My specific interest was aroused last summer. I was in the process of moving back to my hometown and had a contract on a beautiful lake house. In researching the house, I found out that the owner bought the house 4 years earlier and was asking 4 times what he paid. Everyone said it was a steal after I knocked him down to just over 3 times, but he couldn't go any lower because he had refinanced 3 months earlier up to the max. Initially, I felt a little sorry for him until I realized he had spent the money and would be forced to write a check at closing to escape alive. I know where the money went by just looking at the property with its 3 wave runners, boat, and new SUV on the outside, as well as a big screen TV and new stereo on the inside, but no furniture. Now that's a set of priorities! Then the bond market coughed, choked, and gagged on a mere few words from the Fed that appeared to withdraw support for low interest rates. It spooked me! I didn't have to move, so I pulled the plug. I think the poor guy found some other schmuck to buy his house a few months later. I'm sure it was a steal!
This is not an isolated incident
The basis for this Greenspan directed recovery has always appeared to ride on the back of the American consumer. The idea apparently being that if monetary policy remained accommodative for long enough, then consumers would carry the economy forward on a rising tide of consumption until growth could once again become self-sustaining. This is obvious as Greenspan says, "Once again, household spending was the mainstay, with real personal consumption spending increasing nearly 4 percent and real outlays on residential structures rising about 10 percent." Not only does he admit that this is a consumer based recovery, but he subtly acknowledges the rapid rise in residential housing in the same sentence. Greenspan is counting on that 10 percent per year growth rate in home prices and people have come to expect it. It's unrealistic to assume growth of this sort is sustainable, because it would result in a doubling of the average home price every 7.2 years. The fact that these two statements are married reveals with pinpoint accuracy exactly what the Fed was aiming for all along, consumption based on inflated home equity.
He continues, "And it appears that the impetus from fiscal policy will stay expansionary, on net, through this year." This is the deep breath before several more voluminous bellows of hot air are blown into the housing bubble. It also sends the message to the interest rate carry traders that the rate spread will remain intact allowing them to continue feeding at the "free money" trough throughout this whole year. This has the effect of calming the bond market while keeping trillions of derivatives locked into position for the now, somewhat defined, "foreseeable future".
Greenspan reiterates that, "household spending was the mainstay", and that "The very low level of interest rates also encouraged household spending...." In other words, had it not been for their policy of low interest rates, we would likely be in much worse shape. So, what does that mean for us if interest rates do rise through either a Fed hike or unplanned market action? And, what happens if the "mainstay" consumer is unable to continue at even the current level of consumption? He acknowledges, "The lowest home mortgage rates in decades were a major contributor to record sales of existing residences, engendering a large extraction of cash from home equity...." Greenspan thinks this is good? We want to encourage people to ante up their futures in a desperate attempt to fill this economic inside straight? This is hardly sound policy.
He talks very casually about how, "many households took out cash in the process of refinancing", which, "freed up funds for other expenditures..." This resulted in, "Home mortgage debt increased about 13 percent last year, while consumer credit expanded much more slowly..." So, rather than run up the credit cards people took their over-inflated appraisals to the banks, took their "free money", and restarted the clock on their home loans giving rise to, "the ratio of overall household debt to income continued to increase..." He almost seems to gain satisfaction from the fact that consumer credit expansion slowed while people were lured into taking his gift of "free money" through low interest rates.
This was his miracle!
Never mind the fact that many now owe more than they originally paid on their homes and they'll owe it for 30 years---again! What happens when interest rates rise? Will home prices continue to rise? That's not very likely. What about the homeowners with Adjustable Rate Mortgages? When interest rates rise, their disposable income will certainly fall. In my opinion, this whole situation is not sustainable. It is a travesty! The Fed has purposely inflated the housing bubble through artificially low interest rates while simultaneously encouraging our citizens to tap into their home equity. On the horizon, I see many foreclosures and banks in distress. The banks will be forced to dump houses back onto the market for pennies on the dollar in a desperate attempt to remain solvent. Maybe, this is what Sir John Templeton sees ahead when he tells investors to sell excess residential real estate.
