That Seventies Show

There is a serious situation brewing that few people are talking about. This absolutely required a blog update.

One of the most dramatic features of the economic landscape during the 1970s was the disruption of the Oil Shock. Today, people are misled to believe that this was THE cause of inflation in that disastrous decade but that is a long way from the truth. In reality, it was more of a reaction to inflation. LBJ's creation of the modern welfare state combined with his escalation in Vietnam put the US on the path of permanent debt.

Accelerating inflation rapidly ensued for nearly a decade had already resulted in cumulative dollar inflation of over 50% before the Arab Oil Embargo and overnight tripling of prices. OPEC was using their market power and leverage to compensate for the falling value of the dollar and to get ahead of the galloping inflation our government and central bank had created. They noticed that they were being robbed via currency debasement and were in a position to do something about it because they controlled a large chunk of the oil export trade.

Unfortunately, we may be about to see history rhyme if not repeat in the near future. The effects could be extremely serious, with social consequences much greater than in 1974. And it could all be triggered by one medium-sized Southeast Asian nation that few people focus on when looking at economics. That nation is Thailand and the critical commodity that will be impacted is rice.

The likely result arises from the politics of inflation. Thailand's exports are priced in dollars and the severe erosion in value of the dollars earned has created pressure to increase income to revive living standards damaged by inflation. Because Thailand is the largest rice exporter by far in a tight market, they are in a position to demand higher prices - just as OPEC was in 1973-74. The current ruling party in Thailand is committed to increasing the income of farmers and is pursuing policies to control the rice supply and push up prices. From Bloomberg:

Yingluck has said the government will buy unmilled grain from farmers at 15,000 baht ($502) a ton at harvest in November, above current market rates of 9,900 baht. With Thailand the world’s biggest exporter, that may raise rice prices across a region that accounts for 87 percent of global consumption. The leader presented her economic policies to Cabinet yesterday and is scheduled to announce them publicly by Aug. 24.
...

Food makes up more than 30 percent of inflation indexes on average in Asia, according to Rabobank Groep NV. The weighting of rice in consumer-price indexes varies from 9.4 percent in the Philippines, 4.7 percent in Indonesia and 2.9 percent in Thailand, according to Bank of America.

Collateral Damage
The sad irony is that the people most affected by this will be innocent bystanders. The western central banks most responsible for currency debasement will hardly even notice. Few people in the West will be impacted at all. The people who will feel the pain will be Asian city dwellers. Middle and lower class urbanites will be especially hard hit. There will be a partial offsetting benefit in rising incomes for rice farmers but the disruption from shifting so much money from urban consumers is sure to trigger political unrest and likely a great deal of violence as well.

The numbers suggest a 50% increase in rice prices if the official Thai government pricing dictates to the world export market. This seems likely to us since they account for over a third of all rice exports nearly every year. With rice in short supply already, it is doubtful that importers will be able to refuse to buy at the higher price for very long. Because of rice consumption patterns, the effect will be overwhelmingly confined to Asia (85% of world consumption) and North Africa. As if those areas needed more economic pressure place upon them.

Once the Asian nations understand the full consequences of this move, the drive to move their economies away from the dollar should accelerate. With the dollar as the global reserve currency, the Fed is able to inflict widespread damage with its irresponsible policies. It appears the casualties in this round will be overwhelmingly Asian. That will increase the urgency to find alternatives to a dollar that is being sabotaged at the whim of Ben Bernanke.

Catalyst for Jawboning

Over the last several days, the Fed has trotted out multiple spokesmen to suggest there might not be another round of trash credit creation (quantitative easing). The Dallas Fed's Fisher came out on Tuesday and suggested the program should not be extended when it ends in June and that things may already have gone too far. Lockhart of Atlanta stated "it's a high bar" in response to questions about QE3. Minneapolis' Korcherlakota stated the economy would have to "worsen materially" to extend the bond market manipulation. Finally, Plosser of the Philadelphia Fed recommended not merely stopping or even reversing the bond buying but also raising interest rates.

