This blog entry is an updated version of something I wrote way back in 2004. I wrote 90% of this 4 years ago when housing prices were much lower. The fact that I can re-publish this today, largely unchanged, demonstrates how the housing bubble has morphed into a giant of grotesque proportions.
The global economy outperformed our wildest expectations on all counts during the late 1990s. We did experience a shallow recession in 2001. But, since 2003, we have been in full recovery. The Fed’s attempt to reflate the economy after the Tech Bubble by reducing the Fed Funds rate to 1% was successful beyond our wildest dreams. However, this aggressive policy never allowed the inherent disequilibria in the 1990s macro economy to dissipate. As a result, we have what appears to be an ‘echo’ bubble in housing which has just popped. As asset price inflation has been the major factor holding up the economy, this does not portend well for sustained robust economic growth in 2008.
The asset bubble of the late 1990s was one of the largest in history. Rather than allow this bubble to fully unwind, the Greenspan Fed created more asset bubbles, especially in housing, leveraged finance, private equity and asset-backed securities. It is possible that the U.S. will escape with a garden-variety downturn, but, in the face of one of the largest asset bubbles of all time, this is unlikely. In the end, a margin squeeze from high energy prices or a dollar shock could be crucial factors tipping us into a downturn. However, ultimately these factors will be merely the catalysts; the true cause of the expected malaise in 2008 lies in the imbalances in an asset-driven economy.
This downside scenario was not predestined. Unfortunately, crucial policy errors by the U.S. Federal Reserve all along the way have had led us to a ‘point of no return.’ The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.
This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.
For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession. In this piece, I will attempt to define what led us to this point. Hopefully, at a later date, I can define what the likely outcome of these events for asset classes and sectors of the global economy is – i.e. which should benefit and those, which should lose from the situation.
Austrian Economics Foundation
My economic viewpoint is founded on the Austrian economics. This framework rightly associates the business cycle with the credit cycle. Moreover, the Austrians understood that monetary authorities have limited resources to correct the excesses of an investment-led boom/bust and, that attempts to mitigate the credit cycle invariably reflate and exacerbate the bubble.
A Credit Bubble Made in the USA
Utilizing the Austrian Model, my thesis is as follows:
The monetary stewardship of Alan Greenspan’s Fed and the credit bubble it created has manifested itself in several ways that parallel previous episodes of credit-engendered over-investment:
1. Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
2. In a credit boom, less credit is available for productive assets because credit and resources are diverted to marginal debtors and high-growth/high-risk activities. Low interest rates and expansionary credit environment gives the illusion of profitability to unproductive investments and high-risk activities in the economy, that would appear foolish in an appropriate monetary environment.
3. Companies, flush with cash, invest heavily to prepare for expected future growth. An investment and capital-spending boom ensues.
4. Higher asset prices lower the cost of capital, fuelling a further boom in investment and capital spending, creating overcapacity in goods and services industries.
5. The increase in asset prices produces the so-called ‘wealth effect’ for consumers: a decrease in savings and an increase in consumption.
6. As the whole episode rests on an excess creation of credit, debt levels increase greatly.
7. The inflationary monetary policy is extremely distortionary as it redistributes capital to economic actors whose costs rise after their income from those whose costs rise before their income. Those who live from a fixed and interest income like pensioners find their costs rising with higher inflation while their income decreases in real terms.
8. Runaway asset price/consumer price inflation ultimately demands higher interest rates and a contractionary monetary policy, whereupon the whole house of cards collapses.
9. When the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
10. Eventually, the inflationary monetary policy debases the fiat currency, leading to a relative appreciation of the prices of ‘hard’ assets (like gold and silver and commodities like oil and natural gas) relative to the home currency.
11. The result is a wealth effect in reverse, leading to a collapse in consumption, a secular bear market and recession.
12. An expansionary monetary policy in a post-bubble environment can cushion a hard landing but does only lengthen the period before full economic recovery.
In the past 15 years, we have seen similar episodes in Mexico, Southeast Asia, Russia, Brazil, and Argentina. But this was before the Fed moved center stage. By 1998, the U.S. global growth engine was sputtering. And Greenspan’s Fed open the spigots. Nothing has been the same since.
