Thomas E. Woods, Jr is a senior fellow at the Ludwig von Mises Institute. In 2009, he published the book “Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse”. It was on the New York Times Best Seller list for 10 weeks. This is my commentary on the book.
An Austrian's perspective
If you seek a factual and accurate explanation for the recent financial crisis, you will not find it from mainstream – i.e. Keynesian – economists. They have never been able to correctly account for past crises and their rhetoric has not changed. They blame the free market economy for every crisis and their solution is to demand more government regulation. They fail to notice that a free – i.e., an uncontrolled, unregulated, laissez-faire – market economy has never existed in human history and are ignorant of the distortive and destructive impact government intervention has on the economy.
President Barack Obama said in one of his weekly radio and Internet address that “every day we don’t act, the same system that led to bailouts remains in place, with the exact same loopholes and the exact same liabilities. And if we don’t change what led to the crisis, we’ll doom ourselves to repeat it.”
Obama has rightly stated that there is a problem, but he has wrongly identified the problem and has inadvertently proposed and enacted the wrong solution – the same wrong Keynesian solution of more government expenditure, rock-bottom interest rates, and more regulation.
“This is why,” writes U.S. Congressman and Austrian libertarian Ron Paul, in the foreword, “Meltdown is so important. This book actually get things right. It correctly identifies our problems, their causes, and what we should do about them.”
Woods begins by describing the U.S. government’s response to the increasingly dire economic situation in the fall of 2008: “The stock market plummeted, companies folded, and economic fear and uncertainty began to spread…President George W. Bush addressed the nation on September 24, 2008, with the proposed [$700 billion] bailout plan for the financial sector…[and] he devoted some time to [address] what were purportedly the downturn’s “root causes”…[on October 3, 2008,] the [$700 billion “rescue plan”] was promptly passed and signed into law.”
Woods continues by saying that the new Obama Administration is going to be no different. Obama’s promise of “change” is a farce. There is going to be no “change” insofar as the economy is concerned.
Obama supported Bush’s bailout package, appointed Timothy Geithner – who played a supporting role to Henry Paulson in the Bush administration – to Secretary of the Treasury, appointed Ben Bernanke – who chaired President Bush’s Council of Economic Advisors – to Chairman of the Federal Reserve, and appointed Lawrence Summers – Secretary of the Treasury to Democratic President Bill Clinton’s administration – to be director of the White House’s National Economic Council.
This is not “change we can believe in” – it is merely “more of the same – more bailouts, more government intervention, more addressing symptoms rather than causes – along with huge deficits and massive increases in government spending”, which means more of the same mistakes and as a result, more of the same disasters.
The million dollar – nay, $700 billion dollars – question is still unanswered: What is (or, are) the cause(s) of the financial crisis?
Some blame “excessive risk-taking” and “greed” for the crisis – which is as useful as “blaming plane crashes on gravity”. Some blame the free market economy for the crisis – but a free market economy has never existed.
In his speech on September 24, 2008, President Bush attempted to give an answer but it was ambiguously explained. He identified Fannie Mae and Freddie Mac, which are mortgage companies “chartered by Congress”, as the causes of the problem. He spoke about the implicit government guarantee of Fannie Mae and Freddie Mac which “allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.”
However, Bush has yet addressed the “root causes” of the crisis. In the first chapter, “The Elephant in the Living Room”, Woods succeeds where Bush has failed. He correctly identifies the Federal Reserve, the central bank of the U.S., as the “primary culprit” of the whole financial meltdown.
“The Fed,” writes Woods, “is the elephant in the living room that everyone pretends not to notice. Even many of those who blame government for the current mess leave the Fed out of the picture altogether. The free market, meanwhile, takes the blame for the destructive consequences of what [the Fed] does. This charade has gone on long enough. It’s time to consider the possibility that maybe the elephant, and not little Johnny, is the one breaking all the furniture.” How the Federal Reserve’s intervention into the economy creates artificial booms, which must eventually end in busts, is elaborated in Chapter 2 and 4.
Woods starts chapter 2, “How Government Created the Housing Bubble”, by telling the story of the housing market from 1998 – when home prices rose exponentially – to 2006 – when the housing bubble began to unravel. As more people default on their mortgage loans and the rate of foreclosure increased, mortgage-backed securities issued mostly by Fannie Mae and Freddie Mac began to lose value and their investors – which include many large financial institutions such as Lehman Brothers and Goldman Sachs – began to suffer heavy losses.
Next, Woods asks the question: “What institutional factors gave rise to all the foolish lending and borrowing in the first place? Why did the banks have so much money available to lend in the mortgage market – so many indeed that they could throw it even at applicants who lacked jobs, income, down payment money, and good credit?”
His answer – government. “These phenomena, as well as the housing bubble and the economic crisis more generally,” he writes, “are consistently traceable to government intervention in the economy.” Woods points out six specific culprits of government.
The first is Fannie Mae and Freddie Mae.
“At the center of the collapse,” says Woods, “were…Fannie Mae and Freddie Mac.” He proceeds to explain how these “government-sponsored enterprises” had conducted their mortgage business and how as their business came under increasingly political pressure, they took on “significantly more risk” by “[increasing] the number of minority and low-income home owners who [tended] to have worse credit ratings than non-Hispanic whites.”
Those who raised red flags about the two companies were balked at. One of them was Ron Paul, who on September 10, 2003, testified before the House Financial Services Committee warning that because of the “special privileges granted to Fannie and Freddie”, they had “distorted the housing market” by “attracting capital they could not attract under pure market conditions…[creating] a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever.”
Ron Paul was proven right: In the late summer of 2005 and by the summer of 2006, in many parts of the U.S., several markets were facing the issues of ballooning inventories, falling prices and sharply reduced sales volumes. In March 2007, the whole mortgage industry collapsed. By August 2008, shares of both Fannie Mae and Freddie Mac had tumbled more than 90% from their one-year prior levels.
The second culprit is the “Community Reinvestment Act and affirmative action in lending”.
Signed into law in 1977 by President Jimmy Carter and given new impetus by the Clinton Administration, the CRA “opened banks up to crushing discrimination suits if they did not lend to minorities in number high enough to satisfy the authorities.” And, Woods writes, “It wasn’t just the CRA that was pushing lower lending standards. It was the entire political establishment.”
And together with “unscrupulous lenders [who] dishonestly forced subprime mortgages with unfavorable or complicated terms on helpless and uneducated borrowers” and “left-wing groups like ACORN [who] blocked drive-up lanes and made business impossible for banks until they surrendered to demand that they make billions in loans they wouldn’t other have made”, massive amount of excess capital flowed into the U.S housing market feeding the housing bubble.
The third and fourth culprits are “the government’s artificial stimulus to speculation” and “the “pro-ownership” tax code”.
