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June 24, 2005

Crippling Wealth
by Kurt Richebächer

Let us start with a quote from Friedrich von Hayek: "The means of perception employed in statistics are not the same as those employed in economic theory." American economists think far too much in statistical terms, regardless of underlying economic processes. While the statistics do, indeed, show general enrichment, in reality, there is none at all. The homeowner has zero gain in his comfort of living or income.

This perception of wealth has its true basis in nothing but the famous "greater fool theory"; that is, in the expectation that there will be a greater fool to buy the acquired house later at a higher price. Deluded by this wealth chimera, private households have run down their savings and piled up astronomic debts to be repaid with future earned income.

Where, then, are the economic benefits? The one obvious visible benefit is in the push to GDP growth from higher consumer spending, which also increases current incomes. Yes, but much of that spending on cars, furniture and houses is borrowed from the future. That is, the borrowing pulls future spending into the present, but, of course, at the expense of such spending in the future.

If you think it over, you realize that in reality, such a borrowing/spending bubble adds nothing to economic growth. It only distorts the time pattern of spending in relation to its long-term trend, as in the case of the consumer determined by the underlying rate of income growth.

The second problem is that such a bubble distorts and deforms the direction of demand and production in the economy. Consider these grossly disproportionate increases in U.S. domestic spending since 2000: consumer durables +30.8%, residential building +29.5%, nonresidential investment +5.8%, imports +23.5%, exports +5.8%.

Strikingly, all economies with housing bubbles have features in common that were, in the past, generally associated with ailing economies. These are collapsed savings; skyrocketing debts; chronic, large trade deficits; and booming residential investment, but weak business investment.

This coincidence is not accidental. The common denominator of these countries is runaway consumer spending. That is the key point. The big spending excesses in these countries are in consumption, while business fixed investment is in the doldrums. Policymakers and economists in the countries with these symptoms are the first in history to proclaim that people and nations become richer with consumer borrowing-and-spending binges.

Consumption never creates wealth. It is categorical: Capital decreases when consumer spending exceeds production. What is happening in these countries is the exact opposite of wealth. It is capital consumption in the sense that consumption absorbs a growing share of GDP at the expense of investment and the trade balance.

On the macro level, this is impoverishment. As a matter of fact, it is statistically easily verifiable. It shows in the comparison of soaring U.S. foreign indebtedness to the lagging growth of the domestic capital stock, as measured by net capital investment.

U.S. net foreign debts are increasing at an annual rate of around $700 billion, or 6% of GDP. The available data for America's net fixed investment end in 2003; in that year, net private domestic investment amounted to $529.9 billion, or 4.8% of GDP. Of this total, residential building accounted for 3.4% of GDP and nonresidential investment for 1.4%.

Traditional economic thinking assumes that higher consumer spending stimulates businesses to increase their spending on capital investment and employment. This went badly wrong. It has not been realized that excessive consumption, taking up a rising share of GDP, has the exact opposite effect of depressing savings, investment and the trade balance through well-known crowding-out processes.

If you think all this over, you will realize that the American economic reality on the macro level is not record wealth creation, but national impoverishment, foreboding a declining living standard. Take the borrowed import surplus away, and U.S. living standards collapse.

Among the industrialized countries, Japan and Germany are the two great exceptions that have missed the global housing bubble. Japan is still struggling with the aftermath of its building bubble in the late 1980s, while Germany is struggling with the building bubble that developed in eastern Germany in the wake of unification.

Yet speaking of a global housing bubble, we hasten to emphasize again that there is one all-important difference in such bubbles. There are countries where rising house prices have been isolated events in the price system without significant effects on the economy, and there are countries where the housing bubbles have become the dominant influence both on the economies and financial systems.

This really is the dividing line between bubble economies and nonbubble economies.

The inflating house prices in Europe have even failed to prevent a slow decline of consumer spending. Consumers maintained their high saving rates.

Now one question: What does this aversion to consumer borrowing have to do with monetary and fiscal policies? What does it have to do with fundamental economic weakness? Absolutely nothing.

It has to do with a traditional cultural aversion in Europe to consumer borrowing for purposes other than building or buying a house.

And of course, it is stupid to believe that this aversion can be broken with still lower interest rates. In the first place, it robs the savers of income on their large mass of existing savings. It will shock them. The crucial difference to see is that Europeans are primarily savers, while people in Anglo-Saxon countries are primarily borrowers.

Consumption-driven bubble economies reveal themselves at first through sharply falling personal savings. Their second typical, yet spectacular, hallmark is large trade deficits.

In the end, the main question is, of course, what happens when a housing bubble expires. As to be expected, Mr. Greenspan and the bullish consensus deny the possibility of a hard landing. A little logic says that such a landing is inevitable.

An illuminating case in this respect is the very recent experience in the Netherlands. While traditionally a country highly conservative in its finances, it developed a housing bubble in 1998-99, after years of strong economic growth. House prices and credit growth soared at double-digit rates. As homeowners cashing in on their burgeoning home equity went on a spending spree, the household savings rate plunged from 12.9% of disposable income in 1998 to 6.8% just two years later.

As the Dutch central bank raised its short-term rate from 2.5% to 4.5% from 1999-2000, house price inflation came to an abrupt halt. Household borrowing and mortgage equity withdrawal slumped sharply.

Being deprived of their "wealth effects," the Dutch people returned to saving from their current income. Within just three years, the personal savings ratio was back to 12%, driving the Dutch economy into the worst recession among the industrialized countries. The growth rate of consumer spending sagged in a straight line from 4.7% in 1999 to minus 1.2% in 2003.

We have recalled this episode to emphasize one point of greatest importance, yet one that is widely ignored. The Dutch example confirms that for consumer spending to slump in the wake of a fading housing bubble, house prices do not need to fall at all. It is sufficient that they stop rising, thereby depriving households of new wealth effects and the associated borrowing facilities.

Therefore, major housing bubbles imperatively end in a hard landing. A second major adverse influence on economic growth implicitly arises from the sudden cessation of the building boom. Yet the worst looming problem is always the potential damage to the banking system through escalating bad loans.

On Dec. 5, 1996, when Alan Greenspan made his famous remark about possible "irrational exuberance" in the stock market, he asked a rhetorical question: "How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?"

For a central banker, that is really a most astonishing question. With some knowledge in macroeconomics, bubble economies - in the sense that asset bubbles impact the economy - are most easily identifiable. Consider that last year, the United States had recorded an overall credit expansion of $2,718.6 billion, versus virtually zero national saving. As you can see, the simple clue is in the relationship between soaring credit and collapsing savings.

P.S. As of last year, Americans were holding onto $37 trillion in debt - more than $123,000 for every man, woman and child in the United States. This amount of debt is more than three times the total number of dollars in existence anywhere - in home and business equity, checking and savings accounts, stock markets and even those held by foreign investors (66% of all dollars are held by foreign investors, by the way). If all of this debt comes due, there literally isn't enough money on Earth to pay it.

Regards,

Dr. Kurt Richebächer
The Daily Reckoning

A version of this essay was first published in the free daily e-mail: The Daily Reckoning.

Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

Copyright © 2003-2007 Kurt Richebächer

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