The Rude Awakening
Wall Street, New York
Tuesday, September 26, 2006 ------------------------- - The bear market for asset prices takes its first few
bites...and they are hurting,
- Deja vu? What you can do to protect yourself when the
1920's are repeated,
- A public response to Eric's Sister, vigilant Rude
etymologists, dropping bonds and plenty more...
------------------------- Eric Fry, reporting from the dessert-like Eden of Laguna
Beach... Joel and I would like all Rude readers to know that we read
each and every email you send our way – a task that
consumes very little time on the days when we receive
nothing at all. And we would also like you to know that we
appreciate your vigilant attention to every word we
write...or misspell... Just last week, for example, when I mistakenly compared
Laguna Beach to a "dessert," rather than a "desert," the
emails flooded in... "Dear Eric Fry," one reader wrote, "The word is 'desert'
(emphasis on first part of the word). 'Dessert' is the
usually sweet dish eaten at the end of a meal (emphasis on
the second part of the word)." Another reader succinctly advised: "Please have Eric Fry go to a dictionary and look up the
meanings of
a. dessert
b. desert." "Dear Eric," wrote another, "Laguna is in a desert alright,
but you are right that it has been turned into dessert." Even my own sister chimed in! "Hey...I just read your latest 'Rude' letter. It is desert
not dessert," she chided. "Can you believe I have the
audacity to only write you when you make a spelling
error?!! It sounds like life in Laguna is exciting. I
hope the kids are adjusting to their new schools. Please
plan on Thanksgiving here if that will work for you. We
would love to have you come visit. Take care..." Because I have been in France for the last few days, I have
not yet replied to my sister's email. But since she's a
regular Rude reader, I'll answer her publicly now: "Hey Sis, I don't mind the helpful criticism. That just
means you're reading carefully. Thanksgiving out at your
house in Palm Springs sounds like a nice idea. I know the
kids would love to go out to the dessert to see you all.
But just one question: What's for desert?" In the column below, Dr. Kurt Richebacher explains why the
U.S. economy might soon pass through the parched desert of
deep recession. The soon-to-begin recession could become
all the more severe, Dr. Richebacher warns, due to
America's over-reliance on "asset inflation" – another term
for "runaway home prices." The learned German economist delivered this chilling
message in the August issue of The Richebacher Letter.
Under the headline, "A Rude Awakening Ahead," he exposed
the intimate connection between home prices and economic
growth...or lack thereof. Upon first seeing the headline of his August issue, we felt
we simply had to run an excerpt in the Rude Awakening, just
for the sake of espirit de corps. But Dr. Richebacher's
message took on even greater urgency and gravitas after
last Thursday's dismal news from the Philadelphia Federal
Reserve Bank, coupled with yesterday's dire report from the
National Association of Realtors (NAR). Last Thursday, the Philly Fed announced a surprisingly
steep drop in the region's manufacturing index – from 18.5
in August to minus 0.4 in September. That's the steepest
drop in three years. Then yesterday, the NAR disclosed that
median home prices slipped for the first time in eleven
years. Prices in August dropped 1.7% from August of 2005. "There is worse news in the pipeline," Ian Shepherdson,
chief economist at High Frequency Economics, tells
Bloomberg News. "With inventory still rising, there is no
chance of any short-term relief. Prices and volumes have a
long way to fall yet." That's why, warns Dr. Richebacher, U.S. economic activity
also has a long way to fall yet... --- Crisis Investing ---
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By Dr. Kurt Richebacher A recession and a bear market in asset prices are
inevitable for the U.S. economy. Recent economic data leave
no doubt that both are on their way. What keeps triggering
rebounds in U.S. stocks is only the "bad news is good news"
syndrome, reflecting the hope that economic weakness will
stop the Fed's rate hikes. Nonfarm payrolls grew in the second quarter by 108,000 per
month, well off the first quarter's 176,000. It was the
slowest quarter in almost three years. Meanwhile, the
overall economy is already feeling the effects of a slowing
housing market. Residential construction [mostly
homebuilding] contributed only 0.38 percentage points to
real GDP growth during the last two quarters (Q4 2005–Q1
2006). This compares with 1.18 percentage points in the
first half of 2005. Consider that construction spending has
the highest multiplier effects within the U.S. economy,
generating jobs and additional spending. Retail trade and
residential building together account for 75% of GDP. It is no secret what has mainly pulled the U.S. economy out
of its 2001 recession. The Greenspan Fed succeeded in
offsetting the depressive impact of plunging stock prices
and business investment on the economy by inflating house
prices, which lubricated an unprecedented consumer
