Tin Foil Hats at Forbes.com

Well, well, well ...

Someone in the mainstream financial media has finally stumbled across the obvious answer to the question of how China can avoid duplicating some of the mistakes that Japan made with their bulging U.S. dollar reserves back in the late 1980s. Over at Forbes.com we find this illuminating article by Richard Lehmann about the possibility of China acquiring gold bullion with some portion of those U.S. dollars that keep piling up in their central bank.

It seems that instead of being enamored with U.S. entertainment and recreation businesses as the Japanese were (e.g., Rockefeller Center and Pebble Beach), the Chinese are much more practical. (Maybe this practicality has something to do with the unusually high number of engineers, and unusually low number of lawyers, in the Chinese government - not sure where we heard this, but we believe it to be true. It seems to make sense. If it's not true, then it was fun believing it for a while.)

Having recently grown a bit tired of purchasing U.S. Treasuries month after month, the Chinese now seem more inclined to spend those U.S. dollars on mining companies, oil companies, and other natural resource companies to help ensure the steady flow of raw materials needed for their manufacturing juggernaut.

But, with the resistance to the Unocal bid, and sure opposition to similar bids for U.S. companies in the future, Mr. Lehmann writes:

"How then can China reduce its subordination to U.S. interests and use its dollar reserves to strengthen its role in world affairs?

I believe China will eventually find gold as a partial solution to its foreign-exchange problem. While an immediate reaction may be to think this is nonsense, a closer examination may provide some food for thought. Gold was the world reserve standard for centuries until former President Richard Nixon closed the "gold window" on Aug. 15, 1971. What he did, in effect, was end the exchangeability of gold for dollars at the fixed rate of $35 per ounce ... The change was necessitated by the fact that foreign holdings of dollars had gotten well beyond the U.S. reserves for gold ... When America abandoned gold, no one was inclined to step in and continue the gold standard. And since gold earned no interest, nations around the world began to systematically reduce or eliminate their gold holdings. Time has shown that such gold holdings would, through subsequent appreciation, have served quite well as an alternative to U.S. Treasurys. However, in today’s world of multibillion-dollar reserves, the gold market is too illiquid to serve its former role.

To revive gold’s role as a reserve currency, it again would need a sponsor—a buyer and seller of last resort who dictated the support price. That price could increase each year, per government policy, by a set amount. China, with its $700 billion in reserves has the clout to assume this role."

Isn't that delicious? China, the emerging economy of the 21st century tires of the U.S. dollar IOUs piling up in its banks, and decides to take a goodly portion of these dollars and buy gold. The "barbarous relic", as Keynes called it, resurfaces as a store of value in an emerging economy, as the aging empire attempts to sustain it's position as sole economic superpower by creating more and more fiat money.

According to the World Gold Council, Asian countries hold a disproportionately small amount of gold as reserves - only 6% of all central bank gold is in Asian banks. It is the Europeans and the U.S who hold more than two-thirds of the central bank gold which accounts for roughly 20% of all above ground gold. If you listen to European and U.S. central bankers, you'd wonder why they hold any gold at all, given their obvious mastery over paper money.

How long European and U.S. mastery over paper money can continue is likely a question that Chinese government officials ask themselves often.

Mr. Lehmann goes on to say:

"Holding large gold reserves can serve China’s domestic economic policy, as well ... Gold has a long history with individual Chinese as a way to hide and preserve wealth...

The ultimate attraction of such a policy for China is that it allows them to reduce their vulnerability to the United States. Even more so, it allows them to play a dominant role in international affairs, clearly a high priority with current Chinese leadership.

While it is not in the U.S. interest to strengthen China’s role in world affairs, it is a better alternative than letting pressures build inside China’s government over a perceived, if not actual, threat to their sovereignty. Also, other solutions to the dollar reserve problem may be dreamed up that prove to be far more dangerous to the current international order. Forecasts are for China’s reserves to grow to $1 trillion dollars by June 2006. Such an accumulation only puts more pressure on the Chinese to find an alternative solution."

