Anyone who even remotely follows the current state of the U.S. economy realizes one irrefutable fact: our economy is driven entirely by credit. Secondly, we acknowledge the fact that credit feeds on itself and must constantly and consistently expand. Thirdly, we know that the safety of this credit-based economic system lies in the value of its assets used as collateral for that credit. Lastly, we agree that these same assets directly depend on a constant stream of new credit to support their value. So, what happens when credit dries up or contracts? We see asset prices fall, which reduces the collateral value supporting this credit. From that point on, it's a scramble to shore up the leakage in this vicious paper cycle. Because of the drastic ramifications of contracting credit, central bank policy—and our own Federal Reserve—will always favor credit expansion.
The Quantity Theory of Money
This debt-based system (credit-based economy) must constantly expand or else the whole system will eventually implode. That is why the money supply is constantly expanding. It also explains the persistent rise in prices in the United States. The rise in prices can be further explained by “the quantity theory of money.” The basic premise of this theory is that the value of money, or the value of any good, is determined by its quantity. The greater the quantity of any good, the lower becomes its value. This applies directly to the value of money. The greater quantity of money, the lower its value. Consequently, a lower purchasing value of money leads to higher prices. Essentially, it's back to Economics 101: supply and demand applies to money (credit).
In a system that is based entirely on credit, a contraction of credit is the central banker’s worst nightmare. When the quantity of money—or in this case, credit—falls, then the quantity theory tells us that demand for goods must also fall. Falling demand means declining revenues for businesses and less income for workers. As revenues and income fall, the ability of business and individuals to service debts also declines. This leads to declining asset values, which serve as collateral value supporting that debt. The reduction in the ability to repay debt reduces the income and assets of banks. If it persists, it could eventually lead to bank failures. Since our financial system is closely interconnected, the failure of one bank could easily cause the failure of other banks because of the interlocking credit nature of our banking system. As banks fail, credit contracts and the supply of money is reduced in the economy. History shows us that when this process begins, it can often gain momentum. As more banks fail and the supply of money continues to contract, it usually leads to severe asset deflation.
The central banks (in this case, the Fed) that monitor and control money supply and flow are ready to immediately step in at the first sign of a credit crisis. They stand ready to act as "the banker of last resort" reliquifying the credit system through bailouts of failed credit institutions whether banks, hedge funds, or even countries. Recent U.S. history is replete with Fed-engineered bailouts from Continental Illinois Bank, Penn Central, a crashing stock market in 1987, the Savings and Loan industry in the late 1980s, a collapsing Mexican peso in 1994 and the Asian crisis of 1997 to the infamous hedge fund, Long Term Capital Management. At the first sign of credit troubles—which could lead to credit contraction—the Fed steps in and reliquifies the system.
In this rescue process of reliquifying (or increasing money supply), they have helped to foster reckless speculation and unsound investments. This has lead to what James Grant has referred to as the “socialization of credit risk.” In other words, by bailing out failed institutions, the Fed has removed the risk associated with credit dealings from contracting parties and transferred it to our society as a whole.
The consequences of this whole process are that our financial markets have become more speculative, asset bubbles more predominant, and inflation has become a permanent fixture in our economy. This has also removed the curative powers of economic contraction. Every economic downturn is followed by even larger injections of money and credit leading to additional asset booms and busts. The stock market bubble of the 1990s has now been replaced by the mortgage and real estate bubble of this new century.
Our Present Danger
Because the creation of larger amounts of money and credit has become a permanent fixture of our present financial system, many argue that the potential for a massive deflationary contraction has become far greater than in 1929. However, there are many distinct differences between 1929 and today. Unlike 1929, today’s Federal Reserve System has unlimited power to expand the supply of money. It has demonstrated this over and over again with each consecutive financial crisis. Lest we forget, the Fed has been there to remind us. In a speech given before the National Economists Club in November 2002, titled “Deflation: Making Sure 'It' Doesn’t Happen Here,” Fed governor Ben S. Bernanke said,
“… U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology—called a printing press (or, today, its electronic equivalent)—that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of the dollar in terms of goods and services, which is equivalent to raising prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”[1]
The 2002 Bernanke speech, which has been echoed by other Fed spokesmen since then, reminds us that the Fed understands the true nature of inflation, which is the expansion of the money supply. The rest of Bernanke’s speech details various steps the Fed could take in an effort to increase nominal spending and inflation. Even if rates are close to zero or negative as they are today, the Fed has tools at its disposal to help it avoid deflation from expanding its scale of asset purchases to expanding the menu of assets that it buys.
