Greenspan's Legacy? Worldwide Debt Folly
Special Contribution by Sarel OberholsterSimilar to democracy, monetary freedom via central banking is a concept that only works with responsible participants. Without appropriate responsibility, we get anarchy. Governments have hijacked monetary freedom under the banner of good intentions, by claiming absolute right to the creation of money. Yet, wielding this power always requires more power and more wielding. With misguided citizens and irresponsible central banks, intervention breeds debt in the name of "economic stimulus". This breeds more intervention and more debt. As I'll describe in this article, the long-term world wide economic impact is likely to be astronomic.
Edited by Martin Goldberg
A friend asked me whether excessively leveraged consumer mortgages are the reason for the red-hot real estate sector. It seems to be a straightforward answer to ascribe at least some blame to these geared mortgages, yet that would not be entirely true. I had to draw on my 27 odd years of experience in banking and my economic training to answer such a simple question truthfully. No. The real reason is the absence of market forces in the decisions regarding the amount of money in the world economy and the absence of market forces in establishing the price of money, interest rates, in the world economy. Both belong to government and central banks and, in this, Greenspan rules all. Here's how.
Debtors have a misguided high propensity to gear themselves to the maximum they are allowed by the providers of credit, alternatively as a low down second, to the maximum that they can afford. The first question that everyone asks is not what the interest rate is, but "how much can I get". Second is, what will the monthly repayments be. Creditors tend to calculate how much they think the debtor can afford to repay and a deal is struck. Simple. The price of credit is seldom a serious issue provided that it falls within the expected rate range. Almost like buying a burger, price is not relevant, provided that it is more or less the same as other burgers. That is the deception of price control over money, or interest rate policy.
How much can I borrow? As much as you can afford to repay. The repayment amount is then calculated as a function of the interest rate and the term. Will a debtor in this controlled monetary environment be turned away for a lack of money? No. He who controls the price also controls supply and in today's "accommodative environment" will provide whatever is called for. Here is the central banker's and the debtor's temptation all rolled in one. Drop the price of money low enough and debtors will foolishly demand almost unlimited amounts of debt. All that is left to do is to supply unlimited amounts of money. Is it the makings of an economic miracle or as I believe, an economic nightmare?
After trying to explain this to my friend, he looked at me with one of those "what the heck is he talking about" expressions. This example simplifies what's going on. A debtor with an absolute ability to make a $10,000 monthly payment on debt can afford to borrow a maximum $1,036,246 over 20 years at a 10% pa interest rate. At 5%, he can borrow $1,515,253. That increases to $ 2,705,485 if he can stretch his term to 30 years and interest rates drop to 2%. As you can see, I explained, he can now "take-out" an additional $1,669,238 in debt, if he wishes. And that, I conclude, is why we have among other economic abnormalities, a red-hot residential market.
A quick simplistic economic calculation whereby the payment is stated as equal to the debtor's monthly "savings" reveals that he has just obtained the capital equivalent of almost 14 years of savings to spend. Now if only we can guarantee a world of 1% interest rates forever and unlimited supply of debt at this price, then we have arrived in financial paradise. Not quite. A debtor can do this only once, all things being equal. His marginal consumption now reverts back to what it was before the monetary boost. Any increase in consumption must be accompanied by yet lower interest rates if one can go lower than 1% or an increase in income. That's it. Otherwise he has to repay and reduce his consumption. That's the debtor's folly. I will not even mention rising interest rates on variable rate debt.
After evaluation, it became apparent to me that this is the avenue by which a consumer-based economy enjoys short-term stimulation, courtesy of central banks, that is in effect, a "one-time event". The amount of "new debt" that can enter the economy in this manner is astounding. Yet after the party reaches its inevitable conclusion, the piper must be paid. We are seeing the first long chapter of this debt-based bubble now in the red-hot real estate market.
The economic nightmare is the one where the central bankers encourage the misguided debtors to commit the debtor's folly in an attempt to stimulate an economy out of a recession. That is Greenspan's gambit. Can it work in a sustainable manner? I don't think so! A temporary turbo boost in consumption from debt and price control, will have to be followed by a severe contraction in consumption approximating at the least the extent of the stimulation, even if interest rates were not to increase at all. Remember, until the debt is paid off, a debtor can do this once only. Once used, repayment must follow. Any increase in interest rates will make the contraction even greater. Following this process to a logical conclusion is truly the wellspring of all economic nightmares.
