Wednesday, August 31, 2005


An absolutely wonderful article by Andie Xie of Morgan Stanley which very nicely describes the delinking of inflation from monetary stimulus. A must read in gaining understanding of the missteps of the 90's. Essentially, he is saying that central bankers throughout the world created excess money supply, because the classic measures of inflation were not rising. This was probably due to IT enabled productivity gains as well as the global labor arbitrage. However, rampant inflation was there all the time. It just happened to be in the asset economy, and this is the connumdrum the world finds itself in. How to reign in the excess liquidity without destroying the whole world order.

Andie Xie

Tuesday, August 30, 2005

For Whom the selling bell Tolls

Mr. Toll, I congratulate you on making an enormous amount of money. I believe you are doing the right thing by dumping your own stock. I hope you can you some of the proceeds to defend yourselves from all the future lawsuits.

Monday, August 29, 2005

Credit Crunch?

Having digested AG's comments for a few days, I have come up with what I believe is the Fed's ultimate strategy in deflating the housing bubble. He is talking about liquidity/credit "drying up", if "investors" want more of a risk premium. Namely, the Asians will not want to buy our GSE/MBS without more of a risk premium. This along with decrease purchasing of our Treasuries, I think, could cause credit to dry up. And, it seems rather obvious, that at this point, it is excess credit that is driving the leading edge of this bubble. Once credit dries up, and the marginal/highly leveraged buyer will no longer have access to easy money, it will really grease up the property ladder. Obviously, they are going to try to engineer a contolled descent. And perhaps on a national level, in the aggregate, it will be. However, in the bubble zones, I think people will be really hurt. C'est La Vie.

Sunday, August 28, 2005

Back from the Jersey Shore!

I just got back from a week with the family down at the Jersey Shore. I have been going there for 30 or so years. It is my observation that I have never seen so many people down there. I can only conclude that this is the trickle down effect of the cash out refi craze. The most exciting thing, obviously, from the last week were the comments from AG. The housing market is in his crosshairs. The stage is set for the showdown between the housing bulls and bears (and bond bulls and bears for that matter). I cannot agree with him more that there is a tremendous amount of arrogance from the finance community. I still do not sense any anxiety from people regarding the potential risks in the market. I think while the flippers in Florida are more concerned about the hurricane, they may not understand the wealth vortex that is approaching them. With the new bankruptcy laws, many people will not be able to just walk away. Chapter 7 may just be a dream. I wish it didn't have to come to this, but 10 years of living in sin have to be made up for by 10 years in repentance. The probably senario:

House prices down:
Taxes up:
Trade deficit down:
Budget defecit down:
Savings rate up:
Service economy down:
Manufacturing up:
Dollar down, but not out:
Asset Deflation:
Commodity Inflation:
Republicans out:
Democrats in:
Pain - Moderate to Severe!

Sunday, August 21, 2005

Is money going to be more expensive?

Another article pointing to increasing inflationary pressures in England, and thus less likelyhood of further rate hikes. Credit excess lead to inflation, so it's inflation's job to soak up the excess credit. This again does not bode well for the highly leveraged property market. No free lunch!

A problem of Olympic proportions.

There may well be another series of events to worsen the property markets in England. Just as their bubble has seemingly cooled off, and there is much less demand, they have also received the Olympic Games. Concurently, there is a spike in commodity prices leading to increased costs of construction. This will obviously increase inflationary pressures, perhaps causing the BOE to raise rates more. This can only worsen the property market. Interesting.

Saturday, August 20, 2005

Irrational Exuberance.

Nice to see the NYT mentioning Schiller's fine work. Bubble, bubble toil and truble.

Alan, Alan, Who art thou?

Nice article from the observer chronocling AG's tenure.,6903,1553111,00.html

Friday's stream of consciousness

What do I know and when did I know it? There is definitely increasing chatter about rising inventory and perhaps some moderation in prices in certain regions of the country. Certainly, I don't see anything breaking in NJ. However, it seems to me that the condo market is getting itself into a little bit of trouble. That is the first place where we will see an oversupply, and thus a changing of the supply-demand dynamics. My best guess is that this is where we will see the first hit. I believe it will become apparent in the late Fall/early Winter. If the problems in condoland spill over into the credit markets, that is when we may start seeing problems on a larger scale. Real estate is illiquid, that is it's strength, but it is also it's weakness. Speculators owning multiple units will not be able to all run for the door, hoping for a greater sucker to bail them out. It just cannot happen. This kind of supply side shock would really knock the door down on this debacle. On the deman side, AG has to contininue to increase rates to squeeze the life out of the marginal creditors/debtors. I think a soft landing is only possible on a national scale. The hot market are going to get killed. It is unavoidable. A great wealth vortex will be created as speculators start rushing for exits en masse. Pride cometh before the fall.

Friday, August 19, 2005

What does your family owe?

Very nicely written article about our profligate ways. Each family owes $145,000, not including credit card debt. Let's see, if median income is about $58,000, and our savings rate is 0.02% that equals about $11. $145,000/$11 = approx 13,000 years. Yeah, I think it's doable. Perhaps by the next ice age, we will be debt free. Or, a better idea. We'll have a recession, we will take away $145,000/family of equity built in their house and send it to the Asians. Or, we'll raise taxes to 80% to pay for today's fancy living. Or, our country will default on it's debt and just say oops., sorry. Our bad. I just don't see an attractive solution. But, time will tell.

Thursday, August 18, 2005

Oh Canada....

Our great white neighbors to the north have no reason to be politically correct. That why this report from TD bank financial group is so interesting. See for yourself!

Vulture fund ready to pounce.

