Past Bubble Experience Was Different

The Daily Reckoning PRESENTS: When bubbles burst, a ripple is sent through the whole economy – and the bubbles of today are much further-reaching that those of twenty or thirty years ago. Dr. Richebacher explains…


What is the difference between those housing bubbles of the 1970s and the late 1980s and the U.S. housing bubble of today? There are four decisive differences.

First, those past housing bubbles developed in a generally inflationary environment of rising consumer and producer prices. Central banks tightened their monetary reins to fight inflation in general.

Second, those bubbles were pure price bubbles in the sense that house prices rose faster than the general price indexes. There were no major repercussions on the economy.

Third, what the United States and many other countries are experiencing today is completely different from a house price bubble. Rising house prices are used as collateral to finance extraordinary borrowing-and-spending binges that virtually dominate economic growth in these countries. In 2005, consumption and residential building accounted for 92% of U.S. GDP growth.

Fourth, disclaiming that the rapidly rising house prices reflect inflation, the Federal Reserve has readily accommodated them. Rather, it hailed and celebrated the rising prices in a very positive sense as welcome “wealth creation.” The declared intention of the rate hikes since mid-2004 was not to fight inflation, but to normalize short-term interest rates. Policymakers and economists openly invited and encouraged people to prime the bubble and to make as much use as possible of the borrowing facilities it offers.

Has Mr. Greenspan ever realized that he has turned the U.S. economy into a bubble economy? Who else among former and present policymakers and top economists on Wall Street has realized this? Some certainly have. In Japan, even policymakers frankly used this word in public. But in America, everybody painstakingly avoids this admission.
In order to eschew mentioning the dirty word, a new definition has come into general use. U.S. economic growth is neither “bubble driven” nor “debt driven”; it is “asset driven.” It is a term especially invented for the American public to convey the good feeling that the U.S. economy is creating assets, while in reality, with its consumer borrowing-and-spending binge, it is consuming its capital, reflected in falling investment and soaring foreign indebtedness.

The first task, of course, is always to identify undesirable increases in asset prices, emphasis on “undesirable,” classified as “asset bubbles.” In this respect, Mr. Greenspan made his famous remark: “But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.”

Now compare this trivial talk of the world’s leading central banker with the reasoned assessment by economists in a study by the International Monetary Fund (IMF), titled “Monetary Policy, Financial Liberalization and Asset Price Inflation,” published in the World Economic Outlook of May 1993:

“Financial liberalization, innovation and other structural changes in the 1980s created an environment in which excess liquidity and credit were channeled to specific groups in the markets. This includes large institutions, high-income earners and wealthy individuals, who responded to the incentives associated with the changes. These groups borrowed to accumulate assets in the global markets – such as real estate, corporate equities, art and commodities such as gold and silver – where the excess credit apparently was recycled several times over.”

And here is a crucial part of the conclusions of this study:

“To the extent that asset price changes are related to excess liquidity or credit, monetary policy should view them as inflation and respond appropriately. There is nothing unique about asset markets that would suggest that asset prices can permanently absorb overly expansionary policies, without leading to costly real and financial adjustment.

“Actually, the study explicitly and precisely pinpoints the key feature of asset price inflation. It is “a credit expansion in excess of the expansion of the real economy.” In 2005, a credit expansion of $3,335.9 billion in the U.S. economy was matched by nominal GDP growth of $752.8 billion and real GDP growth of $379.1 billion.

In the United States, credit growth since the 1980s has developed increasingly in excess of GDP growth. During the past five years of recovery, though, this discrepancy has widened to extremes that defy economic and financial reason.

We regard this escalating gap between credit and GDP growth as a very serious, however completely unrecognized, problem, and it is rapidly escalating. In the first quarter of 2006, credit expanded by $4,386.5 billion annualized.

The first obvious question is about underlying causes. This news essentially says that an ever-greater proportion of the credit expansion is for purposes other than spending in the economy, which would correspondingly add to GDP growth. Ominously, more and more credit generates less and less GDP.

The most conspicuous cause is, of course, credit-financed asset purchases. In a country without domestic savings, any asset purchases inexorably depend on credit creation.

