Irreparable Cracks in the Financial System

Email Print


A well-respected
independent economist and strategist with a bearish trait told me
recently that he wished he could be bearish, but that he couldn’t
find anything that he thought would disturb the asset markets and
the global economy in the foreseeable future. Looking at the “real”
global economy and at what people produce in terms of manufactured
goods and services (ex-financial services), I would have to agree.

Comparing the
current global economic expansion, which began in the US in November
2001, with previous economic expansions, it seems to me that the
“real economy” isn’t showing any signs of the overheating that,
in the past, led to aggressive central bank monetary tightening.
So, I am, like my strategist friend with the bearish trait, also
impressed by the prospects for the global economy. However, I am
increasingly concerned about the inflated asset markets around the
world, and about the almost unanimous belief that nothing will ever
come between the “Goldilocks” economic conditions and the Fed, in
conjunction with the US Treasury standing ready to support markets
should they decline meaningfully and disturb the current heavenly
asset market conditions.

Let us examine
the differences between the “real economy” and the “asset inflation
economy” more closely. The real economy is typical of people’s daily
lives, their income, and their spending. If there is a boom in the
real economy, wages and prices will tend to increase and the increased
demand will be met by corporations’ increased capital spending.
The overheated economy eventually brings about a slowdown or a recession,
because money becomes tight irrespective of the central bank’s monetary
policies. The recession then cleans up the system and allows the
next expansion to get under way. Put very simplistically, this is
the typical business cycle.

In the asset
inflation economy, we are dealing with a totally different phenomenon.
The higher the asset markets move, the more the increased asset
prices can create liquidity. Let us assume an investor owns a real
estate or stock portfolio worth 100 and that his borrowings are
50. For whatever reason (usually easy monetary conditions), the
value of the portfolio now doubles to 200. Obviously, this allows
the investor, if he wants to maintain his leverage at 50% of the
asset value, to double his borrowings to 100. With the additional
50 in buying power, the investor can then either spend the money
for consumption (as the US consumer has done in the last few years)
or acquire more assets.

If he acquires
more assets, the investor will drive the asset markets – ceteris
paribus – even higher, which will allow him to increase his borrowings
further. Now, I am aware of some economists who will dispute the
fact that rising asset markets create liquidity. They argue that
the seller of a portfolio or real estate or stocks at an inflated
price will have to be met by a buyer at the inflated price. So,
the increased liquidity of the seller is offset by a diminished
liquidity of the buyer. However, the situation isn’t quite that
simple. Let us assume we are dealing with the market for Van Gogh’s
paintings, and let’s assume that with the exception of just three
works, Van Gogh’s paintings are all in the hands of museums, foundations,
or dedicated art lovers who wouldn’t consider selling them except
under the most unusual circumstances. Now enter the Russian oligarch
who wishes to acquire a Van Gogh at any price. He might pay double
the previous price paid for a Van Gogh, for one of the three paintings
still available on the market. As a result of this one buyer, every
Van Gogh work will now need to be revalued, and, in theory, all
the owners of Van Gogh paintings could now increase their borrowings
against the value of those works.

Two works by
Van Gogh now remain on the market, one of which a hedge fund manager
and an oil sheik from the Middle East both wish to acquire. In a
bidding war, they push the price of that painting up another 100%
above the previously paid price. Again, all of Van Gogh’s works
will need to be revalued and their owners can increase their borrowings
against them. In other words, the buyers on the margin can move
asset markets sharply higher in the absence of ready sellers and
thus increase, through the additional borrowing power of the works’
present owners, the overall liquidity in the system.

Under normal
circumstances, the increased borrowings by the present owners would
drive up interest rates. However, in a world of rapidly expanding
money supply, this may not be the case. Moreover, which owner of
a Van Gogh wouldn’t mind paying 6% instead of 4.5% interest on his
loans if Van Gogh’s paintings were appreciating by 30%, or even
100%, per annum? (This is one reason why the Fed doesn’t believe
it can control spiralling asset prices with monetary policies.)
In the real world, we are not dealing with just one Van Gogh market,
but with many asset markets, but the point is that the marginal
buyers set the price for assets. It should also be clear that not
every owner of a Van Gogh will use his borrowing power and leverage
his works of art or other assets.

But if an asset
bull market has been in existence for a while, more and more investors
will become convinced that the up-trend in asset prices will never
end and, therefore, they will increasingly use leverage to maximize
their gains. But not only that: lenders will also become convinced
that asset prices will rise in perpetuity at a higher rate than
the lending rate, and they will therefore relax their lending standards.
This certainly seems to have occurred in the sub-prime lending industry.

