The Daily Reckoning
London, England
Tuesday, March 20, 2007
The Daily Reckoning PRESENTS: Last year set new records everywhere:
records in stock prices, records in mergers and acquisitions, records in
private equity deals, record-low spreads, record-low volatility.
Manifestly, there is not the slightest check on borrowing for financial
speculation. Dr. Richebächer wonders, what can stop this speculative
binge? Read on...AN UNPRECEDENTED SPECULATIVE SPREEby Dr. Kurt Richebächer
A study recently published by the Bank for International Settlements
(Monetary and Prudential Policies at a Crossroad?) says:
"Financial liberalization is undoubtedly critical for the better
allocation of resources and long-term growth. The serious costs of
financial repression around the world have been well documented. But
financial liberalization has also greatly facilitated the access to
credit... more than just metaphorically. We have shifted from a cash
flow-constrained to an asset-backed economy."
Though we basically agree with the analysis and the conclusions of the
study, we radically disagree with the one sentence that "Financial
liberalization is undoubtedly critical for the better allocation of
resources and long-term growth." The indispensable first condition for
proper resource allocation at a national as well as global scale is
avoidance of excessive money and credit creation. In many countries, and
in particular in the United States, they are excessive as never before.
If Mr. Bernanke complains about irregularities of M2, this is nothing in
comparison with the fact that credit and debt growth in the United States
has exploded for more than two decades. When Mr. Greenspan took over at
the helm of the Fed in 1987, outstanding debt in the United States totaled
$10.5 billion. In less than 20 years, this sum has quadrupled to $41.9
billion. In reality, this significantly understates the rise in debts
because, for example, highly leveraged hedge funds with trillions of
outstanding debts are not captured. In 1987, indebtedness was equivalent
to 223% of GDP, which was already pretty high. Lately, it is up to 317% of
GDP.
In actual fact, there used to be a very stable relationship between money
or credit growth and GDP or income growth until the early 1980s. Growth of
aggregate outstanding indebtedness of all nonfinancial borrowers - private
households, businesses and government - had narrowly hovered around $1.40
for each $1 of the economy's gross national product. Debt growth of the
financial sector was minimal.
The breakdown of this relationship started in the early 1980s. Financial
liberalization and innovation certainly played a role. But the most
important change definitely occurred in the link between money and credit
growth to asset markets. Money and credit began to pour into asset
markets, boosting their prices, while the traditional inflation rates of
goods and services declined. The worst case of this kind at the time was,
of course, Japan.
Do not be fooled by the sharp decline in consumer borrowing into the
belief that money and credit has been tightened in the United States.
Instead, borrowing for leveraged securities purchases (in particular,
carry trade and merger and acquisition financings) has been outright
rocketing, with security brokers and dealers playing a key role. Over the
three quarters of 2006, their net acquisitions of financial assets have
been running at an annual rate of more than $600 billion, more than double
their expansion in the past.
Federal funds and repurchase agreements expanded in the third quarter at
an annual rate of $606.3 billion, or an annual 26%. The main borrowers
were brokers and dealers. During the first three quarters of the year,
their assets increased $427 billion, or 27% annualized, to $2.57 billion.
A large part of the money came from the highly liquid corporations. There
is no reason to wonder about low and falling long-term interest rates.
All this confirms that financial conditions remain extraordinarily loose.
Even that is a gross understatement. Credit for financial speculation is
available at liberty. Expectations for weaker economic activity only
foster greater financial sector leverage. Why such unusually aggressive
speculative expansion in the face of a slowing economy?
The apparent explanation is that the financial sector intends to make the
greatest possible profit from the coming decline of interest rates,
promising further rises in asset prices against falling interest rates.
While the real economy slows, the leveraged speculation by the financial
fraternity goes into overdrive. Principally, there is nothing new about
such speculation. New, however, is its exorbitant scale.
Before leading his jumbo-sized delegation to Beijing, Henry Paulson, U.S.
Treasury secretary, cautioned against expecting any big breakthroughs from
the visit. And so it has turned out. The meeting produced plenty of
statements about the desirability of improving relations, but nothing
concrete to do so.
Of course, the Chinese are in a very strong position with the central bank
holding more than $1 trillion of bonds in its portfolio, mostly
denominated in dollars. According to reports, the American visit was
initiated by Mr. Paulson in an effort to contain rising Sinophobia in the
U.S. Congress, which increasingly blames China for America's economic
problems, from its huge current account deficit to stagnating real
incomes. In other words, those troublemakers, not the trade deficit, are
the problem.
One cannot say that U.S. policymakers and economists have been preoccupied
with worries about possible harmful effects of the exploding trade
deficit. They appear obsessed with the conventional wisdom that free trade
is good and must always be good under any and all circumstances, as
postulated in the early 19th century by David Ricardo.
Ricardo exemplified this by comparing trade in wine and cloth between
Portugal and England. Portugal was cheaper in both products, but its
comparative advantage was greater in wine. As a result, according to
Ricardo, Portugal boosted its production and exports of wine. In contrast,
England gave up its wine production and could produce more sophisticated
goods. In both countries, living standards rose.
For sure, it appears highly plausible that American policymakers feel they
are following Ricardo's logic. Only they are disregarding some caveats of
Ricardo's. For equal benefit, first of all, balanced foreign trade is
required. "Exports pay for imports" was a dogma of classical economic
theory. Ricardo, furthermore, disapproved of foreign investment, with the
argument that it slows down the home economy.
With an annual current account deficit of more than $800 billion, the U.S.
economy is definitely a big loser in foreign trade. To offset this loss of
domestic spending and income, alternative additional demand creation is
needed. Essentially, all job losses are in high-wage manufacturing, and
most gains are in low-wage services. In essence, the U.S. economy is
restructuring downward, while the Chinese economy is restructuring
upward.
Considering that Chinese wages are just a fraction of U.S. or European
wages, it appears absurd that the Chinese authorities deem it necessary to
additionally subsidize their booming exports by a grossly undervalued
currency, held down by pegging the yuan to the dollar.
In the U.S. financial sphere, the year 2006 has set new records
everywhere: records in stock prices, records in mergers and acquisitions,
records in private equity deals, record-low spreads, record-low
volatility. Manifestly, there is not the slightest check on borrowing for
financial speculation. There is epic inflation in Wall Street profits.
One wonders what can stop this unprecedented speculative binge. Pondering
this question, we note in the first place that the gains in asset prices -
look at equities, commodities and bonds - have been rather moderate. To
make super-sized profits, immense leverage is needed. We think the
speculation is unmatched for its scope, intensity and peril. Plainly, it
assumes absence of any serious risk in the financial system and the
economy. The surest thing to predict is that the next interest move by the
Fed will be downward.
In our view, the obvious major risk for speculation is in the economy -
that is, in the impending bust of the gigantic housing bubble.
Homeownership is broadly spread among the population, in contrast to
owning stocks. So the breaking of the housing bubble will hurt the
American people far more than did the collapse in stock prices in 2000-02.
For sure, the U.S. economy is incomparably more vulnerable than in 2001.
Another big risk is in the dollar.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning