Monetary Anarchy

The Daily Reckoning PRESENTS: It is an old wisdom that the scale of the boom excesses essentially determines the severity of the following process of economic and financial readjustment. But what will the coming correction hold for the U.S. economy after the fall of the housing market? Dr. Richebächer explores…


The encouragement of mere consumption is no benefit to commerce because the difficulty lies in supplying the means, not in stimulating the desire for consumption; and production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

– Jean-Baptiste Say, A Treatise on Political Economy, 1803

From discussing politics back to discussing economics. Just as before, though, it remains a dialogue among the deaf. The great majority of economists has its eyes stubbornly focused on apparently positive features for the U.S. economy, like the sharp fall in the oil price, abundantly available liquidity, tame inflation, low and falling interest rates and strong profits.

A minority of economists, in contrast, keeps just as stubbornly stressing that the economy’s famous gross imbalances and structural distortions and the associated debt explosion are inexorably undermining economic growth. In this view, the ongoing housing downturn will finally abort U.S. growth and drive the economy into recession, with major adverse spillover effects on consumer borrowing and spending.

Generally, however, optimism distinctly prevails about the U.S. economy. It is not the old buoyant optimism. Yet it is optimism in the sense that some true malaise, like a crash in the asset markets and a recession, let alone a deep and prolonged recession, are absolutely out of the question. Thanks to its superior dynamism and flexibility, the U.S. economy has time and again bounced back smartly from periodic downshifts, and so it will again.

Let us start with the hard facts. For six, seven and more months, U.S. economic data are overwhelmingly surprising on the downside, and moreover, the surprises have been going from bad to worse. Real GDP has successively fallen from 5.6% in the first quarter of 2006 to 2.5% in the second and 1.6% in the third.

That’s bad enough, but what rescued the latter quarter from total disaster was a rather quixotic statistical event. While auto firms slashed their output, it soared in the real GDP account, owing to sharp price cuts on gas guzzlers. In this way, falling vehicle output contributed fully 0.72 percentage points to third-quarter real GDP growth, after subtracting 0.31 percentage points. The price index for gross domestic purchases increased 2% in the third quarter, compared with an increase of 4% in the prior quarter.

It is an old wisdom that the scale of the boom excesses essentially determines the severity of the following process of economic and financial readjustment. It has been comfortingly argued that the U.S. housing boom of the last few years has been less fierce than prior booms, which all ended without steep price declines.

Certainly, there are different possibilities of measurement. For us, the most important, and also easiest, measure of excess is the associated credit expansion. The use of credit in the wake of this housing bubble has been simply bizarre, outpacing all past experiences by far. Over decades until 2000, outstanding total mortgages accumulated to $4.8 trillion. In the second quarter of 2006, they amounted to $9.3 trillion. Mortgage growth over the last five years was almost equivalent to its growth over the prior five decades.

The second highly important point to see is that this housing boom was the first one in the United States to impact the economy at a vastly broader scale than just the building activity. As private households, using the rising house prices as collateral for mortgage equity withdrawals, stampeded as never before into debt to finance additionally other kinds of spending, the whole economy developed into an outright bubble economy.

New single-family homes and multifamily homes rose in 2005 from a trough of fewer than 1.5 million units in recession year 2001 to a postwar high of 2.2 million units. Over the same period, the constant quality price index for new homes rose 30%, and the purchase-only price index of existing homes published by the Office of Federal Housing Enterprise Oversight (OFHEO) rose by 50%.

Boosting the net worth and the borrowing facilities of private households, this drove consumer spending to persistent considerable excess over income growth. In correlation, personal saving plummeted into negative territory, unprecedented for an industrialized economy.

It was a boom that plainly went to extraordinary excess in various ways. As a rule, this suggests a very severe aftermath of painful corrections. The first effects of the housing bust have definitely been bigger and more abrupt than most experts had expected. Yet hopes are riding high for a benign adjustment. To quote Federal Reserve Vice Chairman Donald L. Kohn from a recent speech: “The economy will grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then growth will begin to strengthen.”

Among his comforting arguments were first, the overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters; second, this situation stands in sharp contrast to some past downturns in the housing markets that followed actions by the Federal Reserve to tighten credit conditions; third, as the inventory overhang in residential building and automobiles are worked off, economic growth should pick up again.

