The Problem With Bubbles Is Skewed Incentives
A weekend topic on two housing bubble related reports. The Eurasian Review. “The following interview with Michael Hudson was conducted by Finnish journalist Antti J. Ronkainen. AJR: When the Great Financial Crisis escalated in 2008 the Fed’s response was to lower its main interest rate to nearly zero. Why? MH: The aim of lowering interest rates was to provide banks with cheap credit. The pretense was that banks might lend to help the economy get going again. But the Fed’s idea was simply to re-inflate the Bubble Economy. It aimed at restoring the value of the mortgages that banks had in their loan portfolios. The hope was that easy credit would spur new mortgage lending to bid housing prices back up – as if this would help the economy rather than simply raising the price of home ownership.”
“Banks did make money, but not by lending into the ‘real’ production and consumption economy. They mainly engaged in arbitrage and speculation, and lending to hedge funds and companies to buy their own stocks yielding higher dividend returns than the low interest rates that were available.”
“AJR: In addition to the near zero interest rates, the Fed bought US Treasury bonds and mortgage backed securities (MBS) with almost $4 trillion during three rounds of Quantitative Easing stimulus. How have these measures affected the real economy and financial markets? MH: In 2008 the Federal Reserve had a choice: It could save the economy, or it could save the banks. It might have used a fraction of what became the vast QE credit – for example $1 trillion – to pay off the bad mortgages and write them down. That would have helped save the economy from debt deflation. Instead, the Fed simply wanted to re-inflate the bubble, to save banks from having to suffer losses on their junk mortgages and other bad loans.”
“One therefore can speak of a financial war waged by Wall Street against the economy. The Fed is a major weapon in this war. Its constituency is Wall Street. Like the Justice and Treasury Departments, it has been captured and taken hostage. So neither the Fed nor the Justice Department or other U.S. Government agencies has sanctioned or arrested a single banker for the trillions of dollars of financial fraud. Just the opposite: The big banks where the fraud was concentrated have been made even larger and more dominant. The effect has been to drive out of business the smaller banks not so involved in derivative bets and other speculation.”
“The bottom line is that banks made much more by getting Alan Greenspan and the Clinton-Bush Treasury officials to deregulate fraud than they could have made by traditional safe lending. But their gains have increased the economy’s overhead.”
“AJR: How do TARP and QE relate to the Federal Reserve’s mandate about price stability? MH: There are two sets of prices: asset prices and commodity prices and wages. By ‘price stability’ the Fed means keeping wages and commodity prices down. Calling depressed wage levels ‘price stability’ diverts attention from the phenomenon of debt deflation – and also from the asset-price inflation that has increased the advantages of the One Percent over the 99 Percent. From 1980 to the present, the Fed has inflated the largest bond rally in history as a result of driving down interest rates from 20 percent in 1980 to nearly zero today, as you have noted.”
“Wall Street isn’t so interested in exploiting wage labour by hiring it to produce goods for sale, as was the case under industrial capitalism in its heyday. It makes its gains by riding the wave of asset inflation. Banks also gain by making labour pay more interest, fees and penalties on mortgages, and for student loans, credit cards and auto loans. That’s the postindustrial financial mode of exploiting labor and the overall economy. The Fed’s QE program increases the price at which stocks, bonds and real estate exchange for labour, and also promotes debt leverage throughout the economy.”
“AJR: Why don’t economists distinguish between asset-price and commodity price inflation? MH: The economics curriculum has been turned into an exercise for students to pretend that a hypothetical parallel universe exists in which the rentier classes are job creators, necessary to help economies recover. The reality is that financial modes of getting rich by debt leveraging creates a Bubble Economy – a Ponzi scheme leading to austerity and shrinking markets, which always ends in a convulsion of bankruptcy.”