Woods warns about placing too much emphasis on subprime loans. He says that “foreclosures primarily came about not because of subprime mortgages, but because of adjustable-rate mortgages – the one Alan Greenspan had once urged people to use – whether prime or subprime” and points out that “there was a larger percentage increase in adjustable-rate prime mortgages than there was in subprime mortgages, where all the trouble was said to be.”
The answer to Woods’s rhetorical question “How did prime adjustable-rate borrowers get more bamboozled than subprime borrowers?” is that people, “attracted to the adjustable-rate mortgages” bought houses with the intention of speculating. The adjustable-rate mortgage allows them to “unload their houses well before the teaser rate [“a low interest rate that makes these mortgages initially attractive”] expires”.
Woods also blames government’s involvement with rating agencies. According to economist Art Carden, “SEC regulations hung over the rating agencies like the sword of Damocles, and the raters didn’t want to attract undue regulatory attention by opposing a politically popular initiative” which was making risky subprime loans to those who could not afford to pay. Woods adds that, in fact, “the handful of approved rating agencies…are actually an SEC-created cartel protected from competition by regulatory barriers.”
Another to blame was the “pro-ownership” tax code such as the US$5000 tax break first-time home-buyers receive. Although tax breaks are always good, Woods cautions that “a “tax break” is an oasis of freedom to be broadened, not a loophole to be closed” and “instead, they should be extended to as many other kinds of purchases as possible, in order not to provide artificial stimulus to any one sector of the economy”.
The fifth culprit is the Federal Reserve and its policy of “artificially cheap credit”.
Woods has an entire chapter later dedicated to busting the crap out of the Federal Reserve. So, he is careful not to elaborate too much. He quickly explains without going into detail how “when the Federal Reserve pushes down interest rates…it encourages a boom…Fed’s artificial stimulus is not in line with real consumer demand…it encourages more and different kinds of projects to be undertaken than the economy can sustain…[and eventually] the bust comes.”
The six and final culprit is the “too big to fail” mentality.
This mentality drives the thinking of today’s U.S. politicians and it promotes moral hazard. Woods suggests “letting a few major firms actually go bankrupt” and allowing the market to run its course and correct the vast amount of damage government intervention has inflicted on the American and world economy.
In chapter 3, “The Great Wall Street Bailout”, Woods details the transpiration of events from March 2007 when Henry Paulson said “[the global economy]’s as strong as I’ve seen it in my business career” – to May 2007 when Ben Bernanke said “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system” – to September 2007 when Paulson announced Fannie Mae and Freddie Mac would be nationalized by the U.S. government – to the passing of the “the mother of all bailout”, the US$700 billion “Emergency Economic Stabilization Act of 2008” into law.
Woods also criticizes the ban on short-selling. Such bans, he writes, “have perverse effects, exactly contrary to the purpose for which they are proposed. If investors are to place their money somewhere, they need to know which positions are sound and which unsound. If speculators massively short certain companies, the remaining companies are implicitly given a clean bill of health. Investors can thereby make a safer, more informed decision…”
He explains that the reason why “regulators tend to be highly critical of short-selling” is because “short-sellers often show up the failures of regulators…often call attention to questionable firms before regulators themselves do…” Woods cites Enron as an example: “It was a short
-seller, namely James Chanos, who peered into Enron’s finances…saw a rotting corpse…shorted the stock and blew the whistle.”
In addition, he explains why regulation, not deregulation, is the problem and exposes the overblown claims of a “credit crunch”. Woods closes this chapter by warning us that “when the bill comes due”, there is going to be a price – a high price – to pay and invokes Friedrich von Hayek, who “won the Nobel Prize in economics for showing how central banks set the boom-bust cycle in motion”, as the voice we need to listen to in order to escape the current mess and avoid another one.
Chapter 4, “How Government Causes the Boom-Bust Cycle”, is a tour de force. Woods uses the Austrian Business Cycle Theory to explain how the Federal Reserve is the ultimate initiator of the boom and bust cycle, thereby “exonerating the free market of blame.”
In a free market economy, price is determined by supply and demand. Interest rate, which is the price of borrowing money, is determined by the supply of savers’ monies and the demand of borrowers such as individual consumers, businesses, etc.
When interest rate is low, due to higher net savings than borrowing, it means that, in general, there is “a relatively lower desire to consumer in the present” – which provides businesses an opportunity to engage in long-term investments with “an eye to future production” such as “increasing their productive capacity in the future – e.g., expanding existing facilities, building a new physical plant or acquiring new capital equipment.”
Vice versa: “If people posses an intense desire to consume right now, they will save less – making it less affordable for businesses to carry out long-term projects (because interest rates will be higher).”
In short, “interest rate coordinates production across time. It ensures a compatible mix of market forces: if people want to consume now, businesses respond accordingly; if people want to consume in the future, businesses allocate resources to satisfy that desire as well.”
The interest rate can perform this coordinating function only in a free market economy “where it is allowed to move up and down freely in response to changes in supply and demand.”
So, when there exists a central bank and it manipulates the interest rate through a variety of ways, the “coordination of production across time is disrupted.” The central bank creates a mismatch of market forces. This mismatch occurred when Alan Greenspan lowered real long-term interest rate to 3-3.5% following September 11 in 2001, which, together with factors discussed in chapter 2, launched the U.S. housing market into an artificial boom – which, according to Austrian Business Cycle Theory, had to culminate in a bust – and it did.
But without doubt, more mistakes will be and are currently being made following the bust. The recession, or depression, which results, is a “necessary if unfortunate correction process by which the mal-investments of the boom period, having at last been brought to light, are finally liquidated, redeployed elsewhere in the economy where they can contribute to producing something consumers actually want.”
In its usual delusion and megalomania, the U.S. government does everything it should not be doing: namely, implementing Keynesian policies and more regulation.
The recession is not the problem, but a correction of it. The problem is the Federal Reserve and its mistake is distorting the market interest rate by lowering it to levels which does not reflect economic reality. But, instead of recognizing the mistake, the U.S government (and most governments from the rest of the world) exacerbates the situation by dropping the interest rate even further. On April 28, 2010, I received a “Breaking News Alert” from the New York Times informing me that the “Fed [kept] short-term interest rates near zero.”
Woods quotes Hayek who wrote this during the Great Depression: “Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom…all conceivable means have been used to prevent that readjustment from taking place…one of these means…has been this deliberate policy of credit expansion. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about…”
Woods further criticizes Keynesian “pump-priming”, i.e., government spending: “Take from the economy as a whole [through taxation] and pour resources into particular sectors – that should make us rich! Economic historian Robert Higgs compared plans like these to someone taking water from the deep end of a pool, pouring it into the shallow end, and expecting the water level to rise.” Printing money out of thin air to fund government spending is an equally counterproductive strategy.