Such debt folly is documented by examining the macro-picture. First let's take a look at the behaviour of households as a group to see if in fact, the group does behave in the same manner as illustrated above. Household Financial Obligations as a percent of Disposable Personal Income (Source: Board of Governors of the Federal Reserve System) increased from 17.76% in the first quarter 2001 to 18.09% in the last quarter 2003. Interest rates started falling in May 2001. Thus not only did households maintain debt repayment levels, they in fact committed the gravest sin of increasing payments in a falling interest rate environment. Checking it against the Household Debt Service Payments as a Percent of Disposable Personal Income (Source: Board of Governors of the Federal Reserve System) shows another increasing trend from 12.47% in the first quarter 2001 to 12.98% in the last quarter 2003, confirming the Household Financial Obligations data.
Time to evaluate the ultimate long-term consequences. It follows, that a contraction in consumer spending at least equal to the stimulation effect will now manifest without any increase in interest rates. Exactly how much of it can be ascribed directly to the falling interest rate stimulation is difficult to pin point but hardly relevant as the simple answer is "the majority". The conservative answer is "a significant portion". You can decide how much poison. I think it matters little, as it will be too much poison even if you are only inclined to ascribe less than the majority to the stimulation. Looking at the official numbers is however most revealing.
Personal Consumption Expenditures (Source: US Department of Commerce: Bureau of Economic Analysis) grew by $1.037 trillion from April 2001 to January 2004. Household Sector: Liabilities: Household Credit Market Debt Outstanding (Source: Board of Governors of the Federal Reserve System, "CMDEBT") increased by $2.203 trillion from April 2001 to January 2004. More than double the Personal Consumption Expenditure! Between 33% and 67% of the growth in CMDEBT, judging from moving averages in growth in CMDEBT during the 90's can probably be ascribed to the stimulatory effect. A once off effect due to the falling interest rates to 1%, an effect that cannot be repeated as 1% is about as low as you can go. Using the data as is, points to the conclusion that the total increase in Personal Consumption Expenditure since April 2001 is due to a falling interest rate policy and an "achievement", which cannot be repeated. Here's the paradox, Personal Consumption Expenditures must now fall by say $1.1 trillion just to remain the same as before the artificially induced debt quantum. The effect is immediate for the individual debtor who followed Greenspan's advice and took out the maximum debt. That is almost 3 years worth of debt-induced "growth" in Personal Consumption Expenditures! Is there anything else that can take its place? Probably not. This is simple cause and effect.
I have not touched on any effect from rising energy prices, which are likely, or the potential for rising interest rates due in part to the US government's record-breaking debt load. We're only looking at what will not re-occur. How much poison is an inevitable $1.1 trillion contraction in consumer spending? At best, it's at least equal to what would be needed to force an economic contraction equal to the simulative effect provided by all that extra debt. At worst, it is enough poison to kill off a number of economies particularly those of the US and China, and probably more than enough to cause the world economy to be hospitalised in intensive care for years to come.
As you can see from our current debt-induced economic predicament, similar to democracy, monetary freedom via central banking is a concept that only works with responsible participants. Greenspan's legacy? A worldwide debt-induced folly!
Bcom (Cum Laude), CAIB (SA)
12 September 2004
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The Case for Rally's Near End
Martin GoldbergHaving done some reading of financial periodicals such as Barron's and watching business TV over the last 3 weeks or so, some common themes are apparent to me. Among them:
- Bush's success in the polls is helping the stock market, and the stock market is helping Bush's success in the polls.
- The stock market will be helped if the price of oil does not rise from its current levels.
- The market's resilience in the face of luke-warm economic data and numerous earnings warnings from many company tethered to business fundamentals is a good sign for the longer term stock market.
- Many market technicians have discussed the intermediate trend of lower-lows and lower-highs in spite of the current month-old rally. (This almost begs a contrarians view that the previous market's (lower) high will at least be pierced upside.)