There is one
more point to consider. Liquidity isn’t evenly distributed. Let’s
say that on an island there are two tribes. Ninety-nine percent
of the population are the “Bushes” and 1% are the “Smartos."
The two tribes arrived on the island at about the same time and
had little capital at the time. So, initially, both tribes worked
very hard in industry and in commerce to acquire wealth. But because
of the Smartos’ superior education and skills, their frugality,
and also partly because of their greed and immorality, they soon
acquired significantly more wealth than the Bushes, who, for the
most part, were likeable but quite inept. After 50 years, most of
the island’s businesses were therefore in the hands of the Smartos,
who make up just 1% of the population. Being clever, the Smartos
generously gave some of their wealth to the tribal leaders of the
Bushes, who controlled the entire government apparatus, the military
establishment, and much of the land.

For a while
this system functioned perfectly well. Among the Bushes there were
also some smart people, and they were encouraged to accumulate wealth
as well. However, they had to pay an increasingly high price to
acquire assets, since most of the island’s assets were owned by
the Smartos
and by the elite of the Bushes who, because of their wealth, never
really had to sell any assets. Cracks in the system began to appear
because more and more of the wealth began to be increasingly concentrated
in fewer and fewer hands. (According to the Financial Times,
the concentration of wealth is extremely high in the United States,
with 10% of the population currently holding 70% of the country’s
wealth, compared to 61% in France, 56% in the UK, 44% in Germany,
and 39% in Japan.)

However, the
Smartos then stumbled upon another avenue to wealth: globalization.
The island was opened to foreign trade and investments, which allowed
the business owners to shift their production to low-cost foreign
countries and, at the same time, to keep the masses among the Bush
tribe happy through the imports of price-deflating consumer goods.
In the same way that, in the 18th and 19th centuries, the European
settlers of America had exchanged with the Indians worthless beads
and booze for land, now the Smartos and the elite of the Bushes
exchanged cheap imported goods, whose supply they controlled and
from which they earned handsome margins, for assets. As a result,
the majority of the population of the Bushes experienced a relative
wealth decline compared to the wealth of the Smartos.

Again, this
worked perfectly well for a while: the populace was happy to buy
deflating consumer goods (like Mr. Faber’s wife who, whenever a
favorite shoe store holds a sale, immediately buys three pairs instead
of one), but it overlooked the fact that its wages and salaries
were decreasing in real terms because manufacturing jobs and tradable
services were increasingly shifting overseas. For some time this
wasn’t a problem, because the Smartos had bought the island’s central
bank. They
made sure that sufficient money was made available to the system
to sustain the consumption binge, which was largely driven by inflating
asset prices. Plenty of liquidity and rising asset prices created
among the Bushes
the “illusion of wealth." Naturally, the island’s trade and
current account deficit began to worsen as it consumed significantly
more than it produced, but initially that wasn’t a problem, for
the Smartos had encouraged the Bushes to engage – in the name
of all kinds of good, just, and well-meant causes, and without any
self-interest whatsoever – in overseas military expeditions,
which led foreign creditors to believe in the island’s economic
and military might, and social stability.

For a time,
they were, therefore, perfectly happy to finance the island’s growing
current account deficits. At the same time, the increase in defense
spending shifted wealth from the masses to the elite of the Bushes,
who largely controlled the military hardware and procurement industries.
As a result, wealth and income inequity widened further as the masses
became largely illiquid and had difficulty in maintaining their
elevated consumption, while the Smartos and the elite of the Bushes
accumulated an ever-increasing share of the national wealth. But
never at a loss when it came to creating additional wealth, the
Smartos devised another scheme to enrich themselves even further:
lending to illiquid households (read sub-prime lending). Not that
the Smartos would have lent their own money to these uncreditworthy
individuals (they were far too clever for that); for a fat fee,
they arranged and encouraged this novel type of financing. Credit
card, consumer, and mortgage debts were all securitized and sold
to pension funds and asset management companies whose beneficiaries
were the majority of Bushes, who accounted, as indicated above,
for 99% of the population.

In addition,
these securitized products were sold to some credulous foreign investors.
By doing so, the Smartos achieved three objectives. They earned
large fees, and unloaded the risks indirectly onto the very people
who borrowed the money, and onto foreigners. But most importantly,
they provided the Bush tribe with a powerful incentive to support
their expansionary monetary policies, which ensured continuous asset
inflation. After all, any breakdown in the value of assets would
have hurt the Bushes the most, since they carried most of the risks
by having purchased all the securitized lower-quality financial
instruments. But not only that! The Smartos knew that as asset prices
increased, their prospective returns would diminish.

