Signs of the Economic Apocalypse 6-20-05

From Signs of the Times 6-20-05:

The euro gained some ground back from the dollar last week, closing at 1.2282 dollars, up 1.5% from the previous Friday's close of 1.2106. That put the dollar at 0.8142 euros compared to 0.8261 the week before. Gold closed at $439.50 an ounce on Friday, up 3.1% from last Friday's close of $426.40. Gold converted to euros would close at 357.84 an ounce, up 1.6% from the previous Friday's close of 352.22. Oil closed at 58.47 dollars a barrel, up 9.8% from the previous week's close of $53.23. Oil in euros would be 47.61 a barrel up 8.3% from last week's 43.97. Comparing oil to gold, at Friday's close an ounce of gold would buy 7.52 barrels of oil, compared to 8.01 a week earlier, a rise of 6.5 percent for oil compared to gold. In contrast to commodities, the U.S. stock market was quiet, with the Dow closing at 10,623.07, up 1.1% from 10,512.63 a week earlier. The NASDAQ closed at 2,090.11 up 1.3% from 2,063.00 the previous Friday. As for long-term U.S. interest rates, the yield on the ten-year U.S. Treasury bond closed at 4.08 up four basis points (hundredths of a percent) from the previous week's 4.04.

With the price of oil hitting a new record on Friday before falling back a bit and with gold increasing sharply as well, as well as a record-high current accounts deficit (in a nutshell the difference between the money coming in the U.S. and the money going out) for the United States in the first quarter of 2005, it is not hard to see trouble ahead in the very near future.

We have written about both the "conundrum" described by Alan Greenspan of falling long-term interest rates and rising short-term rates and the potential problems with the rapid rise of hedge funds. Nick Beams ties the two together nicely:

Greenspan first raised the issue in his testimony to the US Senate Banking Committee on February 16, noting that long-term interest rates were lower than when the central bank began its series of tightenings. Noting similar declines in the rest of the world, he pointed out that the greater integration of the world's financial markets had increased the "pool of savings", while there was a lower inflation risk premium. However, these developments were not new and could not be the reason for the long-term interest rate decline over the previous nine months.

"For the moment," he continued, "the broadly unanticipated behaviour of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

Nearly four months on, the Fed chief seems no closer to an explanation. In an address to a bankers' conference in Beijing on June 6, he pointed out that the "pronounced decline" in the return on long-term US Treasury bonds - down by 80 basis points, while the federal funds rate increased by 200 basis points over the same period - was "clearly without recent precedent".

Greenspan put forward several possible explanations for this unusual behaviour. Among them were: the possibility that the market was signaling future economic weakness; that pension funds are making significant bond market purchases and pushing down interest rates; that the accumulation of US Treasury debt by foreign central banks is lowering long-term rates; and that the greater integration of financial markets has increased the supply of savings, thereby lowering the interest rates. However, none of these explanations seemed to provide a satisfactory answer.

Whatever the cause of this unexpected development, Greenspan made clear it was one of the factors behind increased risk in financial markets as investors reached for higher returns.

"The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average, risk-adjusted rates of return, which, of course, can be achieved only by a minority of investors. To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged - in many cases erroneously - to offer excess rates of return."

In other words, the falling rate of return on long-term risk-free Treasury debt has lowered rates of return all along the line. Consequently, to obtain the same rate of return as in the past - or to increase it - financial investors must undertake riskier investments, often through hedge funds which trade in increasingly complex financial instruments.

This process, Greenspan warned, could mean that "after its recent very rapid advance, the hedge fund industry would temporarily shrink, and many wealthy fund managers and investors could become less wealthy." Such an outcome would not pose many problems for the financial system as a whole were it not for the fact that hedge funds often enjoy large support from banks and other financial institutions.

Here Greenspan struck an optimistic note, suggesting that "so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability." That is, so long as things are going well, they should continue to go well.

But this upbeat assessment does not sit well with Greenspan's admission towards the conclusion of his remarks, that "the economic and financial world is changing in ways that we still not fully comprehend."

Cheap credit

Significantly, Greenspan did not point to one development that some observers regard as playing a central role in the present peculiar situation - the rapid increase in financial liquidity over the past five years fueled by the accommodative monetary policies pursued in the US, Europe and Japan.

The reason for this omission is not hard to find - the policy of increased liquidity has come to occupy a central place in the policy platform of Greenspan in the face of growing problems in the US economy. In fact, his first major decision as Federal Reserve Board chairman was to open the lines of credit from the central bank in order to prevent a global financial and economic crisis following the stock market crash of October 1987.

When the stock market began to rise rapidly in 1995-96, Greenspan acknowledged, in the confines of meetings of the Federal Reserve, that a "bubble" was starting to develop. But even after issuing his famous warning of "irrational exuberance", nothing was done. In fact, Greenspan became one of the chief boosters for the so-called "new economy" of the late 1990s, where increased productivity, globalisation, information technology were said to have produced an ever-rising market.

