prices of heating oil, gasoline and natural gas all soared in step with crude oil.

– The soaring energy prices sparked a swift retreat by the stock market, temporarily erasing most of Wednesday’s gains. But the buyers regained their courage – or whatever the exact motivating force may have been – to charge back to market. By day’s end, the Dow Jones Industrial Average had advanced 32 points to 10,117 and the Nasdaq slipped half a percent to 1,858. The stock sellers seem to have exhausted themselves for the moment. But after a bit of R&R, we suspect they will return sometime in August.

– Meanwhile, the oil market continues to dazzle and amaze, holding well above $40 a barrel. Supply worries seem to be the main driver of rising prices – Yukos being merely one of many. For now, Yukos continues to pump oil at the rate of 1.6 million barrels a day, but that production could come screeching to a halt. "Yukos may stop oil shipments to China," Bloomberg News reports, "because the company cannot access its bank accounts…it has prepaid until the end of next week for all rail shipments, which carry one quarter of the company’s output."

– Here’s food for thought: Russia supplied about 8.5% of China’s crude oil imports in the first half of the year. So any major supply disruption by Yukos would send the voracious Asian oil consumer shopping elsewhere for supplies. "If shipments actually stop," one analyst said, "the market will move quite a bit higher."

– Meanwhile, Americans continue burning through more oil than they stockpile, despite soaring imports of crude oil. The latest data from the American Petroleum Institute showed a 3.1 million-barrel fall in crude supplies to 298.7 million barrels for the week ended July 23. Inventories dropped, despite a 1.4 million-barrel-per-day spike in imports. Imports averaged 11.3 million barrels per day last week – the first week ever that has seen more than 11 million barrels per day of crude arrivals.

– For those keeping score at home, the price of crude oil is now a hefty 42% higher than one year ago, and selling for the highest level in the 21-year history of the exchange. But fear not, when priced in inflation-adjusted dollars, the price of crude oil is nowhere near record highs. "The average cost of crude oil used by U.S. refiners was $35.24 a barrel in 1981," Bloomberg News reports. "That’s almost $73 in 2004 dollars."

– But that couldn’t happen again, could it?


Bill Bonner, back in Baltimore….

*** The real estate bubble in the mid-Atlantic area seems to be expanding right before our eyes.

"I was shocked," began Elizabeth after a visit to our old neighborhood in Baltimore. "The place is still a slum but there is renovation going on all over the place. You remember that big building on the corner, which was kind of a flophouse for drunks and drug addicts. You know…where your friends lived? A developer from New York bought it. He’s gutting it completely. I walked over and talked to him just to see what he is doing. He’s really doing it right. They’re putting in nice one- and two-bedroom apartments…with everything. Very nice. But I asked how much he would rent them for. He told me they would go for $1,600 per month. I dared to ask, "do you really think you can get that much?" His response was that he could always cut the rents if he needed to. But I don’t see how he’ll be able to cut them without going underwater on his investment."

The mysteries of real estate investing in the current hysteria deepen. Six months ago, the most you could hope to get, renting an apartment in Baltimore’s poor sections, was about $600 or $700 a month. This was not because poor people were too cheap to pay more; it was neither a reflection of want nor need, but of means. They could not afford more rent.

Now, developers expect poor people to pay more than twice as much rent for a much nicer apartment. Where will these new renters come from? Where will they get the money? We don’t have any idea.

But the math is no different in middle class suburbs. A few years ago, an average family might have bought an average house in Howard County for $250,000 or so. Now, prices look as though they’ve doubled, even though they are still the same people in the area, earning only fractionally more money than they did before.

"But this is one of the best employment markets in the country," a friend explained. "There’s a lot of high tech in the area…and a lot of government-related spending near Washington. The place is booming…"

"Real estate is so funny," a visitor remarked, over a drink yesterday. "We came to Baltimore in 1980. Then, nobody had any interest in property in the city. Everyone was moving out to the suburbs. You could buy anything you wanted for pennies. So, we bought our house right on the main street…well, you’ve seen it. It’s a mansion, one of the best places in the city. We paid practically nothing.

"Well, that attitude lasted for a long, long time. We kept expecting the city to be ‘discovered’ by people from Washington or New York. It never was. Property just kept getting cheaper. It was unbelievable. In fact, for 20 years prices went nowhere. Then, all of a sudden…it seems like it was only 6 months ago…everything started to go wild around here. They’re building million-dollar condos down at the harbor…and around here, none of these mansions are for sale anymore. You can still get nice places…but you’re going to pay a lot for them."

Even in the best markets in the country, prices do not always go up. A recent piece in the New York Times described a one-bedroom apartment on Riverside Drive in Manhattan. "Sold for $180,000 in 1985…ten years later, at the bottom of the region’s most recent real estate slump, it sold for $167,000."

But nearly everywhere we go, we hear the telltale comments that signal a bubble:

"You just can’t go wrong with real estate."

"Better buy now, because it will just be more expensive later on."

"Buy as much house as you can afford…you won’t regret it."

"I’d like to move to another area, but I can’t afford to. I’m making too much money on my house."

Is this a bubble, or what?

*** Sean Corrigan adds numbers to our anecdotes:

"Total Housing dollar turnover [new and existing sales x average prices] hit a record $2,035 billion annualized pace last month, up 28% year over year, and up by 55% in the past two, compared to 1994-02’s trend gain of 11.4% per year compounded (also rather too rapid, in truth), so it now stands at 3.7 times 1995’s low…" "As a proportion of the wage fund (weekly salaries x NFP private payrolls) it has gone from 1989-97’s average of 16.2:1 to today’s 35.6:1 – a gain of 120%… "As a proportion of non-government GDP, it has doubled from 1989-97’s 10.8% to a record estimate of 21.6% this quarter (assuming GDP does, this last quarter, what it did in the previous two)… "Whereas, in 1989-96, it took 12,000 hourly salaries to buy the transaction-weighted average house – 6 yrs and 11 months at the-then average work week – it now takes 15,855 hours – 9 yrs and 5 months at today’s workweek (50 week working years assumed in both cases) – for an increase of 36% per home in the ratio… "Deflated by the CPI (stop laughing at the back), turnover has risen 175% (+10.7% annualized) over the past decade. Prices/CPI have risen 41% from the 89-97 mean and have beaten CPI by 8.9% annualized since Q3 2001… "Oh, I think we can call this a bubble, all right."

*** "How’s business?" we began a typical conversation with a relative.

"Great. It’s unbelievable, really. Our business depends on the economy. When people have money to spend, they buy boats. We don’t sell boats, but we give them a place to keep their boats – down at the marina. And they have weddings down there…and there’s the restaurant.

"Recently, we’ve had to build bigger and bigger boat slips, because people are buying these huge new boats. The little boats…we pull them out of the water, and store them on land. We have much better equipment for moving the boats around than we used to have…"

All around the Chesapeake Bay…on land and on the sea…the bubble expands.

*** Our friend Michel, writing from France, noticed a news item:

"In the Indian press, there was only one article about the Democratic National Convention: it seems there aren’t enough call girls in Boston to satisfy the delegates. It was necessary to bring in extras from Florida and California. The rates begin at $200 an hour…this was in a Reuters dispatch. Did it appear in the American press?"

We must have missed it.

The Daily Reckoning