Chris Martenson Crash Course 3

equivalent house, guess what? They’ve all gone up in price along with yours, and so you have to spend $500,000 for an equivalent house, so nope, no wealth was liberated there. In fact, the only way to liberate the wealth in your house is to downsize and buy a smaller one (or rent). So here’s the rhetorical question of the day: How can everyone downsize? You might be able to, but, on balance, everyone can’t. At least not without creating a massive glut of large homes and a desperate shortage of smaller ones. And if everyone can’t do this, then it means that it is impossible to ever release the full value, or embodied wealth, of all the houses. So the wealth number is fun to look at individually, but it is more or less meaningless as a whole. This same dynamic is true for other assets as well: Sufficient buyers are essential, or the wealth is as good as stranded. I mentioned that there are also two big oversights in the household wealth report, and the first is that the Fed mysteriously does not include the general liabilities of the government when calculating the household net wealth. Wouldn’t it make sense for the Fed to offset these against household wealth? After all, who else besides taxpayers living in households are going to pay off those liabilities? Nobody, that’s who. If the Fed did perform this offset, household net worth would plunge below zero, so I can guess why this comparison is never made. But I would argue that a careful steward of a nation’s monetary policy would be interested in representing the true situation as accurately as possible. The second oversight is that the data is presented as if it applied to our entire country in a fairly even and useful manner. It does not. The top 1% owns 35% of ALL net household wealth AND, looking at stocks, only owns 56% of ALL stock (by value). If you can’t see it, I apologize; the top 1% is represented by a very thin red smear at the top of the column there. So it’s great that our stock market keeps powering higher, but for every trillion dollars it goes up, $560 billion of that goes to only one out of a hundred households. The top 20%, which includes the top 1%, owns 85% of ALL net household wealth and 80% of ALL stock (by value). This means the bottom 80% of the citizens of this country, represented in yellow, holds only 15% of the total wealth of this country, and even there the distribution of wealth is weighted to the top. Remember, an imbalance between rich and poor is the oldest and most fatal ailment of all republics. More immediately, this tells us that our credit crisis is going to be worse than advertised. Just as was true of the wealth gap in the late 1920s before the onset of the Great Depression, the severity of the crisis will not depend on average wealth but the distribution of the wealth. If a large swath of the population lacks the means to weather the storm, then the storm will be longer and harsher than otherwise would be the case. So what does it mean that 80% of our population possesses a meager 15% of the total wealth? For one thing, it means that the recent efforts by the Fed to provide massive amounts of liquidity support to the biggest and wealthiest banks at the inflationary expense of the lower classes were not only misguided, but they were cruel and unusual. This leads to an easy prediction to make: The wealth gap in the US will hamper our recovery and deepen the downturn. In order to really understand why I have been harping on this notion of assets being variable and their value being dependent on the ratio of buyers to sellers, we’ll need to take a quick trip into demographics. Recall that the US government has not saved in any of its entitlement programs, and that it has a massive shortfall in them, measuring in the tens of trillions of dollars. That situation comes about because the entitlement programs are wealth transfer programs, not savings accounts, and they depend on a significant surplus of current workers to retirees. The shortfalls in these programs are being exacerbated by a troubling trend. In 1950 there were seven workers per retiree and the system was balanced. By 2005, that ratio had dropped to only 5 to 1, and the system was already exhibiting signs of distress. By 2030, that ratio will have plummeted to a thoroughly unworkable value of less than 3 to 1. And this trend comes about as a feature of the so-called Baby Boom . This is a demographic chart of the United States. Each bar represents a clustering of all the people who are within a five-year-wide ‘age window,’ as seen on the left axis, and shows how many millions of them there are along the bottom axis. The baby boomers number around 75 million strong and roughly occupy these four bands. While it may not seem like much, the ‘hole’ that exists in the population behind the baby boomers represents an enormous challenge, and even threat, to our entitlement programs, and will greatly complicate our efforts to resolve our levels of debt and our national failure to save. A more ‘normal’ population distribution, and the kind that humans evolved with over countless millennia, looks like