Nice article from NYT about an investor who specializes in bankrupt debt. His track record, according to the article, is excellent. He is convinced that logic will prevail and we will start seeing a large number of bankruptcies within the next 12 months. Others in the article disagree, so it will be interesting to see.

Paper Tiger

Nice article from FT about AG:

Short View: Greenspan - to love him or fear him?
By Stephen Schurr
Published: August 18 2005 20:19 | Last updated: August 18 2005 20:19

Candidates to succeed Alan Greenspan as US Federal Reserve chairman should be asked one question: would you rather be feared or loved?


Chairman Greenspan is widely loved. He has piloted the Fed during nearly two decades of robust economic expansion and market appreciation. Thanks to massive stimulus, the post-bubble suffering has been far less painful than previous hangovers.

Of course, there is an anti-Greenspan contingent that says he has been blithely accommodative of rampant speculation. This led not only to the stock market bubble of the late 1990s, but also to today's housing bubble. The more irreverent have taken to calling him "Easy Al".

Paul Volcker, Mr Greenspan's predecessor, was not always loved - but he was feared at times. Faithful to the notion that the Fed's main role is to take away the punch bowl just as the party gets going, Mr Volcker embarked on a difficult but necessary mission to tame the inflation beast through severe interest rate increases.

Critics of Mr Greenspan, whose 18-year tenure comes to a close in January, contend that he never removed the punch bowl, but at best stood near it and explained to party-goers how ill they might feel tomorrow morning.

The problem is that people don't always listen. Mr Greenspan has been warning that people still engaged in pursuits such as the carry trade - short-term borrowing to invest in longer-dated debt - amid rising interest rates must be "desirous of losing money". But animal spirits are undimmed. That suggests to some that Mr Greenspan lacks the necessary ability to scare the market.

Because of this, the Fed's interest rate increases may cause short-term rates to rise above longer rates - forming an inverted yield curve that almost always presages a recession. Mr Greenspan has said an inverted yield curve may no longer be an effective forecasting tool, but such "new era" predictions are always troubling.

Mr Volcker may have been feared at times, but by the time he left the Fed he was widely loved. The irony of Mr Greenspan's tenure may be that he spent most of it loved, but may depart feared - or at least something less than loved.

Up to your eyeball in debt.

Another interesting AP article. It examines the first time home "buyer" in California, and the degree of leverage they are undertaking to get into the home "buying" game. A realtor is quoted as saying that "these people have seen that anybody who bought real estate in the last 10 years has made a lot of money". Half of these poor people have taken an "exotic" mortgage. I just don't understand why they don't see the dangers. I am sure the government thought they could control this bubble much better than they could control the stock bubble, but the lesson is the same. A little bit of greed is good, but once you let the genie out of the bottle, you can really open up a Pandora's box. How is this going to be reconciled? It's obvious that a lot of people, a lot of young families, are going to be hurt. Is it really worth it. We could of just bit the bullet a few years ago, have our recession and come out of it guns ablazing. Instead the government chose this path. Well we will see how this all shakes out. I cannot see a senario in which this will end without trajedy.

Tuesday, August 16, 2005

Housing Affordability Index

I was just scanning the NAR website at and found an interesting spreadsheat. It is their affordability index for 2002-2005. Besdies the obvious trend of plummeting affordability, it is amazing to see the discrepency in affordability throughout the country. What struck me is how crazy it is out West. Median priced home is $323,200 and Median family income is $57,849. The price is 5.58xincome. WOW! Not surprisingly, the index is lowest for the West at 80.8. Then comes the Northeast with median price home of 247,900 and median incomd of 63,334. A paultry 3.9x income with affordability index of 114. The South and Midwest bring up the rear. As an east coast guy, I can see why so many of the bloggers are from the West coast. It is outrageous. Even more outrageous than here on the East Coast. Anyway, it obviously the willingness of people to leverage themselves, along with easy availability to credit, which is causing this artificial demand. As interest rates rise, and the marginal buyers get squeezed, this thing will start to unwind. Anyway, it obvious that there is a lot more "chatter" about the bubble on the net. The R.E. bubble T shirt headline made it to Yahoo front page. However, until people hear stories that their friends lost money, the herd will not be stopped. Don't swim against a rip tide, to survive it's best to swim to the side. Keeping a close eye.$FILE/REL0506A.pdf


We all know that inflation makes us poorer. But, the question is how does the government define inflation? Oil? Wages? I think this is the real conundrum. Before the fall of the Berlin Wall, when we still had a closed system, excess credit/money supply resulted in classic "inflation". Once 3 billion people (including India) became free to compete for the low paying jobs, and with the advent of the internet, all inflation numbers seemed low. It was a Goldilocks economy. But what about asset inflation? This is the $64,000 question. When stocks were going up 20% a year, inflation was "low". As real estate is going up 20% a year, inflation is "low". I think once the bubble pops, central banks throughout the world should readjust their measurements of inflation to include anything that decreases your purchasing power. It is my understanding that the CPI was adjusted so that home prices, stock prices, energy and food are not included. I think all of this will have to be reassessed. But as allways, there is no action without crisis first.

Monday, August 15, 2005

Modern English?

I guess every generation has to make sacrifices for their country. The burden this English generation has is to pay off tremendous debt it incurred at the incitation of government policy. This article nicely explain how much debt this generation has accrued. Anyway, I guess it's better than being sent to charge German machine guns.

Sunday, August 14, 2005

To Russia with love!

The poor Russians who pay for everything with cash have not yet discovered that you can live way beyond your means with the help of CREDIT! This is a great article, because it shows with what avarice the credit companies are trying to get into this market. Therefore, one must conclude that being a creditor is a lucrative business.

More bond shenanigans.