“Alternatively, the Fed could find other ways of injecting money into the system for example, by making low-interest rate loans to banks or cooperating with the fiscal authorities…Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”[2]
The Bernanke speech reminds us that the Fed will do all within its power to prevent a reduction in the quantity of money. It also leads to the conclusion that the government’s policy of money creation and consequent inflation will continue and inevitably accelerate.
Financial markets and investors must understand that the Fed is an inflation-creating institution. Its sole purpose is to expand the supply of money and credit within the economy and financial system irrespective of the nation’s ability to save and support that supply of credit. Any effort to curb inflation will be nominal. With over $37 trillion in debt, the U.S. economy could not withstand a contraction of credit or afford to pay a higher price for its use. The misperception that now hovers over the markets is that any inflation will be temporary. Looking forward, it is more likely to accelerate. The other misperception is that the Fed will be vigilant in its fight against a rise in inflation. At this point with $37 trillion in debt and $51 trillion in unfunded Social Security, Medicare, and pension liabilities, it would in fact welcome it.
Source: Bill Gross, "Back To The Garden," Investment Outlook, July 2004
One strategy, which the Fed is pursuing in an effort to generate nominal spending and inflation, is negative real interest rates. By keeping the Federal funds rate at historical lows, it has destroyed thrift and savings. Additionally, by keeping the real rate of return on savings negative, it has encouraged spending and speculation to the detriment of savings. In the six months ending this past June, consumer prices have risen at an annual rate of 4.9%. (This rate is actually understated due to hedonic adjustments.) With the Federal funds rate at 1.25% and inflation running at 5%, we are a long way from reaching a neutral federal funds rate. A neutral rate is now closer to 6% than it is 4%. However, rates this high are irrelevant because the Fed will never get that aggressive. A 6% federal funds rate would collapse the trillion debt pyramid in the U.S.
Monetary Tsunami Hits America
The monetary tsunami loosed upon the U.S. economy since 1995 has created one asset bubble following another. First it was the stock market bubble of the mid and late 1990s. That bubble has now been replaced by a mortgage, consumption, and housing bubble. Aggressive rate hikes from the Fed would most assuredly collapse the multiple bubbles in mortgages, real estate, bonds and stocks. Any collapse in asset prices would immediately send the U.S. economy into recession and trigger a wave of bankruptcies never seen before. A major wave of bankruptcies would impair the asset bubble supporting all bank credit.
Put away your deflationary concerns. We are more likely to begin the process of hyper-inflating than we are deflating. At the first sign of economic softness, the Fed will reverse its role of tightening to one of expanding the money supply aggressively. If foreign central banks don’t buy our debt, then the Fed will be forced to monetize it. With America’s twin deficits running at an annual rate of trillion and total debt accumulation running at over trillion annually, the supply of credit must constantly expand. The Greenspan Fed is caught in a trap of its own making. It is repeating the same mistakes made by two of his predecessors, Arthur Burns and William Miller. By targeting interest rates rather than targeting the money supply, we are about to revisit the stag-inflationary environment of the 1970s. This time there will be no Paul Volcker, nor will the Fed take draconian measures. The difference this time around is trillion of debt.
Government Debt Gapping Up
The key question going forward is this: How long it will take bond traders to draw the appropriate conclusions? Government spending is going to accelerate in the years ahead, especially as the baby boom generation heads into retirement beginning in 2008. In a study conducted by Gokhale and Smetters for the government to be included in the President’s FY 2004 Budget, it was estimated that the fiscal gap of unfunded liabilities amounted to trillion. Adding in the new drug benefit passed by Congress in 2003, the fiscal gap increases by trillion. This brings the total fiscal gap to trillion! [3] Understandably, the study was yanked from FY 2004 budget. The administration was too uncomfortable with the truth. According to the authors of the study, we would have to start today in order to correct the growing fiscal gap. This would entail the following remedies:[4]
| Increase federal income taxes | 69% |
| Increase payroll taxes | 95% |
| Cut federal purchases | 106% |
| Cut Social Security and Medicare | 45% |
No politician in his right mind is going to make the tough decisions to cut entitlement benefits and raise taxes to put the government’s budget on a sound footing. The authors of the study conclude that the only way the government will be able to pay its bills is to literally print tons of money. It has been the preferred course of action taken by governments throughout the course of history.