He then points to the dot-com boom and 1980s and 90s Japan as examples of the Austrian Business Cycle Theory in action – particularly Japan, who did everything the Austrians warned against – which is everything the Americans are doing today – the Japanese government cut interest rate to zero, launched over $100 trillion of stimulus packages – and as a result, suffered a “Lost Decade” of economic growth.
Woods writes that “had [the Japanese] government not distorted the market so severely and seized all these resources for its own uneconomic use, the private sector would have been in much healthier position to build toward recovery.”
In Chapter 5, “Great Myths about the Great Depression”, Woods repudiates the myths of the 1920s and 30s depression. This is important because these myths “long since discarded by reputable historians, are making a predictable comeback at the hands of ambitious politicians who seek to malign the free market and grab additional powers for themselves.”
But before Woods does so, he explains why booms and busts occurred before the Federal Reserve came into existence in 1913 when the Federal Reserve Act was enacted by President Woodrow Wilson. Again, he traces it to government: “The Panic of 1819 resulted from the excessive issue of paper money by banks at all levels. This issuing of money did not correspond to gold in their vaults… Chartered by the U.S. government in 1816, the Second Bank of the United States…had joined in this over-issue of paper money…” and “as in later crises, banks were allowed to suspend specie payment (a fancy way of saying that the low permitted them to refuse to hand over their depositors’ money when their customers came looking for it) while permitting them to carry on their operations. The knowledge that government could be counted on to bail out the banks in this way created a…problem of moral hazard…” and “During the 1830s, the Second Bank [chartered by the U.S. government]…orchestrated an inflationary boom that led to an inevitable bust…”, etc, etc.
Now – the Great Depression. First, Woods lays out “the groundwork for the Great Depression”. He describes the economic situation before the Depression and explains how the Fed’s inflationary policy, i.e., “a substantial inflation of money supply”, in “the form of additional loans to business” led to the artificial boom of the capital-goods industries and the stock market. “Finally and inevitably, the correction came. The stock market crash of October 1929…sharp declines in output and employment…”
It is a myth that “President Herbert Hoover, who is described as a strict proponent of laissez-faire, sat back and did nothing as the Great Depression devastated the country” and “only when Franklin Roosevelt took office…was serious action taken to arrest the economy’s decline.”
President Hoover “launched public works projects, raised taxes, extended emergency loans to failing firms, hobbled international trade [one of his policies was the infamous Smoot-Hawley Tariff], and lent money to the states for relief programs. He sought to prop up wages at a time when consumer prices were falling…” which led to Roosevelt accusing Hoover of presiding over “the greatest spending administration in peacetime in all of history” and derided him for believing “that we ought to center control of everything in Washington as rapidly as possible.”
But, President Roosevelt was not the better man. He made “much bolder moves than his predecessor.” He launched a leviathan economic program called the New Deal, which prevented the economy from correcting itself and prolonged the Great Depression.
The last myth to debunk is the notion that – in the words of Keynesian economist Paul Krugman – “what saved the economy, and the New Deal, was the enormous public works project known as World War II, which finally provided a fiscal stimulus adequate to the economy’s needs.”
“If spending on munitions really makes a country wealthy,” writes Woods, “the United States and Japan should do the following…” and he cites Jon Basil Utley’s thought experiment:
“Each should seek to build the most spectacular naval fleet in history, an enormous armada of gigantic, powerful, technologically advanced ships. The two fleets should then meet in the Pacific. Naturally, since they would want to avoid the loss of life that accompanies war, all naval personnel would be evacuated from the ships. At that point the U.S. and Japan would ink each other’s fleets. Then they could celebrate how much richer they had made themselves by devoting labour, steel, and countless other inputs to the production of things that would wind up at the bottom of the ocean.”
The “war brings prosperity” argument “is based on the same central fallacy as the “consumer spending drives the economy” silliness”, which will be refuted in Chapter 7.
“The purpose of this chapter,” says Woods in Chapter 6, “Money”, “is to introduce some important concepts and to overturn some of the myths that stand in the way of evaluating the idea of getting government out of the money business.”
He begins by asking “where does money come from?” and proceeds to explain the old system of barter trade, and when “people who are dissatisfied with…barter perceive that they can acquire a more widely desired good than the one they currently possess, they are more likely to find someone willing to exchange with them”, and money was borne.
“Money has to originate on the market in this way,” Woods writes, “since only then would people know what its value was…”
All economies, after the slow dissolution of the barter system, have always adopted commodity money as the medium of exchange, and they “have most often chosen gold and silver” after millennial of experimentation with other solutions such as whales’ teeth, giant stone disks, string of beads – Homer recalls the use of cauldrons and iron tripods as money in the ancient world.
Fiat currency could not have come about without commodity money first appearing. This is because, if something was to be used as a medium of exchange, it has to be something of universal value such as gold or silver, and “in the processing of becoming a money, it would acquire an array of prices of other goods in terms of itself.”
Paper is of no value if it is not backed with some commodity. Yet this is what we have today. And how did this happen? Woods explains: “The usual pattern runs as follows: (1) society adopts a commodity money; (2) paper notes issued by banks (or by governments) that can be redeemed in a given weight of the commodity money begin to circulate as a convenient substitute for carrying precious metal coins; and (3) government confiscates the commodity to which the paper notes entitle their holders, and thereby leaves the people with an inconvertible fiat paper money.”
“The substitution of fiat paper money for an existing commodity money always and everywhere comes about by some government violation of private property rights. It always involves the threat of violence and never occurs voluntarily,” Woods continues, “After 1993, when the federal government ordered Americans to hand over all their monetary gold to the authorities, the paper money that had once been a claim to a weight of gold continued to circulate out of habit, and because an array of price had already come into existence in terms of that money.”
The central bank controls a nation’s money supply; it controls the value of your money. When the central bank decides to lower interest rate, it inflates the money supply; and the value of your money falls. When you used to spend $8.50 on a movie ticket, now it will cost you more: $10. Keynesians like to define this rise in price as “inflation”. In fact, inflation is the undue expansion of money supply; and the rise in price is its inexorable consequence.
(But not all price rises are due to manipulation of money supply. Ludwig von Mises termed these noninflationary price rises as “goods-induced” price changes.)
Woods explains why “inflation [undue expansion of money supply] can occur without rising prices…for example, an increased abundance of goods had been pushing prices lower, a greater money supply, by putting upward pressure on prices, could cancel out that downward trend and keep overall price level stable… In that case, the inflation deprives us of the increases in our standard of living that falling prices would have brought about.” He also exposes the fallacy of “cost-push inflation”.
Woods distinguishes two kinds of economic growth – one driven by cheap money supplied by the central bank – which is artificial – and one driven by savings and production – which is sustainable. He closes this chapter by refuting those who condemn commodity money. “A note on deflation” is attached at the end of the chapter. Woods dismisses the standard negative claims of deflation with rigorous clarity.