It is ironic isn't it? In China and India, workers sweat and toil, then at the end of the day ride their bicycles to their tiny homes, looking forward to their next paycheck so they can convert some more hard earned local currency into gold - what they believe is a store of value.

In this country, workers sweat and toil, then at the end of the day drive home in their gas guzzling SUVs to their oversized homes, looking forward to their next paycheck, hoping they can make ends meet at the end of the month - all the while going deeper and deeper into debt.

So, will the Chinese start buying gold in a big way?

Put yourself in their position - if you are a bartender and all you have to show from the patronage of your best customer is IOUs, which have been piling up behind the counter for years now and show no signs of stopping, wouldn't you try to prevent the pile from rising any higher?

Wouldn't you try to exchange some of these IOUs for something more tangible?

[By the way, the tin foil hat reference in the title is something that we learned from Barry Ritholtz over at The Big Picture. Apparently gold bugs wear them. They may be all the rage in a few years.]

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Why the Housing Bubble is Bad

The housing bubble is bad for many reasons. According to the recently released Housing Bubble Fact Sheet (pdf) from the Center for Economic Policy Research (CEPR), probably the worst reason is:

The collapse of the housing bubble will throw the economy into a recession, and quite likely a severe recession.

Another reason that the housing bubble is bad, one that you don't often hear about, is that it has given an entire generation of young adults a wholly distorted view of how the world works, and as a result, they are largely unprepared for adversity.

These young adults, roughly between the ages of 20 and 40, have known little other than prosperity in their lives. Having come of age during the early eighties or later, they have lived their entire adult lives with no major wars and no major economic crises.

They have become conditioned to accept debt as a necessary and beneficial part of their lives and many appear to be fearless in the amount of risk they take on in pursuit of making easy money.

Depending on their age, they have witnessed the Reagan Revolution, the fall of the Soviet Empire, a small housing boom, then a small war and a small recession. This was followed by the greatest stock market boom in history, which was then followed by a much smaller recession, terrorist attacks, another war, and then the greatest housing boom in history.

It is as if every time something bad happens, somehow, things not only work themselves out, but they end up better than ever before. How is this possible?

It is as if we have discovered some sort of perpetual prosperity machine.

Well, fiat money, fractional reserve banking, and deficit spending can appear to be a perpetual prosperity machine, but history shows that a system such as this would be better described as a debt bomb.

The Older Generations Know

Much of the growing volume of editorials and letters to the editor from older generations express concern for where the most recent boom - today's housing boom - has taken us. There is a growing sense among the older crowd that things just aren't right - too much debt, too many lost manufacturing jobs, too many Wal-Marts, too many SUVs, and prices that are too high for necessities such as energy and health care.

At the same time many of the twenty and thirty-somethings in the world are buying and selling investment property or figuring out some other way to spend their home equity, many with the mistaken belief that nothing bad will happen. And, if it does, someone will come in and fix it for them.

After all, everyone else is doing it!

Having missed out on the stock market bubble a few years back, many in the younger crowd are able to participate in the housing boom and have huge profits to show for their efforts. Instead of quitting college to start a software company, today some quit college to flip condos. Many are probably trying to figure out where the next bubble will be so they can get in sooner next time.

Why waste time in school studying law or medicine when all you have to do is catch the next wave?

The older generation knows that life does not normally work this way, but today's young adults, in the midst of what some have called the greatest financial bubble in history, have no frame of reference. Maybe they've read about the Great Depression, or the World Wars, or Vietnam, or the 70s recession and stagflation, but they have no first hand experience with adversity.

Many young people have become conditioned to believe that somehow they are special in this world. While this belief may have been shaken just a few years back with the stock market crash and terrorist attacks, these events didn't affect most people directly in a big way, and the recent housing boom has served to reinforce the idea that things will get fixed, and then turn out better than before.

In large part due to recent monetary policy, lending standards, and fiscal policy, many of today's young adults have come to believe that their experience in the world is typical, when in fact it is quite atypical. And, one of the most atypical aspects of the world today is the housing bubble.

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Taxes and the Housing Boom

This argument has been heard before and it is now popping up again:

One of the main reasons for the housing boom in recent years is the Clinton Taxpayer Relief Act of 1997.