Printing Money and Exporting Debt
Printing money is the palliative most often followed by governments to solve their various fiscal crises. The government benefits from running the printing presses in three ways. The first benefit is that it allows the government to exchange depreciating paper money for real goods and services. The second benefit is that it inflates away the government’s debt. Finally, it reduces government expenses by reducing the real value of government expenditures.
The U.S. government has avoided the full inflationary effects of its money printing by exporting dollars to the rest of the world. As long as foreigners accept our dollars, we can continue to export our inflation. Foreign central banks have been absorbing our excess dollars. By using foreign savings in absence of our own, we have dodged the severe inflationary impact of our credit bubble. Until recently most of the impact of our credit creating machine has shown up in severe asset inflation in stocks, bonds, mortgages, and now real estate. However, there are growing signs that inflation is starting to spill over on to Main Street in the form of rising food, energy, and service costs. When the full impact of inflation starts to hit the U.S. economy will depend on three factors:
- Foreign outflows out of the dollar
- Fed monetization of debt
- Increases in money velocity
As governmental expenditures accelerate in the years ahead, it will require more amounts of money printing. The amount of money and credit is starting to rise exponentially with the U.S. economy adding over trillion of new debt each year. If prices keep rising long enough, money velocity begins to rise. An expanding quantity of money slowly—but eventually—changes people's expectations and preferences for holding that money. As prices keep rising—as they are now—consumers conclude that it pays to buy goods immediately before prices rise even further. Holding cash becomes undesirable because of the loss of purchasing power. As a result of low interest rates, consumers and investors have spurned cash and instead invested in real assets such as real estate, financial assets (stocks and bonds), and have increased personal consumption. This is what is now happening in the real estate market.
What investors and consumers are now doing is substituting the holding of cash for other tangible assets such as commodities or other paper assets with higher returns. The rise in the bond market over the last three years is a good example of money seeking a higher return. In addition to consumer preferences for owning or holding other forms of assets other than cash, businesses likewise change their habits.
In an “easy money“ environment such as we have today, businesses operate with lower cash balances. With credit easily available either through banks or the securities markets, the perceived need to hold money is lessened. In effect, prospective credit that is easily available at a low cost serves as a substitute for money. Today consumers tap their mortgages through refinancing or more recently through home equity loans. In addition there is ample opportunity to draw on credit cards. Businesses have access to bank debt in addition to the securities markets.
There are signs that debt monetization is starting to grow. Securities bought by the Fed have grown to 3.5 billion as of the week ending on July 28th. Year-over-year security purchases have risen by .7 billion. Since the beginning of May, Fed purchases of U.S. debt have been averaging over .3 billion a week, an annual rate of over billion a year. There are also signs that money velocity is starting to turn up after falling for most of the last decade. In addition, foreign purchases of U.S. debt has been falling off sharply since peaking in the first quarter of the year.
