Monday, 11 February 2013

The Bust Without A Boom - Part 2

In an article in the, FT 2/3 February, John Authers describes the conditions of the “Goldilocks Economy” of the 1990's and 2000's.

“Things were “not too hot” to force central banks to raise interest rates, but “not too cold” to rid the corporate sector of profit growth.”

Of course, this fairytale ended badly. Goldilocks got eaten by the Bear Market that resulted from the Financial Meltdown of 2008. Now as stock and bond markets soar to stratospheric levels again, the explanation given once more has an air of fairytale once more. Authers describes it as “Goldilocks On Ice”.

“The economy remains cold. Chilly enough for the US Federal Reserve and other central banks to continue with measures to support asset prices; but not so freezing that the economy lapses into crisis again.” 

I suspect that the sequel may end in more gruesome fashion than the original.

In 2008, a huge bust ended what had been a massive boom. Economic activity began to pick up in the 90's, and escalated in the last decade prior to 2008. But, since 2008, growth has been anaemic. The US, which implemented fiscal and monetary stimulus, was at least able to grow by around 2%. The UK adopting similar policies under Gordon Brown, managed a similar figure, before the Liberal-Tories choked off the recovery. Northern Europe managed to grow, and for a time, Germany and Sweden managed robust growth. But, the 2% growth of the US and UK, when it achieved it, could hardly be described as a boom, under conditions of recovery from a massive slump in economic activity.

In fact, even before Britain entered what is likely to be an unprecedented Triple Dip Recession, UK GDP had not recovered its pre-2008 crisis level. That would mean the Liberal-Tories would have presided over a period of economic performance even worse than that of the Great Depression of 1930-33!

Even the economic powerhouse of Europe – Germany – could not sustain growth, as the rest of Europe, suffering from political crisis, and economic austerity, sank back itself into recession. Yet, as Authers points out, during all this period of slow to no growth, all of these economies have been pumped full of performance enhancing credit, even if some of them in Europe have denied ever having taken it.

The less than stellar growth of the US has come on the back of astronomical amounts of money printing that has pushed down the value of the dollar, thereby providing it with some support for its exports. The only limitation on that has been the willingness of international markets to see the US as a safe haven, which has sent money flows into the US, and thereby slowing down the decline of the dollar.

US growth has also come on the back of substantial fiscal stimulus by the Obama Administration, though this has been mitigated by Republican cuts at State and Local Government level, and obstruction by a Republican Congress, in the last year or so to further stimulus. But, the consequence of what might happen in a month's time, when the so called sequester is implemented, was shown in the last quarter's GDP figure. It showed an unexpected decline of 0.1%. That fall was made up almost entirely of the cut in the US defence Budget. But, under the sequester, which looks almost inevitable, tens of billions of dollars will be cut from the budget!

But, at least the US has had some growth to show for all this money printing and spending. The UK has not. On the one hand, the UK has cut its spending, thereby reversing any growth it had. On the other, it has not cut its deficit or debt, by so doing, because, as happened with every other economy that tried it, it simply cut its tax revenues and increased its welfare costs, as a result of the reduced growth.

At the same time, the UK printed huge amounts of money, but with no effect on growth. Increased money printing can only stimulate growth, in conditions of stagnation, if it is combined with fiscal stimulus. But, Britain was doing the opposite! Instead of going to stimulate real economic activity, therefore, the money printing went into asset prices. Share prices and bond prices have been bid up to incredible levels, given the lack of economic growth, whilst the necessary collapse of the house price bubble has been delayed.

In the US, house prices collapsed, as part of the sub-prime crisis, caused by such money printing. In Ireland, house prices collapsed, as the effects of the Financial Meltdown morphed into the Eurozone Debt Crisis, and under conditions where Ireland could not print more money, and the ECB chose not to. In the UK, house prices fell 20% in the immediate aftermath of 2008, but then bubbled up again when interest rates were essentially cut to zero, and even more massive money printing began.