The central bank should set a pace for selling its mortgage and Treasury holdings in conjunction with raising interest rates, Plosser said today in a speech in New York. He suggested selling $125 billion for every 0.25 percentage-point rise in the benchmark rate to almost eliminate $1.5 trillion in bank reserves.

So why is the Fed so concerned suddenly after abusing their authority in blatant fashion for more than two years? Clearly they don't care about inflation - having inflicted a tripling of oil prices, a doubling of most grains and even worse in some commodities upon the world. It would seem that they are concerned that people are catching on to what they are doing and starting to point the finger in the right direction. So now they need to very publicly posture as "inflation fighters" until people's attention wavers. And the spotlight is definitely turning their way. As the Financial Times reports:

The finger of blame is increasingly pointing toward central banks and the US Federal Reserve in particular. By printing money through quantitative easing, there are supposedly more dollars, yen and pounds chasing the same number of Beefy Crunch Burritos. Fed chairman Ben Bernanke actually was asked during a speaking engagement last month whether the central bank was culpable for the revolution in Egypt.

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to US monetary policy because emerging markets have all the tools they need to address excess demand in those countries,” said the clearly annoyed banker.

But an increasingly common view is that, with the very best intentions, he is at fault. Critics regularly cite the words of Milton Friedman, who said that “inflation is always and everywhere a monetary phenomenon”.

Essentially, the Bernak is standing over the body with a bloody knife in his hands and the lights have just turned on. He seems determined to brazen it out and has sent out his minions to talk about all of the wonderful things he's done and will do if we just leave him alone with his power. This is all an attempt to distract attention for the Fed's culpability in the destruction of purchasing power worldwide.

It is all about perception. That is why the Fed cares about inflation expectations, even while deliberately inflicting inflation on the economy. They can more effectively steal the value of your savings and income if you don't know what is going on. That job becomes much harder when the population starts to adjust their thinking and behavior to account for the destructive acts of the Fed. It is so important to prevent that change in thought and deed that Paul Volcker once raised short-term interest rates above 15% to prevent it.

With the spotlight now focused firmly on the Fed, this weeks' jawboning is just the first act of their attempt to change the subject. If that doesn't work, they might actually be forced to DO something. In particular they will need to act to stymie commodity speculation - which is the portion of the iceberg that everyone can see, as it affects the daily life of nearly everyone. While they are also likely to attempt to prop up the stock market, it will be tough to do both at the same time since commodity producers and related firms have been a key driver of the new equity bubble.

With private lending in the US essentially dead, the government is the sole source of credit growth right now. If the debt limit interferes with further bubble finance at the same time as the Fed is forced to try and look responsible, the speculative markets could be in for a rough ride indeed.

The Visible Fist

The Visible Fist of government that is. The Visible Fist is about to crush the property market in China, exploding one of the most egregious bubbles on the face of the planet. The specific blow will take the form of imposing a property tax nationwide - in guidelines recently approved by the State Council. It was reported earlier this week in China Daily.

Although the measures have been considered for some time, the recent push has been given urgency by the dangerous levels that China's property bubble has reached. One of the key contributing factors has been the number of speculators buying property and then holding it off the market to profit from the price run up. Morgan Stanley's Andy Xie estimates that such properties number in the 10-20 million unit range.

Some of his other comments portray a China going through the same stages of economic madness that the US has over the last 20 years. But China is passing through each stage much faster as the (well-deserved) lack of trust in their financial system causes people to only chase really big potential profits. Look at this paragraph and tell me you don't see the parallels:

China's policies have travelled the path of least immediate resistance - monetary expansion and asset inflation. The main purpose behind asset inflation is that the government can tax it. It provides a place for people to chase their get-rich-quick dreams and is popular as long as the market goes up. It also offers insiders who have disproportionate influence to play the game at the expense of little people. It is no coincidence that China's policies have been so pro-asset-inflation in the past few years.

His comments seem to suggest that the lack of a property tax was a deliberate strategy to encourage land speculation and bid up prices in a frenzy. This would make sense as the state was by far the biggest landowner and wanted to extract the maximum price for it. With a large amount of land now in private hands, it can be taxed as the taxable base can now replace diminished land sales as a source of government revenue.

