Inflating the next bubble

by Eric Janszen - Business Day - Friday, August 22, 2008

Re-printed with permission of Business Day. All Rights Reserved.

Editor's Note: Entrepreneur and Venture capitalist Eric Janszen, in a February article for Harper's magazine, dispelled the myth that asset price inflations, commonly called 'bubbles', result from the madness of crowds. Instead, the process is driven by a combination of economic, financial market and government policies and practices unique to the United States. Janszen revisits his hypothesis at the Independent's invitation and finds recent US legislation is pumping up the next bubble.


In the United States in modern times, asset bubbles form within the political and market framework of an economy dominated, financially and politically, by the finance, insurance and real estate (FIRE) industries.

No bubble has occurred since the 1980s without government creating, by changes in regulation and tax policy, the initial market for speculation that later developed into a bubble.

Tax subsidies, loan guarantees, loose monetary and regulatory policy, and a heavy marketing campaign supported by the FIRE economy trade media, created the housing bubble.

Bubbles require a new source of credit, such as the mortgage securities that financed the loans used to purchase homes. Governments of nations dominated by a FIRE economy enable asset inflations to assist failing economies and to generate capital gains to tax and finance government.

After a government lays the foundation for a bubble it requires monetary stimulus to evolve in the case of the housing bubble, after the US Federal Reserve quickly lowered short-term interest rates from 6.5% to 1.75% in 2001.

The London Inter-bank Offered Rate (LIBOR), the rate banks use to lend to each other, fell to 2.5%. Adjustable-rate mortgages, tied to LIBOR, fell more than 50%, cutting monthly mortgage payments proportionately.

Builders need years to buy land, gain permits, hire construction teams and build homes several times longer than the nine months it took the central bank to cut the monthly cost of homes in half. Home prices rocketed as too much credit chased too few homes. Meanwhile, new credit products, such as no-doc or so-called "liar loans'', were created to expand the pool of available homebuyers.

A FIRE economy, in contrast to an industrial economy, grows mainly by FIRE industry companies generating capital gains on sales of inflated assets instead of by manufacturing companies earning profits from sales of goods and services.

The FIRE economy was America's answer in the early 1980s to increased competition from rising industrial giants in Europe and Asia in the 1960s that began to out-compete the US industrial economy in the 1970s.

The ideological cover for the FIRE economy was to lower taxes that financed infrastructure development and maintenance, among other public goods, ostensibly to free households and businesses to use the added disposable income to allocate spending more efficiently than government.

What occurred instead is that all of the money households spent on taxes for the benefit of infrastructure to support the entire economy is now spent to service debt for the benefit of FIRE industries. Ultimately, the debts are financed by foreign borrowing.

After prospering as a net creditor, enjoying a positive balance of trade and running a current account surplus for its entire existence until the 1960s, by late that decade the US not only ran up large net foreign debts, but debts that it could not repay in gold the international currency established after World War II.

The US defaulted on its gold debts and promised to pay only in irredeemable national currency. Never in history had such an arrangement existed. Initially, the US dollar went into a tailspin, but after a brief period of chaos a new international currency regime established itself and irredeemable US dollars became the world's reserve currency under a floating exchange-rate system.

The new system created global demand for dollars used for major transactions outside US borders, including oil purchases, reducing the need for the US to earn foreign exchange as other nations do, through a positive balance of trade, and causing a build-up of dollars in the US to fund current account deficits. The US trade partners least happy with the arrangement were oil producers. The Economist reported in its 1999 cover article, "Drowning in Oil'': "What'', sneered Abdurrahman Salim Atiqi, Kuwait's one-time oil minister, "is the point of producing more oil and selling it for an unguaranteed paper currency?''

By inflating the purchasing power of dollars, the value of oil was suppressed, distorting market signals and causing depletion far more rapid than would occur in a global free-currency market based on a commodity standard. The exchange of finite oil for infinite dollars came back to haunt the world decades later.