Mr. Kohn does not even mention that through the cash-out refinancing boom, this housing bubble had unprecedented spillover effects on the economy as a whole. In 2005, private households raised $1,080 billion through mortgages. Of this amount, they only spent $95.1 billion on higher residential building. Spending on goods and services rose altogether by $539.9 billion, against an increase in disposable income by $354.5 billion. In other words, about one-third of the increase in consumer spending depended on mortgage borrowing.

Actually, it strikes us how promptly the change in the housing market has impacted mortgage borrowing. It peaked in the third quarter of 2005 at $1,225.9 billion at annual rate. Falling steadily, it was down to $819.6 billion in the second quarter of 2006. This sharp decline was, however, to a small part offset by higher consumer credit.

Mr. Kohn stresses that monetary conditions remain quite supportive of borrowing and spending. Clearly, interest rates are so low that they exert zero restraint on borrowing. But more importantly, falling house prices no longer remain supportive for such borrowing. Remarkably, the sharp decline in new mortgage borrowing since the third quarter of last year has occurred even though house prices were still rising, albeit at sharply slowing rates. As the price climate is sure to deteriorate for some time to come, it seems a reasonable assumption that this initial sharp slowdown in mortgage borrowing has some way to go yet.

While this suggests further sharp falls in house prices, this may well take some time to materialize, because the housing market is notoriously sluggish in its reactions. In contrast to financial markets, its initial response to a change in the market situation is not in price, but on how long unsold homes stay on the market until the prices are lowered to realize desired sales. Sellers tend to resist downward price adjustments as long as they can. Instead, the market becomes illiquid. For sure, lenders will notice and adjust their lending conditions.

Mr. Kohn also takes comfort from the fact that the present housing downturn, in sharp contrast to past ones, is not caused by credit tightening. As he rightly stresses, “The Federal Reserve has returned short-term interest rates only to more normal levels and long-term rates are unusually low relative to those short-term rates.” We think, though, that he is drawing a totally false conclusion. All downturns caused by tight money were followed by vigorous recoveries. A downturn happening despite low interest rates and loose money seems to us the most worrying kind.


Dr. Kurt Richebächer
for The Daily Reckoning

Editor’s Note: Dr. Richebacher has found the best investments to protect your portfolio, no matter what lies ahead for us in 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.”

We have gone from one of the world’s least livable cities to one of its most livable ones. Melbourne is 11 hours from Bombay, by air – but it seems like a different planet. Bombay is what is known in economics literature as a ‘third world hellhole.’ Melbourne, on the other hand, could be any city in America – if any city in America were this clean, safe, and modern. Founded in 1835, Melbourne’s fortunes were made by the Victorian gold rush of the 1850s.

“The difference between Australians and Americans,” said colleague Dan Denning, living in Melbourne for the last year, “is a consequence of geography. As Americans made their way from the coastal settlements into the interior they found rich farmland almost wherever they went. They could just go west…and things got better and better.

“But the first Westerners in Australia got dumped out at Sydney Harbor…they almost starved…and then they discovered that they lived on the edge of a huge desert. They explored the country, but found that most of it was uninhabitable. Over every hill was another disappointment.

“In America, the rough, individualistic frontier spirit paid off. A man could hack out his own ground and make his own way in the world. But Down Under, the climate and the earth were less yielding. They had to stick together; and lower their expectations.”

Asked to define what it meant to be an Australian last week, the Prime Minister, John Howard, said it meant ‘mateship’ and ‘having a go.’

“Australians seem more fatalistic…more resigned to accept what comes their way,” said Dan.

What has been coming their way in the ‘lucky country’ has been almost all good lately. There has been no recession here for more than 15 years. Real estate prices have soared. Even where they seem to be backing off from recent highs, there has been no financial trouble. Just when the property boom seemed to come to an end a huge boom in commodities took over.

Perth – the center of mining activity in Western Australia – is still a boom town. Property prices there have gone up more than 40% in the last 12 months. Perth must be an extraordinary place. It is far from everything – the most remote major city in the world.

We’ve never been to Perth, but Melbourne has a familiar feel. It reminds us of Vancouver, with which it vies for the title of the ‘world’s most livable city.’ Both cities are tidy, mostly low-crime, attractive, and easy to get around. Both cities have solid, old-money, sober and respectable British-style administrations with large groups of dynamic new-money immigrants. Both cities are quiet, orderly, civilized, and modern – everything that Bombay is not.