Increasing the carrying cost of speculative assets is one of the surest ways to burst a bubble. That is why rising interest rates nearly always do the trick. Rising ownership taxes have the same impact. China is doing both. The government is both instituting a property tax and requiring higher interest rates on properties other than a primary residence. The impact has been dramatic and nearly immediate and so far, it's just the new financial rules and property restrictions. The tax will aggravate the impact. Here is a report from two weeks ago in China Daily:

The Shanghai market has already felt the chill of the tightening housing policies with new apartment sales falling in April. Over 13,185 units of newly built apartments were traded in April, down 43.7 percent from the same period in 2009, according to data from China Real Estate Index System Shanghai.

Trading in the secondary market in Shanghai also saw a dramatic slump since April 16.

A total of 13,865 housing units changed hands between April 1 to 16, but only 7,974 units were traded from April 17 to 30, said Ma Ji, consulting manager at property consultancy Shanghai Centaline China.

Local media also reported that a property tax might be imposed in the next few months. Houses that fall into the definition for charging property tax will be levied an annual fee of as much as 8 percent of the apartment's total value, the Shanghai Securities News reported on Wednesday.

While I applaud the Chinese government's belated return to sanity, they are now being forced to take action to rein in the monster they created. Recall that we criticized the massive push to force credit through the system last year in Command and Control and The Price of Ponzi. The Sinophiles bragged about how smart the Chinese government was and how the money was going into useful projects. They completely forgot (or never learned) that money is fungible and much of it was bound to end up wasted in financial speculation in stocks and real estate.


Implications
China is trapped in a massive inflationary spiral of its own making. Wages are rising rapidly - undermining their major competitive advantage. But the average worker is still falling behind in terms of housing and other necessities. Just as in the US during the 1970s, inflation's initial effect is seen a purely positive - a feeling of rising prosperity that seems costless. China went through that over the last 18 months and it's time to pay the piper. It is going to be impossible to tame short of crashing their economy to subdue the fundamental labor supply picture, crash the RE market to increase purchasing power in terms of land or crash the stock market through contraction of the overall money supply. I expect more than one will be needed and likely all three will happen when they try to trigger any one readjustment.

One final comment. The divergence between Chinese consumer inflation and US CPI dis-inflation is strong supporting evidence for the Austrian and Monetarist schools view of the matter. Both consider inflation to be a matter of increasing amounts of money (really credit). Private credit is tanking in the US and has been for some time while China forced their banks to lend massively more.

Trembling Pillars of Fraud

Over the last two weeks we have seen a series of indications that some of the key elements supporting manipulation of market pricing mechanisms are beginning to tremble. We have seen equity prices rise despite the lack of any significant increase in profits. We have seen commodity prices spike without much increase in real demand. In our opinion the key institutions behind this mess are the major Wall Street (TARP) banks, government agencies and the Fed. They have all played a major role in creating credit inflation, with subsequent asset bubbles and debasement of our currency. But understand this: if you 'look through' each of those institutions you will find the US government backstopping each and every one of them. Each of those has come under increasing attack and as the supports have begun to shake, the fraudulent pricing they have promoted has also begun to unwind. As politics has supported bubble dynamics, so it can destroy them - live by the sword, die by the sword.


Fear and Loathing
First, Yahoo Finance reports that Wall Street's bonuses being paid out now will total $145 billion. That is greater than 1% of US annual GDP. In a normal year that number would be insane. After the disaster those same players inflicted on the US and global economy, that number is downright obscene. Bailouts were indefensible to start with and now you can add infuriating arrogance to the list of offenses. Public anger may be getting through to Congress and without siphoning off taxpayer money via the legislature, the rest of the Wall Street con game doesn't work. It has now gotten so bad that according to Dow Jones Newswire the TARP still exists only courtesy of a Senate filibuster by its supporters.

Fear of angry constituents has taken on a new urgency for our elected officials in the wake of a shocking Republican victory in the Massachusetts election for Senate. With citizens realizing that the Fed's actions have been a pure handout to Wall Street, the reconfirmation of Ben Bernanke as chairman is now very much in danger. Today, the NY Times reports that two additional senators abandoned him. With Geithner at Treasury already under serious scrutiny by Congress for his role in the bailout of Goldman via AIG and the subsequent attempt to hide the details, the two most prominent faces of bailout nation are both in danger of being forced out.


