The End of Denial: Trouble for the Global Economy

By: Michael Hampton | Mon, Oct 4, 2004
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Commodities are surging, as the Property Correction Begins

Most of the advanced economies of the world have experienced a massive property boom over the past several years. This boom was touched off by two main factors: First, a shift in investment away from equities, after the tech boom of the end of the last Millennium turned to a stock market bust in early 2000. And secondly, an attempt of the US Federal Reserve, and other central banks to rescue the world from an economic slowdown by keeping interest rates at low levels, not seen for decades. The magic elixir has worked, and the economy kept moving. Low rates encouraged homeowners to refinance and top-up their loans, putting the money into refurbishment and spending on consumer goods. And many of those goods came from China, the world's workshop. China will be an important part of the Debt Bubble story, as it unfolds from here.

Cheap money has made it easier to buy and build new homes, and so house prices have surged. The UK has seen a 104% rise in houseprices since December 1999. And a 71.8% rise in Greater London, a hotspot where prices now average £244,628 ($440,000), perhaps the highest for any major city in the world. To some, this looks like a virtuous cycle. Easy money pushes up property prices, and this makes it possible for homeowners to borrow more money, because their collateral value in their homes has increased. Price increases begat price increases, as confidence grew in the upward trend. Newcomers stretched to "get onto the property ladder" before it was too late. The bull psychology, and aggressive lending have built the UK property bubble to a point where the cost of a new home with a full 100% mortgage may be at least 50% more expensive than renting. This is unsustainable. Once the expectation of further capitals gains, prices should fall back towards levels where they can be justified by rental costs.

In years gone, banks would reduce a speculative froth, by tightening lending terms. But not this time. With central banks pumping out cheap money, banks looked for ways to lend it out. Housing seems an ideal risk for a hungry lender. There are two apparent sources of payback: the homeowner can pay regular mortgage payments out of his income, or the loan can be retired when the house is sold. So mortgage loans seem safe. And there are few balance sheet constraints. The banks need not hold the loans on their books. They can "securitise" them, and sell them off in packages of mortgage-backed bonds, keeping a nice fat spread for their trouble. So banks, rather than tightening, have tooled up their money machines, lending on softer terms: at higher percentages of advance, and often accepting "self-certification" from borrowers concerning their ability to repay the loan from income.

Every bubble is built on easy credit. And this one is no different. The well-oiled and efficient money machines, pumping out the housing loans, have added an extra leg to the great debt bubble which has been growing since the early 1950's.

The bubble has now reached in excess of 300% of Global GNP. The previous high was 270% in the early thirties. A 200% level on the eve of the 1929 stock market crash, was pushed higher, not through a surge in lending, but rather due to a swift fall in global GNP, as the negative repercussions of the stock market crash rolled through the 1930's economy. The bubble diminshed back to the previous level of 120% of GNP during the late thirties and forties, as debts were written off, and as individuals and corporations became more risk-averse and lost their appetite for credit. Now that the levels has pushed to 300%+, which is above those historical levels, the risk of a global "train wreck" must be taken seriously. A drop in property prices would be a particurlarly worrying affair, because a huge part of that debt is housing related.

China has an important role in the Bubble story. Cheap Chinese goods have helped greatly to sustain low inflation rates. The factories in the most-populous nation have been able to grind out the goods the world wants at very competitive prices. This has meant an export of industrial jobs from countries like the US and the UK. Fortunately, those jobs have been mostly replaced by new jobs in the financial, retail and distribution sectors of the advanced economies. On the surface it looks as if the "invisible hand" is working, and each country is concentrating upon its competitive advantages. But if the UK and US had to produce more of what they buy, what would the cost of those home-made goods be?

It is deeper down, in the structure of the economy, and the instability of money flows where the real risks lie. Politicians and government economists find it easy to ignore the vulnerabilities. Because to talk about growing risk, is to point the finger at oneself. And even when not in power, to warn about them prematurely, may mean losing a job or an election.

Back in the old monetarist days, a strong economy like China would show its strength by buying gold with its foreign currency reserves, and letting its currency appreciate. It could then benefit, because raw material imports when expressed in that strong currency would get cheaper - so long as the currency appreciation exceeded the commodity price inflation. China is not doing this. It has a huge balance of payments surplus with the US, and so does Japan. The money is not going into gold, it is going back into the US, as the Chinese and Japanese have become the largest buyers of US Treasury bonds. This sterilises the powerful impact of positive trade balances, because there is an nearly equal flow in both directions: the of dollars going out for goods, is the nearly the same as is coming back for the purchase of Treasuries. In effect, the Chinese and Japanese are exporting goods, while the US is exporting paper. And this ongoing flow has enabled the Debt Bubble to continue to grow at an alarming rate, while Chairman Greenspan sits in front of Congress and tells them about how his monetary policy has restored healthy growth to the US economy.