Interesting post from Bloomberg about bond traders decreasing their bets on flattening yield curve. Evidently, a lot of money was made playing the flattening yield curve lately, but they are supposedly decreasing exposure to this trade. Perhaps this points to rising long term rates.??

Counter View.

This is an article with a counter, supply-side view.

Friday, August 12, 2005

Bond Thugs!

Interesting article about bond bubble in US. Explains nicely how Fed's policy of low interest rates pumped up bond prices/real estate prices, and how cary trade became profitable for joe six pack. If they are correct, it does not portend well for US economy. No wonder the Pimco boys are up in arms.

One for the scrapbook.

Another nice article by NYT chronicling the housing bubble. No new ground broken, but still interesting.

Friday's stream of consciousness

For those of us who have been waiting for rising interest rates, this week was brutal. What the hell happened to 10y. yields this week (down around 3 %). It was a great week for bond investors/re bubble heads. I am now starting to understand that these are two head of the same beast. Who will come and slay this credit Hydra. There are obviously great opposing forces at play here. Who is in control? Who has the leverage? Killing this beast will not be easy. 70% of Americans are "home owner" (though equity is all time low). Although it may not be in our short term financial interest to bust this bubble, there is no doubt in my mind that long term it is a must. We cannot become the country of the United Real EStates of America. Then surely this empire will decay. As mighty China is emerging with huge industrial/intellectual capacity, this nation stands self-absorbed in real estate speculation. Real Estate as a college major? Are you kidding me? When house will become home again, and people regain their sanity (sobriety is common after losing money), perhaps we can start rebuilding our manufacturing base. I am sure we are up to the challenge. This is a great country. BUT! We must kill the beast!

WSJ reports on rising inventory!

The number of homes available for sale has increased sharply in some of the nation's hottest real-estate markets -- one of several recent signs suggesting that air may be seeping out of the frenzied U.S. housing market.

Home prices have surged an average of about 50% in the U.S. in the last five years, largely thanks to the lowest mortgage interest rates in more than four decades and what has been a shortage of available homes in many markets. But some economists and housing-industry analysts believe supply is catching up with demand -- a trend that could cause home-price appreciation to slow down in the months ahead.

In San Diego County, for instance, where the median home price has more than doubled in the last five years, the number of homes listed for sale totaled 12,149 on July 8, more than twice the 5,995 available a year earlier, according to the San Diego Association of Realtors.

In northern Virginia, an area dominated by the fast-growing suburbs of Washington, inventories are up 26% from a year earlier. "Sales have slowed down for sure," says Tip Powers, president of Realty Direct Inc., Sterling, Va. He says home prices have flattened out and speculators are starting to shy away from the market because they no longer can count on quickly unloading properties at a profit.


The McMansion Expansion
A similar rise is being seen in Massachusetts, where home inventories are up 31%, according to officials of real-estate organizations there. Real-estate brokers say inventories also are up in such markets as Chicago, Las Vegas and Orlando.

To be sure, housing demand has appeared to stall at previous moments in the boom only to pick up steam again. Judging the strength of the housing market is especially tricky in August, which is normally a slow month for home sales because so many people are on vacation. A year ago, inventories also were up at this point in the year, but supplies grew tighter in some cities later in the year and prices kept surging.

Economists and real-estate analysts say they won't be able to determine whether the market as a whole is slowing until September or October at the earliest, and note that housing conditions vary among communities.

Home builders continue to report strong sales and order backlogs in the new-home market. The National Association of Realtors recently reported that its index of pending sales in June was up 3.6% from a year earlier. (A sale is pending when a contract has been signed but the transaction hasn't been completed.)

Still, signs of a possible peak are appearing, perhaps in part a reaction to widely publicized warnings from Federal Reserve Chairman Alan Greenspan about "froth" in the housing market and a torrent of media reports about the "housing bubble."

"We're beginning to see that the housing market is cooling a little bit," says Mark Vitner, senior economist at Wachovia Bank in Charlotte, N.C., "but I stress a little bit."

The National Association of Realtors reported that 2.7 million "existing," or previously owned, homes were available for sale in June, up from 2.4 million a year earlier. At the current brisk rate of sales, the latest supply figure was enough to last 4.3 months, still considered a fairly small amount but up from 4.1 months a year earlier. If the sales rate slows, the inventory would start to look more plentiful.

"We're hearing from some really big Realtors that there is a little slowing [in the housing market] this month," says David Lereah, the chief economist for the Realtors' association.

If mortgage interest rates keep rising, as they have recently, home sales will slow, says Mr. Lereah. "Many times I have said housing has peaked, and I was wrong," he says. "Still, I think we've peaked and we will come down a little bit."

Meanwhile, builders have been putting up new homes at a breathtaking pace. New homes that either were completed or under construction totaled 354,000 in June, up from 320,000 a year before, according to the Census Bureau.

So far, many home builders say they can't keep up with demand and aren't worried about inventory levels. While they note that orders for new homes are soft in a few markets, such as Denver, South Carolina and the Washington area, there's continued strength in San Francisco, Las Vegas, Phoenix and South Florida.

But, warns Ivy Zelman, a housing analyst at Credit Suisse First Boston in New York, "If the music stops and the sales rate declines, then you're going to have a lot more supply" of new homes on the market.

Several factors point to a possible cooling of the market. Mortgage interest rates have been edging higher in recent weeks, raising the cost of purchasing a new home and knocking some potential buyers out of the market. The average rate for a 30-year fixed mortgage is 5.89%, said Freddie Mac, a mortgage-finance company, this week. That's up from 5.53% in late June.