borrowing-and-spending binge. For the first time in
history, a central bank systematically engineered an asset
and credit bubble for the explicit purpose of precipitating
economic growth. "Asset-driven" economic growth became the conventional
label for this new pattern of growth. Policymakers and
quite a few others have apparently come to appreciate it as
a valid alternative to the traditional income-driven
economic growth. It is not. It is the road into the next
asset bust. Appearances of the last few years are deceptive. Asset-
driven economic growth is a badly flawed and dangerous
alternative for two reasons: First, asset prices cannot
rise in perpetuity; and second, it involves exorbitant
credit and debt growth, lured by the rising asset prices
and excessively optimistic expectations. Bubble-driven growth invariably ends when asset prices stop
rising. In the U.S. case of the late 1920s and Japan's case
of the late 1980s, asset prices collapsed, with huge damage
to the balance sheets of banks, firms and private
households. Of course, the fabulous asset-driven "wealth creation"
kindles the readiness to stampede into debt. In the United
States, debts of private households since 2000 have soared
from $6,966.7 billion to $11,840.1 billion (Q1 2006). This
represents an increase by $4,873.4 billion, or 70%. But
this record debt growth is discarded as irrelevant because
the net worth of private households — asset values minus
outstanding debt — over the same time has surged from
$42,113.5 billion to $53,830.3 billion. In other words,
asset values have risen much faster than debts. Is this a reasonable calculation? Our categorical answer is
no. Few people seem to realize that America's vast real
estate "wealth" arises from imputed values. In other words,
the relatively small number of houses that change hands
every year establishes the value for all of the rest of the
nation's houses. In the United States, only about 5% of all
existing houses are traded every year. The other 95% simply
sit there, while their theoretical values steadily rise.
Americans call this wealth creation. I do not. This wealth
can disappear just as easily as it first appeared. In fact,
it is disappearing already. I have always rigorously disputed the idea that rising
implied home values equal wealth creation. Even the owners
of the houses gain, in reality, very little from the rise
in prices. Everyone may feel richer. But they are no richer
in housing comfort or anything else. If anyone would later
exchange his residence for a place of the same quality, he
would have to pay the same high price for which he sold. In reality, the homeowner gains one thing only, and that is
higher collateral for higher borrowing. Reckless
utilization of correspondingly higher borrowing facilities
is the central feature of every bubble economy, leading to
exponential debt growth. So it happened in the late 1920s
in the United States, and in the late 1980s in Japan, and
so it has happened again in the United States during the
last few years. Assessing the U.S. economy's prospects, the most important
thing first to take into account is that what has happened
over the last few years is not the garden-variety business
cycle. It is a grossly overly indebted and unbalanced
bubble economy, in which borrowing and indebtedness,
particularly for private households, have gone to
unprecedented extremes in chasing house price inflation. 
Also, we have to recognize that once asset prices stop
rising, the game is up. The potential of the post-bubble
crash in asset prices largely depends on the size of the
prior excesses. The other day, professor Robert J. Shiller
of Yale University declared that the present housing boom
in the United States "is the biggest on record." A bubble economy needs rising asset prices to keep it
going. Once the prices of those assets, which have
lubricated the decisive assets — stocks and housing in the
U.S. case — stall, let alone fall, the whole process stops
and reverses with a vengeance, because the formerly ample
liquidity and wealth creation go into reverse. With this in mind, let us take a closer look at the
finances of private households, being the dominant deficit
spender in the U.S. economy, vastly exceeding that of the
government. In 2005, the public sector borrowed $479.5
billion, against $1,208.7 billion borrowed by private
households. With real disposable incomes of private households now in
stagnation, any increase in consumer spending essentially
depends on borrowing — mainly against rising house prices. But if home prices stop rising – or worse, begin falling –
the consumer will stop borrowing and spending. The U.S.
economy, therefore, would begin contracting...And that
would be a very rude awakening indeed. [Joel's Note: Some people must say Dr. Richebacher is
crazy. He is a classical economist who believes in income-
driven growth over asset-driven growth, in saving over
borrowing and wealth preservation over profligacy. Yes, the
folk down in the Capital of this Empire of Debt must be
calling him insane. They seem to be following none of his
advice. If you would also like to be known to the fed-heads
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