The ICIS Chemical Business. “If you go all the way back to March 1637, some single tulip bubbles sold for ten times the annual wages of a skilled craftsman in Holland. Wind the clock forward to China’s debt-charged economic growth in 2008-2013, when house price to earnings ratios reached 14:1 in the country’s Tier 1 cities (Tier 1 cities are the biggest cities in China, such as Beijing and Shanghai).”
“There is no such excuse this time around as today’s economic difficulties – which are centred on the bursting of the China investment bubble – are the third such episode in the space of just 16 years. We might be lucky on this occasion and get away with only a prolonged period of lower global growth rather than another full-blown economic crisis. But every day almost, new data emerges indicating the scale of this most recent bubble – and thus the danger of something at least as big as 2008 – perhaps even bigger.”
“Take a 10 January article in the UK’s Financial Times as a very good example. Quoting Institute of International Finance data, the FT said that emerging market debts in the decade to mid-2015 had risen from $5.4trn to $24.4trn, which left borrowing equivalent to 90% of the region’s GDP.”
“Emerging markets in general were involved in this bubble, with their recent economic success primarily resting on events in China. Think of Brazil and what was once its strong commodity-led growth as China bought every tonne of iron ore it could get its hands on. The problem, as is always the case with these bubbles, is skewed incentives. On this occasion we can blame these skewed incentives on Western central banks, and particularly the US Federal Reserve. Here is how it worked, or, rather, did not work.”
“1. The Fed’s quantitative easing programmes drove interest rates to record lows, while also devaluing the US dollar. This did what the Fed intended, which was to force investors to seek ’stores of value’ in higher-yielding investments. Money poured into emerging markets, where yields were better, resulting in this alarming build-up of debt.”
“2. Because just about everyone believed that this bubble would go on and on, petrochemicals companies, most notably in the US, were tempted into major new capacity investments, particularly in polyethylene (PE). There has also been major over-investment in oil, which explains today’s collapse in oil prices.”
“‘People tend to ignore the warning signs during these bubbles. But in retrospect, they should have been obvious to every single one of us,’ said a Singapore-based business planner at a global chemicals company.”
“Here is another much broader-based statistic on China’s credit boom that should have been widely noticed: between Q4 2008 and Q1 2014 China’s total social finance (TSF) rose from 129% to 207% of GDP, according to Washington DC-based think tank the Brookings Institute. TSF is a measure of total new credit creation in China.”
“And, as we discussed in our last China Monthly, as leverage increased, its effectiveness in delivering growth declined: China’s government estimated that in 2014, each dollar of new debt was adding only 10 cents to GDP growth. But as the bubble inflated, as is the case in every investment mania, a theory emerged to justify why the bubble would go on and on – almost indefinitely.”
“This time around, the China and wider emerging markets bubble was based on the notion that hundreds of millions of people in these countries were rapidly become middle-class, under the definition of what it means to be middle class in the West. ‘The key moment was probably 2011, when the myth began to take hold that China had suddenly become middle-class,’ wrote Paul Hodges, chairman of the UK-based chemical consultancy, International eChem. They chose to ignore the detail of the report, which was that being middle-class in the emerging world actually meant per capita daily incomes of $2–20, based on purchasing power parity, said Hodges.”
“‘Even with two adults earning $20 a day, every day of the year, they would have an annual combined income of just $14,600, well below the poverty line in any Western country,’ he added. The Chinese government’s National Bureau of Statistics also placed average per capita high-end urban incomes in China at just $9,000 per annum in 2013. Anybody earning that amount of money in the developed world would probably be on welfare payments.”
“In the case of US PE expansions, placing all of the extra volumes always felt like a risky proposition, given what is a very mature US market. Here we have taken just one of the three major grades of PE – linear low density polyethylene (LLDPE) – as an example. US consumption is forecast to rise from around 4m tonnes in 2010 to approximately 4.8m tonnes in 2020. Meanwhile, capacity is set to increase from 4.5m tonnes/year to 7.9m tonnes/year.”
