“America’s income-short, consumer-led recovery is the aberration – not the norm – in this Brave New World. It is all about ever-declining saving rates, ever-widening current account deficits, mounting debt burdens and increasingly wealth-dependent consumers. It personifies what I believe is one of the most precarious macro models that has ever existed for a major economic power.”
– Stephen Roach, Morgan Stanley Economist, April 4, 2005
Private households in the United States have embarked on their greatest borrowing binge of all time, fostered and facilitated by the rampant house price inflation and a most aggressive financial system. What has been developing in the balance sheets of private households, therefore, is a race between booming “wealth creation” through rising house prices and soaring indebtedness.
It appears that indebtedness will win this race and wealth creation will lose. Over the five recovery years since the end of 2001, the overall indebtedness of private households surged by 66%. Even though overall indebtedness soared, rising home prices still provided the private households with the biggest wealth gains of all time. The housing bubble, therefore, has been the single most important economic event of the last few years. Homeowners used the sharply rising market values to embark on their greatest borrowing-and-spending binge of all time, financing higher consumer spending through soaring equity withdrawals, even though personal savings were negative in the aggregate.
The bursting housing bubble, therefore, should be the single most important economic event of the next few years.
In a recent speech in Atlanta, Donald L. Kohn, vice chairman of the Federal Reserve Board, remarked:
“Our uncertainty about what pushed home prices and sales to those elevated levels raises questions about how the market will adjust now that expectations of the rate of house price appreciation are being trimmed.”
Please note his explicit remark on “our uncertainty about what pushed home prices and sales to those elevated levels”. The Fed slashed its federal funds rate with unprecedented speed to 1% and accommodated America’s greatest credit inflation, yet Mr. Bernanke stresses the uncertainties in the Fed about what truly pushed homes and sales of housing to those elevated levels.
There never was a secret about what exactly has been fuelling the US asset-inflation bubbles – above all, equities, bonds and the boom in housing. First of all, the Federal Reserve – with Messrs. Greenspan and Bernanke at its helm – played a key role in the late 1990s both with extremely loose monetary policies and highly encouraging public remarks to foster the stock market boom.
Nevertheless, the stock market boom went bust in 2000 and the following years. While the government and the Federal Reserve opened their fiscal and monetary spigots as never before, the economy started its most anaemic postwar recovery. The main support for economic growth came from the developing residential housing bubble, which offset the stock market bust of 2000 to 2002 and provided homeowners with soaring collateral for borrowing through home mortgage refinancing.
To quote Stephen Roach of Morgan Stanley: “The Fed, in effect, had become a serial bubble blower.” By the time the equity bubble popped in early 2000, consumers had moved on to a new strain of wealth effects – taking advantage of possible equity withdrawals from rising housing values to extract newfound purchasing power. But now that home values are falling, this purchasing power is moving in reverse.
According to the Fed’s Flow of Funds Accounts of the United States, new mortgage borrowing by private households peaked in the third quarter of 2005 to an annual rate of US$1,223.6 billion. One year later, its growth sharply slumped to US$672.7 billion, marking a decline by 45% within just one year. Retrenchment in mortgage borrowing and lending over this brief period has been dramatic.
Without rising home values, and continuing access to new credit, the American economy will slide into recession.
The US economy is one of the very cases in the world in which all three main sectors – government, businesses and private households – keep borrowing and spending heavily in excess of their current income growth. In 2005, they together borrowed US$3.35 trillion, of which the nonfinancial sector borrowed US$2.3 trillion and the financial sector another US$1 trillion. This compared with a total credit expansion by US$1.6 trillion in 2000. This coincided with a collapse in national saving from US$582.7 billion to US$7.2 billion.
Therefore, arguments between bulls and bears about the further prospects of the economy and the financial markets are focused more than ever before on one aggregate: excess liquidity and credit growth. Long ago, until the late 1960s, credit growth was closely tied to economic growth, as measured by gross national product. But this formerly close relationship between the two aggregates went completely bust in the 1980s. Ever since, credit has been expanding in excess of GDP growth.
During 2005, total credit grew in that single year by US$3.35 trillion. Compared with nominal GDP growth by US$0.74 billion. In other words, it required US$4.50 of new credit to add US$1 to GDP. Clearly, this is excessive liquidity and credit growth.
It is a fact that each major economic and financial crisis has been preceded by “excess” liquidity. Just think of America’s New Era during the 1920s and of Japan’s famous bubble years in the late 1980s. In both cases, prior excess liquidity vanished in no time when the existing asset bubbles began to burst. If growing asset bubbles are the channels to excess liquidity, bursting asset bubbles are the channels to liquidity destruction and excess debt.
Therefore, we observe with a very critical eye the balance sheets of private households. According to the consensus of economists, American balance sheets are in excellent shape because asset values, mainly equity and housing, have soared in value for years, altogether by about US$19 trillion – or almost 40% – since recession year 2001.
But the bulk of these gains has been entirely in illiquid assets, mainly equity and housing. Liquidity, measuring existing cash against overall liabilities, is at its lowest ratio in postwar history. To us, consumer balance sheets in the aggregate look more like a house of cards.
The great question is whether there is anything in the pipeline that might shake this house of cards. Clearly, we do not want to be standing near this house of cards when the macro-economic trembler finally arrives.
Dr Kurt Richebacher
for Markets and Money
Editor’s note: Noted economist Dr. Kurt Richebacher died recently in Cannes, aged 88. He was the editor of the Richebacher Letter. Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebacher’s insightful analysis stemmed from the Austrian School of economics. France’s Le Figaro magazine once featured a story on him, describing him as “the man who predicted the Asian crisis”.