An economy which relies upon the export of paper money, is not strong, it is getting weaker. And an economy which produces few of the commodities and the goods that its populace needs, is vulnerable to a cutoff or repricing of those imports. The US discovered this vulnerability in the mid-1970's and again in 1980, when oil prices shot up, and the western world suffered the most serious economic downturn since the great depression. Are we about to see a third crisis? One with a similar cause and potentially graver consequences?

OIL chart
WTI Crude : rising dramatically

Chart courtesy of

Oil prices hit a new all time high last week, and look poised to push through $50 in coming days, on their way to $55, $60, or whatever. Meantime gas prices are also rising, and so are metals like copper and lead, which are near their highs for past several years, and have dangerously low levels of inventories.

Copper charts
Stocks Low, Prices rising:

These price shocks mean that Americans are being hit by what amounts to an extra sudden tax burden on their economy. The rise in energy prices is an important reason that the US is suffering slow economic growth, and that has so-far helped to bring down yields in Treasury bonds, as the classic response to slower growth is lower interest rates. Meanwhile, short term rates in the US remain near record lows, and the Fed is slowly pushing them up, not lowering them.

The US central bank has painted itself into a corner. It has committed itself to a gradual tightening, to restrain the dangers of further house price rises. Now it is hit with a commodity price driven inflation that it can do little to stop. Fed governors must be worried that those commodity pressures may soon spillover into a higher CPI, which would damage the bond market. Greenspan's balancing game, has gone on for a long time, and the wire he walking upon is getting narrower. He may soon be tripped up from an unexpected side. China or Japan may decide to divert a portion of their cash surpluses away from the US bond market. If that happened would could see a simultaneous drop in the dollar and a rise in US long term rates. The benefits to the Far Eastern economies is that a weaker dollar would enable them to buy more oil and commodities for their stronger yen and reminbi. But it would risk touching off a downward spiral in the US economy. Perhaps pressure from Washington is keeping them from making this move at least until after the election. The US may be in for a harsh surprise, if they discover that the oil market has a mind of its own, and foreign trade partners cannot counternance a $50 oil price without some adjustment of their currencies.

Meantime, the vulnerability of the property market to adjustments of its own remains a severe threat. In the UK, which may lead the US in this regard, property prices have risen to a dangerous level. Speculation and hype have pushed prices beyond what can be justified based upon the income yield. The Bank of England is pushing its short term rates higher, so the low yields cover smaller amounts of mortgage. It is now substantially cheaper to rent than it is to buy. And a fall of 30-40% may be required to put them back into balance.

The current state of the UK Property market can be assessed through a financial instrument which is unique to the UK: Property Futures. These are traded by a handful of firms, who make markets for individuals and traders who are hedging their homes, or want to take a view on the future progress of house prices. Of particular interest is the contract which settles against the Greater London index, as released by Halifax on a quarterly basis. The price of this contract peaked in late April, when the property-buying hysteria was at its greatest. Since then, it has fallen by about 11%.

What is particularly interesting is the chart sequence. Technical analysts talk about the importance of the "head and shoulders" patterns. In this chart, the Head was the late April high. This was followed by a rapid descent of about 8% into an early July low, creating a "neckline", which is identified as a light blue line. Since then, there was a sideways move covering some 10 weeks, and that ended a few days ago. Last week, we saw a collapse back below the neckline. According to technical analysts, that suggests a sharp fall may lie just ahead. The pattern does not guarantee anything. The futures may bounce back into the recent trading range, and invalidate the signal. But that seems unlikely. Newpapers this past weekend are full of stories talking about how sentiment has changed, and buyers have now grown very cautious. The cozy feelings about future price increases will not easily return, particularly in the face of an economy weakened by commodity price inflation. The likely situation in the days ahead is that: builders will make price cuts, banks will tighten lending standards, and the market fall will take on a momentum of its own.

The chart contains a warning about how severe downturn could become. The Black Downtrend is falling at about £4,000 per month. So if this downtrend continues for 24 months, and stays on the line for two years, then Greater London prices would have fallen to below £160,000. That's a two year fall of 36%. (The previous fall, in 1989 to 1993, lasted over 4 years.) Meantime, the current chart suggests prices may accelerate to the downside for at least a few weeks. But markets do not normally stay in channels for long, so the market may bounce, cross the black line, and invalidate the bleak forecast of a fall of more than one-third.

In summary, the prosperity of the last few years has been predicated upon a huge build up of debt, and a boom in property prices. Like the work of a cowboy builder, cracks have been papered over. The has left us with a Debt Bubble, and a set of uncomfortable vulnerabilities to shocks of various natures, which range from rising rates to higher inflation and terrorist threats. Many experts, media commentators and politicians have been in denial about the debt and property bubbles. Now that denial may be coming to an end. The recent rise of energy prices to fresh highs, and property prices falling through trendlines, suggest that the big bubble is about to be pricked.


Michael Hampton

Author: Michael Hampton

Michael Hampton

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