But this wasn’t
an immediate problem, as they promoted increased leverage to boost
returns to the investors and at the same time their own fees. This
strategy worked, of course, for as long as asset prices appreciated
more than the interest that needed to be paid on the loans. On first
sight, the debt- and, consequently, asset inflation-driven society
of the island seems to work ad infinitum. But in the real world
this isn’t the case. Sooner or later, the system becomes totally
unbalanced and entirely dependent on further asset inflation to
sustain the imbalances. It is at that point that even a minor event
can act as a catalyst to bring down asset prices and produce either
“total," or at least “relative," illiquidity in the system,
because a large number of assets whose value has declined no longer
cover the loans against which they were acquired. “Total illiquidity”
occurs when the central bank, faced with declining asset prices,
doesn’t take extraordinary measures to support asset prices.

“Relative illiquidity”
follows when the central bank implements, in concert with the Treasury,
extraordinary monetary and fiscal policies (cutting short-term interest
rates to zero, and the aggressive purchase of bonds and stocks)
in a desperate effort to support asset prices. In both cases, a
degree of illiquidity occurs and depresses asset prices, but in
different ways. In the case of “total illiquidity” (1929–1932
and Japan in the 1990s), asset prices tumble across the board in
nominal and real terms with the exception of the highest-quality
bonds and, possibly, precious metals (flight to safety). In the
case of the island’s central bank taking extraordinary monetary
measures, asset prices don’t necessarily decline in nominal terms,
and in fact can even continue to appreciate.

However, they
collapse in real terms, and against foreign currencies and precious
metals. How so? Above, we have seen that the island’s asset inflation
led to excessive consumption and to growing trade and current account
deficits because the Smartos and the elite of the Bushes were quick
to understand that much larger capital gains could be obtained by
playing the asset inflation game and by manufacturing overseas,
than by investing in new production facilities and producing goods
on the island.

The growing
trade and current account deficits of the island were not immediately
a problem, because they were offset by external surpluses in other
parts of the world, which were frequently and erroneously labeled
as “surplus savings” or a “savings glut." But whatever one
wishes to call these surpluses or reserves, it is interesting to
note that where they accumulated (mostly in China, Japan, Taiwan,
Singapore, and Switzerland), they led to an interest rate structure
that was lower than on the island. For the Smartos, this was an
extremely fortuitous condition. For one, it was easy to convince
the recipients and holders of these rapidly accumulating reserves
to invest them in higher yielding assets on the island. In addition,
it was for a while extremely profitable to borrow in low-yielding
foreign currencies and to invest in relatively high-yielding assets
on the island.

this all changed when asset prices began to decline and the island’s
central bank had to take extraordinary measures by aggressively
cutting short-term interest rates and supporting asset markets through
bond and stock purchases. The interest rate cuts immediately narrowed
the spread between the interest rate on the island and foreign currencies
and led to a run on the island’s currency, not only by foreigners
but also by the Smartos, who had known all along that the asset
inflation game would one day come to a bitter end. The deleveraging
of this carry trade led to “relative illiquidity," which the
island’s central bank had to offset with even more liquidity injections,
which while stabilizing asset prices led to even greater loss of
confidence in the soundness of the island’s currency, and in its
bond market, which by then was mostly owned by foreign creditors.

As Mao Tse
Tung had observed much earlier, there was by then “great disorder,"
but the situation was “excellent” for the Smartos. On the short
end, interest rates had been cut so much that they were in no position
to compensate for the continuous depreciation of the island’s currency.
So, the Smartos and the Bush tribe’s elite began increasingly to
borrow in the island’s currency and to invest in foreign assets
and precious metals. In fact, the island’s central bank, by its
market-supporting interventions, encouraged this process. Stocks
and bonds were dumped on to the central bank and the Treasury’s
plunge protection team at still high prices, and the proceeds were
immediately transferred to foreign assets and precious metals, which
appreciated at an increasing speed compared to the island’s assets,
which suffered from the continuous depreciation of the currency.

in order to facilitate this trade, the Smartos, who controlled both
the Fed and the Treasury, continued to make positive comments about
“a strong currency being in the best interest of the island."
Sure, it would have been in the best interest of the island to have
a strong currency, but it was certainly not in the best interest
of the Smartos, who had devised their last grand plan: shift assets
overseas and into precious metals, let the currency of the island
collapse, and then repatriate the funds and buy up the remaining
assets of the Bush tribe’s middle and lower classes at bargain prices
since they had never understood that their currency had collapsed
against foreign currencies and against gold.

11, 2007

Marc Faber [send him
] lives in Chiangmai, Thailand and is the author of Tomorrow’s

Email Print