A Tightening Farce
By Kurt Richebächer, September 2006  (Previously... It is far worse than in 2000 )
 

There is total detachment from the bad news that is pouring out of the economy. For several years, the booming housing market has made the difference between recession and recovery for the U.S. economy. Zooming house valuations provided private households with the collateral that allowed them to replace the missing income growth with a borrowing binge.

But as the housing market is sagging, this major source of higher consumer spending is plainly drying up, and most obviously and importantly, income growth is by no means catching up.

In 2005, real disposable incomes of private households in the United States increased $93.8 billion, or 1.2%, while their debts grew $1,208.6 billion, or 11.7%. Total consumer spending on goods, services and new housing accounted for 92% of real GDP growth.

The U.S. economy's recovery from the recession in 2001 has been its slowest in the whole postwar period, and in addition, it has been of a most unusual pattern. Real GDP rose by 11.7% over the four years to 2005. Within this aggregate, residential building soared by 35.6%. Consumption gained 13.4% and government spending 10%. The big laggard in domestic spending was business nonresidential investment, up only 3.6%. Net exports year for year were increasingly negative.

Most economic data have softened, with the downtrend accelerating. In the face of this fact, it could not be doubted that Mr. Ben Bernanke and most others in the Federal Reserve were anxious to stop their rate hikes. In question was only whether they would dare to do so in view of the high and rising inflation rates. They dared. They even disappointed those who had predicted the combination of a declared "pause" with hawkish remarks about fighting inflation.

In its statement, the Fed conceded:

"Readings on core inflation have been elevated in recent months, and the high levels of resource allocation and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative of monetary actions and other factors restraining aggregate demand."

When the Bureau of Labor Statistics (BLS) reported on Aug. 16 that the CPI in July had seasonally adjusted, advancing 0.4%, following a 2% rise in June, both the bond and stock markets responded with strong rallies. What, apparently, had made it so exciting in the eyes of the consensus was the fact that these bad figures had remained in line with distinctly unoptimistic predictions. Never mind that during the first seven months of 2006 the CPI has risen at a 4.8% seasonally adjusted annual rate, compared with an increase of 3.4% for all of 2005.

It is, of course, perfectly true that monetary tightening impacts the economy and its inflation rates with a pretty long delay. The trouble in the U.S. case is that there never was any monetary tightening. There were many small rate hikes, and the Greenspan Fed had probably hoped that the higher costs of borrowing would exert some restraint on credit demand. But it has not happened. It was a vain hope.

The fact is that the credit expansion has sharply accelerated during these two years of rate hikes instead of decelerating. During 2004, when the Fed started its rate hike cycle, total credit, financial and nonfinancial, expanded by $2,800.8 billion. In the first quarter of 2006, it expanded at an annual rate of $4,392.8 billion.

Over the two years of so-called monetary tightening, the flow of new credit has effectively accelerated by 56%. In 2005, credit growth was $3,335.9 billion. Over the whole period of rate hikes, it had steadily accelerated from quarter to quarter. Borrowers and lenders, apparently, simply adjusted to the higher rates, trusting that there would never be serious tightening.

True monetary tightening would have to show first of all in declining "excess reserves" of banks relative to their reserve requirements. These have remained at an elevated level during the rate-hike years of 2004-05.

In 1991, when the Fed tightened, credit expansion slowed sharply from $866.9 billion in the prior year to $620.1 billion. A sharp slowdown in credit expansion in 2000 to $1,605 billion also happened, from $2,044.7 billion the year before. Yet this still represented very strong credit growth in comparison with the years until 1997.

Like all central banks, the Federal Reserve has two levers at its disposal to stimulate or to retard credit and money creation. The big lever is its open market operations, buying or selling government bonds, thereby increasing the banking system's liquid reserves. The little lever consists of altering its short-term interest rate, the federal funds rate, thereby influencing the costs of credit.

It is most important to distinguish between the two instruments. True monetary tightening has to show inexorably in a slower credit expansion throughout the financial system. There is one sure way for a central bank to enforce this, and that is by curtailing bank reserves through selling government bonds.

The other lever at its disposal, as pointed out, is to influence credit costs. But the influence of the central bank on credit costs begins and ends with altering its short-term federal funds rate. During the past two years, the Fed has raised its federal funds rate from 1% to 5.25%. But long-term rates hardly budged. To the extent that borrowers shifted from the low short-term rate to the long-term rate, they encountered higher borrowing costs. But at the long end, interest rates rose less than the inflation rate.