If you'll recall, this is the tax code change that turned home equity gains of up to $500K into "tax free" gains, as long as you lived in the residence for two of the last five years before the sale (the $500K maximum is for couples - there is a $250K limit for singles).

Does this make sense? Could this tax code change be contributing in a big way to the housing mania? Let's look at two recent sources for this line of reasoning.

In Christopher Farrell's latest missive he notes:

What accounts for the housing boom? Economists have cited a number of fundamental factors, including low interest rates, favorable demographics, and restrictions on development. But the unappreciated force that may have infected a strong housing market with home-buying mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act of 1997, signed by Bill Clinton.

And this, from one of our favorite economists, Larry Kudlow:

Upward price momentum has kicked into higher gear in recent years for two important reasons. First, housing is highly tax-advantaged. The 1997 tax-cut bill — proposed by a Republican Congress and signed into law by a Democrat president, Bill Clinton — permitted the first $500,000 of profits from the sale of a home to be tax-free. This came on top of existing law that permits mortgage expenses to be tax deductible depending on one’s income bracket.

These supply-siders agree that somehow the 1997 tax cut has contributed in a big way to skyrocketing real estate prices, but how? The previous law required gains to be reinvested in a higher value residence within two years in order to avoid paying taxes. There was also a one-time exclusion if you were over the age of 55 - this was designed to help retirees relocate to less expensive areas without incurring a big tax bill.

Ahhh, memories. Back in the nineties we would occasionally hear stories about someone who was about to retire and move away from Southern California with a pile of cash from the sale of their home. They had lived in that home for the last 20 years and they only owed another $15K on it, and they were going to sell it for $245K. That was a pile of cash back then - those numbers are almost comical by today's standards, and it wasn't that long ago.

But we digress...

It seems that if anything, this tax law and today's real estate prices would encourage more people to sell than to buy. As discussed in yesterday's post, some people are "cashing out", taking advantage of these tax free gains, then waiting patiently for prices to return to more normal levels.

Whether or not this will work out for them, we don't know. But, on the face of it, for the average homeowner, the 1997 tax law change is an incentive to sell in the bubbly areas, not buy.

It is understandable how real estate investors could move from house to house every two years, fixing one up then selling it at a hefty tax-free gain before moving on to the next one, but surely this cannot explain much of the real estate craziness of recent years.

One person, one house, two years - that doesn't sound like a mania.

Most recent accounts of investor behavior describe individuals buying property to rent out at a loss for a year or two, then sell for a profit. This would not be eligible for the tax-free status, nor would the activity of "flippers", who sell long before the minimum two year period.

Does the 1997 tax law simply encourage people to buy with the expectation of selling sometime in the future with a huge tax free gain? And then what? Move to another state?

Does this supply-sider argument make sense to anyone?

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Money Magazine on "Cashing Out"

We once again turn a curious eye over to the real estate section of the CNN/Money website, where we find this article which asks the question, "Should you cash out of the real estate market?" Not surprisingly, you pretty much know everything that Money Magazine wants you to know on the subject by reading the title and subtitle:

Homes: Cashing out might freeze you out
Is it ever a good idea to try to time the real estate market?

While there is some worthwhile information and some good advice in this article, the headline writers at CNN/Money never cease to amaze. In the title, they colorfully answer a very specific question about cashing out real estate gains (i.e., selling, then renting with the intent to buy again in the same area after prices fall), but then they ask a much more general question on the same subject in the subtitle.

So, what might seem like an obvious question and answer pair really isn't. They get around to answering the general question hundreds of words later, in the last section, while most of the article focuses on the headline answer.

To the unwary Money Magazine reader, the message is clear - DON"T CASH OUT!

[We are spending way too much time commenting on CNN/Money stories, as is clear by looking here, here, here, and here ... no, maybe that is the right amount of time.]

Good Advice

The good advice contained here is pretty simple - if you gamble, be prepared to lose:

The biggest gamblers are even attempting an extremely tricky maneuver, according to Christian Coleman, district director for Zip Realty, a publicly traded real estate broker with offices in 10 states.