This unique arrangement established the FIRE economy by attracting foreign capital beyond the ability of the US economy to absorb it productively. The FIRE economy funded many financial exploits, from the leveraged buyout (LBO) bubble of the 1980s, to the technology, stock and housing bubbles that followed.

More than 20 years ago, foreign central banks arrived as the source of funding for America's FIRE economy. The New York Times said at that time: "The chief guardian against a free fall of the dollar is Paul A Volcker, chairman of the Federal Reserve Board. He told congress that the United States had largely escaped the adverse consequences of the `insidious combination' of low savings rates and high federal deficits by drawing on capital from abroad; its flow last year exceeded all the savings by United States households.

"That situation, Mr Volcker said, cannot last: it is not sustainable economically to pile up foreign debts while failing to make the investments needed to generate growth and earn the money to service the debts; it is not sustainable politically, as pressures on the American industrial base are transmuted into demands for protection, and it is not sustainable internationally, as the confidence that underlies the flow of foreign savings will be eroded.

"'Sooner or later,' Mr. Volcker said, `the process will stop. The only question is how.'''

Twenty years later and counting. Did the US economy "get its act together'' or did the FIRE economy have more than a few surprises for Paul Volcker and company?

Volcker thought, and perhaps still thinks, the US economy has to make capital investments to grow. Through the magic of the finance-based economy funded by foreign capital flows, returns can be generated without capital investment, for as long as the money flows in and the FIRE economy operates. The only problem is that FIRE economy expansion leaves behind piles of debt that cannot be repaid through production. Only the interest can be paid, and even then new FIRE economy inventions, such as the technology stock bubble starting in 1995 that revived the dollar, are needed.

In "The Next Bubble'', I asserted the collapsing housing bubble would lead to rapidly falling prices and defaults on mortgages, causing major dislocations in global financial markets that are "polluted with credit risk'' from years of issuance of mis-priced securitised mortgage debt by US securities firms, sold across the US and Europe to pension funds, but not to Asia where fund managers, with a recent financial crisis still fresh in their minds, said "no thanks''. I also claimed the housing bubble crash, after producing gradual but profound negative wealth effects and knock-off effects on consumption, from home furnishings to car sales, will bring on the first consumer-led recession in the US in a generation, and that the Federal Reserve and Congress will be forced to take bold moves to staunch the bleeding and reflate the economy.

As I told the audience during my keynote speech at the Hard Assets Conference in Las Vegas a year ago, with the dollar already weak and inflation rising from years of negative real short-term interest rates, a hangover from the reflation measures taken following the collapse of the technology stock bubble, US policy-makers are limited to using dollar depreciation to boost economic growth through exports.

Indeed, an unofficial weak dollar policy has been the cornerstone of post housing-bubble reflation policy. I also warned that weak dollar policy, while reasonable in the short term will, if extended for years on end, drive inflation higher; the US economy will then face the dual scourges of recession as fallout from the housing bubble combined with an inflation cycle as rising import prices, especially energy, cut household disposable income just as job growth begins to dry up. How well did the theory forecast events?

Home sales and prices have declined more than during The Great Depression of the 1930s. Credit contraction has spread to business and student loans. Unemployment is rising in every state in the US except for anaemic 0.2% to 0.4% declines in lowly populated Arkansas, Oklahoma, South Dakota, and Wisconsin states that benefit from higher energy and food prices but together account for just 2.5% of the US population.

Unemployment in California, the country's most populous and in gross domestic product (GDP) terms the eighth largest "nation'' in the world, reached 7% in June this year, up from 4.9% just two years ago at the top of the housing bubble.

Debate continues over whether the US as a whole is still in recession, as it was in the fourth quarter of 2007, defined as two consecutive quarters of negative GDP growth. But data ranging from unemployment to retail sales to declining tax revenues flash clear recession warnings.

Evidence of economic contraction in the US is obscured by rising inflation. Real GDP growth reversed in the fourth quarter of 2007 as nominal GDP growth declined 0.2% and consumer price inflation (CPI) increased to 3.6%, not including energy and food prices. The source of the inflation is the outsized impact of rising energy import prices of food and other goods and services that are sensitive to rising energy input costs.Can wage rate inflation be far behind? The Federal Reserve does not believe so and behaves as if it believes that, even while holding short-term rates below the inflation rate, maintaining negative real interest rates, rising unemployment will take care of the inflation problem by lowering demand.

