FABER: Cracks in the financial system
Dr Marc Faber
Wed 10 Jan, 2007
***Rogue comment.....is Dr. Faber refering to the shenanigans of Goldman Suchs?? Read the following article through to the end....it seems like he's sure "on" to someone's playbook or gameplan here.*****
...Concerns about inflated asset prices...
A well-respected independent economist and strategist
with a bearish trait told me recently that he wished he
could be bearish, but that he couldn't find anything
that he thought would disturb the asset markets and the
global economy in the foreseeable future. Looking at the
"real" global economy and at what people produce in
terms of manufactured goods and services (ex-financial
services), I would have to agree.
Comparing the current global economic expansion, which
began in the US in November 2001, with previous economic
expansions, it seems to me that the "real economy" isn't
showing any signs of the overheating that, in the past,
led to aggressive central bank monetary tightening. So,
I am, like my strategist friend with the bearish trait,
also impressed by the prospects for the global economy.
However, I am increasingly concerned about the inflated
asset markets around the world, and about the almost
unanimous belief that nothing will ever come between the
"Goldilocks" economic conditions and the Fed, in
conjunction with the US Treasury standing ready to
support markets should they decline meaningfully and
disturb the current heavenly asset market conditions.
Let us examine the differences between the "real
economy" and the "asset inflation economy" more closely.
The real economy is typical of people's daily lives,
their income, and their spending. If there is a boom in
the real economy, wages and prices will tend to increase
and the increased demand will be met by corporations'
increased capital spending. The overheated economy
eventually brings about a slowdown or a recession,
because money becomes tight irrespective of the central
bank's monetary policies. The recession then cleans up
the system and allows the next expansion to get under
way. Put very simplistically, this is the typical
business cycle.
In the asset inflation economy, we are dealing with a
totally different phenomenon. The higher the asset
markets move, the more the increased asset prices can
create liquidity. Let us assume an investor owns a real
estate or stock portfolio worth 100 and that his
borrowings are 50. For whatever reason (usually easy
monetary conditions), the value of the portfolio now
doubles to 200. Obviously, this allows the investor, if
he wants to maintain his leverage at 50% of the asset
value, to double his borrowings to 100. With the
additional 50 in buying power, the investor can then
either spend the money for consumption (as the US
consumer has done in the last few years) or acquire more
assets.
If he acquires more assets, the investor will drive the
asset markets - ceteris paribus - even higher, which
will allow him to increase his borrowings further. Now,
I am aware of some economists who will dispute the fact
that rising asset markets create liquidity. They argue
that the seller of a portfolio or real estate or stocks
at an inflated price will have to be met by a buyer at
the inflated price. So, the increased liquidity of the
seller is offset by a diminished liquidity of the buyer.
However, the situation isn't quite that simple. Let us
assume we are dealing with the market for Van Gogh's
paintings, and let's assume that with the exception of
just three works, Van Gogh's paintings are all in the
hands of museums, foundations, or dedicated art lovers
who wouldn't consider selling them except under the most
unusual circumstances. Now enter the Russian oligarch
who wishes to acquire a Van Gogh at any price. He might
pay double the previous price paid for a Van Gogh, for
one of the three paintings still available on the
market. As a result of this one buyer, every Van Gogh
work will now need to be revalued, and, in theory, all
the owners of Van Gogh paintings could now increase
their borrowings against the value of those works.
Two works by Van Gogh now remain on the market, one of
which a hedge fund manager and an oil sheik from the
Middle East both wish to acquire. In a bidding war, they
push the price of that painting up another 100% above
the previously paid price. Again, all of Van Gogh's
works will need to be revalued and their owners can
increase their borrowings against them. In other words,
the buyers on the margin can move asset markets sharply
higher in the absence of ready sellers and thus
increase, through the additional borrowing power of the
works' present owners, the overall liquidity in the
system.
Under normal circumstances, the increased borrowings by
the present owners would drive up interest rates.
However, in a world of rapidly expanding money supply,
this may not be the case. Moreover, which owner of a Van
Gogh wouldn't mind paying 6% instead of 4.5% interest on
his loans if Van Gogh's paintings were appreciating by
30%, or even 100%, per annum? (This is one reason why
the Fed doesn't believe it can control spiralling asset
prices with monetary policies.) In the real world, we
are not dealing with just one Van Gogh market, but with
many asset markets, but the point is that the marginal
buyers set the price for assets. It should also be clear
that not every owner of a Van Gogh will use his
borrowing power and leverage his works of art or other
assets.