Foreign purchases of U.S. securities fell to .4 billion in May, down 26% from April. (The U.S. needs billion a month just to finance the trade deficit.) May was the fourth consecutive monthly decline of purchases by foreigners of U.S. assets. Moreover, May was the third consecutive month that foreigners have been net sellers of U.S. stocks. Even Japan, which has been a major lender to the U.S. and which owns 16% of all U.S. Treasuries, bought only .6 billion of debt in May and only .5 billion in April, a significant drop from the average of billion over the previous seven months. China has recently curtailed its purchases of U.S. Treasuries. Chinese purchases of U.S. securities have fallen by 91% this year to only .7 billion.[5]
Because an increase in the quantity of money can reduce the rate of interest only temporarily, the Fed will continue to remain behind the eight ball. The Federal funds rate will be kept below 2% for the next several years. The expedient to keep rates down is explained as follows:
“…As soon as the new additional money is borrowed and spent, it begins to raise sales revenues and profit margins, and thus the rate of profit. (This has occurred in the U.S. financial markets over the last year with rising revenues and profits, the outgrowth of an expanding money supply.) The rise in the rate of profit then raises the rate of interest. To prevent the rate of interest from rising in the face of the higher rate of profit, an acceleration in the rate of credit expansion is necessary. The effect of such an acceleration would be a still more rapid rate of increase in the volume of spending and thus sales revenues, with the result that profit margins and the rate of profit would rise still higher, which of course, would operate all the more powerfully to raise the rate of interest. To prevent the rate of interest from rising at this point, an even more rapid rate of credit expansion would be required, which would cause yet a still higher rate of profit, and so on. Thus, the use of credit expansion to prevent the rise in the rate of interest that results from an increase in the quantity of money would quickly entail such enormous rates of increase in the quantity of money as to destroy the monetary system.[6]
The "Carry Trade" is Seen in Three Segments
In a debt-based economy such as we have in the U.S. ever increasing amounts of new debt require a steepening yield curve and a continuation of the “carry trade.” By keeping borrowing rates low and long-term rates to a minimum through Fed or foreign central bank intervention, the Fed has allowed the “carry trade" speculation to continue. It can be said that it has done all it can to foster it. The Fed has encouraged bond investors to speculate in the trade by borrowing short and investing long. In doing so the bond market—like the Bank of Japan—has done most of the Fed’s dirty work. We now have all three major segments of the U.S. economy, the government, corporations, and households engaged in the “carry trade.”
Government Playing "The Carry Trade"
The U.S. government’s outstanding debt of .3 trillion is mainly short-term. On average, federal debt has a maturity of five years or less. Nearly one-third of this debt will come due in less than a year. By keeping its debt short-term, the government has been able to realize a net decline of 13.4 percent per annum in net interest payments. Instead of being prudent and locking in low interest rates, the government has shortened its debt in order to reduce interest rate expense. While this may save money in the short-term, it could also backfire and raise expenses over time as rates begin to rise. Instead of locking in its debt costs, the government is now subject to the vagaries of the debt markets. The trend in interest rates is up, which means the cost of financing all of that short-term debt will also be rising. This will lead to even higher deficits as rising rates slow down the economy, shrink government tax revenues, and increase its expenses. The U.S. government in effect is playing the “Carry Trade” by financing long-term commitments with short-term debt.
Corporate America Playing "The Carry Trade"
Just as the government is short on its debt and long on its expenses, the same mistake is being repeated in the corporate sector. Contrary to popular opinion, the corporate balance sheet has hardly improved. Debt to equity ratios look better thanks to a rising stock market. However, those ratios could deflate as quickly as you can say the word “crash.” Recent evidence this year points to a record pace of debt issuance with most of that debt carrying a “floating’ rate interest. This debt gets more expensive as interest rates rise. If rates continue to climb as they are now, corporate profits could get squeezed
According to Lehman Brothers, companies worldwide are set to issue more than trillion in floating rate debt this year. Floating rate debt issuance by investment grade companies is up 36% this year. Companies with junk bond ratings are also issuing floating rate debt. The last time there has been this much variable rate financing was back in 1994.[7]
In addition to issuing variable rate debt, companies are taking on increasing risk with derivatives. Companies issuing longer-term debt are changing the nature of that debt through interest rate swaps. Between 40-50% of newly issued, long-term debt has been swapped.[8] Interest-rate swaps involve the exchange of coupon payments—one fixed and the other floating rate. The interest rate payments are usually paid semiannually. In a swap arrangement, the company agrees to pay the floating rate to its counterparty. This rate is usually the six-month London Interbank Offering Rate or Libor. If rates rise, interest expense rises and companies could find it difficult to reverse such transactions. Most swaps trade over the counter rather than on exchanges, which makes them less liquid.
According to Raj Dhanda, Morgan Stanley’s head of global debt syndicate, about half of all U.S. corporate debt is floating rate. This makes the corporate sector vulnerable to rising interest rates more so than in the past since debt levels today are much higher.
