Frankenstein Economy
Made in U.S.A. 1995
Weekly Commentary - March 22, 2006
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3/9/06 - Hedge Funds Still in the Dark
3/15/06 - iTulip.com II: The Sequel
3/22/06 - Frankenstein Economy
3/29/06 - Housing Bubble Correction Update
4/1/06 - Greenspan Says, "Sorry!"
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4/19/06 - China versus USA
What does a Mr. U.S. Economy look like? Can't recall, exactly. Haven't seen him in nearly 20 years. As I remember, he was fit, well proportioned, muscular to the point of intimidating. If you are under 30, you've never seen him. But he was there, many years ago, providing a good example, setting the pace, spreading the wealth, kicking ass and taking names. Evidence of his past influence on the average Joe can be seen in old movies, movies with scenes like this.
The average North American, call him Joe, living in the era of Mr. U.S. Economy, walks into a bank to get a loan to fix up his falling apart house, rather than add another thousand square feet to make room for the Made in China, Bose branded Home Entertainment center. A dour looking loan officer, call him Ed Noway, sits behind a laminate faux walnut desk facing the nervous applicant. Prominently displayed on the edge of Ed's desk, a brass nameplate on a wood block that reads "Ed Noway, Loan Officer." While Joe fidgets, Ed pours over a pile of paperwork that Joe dutifully spent until midnight filling out with his wife the night before. They did not cuddle afterwards. She's not sure Joe can close the loan with Ed. Joe's not sure he wants the extra hours he'll have to work to make the additional payments.
Ed finally looks up to grill Joe about his employment and credit history, his assets, his attitude about saving. Ed wants to know if Joe is likely to pay the loan back or not. He, Ed, the loan officer, is responsible for the decision. He doesn't want the bank, nor he as its representative, left holding the bag if Joe punts on the loan. Ed will look bad. He might even lose his job. Ed's ass is on the line. So is Joe's.
Here we have the basis for a sound business transaction. But those days are over. The Frankenstein Economy is here.
Today, Joe can borrow against the theoretical future value of his home and the statistical probability that he'll have the future income stream needed to pay it back. There is no Ed at the bank to know or care whether Joe can actually pay back a loan, or if he actually uses the money to make home repairs or buy eight tons of snow to build a ski slope in his back yard to snow board in August. The connection between Joe and his newly minted debt today is a collateralized debt obligation, part of a securitized interest in a pool of non-mortgage assets, and Joe's default risk is perhaps sold in a portfolio of private label subordinate pieces to a pension fund of a municipality in Germany. Who's the counterparty of the credit derivative that's hedging Joe's default risk, you ask? No you didn't. You don't know what the heck I'm talking about. Don't feel bad. Ninety nine percent of the lenders selling these loans don't either. They just know the money is there to lend and they'd better lend it or their competition will.
Over the past 15 years or so, the Fed replaced Mr. U.S. Economy in a free market ideology based fit of deregulation. Mr. U.S. Economy, whoever he was, is no more. In his place, the Frankenstein Economy. The Fed may have had had the best of intentions when making the Frankenstein Economy, but let's see what he's left behind as he's stomped across the North American economic landscape.
Since at least 1950, before Mr. U.S. Economy was put in cryogenic storage and replaced by the Frankenstein Economy, U.S. households purchased financial assets at an increasingly higher rate than they took on liabilities. They did this, except during recessions, until 1990. Then they started to take on more and more liabilities. In 1995, when the Frankenstein Economy appeared on the scene, a 50 year trend started to turn upside down. Net acquisition of financial assets not only stopped growing but turned negative, as the chart above from Paul Kasriel at Northern Trust shows.
Large and sudden reversals in long-term trends imply future regressions to the mean; the Frankenstein Economy has made a mess of the markets. The folks at the Fed, of course, think the Frankenstein Economy is doing great! Before we go into that, let's view a few more pictures of the monster's gruesome trail.
Also starting in 1995 -- not by coincidence, in our view -- under the influence of the Frankenstein Economy, North Americans developed religious expectations about the value of their homes. While the nominal (inflation adjusted) value of their homes declined, market value skyrocketed. A few voices of reason were dismissed as egghead mumbo jumbo, such as Yale professor Robert Shiller, whose research concludes that except for two periods — the early 1940s and the late 1990s — when adjusted for inflation, home prices in the U.S. "have been mostly flat or declining."
Justifications for the post 1995 real estate bubble shown in the chart above, again thanks Paul Kasriel at Northern Trust, are legion. The favorite: land scarcity. Little country, the U.S.A. One of the hottest real estate markets? Las Vegas. (Tip for Vegas real estate buyers: land scarcity and thus land value in the desert can be repealed as quickly as the zoning laws that created it.)
What about a nation that has an actual shortage of land relative to population, such as Japan. How did the housing bubble turn out there? Theirs, much like ours, started right after their stock market bubble burst, but unlike ours conked out a couple years later.
The chart above, compliments of a San Francisco Fed's Asset Price Declines and Real Estate Market Illiquidity: Evidence from Japanese Land Values January 2005. They found that if you bought a condo in Japan's version of NYC in 1992, ten years later the market valued it at around 80% of what you paid.
Ten years of flat prices. Maybe this is the report that has given the Fed the confidence to issue the calming view repeatedly expressed in public that housing prices will not "collapse" after the U.S. boom ends but merely "flatten out."
Say you're 50 years old. Are the optimists saying that -- best case -- a house may be worth nominally (price adjusted for inflation) in 2016, when you are 60, what you paid for it in 2006? Let's hope they're right and prices don't regress to the mean.
Back to our hero, the Frankenstein Economy. Just as he's convinced North American's of the inevitability of home price appreciation, he has convinced them that they do not need to save. He's been highly influential on this point, as the chart above from iTulip.com's previous life shows: the U.S. savings rate from 1960 to 2000. Once again, we note a distinct change in trend in the year 1995.
Of all the outlandish features of the Frankenstein Economy, his most outstanding is his enormous head relative to his brain. When he's thinking at all, he imagines that the world outside the USA finds him as attractive as his previous incarnation, Mr. U.S. Economy. Like an aging Hollywood actor who's suffered one plastic surgery after another in the hope that he can keep getting the star role of the 30-something action hero even though he's pushing sixty, he expects to keep getting paid a movie star salary premium. So far the ruse seems to be working. He's taking in $2 billion in foreign investments every day, enough to fund the country's massive budget and trade deficits. But mostly it's Asian central banks that are paying; private and institutional investors baled years ago. The Asian central banks only do it to keep the U.S. consumer borrowing and their exports flowing until they can find a better customer.
His trade deficits are shown in the chart above selected from the highly recommended site Grandfather Economic Report. As you can see, Economic Frankenstein started to work his magic around 1995 as North Americans began to buy a lot more stuff from overseas than they sold. To see exactly how North Americans paid for all this, see our Chart of the Week, Purchases of U.S. Financial Assets.
The crux of our investigation here at iTulip.com going forward is to understand what led to an apparent abrupt change in many long-term economic trends that coincided with the creation of the Frankenstein Economy around 1995. We expect that if we understand that, we'll understand how, why and when these trends are likely to reverse and the impact that will have on our readers. Actually, we believe we already know, but learned from our previous 1998 iTulip.com experience that you can't just give up the answer -- no one will believe us. Readers have to develop an understanding on their own.
In the end, Dr. Frankenstein's monster does not find peace until his creator dies. The monster then departs for the northernmost ice to die.
In the case of the Frankenstein Economy, the sooner the better.
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