Spain's property and construction boom came to a halt under those conditions. But, its larger economy and bigger banks staved off the crash long enough for the ECB itself to begin money printing alongside zero interest rates, which like in Britain, has postponed the inevitable collapse of property prices.

In the US, the fact that property prices fell by 60%, and that US banks were force to recapitalise, by selling additional shares, put a floor under its property market, which has meant that property sales and construction has started to increase. The UK and Spain have yet to go through that necessary stage.

But, the US itself is not finished with its debt problems. For one thing, although it has dealt with its previous property debt, the US has over $ 1 Trillion of Student Debt, and a similar amount of Credit Card debt outstanding. Student Debt cannot be written off even if you declare bankruptcy. Moreover, the situation with property shows the limitations of the Goldilocks scenario.

In part, the recovery in US housing is possible only because, as well as prices having fallen by 60-70%, interest rates remain at near zero. But, the latter has already started to create the same kinds of problems that caused the Financial Meltdown in the first place. In an Editorial in the same FT, Stephen Foley on Wall Street, writes that many of those buying US property are not individuals but Hedge Funds, and other financial institutions. They are buying up property with a view to rental – REO to Rental – but with an eye to selling quickly to make a quick Capital Gain. In other words, “flipping” once again. They are also looking to establish financial derivatives on them once again, by using them as collateral for bonds.

The consequence is that US house prices are back to 2003 levels, with prices rising by 5.5% y/y in November. That will begin to choke off demand from actual home buyers. But, also as Foley says, who do these institutional 'flippers' think they will sell to? On the one hand, these purchases represent an overhang of housing supply, waiting to feed back into the market. On the other, home ownership has fallen from 69% to 65%, and despite low interest rates, many individuals have difficulty obtaining mortgages.

The low interest rates and money printing once more encourage speculation that itself undermines real economic activity. Moreover, if real economic activity does pick up, interest rates will rise, and so, as has happened on each such occasion, in the last 30 years, the slightest rise in interest rates will burst the various asset price bubbles, provoking a new financial crisis. The difference this time is that it will be a massive bust without there having been a previous economic boom. The difference this time, is that with interest rates already at such low levels, it will be impossible to cut them enough to reflate the bubble. In 2008, interest rates in the US stood at 6.5%!

The same can be seen in the other asset price bubbles. From its low point after the 2008 crisis, the Dow 30 has effectively doubled. It is near its all time high. Yet, in the last four years, the US economy certainly has not doubled in size! Over that period, US Corporations have done quite well, returning sizeable profit growth, but again, certainly not double.

In fact, once again, low interest rates have allowed many of these companies to exchange equity for debt. That is they have been able to borrow at low interest rates, and at the same time, use their resources to buy back shares in the company. That has the effect of increasing the share price, which is not insignificant if you are an Executive whose bonus is based on the performance of the shares.

This has a further consequence. For real economic growth, firms need to invest in actual productive capacity – buildings, machines, materials, workers. But, if there is little scope for such additional investment, companies will invest their profits where they think they can make easy gains. They may buy back their own shares, buy up other companies, or buy bonds.

To the extent that these other activities offer the prospect of bigger returns, they will drain money away from productive investment. One means by which companies finance productive investment is by issuing additional shares. This, in fact, has the effect of reducing share prices, because there is now an increased supply of shares available to be purchased.

Economic growth and productive investment are not at all necessarily coterminous with rising stock markets, therefore. In fact, economic growth can have the effect of raising interest rates, as the demand for Capital rises. The consequence is that Bond Yields rise and Bond prices fall. Bond investors desert falling bonds, and buy equities.

But, massive money printing also means rising inflation. The UK has had 4 years with inflation way above the Bank of England target, and real inflation during that time of probably double the target. Mervyn King has now essentially called for the target to be changed.