Friendly Fire
The biggest blow psychologically may be the rhetorical broadside from President Obama against the big banks that are a key leg of the credit inflation machine. His speech yesterday called for them to be cut down to size and shackled. This was a frontal attack on the concept of Too Big To Fail, with its implicit taxpayer guarantee for the stupid risks taken by big banks. The Obama Administration has given Wall Street nearly everything it wanted so the Street must now feel shocked that their tame politician has turned on them viciously. We have long felt that once the anger of the populace rose to sufficient levels, the political class would throw the financial elites under the bus in the interest of self-preservation.

Our government has betrayed our nation's citizens in many ways - from the TARP to the uncapping of taxpayer losses on Fannie and Freddie on Christmas Eve. The failure of those policies to make things better or even to stop them from getting worse is now obvious. The failure has become political kryptonite - so much so that Rep. Barney Frank is calling for Fannie Mae and Freddie Mack to be abolished. Frank has been one of their main defenders and cheerleaders for years if not decades. For him to even contemplate such a call tell us that taxpayer bailouts have become the political equivalent of Ebola.

Political support lies at the very foundation of attempts to revive the bubble by inflating credit and eroding the dollar. It is clear that this political support is evaporating before our very eyes and the state of the markets is beginning to reflect that. Suddenly the political foundation of Bailout Nation isn't looking too stable and the pillars resting on it are beginning to tremble violently.

Fractional Naked Shorting

Every dollar-denominated loan can be viewed functionally as a partial naked short position in FRNs (Federal Reserve Notes, 1.e. cash). The extent of the naked short is the inverse of the reserve ratio, so at 10% reserve, the position is written as 90% naked short. The entry is created where the bank shorts notional dollars into existence where none existed before. The Fed is a mechanism for supporting those naked shorts against margin calls that would otherwise happen in the real world - that's what a bank run really is, a margin call by lenders (depositors).

The continued existence of this naked shorting depends utterly on the willingness of the lenders to accept repayment in virtual instead of real dollars. Wire transfers, checks and book entries are all dollar substitutes, not actual dollars. An entire massive infrastructure has been erected to push people towards the conclusion that these are actually identical to FRNs. Banks will freely exchange your book entry with them for cash - until they can't anymore. The FDIC exists to guarantee that you will get cash for that book entry or other cash substitute. The Fed holds stocks of FRNs which it can exchange on a limited basis to commercial banks in danger of running out.

The scale of the pyramid scheme can be measured by the ratio of actual cash to virtual cash. Total cash in circulation (real cash) is $923 billion per the H.4.1 release dated December 10. The amount of virtual cash is the total credit outstanding, which is $52.6 TRILLION as of September 30 per the Z.1 release also dated December 10. In other words, each one dollar of cash is supporting nearly 57 dollars of credit. Through the mechanism of this gigantic naked short position, the value of the underlying security - the US dollar has been driven down to a huge extent. In fact, the short ratio can also be expressed as 98%. Not coincidentally, that is also the extent to which the US dollar's purchasing power has been reduced since the advent of the Federal Reserve.

This gives you some idea of the extent to which the value of the supply of dollars has been diluted by all of the substitutes that have been introduced into the system. If the dollar were a drug, it would be so heavily cut as to have no discernible effect. It also explains the desperation with which the financial world is attempting to save "the system" - by which they mean the machine that issues dollar substitutes and convinces you to accept them. There are sufficient dollars to cover less than 2% of domestic debt outstanding. That takes no account of the naked short positions of foreign banks. The bankers are short 57 dollars for each dollar that actually exists. You can well imagine what would happen if such a short position were to be squeezed to any significant extent.

One can justify banking to the extent than it increases productive capacity and therefore ultimately wealth. The increase in the pool of dollar substitutes will have minimal inflationary impact as that growth will be counter-balanced by an increase in the pool of goods those dollars can buy. This is a social good and one of the few philosophical reasons to support banking. Of course we are long past the point at which such banking was the norm, or even a large minority of credit activity.

