Can The Fed Inflate Its Way Out of Housing, Credit Mess?

Minyan Nimesh Writes:

For almost thirty years, count them, for almost thirty years people like you have predicted that our economy will collapse and the end of the consumer. Throughout all of those years, it didn't happen. No matter how many logical arguments the "gloom and doom" crowd has made, it hasn't happened.

Nimesh, I have only been on the deflation bandwagon for a few years, not thirty. However, you are correct about one thing: Some notable people have indeed been calling for a collapse for nearly thirty years. However, that does mean an economic collapse can’t happen, now does it?
Chronology Of Things That Can't Happen

• One of the reasons the Fed was created was to manage the economy and prevent further depressions. Guess What? The biggest deflation in history, the great depression, happened 17 years later.
• At one time economists thought that inflation and recession could not happen at the same time. It happened anyway. A new term was coined for it “Stagflation”.
• Deflation supposedly couldn't happen in a fiat regime. Japan proved otherwise.
• If you asked anyone in Japan if housing prices could fall for 18 straight years, they would have said "It can't happen". It did happen.
• For 30 years people have said US housing prices would never again decline on a national scale. They were wrong. It happened.

It is the very nature of the market that it takes the convincing of nearly everyone to believe that something cannot happen, to actually cause it to happen. Consider housing. Everyone became convinced that housing was a one way ticket north, that all housing was local, and housing would not decline nationally.

This mass belief in a faulty housing premise in spite of evidence to the contrary in Japan is what helped form the US housing top. Greater fools everywhere who came to believe that faulty theory eventually rushed in to speculate in housing. That made the top. Even the rating agencies got into the act.

Please consider Fitch Discloses Its Fatally Flawed Rating Model. As amazing as it might seem now, Fitch disclosed as recently as March 2007 that their model for rating CDOs assumed low to single digit home price appreciation forever into the future. They even admitted their model would break down if home prices were flat for an extended period of time. There is a shocking conference call discussed in the above link where Fitch described those fatally flawed assumptions.

Fitch placed so much faith in their models (as did Moody's and the S&P) that the biggest financial speculation in housing history took place. Greenspan and the Fed cheered the miracle of derivatives most of the way. Such foolishness has already cost Citigroup (C) and Merrill Lynch (MER) their CEOs. It may cost Citigroup its entire company. See More Writedowns Force Citigroup To Sell Assets.

Housing speculation is likely to cost both Ambac (ABK) and MBIA (MBI) their companies. See Buffett Signs Death Warrant For Ambac & MBIA for more on the demise of the guarantors.

It's Different Here

All of the above are casualties of the bursting of a housing bubble, a bubble that until last year people denied even existed. Instead of looking at Japan for what was about to happen, all we heard was "It's Different Here. The US is Not Japan".

The above image thanks to The Best of Five Things You Need to Know.

Housing prices rose three standard deviations above norm in relation rental prices and wages yet excuses were made as to "Why it's different this time". Now, in spite of all the evidence to the contrary, most still insist that "Deflation Can't Happen Here". The entire argument rests on one or more of the following faulty premises.

Faulty Premises

• It's Different Here.
• It's Different This Time.
• The Fed won't let deflation happen.

Belief in the third point above goes well beyond amazing to the point of being nearly universal. Yes, there are a handful of us that see deflation coming, but as Nimesh writes "For almost thirty years people like you have predicted that our economy will collapse and it hasn't happened."

That is precisely the sentiment that it takes to make a top (or a bottom). Many predicted the demise too early and are now discredited. Those hopping on the bandwagon near the top are compared to the early visionaries. It becomes guilt by association even though there is no real association.

Mocking of the early visionaries is part of the topping process. Group think sets in and is reinforced over the years. Risk premiums drop as the long term trend reaches the peak. That takes time. Memories fade. Does anyone fear another great depression? Heck, does anyone even remember it, let alone fear it?

Where Prechter Went Wrong

Since everyone knows the early visionary we are talking about, we may as well openly discuss his name. Robert Prechter ignored and/or did not foresee many things that could keep the credit bubble expanding. Let's start with a flashback to conditions of the 70's and 80's.

Why The Credit Bubble Lasted For Decades

• Single household breadwinner became two household bread winners
• Interest rates were at 18% headed to 1%
• Internet revolution provided tremendous numbers of jobs
• Lending standards declined
• Housing boom provided jobs
• Rising asset prices supported consumption

Every one of those things allowed the credit bubble to keep expanding. Many of those factors took years to play out, decades in aggregate. The decline in interest rates alone made housing more affordable for quite some time, at least until things went extremely loony a few years back. And when housing prices went loony, progressively lower credit standards kept the expansion going. The madness ended when there was no one left to buy, and no way to keep that portion of the credit bubble expanding. Sadly, people still give Greenspan credit for his role in keeping the economy expanding. Greenspan deserves absolutely no credit. All Greenspan really did was accelerate the existing trend. Furthermore, he did so in a way that was completely reckless. The only reason the economy did not collapse under Greenspan was the ability of consumers and businesses to take on credit had not yet peaked.

