One Thing Leads to Another in the Bubble Cycle Wonderland
Eric Janszen

The Law of Unintended Consequences

 

"There has been widespread denial that there could be anything like a real estate 'bubble,' even given recent activity. Yet, anyone with a pulse can see wild speculation taking place all around them."
                         —William F. Hague, President, W.F. Hague Investments

Question: Why has the Fed allowed a housing bubble to develop? Answer: Because they didn't have any choice. The past several years of low interest rates have allowed households to extract cash from inflated property via cash-out refis, home equity loans, and sales; and to use lower interest rates to reduce monthly mortgage payments and increase disposable income. These sources of cash and savings compensated for lost wages from unemployment or underemployment. Without low interest rates engineered by the Fed, the U.S. would have sunk into a deep recession. The housing bubble is an unintended consequence. As Hague points out, "The ability to borrow $1 million for a speculative home purchase with a monthly payment of approximately $3,500 versus, say, a cost of almost triple that five years ago paints a clear picture of how this whole thing started in the first place. How many real estate investors today would or could afford $9,000 per month for the same $1 million? I think the answer to that question is easy."

Let's pretend it's April 2000. I tell you that after the stock market bubble pops, the Fed is going to drop interest rates below the rate of inflation and leave them there until housing prices increase more than they did in the previous 20 years. For example, 125% in California. I also claim that nationally, households will extract $183 billion of home equity in 2001, $261 billion in 2002 and $640 billion in 2004. In a single year of this low interest rate period, "consumers will refinance 10 million home mortgages, excluding home equity and construction loans, to the tune of a record $1.75 trillion representing one-third of the value of all home mortgages." (Source: Realty Times) "That's insane! That will never happen!" you'd say. But this is, insanely enough, precisely what happened.

But I did not predict the housing bubble. To do so you needed to forget what you know about the business cycle and enter the Alice in Wonderland world of the Bubble Cycle system, internalize its peculiar self-referencing logic and follow its inside-out view of the world to the most probable next stage in its evolution. Attempting that now, in April 2005, the logic of the Bubble Cycle leads me to conclude that the most likely next event is a major inflation as the latest bubble, centered as it is in bonds and real estate, comes to an end. As in previous bubble cycles, masses of liquidity will be pumped into the System.

However, at some point in the cycle, private foreign holders of dollar-denominated assets (who stopped buying them last year), and some foreign central banks that either stopped buying recently, such as Japan, or central banks with limited exposure to U.S. exports that are already selling, such as France, may by threat of selling or in the act of selling set in motion a self-reinforcing cycle that results in the kind of inflation that causes an increase in general price level. The inflation will provide much needed debt relief to both households and the U.S. government. "That's insane! That will never happen!" you say. And who can blame you. However, the future is no more likely to reward a sane-sounding prognostication today than it was five years ago. The prediction is only illogical when viewed from the world outside the Bubble Cycle wonderland. From within it, it represents a step in a logical progression.

What I'm proposing may not be so radical when viewed as the acceleration of a trend that's been in place for more than 30 years. Since the start of the 1970s Bubble Cycles period, the purchasing power of income in the US has declined dramatically from a trend that had been in place for hundreds of years. Americans have seen their nominal incomes rise while the purchasing power of income has declined.

Here's a symptom. For nearly two centuries the term "millionaire" applied to less than a tenth of one percent of the population in the U.S. It meant financial independence. More than 8.2 million U.S. households today have a net worth of more than $1 million. This suggests we're getting richer, yet $1 million in 1991 was needed to provide the same standard of living that $200,000 provided in 1970. Nominal incomes have increased while the buying power of that income, especially for non-traded goods and services [see We Ain't Got No Inflation], has declined so much that the label "millionaire" doesn't mean much anymore.