The Fed is Broke

Three months ago we published Why Bennie Can't Lend, detailing the Fed's balance sheet and the limitations they were up against. We contended that they were out of cash and unable to sell their bond holdings without serious consequences. That is why their incremental actions have been limited to the TSLF, where they loan out the actual bonds rather than cash. Today, the Fed admitted that we were right all along by arranging for the US Treasury to raise more money for them so they can keep lending via the alphabet soup of liquidity facilities.

The Federal Reserve has announced a series of lending and liquidity initiatives during the past several quarters intended to address heightened liquidity pressures in the financial market, including enhancing its liquidity facilities this week. To manage the balance sheet impact of (ed. - ie. pay for) these efforts, the Federal Reserve has taken a number of actions, including redeeming and selling securities from the System Open Market Account portfolio.

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

http://www.ustreas.gov/press/releases/hp1144.htm

Basically, this is simply another holding action by the Fed to prevent the "fire sale" (actual price discovery) of assets held across many financial institutions. Yet the implications are profound. This would have been a perfect opportunity for the Fed to print money if it had any intention of actually doing so. Yet they did not, even under the extreme pressure of Lehman failing and AIG bailing. Instead they chose to stay within the framework of fractional-reserve banking and they BORROWED instead. If they were going to conjure money out of thin air, this would have been the time to do it and they demurred.

We believe that this is a shock to the market in a number of ways. It clearly demonstrates the limitations of the Fed's power when many market participants believe that power to be virtually unlimited. It shows that the Fed is no different than any commercial bank in this regard - they have to be able to borrow and lend to expand the money supply. They have the advantage of being able to turn to the Treasury in a pinch but they are trying to support asset prices (promoting asset inflation) and they need cash to do it. The Fed either won't or can't create that cash by decree.

Ironically, just as the weaknesses of the Fed's inflationary program are being made clear, the herd is stampeding back into the inflation trades. This appears to be based on the assumption that today's Fed action is inflationary (true on a very small scale) and demonstrates some new power on their part (not true at all). What has been demonstrated is the INABILITY of the Fed to inflate asset prices without the willing cooperation of the market. With sentiment having turned, the best they can hope for at this point is to slow the crash in prices of risky debt used to fund credit expansion. This is a desperate rear-guard action by the Fed

Silent Scream

(editor's note - This blog entry was completed and posted on July 4. The entry date is showing as July 1, as the software uses the date on which the first draft was saved.)


Marc Faber was on Bloomberg TV today and he mentioned that the higher reported consumer inflation rates in Asia were a function of lower per capita GDP and a higher proportion of income spent on food and fuel - which are nearly the only prices that are rising aggressively. Common sense right? But of course that really made me start thinking - always a dangerous prospect.


Asia, Inc.

So Asia's consumer "basket" looks a lot different than that of the average American or Western European. But there are other differences as well. Many Asian nations are resource-poor, major importers of either food, raw materials or both and they depend upon exports of manufactured goods to pay for those imports. Now, let's look at the situation from a slightly different perspective. The industrial sectors of Asian economies look much like any diversified manufacturing enterprise.

Similar to our notional enterprise, these nations' factory sectors buy raw materials and energy. They employ people, paying wages in the process and sell a finished product to a customer. Substitute "import" for buy and "export" for sell and it's actually a pretty good analogy. A few differences, instead of profits, these entities collectively produce a surplus for the nation and they are also responsible for feeding and housing their workforce like an old-fashioned company town to the extent that the workforce doesn't grow its own food.So how do current conditions affect our metaphorical manufacturer? Inputs costs are rising fairly fast overall, with oil being a spectacular example though most increases are far more sedate and a fair number of industrial inputs are falling in price. Just as important, labor costs are rising. This is an obvious corollary to rising living standards and wage costs have been rising by double digits across much of Asia for years. At the same time, demand for many of their products has been weakening as their key markets (US, Europe, Japan) drop into a coordinated recession. So raising prices significantly isn't a solution as they would quickly suffer loss of market share. These factory economies are backed into a corner as surely as domestic manufacturers, with rising costs and falling demand. The Asian suppliers have the additional burden of rising labors costs on top of that. They can choose either lower revenues, lower profit margins (surplus) or some of both.