And the trend, which I discussed before, is that the almost consistent bond-market-friendly data has continued, with only a slight pause for some positive employment data on the morning after the GOP convention. Today's economic data, benign consumer index price data, seemed to be loved in particular by the bond market. In the face of the rally, the friendly bond market seems to be the most significant fundamental factor supporting the stock market rally. We are left with a number of factors that say that this stock market will continue its winning streak.
Yet, a look at some of the technical evidence is telling me that this rally is probably on its last leg, if it even has a leg left to stand on. Time is a bit short, so I'll only touch on a couple of these factors this week. The first is the completion of a broadening pattern in the retail index.
The series of lower lows and higher highs in the form of a megaphone shape is indicative of a market that is overactive in public participation. And of course the retail sector one that is susceptible of excess public participation. "Monkey buy the products, monkey buy the stocks." As Sarel discussed above, the "growth" in retail spending is largely being fed by debt that must be paid back at the expense of future consumption. A drag on future retail sales.
The second factor I wish to mention is the leadership stocks in what appears to be the tail end of this rally. It is the most speculative stocks that are unencumbered by business fundamentals, commonly known as "story stocks". Typical of these stocks is the Internet group. Below is a 5-day chart of some common Internet favorites. Also included at the bottom of the chart is a blue chip technology stock, Dell Computer, where earnings matter, and the Dow Jones Industrial Average. Note that while most blue chips, including technology stocks, have been near or below the flat line, internet stocks have gained between 5 and 14% over the last 5 trading days. It is also notable that the lowest quality stock of the group, Findwhat.com, has posted the best gains, and the highest quality stock, Ebay, has posted the least gains.
That said, the internet stocks are putting out some ugly candlesticks over the last few days, indicating that even these speculative favorites may be tiring of this rally almost as much as me. Here is a 1-month candlestick chart of the Internet Holder's index (HHH).
Here you can see that even the leaders of the latest bull episode are showing signs of weakness. Does this market have a leg to stand on? The evidence suggests not.
Following the CPI data, the bond market rallied, and the stock market raced out of the gate, only to finish with unimpressive gains on well-below-average volume. There was at least 1 52-week high in the homebuilders (NVR), apparently a result of buyers' belief that the multi-year housing boom is entirely sustainable. The stock market is looking heavy except for those stocks that have nothing more than "nice things to say". The Gap announced that they are getting into the booming and uncompetitive market of 35 plus women's dresses. There, they will compete with Ann Taylor, Cato, Chicos FAS, Talbot, Bebe, Dress Barn, Deb Shop, Limited Stores, TJ Max, May Department Stores, Target, Federated, Wet Seal, Abercrombie, Sears, JC Penny, Nieman Marcus, Ross Stores, Coldwater Creek, Nordstrom, and Kohls to name a few. The Gap's diversification occurred less than 2 years from when they had to perform a successful turnaround of their existing business. Looks like a "buy" to me! Eastman Kodak is going to close a photographic paper plant is Australia and lay off 600 employees. Wall Street loved that news. Evidence that digital photos require only a nice computer monitor for viewing and enjoyment.
All indices were little changed but biased to the upside. Bonds rallied and there the evidence suggests that the trends indicated about a month ago are still very much intact. For now, it looks like a lower high will be made in November baring any change in the bond-market-friendly economic data.
Gold was up $2.80 closing at $404.70, and silver was up 0.16, closing at 6.29; the XAU was up 0.40 closing at 93.20, and the HUI was up $3.40, closing at 206.40. The dollar index was down 0.39 closing at 88.97.
Finally "What's the Bull Case"…
People who frequent this site are obviously familiar with the bearish cases for the stock market. Yet the bullish cases espoused on TV and financial publications all seem to focus on rationales that are separated from fundamental and intrinsic values in my view. At the same time, people tend to congregate with their "own", and this tends to result in "group think". This is an accusation I've seen fired by the bearish toward the bullish camp. But are those (such as me at times) who are doing the firing actually guilty of their own "group think"? If that is the case, I would like to invite e-mails from the bullish camp that rationally sets forth the basis that "stocks are cheap" on a fundamental and intrinsic value basis.
Have a great evening.
Martin F. Goldberg, MS, P.E.
As published in www.financialsense.com
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