Here are still a few other credit figures illustrating the Fed's monetary tightening since mid-2004. Total bank credit expanded, annualized, by $957.0 billion in the first quarter of 2006, against $563.5 billion in 2004. For security brokers and dealers, the two numbers were $611.3 billion, against $231.9 billion; and for issuers of asset-backed securities (ABSs), they were $663.3 billion and $322.6 billion. This is monetary tightening à la Greenspan.

Monetary tightening has one purpose: to curb credit expansion fueling the excess spending in the economy and the markets. By this measure, Greenspan's monetary tightening since 2004 has been a sheer farce. During these two years, he presided over a sharply accelerating credit boom, for which the reason is also obvious.

To equate rising short-term rates automatically with monetary tightening can, therefore, be a gross mistake. Later on, we shall explain that this is the great error of the monetarists in assessing the development in 1929 and following years. Borrowing exploded during 1927-29, despite the Fed's rate hikes, and then literally collapsed after the stock market crash.

It can be argued that rate hikes in the past have generally worked. Yes, but the central bankers of the past never forgot to tighten bank reserves. Tighter money to them meant tighter credit, and it always showed in sharply shrinking credit figures. So it also has, in the past, in the United States. But this time, the diametric opposite has happened.

There was reserve easing. Money and credit, moreover, only became significantly more expensive at the short end. All the time, there was nothing in this to slow the housing bubble and the associated borrowing binge. Rising house prices easily offset the effect of rising short-term rates.

Does this mean that the economy can continue to grow as before? No, not at all. All excesses, if not stopped, are sure to exhaust themselves over time. That is no less true for economies than for the human body. In our view, the housing bubble is finished not because credit has become tight, but because the borrowing excesses are running against natural barriers.

One such natural barrier is the affordability of housing and the limited number of greater fools who are able and willing to pay these inflated prices. At some point, excess supply will exceed demand. We read from reliable sources that in June, sale offers of existing single-family homes were up 35%, while actual sales were down 6.5% versus a year ago. So the year-over-year "excess" supply was 42.2%.

Affordability is way down, units offered for sale are way up and price appreciation has all but stopped. It is a radical change in the market situation, which, however, has so far impacted economic activity only moderately.

Past experience with housing bubbles suggests that the first effects are in the steep fall of actual sales and in the lengthening of time until sales materialize. The markets become illiquid. Until sellers capitulate and accept lower prices, it can take a long time. In this way, apparent price stability becomes increasingly treacherous over time.

Present American folklore has it that a protracted slump in house prices is impossible. Let us say for many people it is unthinkable. And that is precisely one reason why this housing bubble could go to such unprecedented excess. The little historical knowledge we have about bursting housing bubbles is from a study published by the International Monetary Fund in its World Economic Outlook of April 2003. It presents past experience in a very different light. Here are some excerpts on decisive points:

"To qualify as a bust, a housing price contraction had to exceed 14%, compared with 37% for equities. Housing price busts were slightly less frequent than equity price crashes... Most housing price busts clustered around 1980-82 and 1989-92, while equity price busts were more evenly distributed across time.

Housing price crashes differ from equity price busts also in other three important dimensions. First, the price corrections during house price busts averaged 30%, reflecting the lower volatility of housing prices and the lower liquidity in housing markets. Second, housing price crashes lasted about four years, about 11/2 years longer than equity price busts. Third, the association between booms and busts was stronger for housing than for equity prices."

An important theme running through the foregoing analysis is that housing price busts were associated with more severe macroeconomic developments than equity price busts. Coupled with the fact that housing price booms were more likely (than equity price booms) to be followed by busts, the implication is that housing price booms present significant risks. For this, the authors give the following reasons:

• "Housing price busts have larger wealth effects on consumption than the equity price busts...
• "Housing price busts were associated with stronger and faster adverse effects on the banking system than equity price busts... All major banking crises in industrial countries during the postwar period coincided with housing price busts.
• "Price spillovers across asset classes matter, as evidenced by the fact that housing price busts were more likely associated with generalized asset price bear markets or even busts than equity price busts.

The authors then give a fourth reason, which was true in the past, but in which the situation in America today radically differs:

• "Housing price busts were associated with tighter monetary policy than equity price busts, reflecting the fact that most housing price busts occurred during either the late 1970s or the late 1980s, when reducing inflation was an important policy objective. The disinflation increased the real burden of debt, which exposed inflation-related overinvestment and associated financial frailty."