What a read! “What now?” Wood asks at the start of the final chapter, “What Now?”
Before that, Woods want us to get one last thing right: consumer spending does not drive the economy: “Consumption is the act of using things up. How did any country ever become rich simply by using things up? Before things can be used up, they need to be produced. Production, in fact, is what makes consumption possible in the first place, because it gives us the means with which we can acquire the goods we want. To consume more, we first have to produce something ourselves.”
Woods invokes John Stuart Mill to back his argument: “What a country wants to make it richer is never consumption, but production. Where there is the latter, we may be sure that there is no want [lack] of the former. To produce, implies that the producer desires to consume; why else should he give himself useless labor? He may not wish to consume what he himself produces, but his motive for producing and selling is the desire to buy. Therefore, if the producers generally produce and sell more and more, they certainly also buy more and more.”
Finally, what should America – and the rest of the world, if it applies – do?
“Let [firms who need to go bankrupt] go bankrupt” – “Abolish Fannie and Freddie” – “Stop the bailouts and cut government spending” – “End government manipulation of money” – “Put the Fed on the table” – “Close those special lending windows” – “End the monopoly money” – and establish the gold/silver standard!
From 2005 to 2007, Peter Schiff, an Austrian proponent, used the Austrian Business Cycle Theory, and accurately predicted and repeatedly warned the public through a series of television appearances that the American economy is “like the Titanic” and “what’s going to happen in 2007” is that “real estate prices are going to come crashing back down to Earth”… “I see a real financial crisis coming for the United States.”
Like Ron Paul, Peter Schiff was proven right. On April 27, 2010, Peter Schiff appeared on CNBC and he warned that if the U.S. continues on its destructive path of low interest rate and high deficit spending, the dollar will lose all its value and collapse.
Such an event will have an even worse worldwide catastrophe than the recent crisis. To prevent this from happening, Woods suggests we “abandon our superstitions about the expertise of Fed officials and their ability to manage our monetary system” and “listen to people who have a coherent theory to explain why these crises occur, saw this crisis coming, and have something to suggest other than juvenile fantasies about spending and inflating our way to prosperity.”
The choice is clear: choose pure economic freedom and prosper beyond your wildest imagination, or some mongrel mix of freedom and control and wait till the government poison kills you. In any compromise between food and poison, it is only death that can win.
Meltdown is available for purchase at Kinokuniya for S$48.44 — a reasonable price to pay for the truth.
great article. this book on my next amazon shipment.
http://www.youtube.com/watch?v=ivmL-lXNy64
This is a very informative video about how U.S. politicians, including Barack Obama, are intimately connected with the whole mortgage crisis.
Peter Schiff has made a lot of wrong predictions.
Some of his predictions in 2008 for 2009 include:
(1) The price of gold going up to 2000 USD/OZ. Nope, we were and still are nowhere near that level.
(2) The USD index falling to 40 or even 20. Nothing of that sort ever happened. In fact, the USD index shot up last year.
(3) Price of commodities would go up. Nope that didn’t happen.
(4) Hyperinflation because of record low interest rates. Nothing like that ever happened.
He would not be able to get everything right unless he has a time machine. But his analysis of the pertinent causes of the problems were absolute spot on. Hyperinflation doesn’t happen overnight. It takes a sovereign debt crisis to trigger such an event. Right now politicians will do whatever it takes to prop the system up with more money and lower interest rates. I do not see how a crisis created by low interest rates and increasing money supply can be followed up with even lower interest rates and even higher money supply
The USD Index is a fallacious indicator. The US dollar is highly inflated and when measured against a basket of inflated currencies, you can get no reliable and accurate feedback.
But, if you measure the US dollar against an objective value, which is gold, you will see that the USD has been on a constant decline since 2001.
@Christopher Pang: “I do not see how a crisis created by low interest rates and increasing money supply can be followed up with even lower interest rates and even higher money supply”.
Oh come on. The recession started in 2007 and the Feds started to raise the rate in 2005. That was what triggered the sub-prime mortgage default crisis.
@HSP: “But, if you measure the US dollar against an objective value, which is gold, you will see that the USD has been on a constant decline since 2001.”
First of all, gold was in the dumps in 2001 as a result of excessive exuberance over the internet boom. Taking 2001 as the base index is a little sneaky.
There is nothing objective about the value of gold or anything. The price of gold has gone through through the roof because a speculative bubble on gold is forming. If people were really worried about inflation, then the price of treasury inflation-protected bonds would have shot up.
Fox: “The recession started in 2007 and the Feds started to raise the rate in 2005. That was what triggered the sub-prime mortgage default crisis.”
You are right, this was what happened. When the Fed increased the money supply in late 2001 and lowered interest rate, with other factors taken into account, it sent the housing market on an artificial boom.
The interest rate was not meant to be low, but high. It was kept low by the Fed. So, when the Fed raised interest rate in 2005, which would have occurred much earlier in a free market economy, a great number of excess projects funded by the Fed’s artificial credit were liquidated. This was the recession – the correction of the malinvestments made from late 2001 to 2007.
However, the U.S. government does not understand the corrective nature of a recession, and hence, attempts to cure the economy with the poison that landed it in the hospital bed: by cutting interest rates to near zero.
“First of all, gold was in the dumps in 2001 as a result of excessive exuberance over the internet boom. Taking 2001 as the base index is a little sneaky.”
Whenever there is a boom, there is a flight from gold as more people seek to divert their money to the artificially-stimulated sources. When the dot-com bubble burst, the Fed reacted with its usual delusional policy of lowering interest rate. The value of the dollar dropped. Gold went up, as people sought a safe haven against the decline dollar. And since, as the Fed continued with its policy of low interest rate, it has continued its steady rise against the declining dollar.
“There is nothing objective about the value of gold or anything. The price of gold has gone through through the roof because a speculative bubble on gold is forming. If people were really worried about inflation, then the price of treasury inflation-protected bonds would have shot up.”
If you notice, I never talked about the objective price, but the objective value of gold. The value of gold has remained steady for millenial. But its price has fluctuated. Price does not always reflect value. How gold came to be an objective value is a long story. If you are curious, perhaps you should read Nathan Lewis’s “Gold: The Once and Future Money”.
Say Peng,
You are ignoring the fact that after the recession of 2000-2001 there was an enormous inflow of hot money from China and other Asian countries into the US which drove the cost of money down. US had an enormous capital account surplus from 2002 onwards. It would have made no sense for the Feds to maintain a high interest rate.
Also, like everything else, gold has no objective value apart from its exchange value.
@HSP: “The USD Index is a fallacious indicator. The US dollar is highly inflated and when measured against a basket of inflated currencies, you can get no reliable and accurate feedback.”