But the inflation was not caused by excess demand in the first place but from falling demand for dollars causing rising energy input costs for businesses and households. If the US cannot attract new foreign private investment to support the dollar, the Fed's wait-and-see policy will not lower inflation.

"The Next Bubble'' concluded the only way to clean up America's structural stagflationary mess is to use the apparatus of the FIRE economy to shift the US economy from dependence on asset price inflations to "re-industrialise'' America. Policies need to focus on rebuilding essential transportation and communications infrastructure left in shambles by the FIRE economy, increasing energy efficiency to reduce US dependence on energy imports, and increasing national and household savings. Such a politically inexpedient set of policies will require strong leadership spurred by economic and financial crisis.

If this thesis strikes you as far-fetched, consider that at the time "The Next Bubble'' appeared, candidates for the upcoming US presidential election were not talking about the economy, or alternative energy, or infrastructure. Now they talk about little else.

"Next Bubble'' development proceeds according to the inexorable logic of the US political economy. Two examples make the point.

The seeds of US government sponsorship of an alternative energy boom were planted in legislation intended to rescue the US economy from the damage done by the collapsing housing bubble. Emergency legislation titled "Housing and Economic Recovery Act of 2008'' passed recently. It provides loans to new home buyers, and has controversial provisions that allow the US Treasury to directly purchase the bonds and stock of government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac a policy not allowed under the US Constitution.

The bill, rushed through congress and signed by the president with alacrity not justified by the gradual pace of economic decline is really about reassuring foreign central banks that hold nearly $US1 trillion of US agency debt the US government intends to guarantee the GSE's credit, and even stock if necessary, to avoid foreign official sales of agency securities that will cause a spike in mortgage rates at this precarious time for the US housing market.

The bill is also about getting the new alternative energy and infrastructure boom going. Tagged on to the end of the bill is Title X: "Clean Energy Tax Stimulus Act of 2008''. To the uninitiated the add-on is incongruous. Why include energy-related tax subsidies in a bill to rescue home owners and mortgage lenders? What does alternative energy have to do with home foreclosures and failing mortgage companies?

Students of "The Next Bubble'' understood the implications immediately: US Congress is eager to get a new boom going before the collapse of the previous one pulls the US economy, likely already in recession, into an uncontrollable tailspin.

The second example is proposed government bailouts of US car-makers. Proposed legislation has an alternative energy focus. Michigan lawmaker John Dingell is pushing for $US25b in government loans to convert General Motors, Ford and Chrysler factories to build alternative-fuel vehicles.

Legislation to seed the next bubble is in train as the previous bubble collapses. New investment vehicles and sources of foreign capital are needed to grow it. Keep an eye out for new securities from Wall St firms and watch for sovereign wealth funds as the primary foreign buyers.

Is there a better way?

A book I am writing, titled New New Deal: Re-industrialization of Post Depression America, proposes an alternative approach to FIRE economy post-bubble economic recovery. Instead of a Next Bubble, remove government subsidies of FIRE industries and use the funds generated to finance tax cuts and other subsidies to boost the productive sectors of the US economy by leveraging the US's unique innovative capacity.

Debts will be restructured to free households and businesses of high interest burden they carry today to allow them to increase savings and capital investment. Revenue from exports of goods and services will exceed exports of financial assets, eventually, and the US trade balance and current account will turn positive.

The US will gain a constructive role in the world economy as the nation that invents the next generation of vehicles and communications substitutes for transportation, and develops for export the leading technologies that allow nations to conserve energy and use petroleum alternatives.

Eric Janszen is the founder and president of iTulip, Inc. He was formerly managing director of venture capital firm Osborn Capital, chief executive of Autocell and Bluesocket and entrepreneur in residence for Trident Capital.

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