According to Standard & Poor’s, companies have only marginally reduced debt from 52.7% in 2000 to 52.5% at the end of 2003. Examining the footnotes of companies ranging from GM, GE, Ford and Wells Fargo to Citigroup reveals that companies have turned to variable rate debt to reduce borrowing costs. Although companies don’t like to reveal how much of their debt is variable, they oftentimes disclose its impact. Citigroup disclosed that pretax earnings could decline as much as 6 million over the next year, if interest rates rose by 1%.[9]
The automobile industry is a big user of variable rate debt and interest rate swaps. Ever wonder how auto companies could offer such low finance rates or zero percent car financing? The answer is variable rate debt and interest rate swaps. This is what has driven profits recently at Ford and GM. Ford, which recently reported that second quarter net income tripled to .17 billion, made that profit entirely from its Ford Credit unit. The No. 2 auto maker lost money in its core car-making business worldwide. GM’s second-quarter earnings were driven almost entirely by a record performance at GMAC (General Motors Acceptance Corporation).
Financial America Playing The "Carry Trade"
Corporate America is playing the “carry trade” game by borrowing short and investing long. Financial America is playing the same game in an even a bigger way. From hedge funds to money center banks, large financial players have borrowed short and invested long. High risk investments, which carry a higher interest rate such as junk bonds and emerging debt, are the favorite playground of financial players plying the carry trade. These leveraged players are speculating by borrowing U.S. dollars denominated short-term debt. They then reinvest the borrowed money in higher yielding bonds. The problem arises when rates rise, which reduces the value of high risk assets. The degree of leverage determines how capable a fund or bank would be in sustaining losses. A one percent rise in rates can wipe out as much as 10-15% of the value of a high risk bond. If you are leveraged by 20:1, you go under unless you are hedged or can quickly unwind your position. April and May’s bond market debacle was a sampling of what can go wrong when rates suddenly rise and funds want to get out of their positions.
Even though hedge funds only represent about 7% of the size of the world’s mutual fund assets, they are usually more leveraged. In addition to leverage, their investment style employs more active trading. The problem with these funds is that nobody really knows how much leverage they are employing. According to a recent article in The Financial Times, hedge fund leverage in the form of bank debt has crept up to an average of 141% as of last year. However, this figure understates leverage because most funds extend the use of leverage through derivative investments.
Source: FDIC Outlook, Summer 2004
American Banks Playing The "Carry Trade"
In a worldwide economy that is becoming more levered with high amounts of debt being taken on by governments, corporations and consumers, Cassandras are starting to worry. However, the greatest amount of angst is coming from the banking sector. Hedge funds are small players. The big elephants in derivatives are the money center banks. They are the biggest players in this sector. This small handful of institutions not only trade and facilitate the issuance of new derivative contracts, they are also the insurer that stands behind them. With over 0 trillion in derivatives worldwide that is a lot of high risk exposure for just a handful of players.
American Consumers Playing The "Carry Trade"
Governments, corporations, banks and hedge funds aren’t the only players in the “carry trade” game. The individual consumer and householder are also taking advantage of yield spreads by borrowing short-term and investing long. One reason the real estate market has remained this hot is that homebuyers and households have switched to short-term variable rate debt. Home equity loans are tracking at an annual rate of 0 billion this year. The percentage of ARMs (adjustable rate mortgages) has more than doubled this year in the U.S. This year ARMs have risen to 36% of all loans closed as of May. According to Fitch ratings, nearly two-thirds of all mortgage debt held by sub-prime borrowers is adjustable rate.[10]
Even worse is the new trend towards hybrid adjustable mortgages. This kind of mortgage allows the buyer to purchase a house with virtually no money down. The borrower pays only interest on the loan during the first two years. The buyer builds no equity. Another twist of the interest-only adjustable mortgage is the Option ARM. This kind of loan is adjustable and carries a low interest rate with negative amortization. With the Option ARM, the borrower pays only part of what is owed early on in the life of the loan. The unpaid interest is added to the loan’s balance each month. These riskier type mortgages can often adjust monthly. This means interest rates on the loan could rise every month instead of every six months. The borrower in this case is playing the carry trade to the extreme, betting that housing appreciation will exceed negative amortization. It hasn’t occurred to most of these types of borrowers—who tend to be marginal—that rates could rise and housing prices could fall. Borrowers in this kind of mortgage are buying an asset in the hope of building equity.