They're selling their houses with the intention of buying back into the market at a lower price in a couple of years or so -- after the bubble bursts, they believe.

The advice from the real estate industry pros is: Resist this temptation. It's almost impossible to time this market.

Now, investing in condos in the summer of 2005, with expectations of quick and plentiful capital gains would seem to be a much trickier maneuver than selling your primary residence at a time that appears to be, more and more, the peak of a bubble. But, that's not really relevant here.

The cash out maneuver described above is tricky indeed.

It is similar in some ways to selling a stock, and then shorting it - the short sale part of the transaction being the intention to buy back into the market, sometime in the future, at what is hopefully a lower price. Of course, when you do this with stocks you must cover the short position. For housing, you have the option of moving to a lower cost state.

So, if a seller is planning to live in an area for the rest of his life, then, yes, this is very risky. Anyone who has unsuccessfully shorted equities knows the old adage, "the market can remain irrational, longer than you can remain solvent", and it is indeed possible that housing prices will just flatten out or rise moderately while rents and incomes catch up.

The couple from San Diego who sold two years ago at $850,000 and now look at that same home with a price tag of $1.2M, must be painfully aware of this by now. Let's hope they invested some of their home sale profits in oil and oil stocks two years ago.

Wait Just a Second!

Before we continue, can we just pause and think about how bizarre this whole situation is?

A major personal finance magazine has actually published an article asking if it is wise to cash out real estate gains on your primary residence and rent a home while waiting for a real estate bubble to burst. This question is being directed at millions and millions of homeowners in the bubble areas of this country, many of whom are now obsessed with their home equity - either trying to figure out how to spend it, how to invest it, or how to preserve it.

Can you imagine your parents or grandparents faced with questions like these when they were young adults?

Other than the 1925 Florida real estate market, can you think of any other time in history when questions like these were asked?

Imagine if you could pocket a cool half million today, then everything falls apart next year, and then after another three or four years, you use that half million to buy back in. You end up with the big house on the hill that you longingly looked at back in 1997 and thought, "there's no way I'll ever be able to afford a house like that".

In 2009, you are pretty much the same person you were in 1997, a steady job, some moderate salary increases over the years, but now you're living in that big house on the hill.

Calling this one correctly could set you up for life! Is this a great country or what?

Nothing Bad Will Ever Happen

While Money Magazine does offer good advise from time to time, they also know that part of their job is to help prevent confidence from faltering:

Anyone even considering it should take heed that many experts predict that the strength of the housing market will continue for the near term.

The latest forecast from chief economist Doug Duncan of the Mortgage Bankers Association, for example, is that the price of a median house will rise a total of 6.8 percent in 2005 and between 4 and 5 percent in each of the two following years.

Many people have made many forecasts in this world, and with the exception of predicting quarterly financial results, pessimistic forecasts are few and far between. What's the point? No one goes back to check on your forecast unless you issue stock - in that case it matters.

What harm does it do for any economist to predict blue skies and clear sailing? What fun is there in being a wet blanket?

And, finally to the "elephant in the living room" as some call it - the argument that real estate will not falter because the underlying economy is strong:

Drops of more than 20 percent in local real estate prices have never been common and the worst falloffs are almost always related to reversals in the economic fortunes of an area.

Conveniently omitted from this shot of confidence is the horrifying reality that our economy is, as never before, dependent upon a booming real estate market to not only provide jobs (construction, home improvement, and finance), but also to enable increased consumer spending via home equity withdrawal. This phenomena, for the county of San Diego, has been previously discussed here and here.

To use this argument is to completely ignore the role that real estate has played in today's Frankensteinian economy.

At some point in time, we will all look back and wonder what we were thinking. How could so many people in such high places have thought that it was OK for real estate values to play such a large role in economic growth?

But, for now, we just watch and wait.

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The Yuan, the CPI, and the Fed

After China took the first baby-steps toward a floating currency last week, it is natural to wonder what effect the continuation of this process may have on consumer prices and monetary policy here in America.