In some markets, such as California and Florida, prices have surged past the ability of many people to afford a home. Additionally, banking regulators have begun to raise questions about whether mortgage lenders are being prudent enough -- which eventually could prompt some lenders to tighten credit standards.

House prices have continued to rise partly because some lenders have promoted loans that help people buy houses they otherwise couldn't afford. For instance, Countrywide Financial Corp., the nation's largest mortgage lender, says that about a fifth of its home loans so far this year have been "pay option" mortgages. These loans give borrowers the option of delaying any repayment of principal and even paying less than the interest due some months, which results in a rising balance due.

But if regulators keep raising questions about the risks of such loans, that could push some potential home buyers out of the market, reducing demand, says Ms. Zelman.

George McCabe of Brown & Partners, an advertising and public-relations firm that compiles housing data, says that as prices continue to rise fast, more people are putting their homes on the market. "People want to cash there is a lot of competition for resales," he says. He still sees the housing market as strong, adding: "We're just in an adjustment period."

At Wachovia, Mr. Vitner says supply and demand for houses are beginning to move into better balance. "That doesn't mean prices will be a bargain," he says. "It may mean they won't continue to rise in double-digit rates."

Ms. Zelman of CSFB says that prices in some cities are likely to decline at least modestly once the housing boom ends. She noted that housing booms in the late 1980s led to falling prices a few years later in California and New England.

--Jessica E. Vascellaro contributed to this article.

Write to James R. Hagerty at and Kemba Dunham at

Thursday, August 11, 2005

China Syndrome!

Nicely written article by Robert Reich, former Clinton Secretary of Labor. So China makes stuff, creating manufacturing jobs, and sells to us, who buy it with cash out refi money. In order to have that cash out refi, China buys our Treasuries to keep interest rate low, thereby perpetuating our housing bubble/consumerism. We deindustrialize and consume, while they build an empire. We are sacrificing tomorrows standard of living, for todays consumption. The great wealth machine that is our housing bubble will ultimately make us poor, because business investment is non existent. Our future: No jobs/ just houses???? Alan, when are you going to fix this mess!

Wednesday, August 10, 2005

Ownership Society!

Now it's starting to come together. There will be no bust until October, because of the new bankruptcy bill. From a nice article on

Tougher homestead exemptions: Currently, if you declare bankruptcy, the state where you file may allow you to protect from creditors some or all of your home equity. In Florida, for instance, your home may be entirely exempt, even if you bought it soon before filing. In Nevada, you may exempt up to $200,000.

The new law, however, places more stringent restrictions on the homestead exemption. For instance, if filers haven't lived in a state for at least two years, they may only take the state exemption of the state where they lived for the majority of the time for the 180 days before the two-year period.

Filers may only exempt up to $125,000, regardless of a state's exemption allowance, if their home was acquired less than 40 months before filing or if the filer has violated securities laws or been found guilty of certain criminal conduct.

Unlike most of the other provisions, the new homestead exemption rules go into effect immediately.


Obviously, when President Bush is talking about an ownership society, he must be talking about owning your debts!

Tuesday, August 09, 2005

Bernake watch.

From today's economic press conference in Texas:

Q Did the housing bubble come up at your meeting? And how concerned are you about it?

DIRECTOR HUBBARD: Let me let Ben answer that question.

CHAIRMAN BERNANKE: We talked some about housing. There's a lot of good news on housing. The rate of homeownership is at a record level, affordability still pretty good. The issue of the housing bubble is one that people have -- whether there is a housing bubble is one that people have raised. Housing prices certainly have come up quite a bit. But I think it's important to point out that house prices are being supported in very large part by very strong fundamentals.

And particularly, we have a strong economy, we have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas. And those supply-and-demand factors are a big reason for why housing prices have risen as much as they have.

I think over a period of time, the housing prices are likely to stabilize. I don't expect them to keep rising at this rate indefinitely; I don't think anybody really does. But, again, I do think that the bulk of the increases are associated with strong economic fundamentals.


My favorite quotes:
we have lots of jobs.
high incomes
very low mortgage rates

Please refer to previous blog!

Hey, Ralph Cramden had an appartment!

The National Housing Conference made a nice statistic of how short of income regular working people are in their attempts to buy a home. This is just another example of the ridiculousness of the market. It used to be a woman could stay home to be a homemaker, is she chose to do so. Now, you need two incomes just to buy a house. The government is stealing the money from working people/middle class and giving it to the wealthy people. This is all part of Greenspan's legacy. i.e. the enromous CONCENTRATION of wealth. I don't know if it his fault, but it was certainly his responsibility. We have become like "old" Europe. An asset oligarchy.

NAR-ly dude!

Hey, I can't think of the right word. Vacilation. Ambivolence. Ambiguity. The NAR said sell now, but buy later, or buy now and finance better or do anything you think is right depending on how you feel. Just don't blame us when you get taken to the cleaners.

NAR President Al Mansell, of Salt Lake City, said housing shortages persist. “Because there is such a tight supply of homes available for sale, we’re now projecting the national median existing-home price this year to rise at a double-digit rate, which will be the strongest rate of price growth in 25 years,” he said. “It’s a great time to sell, but it may be a better time to buy about a year from now when the market should come closer to balance. However, postponing a purchase for another year would mean higher borrowing costs, so there are advantages to getting in now – it all gets down to a buyer’s needs, resources and time horizons.”

Lets see if we can use logic:

A. Housing shortages persist because of low supply for sale.
B. Projecting median home prices to rise at strongest rate in 25 years.
C. It's a Great Time to Sell!
D. BUT It will be a better time to buy NEXT YEAR when market will be more in Balance
E. However, If you wait, borrowing costs will be higher
F. Therefore: There are advantages to buying now

In Conclusion, You can buy now and pay a higher buying price with lower financing costs or you can wait till next year and buy at a lowere price with higher financing costs. Therefore, I am a double talking salesman who just covered my ass in both directions.

