Convergence between Wealth Itself & the Flow Lines of ‘Claims on Wealth’ in the US Real Estate Market
The other day, I mentioned that the West is addicted to economic disequilibrium. By this, I meant that the West is addicted to diverging tendencies between wealth itself and the flow lines of ‘claims on wealth’ (to quote Carroll Quigley). However, as is evident by the deteriorating US real estate market, it is not always possible to ‘engineer’ such a scenario. In the case of the US real estate market, the cat is well and truly out of the bag, and not even the most extravagant of ‘money printing’ exercises seems to be able to get it on the “right” track. The behavior of this market represents an example of convergence between wealth and the flow lines of ‘claims on wealth’. Here, I get to grips with the nature of this convergence and outline why the attempted interventions will prove futile.
The Great Divergence:
As the reasons for the US real estate bubble have been well-acknowledged by the financial press, I won’t say much about them. I’ll just say that by 2006, the US had experienced a long period of excessive credit growth. This manifested itself in a gigantic housing bubble.
The rudimentary reason was that – due to the nature of modern-day monetary systems – the stock of ‘claims on wealth’ (or ‘IOU dollars’ / liabilities on commercial banks) seemed to provide sufficient resources for enormous (and long) investment projects. This – in essence – amounted to a colossal disconnect between the flow lines of ‘claims on wealth’ and the true state of the stock of wealth.
The Convergence Process Begins:
By 2006, the lack of viability of all things pertaining to housing became evident. That is, it came to be realized that the prevailing structure of production was unsuitable for the real world.
To get this clear, simply consider the rudimentary mechanism of the profit-motive. A profit is a ratification of what the profit-seeker is doing. It is a declaration (by the market) that the value of the results (selling proceeds) is higher than what it took to get those results (cost receipts). In this way, a profit implies that resources have been utilized well (by the perception of market participants at a given time), whereas a loss implies that resources have been wasted (again, by the perception of market participants at that given time). So, this period of widespread losses in the US real estate market is essentially a mass realization that the activities in the housing market are wasteful. Or, in other words, a realization that the activities in the housing market are not a good use of scarce resources by the perceptions of the potential customers. Indeed, a realization that the activities would only be suitable for a richer (and/or more abstinent) parallel universe. The initial downturn in all things housing-related was the beginning of a convergence process between the flow lines of ‘claims on wealth’ to the true stock of wealth (and the markets preferences relating to it).
The Attempt to Fix the Game – QE1:
After a bout of extreme (and barely precedented) market stress, the monetary authorities attempted to fix the game. This is unsurprising, given the West’s addiction to economic disequilibrium (or — as Marc Faber puts it — the West’s addiction to credit).
In the eyes of state-intellectuals and monetary authorities (which are perhaps an extension of the masses’ perceptions), the situation was just unacceptable. They identified the problem from the perspective of the market participants involved with the real estate market (i.e. producers, MBS holders etc.). Those guys owned things related to the real estate market, but owed dollars (i.e. liabilities on the Federal Reserve). Due to the revelation that they had prepared for a fictitiously wealthy (and/or abstinent) population, they found themselves insolvent or close to insolvency (as the dollar strengthened against all things housing-related).
Thus, the monetary authorities (who, unfortunately, lack authority when it comes to monetary matters!) attempted to ‘fix’ the game. They drastically altered the assets backing the outstanding stock of Federal Reserve notes (& Federal Reserve balances) in favor of – by and large – Mortgage-backed securities. To put it analogously, they ‘moved the goal-posts after the shot at goal had already been taken‘. That is, they attempted to reduce the burdens upon institutions that owned MBSs and owed dollars by making dollars — themselves — ‘good for’ MBSs.
This debauched practice had the effect of reducing the burdens upon said institutions, however, it also had the affect of drastically reducing the burdens on the levered speculative class. In this way, although we had a minor rebound in housing prices, the structure of production did not reignite animal spirits in the housing market (precisely because the cat was well and truly out the bag). The investment projects that reached a peak in 2005/2006 had been revealed as suitable for a richer and/or more abstinent population. So, regardless of any increases in the dollar prices of the real estate market, the ‘everything else’ price of housing continued to plummet. In other words, for every percentage point that the housing market rose, the plethora of ‘risk assets’ rose several percentage points.
