| PERFORMANCE ANNOUNCEMENT |
As Of: January 29, 2002
It Isn't Over 'Til Its Over
And it isn't over!
I have referred in previous articles to the disservice that the Federal Reserve has performed by manipulating interest rates. I would like to elaborate on that remark as an explanation for why our economic troubles are far from over. We have been witnessing a collapse of prices in the stock market. We have yet to see an equivalent dramatic collapse of prices in other markets. In particular, I am most concerned about the real estate market.
In his now famous speech in December 1996, Alan Greenspan said, "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?" He was of course referring to the stock market. But real estate prices have also been escalating at a remarkable rate. Other segments of the economy, such as health care costs and educational costs, have additionally been growing at disproportionate rates. Since the entire economic boom of the 1990's was in part deliberately engineered by the monetary policies of the Federal Reserve, I believe that Mr. Greenspan was addressing the apparent dislocation of resources and prices, while ignoring the role that economic stimulation might have played. It wasn't until toward end of the decade that the FED recognized (too late) that it was promoting a bubble, and overreacted by raising interest rates too much. It then overreacted again by lowering interest rates too fast and too far. The Federal Reserve introduced an unnecessary element of instability into the economic system that has caused businesses and consumers to make incorrect and costly decisions.
If prices are stable, or at least fully predictable, then behavior will proceed rationally toward the most efficient employment of resources; and the risk (or cost) of engaging in business will be minimized. When prices are allowed or encouraged to fluctuate widely, and/or in unpredictable directions, people are misled into making bad decisions. If prices (including the price of money as dictated by interest rates controlled by the Federal Reserve) fluctuate widely, then dislocations and financial distress will occur such as those affecting the commodity markets in the 1970's and early 1980's , the banking and finance markets in the mid-1980's and early 1990's, and the stock markets most recently. The Federal Reserve engineered growth in the 1980's and 1990's through a policy of easy money, while exporting inflation through a strong dollar. A dislocation of capital to the stock market created a bubble in capital investment by businesses. The bubble was followed by a collapse. This has not been a typical recession which is led by higher interest rates causing the consumer to withdraw from the marketplace. This time, at the first sign of weakness, the FED lowered interest rates and the consumer has continued to purchase.
In a typical boom-bust cycle, excessive consumption, as a result of easy money, tends to lead to excessive debt. Excessive debt can lead to deflation. When borrowers cannot repay their debts, the marketplace becomes vulnerable to distress selling which (through competition) lowers prices across the whole market. As debt is liquidated, the money supply declines (as does the velocity of money in the system), further lowering the price levels. The burden of carrying debt increases as deflation increases, creating a spiral of increasing bankruptcies and declining economic activity.
The big difference this time around is that the Federal Reserve thinks it can reverse the economic slowdown by injecting liquidity into the system through low interest rates. To quote William Poole, President of the Federal Reserve Bank of St. Louis in a speech given on 1/21/02, "Professional opinion has also changed about the source of deflation in the 1930s. It is now widely acknowledged that, at a minimum, the intensity of the Great Depression was magnified by the failure of the Federal Reserve to provide sufficient liquidity to the economy in the face of widespread bank failures. The Federal Reserve in turn has learned from that experience. When the U.S. economy has been threatened by liquidity crises in recent years, such as the stock market crash of 1987, the Asian crises and Russian default of 1998 and the terrorist attack last September 11, the Fed has moved rapidly to inject large amounts of liquidity into the economy. Liquidity crises have been averted, inflation has remained low and stable and deflation has not occurred."
I contend that the Federal Reserve has taken its eye off the ball. The ball in this case is the consumer. All the business to business commerce in the world serves only one ultimate end: to satisfy the needs of the consumer. Without the consumer, moving inventory between businesses and building infrastructure is a meaningless exercise. Lowering interest rates to encourage capital spending by businesses is worthless without the consumer. And where is the consumer? The consumer has been there all along, consuming and taking on more and more debt. The policies of the Federal Reserve have encouraged bad decisions. Businesses have built too much capacity, and the consumer has taken on too much debt. Instead of the normal debt liquidation that is typical of a recession, the consumer has refinanced his home, and financed the purchase of new automobiles with enticing low interest rate loans.