Conversely, Greenspan tells us that, "expenditures on nonresidential structures continued to contract on balance, albeit less rapidly than in 2001 and 2002. High vacancy rates for office buildings and low rates of capacity utilization in manufacturing evidently limited the demand for new structures...." In other words, the commercial real estate market is deflating. There's an overabundance of office and factory space driving the price down. This hardly sounds like evidence of a recovery that can sustain itself without the "mainstay" consumer.
He proudly offers, "Corporate treasurers took advantage of the attractive market conditions by issuing long-term debt to lengthen the maturities of corporate liabilities. As a consequence, net short-term financing was extremely weak." It also makes sense for businesses to take advantage of low rates and refinance. If it works for the consumer, why wouldn't it work for the business world? Only one problem, as these corporations rolled their short term debt into longer term debt it caused the loss of the multiplier effect resulting in a decline in the velocity of money and subsequent move toward a contracting money supply. Further evidence of that is provided when he says that there was, "slack demand for short-term credit...", and it, "...declined more than $100 billion over the year...." This is not insignificant and is cause for concern as liquidity evaporates.
Greenspan cites, "The strong gains in productivity..." have allowed businesses, "... to meet increasing orders without stepping up hiring." I dispute this outright and make my case in a previous editorial where I feel we're taking credit for final assembly of components produced abroad. This is skewing the Industrial Production and Manufacturing Output numbers upward. Aside from that, they continue using fraudulent "hedonic" pie-in-the-sky additives to the GDP for things like faster computers. And, then there's their myopic productivity calculations that fail to account for anything other than GDP per hour worked while discounting the millions of unemployed.
Nevertheless, he goes on to say, "In all likelihood, employment will begin to grow more quickly before long..." That's not a very confident or definitive statement coming from the Fed Chairman that knows all recoveries include job gains, not loss. And, how long is "before long"? This isn't comforting for the unemployed who desperately want to work.
Finally, he says, "A consequence of the rapid gains in productivity and slack in our labor and product markets has been sustained downward pressure on inflation....." If inflation goes down too far it becomes deflation. How in the world can you rely on your "mainstay" consumers to continue the same or higher levels of consumption when their wages are under pressure? It's not possible, this recovery is not sound, and deflation is still a threat.
Regarding the dollar, he says, "Against a broad basket of currencies of our trading partners, the foreign exchange value of the U.S. dollar has declined about 13 percent from its peak in early 2002." This statement really bothers me, because it is so far off the mark that I don't know what to make of it. I'm baffled! Regardless, it's just patently false. Here's a chart of the US Dollar Index dating back to early 2002. The drop against that "basket of currencies" he alludes to is actually closer to 30%, not 13%, as shown below.
I'm not even going to draw any trend lines here, because the trend is obvious, down. Greenspan relates how this trend is being viewed by the international community, "Apparently, foreign exporters have been willing to absorb some of the price decline measured in their own currencies and the consequent squeeze on profit margins it entails." How can this last for long? Eventually, they'll be forced to raise prices to avoid revenue shortfalls resulting in ongoing and unsustainable net profit losses. He explains one of the ways that they're currently dealing with it as, "Part of exporters' losses, however, have apparently been offset by short forward positions against the dollar in foreign exchange markets." They are not alone. Warren Buffett and George Soros are right along with them betting that the Dollar will continue its decline. They know. The question is, will that decline remain orderly, or will it spiral? Never underestimate the extremes a market can travel when fear based panic sets in causing an eye watering overshoot of any rational, reasonable, or logical target level.
Greenspan puts a happy face on it by saying, "Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States." Is this what they're hoping for? Do they hope those foreign exporters are choked out of our markets by a weak dollar? Do they want them to just close their plants and quietly retreat? He warns against Smoot-Hawley type protectionism in this speech, but this currency depreciation is a tariff just the same, even though it's not targeted.
The falling Dollar is worse; it's a tariff on everything!
The first thing that'll happen is merchandise in Wal-Mart will get much more expensive, because we no longer make the things we need, we import them. And they still want us to consume. You can't have it both ways. Then other less subtle things will follow as foreign exporters are squeezed into failure likely causing excess global capacity, unemployment, and recession. Do they hope that this is when the factories we shipped abroad will return and re-open?