The Attempt to Undo Some of the Damage – QE2:
After having supposedly ‘saved us from disaster’, I suspect that the fiscal and monetary authorities thought it was prudent to undo some of the emergency measures implemented during 2008 and 2009. To name a few examples of this ‘clean-up’ operation that pertain to the ‘QE2′ period:
- The Federal Reserve reduced its holdings of Federal Agency Debt Securities.
- The Federal Reserve reduced its holdings of Mortgage-backed Securities.
- The Federal Reserve unwound some of its loan facilities.
- The Federal Reserve reduced its holdings of the range of LLC’s made from the carcasses of AIG etc.
Moreover, the US Treasury have also taken part in this clean-up operation by (at least):
- Unwinding the supplementary financing account program.
- Unwinding its holdings of Mortgage-backed Securities.
With the above said, one should note that the vast majority of financial people have considered QE2 to be an extraordinary piece of monetary debauchery. To be sure, it is unwise, but – by my perception at least – it doesn’t match the inflationary fears that I have seen in the eyes of lots of investors lately. Rather, the composition of the Federal Reserve’s assets has become more ‘traditional’ (insofar as we can take the monetary unorthodoxy of the past 40-years as a standard of ‘tradition’).
As everyone knows, the US real estate market has taken another harsh blow in recent months. I would guess that this is not unrelated to the ‘clean-up’ effects of QE2.
On the Irony of Using Monetary Methods:
As I mentioned above, the fractional-reserve banking system can lead entrepreneurs to stray from economic prudence by exaggerating the stock of savings. The use of monetary methods to combat the required adjustment has some ironic implications.
The problem is that the ‘savings-consumption’ ratios are improperly represented by the fractional-reserve banking system. A ‘solution’ then, might be to manipulate the ‘savings’ part higher. However, with the outrageous and unprecedented monetary manipulation seen in the past few years, one can only expect people to reduce their savings (in response). After all, with the conjured images of hyperinflation in the Weimar Republic, people might think that they should consume while they can!
On the Inevitability of Deflationary Shocks & A Comparison of US and Europe:
This brings us to an interesting phenomenon. Regardless of whether I’m right about this clean-up operation or not, it seems that a deflationary shock is almost inevitable.
If I’m right about this ‘clean-up’ operation, then it demonstrates that the status quo is highly dependent on continued flows of stimulus. In this case, any slow down in the rate of stimulus (which seems inevitable with the decreasing appetite for the Federal Reserve) will bring a resumption of the private-sector deleveraging trend.
If I’m wrong, and QE2 was yet another bailout for another class of speculators (which it could well be), then it shows the problems with tinkering with the dollar. The Federal Reserve does not contain a group of highly alert speculators – the Fed does not employ the fabled investors of our time, and hence their capacity to foresee and weigh the severity of financial manias is limited at best. In this way, with many markets “merrily up and dancing the Chuck Prince Charleston as if 2008 never happened” (to quote Sean Corrigan’s excellent article), it is conceivable that the monetary authorities will struggle to identify the ‘least common denominator’ until after the fact (i.e. after profound market stress).
In this way, we could compare the abundance of financial manias in the US to the plight of European sovereigns. The European monetary system has been criticized for not being ‘unified’. In other words, it has been criticized because the Euro isn’t outrightly and automatically debauched to suit the least common denominator. Thus, it takes severe market stress before the ECB changes the rules to alleviate pressures on the banking system and sovereign debt issuers.
Likewise, conceivably the sheer range of financial manias will get the Fed confused about which one to subsidize the most! In this way, a manipulation of the dollar in favor of one group of speculators (e.g. the banking system) may be deemed to be harmful to other groups (e.g. the housing guys)!
The rudimentary problem with the housing sector is that it is suitable for some other, fictional US population. The attempts to paper over the problem are inevitably bound to fail, in fact, they act to worsen the problems.
Moreover, the employees of the Federal Reserve are not omniscient. Hence, it is likely that we will see further brief bouts of financial stress in the coming years (regardless of their attempts at monetary debasement!).
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012