Now let's look at factors that introduce some added complexity to the model. Instead of cutting wages, nations also have the option to devalue their currency. This effectively reduces labor costs though not other inputs if they are imported. Lower "profits" can take the form of actual margin compression at the individual companies or smaller surpluses in the trade account. The factory sectors of Asia have an additional burden of the industrial surplus having to subsidize food imports - which of course are rising in price fairly quickly also.

What we see then are economies that likely will have to accept either smaller surpluses, lower corporate profits, lower wages, weaker currencies or some combination of the above.


Theory meets fact
Normally, high inflation rates tend to be associated with weakness against other currencies. Rapid declines in domestic purchasing power usually are accompanied by lower international purchasing power - again common sense. This is doubly true if the high-inflation economy does not raise interest rates to restrain demand. CPI equivalents have been high and rising across Asia for some time now, yet the currencies - like most others have been gaining vs. the dollar. To make matters worse, real interest rates in those countries are negative as well and have been for some time. Consumer prices are going up faster in most Asian economies than even the worst-case numbers here in the US - for instance John Williams at Shadow Government Statistics.

It has been odd to see such currencies rising against the dollar but there are several factors that have contributed. First was the differential in growth rates. Second was the perception of deep trouble in the US financial system combined with the impression of unstoppable rise for Asia. Third was the systemic imbalance of trade. Well, now we see that the extenuating factors are all at least beginning to falter. Growth rates are falling across Asia and we believe this is only the beginning of a very deep retrenchment there. The perception has shifted and the false impression that Asia would be immune to the problems of the US has been broken. The terms of trade are also starting to shift as fewer goods are sold to the US and other export markets. US trade deficit remains relatively flat with less of a gap with Asia being offset by higher oil prices.

In light of these factors, we are seeing high CPI and deeply negative real interest rates catching up with many Asian nations. Significant, and in some cases quite large currency reversals have taken place. One of the worst is India, where double-digit CPI, twin structural deficits and a severe slowdown are the story. With CPI pushing 12% and policy rates between 6.0% and 8.5% it's no wonder the Rupee recently reversed - down over 10% vs the dollar this year. Similar situations are brewing in Korea, the Philippines, Thailand, Malaysia and China, not to mention Vietnam. With the exception of still-hyped China, these currencies have lost 5-14% against the dollar from their recent highs. It's taken a while but normal economic relationships seem to be asserting themselves.

As we mentioned above, these economies are in the midst of a squeeze that will push down revenues and profits as well as the currency. Despite significant drops in many regional exchanges, fundamental deterioration can drive this process much further. The potential for a currency kicker on the downside simply makes these markets even more attractive as shorts. Loss of confidence could inspire capital flight, which would devastate both the local stock markets and the currencies. Again, with the exception of China, these nations probably won't have to worry about their currencies being too strong for much longer.

The stock markets and currencies of Asia's industrializing nations are screaming but few people seem to be listening. They were key beneficiaries of the UDB and it's demise will hurt them in direct as well as indirect ways. But that is a subject for another post.


Tea Leaves
So, why does the dollar index still look so weak? The index really isn't a good indicator of the strength of the dollar against the world since it is a trade-weighted index. Note that the Euro accounts for 57.6% of the weight, with both the Pound and the Yen also in double digits. The policies of the Fed have done nothing to help the dollar but at this point, the weakness is just as much a tribute to the ambitions of the EU and Germany's near-pathological fear of inflation as they are the result of incompetence at the Fed (though there is plenty of that). I have almost nothing good to say about the Federal Reserve but they only deserve half of the credit for the decline of the dollar index.

Global Reversal

It's been a few weeks and there's been a bit of excitement surrounding the Fed. But from an economic and credit standpoint, it's largely "sound and fury, signifying nothing." Risk spreads are still wide, lots of high-grade and few low-grade bonds are being issued, market rates (all but the shortest maturities) are higher not lower. Sure, stock markets are rallying on the promise of inflation but the Fed may not be able to deliver, especially since only the Bank of Japan is using the same playbook.