A second major cause is the trade deficit. To compensate for the implicit extraction of spending and incomes in favor of foreign producers, additional credit expansion is needed to create spending for domestic producers.

And a third rapidly growing cause of America’s unprecedented thirst for credit, as we have repeatedly explained, is certainly Ponzi finance. A large and growing part of the borrowing binge reflects the capitalization of unpaid, rapidly compounding interest.

According to the available figures, barely one-quarter of the credit expansion is for GDP growth and three-quarters for these other purposes.

The question to ask in the face of these facts, of course, is whether this runaway credit expansion in relation to grossly lagging GDP and income growth is sustainable. For sure, it is not. All this prodigious borrowing and lending has been undertaken in the grossly flawed assumption that rising asset prices, rather than rising incomes, will some time in the future take care of interest payments and repayments.

Assuming the normal rule that debts have to be serviced and amortized by future income, the great mass of American consumers could never afford the debts they have incurred in recent years. For many, the borrowing has even been the substitute for lacking income growth. In real terms, in 2005, this was 1.2%, well below its growth rate of 1.9% during recession year 2001. Given the reported sharply slower employment growth, further deterioration is clearly on its way.


Dr. Kurt Richebacher
for The Daily Reckoning
September 26, 2006

Editor’s Note: The Good Doctor has found the only five investments you’ll need in 2006 – and one of them is a mighty hedge against the forces of dollar weakness and inevitable inflation. At the very least, it will help protect your money from the boneheaded inflationary policies and programs of the Federal Reserve – especially under Ben “Printing Press” Bernanke.

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.”

Poor Bernie Ebbers. His number’s up. The man drove up to the Oakdale Correctional Complex in Louisiana yesterday. He got out of his Mercedes and joined the former governor of the state, Edwin Edwards, in the federal pen. Hizonner faces 10 years in the hoosegow for extorting money out of riverboat casinos. Ebbers got 25 for his role in a telecom scandal. Accountants working under his direction took some whole numbers out of the operational columns, they say, and slipped them into the capital budget.

Both men did naughty things, we don’t deny it. But putting poor Bernie behind bars for a quarter of a century for some financial hanky-panky seems excessive. When it comes to numbers, after all…anyone can make a mistake. The things are downright slippery.

Just look at poor Brian Hunter. He would tell you. The man was making $75 to $100 million per year, as an ace energy trader. He was so good that even the savviest players in the industry wanted in on his game. Both Morgan Stanley and Goldman Sachs had invested money with Hunter’s employer, Amaranth Advisors, the $9 billion hedge fund that blew up last week.

What went wrong? Hedge funds are supposed to be good at numbers, after all. They hire people with advanced degrees in mathematics simply to make sure they’ve calculated the odds correctly and offset their risks with their expectations in a logical manner.

“Somebody was not monitoring this correctly,” said one pro, referring to the extraordinary bet that Hunter placed on gas prices, a bet so large that at one time, he held about 10% of the global market in natural gas futures.

As far as we can tell, these are the numbers in a nutshell: Hunter was long. And investors were short as much as $6 billion.

“It appears we have had a major malfunction,” might have been another way to put it. But that famous understatement has already been taken. That was on January 28, 1986…with 50 million TV viewers watching. It was the day the spacecraft Challenger exploded into smithereens.

Nobel prize-winning physicist Richard Feynman described the NASA catastrophe as an institutional failure. The scientists and engineers at NASA, he charged, has been upstaged by bureaucrats who had been allowed to “pervert standards.”

But in the financial world, standards are perverted so easily they must have a twisted gene to start with. [See the letter from a dear reader, below, about slipping standards during the Roman era credit collapse. “Rigor at the outset,” says Tacitus, speaking broadly about financial affairs, “becoming negligence at the end.”]

That’s why we can’t help but feel sorry for Brian Hunter. Like Ebbers, he came from nothing to make a fortune. He went to college in Alberta, where he was a star at mathematics, of course, specializing in financial models. But the poor 32-year-old had barely gotten used to being extraordinarily rich and extraordinarily talented, when a very ordinary little slip-up with numbers derailed his extraordinary career.

We are reminded of the now legendary Nick Leeson whose rags-to-riches rise also came apart over some mundane, barely noticed figures…figures of eight, in his case.

Leeson, the working class son of a plasterer, who failed his final math exam, made such an impression at Britain’s prestigious Barings Bank that he was quickly promoted to the trading floor and then given a new operation in futures markets on the Singapore Monetary Exchange (SIMEX) where he began pulling in millions for Barings by gambling on the movement of the Japanese stock market (Nikkei Index). The whiz kid seemed to have it altogether. By the end of 1993, he had made more than £10m for Barings – nearly 10 percent of its total profit that year.

What Barings didn’t know was that Leeson, by now both Chief Trader and also in charge of settling accounts in the office (jobs that were usually done by different people), was hiding his mistakes in an account, numbered 88888, for which the company was liable. By December 1994, the numbers in 88888 had piled up…to over half a billion. A desperate Leeson then placed his most desperate bet – that the Nikkei would not fall below 19,000 points. It would have been a reasonable assumption under ordinary circumstances. But then came one of those fat tail events that give bell curves their shape – on January 17, 1995, a 7.2 earthquake hit Kobe in Japan and the Nikkei crashed by 7% in a week.

Leeson’s gambling spiraled out of control as he piled on more and more debt hoping to push the index back the other way. Most of the $1.3 billion he eventually lost for Barings came from trying to cover up what had happened.

On the verge of turning 28, the whiz kid could take it no more. Leaving a scribbled apology, he fled with his wife to Borneo and then to Frankfurt, where he was caught.

The numbers then looked pretty bad: The futures market was in shock, a 233 year-old bank to the Queen was bust; more than a thousand bank employees were out of jobs; and investors were wiped out.

And all for a string of single digits. Ordinary insignificant set of numerals – 88888.

More news, from our currency counselor…


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis:

“I’m not even going to get on my soapbox regarding this U.S. Consumer Confidence soaring. All I’ll say is that they didn’t ask me! I would give them a thing or two to think about regarding a lack of confidence!”

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


And more thoughts…

*** “Time to read up on the Panic of 1837,” says our Pittsburgh man, Byron King. “One of the more cogent observers of the time was Ralph Waldo Emerson, who was trying to uphold the old standards and protest against the easy morality of the new age.

“‘This invasion of Nature by Trade with its Money, its Credit, its Steam, its Railroads,’ he complained, “threatens to upset the balance of man, and establish a new universal monarchy more tyrannical than Babylon or Rome.’

“Interesting that Emerson comments on ‘Railroads.’ His pal Henry Throreau once said, ‘Men do not ride on railroads. The railroads ride on us.’

“Emerson actually welcomed the Panic of 1837, as a wholesome lesson to the new monarchs of manufacturing: ‘I see good in such emphatic and universal calamity…’

“He saw the Panic of 1837 as the taking-down of the juggernauts of finance, the destruction of the moneychangers in the Temple, vengeance against those who traded nothing for something, and who sucked off of the honest toil of the working people of the world. Emerson was a champion of old fashioned hard work, the mechanical arts, of raw creation, of molding useful things from the soil and rock of the earth…

“‘The American workman who strikes ten blows with his hammer, whilst the foreign workman only strikes one, is as really vanquishing that foreigner, as if the blows were aimed at and told on his person.

“‘I look on that man as happy, who, when there is question of success, looks into his work for a reply, not into the market, not into opinion, not into patronage. In every variety of human employment, in the mechanical and in the fine arts, in navigation, in farming, in legislating, there are among the numbers who do their task perfunctorily, as we say, or just to pass, and as badly as they dare, – there are the working men, on whom the burden of the business falls, – those who love work, and love to see it rightly done, who finish their task for its own sake; and the state and the world is happy, that has the most of such finishers. The world will always do justice at last to such finishers: it cannot otherwise.

“‘He who has acquired the ability, may wait securely the occasion of making it felt and appreciated, and know that it will not loiter. Men talk as if victory were something fortunate. Work is victory. Wherever work is done, victory is obtained.'”