Major Bubbles Fueled By Greenspan

• Greenspan fueled an overall stock market bubble by bailing out banks exposed to Long Term Capital Management. For more on LTCM please see Genius Fails Again.
• Greenspan fueled a dotcom bubble in 1999-2000 out of irrational fear of a Y2K crash. Greenspan embraced the productivity miracle and was worried about the economy overheating just months before it imploded. The story is documented in FOMC minutes.
• Greenspan fueled an even bigger bubble between 2003-2006 by embracing ARMs and slashing interest rates to 1% to bail out his banking buddies caught up in bad loans to dotcom companies and bad loans to countries like Argentina.

In a sense, Greenspan was the luckiest Fed chair in history. He had a tailwind of productivity at his back that helped keep consumer prices low while he fueled bigger and bigger and bigger credit bubbles when each of several smaller bubbles popped.Greenspan has now left an unsolvable mess for Bernanke to cleanup. This time, there is no bigger credit bubble to be blown.

What They Were Saying And When

• In 1999-2000 people were saying "The Nasdaq hasn't crashed yet so it's not going to".
• In 2006 Lereah wrote: Why The Real Estate Boom Will Not Bust. Ironically, it already had.
• In 2007 many are writing me with reasons why the credit bubble will not bust. It already has. However, just like housing in 2006, the implications have not yet been fully felt.

The party is over once the ability and willingness of banks to lend, or ability and willingness of consumers and businesses to borrow is exhausted. Those signs in place today for all but ostriches. One thing I want to be clear on is that I am not calling for another "great depression". We could have one, but I am inclined (at least right now) to doubt it. Japan went through 18 years of deflation and the world did not end. The US will survive deflation as well.However, we are likely to see something the US has not seen since the great depression: a falling standard of living and a declining middle class. Many things will be A Matter Of Choice but no one alive knows exactly what choices government will make. One thing I am sure of is the more money we waste in Iraq and the more money we waste attempting to be the world's policeman, the worse off we will be.

Can The Fed Inflate Out Of This Mess?

There is enormous and unwarranted belief in the Fed's ability to "inflate out of this mess". It's all an illusion. Greenspan presided over an economy that added enormous numbers of internet jobs followed by enormous numbers of housing related jobs and enormous numbers of jobs related to the buildout of commercial real estate.This was not "success"; This was forestalling the day of reckoning by repetitively blowing bigger bubbles. Greenspan appeared successful only because the ability and willingness of consumers and businesses to take on more debt was not yet exhausted. Bernanke, on the other hand has no dotcom boom to bail out the economy. Nor does Bernanke have a housing bubble to look forward to that will bail out bad bank lending practices and provide jobs to the economy.

Problems Bernanke Faces

• Falling real estate prices
• Subprime housing mess
• Alt-A mortgage mess
• Pay Option ARM mess
• Sharply rising unemployment
• Rising credit card defaults
• Commercial Real Estate implosion
• Global wage arbitrage
• Falling US dollar
• Overheating China
• Slowing global economy
• Tapped out consumers
• Implosion of $500 trillion in derivatives
• Solvency issues at banks
• Forced unwind of massive Yen carry trade
• Boomer retirement
• Pension plan assumptions in an economy starving for yield
• Rising corporate defaults

Greenspan never had to deal with anything remotely close to that set of problems. It's a lethal combination of things given that solvency issues at banks that will restrict lending. It is also a lethal combination in the face of consumers and businesses that are unwilling to expand because consumers are tapped out. In addition, rising unemployment sure is not going to do anything about consumer's willingness or ability to take on more credit. Yet because of Greenspan's so called success, many came to believe in the magic of the Fed. The idea was further enhanced by one of the most ridiculous Fed speeches ever Deflation: Making Sure "It" Doesn't Happen Here.

Trends Do Not Die Easily

With Bernanke's speech, came the near universal belief that Bernanke would succeed in fending off deflation as well. However, near universal belief in a flawed idea is a necessary but insufficient condition for a primary trend exhaustion. The housing boom morphed into merger mania, leveraged buyout speculation, buyout bingo and all sorts of other nonsense including covenant lite deals where debt was paid back not with interest but with more debt. There were not really any more players because there was no one left to convince. Rather the players involved just got greedier and greedier. Even as housing died, credit expansion looniness continued for two more years.

Chuck Prince Dances At the Top

When everyone acts as if every risk no matter unsound will go unpunished by the Fed and the market, it fosters the environment where the greedy participants (and even some innocent bystanders) are going to be tremendously punished.It is fitting that Chuck Prince marked the top of the insanity in July of 2007 when he announced No End Soon To Buyout Boom. Chuck Prince resigned in disgrace four months later.

