Sunday, January 27, 2008

The Bubble Up Economy - Part Deux


A fascinating article in the February edition of Harper's in which veteran venture capitalist Eric Janszen predicts the next bubble for America's economy, arguing that, in the U.S., "...The bubble cycle has replaced the business cycle." Here are a few excerpts:

"A financial bubble is a market aberration manufactured by government, finance, and industry, a shared speculative hallucination and then a crash, followed by depression. Bubbles were once very rare - one every hundred years or so..."

"...Nowadays we barely pause between such bouts of insanity. The dot-com crash of the early 2000s should have been followed by decades of soul-searching; instead, even before the old bubble had fully deflated, a new mania began to take hold on the foundation of our long-standing American faith that the wide expansion of home ownership can produce social harmony and national economic well-being.

"...That the Internet and housing hyperinflations transpired within a period of ten years, each creating trillions of dollars in fake wealth, is, I believe, only the beginning. There will and must be many more such booms, for without them the economy of the United States can no longer function."

"A few weeks after D-Day, the allies met at the Mount Washington Hotel in Bretton Woods, New Hampshire, to determine the future of the international monetary system. ...The United States, now the dominant economic and military power, successfully pushed to peg the currencies of member nations to the dollar and to make dollars redeemable in American gold.

"Americans could now spend as wisely or foolishly as our government policy decreed and, regardless of the needs of other nations holding dollars as reserves, print as any dollars as desired. But by the second quarter of 1971, the U.S. balance of merchandise trade had run up a deficit of $3.8 billion, ...until that time the United States had run only surpluses. Members of the Bretton Woods system, most famously French President General Charles de Gaulle, worried that the United States intended to repay the money borrowed to cover its trade gap with depreciated dollars. Opposed to the exercise of such "exorbitant privilege," de Gaulle demanded payment in gold. With the balance of payments so greatly out of balance, newly elected President Richard Nixon faced a run on the U.S. gold supply, and his solution was novel: unilaterally end the U.S. legal obligation to redeem dollars with gold; in other words, default."

"...After 1975, the United States would never again post an annual merchandise trade surplus. Such high-value, finished-goods-producing industries as steel and automobiles were no longer dominant. The new economy belonged to finance, insurance and real estate - FIRE.

FIRE is a credit-financed, asset-price-inflation machine organized around one tenet; that the value of one's assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals. With FIRE leading the way, the United States, free of the international gold standard's limitations, how had great flexibility to finance its deficits with its own currency. This was "exorbitant privilege" on steroids.

"...As FIRE rose in power, so did a new generation of politicians, bankers, economists, and journalists willing to invent creative justifications for the system, as well as for the projects - ranging from the housing bubble to the Iraq war - that it financed. The high-water mark of such truckling might be the publication of the Cato Institute report "America's Record Trade Deficit: A Symbol of Strength." Freedom had become slavery, persistent deficits had become economic power."

"...Deregulation had built the church, and seed money was needed to grow the flock. The mechanics of financing vary with each bubble, but what matters is that the system be able to support astronomical flows of funds and generate trillions of dollars' worth of new securities.

"...The media stood by cheeering, carrying breathless profiles of wunderkinder in their early twenties who had just made their first hundred million dollars; business publications grew thick with advertisements. The media barely questioned the fine points of the new theology.

"...In a bubble, fictitious value goes away when market participants lose faith in he religion - when their false beliefs are destroyed as quickly as they had been formed. Since the early 1980s, the free-market orthodoxy of the Chicago School has driven policy on the upward slope of an economic boom, but we're all Keynesians on the way down; rate cuts by the Federal Reserve, tax cuts by Congress, deficit spending, and dollar depreciation are deployed in heroic proportions.

"The Internet boom had been a matter of abstract electrons and monetized eyeballs. ...At the bubble's peak, $12-trillion in fictitious value had been created, a sum greater even than the national debt."

"...Historically, the price of American homes has risen at a rate similar to the annual rate of inflation. ...discounting the housing boom after WWII, that rate has been about 3.3 per cent. Why, then, did housing prices suddenly begin to hyperinflate? Changes in the reserve requirements of U.S. banks, and the creation in 1994 of "sweep" accounts, which link commercial checking and investment accounts, allowed banks greater liquidity - which meant they could offer more credit. this was the formative stage of the bubble. Then, from 2001 to 2002, in the wake of the dot-com crash, the Federal Reserve Funds Rate was reduced from 6 percent to 1.24 percent, leading to similar cuts in the London Interbank Offered Rate that banks use to set some adjustable-rate mortgage (ARM) rates. These drastically lowered ARM rates meant that in the United states the monthly cost of a mortgage on a $500,000 home fell to roughly the monthly cost of a mortgage on a $250,000 home purchased two years earlier. Demand skyrocketed, though home builders would need years to gear up their production.

"...All that was needed for hypergrowth was a supply of new capital. ...for the housing bubble, starting around 2003, it came from securitized debt.

"...The U.S. mortgage crisis has been labeled a "subprime mortgage crisis," but subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers. The main event was the hyperinflation of home prices. Risks are embedded in price and lurk as defaults. Even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds.

"...The housing bubble has left us in dire shape, worse than after the technology-stock bubble, when the Federal Reserve Funds Rate was 6 percent, the dollar was at a multi-decade peak, the federal government was running a surplus, and tax rates were relatively high, making reflation - interest rate cuts, dollar depreciation, increased government spending, and tax cuts - relatively painless. Now the Funds Rate is only 4.5 per cent, the dollar is at multi-decades lows, the federal budget is in deficit, and tax cuts are still in effect. The chronic trade deficit, the sudden depreciation of our currency, and the lack of foreign buyers willing to purchase its debt will require the United States government to print new money simply to fund its own operations and pay its 22 million employees.

"Our economy is in serious trouble. Both the production-consumption sector and the FIRE sector know that a debt-deflation Armageddon is nigh, and both are praying for a timely miracle, a new bubble to keep the economy from slipping into a depression."

"..There is one industry that fits the bill: alternative energy, the development of more energy-efficient products, along with viable alternatives to oil, including wind, solar and geothermal power, along with the use of nuclear energy to produce sustainable oil substitutes.

".,..Supporting this alternative-energy bubble will be a boom in infrastructure - transportation and communications systems, water and power.

"...The next bubble must be large enough to recover the losses from the housing bubble collapse. How bad will it be? Some rough calculations: the gross market value of all enterprises need to develop hydroelectric power, geothermal energy, nuclear energy7, wind farms, solar power, and hydrogen-powered fuel-cell technology - and the infrastructure to support it - is somewhere between $2 trillion and $4 trillion; assuming the bubble can get started, the hyperinflated fictitious value could add another $12 trillion. Thus, we can expect to see the creation of another $8 trillion in fictitious value, which gives us an estimate of $20 trillion in speculative wealth, money that inevitably will be employed to increase share prices rather than to deliver "energy security." When the bubble finally bursts, we will be left to mop up after yet another devastated industry. FIRE, meanwhile, will already be engineering its next opportunity. Given the current state of our economy, the only thing worse than a new bubble would be its absence."

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