It doesn’t matter. Peter Schiff made a specific prediction with regards to the USD index and got it wrong.
@CP: “He would not be able to get everything right unless he has a time machine. But his analysis of the pertinent causes of the problems were absolute spot on.”
Nouriel Roubini predicted the property asset bubble. So did Paul Krugman and Bob Schiller of the Case-Schiller index. All three of them support a fiscal stimulus and govt deficit spending.
“Right now politicians will do whatever it takes to prop the system up with more money and lower interest rates.”
The US banking system has been awashed with household savings since 2008. There is no point in increasing interest rates because that would induce even more savings. There is less harm in low interest rates in a deflationary environment. You don’t need high interest rates to induce savings because falling prices are already doing that.
Savings are good only up to a point and certainly not a good thing in the middle of a recession if you understand the paradox of thrift. Interest rates should be raised but only when prices start rising. The low interest rates are now starting to induce a bubble in assets (gold, equities, etc).
@fox “Oh come on. The recession started in 2007 and the Feds started to raise the rate in 2005. That was what triggered the sub-prime mortgage default crisis.”
The subprime consists of mortgages that were on ARMs (adjustable rate mortgage), all pegged to a floating Fed Fund Rate. By the time they had increase the rate in 2005, it was already too late to remedy. It was not because they increase the rate that caused the subprime crisis. The subprime crisis started because of cheap money and low interest rates with no down payment. Such lax lending standards and the securitization of these mortgages were the main reason home prices start to fall.
Increasing interest rates is supposed to reflect the price of money. Money cannot be free. There is a cost to it. Is 1% a good reflection of the cost? Certainly not when monetary inflation is much higher than that yearly.
Housing prices are a typical function of cash inflows less net outflows. The yields are the fundamentals of how a house should be priced. Stronger yields will then be reflected with a higher valuation for the house. Housing prices cannot be appreciating at exponential rate because of demand. Such demand is driven by sentiment and usually is unsustainable.
Interest rates were fixed at too low a levels for too long after the dot com bubble burst, which induced all the excessive spending and malinvestments in housing. People start to believe housing prices would never come down, especially after they been hurt in the stock market.
Higher rate did not cause the problem. This is always the issue with you and the same mainstream economists who consistently identify the wrong causes. The rates were pegged at 1% for more than 4 years. These 4 years were the period where the speculators and public were flipping their homes for money, using reverse mortgages to cash out to spend, thus the high GDP growth figures during the Bush administration. Credit cannot be created out of thin air, it has to be created from savings. Someone has to save so that someone else can borrow to produce and generate an income to repay the debt. It cannot be based on the assumption of ever increasing prices like the dot com or housing, which essentially is driven by the same Fed policy and same government policies from 2000-2010.
“Savings are good only up to a point and certainly not a good thing in the middle of a recession ” Savings are good to a point where you not suffer just to save. People save because of uncertainty in the future, because of plans for the future. That is a sacrifice in current period so that they can enjoy their fruits of labour in a future period. Recession happens not because people start to save, but because people overspend in the boom of the cycle. The savings during the recession is to cleanse and repay the debt they had accumulated by overspending during the boom.
Christoper Pang:”The rates were pegged at 1% for more than 4 years. These 4 years were the period where the speculators and public were flipping their homes for money, using reverse mortgages to cash out to spend, thus the high GDP growth figures during the Bush administration. Credit cannot be created out of thin air, it has to be created from savings. Someone has to save so that someone else can borrow to produce and generate an income to repay the debt.”
So, basically, you are telling me that if interest rates were raised, businesses would have borrowed more money to invest in production?
REALLY?
No. If interest rates were raised, people would stop spending so much, and the loans would have been reined in. There would not be as much demand for money as freely supplied, housing prices would not have reached that kind of heights. Expectations of people in US were that housing prices can never drop because it didnt drop even in the recession after the dot com. The only reason was the Greenspan was so accommodating to the markets that right after the dot com burst, instead of taking the pain, he lowered interest rate and increased the money supply to stimulate another bubble, this time in housing.
I am saying interest rates were raised, businesses would not have borrowed more, but they would have been more prudent with their investments and production. In this case, they would constantly drive costs lower or maintain good credit standing, improve efficiency within the firms either through capital investments like machines or streamline workflows. If money was in abundance and so cheaply available, the budgeting process is made much easier because they could easily borrow at low interest rates with little costs.
The recession is painful but is necessary for recovery and to cleanse the companies that should have failed. That is capitalism. What we are seeing today is fascism, perhaps some parts even close to socialism.
“The savings during the recession is to cleanse and repay the debt they had accumulated by overspending during the boom.”
Then please explain to me why the Gross National Savings of the United States as a percentage of GDP went up between 1995 and 1999 when the internet boom was happening.
See: http://www.economywatch.com/economic-statistics/United-States/Gross_National_Savings_Percentage_of_GDP/
“I am saying interest rates were raised, businesses would not have borrowed more, but they would have been more prudent with their investments and production.”
If businesses are borrowing less, then whom are the banks going to lend the savings to?
Also, I see, you also advocate reduced production along with reduced consumption. What a wonderful recipe for economic growth.
“Also, I see, you also advocate reduced production along with reduced consumption. What a wonderful recipe for economic growth.”
You do not get economic growth by consuming/spending, then why don’t we request the government to build bridges all around the reservoirs in Singapore or spend all our savings on TVs and cars? This would consistently increase government spending or private sector spending and boost GDP. But are we better off? Have we had better standards of living by having 5 Tv and 3 cars? The answer is clearly no. Overconsumption is not sustainable economic growth.
The most important point I want to make is you do not want to consume just because the economy can grow. You consume because you want to enjoy the fruits of your labour(TV, car, travel, iphone etc), or it is necessary to survive (food, lodgings), whether it is current or future. You do not consume so that others can keep their jobs. Slaves have jobs, but they cannot enjoy their fruits of their labour. What is happening now is a global imbalance provided by “slaves” in China/Japan providing their “fruits of labour” to the Americans and Europeans. This global imbalance has to stop before the entire system and our savings get destroyed totally by our governments and the western governments.
“If businesses are borrowing less, then whom are the banks going to lend the savings to?” There is a right price (interest rate) for money. The problem has always been that the Fed has decided on the price and the supply. So there has not been any equilibrium at all since the start of the central banking system. At a right price, there will be enough savers to match enough borrowers. And if the banks lend excessively, they would be kept in check by the depositors that can demand any time(if FDIC did not provide the deposit guarantee). This would create a check on the bank itself because they would fear bank runs and ensure the lending is both prudent (generate good rate of returns for the deposit with good credit analysis) and not overleverage on their position such that bank run would occur.