After all, one of the Federal Reserve's duties is to conduct the nation's monetary policy in pursuit of:

• Maximum employment
• Stable prices
  
• Moderate long term interest rates

The process whereby floating currencies correct trade imbalances will, by design, result in higher prices in terms of the currency that is losing value - whether these higher prices are stable or unstable is, apparently, the important question.

The two percent move last week should affect consumer prices negligibly, however, as we look further down the road to what many feel will eventually be an adjustment in the 20% to 40% range or beyond, there could be a significant impact on life as we know it - could this turn out to be a case of "be careful what you wish for"?

[Note: In chapter II of the recent Bank of International Settlemenst 75th Annual Report, referenced in a recent Stephen Roach article, the point is made that changes to import prices do not make their way through to consumer prices like they once used to - perhaps this has as much to do with how consumer prices are calculated today as it does with other factors sited in the report. If this truly is the case, it seems odd that Treasury Secretrary John Snow would have spent so much time pounding the table for Asian currency reforms.]

Consumer Prices

It is no secret that U.S. consumers have grown accustomed to inexpensive Asian imports. In fact, whole categories and subcategories of the Consumer Price Index are dominated by falling prices for Asian goods. These falling prices are primarily due to the continuing transition of manufacturing production from higher cost producers around the world to low cost producers in Asia, while at the same time the Asian currencies are either explicitly or implicitly pegged to the dollar.

The result? Low prices and big trade deficits.

The effect on prices can be seen in dramatic fashion (excuse the pun) in the apparel category of this chart of CPI price changes over the last ten years:


Click to enlarge

The yellow line above represents a full 10 percent decline in this major category of consumer prices. One walk through any department store will make clear the state of the U.S. apparel industry - just look at the labels on clothing for sale. In stores like Wal-Mart and Target, China is the predominant supplier, and in higher end department stores you'll see a variety of labels from all over the world, but very few, if any, will be found that say, "Made in the U.S.A".

It is amazing how inexpensive clothes made in China can be.

Low and falling prices can be found in other areas as becomes clear when selected sub-categories of the CPI recreation category are broken out. When was the last time that you heard of televisions or toys being made in America?


Click to enlarge

As a result of changing currency valuations in Asia, the price of imported goods, in U.S. dollar terms, will rise over time - how much depends on how freely the currencies are allowed to float. But, the important point is that instead of falling prices, which have helped to offset rising prices in areas such as energy and health care, rising prices for imports will soon be adding to the calculated inflation index.

This is not too different from the social security surplus making the federal budget deficit appear less than it would otherwise be - at some point the artificial adjustment begins to work in the opposite direction, and the misrepresentation of previous years becomes clear ... very clear.

Monetary Policy

So, what does this mean for monetary policy?

Many economists seem to be fond of the phrase "non-inflationary growth", which is repeatedly used to describe the unique ability of the American economy to maintain excellent growth in recent years, with inflation that is historically low.

As long as inflation is low, the thinking goes, there is no reason for money to be anything other than "easy".

The fact that a large part of the inflation index is based on cheap imports and currency pegs is never disclosed when "non-inflationary growth" is touted. Similarly, the fact that there is such a disparity in price trends for U.S. based services and imported goods, as evidenced in the charts above, is also not disclosed.

It is as if this is just how the world works - they sweat, we shop! The money we save by purchasing cheap imported goods is used to pay for expensive services provided here in America, and in the end, inflation is benign.

Did anyone ever really think that this was sustainable?

Low inflation, in and of itself, is not dangerous. That is how globalization works - absent trade restrictions, the business goes to the low cost supplier, wherever they may be. The trade imbalances between nations that build up are supposed to be brought back into balance through relative changes in currency valuations, and over time, the cost of goods from low cost suppliers gradually rises as their currency strengthens.

With the rise of imports from Asia, China in particular, huge trade imbalances have been built up which have not been allowed to be brought back into balance because of the currency peg. Many have argued that what would otherwise show up in inflation statistics now shows up in the trade deficit instead - a trade deficit that just keeps getting larger.

So, back to the monetary policy question ... how wise is it to base monetary policy on inflation data that is so heavily influenced by something that is not sustainable?

Has the Federal Reserve been fooling themselves in thinking that easy money to stimulate the economy was justified by low inflation?

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