We Are In Denial
The financial markets today are held together by a thin tread of unreality. In effect, America is in denial. This is evident by an alarming lack of fear of debt. The government’s debt is over .3 trillion and growing rapidly. Moreover, both candidates running for the presidency promise to spend even larger amounts of money by expanding existing entitlements and creating new ones. Corporate debt has hardly budged over the last four years despite a bear market in equity. Companies have used historically low interest rates to add additional debt to the balance sheet. Households are also loaded to the gills with debt, chiefly in the form of mortgages, home equity loans, and credit card debts.
Wall Street analysts and government economists quickly dismiss the thought that consumers and businesses are over-leveraged. They immediately refer to rising home and equity prices. The amount of debt is marginalized by constantly inflating asset prices. 21st century memories tend to be short. Many have forgotten what can happen to the equity markets when the Fed embarks on a rate raising cycle. The last time this happened in June of 1999, it took only a 1.75 percentage point increase in the Fed funds rate to bring about a stock market collapse and a recession. Yet, Wall Street repeats the mantra that as long as the Fed rate hikes are gradual, the party will continue. Nothing could be further from the truth. Nearly all rate raising cycles end in financial and economic mishaps. When the Fed begins raising rates, bad things happen to the financial markets and the economy. It won’t be any different this time. The only difference will be that it will take fewer rate hikes to send the markets and the economy into a downward spiral.
When this bubble will burst is not a question of “if” but of “when.” A look at history shows us that bubbles can last longer than expected. The NASDAQ bubble lasted for nearly five years before it burst. Price earnings multiples went from the high teens to the high hundreds. In the case of Internet stocks, P/E multiples went as high as multiple thousands. Today stock prices and P/E multiples are high. Dividends remain minuscule and bond yields remain at half century lows. The housing bubble continues to inflate, despite higher fixed rate mortgages. Buyers have merely switched to variable rate debt, interest only mortgages, and negative amortization loans. Instead of deflating as mortgage rates rose, just the opposite is happening. Housing prices and sales have continued to rise.
The Reality of Credit-Induced Asset Bubbles
The classic reaction in the beginning of an inflationary cycle—get out of cash and own something tangible—is now taking over. No one wants to miss buying a new home out of fear of being shut out of the market. What is now happening globally in asset markets, and especially here in the U.S., is similar to the events preceding the Great Inflation in Germany in 1920s as noted by author, Adam Fergusson:
“As the old virtues of thrift, honesty and hard work lost their appeal, everybody was out to get rich quickly, especially as speculation in currency shares could palpably yield far greater rewards than labor. While the anonymous, mindless Republic in the shape of the Reichsbank was prepared to be the dupe of borrowers, no industrialist, businessman or merchant would have wished to let the opportunities for enrichment slip by while others were making hay. For the less astute, it was incentive enough and arguably morally defensible, to play the markets and take advantage of the unworkable fiscal system merely to maintain one’s financial and social position."[11]
In an equal fashion Jens O. Parsson wrote similarly of that era:
"Speculation alone, while adding nothing to Germany’s wealth, became one of its largest activities. The fever to join in turning a quick mark infected nearly all asset classes, and the effort expended in simply buying and selling paper titles to wealth enormous. Everyone from the elevator operator up was playing the market. The volumes of turnover in securities on the Berlin Bourse became so high that the financial industry could not keep up with the paperwork, even with greatly swollen staffs of back-office employees, and the Bourse was obliged to close several days a week to work off the backlog….Concentration of wealth and business was still another characteristic trend. The merger, the tender offer, the take-over bid, and the proxy fight were in vogue. Bank mergers were all the rage [as they are today]. Great ramshackled conglomerates of all manner of unconnected business were collected together by merger and acquisition." [GE, Tyco] [12]
Today business headlines are full of bank mergers and industry takeovers and mergers. Asset flipping has become commonplace in the stock market as well as in real estate. In May, the L.A. Times reported that the number of homes sold in the region that had been owned by sellers for six or fewer months was 47% higher than a year earlier. Flipping (the buying of a house for the sole purpose of selling at a quick profit) is now close to 3.1% of all homes sold in a month according to La Jolla based DataQuick.[13]
Another characteristic of credit induced asset bubbles is that they inflate faster as the cycle nears completion. The NASDAQ rose more rapidly between 1997-and March of 2000. Housing prices today are rising more rapidly and mortgage origination and asset sales are still setting records. Wall Street sold 5 billion in asset back securities during the first five months of this year, up 22% over the same period last year.