“Then please explain to me why the Gross National Savings of the United States as a percentage of GDP went up between 1995 and 1999 when the internet boom was happening.” Gross National savings include both private sector and government savings. From the consistent deficit spending, it is quite safe to assume that the majority of the savings would come from the private sector. This does not differentiate the private sector into individuals or companies. And furthermore, such statistics include investments which means probably the individuals 401k and pension plans.
“And if the banks lend excessively, they would be kept in check by the depositors that can demand any time(if FDIC did not provide the deposit guarantee). This would create a check on the bank itself because they would fear bank runs and ensure the lending is both prudent (generate good rate of returns for the deposit with good credit analysis) and not overleverage on their position such that bank run would occur.”
There has been bank runs in the US even before the FDIC was started to provide deposit guarantees.
“What is happening now is a global imbalance provided by “slaves” in China/Japan providing their “fruits of labour” to the Americans and Europeans. This global imbalance has to stop before the entire system and our savings get destroyed totally by our governments and the western governments.”
The imbalance in the balance of payment is mostly induced by the PRC central bank which refuses to allow the RMB to appreciate.
If you think the PRC central bank is doing a great job, think of the RMB they must be printing to soak up all the USD to purchase all the T-bills, something commonsensical that Peter Schiff does not tell you.
“There has been bank runs in the US even before the FDIC was started to provide deposit guarantees.”
What I was trying to explain is that bank runs are actually good for the financial system so that leverage would not go to 40:1 or even 10:1 which is ridiculous. If there was no deposit insurance, banks would be more prudent with their lending and also try to entice customers with higher interest rates for their savings. The bid/ask spread between the deposit rate and the lending rate would be a more sustainable rate than a rate fixed by the central bank.
“The imbalance in the balance of payment is mostly induced by the PRC central bank which refuses to allow the RMB to appreciate.
If you think the PRC central bank is doing a great job, think of the RMB they must be printing to soak up all the USD to purchase all the T-bills, something commonsensical that Peter Schiff does not tell you.”
He actually does address that many times in his podcasts and Tv interviews. The idea of Chinese soaking up the imbalances is so that they can keep their citizens in jobs. But unfortunately they fail to realize that having jobs does not relate to rising standards of living, similarly to Singapore. Translation to rising costs of living is more apparent than living standards. What good is a job if they cannot increase their standards of living with it?
“You do not want a job so that you can work. You want to work so that you can enjoy the fruits of your labour.”
“What I was trying to explain is that bank runs are actually good for the financial system so that leverage would not go to 40:1 or even 10:1 which is ridiculous. If there was no deposit insurance, banks would be more prudent with their lending and also try to entice customers with higher interest rates for their savings.”
Without FDIC guarantees or any form of insurance, the cost of maintaining deposits would go up i.e. the supply curve of money for a bank would go leftwards. Yes, interest rates will go up BUT total savings will be *reduced*. Banks will simply use other debt instruments (bonds, notes, etc) to raise money.
“He actually does address that many times in his podcasts and Tv interviews. The idea of Chinese soaking up the imbalances is so that they can keep their citizens in jobs.”
No. Peter Schiff has never mentioned anything about HOW the Chinese central bank sterilizes RMB appreciation and he persistently recommends that people invest in China. The Chinese central bank has performed more ‘quantitative easing’ than the Fed.
He rails against the expansion in the US money supply by the Fed and then turns around advising people to invest in China. He is either ignorant or dishonest. Furthermore, Euro-Pacific Capital actually actively invests in the Chinese construction industry which is experiencing a boom as a result of the expansion in the PRC money supply. How else can you explain the current property boom in China?
And as we have all learnt, no boom lasts forever. The drawback in China is going to be doubly painful because real estate prices will fall and PRC exports will become more expensive.
“No. Peter Schiff has never mentioned anything about HOW the Chinese central bank sterilizes RMB appreciation and he persistently recommends that people invest in China. The Chinese central bank has performed more ‘quantitative easing’ than the Fed.”
He did address this since the Chinese started pegging and even went further to elaborate the difference between the Chinese and the American.
Refer to : http://www.lewrockwell.com/schiff/schiff88.1.html, http://www.safehaven.com/article/15079/the-truth-behind-chinas-currency-peg
“He rails against the expansion in the US money supply by the Fed and then turns around advising people to invest in China. He is either ignorant or dishonest. Furthermore, Euro-Pacific Capital actually actively invests in the Chinese construction industry which is experiencing a boom as a result of the expansion in the PRC money supply. How else can you explain the current property boom in China?”
He is neither ignorant or dishonest. It may look the same to you just because both central banks increase money supply. Similar actions do not result in similar consequences when fundamentals are different. There is a very thin line of difference between speculation and investment. He acknowledged that China has increased their money supply but sees the underlying difference between the property boom in China and US. China property boom is a hedge against inflationary pressure from the government in increasing money supply. Most of the apartments are empty but they are still owned by the people as a 2nd apartment for investment to hedge inflation risk. Most of the apartments in US are empty but owned by the banks or under foreclosure. Most of the Chinese buyers are buying it with their own savings, with little financing from banks. Note the bank financing was up to 50% only. This is very much different from the no downpayment and adjustable mortgage payments based on a “teaser rate” used in the subprime market. To me, it is purely speculation in the US housing market but part speculation part hedge against inflation in the China housing market.
When buyers in US have no downpayment, and prices fall, they could easily walk away because they have nothing to lose except a credit rating. When Chinese buyers put in a 30-40% downpayment on their investments, and prices fall, they take the hit in their savings but have the option of not selling into the market at depressed levels because they have the capacity and ability to support the mortgage unlike the US speculators.
The Chinese citizens realize that their savings will be eroded by the government if they keep in banks. The Chinese government has also urged their citizens to buy bullion to hedge the risks their government is taking. Refer to (http://seekingalpha.com/article/159962-china-urges-citizens-to-buy-gold-and-silver) This is a major reverse of policy from the ban on gold possession only lifted in 2002. To me that is an indication of the loss of confidence in the dollar and willingness to diversify away from the dollar. Note the commodities purchase in bulk recently also in iron and copper. Further acquisitions in other countries in Africa for oil fields and mines were also made by the China Investment Corp to diversify away from dollars. The recent regulation on housing purchase only for one for one family would limit Chinese investors to less array of investment options for hedge against inflation.
I agree that the Chinese has overbuilt in the last few years because of this currency peg. But Peter has leveraged on the fact that the currency will either be pegged or it will appreciate against the dollar. Why so? The Chinese has accumulated the reserves in USD and can sell in the open markets to buy back the excess RMB they have printed. The US Government have only accumulated more n more IOUs to the Chinese with no assets to back their liabilities. When US govt sells their treasuries, they accumulate the USD(which the Chinese have printed and released into the markets buying USD) and spend it into government projects and military etc. Given that Peter’s clients are based in US, the fx risk would be in their favour. So that is one risk less to consider. Considering the high demand in China for assets to hedge inflation, he picked the construction companies he has recommended, also with much due diligence done by sending representatives from his firm to do site visit on the companies and the sites of construction and knowing how the area is developing. He has also consistently recommend mining stocks, especially those in silver and gold mining, Gold and silver coins instead of futures and GOLD shares which has counterparty risk.