Following the bursting of the bubble in March 2000, Greenspan initiated a series of cuts in the federal funds rate, eventually bringing it to an historic low of 1 percent in 2003-2004. The sharp reduction in official interest rates has led to the growth of so-called "carry trades" - the process in which investors borrow funds at the low short-term rates in order to lend at higher rates. But the longer it continues, the greater the dangers this process poses for the stability of the financial system. This is because so long as the flow of funds continues, rates of return on less risky ventures start to come down and consequently increasingly riskier financial operations have to be undertaken to achieve the same return as previously.

It would be wrong to conclude, however, that the mounting problems of the global financial system can simply be attributed to the "wrong policies" of Greenspan and the other central bankers. Rather, the fact that the world's central bankers have fueled an increase in the money supply is indicative of deeper problems. Above all, it is a sign of falling profit rates and the ever-present recessionary tendencies within the global economy.

In parallel to the increasing instability and ominous nature of political news lately, the economic situation seems increasingly precarious. Keeping everything afloat by allowing massive debt can only work so long. Strains are beginning to show. It appears that housing foreclosures are up 57% from a year ago in the United States. Given the popularity of interest-only loans lately, we can expect to see a lot more foreclosures and bankruptcies in the near future. And, now that the housing bubble has spread from the United States to much of the rest of the world, the bubble is now being called the largest in history by the Economist:

The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.

NEVER before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000. What if the housing boom now turns to bust?

According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries' combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1990s (an increase over five years of 80% of GDP) or America's stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.

…And after the gold rush?

The housing market has played such a big role in propping up America's economy that a sharp slowdown in house prices is likely to have severe consequences. Over the past four years, consumer spending and residential construction have together accounted for 90% of the total growth in GDP. And over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors, such as construction, real estate and mortgage broking.

One of the best international studies of how house-price busts can hurt economies has been done by the International Monetary Fund. Analysing house prices in 14 countries during 1970-2001, it identified 20 examples of "busts", when real prices fell by almost 30% on average (the fall in nominal prices was smaller). All but one of those housing busts led to a recession, with GDP after three years falling to an average of 8% below its previous growth trend. America was the only country to avoid a boom and bust during that period. This time it looks likely to join the club.

Japan provides a nasty warning of what can happen when boom turns to bust. Japanese property prices have dropped for 14 years in a row, by 40% from their peak in 1991. Yet the rise in prices in Japan during the decade before 1991 was less than the increase over the past ten years in most of the countries that have experienced housing booms (see chart above). And it is surely no coincidence that Japan and Germany, the two countries where house prices have fallen for most of the past decade, have had the weakest growth in consumer spending of all developed economies over that period. Americans who believe that house prices can only go up and pose no risk to their economy would be well advised to look overseas

The rise in foreclosures, a sure sign of the impending end of the housing bubble, in the face of massive infusion of debt-driven consumption money into the economy shows that the fundamentals of the economy are much worse then mainstream commentators are letting on. If the economy was not so weak, they wouldn't need to pump so much money into it. Max Fraad Wolf isn't fooled:

Which Macro Economy?

"Despite the uneven character of the expansion over the past year, the U.S. economy has done well, on net, by most measures" - Federal Reserve Chairman Alan Greenspan June 09, 2005

The above assessment suffers from one problem, it is not really true. The remarks are important as a stark reminder of a powerful sea change in thinking and talking about the economy. For many on Wall Street and at the Fed, the macro economy has been reduced to Fortune 500 profitability and asset market performance. These are certainly important metrics. However, the economy they are not!

The IMF has lowered its forecast for global growth and called attention to risks from US imbalances. The National Association of Business Economists (NABE) just reduced its US GDP growth forecast by 0.2% to 3.4%. More sanguine forecasts are increasingly driven by a differently defined macro economy. We are no longer all on the same page regarding the object of analysis. The relentless search for the positive while ignoring asset bubbles and income redistribution from public view has required shifting focus. It has also required equating the health of the macro economy with equity and bond market performance, corporate profits and the housing market. Maybe this is what they really meant by "the new economy"

Broadly the US economy is composed of the actions and decisions of consumers, firms, governments and international trade and financial flows. Enterprises, particularly the largest 500-1000, have been performing well. There are some glaring exceptions like autos, auto-parts and airlines. Heavy financial-ization in a wide range of firms- taking advantage of cheap money and debt hungry consumers- has reached a fever pitch as a profit driver. Thus, profits remain strong notwithstanding serious risk of profit deceleration from a flattening yield curve, over exposure to highly leveraged consumers and strengthening dollars. One might pause to note that leading American firms have worked ceaselessly over the last 30 years to diversify away from excessive reliance on what used to be called the US economy. BEA estimates suggest that more than a quarter of American corporate profits were earned outside the US in 2004. There is consensus that this number will continue robust growth in the years ahead. This might suggest the dangers of conflating profits with domestic economic health.