“It’s all based on credit, just like in America,” said one of our Dear Readers last night. We held a cocktail reception for Melbourne-based DR sufferers…more turned up than we expected. “It will have to end sometime, but you can go broke waiting for a downturn in Australia. And then, when you give up waiting, it will hit hard.”

“Yes, look at the big buildings downtown,” said another reader. “They’re almost all big banks. The banks made a fortune lending to consumers…and then to the natural resource industry. One boom after another, it really is a lucky country…except of course that there’s no water and it’s on fire.”

Firefighters have been battling a huge blaze not too far from Melbourne for several weeks. Forest fires in other parts of Australia too are burning up houses…and sending a pall of smoke all over Southeast Asia. Yesterday, the papers reported that two big fires had come together to produce an immense blaze. Thousands of firefighters, bulldozers, and fire trucks are doing what they can to contain it. But it looks at though it will just have to burn itself out.

“Yes, the whole country has always been dry, but now it’s drier than ever,” our guest continued. “The only solution I can see is desalinization on a massive scale. We’ve got plenty of sea-water…I mean, we live on an island…”

More news:


Eric Fry, reporting from Laguna Beach, California…

“…Betting against a year-end stock market rally is a little like betting against tomorrow’s sunrise. Even so, we think this might be a bet worth taking…against a year-end stock market rally, that is…”

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


And more thoughts…

*** The dollar looked like it was stabilizing…even strengthening…then along came our old Fed chief, Alan ‘Bubbles’ Greenspan with an opinion. The buck could stay weak for years, he said.

“I expect that the U.S. dollar will continue to drift downwards until there will be a change in the U.S. balance of payments,” said the former maestro.

And then, wouldn’t you know it, the currency markets acted as if Mr. Greenspan knew what he was talking about.

Despite strong employment numbers, says the report in the Australian Financial Review, “U.S. dollar weakness returned.”

One thing we like about traveling around is that we get different points of view. But one thing we notice now is that no matter where we go…we get the same story. Property prices are up…share prices are up…everyone wonders what keeps the boom booming…and everyone is pretty sure that it will continue.

As to the U.S. dollar…that too is generally viewed with awe and admiration. How it stays up no one knows…but everyone is sure it won’t come crashing down. Instead, they all imagine a period of ‘dollar weakness’ that will be good for the U.S. economy.

But dollar weakness threatens the entire world economy – not just the United States. The Chinese sell their products to Americans who are able to buy because their dollars are still relatively strong. When the dollar goes down, so does their purchasing power.

*** Meanwhile, in the housing market, there are signs of trouble ahead. Barron’s reports:

“One of the largest providers of mortgages to borrowers with marginal credit, abruptly closed its doors earlier this week. Moreover, derivatives based on the lowest tier of sub-prime mortgage securities have been plummeting in price in recent days, sending the cost of insuring against these loans’ default sharply higher.”

At the same time, more and more mortgages are becoming more and more dangerous to the people who pay them.

As recently as three years ago, only eight out of every 1,000 Californians who took out a mortgage chose a ‘pay option’ model. By 2005, one of every five new mortgages was of the ‘pay option’ variety. More recently, the number has risen to one of every three.

The genius of the ‘pay option’ mortgage is that it allows a homebuyer the option of not really buying his house. Instead, the ‘pay option’ gives the buyer the option of not paying, which means that the interest he should have paid is added to the principal. Or, another way to look at it, is that the money he should have paid is subtracted from his equity. So every day that the buyer fails to bring his interest payments up to par…he owns less of his own house.

In other words, the ‘pay option’ gives the new homeowner the option to short his own house.

Why would buyers do such a thing? Well, who knows?

We have a theory, however. In the 20th century, politics were the rage. The ‘isms’ were the great fashion of the time. And people believed so fervently that one ‘ism’ or another would make the world a better place, that they were ready to kill…or die…for them.

Now, no one cares too much about ‘isms’…all they care about it is getting rich. And they are so eager to get rich that they are willing to go broke trying.

So, a man buys a house…hoping it will make him rich. Then, he ‘takes out’ equity, using these handy get-rich mortgage devices – such as the ‘pay option.’ Unless his house goes up in value faster than he can spend the money he’s taking out – his equity goes down. Finally, he is living in a house in which he has no equity at all – or even a mortgage greater than the house value itself.

Few house buyers have any experience with a bear market in housing. Imagine their surprise when the home they expected to make them rich actually drags them to the poorhouse.

The Daily Reckoning