P.S. It is alway better to buy when money is expensive, because the collaterolizing asset is less.

Monday, August 08, 2005

It's absolutely pathetic.

We are told that illegal immigrants take the jobs that Americans won't take. So perhaps it only makes sense that illegals will take the loans that no American would (or at least should) take. In a bizare policy, banks are after illegal immigrants to sell them on the "American Dream". I wonder if the parties buying the MBSs from these "lenders" know that the customers are illegal immigrants. Pathetic!

Ivana Trump Tower! Are you joking?

Can I have a condo named after me too?

Sunday, August 07, 2005

Aussie land!

Hey mates, throw another shrimp on the barbie!

A must read.

Great article in NYT by Krugman!

An English preview!

It's just sad.

It just makes you feel sorry for young people who are desparate to "own" a home. On the other hand, the professionals who are part of the feeding frenzy should go to jail. Any mortgage originator/underwriter who approves these types of loans should be fired, fined and prosecuted. Loose lending standards and low interest rates are the only "fundamentals" driving this titanic now.

Very well stated.

This article articulates very well the underlying problem.

The wealth of nations?

Adam Smith is turning over in his grave!

South Beach Diet?

It's just easy money! No effort or brains necessary!

Saturday, August 06, 2005

Original Sin by Stephen Roach

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the US central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories. The problem is that this recasting of macro is very self-serving. It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles. The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind. It all began with Alan Greenspan’s worries over “irrational exuberance” on December 5, 1996, when a surging Dow Jones Industrial Average closed at 6437. The subsequent Fed tightening in March 1997 was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy -- consumers and businesses alike. It was a classic example of the Fed playing the role of the tough guy -- the central bank that, to paraphrase the words of former Chairman William McChesney Martin, “takes away the punchbowl just when the party is getting good.” Unfortunately, the tough guys weren’t so tough after all. Predictably, there was a huge outcry on Capitol Hill as the Fed took aim on the US stock market. But rather than stay the course as an independent central bank should, the Fed ran for cover in the face of political criticism. Not only were its initial bubble-containment efforts put aside, but Alan Greenspan went on to champion the notion of a sea-change in the macro climate -- a once-in-a-century productivity miracle that would justify the stock market’s exuberance as rational. That was the Original Sin that has since been compounded in the years that have followed.

Out of that pivotal moment in the late 1990s, a New Economy actually did come into being. But it was not the new economy of ever-accelerating productivity growth that infatuated the New Paradigm Crowd and legions of equity-market speculators. Instead, it was the Asset Economy that enabled consumers and businesses to draw on the pixie dust of a new source of purchasing power -- asset appreciation -- as a means to augment what has since turned into a stunning shortfall of organic domestic income generation.

Unfortunately, the asset-based spending model has given rise to many of the distortions and imbalances evident in the US today. That’s especially true of low saving rates, the housing bubble, high debt loads, and a runaway current account deficit. When the equity bubble burst, asset-dependent American consumers barely skipped a beat. Courtesy of an extraordinary shift to monetary accommodation, the pendulum of asset depreciation quickly swung into property markets; US house-price inflation has since surged to a 25-year high. To the extent that equity extraction from ever-rising property appreciation was viewed as a substitute for organic sources of labor income generation, hard-pressed consumers went deeply into debt to monetize the windfall. As a result, household sector indebtedness surged to nearly 90% of US GDP -- an all-time record and up over 20 percentage points from levels in the mid-1990s when the Asset Economy was born. Secure in the asset-driven spending posture that resulted, consumers saw no need to save the old-fashioned way out of earned labor income. That’s why the personal saving rate has collapsed and currently stands near zero. Asset-based consumption is also at the core of America’s current-account problem. In an income-based accounting framework, the “missing saving” has to come from somewhere. In this case, that “somewhere” is the foreign saver -- giving rise to the current-account and trade deficits required to attract the foreign capital. As a result, the US current-account gap probably exceeded 6.5% of GDP in the first quarter of 2005 -- easily another record and well in excess of the 4% deficit prevailing in the mid-1990s.

This whole story, in my view, remains balanced on the head of a pin of absurdly low real interest rates. And the Fed has certainly been pivotal in nurturing this low-interest-rate regime. In an extraordinary display of policy accommodation, the real federal funds rate is only now moving above the zero threshold after having spent three years in negative territory. Of course, a central bank has little choice to do otherwise if it has made a conscious decision to underwrite the Asset Economy. After all, it takes low interest rates to provide valuation support to most financial assets -- initially stocks, then bonds, and now property. Furthermore, it takes low rates to make refi debt -- and the equity extraction it sponsors -- look attractive from a carrying cost perspective. Low rates also discourage income-based saving by underscoring the paltry returns available to savers in traditional asset classes. A migration to riskier assets -- such as property and “spread” products (i.e., high-yield and emerging market debt) -- is encouraged as a result. And low real rates make it easier to finance an ever-widening current-account deficit -- especially if the incremental flows come from foreign central banks, where there is reason to tolerate subpar returns in exchange for currency competitiveness. In short, without low real interest rates, the Asset Economy -- and all of its inherent imbalances and excesses -- is nothing.