What we should be well aware of after the NASDAQ and technology bubble burst is that there is no guaranteed permanence to asset bubbles and the wealth effects they spawn. Eventually, all asset bubbles deflate even after great inflations. It remains a question now whether the bubble creating policies of the U.S. Federal Reserve are sustainable.
Misplaced Expectations
The markets are operating under four misperceived assumptions. It is imperative that we understand these critical misperceptions to know what lies ahead of us. They are as follows:
- The rise in inflation is a temporary blip.
- The economy has hit a temporary soft patch, growth will resume shortly.
- The Fed will get tough in its fight to contain inflation.
- The financial markets can withstand a gradual rise in interest rates.
These assumptions will be tested as we head into this fall. There is growing evidence that economic softness is gaining momentum. Global economic growth and corporate profits show every sign of peaking. The Fed has assumed a perfect blend of growth and inflation in its forecast. This is the so-called Goldilocks Forecast. However, instead of being not too hot and not too cold, it is looking like growth is too cool and inflation is becoming too hot. Inflation indexes have moderated very little given the economic slowdown, that is if you dismiss rising food and energy costs. The CRB Index is still up this year with oil prices hovering near a barrel. The Fed shows no sign of moving aggressively to raise interest rates for fear of collapsing asset markets. And as shown in the three charts of the major stock indexes this year, all major markets have had difficulty absorbing even a quarter point rate hike in interest when it was raised on June 30th
What I suspect happens next is that the Fed will proceed very cautiously in the months ahead as it is well aware of the amount of leverage in the economy. The more dependent on debt the economy becomes, the more harm will be done by a rise in interest rates. The Fed knows that it has very few arrows left in its quiver. It is also aware that household balance sheets are hardly in strong enough shape to withstand a drop in housing prices. The property wealth effect is a far more debt-intensive phenomenon than the stock market wealth effect. Household debt is equal to 85% of GDP. That is up from 70% in 1995. This means that debt service burdens are at the upper end of historical experience. The shift by homebuyers and households to variable rate debt and a similar switch by corporations to variable debt places U.S. asset markets and the economy in the danger zone.
Our economy is too leveraged. Raising the Federal funds rate to a "neutral" rate of 4 to 6% is a pipe dream. In reality, a few rate hikes is all we'll get before the unraveling begins. The other three assumptions as noted above will all prove to be a chimera as well.
To quote Jens O. Parsson again:
"Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular prosperity, all in the midst of temporary stable prices. Everyone benefits, and no one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the later effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock prices, rising taxes, still larger government deficits, and still soaring money expansion, now accompanied by soaring prices and the ineffectiveness of all traditional remedies. Everyone pays and no longer benefits. That is the full cycle of every inflation." [emphasis added] [14]
Alan Greenspan once remarked to someone in the 1970s that he would love to be Fed chairman at the onset of the next deflation. He felt he had the palliative cure: a surfeit of money and credit. Whether his cure becomes the palliative to a deflating asset market or the onset to the next Great Inflation has yet to be determined. No one knows at this point when the great storm will arrive. What we do know is that when fiscal and monetary pressures get too high, financial markets begin to boil and become unstable. Interest rates begin their inexorable rise, currencies begin to gyrate, and stock markets begin to swoon. That is exactly what all markets are doing now.
