Credit Bubble Bulletin
by Doug Noland
The Reasons
April 11, 2003
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It is difficult to believe that our financial policymakers are instilling much confidence in the rest of the world these days. To blame others for our huge and incessant current account deficits may play well domestically, but it is simply not credible. Yet it is consistent with the current contemptible state of economic discourse.
This week Fed chairman Greenspan delivered a speech at the Ronald Reagan Library in Simi Valley, California. During the question and answer session he addressed two issues near and dear to our analytical hearts: the real estate boom and the issue of Japan and its post-Bubble quagmire. It is, of course, my view that we are in the midst of committing truly monumental errors in central banking. The chairman’s comments provide clear evidence of a flawed and dangerous analytical framework. The amazing thing is that his carefully crafted arguments come across as almost reasonable.
Question: Is the housing market overvalued, and if so, what effect would it have if it collapsed?
Chairman Greenspan: “First let me just say, that there’s one unusual thing about homes: that we all tend to want a house that’s different from our neighbor's. And that means what we tend to have is custom-built housing in the United States, which is exactly the opposite of what you’d want to do if productivity was your purpose. In other words, if it’s only one of a kind, you don’t learn and build productive capabilities. This means that output per hour – or productivity in residential construction – its growth is very low. It is very substantially lower than the average rate of productivity in our economy; which essentially means that unit costs of producing homes tends to go up progressively year after year, decade after decade, at a pace faster than the average price level. And so when we look at the price level for homes – which over the past few years has been going up a good deal – remember that, first of all, there is a long-term uptrend in the ratio of house prices to the existing price level. And so there’s a tendency to, I think on occasion, to over-judge whether or not a housing bubble is building – which other people have raised issues of.
I personally don’t think that there’s a housing bubble similar to that which exists in stocks. First, because the transaction costs of selling a home are far larger than they are in stocks. Besides, you have to move. You don’t have to do that (with stocks). And it’s fairly evident that, unlike the stock market, the housing market in the United States is really a whole series of metropolitan area markets. Portland, Oregon’s housing market does not compete with the housing market of Portland, Maine. Yet, stock prices do. So you have regional, localized markets. And it is perfectly possible, and indeed it happens on occasion, that you get a housing bubble in a localized region – I think we have had some in this particular state (California). But it is very hard to make the case that you get a bubble created for the country as a whole, and therefore a significant contraction in overall housing prices and, therefore, if it were to happen, a significant damper on economic activity.
I don’t deny that overall – after running up quite a good deal – that the rate of increase in housing prices could slow very dramatically and even decline modestly. But that’s not likely to be a major negative for us. It’s a removal of a positive force, because the rise in housing prices has been a very important factor in galvanizing house turnover and the extraction of equity out of homes, which has been a major factor in support of consumer markets. As I said in that speech a few weeks ago, I think it’s been so extraordinary that the presumption that it continues is just not all that credible. As a consequence, I can see some effects from housing impacting the economy, but I would be very doubtful about a major problem with the economy as a result of some retrenchment in the housing markets. Remember that we have got a very strong rate of household formation in this country, and indeed, immigration accounts from somewhere between a third and perhaps even as high as a half of the total increase in the number of households...
Housing has been an extraordinarily positive force in the American economy, especially during this period when we have been under stress from significant weakness in stock prices and the various shocks… I think it is going to be tough to keep that process going, but I would be most surprised if it came off more than just very modestly.”
Question: If a Japanese-style deflation were to occur in the United States, is there anything the Federal Reserve can do?
Chairman Greenspan: “As I have said publicly, the odds of that happening we perceive as to be quite small. But as I said to a colleague the other day, we spend a very small fraction of our time at the Federal Reserve and at the Federal Open Market Committee in actually being engaged in operational monetary policy. The rest of our time we ask ourselves every sort of question of what could go wrong and how would we respond to that event if it happened. And needless to say, the experience that the Japanese have exhibited to the rest of the world has not only gotten our attention but every central banker’s attention, largely because [all] of us presumed that a fiat currency - which of course is one not backed by gold or some other commodity or physical wealth - is prone to excess and inflation. And, indeed, the evidence subsequent to the 1930s into the 1950s was clear evidence of that fact. What we have learned is that indeed prudent policies can replicate the type of environments that are created under a gold standard or under a commodity standard, and therefore, you can have deflation as we had in the nineteenth century for example. And indeed, the Japanese demonstrated that it’s possible and there are other countries who are having similar characteristics.
So we have examined what type of policies we at the Federal Reserve would engage in were that low probability event to emerge. And we’ve been looking at a number of different operational procedures which I and my colleagues have been discussing on and off in public recently. And we will continue to evaluate all the various different types of procedures… In summary, it’s not one of the things that we are very much concerned about happening. But should it happen, I trust we will be fully prepared from the central bank’s point of view to address it the best way we know how.”