The Fed is not only hard at work in the engine room in keeping the magic alive with a super-accommodative monetary policy but is has also become the intellectual architect of the New Macro. Time and again, since Alan Greenspan rolled out his New Paradigm theory in the late 1990s, senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy. The examples are far too numerous to mention, but consider the following highlights:

* Chairman Greenspan has made light of traditional measures of household indebtedness -- even going so far as to urge consumers to move from fixed to floating rate obligations (see his February 23, 2004, speech, Understanding Household Debt Obligations. Note: All references are to speeches available on the Fed’s website at

* Fed governors have also borrowed a page from the Roaring 1990s in denying the possibility of a housing bubble (see Chairman Greenspan’s October 19, 2004, speech, The Mortgage Market and Consumer Debt, and Governor Kohn’s April 1, 2004, speech, Monetary Policy and Imbalances).

* More recently, an army of senior Fed officials -- namely, Chairman Greenspan, Vice Chairman Ferguson, and Governors Bernanke and Kohn -- have unleashed a veritable broadside against the time-honored notion of the current-account adjustment (see their various 2005 speeches, especially Governor Kohn’s April 22 speech, Imbalances and the US Economy, Vice Chairman Ferguson’s April 20 speech, U.S. Current Account Deficit: Causes and Consequences, and Chairman Greenspan’s February 4 speech, Current Account).

* Governor Bernanke has also led the charge in coming up with a new theory of national saving -- that the United States is actually doing the world a favor by absorbing a so-called glut of global saving (see his April 14, 2005, speech, The Global Saving Glut and the U.S. Current Account Deficit); Vice Chairman Ferguson has been on a similar wavelength in dismissing concerns over subpar personal saving (see his October 6, 2004, speech, Questions and Reflections on the Personal Saving Rate).

Is this is an appropriate role for a central bank? In my view, absolutely not. The problem with an activist central bank is that decision makers in the real economy -- consumers and businesspeople alike -- mistake the Fed’s point of view for strategic advice. And so do financial market participants. After hearing the Fed pound the table, consumers feel left out if they don’t spend their housing equity. Business managers felt equally deprived in the late 1990s if their companies didn’t achieve the dotcom-type valuations in the stock market that Chairman Greenspan insisted in the late 1990s and even early 2000 were well grounded in a once-in-a-century productivity miracle. The resulting overhang of excess IT spending was a direct outgrowth of this perceived deprivation. Needless to say, when investors and financial speculators saw the equity train leave the station and the Fed condone the high growth of a productivity-led economy by leaving interest rates low, they saw no reason to believe that a bubble was about to burst. When consumers hear from a Fed chairman that it makes little sense to take on fixed rate debt, they rush to floating rate instruments; not by coincidence, the adjustable rate portion of newly originated mortgage debt shot up in the immediate aftermath of Chairman Greenspan’s comments on consumer indebtedness. And should asset-dependent, saving-short, overly indebted American consumers feel at risk if the Fed assures them that there is no housing bubble -- that the asset-based underpinnings of their decision making are well grounded? A record consumption share in the US economy -- 71% of GDP since 2002 versus a 67% norm over the 1975 to 2000 period -- speaks for itself.

The rhetorical flourishes of America’s central bankers have dug the US economy -- and by definition, a US-centric global economy -- into a deep hole. To this very day, the Fed has never confessed to the Original Sin of condoning the equity bubble. On the contrary, Greenspan & Company have been on the defensive ever since by dismissing the increasingly dangerous repercussions of the original post-bubble shakeout. Far from playing the role of the tough guy that is required of independent central bankers, the Fed has become an advocate of the easy money of a powerful liquidity cycle. One bubble has since begotten another -- from equities to bonds to fixed income spread products (i.e., emerging market and high-yield debt) to property. And financial markets have gone along for the ride -- not just in the US but also around the world as global investors and foreign central banks have rushed with reckless abandon to finance America’s record current-account deficit.

The day is close at hand when US monetary policy must get real. At a minimum, that will require a normalization of real interest rates. Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone -- possibly as high as 5.5%. Yes, this would cause an outcry -- perhaps similar to that which occurred in the spring of 1997 on the occasion of the Original Sin. But in the end, there may be no other choice. Fedspeak has taken us into the greatest moral hazard dilemma of all -- how to wean an asset-dependent system from unsustainably low real interest rates without bringing the entire House of Cards down. The longer the Fed waits, the more perilous the exit strategy.

We're turning Japanese!

How Japan financed global reflation
By Richard Duncan
FinanceAsia February 2005

In 2003 and the first quarter of 2004, Japan carried out a remarkable experiment in monetary policy – remarkable in the impact it had on the global economy and equally remarkable in that it went almost entirely unnoticed in the financial press. Over those 15 months, monetary authorities in Japan created ¥35 trillion. To put that into perspective, ¥35 trillion is approximately 1% of the world's annual economic output. It is roughly the size of Japan's annual tax revenue base or nearly as large as the loan book of UFJ, one of Japan's four largest banks. ¥35 trillion amounts to the equivalent of $2,500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime.

Why did this occur? There is no shortage of yen in Japan. The yield on two year JGBs is 10 basis points. Overnight money is free. Japanese banks have far more deposits than there is demand for loans, which forces them to invest up to a quarter of their deposits in low yielding government bonds. So, what motivated the Bank of Japan to print so much more money when the country is already flooded with excess liquidity?

The Bank of Japan gave the ¥35 trillion to the Japanese Ministry of Finance in exchange for MOF debt with virtually no yield; and the MOF used the money to buy approximately $320 billion from the private sector. The MOF then invested those dollars into US dollar- denominated debt instruments such as government bonds and agency debt in order to earn a return.

The MOF bought more dollars through currency intervention then than during the preceding 10 years combined, and yet the yen rose by 11% over that period. Historically, foreign exchange intervention to control the level of a currency has met with mixed success, at best; and past attempts by the MOF to stop the appreciation of the yen have not always succeeded. They were very considerably less expensive, however. It is also interesting, and perhaps important, to note that the MOF stopped intervening in March 2004 just when the yen was peaking; that the yen depreciated immediately after the intervention stopped; and that when the yen began appreciating again in October 2004, the MOF refrained from further intervention.

