Debt and super cars replace soup lines and super cars
Asset bubbles create wealth inequality that leads to crises that are resolved by a redistribution of wealth by inflation.
Weekly Commentary - April 27, 2006
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Recent Weekly Commentaries 3/2/06 - Prediction: Governor Mark Warner will win the 2008 U.S. Presidential Election 3/9/06 - Hedge Funds Still in the Dark 3/15/06 - iTulip.com II: The Sequel 3/22/06 - Frankenstein Economy 3/29/06 - Housing Bubble Correction Update 4/1/06 - Greenspan Says, "Sorry!" 4/5/06 - Financial Markets are Poluted with Risk 4/19/06 - China versus USA |
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| During
the waning days of the Internet bubble, sitting with my card buddies
playing poker at one of our homes, in conversation between hands
I’d give a short lecture on macroeconomics and precious
metals. I did this even though my sister’s pet
rabbit Barry
has more interest in either topic. The banter at our games
relates more to anatomy than economics. A beery poker game
might
seem like an odd place to wax philosophical on commodities investing,
especially early in the year 2000 when everyone was fixated on the
price of Nortel, Cisco and Lucent stock. But
there’s a
method to my apparent madness. On the other end of the scale of interest and aptitude in economics and finance, I spent 40 minutes talking to Intel Chairman Craig Barrett on the same topic in 2002 and got an animated response. I’ve talked to hundreds of people, from CEOs of public and private companies, to investment bankers from London to Tokyo to NYC, to venture capitalists from California to Finland to Boston. I talk to the neighbors. I talk to old friends from college. A thousand informal conversations are surveys taken frequently over long periods of time with a wide range of subjects in all kinds of places. Then there are the "deep throats," from Wall Street investment bankers to central bankers in foreign lands, who write in to iTulip.com with key bits of information, their identities always kept in confidence. By this method I collect information needed to develop my observations of events and hope to make relatively accurate predictions based on them. We're all Rich! The exception in our poker group – I’ll call him Ralph – made his living during the stock bubble era as a personal financial advisor. At the time that meant someone who repeated the financial services firms’ sales pitch de jour aimed at middle class investors: “Buy and hold our stock mutual fund. Stocks go up.” Hardly anyone believes that about stocks anymore, but the seed of the magical belief that there exists a kind of asset that only rises in value was quickly passed on to real estate “investors” where it took root and grew in many regions around the nation like kudzu in a Georgia swamp in July.  In 2000, hedge funds numbered 3,000 with less than $500 billion in total capital. Although they managed a lot more money in aggregate than venture capital funds, they were dwarfed in prestige and visibility by the VC funds that got all of the attention during the stock market bubble. Wall Street was helping VCs produce billions of dollars through initial public offerings of profitless companies and recycle the money back into venture funds and out again via new IPOs. The public nature of this game got the VCs a lot of press, was called "public venture capital" for a brief period during the so-called "New Era." Meanwhile the hedge fund manager “toiled,” if that’s the word, in his garden in relative obscurity. The IPO financing system had been cultivated over many decades as a disciplined institution for pricing profitable companies in the market. Given the horrific abuse of that system during that period, is it any wonder that six years after the dot com crash the IPO machine is still broken in the U.S.? As Robert Reno said after the 1987 crash, “Nobody who has ever been on a falling elevator and survived ever approaches such a conveyance without a fundamentally reduced degree of confidence.” Venture capital investing collapsed from its peak of $95 billion in 2000 to $19 billion in 2003, nearly back to where it was in 1998 when iTulip.com caught its first whiff of the blossoming tulip mania that was soon to overtake the tech stock markets. iTulip.com was founded as a cautionary tour guide.  For a few years following the crash in the market for venture-backed companies, private and institutional investors stayed away from venture capital funds in droves. In 2002, VC funds raised just $3.9 billion and placed only $21.8 billion in high tech start-ups. That’s less than 20% of the $105 billion in new funds that VC firms raised in the year 2000 alone. This delta between money available for investment and money invested came known at the time as the “VC overhang” because that sounds better than “VC hangover.” [As a quick aside, during that darkest, foulest period in that downturn in VC funding, from 2001 to 2003, yours truly was out raising VC as CEO of wireless security start-up Bluesocket. Although the effort appeared hopeless, I and every other CEO in my position at the time was compelled to succeed because failure meant sending scores of great and brilliant people out into a dead job market with all their hard work lost. After more than 150 VC meetings – I lost count -- with more than 80 VCs, the company got funded. Satisfying, but not the kind of experience a sensible person repeats.] Private equity investors were slow to get back into VC funds while the scent of rot hung over them after the crash, but hedge funds came out smelling like roses, budding just as the rate cut and tax cut induced spring arrived. Hedge funds were ideally positioned to take part of the torrent of post stock bubble collapse liquidity that poured out of the Fed to water the economy, parched after the collapse of the stock bubble. The liquidity pooled around the hedge fund rose bushes and real estate kudzu. Reassuring words from Fed mouthpieces aimed at all markets bathed the real estate kudzu and hedge fund rose farms in the warm glow of official confidence. They gew like crazy.  