Unsound Beliefs Foster Unsound Actions

Few have stopped to consider that credit conditions only got as insane as they did because of fundamentally unsound belief the Fed cannot fail. Similar beliefs marked the top of the housing boom in the summer of 2005. Yet in spite of the housing implosion, everyone acted (and most still do) as if there is no risk of deflation. Most still fail to see that it was unsustainable credit expansion that fueled not just housing, but the economy in general.

Ironically, it is the unvarnished arrogance by Bernanke in conjunction with greater fools who believe in his untested academic wizardry, that fostered the very extreme risk taking attitudes towards credit that makes deflation inevitable. Things that can't happen, are about to.

Comments

[Genesis]

Spot-on.

A few days ago I published my "07 look back and 08 look forward" at market-ticker.denninge... where I essentially laid out the same prognostication, with a LOT of background.

Comments I've received include that "its hard to read".

Well, yeah.

But the herd doesn't want to hear it, and that will be their undoing. The "to the moon Alice" folks keep believing because, well, so far it has worked.

Why?

As you noted, its a matter of consumers and others being willing and able to borrow, and others being willing to lend.

Unfortunately now all the collateral that's worth anything has been pledged, along with a lot of worthless collateral or that pledged at
FAR beyond its "fair value."

Now the deflationary downstroke comes. Whether we like it or not, when you pump asset values beyond their intrinsic reality, the debt that leverages off it will default. There is simply no other alternative.

And as debt defaults, deflation happens. This too cannot be avoided.

Buckle up folks - this is the fun part of the ride....

[ErnieMontague]

Well, there is certainly no doubt that inflation has been the primary tool of the Fed financial policy. Anyone who has been alive long enough can vouch for that. When a house in Ca that cost $35k in 1965 is worth $1.3 million forty years later, you have inflation. At a 9.5% yearly rate. There is simply no way around that, and 50% of that inflation has been in the last six years.

Yes, I would say inflation ( the favorite government tool to keep expanding bureaucracy and "paying" off debt) has been extreme. And they still insist it is 2-4% yearly.

[robert.bohrer]

Excellent article. I love arguing with fools, because they generally base their arguments on untrue premises which are easily demolished with simple reason - And then, vindication through predictions that usually come to pass. This time will be no different. Unfortunately, those same fools probably will learn nothing of themselves or their lack of reasoning skills, and will go on to make more baseless predictions based on a combination of whatever their "gut" tells them combined with their take on whatever they see on the boob tube. It would seem that fools are everywhere, even in the high dollar, high stakes financial world - And that here, too, they will never change their ways. Score one for objective reasoning, minus one for everything else.

[cheesecake]

too pessimistic. there is a credit bubble and certainly inflation on the horizon, but it's not the end all. that's why the stock market is still near it's all time high's. the subprime mess is simply too many risky loans (a small % of the total though). credit / loans based derivatives as a % of total financial instruments are small also.
inflation is a real problem, but global growth also has a lot to do with it.

[Peter Davis]

Much like Mr. Bohrer writes, I, too, love arguing with fools. I actually had someone tell me the other day that market crashes are caused by lack of information disclosure (i.e. market participants don't have all the relevant information and therefore act irrationally). I honestly didn't know where to start my response other than to point out the fact that people rarely act rationally and what is rational to one person is completely irrational to another.

As for the presence of fools, even in the world of high finance, why not? I've often thought that financial "professionals&qu... get far too easy a ride from the general public. Because most people are mystified and intimidated by the markets, they assume that everyone who makes their living in the markets is somehow brilliant. I couldn't disagree more.

Basic Darwinian theory tells us that survival indeed belongs to the fittest. Expanding upon that, I'd argue that the percentage of people who are highly competent at whatever they choose to do is small. Most people are average; thus, the definition of the word. If most people are average, it's reasonable to assume that they will fall prey to the same mistakes, the same follies. Why should financial professionals be any different?

Throw in ego, greed and fear and the "average" mistakes become real doozies, but is there really any surprise? Isn't history rife with bubbles and crashes caused by the wisdom of the average masses?

So I say, "Let the fools continue!" It sure makes for great arguments.

[Kunst]

I was in New Orleans about a year and a half before Hurricane Katrina. It was obvious and acknowledged that NO was at tremendous risk of exactly the kind of catastrophe that happened on August 29, 2005. Yet there were people who basically said, "no serious hurricane has hit here since 1935, so we don't need to worry." If someone warned of this danger for decades, does that mean they were wrong and should be ignored? Winston Churchill was considered a bit of a nut case for being so hung up on the danger posed by Adolph Hitler in the 1930's. Neville Chamberlain was the popular hero because he told people what they wanted to hear; too bad it wasn't true. There will be a big earthquake in California in the not-to-distant future. Geologists have been saying that for decades. Should we mock and disregard them because it hasn't happened yet? What will you say when it does? What will you say when the unsustainable American system of debt-based overconsumption finally crashes? Putting off the inevitable doesn't change the end result.