I don’t want to go off on a rant here, but is the Fed chairman really claiming that the Japanese quagmire is the consequence of “prudent policies” whereby a fiat currency system replicated “the type of environment that (is) created under a gold standard”? And that a gold standard and its “replicated” descendants were prone to deflation? Wow. At this point, this really is astonishing, reckless reasoning, but fully consistent with the propaganda streaming from the Federal Reserve. It is also a “clever” refinement of the Milton Friedman contention that monetary policy mistakes needlessly transformed the sound Twenties prosperity into deflation and depression.
Yet, the Japanese financial authorities would be the first to admit that they gravely erred by imprudently accommodating historic financial and economic excess. Things ran completely out of control, and only the most brazen revisionist would nowadays claim otherwise. The issue in Japan during the late eighties and the U.S. today is anything but a system replicating a gold standard. Rather, they are both historic examples of uncontrolled Credit systems that fueled self-reinforcing asset inflation, rampant destabilizing speculation, and the resulting highly maladjusted economies. Just as one would expect, when the Japanese Bubble burst, over- borrowed and chastened households and businesses retrenched. Collapsing asset prices then forced the impaired Credit system into full retreat.
The very essence of a gold standard is to harness money and Credit creation, thus tempering destabilizing excess and processes. A sober Credit system specifically does not incite the type of wild financial and speculative excesses that, over time, impart intensifying distortions to the scope and nature of demand and the structure of (mal and over) business investment/spending. In stark comparison, today’s fiat currency and uncontrolled Credit systems are the archenemy to the type of stable financial and economic environment that would emerge from a well-functioning gold standard. As was witnessed clearly in Japan, unharnessed Credit systems are prone to self-reinforcing excess, especially with regard to asset inflation. Credit excess begets assets inflation, which begets higher collateral values, heightened speculative impulses, a financial sphere increasingly engrossed by speculative profits in the assets markets, and only greater Credit inflation and speculative vehemence. A Credit Bubble begets asset Bubbles and an increasingly deranged Credit System. A restrained Credit system, conversely, does not occasion financial fragility nor economy vulnerability. Business cycles remain, but without major booms and busts.
Another critical attribute of a gold or commodity-backed monetary system is that it is not dependent on discretionary central bank policies. As such, Mr. Greenspan’s above-noted “analysis” of the U.S. housing market provides strong evidence as to why it is inadvisable - and in certain instances utterly dangerous - to rely on one individual’s judgment. As I have noted often, the trouble with discretionary central banking is that mistakes engender only greater error. We are watching this play out in an historic manner. Incredibly, the lesson Mr. Greenspan has taken from the miserable Japanese experience is to never let the Bubble burst. He could not be a poorer student. We are today in the midst of unprecedented excess and an historic Mortgage Finance Bubble; the chairman has chosen to avoid meaningful discourse and expound absolute gibberish. It’s never been so clear that he’s BSing us.
Indeed, Mr. Greenspan’s housing propaganda is increasingly sounding all too similar to the late nineties “stock prices always go up over the long-term.” And it is worth noting that this silly mantra became boilerplate doctrine during the destructive final stock market blow-off. And as much as Mr. Greenspan conveniently disregards the critical role of lending excess (and rampant Credit market speculation), we are clearly operating in an environment dominated by a desperately overheated national mortgage Credit system. Accordingly, we should expect inflationary manifestations countrywide. As we are observing, lending excesses are national in scope; speculation endemic to the U.S. Credit system. And the desire for “custom” homes could not be further removed from today’s critical issues.
Importantly, Bubble dynamics remain near full force. And the longer excesses run uncontrolled, the more certain that this ends in a devastating crash, as opposed to Greenspan’s hope and expectation that things come off only “just very modestly.” That’s the nature of highly speculative, Credit excess-induced markets, whether the Fed accepts this reality or not. The household sector is today thoroughly captivated by housing as the superior “risk free” investment, while inflating home equity is the recognized best-source for permanent wealth creation to be tapped at will. As enamored as the household sector was in trading technology stocks for fun and profit just a few years back, playing mortgage rates and the refi boom is today a much more commanding inflationary psychology. In the late nineties the Greenspan Fed nurtured manic behavior by spouting New Era propaganda, while massive Credit (junk bonds, syndicated bank loans, margin debt, derivative-related borrowings, household debt, etc.) and speculative excess fueled a runaway technology/equity Bubble. Amazingly, a more conspicuous, momentous, and precarious Bubble today throughout mortgage finance incites only more outrageous central bank propaganda and acquiescence.