Probably the most discomforting thing from Chairman Greenspan came toward the end of his speech where he plotted his route to the tall grass and said, "When the future surprises, history tells us, it often surprises us all. We must, as a consequence, remain alert to risks that could threaten the sustainability of the expansion." While there is truth in what he says and I'm happy they remain "alert", I find no great comfort in this seemingly nonchalant shoulder shrug about "future surprises". He's covering his tracks while preparing us for the unknown surprises coming soon. In my opinion, it's just a matter of time.
In an effort to keep mystery in the air, Greenspan leaves himself an opening for a course reversal by saying, "But the evidence indicates clearly that such a policy stance will not be compatible indefinitely with price stability and sustainable growth; the real federal funds rate will eventually need to rise toward a more neutral level." They certainly can't go down as he just admitted that "real" interest rates are already negative; and, he told us we can expect these rates through the end of this year, unless he changes his mind, I suppose. Watch out if a course reversal comes without adequate warning, or happens on its own through natural market forces.
He appears unconcerned about the fact that, "The monetary aggregate M2 expanded only 5-1/4 percent during 2003, somewhat less than nominal GDP, and actually contracted during the fourth quarter." Let me tell you, contraction is not good when you consider its coming during the Fed's most accommodative monetary policy ever. One of the reasons for this contraction was the rolling of short term debt into longer term debt as stated above, but another contributor is brought to light when Greenspan says, "However, a significant portion of that growth was associated with the record turnover of existing homes and the high level of cash-out refinancing, which are not expected to continue at their recent pace." This is likely to cause a further contraction of the money supply from not only the loss of the cash-out refi multiplier effect, but from the lack of consumption as the "mainstay" consumer is already tapped out. He's telling us it's coming to an end and gives no evidence of who or what is going to fill this consumption void.
He proudly states, "All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit." It doesn't "seem" so, and he thinks they have it just about right. I think we're in for one of his "future surprises" when I look at these two charts below.
The household debt looks like there's no end in sight. It can't continue to rise forever; and the M3 has been rising without pause, until recently. Unfortunately, with the imbalances in place, now is the worse possible time for a money supply contraction as you can see by the hook at the top.
Regarding the stock market, Greenspan says, "Broad measures of equity prices rose 25 percent in 2003, and technology stocks increased twice as quickly. However, history shows that pricing financial assets appropriately in real time can be extremely difficult and that, even in a seemingly benign economic environment, risks remain." Is this the definition of "irrational exuberance"? Almost a solid year of uninterrupted rising markets with virtually no bearish sentiment in sight would tend to suggest more than just an average dose of "risk". This market action is not normal, or did I miss another one of those "new paradigms"?
Just to emphasize the "non-political" nature of the Fed, Greenspan carefully says, "very sizable deficits are in prospect in the years to come..." and, "to date no effective constituency has offered programs to balance the budget..." In other words, deficits are a problem and none of the politicians have the political will to put forward a plan to fix it. So, when bad things happen, remember, Greenspan warned them absolving him of any responsibility.
Furthermore, he says, "The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties. Our demographics--especially the retirement of the baby-boom generation beginning in just a few years--mean that the ratio of workers to retirees will fall substantially. Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level, without debilitating increases in tax rates. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be." Finally, I agree with him! He has this one right and hopefully somebody is listening. The "pressure" will mount until it becomes unbearable unless we address it now. For me, Social Security is dead!
Greenspan recognizes the seriousness of the threat from, "foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents." If foreigners don't buy our treasuries, we're sunk and he knows it. We can only buy our own debt with printed money for so long before everyone catches on to our secret little game. When our creditors have had enough, they'll all head for the exit at the same time. If this comes to pass, it will not foster a controlled decline in the Dollar, but will more than likely bring about collapse. The currency and bond traders already know and are registering their votes daily as evidenced by the US Dollar Index above. There's no telling what was said behind closed doors at the recent G7 meeting, but if their Central Banks or other large institutional investors abandon us, then look out below. Regardless, for Greenspan to think he'll be able to control the Dollar's descent to the lows that will reignite employment and balance the trade deficit is nothing more than his.............
I'm thinking lake houses will be cheap soon.
February 14, 2004
Copyright © 2004 David S. Chuhran. All Rights Reserved