Can the inevitable be forestalled? I do not think so. Quoting from William Poole's speech again, we have a role model in Japan: "Experience elsewhere has not been as benign. Over the period from 1981 through 1990, the Japanese economy grew at an annual rate of 3.7 percent and the inflation rate (measured by the GDP price index) averaged 1.5 percent per year. The situation in Japan in the 1990s has been remarkably different. The Japanese economy has struggled in and out of recession, and real growth from 1991 to 2000 averaged only 1.1 percent. Over the same period, very low inflation has turned into deflation. From 1991 to 1996, the Japanese consumption deflator rose at an average annual rate of only 0.5 percent; for 1996 to 2000, the rate was -0.2 percent. Asset prices fell dramatically. The decline of the Nikkei equity price index from a value of close to 40,000 in late 1989 to its recent level of between 10,000 and 11,000 is common knowledge. What is not as well known outside Japan is that land and real estate prices have experienced equally dramatic declines to those seen in equity markets over the past decade. In terms of the impact on Japan's output and employment, the large deflation of asset prices was probably more important than the gentle deflation of goods prices." Mr. Poole blames Japan's problems on insufficient liquidity and says that we are not making the same mistake in the United States. (The Federal Reserve has recently lowered interest rates eleven times in a row to the lowest levels seen in more than 40 years.) I would contend that Japan's problems stem from an economic/political system that has not allowed debt liquidation to occur. Japanese banks are still carrying bad loans. The Japanese people have not only a cultural propensity to save, but also a good reason not to spend: Why buy now when the price will be cheaper in the future? Low interest rates have not been the solution for Japan.
Here is the crux of the matter. Conceptually, people think of real estate as a commodity; but this belies the fact that they treat real estate as a financial asset. If we compare real estate with common stock, we see a lot of similarities. Unlike commodities, which are purchased for their intrinsic value and their functional value, stock is purchased for its investment value. Common stock is purchased less for what it is today (hopefully a store of value), and more for what it will represent tomorrow (growth in value). Stock is a forward looking instrument. It is a claim against the future earnings stream of a corporation. Hopefully earnings will grow, and the price of the stock will go up.
Real estate is purchased for its functional value. You can live in residential real estate. A house is subject to depreciation and functional obsolescence. But just ask any homeowner, and he will tell you that he expects his house to not only be a store of value, but to also go up in value (like stock). People do not finance their groceries. They buy them and they consume them. But almost everyone finances real estate. Why? Because they expect that the property will appreciate faster than their cost of carry. They will not only enjoy the pleasure of having a place to live, they will also leverage their equity over time. If this wasn't true, people should be making large down payments or paying cash in full. And if real estate prices are falling, it is better not to own at all - a short term lease is preferable. Today, people are purchasing real estate with a strong eye toward future expectations; but they are basing their actions on past experience, not future knowledge. Most people have not experienced a period of declining prices.
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So what? Why should real estate prices decline? The answer is leverage. Residential real estate is the single most leveraged asset in the United States. You can't buy stock with a 5% down payment! Real estate prices don't have to soften very much for the leverage of high loan to value financing to work against the homeowner. Even with low interest rates, the cost of carry in a weak economy can create a decrease in prices that may rapidly spiral downward. Just a 5% or 10% drop in price can wipe out the entire equity of many homeowners. The homeowner may not get a margin call from his lender, but the loss of a job will have the same effect. Once the dam starts to leak, it becomes subject to a complete collapse. I view the real estate market as a very high risk area right now. I believe that the Federal Reserve is compounding the problem by encouraging more consumer debt rather than leading people to decide to reduce debt and protect themselves in an uncertain economic environment. I believe that the Federal Reserve, through being the architect of higher volatility and thus increased risk, has in fact become the problem, rather than the solution to the problem.
In the panic of 1857, real estate prices led the collapse. In the panic of 1873 the real estate boom in the western states once again was a leader in the collapse of prices. A decline in price can be particularly harsh when it isn't foreseen, but it is still a normal part of the process when the economy cycles down into an anticipated deflationary period as it did after World War I and World War II. It has always been traditional for real estate prices to decline as part of the debt liquidation process. If everyone is led to believe that the recession will be over by the second half of 2002 and then real estate prices break down, it could be a very painful shock. Even if real estate prices do not collapse, I believe it is unlikely that we will see any kind of a robust recovery. The consumer is at the heart of the process, and the consumer is in a weakened position. Not only is consumer debt at record levels, debt service payments as a percent of disposable personal income are at their highest levels in twenty years.
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We would all like to believe that the drop in the stock market signals the bottom of the recession, but it isn't over until it is over. And it isn't over yet!