The number of hedge funds increased 300% from 3,000 in 2000 to over 9,000 today and manage over a $1 trillion versus $500 billion in 2000. As for real estate, one measure of growth is that California alone added 113,307 licensed real estate agents since July 2000. The total number of RE agents in California is now 427,389 or 1.9% of the total working population of California. Two out of every 100 employed people in California is a real estate broker. A Tale of Two Classes of "Wealth" As a result, today you can’t throw a beer can out the window without hitting a real estate agent or hedge fund manager, each representing the farmers of two classes of “wealth” holders that now dominate the poles of the bifurcated U.S. economy. One, the indebted middle class so-called “home-owner” owns less of his home and owes more to his bank than ever (here at iTulip.com we call him a “bank-ower”). Two, the top 5% who own most of the financial assets. The differences between the two groups existed before the bubble collapased and intensified as a result of Fed monetary policy and government tax policy intervention after the stock market bubble collapsed, as we can see in the following four charts. The first shows how the rich got richer: the share of capital income (money made from money versus economic activity) earned by top 1% and bottom 80%, 1979-2003.  Source:
Shapiro & Friedman, 2006
The second chart shows what happened to mean and median income of wage earners during the period: it went down.  The third chart shows what happened to mean and median net worth of households during the period -- down.  The fourth and final chart shows what the median household did for cash to compensate for loss of wage income.  Source:
Northern Trust
The American middle class is compensating for loss of income by increasing their debt load with credit card debt and home equity extraction. Banks and credit card companies have been glad to oblige, as credit cards and fees on home re-financings are the most profitable of all credit products and bank transactions. In the early days of researching for iTulip.com, one of the surprising discoveries was the large numbers of very wealthy around during The Great Depression as the dust bowl blew and millions of poor waited in soup lines. Text books in U.S. schools teach that The Great Depression made everyone poor. In fact, deflation made a number of people very rich. Not to say that many who made fortunes during the boom did not lose a lot of money after the crash; many did, but those who played it well made money during the bubble and preserved it by storing their wealth as cash in the bank, which at the time meant gold. During the deflation that followed the collapse of the credit system, then nearly completely dependent on the banking system, the purchasing power of this hoarded cash increased. In this way, the rich got richer. There was a lot of money in the bank, but little in circulation. Meanwhile, the average wage earner had no access to credit and with unemployment running at 25% and no employment insurance, little or no income. We’ve all heard the stories. A friend’s parents reported literally breaking up the furniture to heat their home in the winter. The Fed lowered interest rates and tried to get the banks to lend, but the problem was more political than economic. Politically, there wasn't much the Fed could do to solve the problem of getting wealth holders to put their hoarded cash back into circulation. The stock market and credit collapse was keeping them from doing so much the way the collapse of the dot com bubble kept investors away from venture funds for years. Who could blame them? Still, they did have money and they spent it, but not in a way that was much help to the economy. Symbolic of the wealth disparity, the most ostentatious cars of the age -- the modern equivalent of today’s Super Cars -- were designed and sold in the depths of The Great Depression. It was an era of soup lines and super cars. The post-bust period that has followed the 1990s stock and credit bubbles shares one characteristic in common with the bust that followed the 1920s boom. The yawning wealth disparity created during the bubble period has grown following policy efforts to soften the impact of the downturn following the 2000 bubble's collapse. The difference is that this time the credit system not only continued to function but, as it is no longer dependent on the banking system and is in fact more or less out of its control, the credit system went into hyperdrive. It has served to compensate the middle class' loss in income but also to provide billions for leverage in the private equity markets. This era’s post bubble bust “poor” are poor only on paper. They have few assets net of liabilities and a lot of debt, but they still have their homes and lots of consumer goods, and in fact continue to pile them on, on the assumption that access to credit will continue as far as the eye can see. (This is in fact what consumer confidence is actually measuring today, expectations of future access to credit.) Today we don’t have soup lines but we do have millions of middle class households who have been breaking up the household financial assets “furniture,” so to speak, by selling the equity in their homes and consuming their credit to maintain the standard of living to which they have become accustomed. The Die is Cast Where is all of this headed? The Fed maintains that all is well, but the FDIC is starting to worry out loud what the next recession might look like, given these circumstances:
No one knows for sure what might happen during the next recession, but here’s a scenario. Let’s say there is a crisis that causes a sudden drop in consumers' access to credit and a corresponding decline in demand. A U.S. war with Iran and sympathetic withholding of oil by Venezuela that causes a spike in the price of oil to $200 a barrel would do it. Interest rates will rise and credit will tighten, reducing the flow of credit to the median household that has come to rely on it to compensate for loss of wage income. We’d then have a situation not unlike the early 1930s, with an economy comprised of a few million rich unable to generate sufficient demand in the economy to employ several hundred million without access to the credit they use to pay the bills. When FDR took over in 1933, he had a similar problem. Thousands of very rich buying super cars cannot generate enough demand to employ millions of workers. The problem was not unique to the U.S. but was global, just as housing and other related credit bubbles today are not unique to the U.S. Both eras’ stock market and credit bubbles produced wealth inequality. The economic crisis that followed turned this inequality into a political nightmare. The way it was addressed in parts of Europe was the wholesale redistribution of wealth in Communist movements. There was a period in the early 1930s when many were convinced that a Communist movement was all but inevitable in the U.S. In his memiors, Alistair Cooke noted that he came to the U.S. from the UK to cover the Communist revolution that was at hand, seeing this as a once in a lifetime career opportunity for a young journalist. Political developments overseas made FDR’s solution an easier sell to the wealthy elite in the U.S. when he came into office. The U.S. president that follows the administration that follows the Bush II administration, take note. FDR offered the top 1% in American society a better option than Communism: "Turn in your gold and the government we will pay you in currency which we will then inflate. The impact will be that your money will be put back into circulation to get the economy moving and we’ll get the banking system working again. Everyone wins, and it’s a better deal than the creditor class is getting in, say, Hungary. This will cost you only 30% of the purchasing power of your wealth." Most responded by voluntarily turning in their gold to the government in exchange for currency. To take care of stragglers, Executive Order 6102 was issued in April 1933 (repealed in 1975), making private gold ownership illegal in the U.S. This law was intended to keep bankers from cutting deals with their wealthy clients. Once the government had the gold, they marked it up from $20 to $35 an ounce. At once, a 30% inflation occurred to halt the deflation that had been crippling the economy. Asset bubbles create wealth inequality as only the top income brackets tend to benefit. Post bubble policies to manage the aftermath, one way or another, tend to intensify these disparities. A secondary crisis that results from the effort to manage the initial post-bubble crisis can be resolved by the politically expedient of redistribution of wealth via inflation. I have no reason to believe that a future crisis, if one occurs, will not be resolved by similar means. Back to our card game. In 2001 when gold fell into the mid 200s, silver was below $5 and platinum well below $500, I told the guys I was buying. Our financial advisor Ralph shook his head and told me PMs are out-of-date and certain to decline another 50% over the next few years. He adhered to the stocks-go-up theory to the bitter end. Later, in 2001, he said they were coming back -- you know, Nortel, Lucent, Cisco, and so on. Any day now. In September of that year I published the one and only piece I ever wrote on gold. When I was predicting inflation as an outcome of the crash in the stock market bubble in 2000, reporter Ross Kerber of the Boston Globe said in an article on iTulip.com in 2002 that my prediction was incorrect so far. He was right, at the time. My prediction in 2002 of the result of the decline of the housing bubbles? More inflation. The problem with making these kinds of long term predictions is they take many years to play out. But as far as I'm concerned, the die was cast in 1996 when Greenspan noted the stock market bubble but decided for reasons historians will debate for decades to allow it to grow to outrageous proportions. Now the Fed is on a liquidity treadmill -- they have to keep The System going -- and any random exogenous event that may occur only raises inflation risks. Since 2001, the best return on risk has been to buy assets that hedge inflation. The fortunes of the real estate farmers are starting to shrink as kudzu for sale reaches its nadir for the cycle. Hedge funds started to see their returns fall off in 2005 and have been placing inceasingly risky bets in order to maintain returns. Maybe the Fed has built a better mouse trap and the secondary bubbles in real estate and other assets that formed as a result of policy actions to mitigate the impact of the collapse of the stock bubble will this time end with a wimper not a bang. Still, taking out some insurance against the possibility of an inflationary result is wise. Discuss this... |
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