this. A pyramid. Again, this shows five-year-wide age brackets, with men in red and women in yellow. This distribution is capable of supporting an entitlement program such as the one in the US that is based on transferring wealth directly from workers to retirees. But when we cast this chart forward to 2000, the baby boomer bulge is quite apparent. Besides the challenge that this demographic profile offers to the entitlement programs, an even larger challenge is presented to both the debt and savings issues I painted in previous chapters and even to the value of our assets. Here’s what I mean. The boomers are the wealthiest generation ever, they hold nearly all of the assets, and they will need to dispose of those assets to fund their retirements. Who exactly are the boomers planning on selling their assets to? This guy? Even if his generation somehowcould afford to buy all these assets, there simply aren’t enough people in his generation to buy them. In order to fund their retirement dreams, boomers are going to have to sell off their assets. And again we might wonder, to whom, exactly? And lastly , if the massive accumulation of debt over the past 23 years was predicated on the assumption that the future will be much larger than the present, we might also question how exactly that will come to pass if boomers are retiring en masse and there are fewer behind them to take their place? Man…the next generation better be prepared to work really, really hard! Too bad they are graduating with the highest levels of college debt ever recorded. This sort of demographic profile will be with us for decades and cannot be wished away or fixed by some clever policy. It is simply a fact of life, and one that we’d do well to recognize and plan for rather than ignore. Boomer retirement has already begun, and the pace of this will accelerate rapidly over the next 15 years, which will make the twenty-teens quite interesting and leads me to conclude that the next twenty years are going to be completely unlike the last twenty years. Next time we’re going to discuss asset bubbles. Understanding the destructive dynamics of bubbles is critical if you want to know what’s coming next and why the Federal Reserve is panicking right now. Ch 15: Bubbles Okay, now that we’ve taken a look at US assets, we need to spend some time understanding what an asset bubble is, how one might form, and the consequences of the aftermath. And we are specifically going to examine the housing bubble in detail, because it’s happening right now and is the largest bubble in all of history and will probably be the most destructive. Through the long sweep of history, the bursting of asset bubbles has nearly always been traumatic. Social, political, and economic upheavals have a bad habit of following asset bubbles, while wealth destruction is a guaranteed feature. Along the continuum of irrational financial behavior, it can be tricky to tell the difference between a bubble, a mania, and mere touch of exuberance. A bubble is reserved for the height of folly, and history is rich with folly. Bubbles used to happen once every generation or so, because it took time to forget the pain from the damage. Today we are facing the bursting of a second major asset bubble, housing, spaced less than ten years from the bursting of the dot-com bubble. This is simply astounding and thoroughly unprecedented. So how would we know that we’re in an ‘asset bubble’? What do they look like, and what can we expect when one bursts? The Fed famously likes to claim that you can’t spot one until it bursts. But actually you can, and the definition is pretty simple: A bubble exists when asset price inflation rises beyond what incomes can sustain. A bubble represents people abandoning reason and prudence for hope and greed. Out of that prior list, let’s look at one of the more interesting bubbles that happened in Holland in the 1600’s. For some reason, the people of that time became infatuated with tulips, saw them as a sure-fire path to riches, and a financial mania set in. Yes, we’re talking about the flowers that come from bulbs. The bubble began when beautiful and unique variants in tulip coloration were developed, and bulbs began trading at higher and higher amounts as the speculative frenzy built. At the height of the bubble, a single bulb of the most highly sought after example, the Semper Augustus seen here, commanded the same selling price as the finest house on the finest canal. But eventually people figured out that you actually could grow quite a few tulips if you set your mind to it, and that perhaps bulbs were, after all, just bulbs. It is recorded that the tulip craze ended even more suddenly than it began, ending almost in a single day at the start of the new selling season in February of 1637. On that day, a silent whistle blew that only dogs and buyers could hear, and prices crashed. This example illustrates two characteristics of bubbles. First, that they are self-reinforcing on the way up, meaning that higher prices become the justification for higher prices, and second, that once the illusion is lifted, the game is suddenly and permanently