Boom and bust cycle is created by credit expansion and credit contraction cycles. Watch: http://www.econstories.tv/home.html
“He acknowledged that China has increased their money supply but sees the underlying difference between the property boom in China and US.”
Nowhere does Peter Schiff actually mention that the Chinese central bank is expanding the money supply in China. Find me a sentence in which he says that the Chinese central bank has expanded its money supply tremendously.
The fact of the matter is prices in the Chinese property market are rising quickly and it is not matched by any rise in disposable income. It is a classic bubble with clear parallels to the US in the 2000′s and Japan in the late 80′s. Also, the injected liquidity in RMB is going into Chinese banks which are then lending it out at a frenzied pace.
“Most of the Chinese buyers are buying it with their own savings, with little financing from banks.”
Really? Whom are the Chinese banks lending their money to?
“To me, it is purely speculation in the US housing market but part speculation part hedge against inflation in the China housing market.”
By definition, a bubble is formed when the rise in future price in factored into the pricing of the assent. You have just described a classic positive feedback system i.e. I will buy more of X because its price has risen and X will become more expensive in the future.
X
= crude oil in 2007 and 2008 or
= US real estate between 2002 and 2007 or
= Japanese real estate in the late 1980s or
= US stock market between 1995 and 1999 or
= Spanish real estate between 2002 and 2006 or
= Uranium from 2005 to 2007 or
= Gold from 2007 to …
Let me explain this on his behalf: Buying Treasuries by Chinese Central Bank is increasing the money supply. Whenever they have to buy Treasuries, they have to sell RMB to buy USD in order to buy Treasuries. Such action itself is increase of money supply. He obviously didn’t expect there will be people who need such a blatant explanation.
“Really? Whom are the Chinese banks lending their money to?”
I mentioned little. Not NONE.
“To me, it is purely speculation in the US housing market but part speculation part hedge against inflation in the China housing market.”
I was basing this on the leverage and the dynamics of the market. There is a difference between (1) i will buy more of X because its price has risen and X will become more expensive in the future and (2) I have excess capital on hand and if I do nothing about my capital, the value(purchasing power) of this capital would depreciate
1) is driven by greed. 2) is driven by fear. Both feelings are part of behaviour finance. However when people are greedy, people leverage to attempt to gain more out from the circumstances as we seen in the US.
There are many differences between the lending practices in US and in China. As you should have already known, there were many tranches in the structured products which include subprime mortgage loans. These tranches were sold by the banks who lend these money to the owner buying the house. You do realize the difference between the subprime transactions and a normal banking transaction do you? Ok, I shall not assume you know everything.
Qtn: When a mortgage broker in US tries to sell the house, what does he earn?
Ans: A commission based on the valuation of the house.
(it is therefore better if the valuation was as high as he could get it)
Qtn: When a valuation personnel hired by the mortgage broker values the house, where does he gets his income from?
Ans: Mortgage broker.
(Obviously he will try to push as high a valuation so he would be recall back for more valuation work. The inherent conflict of interest will entice people to work for themselves and not for the good of the clients. Therefore valuations are also driven up because of the realtors who constantly values the properties higher and higher)
Qtn: If a bank lends out the money but securitize the entire loan portfolio into structured products such that the banks no longer hold the risk, would they really care if they do a proper credit analysis?
Ans: Obviously no. Goldman, BoA, Citi, MS, ML, Bear Sterns, JPM were all guilty of this. Objectives of the banks are more n more mortgage backed securities which they could sell to Chinese, Singaporeans, packaged into Minibonds, High Notes 5, Pinnacle Notes etc.
Qtn: If you were a owner of a 2nd property(so you would not be homeless) with no downpayment and you have only paid minimum installments such that you only hold a 10% equity stake in the house but the bank still holds the 90%, but prices have plunged more than 40%. Would you walk away?
Ans: Obviously yes. I have nothing to lose except a credit rating. What use is the credit rating if I do not need a credit line? Would you rather lose fork out 150k USD more on top of the previous installments, at the same time risk further downside or a credit rating?
The above scenarios were all what happened in the US. If you then look at the conventional borrowing and lending.
Banks lend 60% to a Chinese home buyer and he pays 40% downpayment. If prices fall by more than 50% then the home buyer would walk away. But prices take time to fall 50%. The home buyer would have put in more equity stake with his monthly installments by the time it hit 50% such that it should exceed 50% and he would not risk such a small % amount for a bad credit rating.
The other difference is also the monthly installment. Because US subprime thrives on ARMs (Adjustable rate mortgages) where the initial rates are a fixed rate that is a minimum sum, barely enough to cover the interest and further installments would be a heftier sum, the input by the mortgage holders would be much lesser in US as compared to a Chinese.
The economy in China would be less affected comparatively even if it was a bubble because of the lower leverage ratios as compared to US. As the people are the ones who take the bulk of the loss, the banks will be less susceptible to risk.
Furthermore, when the banks lend out the money to these home buyers, the mortgages would still be on their books. Therefore the realtor to value the home is important to the banks because They have to assess the amount involved and whether the buyer can be able to repay the debt as they might be the one who face the risk of default. And in the event of default, the home buyer would only stop paying if his entire equity has been lost, which is also a reason for the higher downpayment.
“There are many differences between the lending practices in US and in China. As you should have already known, there were many tranches in the structured products which include subprime mortgage loans.”
You can’t have subprime mortgages and securitization in China because China doesn’t have a credit rating system in the first place. Which makes their loans even more dangerous.
“Buying Treasuries by Chinese Central Bank is increasing the money supply. Whenever they have to buy Treasuries, they have to sell RMB to buy USD in order to buy Treasuries. Such action itself is increase of money supply. He obviously didn’t expect there will be people who need such a blatant explanation.”
Actually, he represent the augmentation of bank reserve deposits with Fed as printing money. He is right because that amounted to an increase in the money supply. You can google “Peter Schiff Fed printing money” and you’ll get a million links. Google Peter Schiff and the Chinese central bank and you won’t get a single link that says anything about the Chinese central bank printing money, even more than the Fed. The fact of the matter is that Chinese central bank has expanded their money supply more than the Fed did. Peter Schiff is always ready to point out the money printing by the Fed but fails to mention the even greater money printing by the Chinese.
Maybe that has something to do with the fact that he has gold investments and invests in China… Talk about talking up the market.
“The economy in China would be less affected comparatively even if it was a bubble because of the lower leverage ratios as compared to US. As the people are the ones who take the bulk of the loss, the banks will be less susceptible to risk.”