Deflationists believe that Greenspan will fail. There is too much debt and debt contraction always leads to deflation. They point to Japan and the U.S. in the 1930s as an example. However, Japan has yet to experience the full effects of its expanding money supply. Government money creation in Japan has been offset by a sharply contracting banking system. As the government pumps money into the economy by expanding the monetary base, the banking system continues to offset government money expansion by continuing to contract and refrain from making new loans. Many of Japan's banks are technically insolvent. Like U.S. banks in the 1930s, they are afraid to make new loans or renew existing ones. As long as the economy remains in the dumps, the government can continue to run the printing presses with very few pricing effects. The trick is when the economy revives. Then the full impact of higher prices and inflation are felt. This is what led to hyperinflation in Germany during the 20’s and 30’s. It is also what has happened to Argentina and what may occur in Brazil, Venezuela, Turkey and Russia next.
Can It Happen Here?
I believe the answer to that question is yes, it is more likely this time around. Unlike the U.S. in the 1930s and Japan in the 1990s, the U.S. is no longer a creditor nation. It has become the world’s largest debtor. The inflation consequences of debtor nations are much different than creditor nations. Debtor nations are more apt to suffer the inflationary consequences of their credit inflations. The recent turmoil in Mexico and Latin America throughout the 1980s and 90’s and the Asian crisis are recent examples of what happens when credit expands and currencies collapse.
In addition to being the world’s largest debtor nation, the U.S. is no longer self sufficient in manufacturing and must rely on the rest of the world to supply our basic needs. This also applies to our situation in energy. The U.S. has gone from the world’s largest exporter of oil to the world’s largest importer and consumer of oil. We pay for those imports and oil in dollars. As long as the world gives us manufacturing goods and oil in exchange for our dollars, we can export our inflation to others. When the world no longer accepts our dollars as payment for goods or oil, the real inflation story begins. It boils down to a confidence game. The question is how much longer they will accept the dollar chimera. As to what happens when they wake up to this fact is described by Parsson’s in his book, Dying of Money:
As for the speculators, the most extra-ordinary feature of the Reichsmarks joyride (the boon of 1921) was not any attack against it, but quite the opposite, an incredible (“ pathological “, it was later called) willingness on the part of investors at home and abroad to take and hold the torrents of marks and give real value for them. Until 1922 and the very brink of collapse, Germans and especially foreign investors were absorbing marks in huge quantities. Only the international reputation of the Reichmark, the faith that an economic giant like Germany could not fail, made this possible. The storage factor caused by the investors willingness to save marks kept the marks from being dumped immediately into the markets, and thereby for a long while held prices in check. The precise moment when the inflation turned sharply upward, toward its vertical climb, was undoubtedly timed by no event, but by the dawning psychological awareness of the German and foreign investor that Germany was not going to back its money. With that, the rush to get out of the mark was on. Like a damn bursting, the seas of marks flooded into the markets and drove prices beyond all bounds. The German government strove mightily to outflood the sea. The sea of marks which had been stored up by Germans and especially by trusting foreigners flooded forth and fought to buy into other investments, foreign currencies, tangible goods, almost anything but marks.[15]
Coming in September “The Great Inflation”
Chart Courtesy: StockCharts, Economagic, WallStreetJournal, BIS, MarketWatch, and Bloomberg
References
[2] Ibid.
[3] Lucchetti, Aaron, "Companies Are Taking on Risk with Floating-Rate Debt," WSJ, July 26, 2004.
[4] Ibid.
[5] Ibid.
[6] Wiggins, Jenny, "US Homebuyers Risk Rates 'Time Bomb'," Financial Times, July 25, 2004.
[7] Kotlikoff, Laurence J. and Scott Burns, The Coming Generational Storm, The MIT Press, 2004, p. 65.
[8] Ibid., p.65.
[9] Karmin, Craig, "Foreigners Seem to be Souring on U.S. Assets," WSJ, July 26, 2004.
[10] Reisman, George, Capitalism: A Treatise on Economics, Jameson Books, 1996, p.521.
[11] Fergusson, Adam, When Money Dies: The Nightmare of the Weimar Collapse, Kimber, 1975, p.229.
[12] Parsson, Jens O., Dying of Money: Lessons of the Great German and American Inflations.
[13] Vrana, Debora, "Not Everyone is Doing Cartwheels Over Flipping," L.A. Times, July 18, 2004.
[14] Parsson, Jens O., Dying of Money: Lessons of the Great German and American Inflations, p. 31.
[15] Ibid., p.31.