over. A second example of a bubble comes from the 1700’s and goes by the name “The South Sea Bubble.” The South Sea Company was an English company granted a monopoly to trade with South America under a treaty with Spain. The fact that the company was rather ordinary in its profits prior to the government monopoly did not deter people from speculating wildly about its potential future value, and the share price rose dramatically. Nor did the fact that the company was billed as “A company for carrying out an undertaking of great advantage, but nobody to know what it is." Sir Isaac Newton, when asked about the continually rising stock price of the South Sea Company, said that he “…could not calculate the madness of people.” He may have invented calculus and described universal gravitation, but he ended up losing over 20,000 pounds to the bursting bubble, proving that intelligence is no guarantee of avoiding being swept up in the animal instincts of a still-expanding bubble. In 1720, the mania took off, displaying a text-book-perfect example of an asset bubble. Here we see reflected two additional essential features of bubbles: They are roughly symmetrical in both time and price. That is, however long it took to create the bubble is roughly the amount of time it will take to unwind the bubble, and prices usually get fully retraced, if not a bit more. Here we can see those features in perfect form. Keep an eye on this shape. We’ll be seeing it again, and again, and again. And here in a chart of the Dow Jones, beginning in 1921 we can see that the stock bubble that preceded the Great Depression followed the same rough trajectory, requiring about as much time to deflate as it did to inflate, and that prices roughly returned to the levels from which they started. And here’s the stock price of GM in the blue line between the years 1912 and 1922, and Intel in the red line between 1992 and 2002, periods during which both stocks were swept up in bubbles. Here we might also note that the price data looks very similar for both stocks, despite the fact that they reflect a car company and a high tech chip manufacturer separated by a span of 80 years. The fact that bubbles display the same price behaviors over the centuries tells us that they are not artifacts of particular financial systems, but rather are shaped by the human emotions of greed, fear, and hope. Those have not changed through the years, and this is why you should hold onto your wallet any time you hear the wordsthis time it’s different. Somewhere along the way, people started to believe this about houses. It got to the point that people began to really believe that a house was a path to riches. And, even better, it was a magical path that would transport you to easy street even if you sat on your sofa the whole time drinking beer. Now, there’s simply no way for this to be true, and we should have known better, but bubbles usually have their way with the masses. Regardless, over the long haul house prices will be set by whatever it costs to build a new house, meaning that inflation will dictate house prices. This amazing chart of inflation-adjusted house prices, created by Robert Shiller, reveals that between 1890 and 1998, house prices tracked the rate of inflation very closely. Any time the chart line is rising, houses are appreciating in price faster than the rate of inflation, and any time the line is falling, they are losing ground compared to inflation. Over this entire 118-year period, house prices averaged 101.2, meaning that inflation-adjusted house prices are roughly comparable across this entire sweep of history. Real estate prices were stable compared to inflation, then fell before and during the Great Depression, stabilized again, and then rose dramatically after the war. See this little bump right here? That was a property bubble that I still remember clearly, because it impacted the Northeast, where I lived at the time, and I got to ride my bike though abandoned construction projects. Notice that this property bubble returned to baseline in a fairly symmetrical fashion, as did the property bubble of 1989. Well, if those were property bubbles, then what’s this? This housing bubble has no historical precedent and is massively out of proportion to anything we’ve ever experienced before. There is nothing even remotely close to it in magnitude, so we are left without any history to guide us as to what the impacts are likely to be. And also note that this bubble did not suddenly begin in 2004; it began in 1998 and had eclipsed the past two by 2000. You might ask yourself, “If the Federal Reserve had access to this data, and knew we had a property bubble on our hands as early as 2000, why did they continue to aggressively lower interest rates to 1% and hold them there for a year between 2003 and 2004?” That’s a darn good question, and I’ll get to that in a minute. Based on this chart, where and when might we predict this bubble to finally bottom out? Well, symmetry suggests the bottom will be somewhere around 2015, while history suggest that prices will decline by roughly 50% in real terms. The other way we could look