Mr. Ponzi Salutes

by Dr. Kurt Richebächer

For us, it is a compelling conclusion that this debt explosion overwhelmingly mirrors Ponzi finance, meaning that debt service is paid with new debt. Assuming an average interest rate of 5% on outstanding debts of $36.2 trillion in the United States, current overall debt service is running at an annual rate of about $1.8 trillion.

Focusing on the consumer, we note the following financial development. In 1996, the start of the equity bubble, his disposable income rose by $280.3 billion. Simultaneously, he increased his spending on goods, services and new housing by $312.3 billion, and his borrowing by $332.2 billion.

In 2000, the equivalent figures were $499 billion for disposable income, $478.9 billion for total spending and $558.6 billion for total borrowing. For 2004: disposable income up $474.1 billion, total spending up $560.1 billion and borrowing up $1,017 billion.

In 2004, household debt increased more than twice as fast as disposable income. Debt production in the United States has run absurdly out of proportion to income production.

Earlier, we mentioned that it is mainly bad loans on real estate that have paralyzed Japan’s banking system. America’s commercial banks, not to mention its numerous subprime lenders, are doing their best to beat the follies of their Japanese brethren. Real estate lending by commercial banks has soared as a share of total lending in the past few years, lately accounting for 63% of total outstanding loans, as compared with 41% 10 years ago.

So is there a housing bubble? An infallible measure of a housing bubble is associated debt creation. In the United States, the increase in debt defies economic and financial reason – and imagination.

Asset and credit bubbles implicitly end in busts. Only a bust’s timing is unforeseeable. In the United States, the lenders are desperately trying to prolong the bubble by laxer and laxer lending conditions.

In a rousing defense of the credit bubble, Mr. Greenspan – in his speech “The Mortgage Market and Consumer Debt,” made on Oct. 19, 2004, before America’s Community Bankers in Washington – flatly dismissed any debt perils with the argument that this borrowing was fine as long as it remained in reasonable alignment with rising property values.

That is, of course, the popular view in the United States. Still, it is a shame for the chairman of the Federal Reserve to say such a thing. A fact to consider is that credit bubbles drive asset bubbles with tremendous leverage, as the price of the last trade is mechanically translated into an equivalent change in the value of all existing houses.

Put bluntly, when the prices of a small percentage of existing houses are sold 5% higher in any given month than trades in the prior month, this lifts the value of perhaps 150 million existing houses in the United States by the same percentage. This is around 200 times leverage in wealth creation. In reality, it is dubious statistical arithmetic.

“Wealth creation” is the prevailing euphemistic American interpretation. According to reports, American households are amassing wealth in this way as never before, vastly outpacing their soaring debt growth. For us, it is scandalous that policymakers and economists can propagate this nonsense without a single voice of protest.

What about the wealth aspect? In principle, a rise of asset values can have three different causes: first, higher yields; second, higher available savings; and third, artificially low interest rates driving credit-financed purchases.

Of the three possible causes, the third is definitely decisive for the protracted rise in U.S. house prices. This unmistakably qualifies it as “house-price inflation,” not as “wealth creation.”