The news on the other three fronts, representing over three-quarters of the American economy, is terrible! Our general public, larger by over 10 million since 2001, is just recovering the jobs lost across a short and steep recession followed by a protracted and painful "recovery." In May 2005 we finally recovered March 2001 employment numbers. The stunning growth in employment that has so many crowing is net 0.03% private sector employment growth over 50 months. Since WWII, it has taken an average of 23 months to regain pre-recession employment levels. This time it took 50 months to generate growth not statistically different form 0%. Real median wage and salary growth has under-performed badly. Miraculously consumer spending has risen by several percentage points as a GDP component while wages and salaries have fallen as a national income component. Consumer debt, particularly in the housing area, has grown at super-exponential rates. 2004 marked the all time high water mark for corporate profits as a percentage of national income and a 40 year low for wage compensation as a national income share. Before the new economy, when macro economics referred to more than assets, bubbles and profits, this was called redistribution and viewed with some nervousness. Fortunately our leading lights are busy taking the dismal - and perhaps the science - out of the dismal science.

The Federal Budget, despite recently ballyhooed excitement about mere $350 billion projected shortfalls, is dismally in the red. Long term commitments, prescription drug coverage, $354 billion in under-funded insured pensions and changing population demographics beg for skepticism regarding these projections. In addition, the supplemental spending games and likely high future costs of foreign and domestic security operations mock rosy forecasts. Rapid growth in non-discretionary spending and proposed tax cut extension, render ebullience absurd. So goes another pillar of that strong macro economy. Perhaps, the Fed and many on The Street prefer to focus on Fortune 500 profits and asset markets because they are macro economic high points. However, calling them the macro economy requires jettisoning the presumptions that economic models are based on. Dropping more than half of the measures formerly known as 'the economy' seems to do wonders for bullishness- in many senses of the word.

The Anglo-American branch of the Powers That Be have been as desperate in their patching of the weak economy as they have been in the patching of the failing wars in southwest Asia. That is because the one (the war) was supposed to prop up the other (the economy) and vice-versa. See this, for example, from Stirling Newberry in Newtopia and Truthout:

[In the nineteenth century]the British would fight wars to secure resources, cheap labor, and to open markets. But it meant they had to find gold for currency, and coal for their industry, and later, their navy. The navy built with gold, and run on coal, was used to find more gold and coal. India and Ireland were used to grow food and cotton, allowing more people in Britain to be employed supporting "The Empire" without creating inflation. On the contrary, Victorian England was under deflationary pressure.

This "first era of globalization" expanded trade, but it also created misery in Britain, as wages raced down to parity with colonial wages, and it caused famines in Ireland and India, as the price of food raced upward to the price that the British were willing to pay for it. The Irish potato famine was one example: even as people starved, food continued to be sold to Great Britain. Famine is not caused by a shortage of food for people, but by the people having a shortage of money to buy the food they need.

In the wake of World War II, America set up its own system of triangular trade, because we had most of the working industrial base of the world. In the 1960s and early 1970s, the modern post-war triangular trade system fell apart, in no small part because the exporters of cheap resources rebelled against it. OPEC is the most well-known example of this, but the entire era was one of colonies that had had triangular trade imposed on them rebelling against the nations of Europe. As with the British system of triangular trade, its disintegration left behind high inflation and the collapse of the monetary basis of the old currency. What happened to the pound in the 1790s happened to the dollar in the 1972, with the failure of the Bretton Woods agreement.

As with the British before us, when triangular trade failed, we turned to hegemony, and the implementation of it came to have a name, "The Washington Consensus." This system used the dollar, and the access to oil that it brought, as a lever to open the capital markets and economies of developing nations. The profits from this would be used to keep the dollar as the gateway to a commodity which was both the gold and the coal of the new system: petroleum.

In the larger picture, Iraq was to be our India, not merely a client state, but the place where Americans would go to earn high wages in turning a country into a mirror of ourselves. We were to build hotels, oil infrastructure and other assets.

…The Neo-Victorian world now trying to emerge is being driven by "Conservative" parties that are much like the "Conservative" parties of the late 19th century. Social conservatism creates society that concentration of economic power through hegemony requires. Every prop that people might have that is not part of the hegemonic enterprise is taken away; instead, incentives to buy land and to pour retirement money into the stocks of large corporations are being given, so that each individual is bound to it by personal interest.

Thus, the political fights over Iraq, Social Security, and now the filibuster are not isolated, they are about whether we are going to create the kind of society that a military hegemony requires to sustain itself: filled with people who are desperate for work, a stone's throw from poverty, and feeling themselves surrounded and beset by terrors and disaster. People who, therefore, cling zealously to arbitrary rules and partisan passions. Each fight is not about the margins of a few court decisions, nor a few dollars in a monthly check, nor over how much testing to do in schools - instead, it is over what kind of people we are to become, and what kind of nation we are to be, now, and for a century to come.

Even if things in Iraq had gone according to plan, average Americans would have found themselves in much worse shape economically. Now, however, disaster looms, as failure in the war exacerbates economic failure.