As mentioned above, the Mortgage Banker’s Association this week increased its estimate for 2003 originations by 47% to a record $2.6 Trillion. Paralleling the technology and equity Bubbles – and doing precisely what Bubbles do - the Great Mortgage Finance Bubble has taken on a precarious life of its own. Powerful inflationary psychology has become ingrained, affecting millions of potential first- time homebuyers, legions of homeowners wishing to upgrade or acquire a vacation home, and speculators using ultra-cheap finance to buy properties with inflating market values. Just as sending money to technology funds seemed more than reasonable not too many years ago, today most feel it completely rational to stretch to purchase the most expensive home (“investment”) possible. At the same time, a powerful inflationary psychology has captivated the entire mortgage banking super- structure, with lenders, builders, appraisers, insurers, guarantors, investors, speculators and investment bankers predictably enamored by incredibly easy and enormous profits. Only our central bank had the power (and responsibility) to nip these inflationary expectations in the bud. They choose instead to continue to nurture them. The Fed is locked in hopelessly failed policies of ultra-easy money, fixated on sustaining unsustainable financial and economic Bubbles.
Many, apparently including Mr. Greenspan, believe that the Great Depression and devastating deflation could have been avoided simply by creating additional money supply. And I know from my own thinking about the early thirties, I have often pondered The Reasons why it would not have been possible for the Fed to simply create new money and successfully recapitalize the faltering banking system and reliquefy the economy. Well, if we focus carefully on our analysis we are today beginning to witness The Reasons. Sure, our contemporary financial system today retains the will and capacity to inflate money and Credit. And although it requires an enormous amount of new Credit to keep the U.S. Bubble economy wheels in motion, the Mortgage sector has thus far provided ample spending power for the household sector and liquidity for the financial sector. And each week brings evidence that this flood of liquidity is working its magic, in particular by “recapitalizing” impaired financial institutions, domestic and international. Money is again flowing into junk and emerging market bond funds. The appetite for risk has returned with a vengeance. Speculators, once again, have been emboldened.
But what about The Reasons inflation will not prove the magic elixir? Well, we are today witnessing how even alarming quantities of new Credit have only a muted impact on the aged Bubble economy (Credit growth vs. GDP growth). We are witnessing how this newly created finance is spread quite unevenly over the real economy (i.e. housing vs. manufacturing). We are witnessing irregular effects on “investment” (i.e. millions of new residences while our goods-producing capacity is gutted). We are witnessing how Credit inflation has disparate influences on prices (i.e. oil vs. semiconductors). We are witnessing how Credit inflation has a quite uneven influence on income (i.e. mortgage brokers/attorneys/real estate agents vs. manufacturers). We are witnessing how continued ultra-easy money has its greatest impact on inflating the size and destabilizing influence of the leveraged speculating community (“money” continues to flood into the hedge fund community). We are witnessing how continued rampant Credit inflation has a much greater impact on the animated financial sphere (inciting speculation) than it does on the despondent economic sphere (spurring sound investment). We are witnessing how this newly created finance gravitates specifically to inflating asset classes (real estate, mortgage-backs, agencies, and Treasuries), exacerbating distortions. We are witnessing how Credit inflation, after earlier manifestations (rising stock and bond prices) attracted financial flows, at this stage of the cycle instead exacerbates dollar weakness. We are witnessing how money and Credit excess is the problem and definitely not the solution.
We can today better appreciate how continued inflation at this stage of the cycle further destabilizes the financial and economic systems. Most importantly, we have a clear sense how the ballooning financial sector becomes, over time, increasingly wedded to inflating real estate and fixed-income prices – Monetary Processes from the Credit system to asset markets become only more indelible. A Credit system with dominant Monetary Processing financing sound investment is relatively constrained and stable; today’s deranged Credit system with Monetary Processes feeding and being sustained by asset inflation is hopelessly unrestrained and acutely unstable. Yes, the contemporary Monetary Regime is capable of inflating at will and recapitalizing troubled lenders and borrowers alike. But this in no way avoids the reality that The Regime is now held hostage to levitated real and financial asset prices.
Japan’s Bubble could have survived to this day had they only continued inflating already exorbitant real estate and stock prices to the moon. But inescapable financial and economic crisis would wait patiently and confidently. Faltering asset prices would have at some point stymie requisite Credit growth and the house of cards would have come tumbling down. We should also today better appreciate how recapitalizing the U.S. banks in the early thirties would in no way have resolved the critical issue of the deep domestic and global financial and economic imbalances that had developed over several decades.
Keeping this game going will require enormous and continuous Mortgage Credit growth. Inflated housing prices, especially the conspicuous housing Bubbles in California and the East coast, demand unrelenting lending excess. Nationally, free- flowing mortgage Credit will be necessary to sustain boom-time consumption. And, importantly, mortgage Credit has become the key liquidity source for the speculative financial markets. Yes, “reflation” is working, at least sufficiently to prolong The Great Credit Bubble. But there is no escape afforded through the massive inflation of non-productive Credit. There is no escaping the damage inflicted upon the real economy. Asset inflation is no panacea but only a seductive and addictive narcotic. And there is no possibility for miraculously circumventing acute financial fragility – a respite yes, but no more. The dollar remains the obvious weak link, but the highly over-leveraged and speculation-rife Credit market bears watching. May we live in interesting times…
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