I don’t entirely disagree with you but you do realize that real estate developers who are busy buying up the land and building all the new apartments don’t conjure up credit out of thin air? You also realize that savings, if tied up in real estate, cannot be used for the purpose they were intended for i.e. medical, retirement, education, investment, etc.
Also, the Japanese were prodigious savers in the 80′s…
“I have excess capital on hand and if I do nothing about my capital, the value(purchasing power) of this capital would depreciate”
They had high inflation in around 2006 to 2007 in the US. They had high inflation in Japan in the late 80′s. So what if there was inflation? That doesn’t obviate the fact there is a positive feedback system.
Christopher,
I will like to point out something else. Yes, the Chinese are prodigious savers but this means that the banks are awashed with deposits. What are the Chinese commercial banks doing with these savings? They must be lending it out to someone. Do a little research to find out what type of loans do Chinese banks like to make. Here’s a bonus question: find out what type of loans did the Japanese banks like to make in the 80′s.
“You can’t have subprime mortgages and securitization in China because China doesn’t have a credit rating system in the first place. Which makes their loans even more dangerous.”
Securization does not make it more dangerous because these would be on the banks books. They would then place more emphasis to do a proper valuation and credit analysis like i pointed out. It is securization that is the danger to the economy because of the endless loop in money being sucked out of the economy. By taking the proceeds from the securization, they start to lend out and repackage new mortgages again and again until the music stops and the bubble pop. What good are those ratings when AAA could default in less than 9 months from the time they got the rating?
“The fact of the matter is that Chinese central bank has expanded their money supply more than the Fed did. Peter Schiff is always ready to point out the money printing by the Fed but fails to mention the even greater money printing by the Chinese.”
Like I have said, the actions may look similar, the consequences of such actions could differ very much. When the Chinese prints RMB and buys Treasuries, they have the power to dictate the currency peg and not the Americans.
Hypothetical situation: Assume the US government needs 100Bn of USD. Supposed the Chinese buys the entire 100Bn USD of Treasuries, they would have to print 682Bn RMB to buy those treasuries based on the current pegged ratio . They would sell 682Bn RMB into the open markets and buy 100Bn USD from the markets then use this 100Bn USD to buy the treasuries of 100Bn. Agree?
The US government is in debt and the Chinese has US treasuries as assets. If they really want to continue to peg the ratio and buy up more worthless US treasuries which the US government can never repay, then yes, they will continue to print and increase their own money supply to buy. But in the event that they do not wish to carry on this mistake, they have the luxury of selling off Treasuries and buying back RMB to reduce the money supply, even if it is at a loss. What has the Fed got in its reserves? A printing press, a vault in fort knox with 147.3 million troy ounces of gold (http://www.timesonline.co.uk/tol/news/world/us_and_americas/article5989271.ece) that is unaudited for several decades and trillions of mortgage backed securities that is worth much lesser than its valuation.
I would place more trust in the Chinese economy(I acknowledge there are things I am skeptical about the Chinese 1.announcing GDP figures the day after the quarter ends and 2. empty shopping malls and office buildings not being reported.) Based on 2, I do agree that some parts of the Chinese property market is over hyped and being urbanized faster than the population can adapt to. But the lower leverage should see it being contained to the owners who made the bad decisions and the banks who make the bad loans. If the Chinese government let the market take the hit(instead of bailout the bad money users) and people who made the bad decisions take the loss, the market can hit an equilibrium faster.
This is what I see as healthy capitalism. You get rewarded for foresight and good due diligence, and punished for bad decisions and predictions.
“Here’s a bonus question: find out what type of loans did the Japanese banks like to make in the 80’s.”
Its most likely individual mortgage loans or possibly stock market loans because both markets popped at the same time.
Extracted from:
http://homeguide123.com/articles/US_Housing_Bust_vs._Japan_Housing_Bust:_What_We_Can_Learn.html
(couldn’t have explain this any better, author based in USA)
“Low interest rates, easily obtainable credit and speculative mania helped to fuel the real estate boom in Japan, just like it did here. The fall was hard for Japan, and worse yet, it took a long time for prices to hit bottom.
This was partly (though some say mainly) the fault of the Japanese government. Japan’s Ministry of Finance attempted to regulate the economy through the banks. They were keen to help the banks from filing bankruptcy and began to subsidize failing banks and similar businesses. The Ministry was very slow to allow the lenders to take responsibility and banks took advantage, making bad loans into late 1997.
Bailing out the banks and propping up the economy was Japan’s fallacy. If we allow U.S. politicians to bail out our banks by expanding the capabilities of the FHA and lifting caps on Freddie Mac and Fannie Mae, we will delay the inevitable price correction just like Japan did.
A true correction will not occur until all bad debt has been liquidated. Making sure this happens as soon as possible should be our government’s goal, and a hands-off policy is the only way to achieve it.”
Like I said excess money supply drives higher prices. No doubt the Chinese is doing that. The slight difference is the interest rate of 5+% and credit availability. They are trying to reduce the sentiment in the property market with their regulations and even a one home one family policy in urbanized Beijing. A higher interest rates would cleanse out the bad debts earlier than later.
The property market in China might be overhyped in pricing but the only losers will be the home buyers. As long as valuations correct and bad decisions makers get punished with their losses. Things will get back to normal albeit no more government intervention such as bailouts or increase money supply further or lowering of interest rates.
The only reason why Japan didn’t end up in a situation worse than what they had is because the government owed the debt to their people. Look at the amount of JPY that is being floated overseas or held in foreign hands? It is possibly not more than 20%. China too is quite similar in this manner. What the Chinese should not do when the property market collapses is 1) reduce interest rates, 2) increase money supply 3) bail out the bad companies. As long as they do none of these, the economy can cleanse out the excesses and progress faster.
“Banks lend 60% to a Chinese home buyer and he pays 40% downpayment. If prices fall by more than 50% then the home buyer would walk away. But prices take time to fall 50%. The home buyer would have put in more equity stake with his monthly installments by the time it hit 50% such that it should exceed 50% and he would not risk such a small % amount for a bad credit rating.”
There is one big problem with this example: China does NOT have a credit rating system. The Chinese banking system is really that undeveloped.
“The economy in China would be less affected comparatively even if it was a bubble because of the lower leverage ratios as compared to US. As the people are the ones who take the bulk of the loss, the banks will be less susceptible to risk.”
Glad that you are such an optimist. They don’t have securitization but you still believe that the losses by Chinese banks will be limited.
“If the Chinese government let the market take the hit(instead of bailout the bad money users) and people who made the bad decisions take the loss, the market can hit an equilibrium faster.”
Do you really really believe that in the event of a hard landing, the Chinese government will NOT loosen money supply? REALLY?
If you were an investment advisor like Schiff, is that what you would plan for as a contingency?
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