What is the difference between those housing bubbles of the 1970s and the late 1980s and the US housing bubble of today? There are four decisive differences.
Why is the housing bubble different this time?
First, those past housing bubbles developed in a generally inflationary environment of rising consumer and producer prices. Central banks tightened their monetary reins to fight inflation in general.
Second, those bubbles were pure price bubbles in the sense that house prices rose faster than the general price indexes. There were no major repercussions on the economy.
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Third, what the United States and many other countries are experiencing today is completely different from a house price bubble. Rising house prices are used as collateral to finance extraordinary borrowing-and- spending binges that virtually dominate economic growth in these countries. In 2005, consumption and residential building accounted for 92% of US GDP growth.
Fourth, disclaiming that the rapidly rising house prices reflect inflation, the Federal Reserve has readily accommodated them. Rather, it hailed and celebrated the rising prices in a very positive sense as welcome 'wealth creation.' The declared intention of the rate hikes since mid-2004 was not to fight inflation, but to normalize short-term interest rates. Policymakers and economists openly invited and encouraged people to prime the bubble and to make as much use as possible of the borrowing facilities it offers.
Has Mr Greenspan ever realised that he has turned the US economy into a bubble economy? Who else among former and present policymakers and top economists on Wall Street has realised this? Some certainly have. In Japan, even policymakers frankly used this word in public. But in America, everybody painstakingly avoids this admission.
What is the 'asset driven economy'?
In order to eschew mentioning the dirty word, a new definition has come into general use. US economic growth is neither 'bubble driven' nor 'debt driven'; it is 'asset driven.' It is a term especially invented for the American public to convey the good feeling that the US economy is creating assets, while in reality, with its consumer borrowing-and-spending binge, it is consuming its capital, reflected in falling investment and soaring foreign indebtedness.
The first task, of course, is always to identify undesirable increases in asset prices, emphasis on 'undesirable,' classified as 'asset bubbles.' In this respect, Mr Greenspan made his famous remark: 'But bubbles generally are perceptible only after the fact.
To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best.'
Now compare this trivial talk of the world's leading central banker with the reasoned assessment by economists in a study by the International Monetary Fund (IMF), titled 'Monetary Policy, Financial Liberalization and Asset Price Inflation,' published in the World Economic Outlook of May 1993:
'Financial liberalization, innovation and other structural changes in the 1980s created an environment in which excess liquidity and credit were channelled to specific groups in the markets. This includes large institutions, high-income earners and wealthy individuals, who responded to the incentives associated with the changes. These groups borrowed to accumulate assets in the global markets - such as real estate, corporate equities, art and commodities such as gold and silver - where the excess credit apparently was recycled several times over.'
And here is a crucial part of the conclusions of this study:
'To the extent that asset price changes are related to excess liquidity or credit, monetary policy should view them as inflation and respond appropriately. There is nothing unique about asset markets that would suggest that asset prices can permanently absorb overly expansionary policies, without leading to costly real and financial adjustment.
'Actually, the study explicitly and precisely pinpoints the key feature of asset price inflation. It is 'a credit expansion in excess of the expansion of the real economy.' In 2005, a credit expansion of $3,335.9 billion in the US economy was matched by nominal GDP growth of $752.8 billion and real GDP growth of $379.1 billion.
How credit growth defies financial reason
In the United States, credit growth since the 1980s has developed increasingly in excess of GDP growth. During the past five years of recovery, though, this discrepancy has widened to extremes that defy economic and financial reason.
This escalating gap between credit and GDP growth is regarded as a very serious, however completely unrecognized, problem, and it is rapidly escalating. In the first quarter of 2006, credit expanded by $4,386.5 billion annualized.
The first obvious question is about underlying causes. This news essentially says that an ever-greater proportion of the credit expansion is for purposes other than spending in the economy, which would correspondingly add to GDP growth. Ominously, more and more credit generates less and less GDP.
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The most conspicuous cause is, of course, credit- financed asset purchases. In a country without domestic savings, any asset purchases inexorably depend on credit creation.
A second major cause is the trade deficit. To compensate for the implicit extraction of spending and incomes in favor of foreign producers, additional credit expansion is needed to create spending for domestic producers.
And a third rapidly growing cause of America's unprecedented thirst for credit, as we have repeatedly explained, is certainly Ponzi finance. A large and growing part of the borrowing binge reflects the capitalization of unpaid, rapidly compounding interest.
According to the available figures, barely one-quarter of the credit expansion is for GDP growth and three- quarters for these other purposes.
Is this credit expansion sustainable?
The question to ask in the face of these facts, of course, is whether this runaway credit expansion in relation to grossly lagging GDP and income growth is sustainable. For sure, it is not. All this prodigious borrowing and lending has been undertaken in the grossly flawed assumption that rising asset prices, rather than rising incomes, will some time in the future take care of interest payments and repayments.
Assuming the normal rule that debts have to be serviced and amortized by future income, the great mass of American consumers could never afford the debts they have incurred in recent years. For many, the borrowing has even been the substitute for lacking income growth.
In real terms, in 2005, this was 1.2%, well below its growth rate of 1.9% during recession year 2001. Given the reported sharply slower employment growth, further deterioration is clearly on its way.
By Dr Kurt Richebacher for The Daily Reckoning. You can read more from Kurt and many others at www.dailyreckoning.co.uk
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