But if an asset bull market has been in existence for a
while, more and more investors will become convinced
that the up-trend in asset prices will never end and,
therefore, they will increasingly use leverage to
maximize their gains. But not only that: lenders will
also become convinced that asset prices will rise in
perpetuity at a higher rate than the lending rate, and
they will therefore relax their lending standards. This
certainly seems to have occurred in the sub-prime
lending industry.
There is one more point to consider. Liquidity isn't
evenly distributed. Let's say that on an island there
are two tribes. Ninety-nine percent of the population
are the "Bushes" and 1% are the "Smartos". The two
tribes arrived on the island at about the same time and
had little capital at the time. So, initially, both
tribes worked very hard in industry and in commerce to
acquire wealth. But because of the Smartos' superior
education and skills, their frugality, and also partly
because of their greed and immorality, they soon
acquired significantly more wealth than the Bushes, who,
for the most part, were likeable but quite inept. After
50 years, most of the island's businesses were therefore
in the hands of the Smartos, who make up just 1% of the
population. Being clever, the Smartos generously gave
some of their wealth to the tribal leaders of the
Bushes, who controlled the entire government apparatus,
the military establishment, and much of the land.
For a while this system functioned perfectly well. Among
the Bushes there were also some smart people, and they
were encouraged to accumulate wealth as well. However,
they had to pay an increasingly high price to acquire
assets, since most of the island's assets were owned by
the Smartos and by the elite of the Bushes who, because
of their wealth, never really had to sell any assets.
Cracks in the system began to appear because more and
more of the wealth began to be increasingly concentrated
in fewer and fewer hands. (According to the Financial
Times, the concentration of wealth is extremely high in
the United States, with 10% of the population currently
holding 70% of the country's wealth, compared to 61% in
France, 56% in the UK, 44% in Germany, and 39% in
Japan.)
However, the Smartos then stumbled upon another avenue
to wealth: globalization. The island was opened to
foreign trade and investments, which allowed the
business owners to shift their production to low-cost
foreign countries and, at the same time, to keep the
masses among the Bush tribe happy through the imports of
price-deflating consumer goods. In the same way that, in
the 18th and 19th centuries, the European settlers of
America had exchanged with the Indians worthless beads
and booze for land, now the Smartos and the elite of the
Bushes exchanged cheap imported goods, whose supply they
controlled and from which they earned handsome margins,
for assets. As a result, the majority of the population
of the Bushes experienced a relative wealth decline
compared to the wealth of the Smartos.
Again, this worked perfectly well for a while: the
populace was happy to buy deflating consumer goods (like
Mr Faber's wife who, whenever a favourite shoe store
holds a sale, immediately buys three pairs instead of
one), but it overlooked the fact that its wages and
salaries were decreasing in real terms because
manufacturing jobs and tradable services were
increasingly shifting overseas. For some time this
wasn't a problem, because the Smartos had bought the
island's central bank.
They made sure that sufficient money was made available
to the system to sustain the consumption binge, which
was largely driven by inflating asset prices. Plenty of
liquidity and rising asset prices created among the
Bushes the "illusion of wealth". Naturally, the island's
trade and current account deficit began to worsen as it
consumed significantly more than it produced, but
initially that wasn't a problem, for the Smartos had
encouraged the Bushes to engage - in the name of all
kinds of good, just, and well-meant causes, and without
any self-interest whatsoever – in overseas military
expeditions, which led foreign creditors to believe in
the island's economic and military might, and social
stability.
For a time, they were, therefore, perfectly happy to
finance the island's growing current account deficits.
At the same time, the increase in defence spending
shifted wealth from the masses to the elite of the
Bushes, who largely controlled the military hardware and
procurement industries.
As a result, wealth and income inequity widened further
as the masses became largely illiquid and had difficulty
in maintaining their elevated consumption, while the
Smartos and the elite of the Bushes accumulated an ever-
increasing share of the national wealth. But never at a
loss when it came to creating additional wealth, the
Smartos devised another scheme to enrich themselves even
further: lending to illiquid households (read sub-prime
lending). Not that the Smartos would have lent their own
money to these uncreditworthy individuals (they were far
too clever for that); for a fat fee, they arranged and
encouraged this novel type of financing. Credit card,
consumer, and housing debts were all securitized and
sold to pension funds and asset management companies
whose beneficiaries were the majority of Bushes, who
accounted, as indicated above, for 99% of the
population.
In addition, these securitized products were sold to
some credulous foreign investors. By doing so, the
Smartos achieved three objectives. They earned large
fees, and unloaded the risks indirectly on to the very
people who borrowed the money, and on to foreigners. But
most importantly, they provided the Bush tribe with a
powerful incentive to support their expansionary
monetary policies, which ensured continuous asset
inflation. After all, any breakdown in the value of
assets would have hurt the Bushes the most, since they
carried most of the risks by having purchased all the
securitized lower-quality financial instruments. But not
only that! The Smartos knew that as asset prices
increased, their prospective returns would diminish.
But this wasn't an immediate problem, as they promoted
increased leverage to boost returns to the investors and
at the same time their own fees. This strategy worked,
of course, for as long as asset prices appreciated more
than the interest that needed to be paid on the loans.
On first sight, the debt- and, consequently, asset
inflation-driven society of the island seems to work ad
infinitum. But in the real world this isn't the case.
Sooner or later, the system becomes totally unbalanced
and entirely dependent on further asset inflation to
sustain the imbalances. It is at that point that even a
minor event can act as a catalyst to bring down asset
prices and produce either "total", or at least
"relative", illiquidity in the system, because a large
number of assets whose value has declined no longer
cover the loans against which they were acquired. "Total
illiquidity" occurs when the central bank, faced with
declining asset prices, doesn't take extraordinary
measures to support asset prices.
"Relative illiquidity" follows when the central bank
implements, in concert with the Treasury, extraordinary
monetary and fiscal policies (cutting short-term
interest rates to zero, and the aggressive purchase of
bonds and stocks) in a desperate effort to support asset
prices. In both cases, a degree of illiquidity occurs
and depresses asset prices, but in different ways. In
the case of "total illiquidity" (1929-1932 and Japan in
the 1990s), asset prices tumble across the board in
nominal and real terms with the exception of the
highest-quality bonds and, possibly, precious metals
(flight to safety). In the case of the island's central
bank taking extraordinary monetary measures, asset
prices don't necessarily decline in nominal terms, and
in fact can even continue to appreciate.
However, they collapse in real terms, and against
foreign currencies and precious metals. How so? Above,
we have seen that the island's asset inflation led to
excessive consumption and to growing trade and current
account deficits because the Smartos and the elite of
the Bushes were quick to understand that much larger
capital gains could be obtained by playing the asset
inflation game and by manufacturing overseas, than by
investing in new production facilities and producing
goods on the island.
The growing trade and current account deficits of the
island were not immediately a problem, because they were
offset by external surpluses in other parts of the
world, which were frequently and erroneously labelled as
"surplus savings" or a "savings glut". But whatever one
wishes to call these surpluses or reserves, it is
interesting to note that where they accumulated (mostly
in China, Japan, Taiwan, Singapore, and Switzerland),
they led to an interest rate structure that was lower
than on the island.
For the Smartos, this was an extremely fortuitous
condition. For one, it was easy to convince the
recipients and holders of these rapidly accumulating
reserves to invest them in higher yielding assets on the
island. In addition, it was for a while extremely
profitable to borrow in low-yielding foreign currencies
and to invest in relatively high-yielding assets on the
island.
Obviously, this all changed when asset prices began to
decline and the island's central bank had to take
extraordinary measures by aggressively cutting short-
term interest rates and supporting asset markets through
bond and stock purchases. The interest rate cuts
immediately narrowed the spread between the interest
rate on the island and foreign currencies and led to a
run on the island's currency, not only by foreigners but
also by the Smartos, who had known all along that the
asset inflation game would one day come to a bitter end.
The deleveraging of this carry trade led to "relative
illiquidity", which the island's central bank had to
offset with even more liquidity injections, which while
stabilizing asset prices led to even greater loss of
confidence in the soundness of the island's currency,
and in its bond market, which by then was mostly owned
by foreign creditors.
As Mao Tse Tung had observed much earlier, there was by
then "great disorder", but the situation was "excellent"
for the Smartos. On the short end, interest rates had
been cut so much that they were in no position to
compensate for the continuous depreciation of the
island's currency. So, the Smartos and the Bush tribe's
elite began increasingly to borrow in the island's
currency and to invest in foreign assets and precious
metals.
In fact, the island's central bank, by its market-
supporting interventions, encouraged this process.
Stocks and bonds were dumped on to the central bank and
the Treasury's plunge protection team at still high
prices, and the proceeds were immediately transferred to
foreign assets and precious metals, which appreciated at
an increasing speed compared to the island's assets,
which suffered from the continuous depreciation of the
currency.
And in order to facilitate this trade, the Smartos, who
controlled both the Fed and the Treasury, continued to
make positive comments about "a strong currency being in
the best interest of the island". Sure, it would
have been in the best interest of the island to have a
strong currency, but it was certainly not in the best
interest of the Smartos, who had devised their last
grand plan: shift assets overseas and into precious
metals, let the currency of the island collapse, and
then repatriate the funds and buy up the remaining
assets of the Bush tribe's middle and lower classes at
bargain prices since they had never understood that
their currency had collapsed against foreign currencies
and against gold.
dailyreckoning.co.uk
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