(This is Part 3 of a series. Go back to Part 2.)
Another Katrina waiting in the wings, and then some, is the "financial tsunami" that's just offshore of reality but moving in on us fast.
The thing about this financial hurricane, though, is how invisible it is on the surface. On the surface, growth in GDP is 3.5%; unemployment is 4.9%; the CPI is about 3%; and houses are in a bull market. What's not to like?
But beneath the surface, trouble is brewing and has been for quite some time now. And what is the essence of that trouble? There are many factors to this building hurricane, but the essence of it is the enormous debt bubble that the U.S. has built up.
Debt bubbles are trouble. Just ask Argentina. All during the 1990s Argentina seemed to be very prosperous. It had low inflation, low unemployment, and a nicely rising GDP. So what was the problem?
The essence of the problem was that the Argentine government kept relentlessly spending more than it was taking in—and financing the resulting deficits with bonds issued to foreigners. Sound familiar?
But the Argentines weren't concerned. Times were good. True, the government debt kept piling up and up and up, but Argentina wasn't really focused on that. The excessive spending by the government suited the citizens and suited the government, since everybody seemed to be getting something for nothing. So what if Argentina was issuing lots of bonds to foreigners to pay for the good times?
The whole process worked spendidly right up until the moment that Argentina suddenly went broke. As the debt kept piling up the markets started getting more and more nervous, so the interest rate that Argentina had to pay on its bonds started rising too—and then kept on rising.
"How foolish you are, Jimmy, to compare Argentina then to the U.S. now," you might say. After all, aren't United States Treasury bonds selling at the lowest interest rates in two generations?
Yup, indeed they are. And that's where the plot thickens.
You see, Asia wants to sell us lots of stuff—textiles, shoes, electronics, garden hoses, computers, cars, you name it. Their economies are export-oriented. That's where most of their growth has been coming from.
This being so, they've had a strong incentive to keep their currencies down in relation to the U.S. dollar, so that their exports will seem inexpensive to us. To accomplish that goal, the Asian countries have been buying enormous amounts of U.S. Treasury paper—and in the process drastically holding down U.S. long-term interest rates.
Again, it's a game that seems to suit everybody. The U.S. government gets to finance its increasing deficits at low rates. U.S. consumers like it because it holds down U.S. long-term interest rates, thus financing all those new housing mortgages. Here's a quiz for you: Do you think all that ocean of available financing could have anything to do with exponentially-rising house and condo prices?
And of course the Asian countries—China, Japan, South Korea, India, etc.—like it because they get to sell us lots and lots of manufactured goods. Just check the label the next time you buy something. And of course, a little side-effect: the hollowing-out of the U.S. manufacturing base as jobs flow to Asia. Gee, I wonder if that's why incomes have stagnated while profits and asset prices have soared?
Recently, the game has changed a little. Middle East oil countries swimming in high oil revenues and hedge funds based in the Cayman Islands have partly replaced Asia as the marginal source of funds buying U.S. Treasury paper. No matter; the game continues and times are good.
Meanwhile, the riskiness of the debt keeps rising. Junk bonds now represent 62% of corporate bond issuance. And consumers are buying houses with adjustable-rate mortgages, interest-only mortgages, negative-amortization mortgages and other fantasmagorical financing that allows buying much more house on the same income.
I know it's uncouth to ask, but what happens if foreigners tire of our debt and the overvalued dollar starts crashing? What happens if foreigners tire of our debt and so long-term interest rates start rising dramatically? Can we spell "housing, stock and bond crash"?
Meanwhile, also, U.S. banks have decreased loan-loss reserves to only 1.2%, an all-time low. But then, who needs reserves when you're making so much money on your loans, right? Oh I forgot, that's what the banks in Argentina said right up until the systemic banking crisis hit the country and bank deposits were frozen.
By the end of 2002, a country that had once been one of the ten wealthiest in the world had 60% of its population below the poverty line. The Argentine middle class had basically disappeared. But it couldn't happen here, right?
The thing is, U.S. banks cannot now withstand any shocks or stresses. U.S. consumers and municipalities, up to their respective eyeballs in debt, cannot stand any stresses or shocks either. And the U.S. government, its trade deficit at 6% of GDP—hmm, right at the level where currencies tend to fall into crisis—also cannot stand any stresses.
Yet we know that the nature of reality is that every system is presented with a severe stressor from time to time. This time will be no exception; it's just a matter of when not if. A new Hurricane Katrina is waiting just offshore.
I wish I could say that there was something to be done, but once a debt bubble has gotten beyond a certain point its bursting becomes a virtual certainty. The bursting can be delayed—by fresh injections of fiat credit—but not avoided. And the longer the bursting is delayed, the more catastrophic its effects when it finally does occur.
In this case we cannot avoid the hurricane, but we have the opportunity to learn its lessons. An economy grows sustainably by saving and investing in new productive capacity that in turn creates sustainable jobs. There's no shortcut; when growth in credit runs substantially ahead of GDP for an extended period, trouble lies ahead.
In future, governments would be wise to keep the lessons of Argentina in mind when considering their budgets and spending bills. And central banks would be wise to nip asset bubbles in the bud by restricting credit before credit booms reach the point of no return.
When something is allowed to reach an extreme, it will sooner or later produce its opposite extreme. This is an interesting principle we'll talk more about further on.
(This is the end of Part 3. Go to Part 4.)
—jim sloman, 9.5.05
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