at this is in terms of affordability. Again, over the long haul it is impossible for median house prices to rise faster than median incomes. Why? Because the amount that people can afford to pay sets a limit on house prices. Here’s a chart I put together that compares median incomes to median house prices. The bubbles of 1979 and 1989 are not very dramatic on this graph, but there they are, marked by black arrows. The fact that median incomes did not deviate very far from those prior bubbly house prices helped to limit the impact of the bursting of those bubbles, painful though they were, because incomes and house prices did not have to travel very far to meet up once again. This time? Again, we have no historical precedent for the gap between income gains and house prices, and we see disturbing signs as early as 1999 that things were getting off track. Based on income gains alone, how much would house prices have to fall to bring these lines back together? The answer is 34% - nationally - indicating that there’s a long way to go yet. Given the propensity of bubbles to overshoot to the downside, we can’t discount that a 40% to 50% decline is in store. Here we might also guesstimate that house prices would bottom somewhere in the vicinity of 2012 to 2015. Remember, a bubble exists when asset price inflation rises beyond what incomes can sustain. And that’s exactly what we see here in this chart. So, where was the Fed during all of this? They were busy writing “research” papers convincing themselves that there was no housing bubble, as seen in this 2004 Fed study entitled, “Are Home Prices the Next Bubble?” The main summary of the study started off on a good note, stating, “Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the US economy.” But then main conclusion of the paper veered sharply off into a ditch, reading: “A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.” “Essentially moved in line with increases in family income?” What? One of the most widely known facts of our time is that family incomes have not moved up at all over the past 8 years on an inflation-adjusted basis and is one of the principal economic failures of this decade. This just goes to show that the Federal Reserve is either stocked with inept or biased researchers, and, of the two, I am not sure which makes me feel worse about our chances of pulling through this mess. But the Fed’s researchers were simply doing what millions of people did; namely, falling prey to believing that somehow “this time it’s different.” But that’s just how bubbles are. People take leave of their senses, use all manner of rationales to justify their positions, but then, suddenly one day the illusion lifts, and what seemed to be unassailably true no longer makes any sense at all. Once that day happens, the fate of the bubble is reduced to measuring the speed of its collapse. Why is any of this important to us? Because we are going to be living with the after-effects for a very long time. While it’s tempting to lay the blame for what’s happening on the housing bubble, it’s important to remember that the dramatic rise in house prices was itself just a symptom of a credit bubble run amok. Total credit at the end of 2000, when the stock bubble was bursting, stood at $27 trillion dollars. By the end of 2007, it stood at an astounding $48 trillion dollars. This $21 trillion increase in borrowing is five times larger than the increase in US GDP over the same period of time. Any attempt to understand the housing bubble has to be viewed against the backdrop of this massive increase in debt. But as we noted in an earlier chapter, this credit bubble has been going on for 25 years. Unwinding a multi-generational debt-binge is going to require some enormous changes in attitudes and habits. One reason that any bubble, but especially a housing bubble like this one, is so destructive is because so many bad investments are made along the way. Too many houses were built, too many shopping centers, too many condos, and nearly all of them too large and ill-positioned for a future of expensive energy. Sorry to say, but all those trillions of dollars were wasted, and, worse, stole opportunities from the things that needed that money more. The Austrian school of economics has a very crisp and historically accurate definition of how a credit bubble ends. According to Ludwig Von Mises: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” This is a view I happen to ascribe to and explains my strong preference for placing my wealth out of the path of a potential dollar collapse. As a nation, we’ve undertaken desperate measures to avoid abandoning the continuation of our credit expansion, leaving a final catastrophe of the currency as our most likely outcome. As for the timing? It could hardly be worse. Dealing with a bursting housing bubble is hardly the sort of challenge we need at this particular moment in history, but here we are. The stewardship and vision displayed by the Federal Reserve and Washington, DC in bringing this all about have been utterly atrocious. So what can we expect from a collapsing credit bubble? Simply put, everything