The Federal Reserve and Housing: A Cluster of Errors?

Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop.

~ Murray Rothbard

In my two decades as a surety bond underwriter, I have seen financial fads come and go. One aspect of my job entails analyzing personal financial statements, and I most certainly have seen scores of them. Along the way, I have been able to discern distinct patterns in the financial behavior of people. What is so striking to me is the herd-like behavior of human beings — many of whom seem to be easily swayed by the marketing blitzes of Wall Street brokerage houses, banks, and other financial services companies. As Ludwig von Mises stated in his magnum opus Human Action:

Common man does not speculate about the great problems. With regard to them he relies upon other people’s authority, he behaves as “every decent fellow must behave,” he is like a sheep in the herd. It is precisely this intellectual inertia that characterizes a man as a common man. Yet the common man does choose. He chooses to adopt traditional patterns or patterns adopted by other people because he is convinced that this procedure is best fitted to achieve his own welfare. And he is ready to change his ideology and consequently his mode of action whenever he becomes convinced that this would better serve his own interests.

Unfortunately, the common American does not understand he is being manipulated and impoverished by the Federal Reserve. When money is no longer real (i.e. fiat currency vs. gold and silver), then people may come to believe in the surreal, and a hyperreality emerges. In particular, during the reign of Alan Greenspan, money and credit — created out of thin air — rained upon Americans as if to assure us that crop failures and misfortune had been banished from U.S. soil. Hence, we came to live in a world of plenty where one may become wealthy by simply purchasing a house — with lots of borrowed money — and by "investing" in stocks for the long run. What a dream it is to become wealthy without effort. This mass delusion is only one step away from collectively believing that cotton candy is a cash crop. Alas, Americans will soon discover that housing values don’t grow to the sky and that heavy mortgage debt leads to a harvest of financial despair. The Austrian theory of the trade cycle will be validated yet again.

So here’s a quick trip down memory lane. Early in my underwriting career, cash and savings were king. Accordingly, this frame of mind was reflected in personal financial statements. As the 80s rolled on, Americans bought into the pop culture that is Wall Street. Without fail, I saw people cash in CDs and purchase mutual funds. Peter Lynch, indeed, popularized such "investment" vehicles for long-term wealth creation. Then John Bogle flaunted the low-expense-ratio S&P 500 Index Fund as the wisest way to build a substantial retirement nest egg. And who can forget the and telecom crazes of the late 90s? Americans envisioned themselves retiring to Easy Street based upon owning shares of and Global Crossing. Lastly, let’s not forget the Wall Street darling known as Enron. This company’s common stock was going to make each of its shareholders wealthy. So why aren’t Americans taking early retirement, en masse, to lives of luxury? Where is all the wealth promised by Wall Street?

To date, I can’t say that I have seen a single individual become wealthy by investing in the "products" promoted by Wall Street. From the results I have witnessed, Wall Street preys upon the economic illiteracy of Americans and does a most efficient job of transferring wealth from the masses to the bank accounts of the Wall Street — mostly Ivy League — elites. Over the years, a familiar pattern has emerged: Wall Street brokerage houses make their recommendations, the sheeple get fleeced, and I bear witness to a clustering of human financial error as reflected in the personal financial statements that I survey daily. For the most part, such financial errors have not been devastating, but were merely temporary misadventures on the part of misguided individuals.

As a quick aside, yes, I have seen some individuals become wealthy. Yet such wealth emerged by way of starting up and maintaining successful businesses. Such entrepreneurs, typically, maintain strong personal liquidity and keep debt loads at reasonable levels.

Nothing, however, could have prepared me for the horrors I have witnessed the past few years. Because of the housing bubble, as engineered by the Federal Reserve, Americans are now drowning in mortgage debt while navely believing that living in a house is the path to wealth creation via long-term capital appreciation. Thus I am just going to come out and say it: countless American homeowners are already insolvent and simply don’t know it; and many of them continue to make ends meet by borrowing against credit cards and ever-shrinking home equity.

It is commonplace for me to see married couples with mortgage-debt-to-income ratios that are wildly askew. The hyperreality conjured by the Federal Reserve’s relentless inflation of the money supply is characterized by a populace which believes that a permanent plateau of prosperity has been attained. This is the boom phase of the trade cycle. A mindset, correspondingly, arises in which people have absolutely no fear of debt. After all, the Federal Reserve has the economy under control. Debt, in fact, is embraced as a means to lever up one’s return on investment.

When the bust phase of the trade cycle materializes — and followers of Austrian economics know it will, eventually — then the real horror show will unfold. Let’s face it: highly leveraged Americans have little to no chance of ever paying back their enormous mortgage debts. All it will take is for a husband or a wife to lose a job, or for interest rates to go higher, in order for mortgage debt to become unmanageable. In the bust phase, mortgage defaults will become a deluge.

Earlier, I mentioned that the Federal Reserve "engineered" America’s housing bubble. To be sure, there are those who deny a housing bubble exists. Hence, such deniers argue there is no correlation between aggressive growth in M3 and the spectacular rise in housing prices across the United States — as if the Federal Reserve’s pounding down of interest rates occurred in a vacuum. To this I respond with a quote from page 1 of a September 2005 study sponsored by the Board of Governors of the Federal Reserve System titled House Prices and Monetary Policy: A Cross-Country Study. Here is the smoking-gun quote: "Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission."

With the bursting of the NASDAQ bubble signaling that the U.S. was heading into a recession — not to mention the shock of 9/11 — the Federal Reserve took desperate measures by goosing the money supply and driving the Fed Funds rate down to 1%. These monetary central planners knew that housing demand was very much interest rate sensitive, and they were counting upon the opiate of easy credit, at remarkably low interest rates, to stimulate the "animal spirits" of Americans in order to set the housing market ablaze. The Federal Reserve’s central plan worked. Uncle Sam’s economy was rekindled as trillions of dollars were loaned into existence via the housing market — the Fed’s monetary transmission mechanism. Therefore, America’s housing bubble did not emerge spontaneously in a bona fide manner. Rather, it is a debt-laden financial monster created by the mad doctors populating the Federal Reserve.

As surely as night follows day, a credit-induced boom is followed by a bust. Moreover, only the Austrian theory of the trade cycle provides the intellectual framework allowing one to understand the boom-bust cycle. Before delving a bit further into this theory, there are a couple of things to keep in mind. First of all, as premeditated by the Federal Reserve, the housing boom was credit-induced. Secondly, America’s savings rate is near zero, so savings-induced growth cannot explain the housing boom. What we will find, as elucidated by Roger Garrison, is that central banking is at the epicenter of the boom-bust cycle. Dr. Garrison provides the following explanation in the Mises Institute’s remarkable book The Austrian Theory of the Trade Cycle:

The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy’s capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust.

Assuredly, the housing boom is destined to bust just as the NASDAQ bubble did — anecdotal evidence is already pointing toward this end. When the NASDAQ bubble did burst, I saw the liquidity of many Americans diminish significantly. Yet the housing bubble is vastly different and the financial pattern is unmistakable. Trillions of dollars of mortgage debt came into existence in a very compressed timeframe — in less than five years. Consequently, over the last three years, I have never seen so many dangerously-leveraged personal financial statements in my entire underwriting career.

This mortgage-debt bubble, as engendered by the Federal Reserve, is leading millions of Americans to financial ruin. This may become the most calamitous clustering of financial error in U.S. history. If anything positive comes out of this economic mess, perhaps it will be the demise of the Federal Reserve itself. Regrettably, the Fed’s failure will have come at an enormous price, including the possibility of volatile social unrest.

A terrifying thought it is.