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American Bubble

August 18, 1998

While Wall Street wonders whether these past few weeks signal the end of the stock market bubble, a more important question for Main Street is, "Is the economic bubble ready to burst, as well?" This bubble is the result of America's new found limitless ability to create credit, which in turn has induced businesses to expand too far and for consumers to spend far beyond their means.

This credit-induced bubble will burst, sooner rather than later. We've seen credit bubbles popping elsewhere, in Japan nine years ago and in Southeast Asia recently. These economies imploded because expanding credit turned quickly into contractions. It could happen here, leading to a self-feeding economic and financial collapse.

This, of course, sounds crazy to anyone looking only at low inflation, moderate interest rates and a Fed chairman who seems to have the economy totally under his control. But there is more to economic health than stable prices. Just because most recessions start with a rise in interest rates, it doesn't mean they always do. A tug-of-war between supply-driven deflation and credit-driven inflation has yielded the stable price level so prized today by the Fed and most investment strategists. By separating these countervailing forces, we can see the end of the credit bubble.

Let's take deflation first. Effective use of technology, corporate layoffs and manufacturing outsourcing have generally raised productivity and reduced costs. Meanwhile, a worldwide capital-spending boom has brought down the marginal cost of production. As a share of gross domestic product, American capital investment has risen to 17% in 1997 from 13% in 1990, representing a 30% increase. Specifically, half the real annual increase in investment has been in the high-tech sector.

One would expect all of this new capacity and efficiency to result in lower prices overall. In fact, we should be asking ourselves how consumer prices can be increasing at all. Yet consumer prices are creeping higher at a rate of 1%-2% year. This rise in the general price level wouldn't have been possible without substantial monetary stimulus in the form of rampant credit and the issuance of new equity. This liquidity boom has been the force tuggingfrantically against deflation, creating a dangerous asset inflation in stocks, real estate and luxury goods.

Our environment of easy, breezy credit can be demonstrated both anecdotally and with hard numbers. The U.S. money supply as measured by M3 has been growing at an annual rate of more than 10% for the past year. The balance sheet of Japan's central bank has recently grown at a 50% annual rate, providing a massive injection for bond and equity markets around the world. Fannie Mae and Freddie Mac have expanded their assets at compound rates of 17% and 31% over the last five years. U.S. bank loans for securities purchases have increased at a 50% rate over the past year. Meanwhile, total personal disposable income is at a record percentage of GDP, and has grown as a percentage of income to 95% from 68% over the past 15 years. For that we can thank the home-equity loan, the six-year car loan and junk mail with credit cards attached.

The boom in home-equity loans is especially worrisome. When individuals who were arguably overleveraged before are given the ability to borrow 125% of their home value, families can easily live beyond their means. Additionally, a tremendous amount of money has been borrowed by consumers in anticipation of stock-market gains, much of it in home-equity loans or loans against 401 (k) accounts. This is in addition to margin debt, which has recently swelled at a 50% annual rate.

[Media] Economic bulls argue that credit expansion as measured by the government has been modest, but bank credit is only one ball in the credit lottery. Just as our changing economy made the focus on M1 obsolete, how we judge the growth in leverage in the economy is due for an update as well. The formal banking system is responsible for a much lower percentage of total lending, thanks to a proliferation of new types of financial institutions. Now there are also derivatives and outperformance contracts, esoteric swap agreements and overseas borrowing. There are loans made by non-banks that are securitized and sold to institutions to the tune of billions of dollars. We can't forget auto leasing, an arrangement responsible for 30% of new car financing but a figure still not included in the Federal Reserve's accounting for consumer debt.

Loan quality and pricing are also important variables, and it is disturbing that credit spreads are at record low levels. The respected former chairman of Wachovia Bank said recently that credit standards were more lax than at any time in his 40-year career.

There is a precedent for this kind of behavior; we simply haven't witnessed it in a while. In the 1920s, the Fed was also fixated on the general price level while speculative and credit excesses fueled the economy and asset inflation. In America's Great Depression, Murray Rothbard argued logically that inflation from credit expansion obscured the deflationary forces in the economy that resulted from an increased supply of goods. The resulting low inflation of the 1920s persuaded the Fed to maintain an expansionary policy. This fueled the boom further and set the stage for the Depression.

Today's bubble will burst as did the bubble of the 1920s and we will face the potential for dangerous deflation accompanying a very painful recession. The trigger will undoubtedly be a broad and deep stock-market decline set off by any number of factors, most likely a sharp decline in corporate profits or a significant problem in a foreign economy ( but probably not higher interest rates ) .

After the credit-induced stimulus side of the equation is wiped out by a stock-market plunge, the economy will be left with the deflationary side growing stronger as demand falls dramatically in the recession. Once deflation starts, no matter how hard the Fed tries, there could still be a contraction in the money supply just as there was in the 1930s in the U.S. and currently in Japan.

The prevailing view today is that the 1930s Fed made a huge mistake by being restrictive and, having learned its lesson, will be extremely accommodative to avoid any future deflationary bout. Rothbard found that the Fed tried mightily to inject reserves, yet still there was a contraction in the money supply.

Again this time, bankers will realize that they can't continue to aggressively extend credit once delinquencies start going through the roof. Therefore, again it may be impossible to expand the money supply and prevent deflation.

Let's hope we can avoid mistakes in trade, tax and monetary policy in the recession's aftermath that could make a terrible recession even worse. The problem is that it will be easy to make mistakes in an effort for a "quick fix" to solve millions of citizens' significant pain. It's just a shame that our policy-makers let the party go on this long.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.
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