that fed upon and grew as a consequence of too much easy credit will collapse. I am especially leery of financial stocks, low grade bonds, and of course, real estate. I see very few conventional ways to protect ones wealth, and so I invite you to begin asking yourself (and, if you have one, your financial advisor) some very hard questions about the safety of your holdings. You’ll be glad you did. Remember, this time it’s probably NOT different. Please join us for the next chapter, where we explore the extent to which we have been telling ourselves pleasant half-truths and other falsehoods, which I call “Fuzzy Numbers.” Ch 16: Fuzzy Numbers What if it’s true, as Kevin Phillips recently stated in an article in Harpers’, that “[e]ver since the 1960s, Washington has gulled its citizens and creditors by debasing official statistics, the vital instruments with which the vigor and muscle of the American economy are measured?” What if it turned out that our individual, corporate, and government decision-making was based on deeply misleading, if not provably false, data? That’s what we’re going to take a look at here, by examining the ways that inflation and Gross Domestic Product, or GDP, are measured. As you now know, inflation is a matter of active policy. Too little and our current banking system risks failure. Too much and the majority of people noticeably lose their savings, which makes them politically restive. So keeping inflation at a "goldilocks" temperature – not too hot and not too cold – is the name of the game. Inflation has two components. The first is the simple pressure on prices due to too much money floating around. The second component lies with people’s expectations of future inflation. If expectations are that inflation will be tame, they are said to be well-anchored. If people expect prices to rise, they tend to spend their money now,while the getting is still good, and this serves to fuel further inflation in a self-reinforcing manner. The faster people spend, the faster inflation rises. Zimbabwe is a perfect modern example of this dynamic in play. Accordingly, official inflation policy has two components – the first is regulating the money supply and the second is anchoring your expectations. And how exactly is this anchoring accomplished? Over time, this has evolved into little more than telling you that inflation is a bit lower, or even a lot lower, than it actually is. The details of how this is done are more complicated but worthy of your attention. Let me be clear, the tricks and subversions we will examine did not arise with any particular administration or political party. Rather, they arose incrementally during every administration you care to examine over the past 40 years. Under Kennedy, who disliked high unemployment numbers, a new classification was developed that scrubbed so-called ‘discouraged workers’ from the headline data, causing unemployment figures to drop. Johnson created the “unified budget” that we currently enjoy, which rolls surplus Social Security funds into the general budget, where they are spent but then not reported as part of the deficit you read about. Richard Nixon bequeathed us the so-called “core inflation” measure, which strips out food and fuel, which, as Barry Ritholtz says, is like reporting inflation ex-inflation, while it was Bill Clinton who left us with the current tangled statistical morass that is now our official method of inflation measurement. At every turn, a new way of measuring and reporting was derived that invariably served to make things seem a bit rosier than they actually were. Economic activity was higher, inflation was lower (a lot lower), and jobs were more plentiful. Unfortunately, the cumulative impact of all this data manipulation is that our measurements no longer match reality. We are, in effect, telling ourselves lies, and these fibs serve to distort our decisions and jeopardize our economic future. Let’s begin with inflation, which is reported to us by the Bureau of Labor Statistics, or BLS, in the form of the Consumer Price Index, or CPI. If you were to measure inflation, you’d probably track the cost of a basket of goods from one year to the next, subtract the two, and measure the difference. And your method would, in fact, be the way inflation was officially measured right on up through the early 1980s. But In 1996, Clinton implemented the Boskin Commission findings, which now have us measuring inflation using three oddities: substitution, weighting, and hedonics. To begin with this list, we no longer simply measure the cost of goods and services from one year to the next, because of something called the "substitution effect." Thanks to the Boskin Commission, it is now assumed that when the price of something rises, people will switch to something cheaper. So any time, say, that the price of salmon goes up too much, it is removed from the basket of goods and substituted with something cheaper, like hot dogs. By this methodology, the BLS says that food costs rose 4.1% from 2007 to 2008. However according to the Farm Bureau, which does not do this and simply tracks the exact same shopping basket