How would you prefer to be impoverished? - May 27, 2004
To illustrate why relative prices matter, my favorite boring story asks which regime was preferable: Weimar Germany or Great Depression America? In the former, the price of money plummeted and Germans had to carry out their life savings in a wheelbarrow to buy a loaf of bread. In the latter, it was the price of goods plummeted and people cashed out their life savings of newly worthless stock certificates to buy the loaf of bread. The economic indicators evolved differently, but what you ended up eating was the same.
I'm reminded of this every time a Federal Reserve Board member makes a speech (as a side note, these speeches appear to be much more frequent these days, a solid indicator the value of a word from Alan and company is worth less than it used to be) reminding us that deflation will never, ever, ever, ever happen again as long as they've got working helicopters and a printing press.
I take them at their word, considering they've created an inflationary spiral that threatens to spiral out of control globally. U.S. consumer prices inflation is now running at a 4.4% annual rate. Chinese inflation is heading north of 5%. Even Japan is beginning to experience inflation, which most economists had nearly given up on after 15 years of trying.
Yet inflation has its own unintended consequences. The strength, or should I say lack of weakness, of the dollar has been almost entirely supported by foreign central bank purchases, and those purchases have almost entirely been from East Asian countries with the means to do so. Inflation in East Asia means that these countries will have to devote more resources to buying the goods and infrastructure necessary to keep their export-led economies functioning, and that regrettably means less money to purchase dollar-denominated U.S. debt securities.
It also means that countries don't profit as much from pegging their currency to dollars, so this type of analysis becomes more attractive.
While recent strength in the dollar has been encouraging, it is likely simply a speculative short squeeze. Now the squeezing has been done and hedge funds have liquidated their portfolios, we can get back to the longer term trend: higher interest rates and a weaker dollar for the United States. Higher inflation is going to be a big negative.
The impoverishment of Americans can just as easily be accomplished in an inflationary environment as in a deflationary one. Deflationary environments tend to be more exciting, with the stock market crashes and mass bankruptcy. However, senior citizens and college students have found out recently that inflation can impoverish you quite as efficiently when your income doesn't increase as fast as your expenses, you have to borrow more to finance your lifestyle and paying interest rates is always done in nominal terms.
Stockholders are also relearning the lesson of the stagflationary 1960s and 1970s: that the stock market doesn't have to go down to lose you money. Even at recent low official inflation rates and with a Dow Jones Industrial Average hovering around the same 10,000 level, stockholders have lost nearly 20% of their purchasing power since 1998. Compared to nothing, even those 1% money market rates are starting to look good.
And the American consumer has to be wondering why it's so difficult these days to make a living despite such rapid GDP growth. Jobs are harder to come by and raises are imperceptible. Homeowners are committing 40% or more of their income to house payments for the next thirty-odd years, savings is zero, and now the price of the remaining 60% of their expenses is getting higher.
Alan Greenspan praises his efforts as "wealth creation", but Kurt Richebacher notes:
"The striking key feature of so-called wealth creation through asset bubbles in favor of the consumer is, first of all, the associated record production of debt, set against the total absence of income creation. To maintain demand creation through this kind of wealth creation, ever more debt creation is needed - first, to keep the asset prices inflating; and second, to fund the spending on consumption.
Thinking it over, one realizes that "wealth creation" is really a grotesque misnomer for asset prices that are rising out of proportion to current income. The economic reality is not wealth creation, but impoverishment. We repeatedly hear from Americans that they are living in houses or apartments they cannot afford to buy with their present incomes. But many years ago, with incomes and prices as they were at the time, they could afford the houses. That says it all."
So don't you feel richer now?
The insidious development of the so-called recovery has been the complete lack of improvement in consumer finances. In fact, many consumers seem to be going out of their way to accumulate both debt and interest rate risk. Inflation doesn't help us here, either. With no savings there is only one way to keep consuming: borrow even more.
Consumers may be under the impression that a central bank committed to achieving inflation is one committed to achieving a reduction in the real value of their debts. This only works in the short run if your expenses are growing slower than your income, and only in the long run if your income is growing faster than your total debt. Debt service is a near record 18% of income and consumer debt is well above 100% of annual disposable income. Both are worse than in 2000 and near all-time records. Neither is indicative of a consumer that can adapt to inflation very well.
And I don't like the way some things are developing at all. Here's a story related from Thursday's Daily Reckoning.
"Interest-Rate Fears Spur Home Sales," declared a front- page headline in the "Personal Journal" section of yesterday's Wall Street Journal. A few pages away, a headline emblazoned across the top of the Journal's "Heard on the Street" column read: "Buying into Housing Stocks: Value Investors See Bargains Among Rate-Battered Shares; Betting Things Will Be Different."
The former story explains that folks like Danene and Greg Hanemann are accelerating their home-buying plans because they've "grown nervous that rising interest rates would make monthly payments unaffordable." But the latter Journal story asserts that housing stocks are cheap...as long as nothing bad happens to the housing market.
We agree...as long as nothing bad happens to the housing market.
We do not know if home prices will rise or fall, nor do we know if home-building stocks will rise or fall. But we do know that a few bad things are happening in the housing market. Thirty-year mortgage rates have jumped one full point, from 5% to 6%, in two months. A thirty-year mortgage at 6% is not a catastrophe, but the trend is troubling and it is beginning to affect the behavior of buyers and sellers.
The Hanemanns, who had been planning to begin shopping for a home in October, instead plunked down a deposit for a new home last March. "We weren't going to dicker with the house," says the Missus, "if our payments went up by even $100, we would have had to seriously think about backing away from buying a home."
We wonder how many more "Hanemanns" are accelerating their purchase plans - snapping up a home now while they can still barely afford it. How many more "last chance" homebuyers are boosting demand - temporarily - because they fear rising rates will force them to abandon or downsize their home-buying dreams? And what does this "front- loading" of demand portend for homebuilders? Are today's sales stealing from tomorrow's sales?
Furthermore, what if Danene and Greg are correct, and rates continue rising?
Doesn't this reasoning seem awfully familiar?
Automakers and SUV buyers have already discovered the inflationist paradox. Zero-percent financing was originally intended as a short-term program to boost auto sales during the recession. Now the program is well into its fourth year, though accelerating rebates are often used to get consumers to pay interest on their purchases. Every time automakers try to reduce the incentives, sales drop more dramatically.
Now sales are dropping without any reduction in incentives, thanks to rising gas prices. Everyone involved in supply and demand is beginning to have problems. Auto finance companies need to borrow more and at higher rates to finance these incentives. Their customers see the rising price of gas reducing the enjoyment of their SUVs. Selling the behemoths is usually right out - most consumers are already under water from 6+ year loans and collapsing used car prices. The companies shift income abroad rather than pay higher wages and benefits to auto workers. The system is becoming rapidly unaffordable by anyone, but the alternative is increasingly unthinkable.
It's the same way for the Fed. Do they really have any power with an economy they cannot afford to slow down, with interest rates they have almost no room to move lower? Should they be celebrating their "triumph" over deflation when they feel compelled remind us we're not going to have it? He can keep up appearances in public, but in private Alan Greenspan must be cursing his luck. Another four years of dodging bullets for Sir Printsalot.