Not Sustainable

It's always a pleasure to read the writing of Dr. Kurt Richebacher. At around 80 years old, he still knows how to blast a Federal Reserve Chairman and, having been around so long and having seen so much, he takes great issue with what he's witnessed in the U.S. economy in the last couple decades.

From the little noticed but resurgent Austrian school of economics, he maintains a point of view that seems to make obvious sense to a few, yet most carry on as if what's been happening in recent years is just par for the course - as if asset bubbles expanding, hissing, contracting, and in some cases popping, is the way that economies are supposed to function.

Recall that the Austrians were blamed for the severity of The Great Depression.

With a rigid gold standard, after the credit excess of the 1920s (something that few contemporary economists acknowledge), there was little that could be done to stimulate the economy after the stock market crash of 1929.

Dismal practitioners from the Austrian school, who had the ear of policy makers in the White House at the time, thought it would be best if things were left to work themselves out alone rather than printing up money in an attempt to fix what ailed the economy.

That decision sent the Austrians "back to school" for about seventy years, however, they seem to have recently completed their course work and are gaining new respect.

As he predicted, Keynes is dead in the long run, leaving bankers, businessmen, and politicians the world over to asses the long run impact of decades of problem solving facilitated by money printing and expanding credit.

Dr. Richebacher's commentary from last week focused on (what else?) asset bubbles.

Has Mr. Greenspan ever realized that he has turned the U.S. economy into a bubble economy? Who else among former and present policymakers and top economists on Wall Street has realized this? Some certainly have. In Japan, even policymakers frankly used this word in public. But in America, everybody painstakingly avoids this admission.

In order to eschew mentioning the dirty word, a new definition has come into general use. U.S. economic growth is neither "bubble driven" nor "debt driven"; it is "asset driven." It is a term especially invented for the American public to convey the good feeling that the U.S. economy is creating assets, while in reality, with its consumer borrowing-and-spending binge, it is consuming its capital, reflected in falling investment and soaring foreign indebtedness.

The first task, of course, is always to identify undesirable increases in asset prices, emphasis on "undesirable," classified as "asset bubbles." In this respect, Mr. Greenspan made his famous remark: "But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best."

Now compare this trivial talk of the world's leading central banker with the reasoned assessment by economists in a study by the International Monetary Fund (IMF), titled "Monetary Policy, Financial Liberalization and Asset Price Inflation," published in the World Economic Outlook of May 1993:

"Financial liberalization, innovation and other structural changes in the 1980s created an environment in which excess liquidity and credit were channeled to specific groups in the markets. This includes large institutions, high-income earners and wealthy individuals, who responded to the incentives associated with the changes. These groups borrowed to accumulate assets in the global markets - such as real estate, corporate equities, art and commodities such as gold and silver - where the excess credit apparently was recycled several times over."

And here is a crucial part of the conclusions of this study:

"To the extent that asset price changes are related to excess liquidity or credit, monetary policy should view them as inflation and respond appropriately. There is nothing unique about asset markets that would suggest that asset prices can permanently absorb overly expansionary policies, without leading to costly real and financial adjustment."

Actually, the study explicitly and precisely pinpoints the key feature of asset price inflation. It is "a credit expansion in excess of the expansion of the real economy." In 2005, a credit expansion of $3,335.9 billion in the U.S. economy was matched by nominal GDP growth of $752.8 billion and real GDP growth of $379.1 billion.

In the United States, credit growth since the 1980s has developed increasingly in excess of GDP growth. During the past five years of recovery, though, this discrepancy has widened to extremes that defy economic and financial reason.

We regard this escalating gap between credit and GDP growth as a very serious, however completely unrecognized, problem, and it is rapidly escalating. In the first quarter of 2006, credit expanded by $4,386.5 billion annualized.

Yes, one of these days, all the recent credit creation that has been driving all the recent GDP growth in the U.S. economy may turn out to be a problem that can't be solved by more credit creation.

We'll see.

But, the problem of credit creation does seem to be more recognizable these days. It will likely become more so next spring when more than a trillion dollars of adjustable rate mortgages adjust upward. Those loans were a sort of "emergency" credit creation from a few years back when the aftermath of the prior asset bubble was looking dire.

Over the last two years, despite all the talk of normalizing interest rates and fighting inflation, credit creation has actually increased not decreased, as one might believe when hearing of actions taken by the Fed.

There is no choice but for the credit creation juggernaut to continue on, destination unknown. It remains to be seen whether it will be a long, smooth ride or if recent bumps in the road portend a shorter, more difficult journey now that prices for the latest asset bubble are no longer rising.

Did anyone really think this was sustainable?

The question to ask in the face of these facts, of course, is whether this runaway credit expansion in relation to grossly lagging GDP and income growth is sustainable. For sure, it is not. All this prodigious borrowing and lending has been undertaken in the grossly flawed assumption that rising asset prices, rather than rising incomes, will some time in the future take care of interest payments and repayments.

Assuming the normal rule that debts have to be serviced and amortized by future income, the great mass of American consumers could never afford the debts they have incurred in recent years. For many, the borrowing has even been the substitute for lacking income growth. In real terms, in 2005, this was 1.2%, well below its growth rate of 1.9% during recession year 2001. Given the reported sharply slower employment growth, further deterioration is clearly on its way.

But, isn't that the whole basis of this latest monstrous asset bubble in the form of real estate - that the borrowed money would never have to be paid back? Does anybody who just purchased a $600,000 home, taking on $500,000 in new debt in the process really think that they're going to pay back all that money out of their earnings?

While asset prices continue to rise faster than debt, all seems well in the world and the wealth creation feels both pleasant and sustainable.

But, when asset prices stop rising and then reverse - look out.