So, what happened in 2003 that prompted the Japanese monetary authorities to create so much paper money and hurl it into the foreign exchange markets? Two scenarios will be explored over the following paragraphs.

In 2002, the United States faced the threat of deflation for the first time since the Great Depression. Growing trade imbalances and a surge in the global money supply had contributed to the credit excesses of the late 1990s and resulted in the New Paradigm technology bubble. That bubble popped in 2000 and was followed by a serious global economic slowdown in 2001. Policy makers in the United States grew increasingly alarmed that deflation, which had taken hold in Japan, China and Taiwan, would soon spread to America.

Deflation is a central bank's worst nightmare. When prices begin to fall, interest rates follow them down. Once interest rates fall to zero, as is the case in Japan at present, central banks become powerless to provide any further stimulus to the economy through conventional means and monetary policy becomes powerless. The extent of the US Federal Reserve's concern over the threat of deflation is demonstrated in Fed staff research papers and the speeches delivered by Fed governors at that time. For example, in June 2002, the Board of Governors of the Federal Reserve System published a Discussion Paper entitled, "Preventing Deflation: Lessons from Japan's Experience in the 1990s." The abstract of that paper concluded "...we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal- should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity."

From the perspective of mid-2002, the question confronting those in charge of preventing deflation must have been how far beyond the conventional levels implied by the base case could the economic policy response go? The government budget had already swung back into a large deficit and the Federal Funds rate was at a 41 year low. How much additional stimulus could be provided? A further increase in the budget deficit seemed likely to push up market determined interest rates, causing mortgage rates to rise and property prices to fall, which would have reduced aggregate demand that much more. And, with the Federal Funds rate at 1.75% in mid- 2002, there was limited scope left to lower it further. Moreover, given the already very low level of interest rates, there was reason to doubt that a further rate reduction would make any difference anyway.

In a speech entitled, "Deflation: Making Sure 'It' Doesn't Happen Here", delivered on November 21, 2002, Federal Reserve Governor Ben Bernanke explained to the world exactly how far beyond conventional levels the policy response could go. Governor Bernanke explained that the Fed would not be "out of ammunition" just because the Federal Funds rate fell to 0% because the Fed could create money and buy bonds of longer maturity in order to drive down yields at the long end of the yield curve as well. Moreover, he said, "In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices."

He made similar remarks in Japan in May 2003 in a speech entitled, "Some Thoughts on Monetary Policy in Japan". He said, "My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt-so that the tax cut is in effect financed by money creation." These speeches attracted tremendous attention and for some time financial markets believed the Fed intended to implement the "unorthodox" or "unconventional" monetary policy options Governor Bernanke had outlined.

In the end, the Fed did not resort to unorthodox measures. The Fed did not create money to finance a broad-based tax cut in the United States. The Bank of Japan did, however. Three large tax cuts took the US budget from a surplus of $127 billion in 2001 to a deficit of $413 billion in 2004. In the 15 months ended March 2004, the BOJ created ¥35 trillion which the MOF used to buy $320 billion, an amount large enough to fund 77% of the US budget deficit in the fiscal year ending September 30, 2004. It is not certain how much of the $320 billion the MOF did invest into US Treasury bonds, but judging by their past behavior it is fair to assume that it was the vast majority of that amount.

Was the BOJ/MOF conducting Governor Bernanke's Unorthodox Monetary Policy on behalf of the Fed? There is no question that the BOJ created money on a very large scale as the Fed would have been required to do under Bernanke's scheme. Nor can there be any question that the money created was used to buy an increasing supply of US Treasury bonds being issued to finance the kind of broad-based tax cuts Governor Bernanke had discussed. Moreover, was it merely a coincidence that the really large scale BOJ/MOF intervention began during May 2003, while Governor Bernanke was visiting Japan? Was the BOJ simply serving as a branch of the Fed, as The Federal Reserve Bank of Tokyo, if you will? This is Scenario One.

If this was globally coordinated monetary policy (unorthodox or otherwise) it worked beautifully. The Bush tax cuts and the BOJ money creation that helped finance them at very low interest rates were the two most important elements driving the strong global economic expansion during 2003 and 2004. Combined, they produced a very powerful global reflation. The process seems to have worked in the following way:

US tax cuts and low interest rates fuelled consumption in the United States. In turn, growing US consumption shifted Asia's export-oriented economies into overdrive. China played a very important part in that process. With a trade surplus vis-à-vis the United States of $124 billion, equivalent to 9% of its GDP in 2003 (rising to approximately $160 billion or above 12% of GDP in 2004), China became a regional engine of economic growth in its own right. China used its large trade surpluses with the US to pay for its large trade deficits with most of its Asian neighbors, including Japan. The recycling of China's US Dollar export earnings explains the incredibly rapid "reflation" that began across Asia in 2003 and that was still underway at the end of 2004. Even Japan's moribund economy began to reflate.

Whatever its motivation, Japan was well rewarded for creating money and buying US Treasury bonds with it. Whereas the BOJ had failed to reflate the Japanese economy directly by expanding the domestic money supply, it appears to have succeeded in reflating it indirectly by expanding the global money supply through financing the sharp increase in the MOF's holdings of US Dollar foreign exchange reserves. There is no question as to if this happened. It did. The only question is was it planned (globally coordinated monetary policy) or did it simply occur by coincidence, driven by other considerations?