*** “And now, as promised, more on America’s growing balance of payments problem. For the first time in 90 years, the United States is paying more to foreign creditors than it gets in payments from its overseas investments. The difference grew to $2.5 billion in the second quarter of 2006. This, according to the Wall Street Journal, was the equivalent of a quarterly debt payment of about $22 for each American household, “a turnaround from the $31 in net investment income per household it received a year earlier.”

Still peanuts. But going in the wrong direction fast.

“Our net international obligations are coming home to roost,” says Catherine Mann, a senior fellow at the Institute for International Economics.

“Since the end of 2001, when the current economic expansion began, the nation’s consumption, investment and other outlays have exceeded income by a cumulative $2.9 trillion – the largest gap on record. That current-account deficit contributes directly to the nation’s total foreign debt, the value of all the U.S. stocks, bonds, real estate, businesses and other assets owned by non-U.S. residents. As of the end of 2005, total U.S. foreign debt stood at $13.6 trillion – or about $119,000 per household. Net foreign debt, which excluded the $11.1 trillion value of U.S.-owned foreign assets, was $2.5 trillion.

“Foreigners’ willingness to lend at low rates has also encouraged Americans and their government to borrow and spend. By buying U.S. Treasuries, foreign investors put up more than four-fifths of the $1.3 trillion the federal government has borrowed since 2001 to help pay for tax breaks, the new Medicare prescription-drug benefit and wars in Afghanistan and Iraq. Over the same period, foreigners put more than $700 billion into various types of U.S. mortgage-backed securities, providing the money for millions of Americans to buy new homes — or extract cash from their existing homes to spend on goods such as washing machines and Hummers.”

*** And finally, a dear reader writes:

“I believe I have found a Roman parallel to the housing bubble for your Daily Reckonings. In the course of my thesis research I came across this passage in Tacitus’ Annales relating to a ‘credit crunch’ in 33AD:

‘The Senate passed a measure requiring two-thirds of loaned money to be reinvested in Italian real estate to prevent the collapse of land prices resulting from the sale of assets to repay loans. Tiberius himself later offered 100m sesterces on loan for three years to ease the credit crunch.

From Tacitus: “Meanwhile a powerful host of accusers fell with sudden fury on the class which systematically increased its wealth by usury in defiance of a law passed by Caesar the Dictator defining the terms of lending money and of holding estates in Italy, a law long obsolete because the public good is sacrificed to private interest. The curse of usury was indeed of old standing in Rome and a most frequent cause of sedition and discord, and it was therefore repressed even in the early days of a less corrupt morality. First, the Twelve Tables prohibited any one from exacting more than 10 per cent, when, previously, the rate had depended on the caprice of the wealthy. Subsequently, by a bill brought in by the tribunes, interest was reduced to half that amount, and finally compound interest was wholly forbidden. A check too was put by several enactments of the people on evasions which, though continually put down, still, through strange artifices, reappeared. On this occasion, however, Gracchus, the praetor, to whose jurisdiction the inquiry had fallen, felt himself compelled by the number of persons endangered to refer the matter to the Senate. In their dismay the senators, not one of whom was free from similar guilt, threw themselves on the emperor’s indulgence. He yielded, and a year and six months were granted, within which every one was to settle his private accounts conformably to the requirements of the law.

“Hence followed a scarcity of money, a great shock being given to all credit, the current coin too, in consequence of the conviction of so many persons and the sale of their property, being locked up in the imperial treasury or the public exchequer. To meet this, the Senate had directed that every creditor should have two-thirds his capital secured on estates in Italy. Creditors however were suing for payment in full, and it was not respectable for persons when sued to break faith. So, at first, there were clamorous meetings and importunate entreaties; then noisy applications to the praetor’s court.

“And the very device intended as a remedy, the sale and purchase of estates, proved the contrary, as the usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined. The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found. The purchase too of estates was not carried out according to the letter of the Senate’s decree, rigour at the outset, as usual with such matters, becoming negligence in the end.'”

The Daily Reckoning