Roots of Boom in Beginning of Secular Bull Market
The present economic situation has its roots in the recession of 1980-82. At that time, after years of inaction in the 1970s, the U.S. Fed under Paul Volcker finally stamped out monetary inflation by raising interest rates. Credit excesses built up in the inflationary “Guns and Butter” Go-Go years of the 1960s were eliminated. Simultaneously, the U.S. moved toward the free market. Massive economic dislocations, unemployment, and bankruptcies ensued. This set the stage for healthy expansion and a great bull market. This was a very tough period in the US. But the underpinnings were in sound monetary policy, setting the preconditions for the consumer price disinflation, which has underpinned the bull market we have enjoyed since. By 1987, excess money had again led to asset price inflation worldwide. The bubble came to a timely demise with the Crash of 1987. Monetary easing worked wonders and we recovered from a near-miss calamity.
A US-Centric Global Economy
Unfortunately, the only lesson Alan Greenspan learned from this calamity is that monetary easing can result in a soft landing in an overheated economy. For Greenspan, the Fed cannot stop bubbles; it can only ease the pain in the aftermath. Witness Greenspan’s comments in the Wall Street Journal from December 11, 2007.
As a result, the Fed has acted like a one-trick pony ever since. Greenspan pulled us from the jaws of recession in 1995 and again in 1998 by lowering interest rates and increasing the money supply. From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.
Until the 1997-1999 period, the U.S. bubble was ‘manageable’ (of a similar magnitude to the 1987 bubble), despite unprecedented gains in the U.S. stock market. However, with the post-Asian Contagion monetary injection in 1997 followed by the bailout of Long-Term Capital Management in 1998 and the Y2K monetary injection in 1999, the crisis came home in the form of the ‘Nasdaq-Tech-Telecom misallocation of capital bubble.’ Because global growth was built on the quicksand of excessive credit creation and concomitant increases in debt, once the bubble infected the U.S. economy – the global growth engine — this massive house of cards was destined to collapse under the weight of excess capacity and mountains of debt.
The True Lessons of Japan
To my mind, this is a re-run of 1980s Japan, where the Japanese have resisted the credit-unwind process. After the crash in 1987, all central banks around the world adjusted to a tighter monetary policy after it was clear the ’87 Crash was not going to cause a depression. Tightening (and the unwinding of the S&L crisis) did eventually result in the 90-91 recession but we pulled out successfully.
Japan did not tighten because the United States requested they keep interest rates low to get the Dollar-Yen exchange rate down (very similar monetary policy to Greenspan’s loose policy post-LTCM and Russian devaluation in 1998). This was a grave error because the result was an even larger bubble, which popped in 1990. The Japanese real estate sector kept going strong until 1992, before it collapsed.
Even after massive stimulus campaigns by the Japanese since then, the Nikkei is easily down more than two-thirds from its all time highs over 15 years later! Japanese residential property prices are half of their peak levels. All the while, the Japanese have pumped money into the economy like mad, running massive budget deficits.
An inflationary monetary policy and Keynesian government spending stimuli are not a panacea to a post-bubble depression. This is a lesson the Fed has failed to take on board.
Revulsion
So, where are we now? We are clearly in the midst of a massive unwinding of nearly 20 years of credit excesses. The debasing of the U.S. Dollar is in full effect and gold and the Euro have risen. The Canadian Dollar, the Swiss Franc and the Australian Dollar have all risen against the Greenback. Even the Pound is rising against the dollar. Fed policy has also created a massive savings shortfall in a consumerized U.S. domestic economy by encouraging consumption and speculation in asset markets at unreasonably high prices. All of this has imprudently been financed by the rest of the world as evidenced by the U.S. gigantic current account deficit (the Japanese and Chinese have been the most conspicuous consumer of U.S. Treasury debt as they are fighting deflationary demons by trying to keep their currencies down). These imbalances will be corrected. However, allowing the flames of bubbleconomics to be stoked further increases the chance that this inflationary experiment will end poorly. In the end, the American consumer will be left holding the bag, saddled with massive debt, higher taxes and/or fiscal deficits, and lower net wealth from housing and stocks.
This is why we need change in America. This is a problem the U.S. has not faced in three generations. We need solutions and we need them now.