But, I've written previously about the consequences that also has for bonds – The Zombies Are Coming. In an article in the  - FT on 31st January 2013 - Michael Hassentstabs, who runs the Franklin Templeton Bond Fund ($175 billion) warns that a rout of bonds is approaching. He makes the same point I have made previously. At these levels, the cost of selling too early is negligible. There is essentially no room for further upside on the price, and the yield is next to zero anyway. But, the cost of being late could be catastrophic. Speaking of similar plays previously, he says,

“It didn’t work for years and then when it happens, it happens pretty big, pretty quickly. You can’t come in after it starts happening.”

We have had more than four years now of near zero interest rates and massive money printing. That in itself is unprecedented. But, history suggests that such conditions cannot persist. Sooner or later, someone will blink, the bond market bubble will burst, interest rates will shoot up, and that will crush the stock market and property bubbles.

In fact, there may be another reason to believe such a scenario may be imminent. That is not just that such bubbles have repeatedly burst, whenever interest rates rise – and US and UK 10 Year Yields have already risen by about 30% in the last few months. It is that there is a 13 year cycle for stock market crashes. In the last 50 years, there have been serious falls in Stock Markets in 2000, 1987, 1974, and 1962. That makes 2013 the next year when such a crash is due. This periodicity appears to be possibly connected with the conjunctural changes of the Long Wave between its Spring, Summer, Autumn and Winter phases.

These crashes are often not just single events, but processes. The 2000 Crash for instance, began in March with huge falls in share prices, particularly on the NASDAQ, which fell in the end by 75%. But, after some recovery, the fall resumed again later in the year, despite interest rate cuts by the Federal Reserve. In fact, the decline continued through 2001. Between August 2000 and December 2001, the Dow Jones dropped approximately 11 percent, the S&P 500 fell 23 percent and the NASDAQ nearly 49 percent.

The October 1987 Stock Market Crash had the largest one day decline in US stock market values in history, surpassing the 1929 Crash. On October 19, the Dow Jones fell 22.6 % and for the month, the index was down 23.2 %. As measured by the S&P 500, the market fell 12.1 % in October and 12.5 % in November. Its possible that the actions of the Federal Reserve in massively relaxing monetary policy could have acted to prevent this crash from spreading, but its also possible that it merely spread out the period of the process of unwinding. So, in the following year, stock prices as well as property prices rose sharply. However, this merely led to a new bubble that burst in 1990. In August 1990, a major stock market decline began with the Dow Jones falling 10 % and the S&P 500 declining 8.1 %. By October 1990, these market had fallen 15.9 % and 14.7 %. A similar pattern occurred in the UK, where also during this period house prices fell 40%.

The 1974 Stock market falls actually began at the end of 1973. Beginning with a monthly fall in the Dow Jones of 14% and the S&P 500 of 7% in November 1973, the twelve month declines ending in October 1974 were 30.4%, 26% and 36.8% for the two indexes.

The 1962 stock market crash occurred at a time when the economy was still growing robustly, as part of the 1949-99 Long Wave. 1962 marks the conjuncture between the end of the Spring Phase of the Long Wave, and start of the Summer Phase. Beginning April 1962, the market had lost 20.6% of its value as measured by the Dow Jones by June and 20.9% by the S&P 500.

Of course, these are not the only stock market corrections during the period, and certainly not during the 20th Century. But, these were major corrections that appear to occur on a regular cyclical basis, and one whose periods tie in with the conjunctural phases of the Long Wave. On that basis, 2013 is the next year when such a conjuncture arises, marking approximately the end of the Spring Phase of the 1999 – 2050 Long Wave, and commencement of the Summer Phase. The fact, of the 2008 Crash, therefore, does not undermine that any more than the fact that Halley's Comet visits the inner solar system every 75-6 years means that other comets don't also pass by at different times. In fact, looking at previous cycles this would be expected, and the 2008 Financial Crash should, therefore, be seen more as a warning tremor, preparing for the main event in 2013.

