After the Fall

Thursday, June 24, 2010
By Paul Martin

By Dan Denning
June 24th, 2010

So the mining tax, among other issues, has cost Kevin Rudd his job. As an economic matter, investors might now revalue the miners as if the tax itself is dead, or at least dormant until after the next Federal election. But as fascinating as the domestic political scene is, today’s Daily Reckoning begins with an old foe, the U.S. housing market.

Why? The current direction of U.S. home prices (down) has been brought about by many of the same economic management principles applied here in Australia. In fact, the whole Keynesian effort to support aggregate demand and “bring forward” demand through tax credits and handouts has been used the world over. And its effects are the same the world over – a temporary spike in economic activity giving the illusion of vitality…and then a crash to earth.

Nowhere is this process more advanced than in America’s housing market. In first decade of this millennium, it was the prime beneficiary of the cheap money policies of both Alan Greenspan and Ben Bernanke. Bank and non-bank credit creation found its way into an asset class everyone could profit from – residential real estate.

But yesterday America’s Commerce Department reported that new home sales in the United States fell 33% in the month of May from April. Just over 330,000 new homes were sold across the great land for the entire month. It was the lowest and slowest rate of sales since 1963. And since their peak in 2005, new home sales are down 78%.

The good news is that U.S. home prices reaching a clearing level. The median price on a new U.S. castle is just over US$200k. Even without the $8,000 Federal tax credit, the price is just under four times the median U.S. household income of $52,000. So how come no one’s buying?

Because they’re all in! That is, at the peak of the market, homeownership levels in the States reached 70%. When seven out of ten households own a home or have mortgage, there aren’t many buyers left. Does this mean there is some theoretic level of homeownership that’s achievable AND sustainable in a market?

Well, no. But it does mean that when you “bring forward” demand so much in a credit boom, you rob from future demand. That’s what’s happening now in America. And we suspect that is what will happen too in Australia, when all the various ways of bringing people into the market with grants and tax deductions are exhausted.

But what does this have to do with the big picture? There is a good argument to be made that what artificially low interest rates did to America’s housing market…they have done to many of the world’s stock, commodity, bond, and real estate markets. With the Fed, the Bank of Japan, the European Central Bank, and the Bank of England all setting historically low short-term interest rates, they’ve provided huge support to markets.

And if that support fails? The lack of gimmicks to prop up U.S. house prices is making it likely that there will be a second fall in that market. The knock-on effects on U.S. employment won’t be pretty. But the destruction of bank collateral will be uglier still, and that’s what poses the biggest risk to the financial system.

Yet it’s not just America we’re talking about. Stock market veteran Richard Russell, who edits the Dow Theory Letter, writes that, “We’re now in the process of building one of the largest tops in stock market history. The result, I think, will be the most disastrous bear market since the ’30s, and maybe worse.” Russell argues that the Fed and its central bank cronies have pumped up stock, commodity, and real estate markets and that they are all now primed for a big fall.

He suggests that the disintegration of fiat currencies is what will spark the fall in asset markets. But – assuming you agree with Russell’s primary thesis that global stock prices have been pumped up by a sea of central bank liquidity – the catalyst for that fall is anyone’s guess. And the timing is unknowable.

In theory, though, you CAN know that when interest rates are manipulated lower for the sake of achieving politically mandated GDP growth (or growth for its own sake), they invariably create a bubble somewhere. What we’ve had – really since 1974 – is a series of ever larger bubbles encompassing more asset classes and more national economies.

Finance has aided and abetted this process. So has technology. The digitisation of finance has facilitated global capital flows, making it possible for cheap money borrowed in one currency to charge into assets in another. What all these micro-bubbles have in common is that they inflate asset prices…and when those assets increase household net worth on paper (house and stock prices) it seems like a good thing.

What we’re about to find out – after all the bad debts are liquidated and asset values – is whether all that money printing has actually created a lasting prosperity, backed by good investments in capital assets or industries with demand not propped up by ever-larger amounts of credit. Or whether we’ve just enjoyed a one-off period of global growth based on cheap energy and cheap credit that will never be repeated and must now, as credit and money shrink, contract.

Incidentally, the Federal Open Market Committee in the US decided to leave rates low. In its statement, the FOMC said, “Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.” Europe?

But all of these things are connected. And to stretch the thematic connections…the central error of central bank control over interest rates (a non-free market price for money, or the cost of capital) is probably the same error Kevin Rudd made. One man doesn’t know better than a market.

In a complex system, there are too many moving parts, too many variables, for one man or a small group of men to know what they need to know in order to devise a plan. The Austrian Economist Friederich Hayek called this problem a “knowledge” problem and pointed out no one is ever given enough total knowledge to wisely make a grand plan.

Nor, we would humbly suggest, should any man presume to know enough that he tries to put his grand plan in the place of the private plans of millions of others, making their own private calculations based on factors unknown to The Man. It’s a big ask. And you set yourself up for a fall when you do it.

Of course, in the end, we’re all headed for a fall of at least six feet under. But what you do between now and then is a matter of choice. And returning to financial markets, we’d still choose not to be a buyer at these levels. Aussie stocks may get a bounce from the demise of Kevin Rudd and the shelving of his mining tax until after the election.

But the larger global issue – as you can see from the fall in U.S. new home sales – is that economic activity supported by credit growth isn’t sustainable. Nor are the asset price gains based on easy credit. So what will lead to the Fall? More on that tomorrow…

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