What other considerations could have prompted the BOJ to create ¥35 trillion over 15 months? A second scenario is that a "run on the dollar" forced the monetary authorities in Japan to intervene on that scale to prevent a balance of payments crisis in the United States. This is Scenario Two.

During the Strong Dollar Trend of the late 1990s, foreign investors, both private and public, invested heavily in the United States. Those investments put upward pressure on the dollar and on US asset prices, including stocks and bonds. The trend became self-reinforcing. The more capital that entered the US, the more the dollar and dollar denominated assets rose in value. The more those assets appreciated, the more foreign investors wanted to own them. Because of the large sums entering the country, the United States had no difficulty in financing its giant current account deficit, even though that deficit nearly tripled between 1997 and 2001.

By 2002, however, with the US current account deficit approaching 5% of US GDP, it became increasingly apparent that the Strong Dollar Trend was unsustainable. The magnitude of the current account deficit made a downward adjustment in the value of the dollar unavoidable. At that point, the Strong Dollar Trend gave way and the Weak Dollar Trend began. Foreign investors who had invested in US dollar denominated assets during the late 1990s naturally wanted to take their money back out of the United States once it became clear that a sharp correction of the dollar was underway. Moreover, many US investors, and hedge funds in particular, also began selling dollar- denominated assets and buying non-US dollar-denominated assets to profit from the dollar's decline.

The change in the direction of capital flows can be seen very clearly in the breakdown of Japan's balance of payments.

The preceding chart shows the balance on Japan's current account and financial account, the two principle components of Japan's balance of payments, going back to 1985. Traditionally, Japan runs a large current account surplus and a slightly less large financial account deficit, with the difference between the two resulting in changes (usually additions) to the country's foreign exchange reserves.

Beginning in 2003, however, there was a startling change in the direction of the financial account. Instead of large financial outflows from Japan to the rest of the world, there were very large financial inflows. For instance, in May 2003, Japan's financial account reflected a net inflow of $23 billion into the country. The net inflow in September was $21 billion. These amounts increased considerably during the first quarter of 2004, averaging $37 billion a month.

The capital inflows into Japan at that time were massive, even relative to Japan's traditionally large annual current account surpluses. But, why did Japan, which normally exported capital, suddenly experience net capital inflows on a very large scale in the first place? The most likely explanation is that very large amounts of private sector money began fleeing the dollar and seeking refuge in the relative safety of the yen.

When the Strong Dollar Trend broke, had the BOJ/MOF not bought the dollars that the private sector sold in such large quantities, the United States would have faced a balance of payments crisis, in which, in addition to having to fund a half a trillion dollar a year trade deficit, it would have had to find a way to fund a deficit of several hundred billion on its financial account as well.

Any other country facing a large shortfall on its balance of payments would have experienced a reduction in its foreign exchange reserves. The United States, however, maintains only a limited amount of such reserves; only $75 billion as at the end of 2003, far too little to fund the private capital outflows occurring at that time.

Once those reserves had been depleted, market-determined interest rates in the US would have begun to rise, in all probability, popping the US property bubble and throwing the country into recession. Under that scenario, a reduction in consumption in the United States would have undermined global aggregate demand and created a severe world-wide economic slump.

The US current account deficit more or less finances itself since the central banks of the surplus countries buy the dollars entering their countries to prevent their currencies from appreciating and then recycle those dollars back into US dollar-denominated assets in order to earn interest on them.

Large scale private sector capital flight out of dollars presented the recipients of that capital with the same choice. The central bank of each country receiving the capital inflow had the choice of either printing their domestic currency and buying the incoming capital or else allowing their currency to appreciate as the private sector swapped out of dollars. The European Central Bank chose to allow the euro to appreciate. The Bank of Japan and the People's Bank of China chose to print yen and renminbe and accumulate the incoming dollars to prevent their currencies from rising. If some central bank had not stepped in and financed the private sector capital flight out of the dollar, then sharply higher US interest rates most likely would have thrown the world into a severe recession. It is quite likely that this consideration also played a role in influencing the actions of the Japanese monetary authorities during this episode.

The BOJ/MOF stopped intervening in March 2004. By that time, the Fed had indicated that it planned to begin tightening interest rates. That put a stop to the private sector capital flight out of the dollar. Therefore no more intervention was required. At the same time, by the end of the first quarter of 2004, it was becoming clear that strong economic growth in the US was creating higher than anticipated tax revenues. That meant a smaller than expected budget deficit. In July, the President's Office of Management and Budget revised down its estimate of the budget deficit from $521 billion to $445 billion. The actual deficit turned out to be $413 billion. Thus less funding was required than initially anticipated.

So, what did motivate the monetary authorities in Japan to create the equivalent of 1% of global GDP and lend it to the United States? Was it simply, straightforward self interest to prevent a very sharp surge in the value of the yen? Was it globally coordinated monetary policy designed to pull the world out of the 2001 slump and prevent deflation in the United States? Or, was it necessary to stave off a US balance of payments crisis that would have produced a global economic crisis?

Perhaps it was only straightforward foreign exchange intervention to prevent a crippling rise in the value of the yen. Intentionally or otherwise, however, by creating and lending the equivalent of $320 billion to the United States, the Bank of Japan and the Japanese Ministry of Finance counteracted a private sector run on the dollar and, at the same time, financed the US tax cuts that reflated the global economy, all this while holding US long bond yields down near historically low levels.

In 2004, the global economy grew at the fastest rate in 30 years. Money creation by the Bank of Japan on an unprecedented scale was perhaps the most important factor responsible for that growth. In fact, ¥35 trillion could have made the difference between global reflation and global deflation. How odd that it went unnoticed.

This should have helped give you yet another perspective on Asia and our current account deficit.

Your watching the global flow of money analyst,

John F. Mauldin

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