of thirty goods from one year to the next, food prices rose 11.3% over the past year, compared to the BLS which says they only rose 4.1%. That’s a huge difference. In my household, our experience is better matched by the Farm Bureau. One impact of using substitution is that our measure of inflation no longer measures the cost of living, but thecost of survival. Next, anything that rises too quickly in price is now subjected to so-called “geometric weighting,” in which goods and services that are rising most rapidly in price get a lower weighting in the CPI basket, under the assumption that people will use less of those things. Using the government’s own statistics from two different sources, we find that health care is about 17% of our total economy, but it is weighted as only 6% of the CPI basket. Because healthcare costs are rising extremely rapidly, the impact of including a much smaller healthcare weighting is a reduction in reported inflation. By simply reinstating the actual level of healthcare spending, our reported CPI would be several percent higher. But the most outlandish adjustment of them all goes by the name “hedonics,” the Greek root of which means “for the pleasure of.” This adjustment is supposed to adjust for quality improvements, especially those that lead to greater enjoyment or utility of the product, but it has been badly overused. Here’s an example. Tim LaFleur is a commodity specialist for televisions at the Bureau of Labor Statistics, where the CPI is calculated. I’m guessing he works in a place that looks like this. In 2004, he noted that a 27-inch television selling for $329.99 was selling for the same price as last year, but was now equipped with a better screen. After taking this subjective improvement into account, he adjusted the price of the TV downwards by $135, concluding that the screen improvement was the same as if the price of the TV had fallen by 29%. The price reflected in the CPI was not the actual retail store cost of $329.99, which is what it would cost you to buy, but $195. Bingo! At the BLS, TeeVees cost less and inflation is heading down. At the store, they’re still selling for $329.99. Hedonics are a one-way trip. If I get a new phone this year and it has some new buttons, the BLS will say the price has dropped. But if it only lasts eight months instead of 30 years, like my old phone, no adjustment will be made for that loss. In short, hedonics rests on the improbable assumption that new features are always beneficial and are synonymous with falling prices. Over the years, the BLS has expanded the use of hedonic adjustments and now applies these adjustments to everything from DVDs, automobiles, washers, dryers, refrigerators, and even to college textbooks. Hedonics are now used to adjust as much as 46% of the total CPI. What would happen if you were to strip out all the fuzzy statistical manipulations and calculate inflation like we used to do it? Luckily, John Williams of shadowstats.com has done exactly that, painstakingly following each statistical modification over time and reversing their effects. If inflation were calculated today, the exact same way it was in the early 1980’s, Mr. Williams finds that it would be running at closer to 13% than the currently reported 5%. This is a stunning 8% difference, which explains much that we see around us. It explains why people have had to borrow more and save less – their real income was actually a lot lower than reported. A higher rate of inflation is consistent with weak labor markets and growing levels of debt. It fits the monetary growth data better. So many things that were difficult to explain under a low-inflation reading suddenly make sense. The social cost to this self-deception is enormous. For starters, if inflation were calculated like it used to be, Social Security payments, whose increases are based on the CPI, would be 70% higher today than they actually are. Because Medicare increases are also tied to the CPI, hospitals are increasingly unable to balance their budgets, forcing many communities to lose services. These are real impacts. But besides paying out less in entitlement checks, by understating inflation, politicians gain in another veryimportant way. Gross Domestic Product, or GDP, is how we tell ourselves that our economy is either doing well or doing poorly. In theory, the GDP is the sum total of all value-added transactions within our country in any given year. Here’s an example, though, of how far from reality GDP has strayed. The reported number for 2003 was a GDP of $11 trillion, implying that $11 trillion of money-based, value-added economic transactions had occurred. However, nothing of the sort happened. First, that 11 trillion included $1.6 trillion of imputations, where it was assumed that economic value had been created but no actual transactions took place. The largest of these imputations was the “value” that the owner of a house receives by not having to pay themselves rent. Get that? If you own your house free and clear, the government adds how much they think you should be paying yourself rent to live there and adds that amount to the GDP.