If you look closely, the recent past is very similar to the 1970s. We have rising inflation everywhere, though masked this time using statistical manipulation in the First World. Inflationary credit excess driving unsustainable demand for all kinds of stuff. This benefits rising industrial exporters (Japan then, China now) and commodities producers (OPEC, Chile, Brazil, Canada, Australia, Texas, Alberta and various African nations). We experienced a co-ordinated global boom then, just as now and for the same reasons. In fact, we are currently experiencing the highest sustained rate of global GDP growth since the early 1970s - not a terribly auspicious precedent.

Even with cuts in the Fed funds target rates, the US economy seems to be well along the road to a severe recession. Housing can only be described as collapsing. To those who argue that prices haven't come down much, you are correct - that comes later. Prices are sticky in housing since the average market participant is poorly informed. Price declines often continue well after a bottom in sales and construction. Just given what's happened already, we can look forward to 18-24 months of falling prices.

Predictably, lending against depreciating collateral isn't terribly popular and the initial effects of less EZ credit are being seen in the first small drops for consumer spending and retail sales. The declines would have been worse without rapid growth of credit card balances.

The Federal Reserve reported that consumer credit rose at an annual rate of 5.9 percent in August, the biggest increase since a 7.9 percent jump in May.

The increase was led by an 8.1 percent leap in revolving credit, the category that includes credit card loans.

This will get much worse for at least a year. With consumer spending now accounting for an unprecedented 72% of the economy, the vulnerability to a consumer spending slowdown is obvious. Of course American consumers have been spending money they don't have for the last 5 years and the engine for excess spending - the housing bubble has been sputtering and has now shut down.

What's fascinating is that similar dynamics are now being seen overseas. Many nations have experienced simultaneous housing bubbles and their associated wealth effects. A number of them are now rolling over in credible imitations of the US housing market of 2006. What ties them all together is credit. Live by the (credit) sword, die by the sword. It hasn't hit the inflation boom economies yet but it very likely will.

UK Builders
UK Lenders
Australia
New Zealand
Ireland
Spain

There's evidence of housing rolling over in such diverse locations as Sri Lanka, the Baltic States and Thailand. Once again, the only common thread is a deflating global credit bubble.

First Principles

Well, it's been one heck of a week. With all of the insanity going on around us, sometimes it's best to take a step back and return to first principles. One of those is the Business Cycle - you know that thing that the Fed has supposedly abolished? The two questions that come to mind immediately are "why did the cycle exist?" and "how did the Fed get rid of it?"


The first one is easy. Economic cycles have existed throughout our history and always will exist as long as emotional humans are making economic decisions. The National Bureau of Economic Research has tracked US economic cycles going back to the mid-19th century. In the immediate postwar period, the cycles became more predictable as the Fed began to regulate them and induce the occasional recession to purge excesses before the market did it for them. During this period, it was discovered that the cycle could be manipulated though not controlled. The typical pattern was roughly three years of expansion, followed by a 12 month recession. The only major exception was the long expansion which lasted through most of the 1960s. The excesses from that one contributed to the really ugly decade that followed - and I'm not just talking about disco and afros for white guys either.

Unfortunately, other than Paul Volcker the Fed seemingly learned little from that experience. After Saint Paul imposed a painful but effective remedy for inflation, his successor Alan Greenspan embarked on a policy of continuous credit expansion. This has "worked" in the sense that economic growth was sustained over a long period, few setbacks were encountered and those were short and shallow. But the price was a crumbling economic foundation. Consumption became the dominant basis of the economy. Consumption growth was funded first with falling savings, then with growing debt. The major collapses in the savings rate came during the 1990s as it fell from 7% to 2% and again after 2002 when it went from 2% to negative.

We essentially outsourced the necessary but burdensome job of saving to Asia. Few economists seem to have drawn any connection between the outsourcing of manufacturing and of savings. Manufacturing requires investment and investment requires savings. It would seem reasonable that the nations which save and invest in the real economy (not just financial paper) would increase their manufacturing and that seems to be the case. The US is left with little savings, heavy debt, bad loans and a weakened manufacturing base. The cycle has not been abolished. It has simply been stretched and distorted beyond all recognition.