Do Americans complain that the purchasing power of their income is steadily declining? No. Real estate inflation makes you feel more wealthy today because your home has increased in value in dollar terms. Manufactured goods purchased from Walmart and Home Depot are far less expensive in real terms than many years ago, despite depreciation of the dollar, due to the mercantilist trade block's short-term currency policies that keep Asian currencies at par with the dollar. But aside from noticing insurance, medical, and housing costs that have increased markedly, to get yourself calibrated to the level of inflation that you are living in and how it is in fact making you poorer, take a one week vacation in Europe or Asia. The experience of paying $5 for a cup of coffee and hundreds of dollars for a cheap hotel room will teach you just how much purchasing power you are losing as the dollar depreciates. Your home may seem more valuable, but not so valuable when priced in euros. We are becoming poorer, but no one seems to notice.

This tendency of a nation's citizens to not notice the "inflation tax" is not lost on politicians and is why inflation has been and will always be the preferred method that governments use to deal with the aftermath of years of fiscal and monetary mismanagement. After the current asset bubbles end and monetary and fiscal stimuli kick in to counter deflationary forces—much greater today than in 2000—we'll get more inflation and lots of it.

Another question: When inflation got out of control in Weimar Germany or Argentina or during any of the 18 hyperinflations this century, why didn't the central banks of these nations simply stop printing so much money? Certainly that would have stopped the inflation. Answer: Because they worried that if they allowed the rate of increase of the money supply to decline, the government and its citizens would not be able to meet their obligations; they'd be forced to default and a deflationary cycle might set in.

One interpretation of history is that hyperinflation is the logical conclusion of a series of decisions to keep expanding credit in order to avoid deflation. By this definition, you can say that we've been in the early phases of a hyperinflationary decision process  for several years. The symptoms of the inflation, rising prices, are not yet apparent primarily because our Asian trading partners' central banks continue to support the dollar to keep exports flowing.

No, the U.S. is neither Weimar Germany nor Argentina, and the comparison has many flaws. Some experts in fact hold up Japan as a better model, where deflation has dogged the nation for years. But the U.S. is not Japan, either. Median household savings, net of property, was $140,000 in Japan at the start of their fifteen-year period of economic stagnation, which started in 1990. Japanese households have been in a good position to weather a long period of economic stagnation. More importantly, Japan was and remains a net creditor, with a $1.6 trillion net international investment position (NIIP). Japan is in control of how it repays its debt to itself.

This is not the case with the U.S. "NIIP is the value of foreign assets owned by U.S. residents minus the value of U.S. assets owned by nonresidents. Until 1989, the United States was a creditor to the rest of the world; the NIIP peaked at almost 13 percent of GDP in 1980. But chronic current account deficits ever since have given the United States the largest net liabilities in world history. Since foreign claims on the United States ($10.5 trillion) exceed U.S. claims abroad ($7.9 trillion), the NIIP is now negative: -$2.6 trillion at the start of 2004, or -24 percent of GDP." (Source: Foreign Affairs) This means that the U.S. must remain the most attractive foreign investment. If a crisis occurs in the U.S. that makes our country appear to be a higher investment risk than other nations, foreign investors will sell.

Right now, U.S. median household savings net of property stands at around $20,000. This does not give U.S. households much cushion to use to muddle through a transition to an economy that is less dependent on foreign debt. U.S. households find themselves in this situation because they have largely substituted their homes for traditional liquid savings options; the low interest rate environment has provided a long period of available cash from cash-out refinancing, equity loans, and profitable sales; and has created the illusion that real estate is always a liquid form of savings. This is another negative unintended consequence of low interest rates.

The cause of major inflations is always the same: a government, finding itself forced in a crisis to choose between inflation and deflation, chooses to live to fight another day. Major inflations don't start with printing too much money, they end there. They start with governments taking on more debt than can be repaid out of GDP growth and by taking on unfunded entitlement programs that cannot be paid for without raising taxes to politically unacceptable levels.

To the deflationists who worry that the heavily indebted U.S. may fall into a major debt deflation, I say: in your dreams.

Like it or not, if the status quo cannot be maintained, we're more than likely heading into a period of inflation. In my final installment in this series, I'll look at what that means for the average person.


Next: Inflation is Dead! Long live Inflation!

ericjanszen [Trident Capital]