In fact, the even greater money printing undertaken after 2008, and fact that there is no scope left for further such accommodation, apart from Helicopter Ben's proposal to throw money from the sky – which will not happen because, why would anyone work if you could get free money in such a way – means that 2008, has merely prepared the ground for an even more severe crisis, though one which is both inevitable, and necessary before Western Capitalism can begin to ensure that resources are ploughed into productive investment, rather than speculation. The money printing did not prevent the earthquake, it simply acted to delay it, and build up greater pressure to be released.

After all, it is not just the property bubbles in the UK and Spain that are yet to burst, nor the fact that speculation has returned to the US property market. Nor is it just that Bond Markets are in serious bubble territory, even more so than in 2008. Nor even is it just that the Dow Jones has doubled since 2009. Other Stock Markets have risen by similar amounts despite even worse economic performance than the US. In fact, the only Stock Market that has performed badly is the one whose country's economy has been growing rapidly – China. China's economy like most other Asian economies, and those in Latin America and Africa, has continued to grow apace – around 8% in China's case. The Shanghai Composite Index has fallen steadily since 2010, though it has begun to rise again sharply at the beginning of 2013, as it appears that the Chinese economy is about to begin a new period of more rapid growth.

Financial and property markets have clearly lost all contact with reality, and certainly with the real economy. For a Marxist when such a division between appearance and reality so clearly exists, that is an indication that the underlying contradictions have reached a stage where they can only be resolved by some kind of violent crisis.

In Part 3, I will look at the further manifestations of that.


George Carty said...

Is it the case that UK house prices haven't truly crashed like US house prices because in the UK (unlike in most US states) a buyer in negative equity isn't freed from their mortgage obligation if they hand back the property to the lender?

Boffy said...

I don't think so. I think its merely a question of sequencing. In the US, house prices began to fall in 2007. That was really the spark to the crisis. As soon as prices stopped rising, the idea that you could keep refinancing out of a higher house price stopped. The basis of sub-prime lending ceased. Sub-prime borrowers started to fail, house prices began to fall faster as a result. Before long, it was not just sub-prime borrowers who were in difficulty.

The house price crash occurred alongside the Credit Crunch, and prior to the action taken by the Government and Federal Reserve to reverse it. The same thing is essentially true of Ireland. Property prices started falling, and the banks that had lent excessively against it, failed creating a feed back. The banks were only bailed out after that occurred, whilst the ECB did not begin printing money (LTRO, which it denies is money printing) until 2011. Consequently, borrowers were already being crushed before they could be saved by zero rates, and bank forbearance.

In the UK, prices did not begin falling until after the Financial meltdown had already started. But, by that time, the UK Government had already responded by nationalising the banks, and cutting interest rates to zero. In fact, in 2008, the average mortgage payer received the equivalent about £7,000 as a result of the cut in mortgage rates, and that is why the Retail Sales figures for 2008-9 remained robust, and GDP recovered - alongside the other fiscal stimulus that Brown provided.

As a result house prices dropped sharply by about 20%, but bounced back equally sharply, so there was no big series of defaults - where people did go into arrears (and they did as much as in the 1990's) they were saved by the banks who granted forbearance, worried that any repossessions would cause a firesale, and destroy the value of the property on their books.

As in Spain, the longer they can maintain the fiction of the value of that property, the longer they have to repair their balance sheets. But, of course, as I've pointed out before prices have actually fallen, its just that asking prices are a fiction. Selling prices in both Spain and the UK are about 30% below asking prices, and in Spain asking prices too have fallen by about 30% in many places.

In Spain, the debt is attached to the property. Where someone defaults the bank is left with the debt, though you have to be careful if you are buying from an owner rather than the bank that you are not inheriting the debts on the property. In the UK, my guess is that as in the 90's, when the real avalanche of repossessions starts, people will in many cases, declare themselves bankrupt to clear their debts, which will pose even greater problems for banks, because that will mean that those whose mortgage debts are written off, will also be writing off their credit card, store card, overdraft, and other debt at the same time.