- Stephen Roach, Morgan Stanley Economist, April 4, 2005

Private households in the United States have embarked on their greatest borrowing binge of all time, fostered and facilitated by the rampant house price inflation and a most aggressive financial system. What has been developing in the balance sheets of private households, therefore, is a race between booming “wealth creation” through rising house prices and soaring indebtedness.

It appears that indebtedness will win this race and wealth creation will lose. Over the five recovery years since the end of 2001, the overall indebtedness of private households surged by 66%. Even though overall indebtedness soared, rising home prices still provided the private households with the biggest wealth gains of all time. The housing bubble, therefore, has been the single most important economic event of the last few years. Homeowners used the sharply rising market values to embark on their greatest borrowing-and-spending binge of all time, financing higher consumer spending through soaring equity withdrawals, even though personal savings were negative in the aggregate.

The bursting housing bubble, therefore, should be the single most important economic event of the next few years.

In a recent speech in Atlanta, Donald L. Kohn, vice chairman of the Federal Reserve Board, remarked:

“Our uncertainty about what pushed home prices and sales to those elevated levels raises questions about how the market will adjust now that expectations of the rate of house price appreciation are being trimmed.”

Please note his explicit remark on “our uncertainty about what pushed home prices and sales to those elevated levels”. The Fed slashed its federal funds rate with unprecedented speed to 1% and accommodated America’s greatest credit inflation, yet Mr. Bernanke stresses the uncertainties in the Fed about what truly pushed homes and sales of housing to those elevated levels.

There never was a secret about what exactly has been fuelling the US asset-inflation bubbles - above all, equities, bonds and the boom in housing. First of all, the Federal Reserve - with Messrs. Greenspan and Bernanke at its helm - played a key role in the late 1990s both with extremely loose monetary policies and highly encouraging public remarks to foster the stock market boom.

Nevertheless, the stock market boom went bust in 2000 and the following years. While the government and the Federal Reserve opened their fiscal and monetary spigots as never before, the economy started its most anaemic postwar recovery. The main support for economic growth came from the developing residential housing bubble, which offset the stock market bust of 2000 to 2002 and provided homeowners with soaring collateral for borrowing through home mortgage refinancing.

To quote Stephen Roach of Morgan Stanley: “The Fed, in effect, had become a serial bubble blower.” By the time the equity bubble popped in early 2000, consumers had moved on to a new strain of wealth effects - taking advantage of possible equity withdrawals from rising housing values to extract newfound purchasing power. But now that home values are falling, this purchasing power is moving in reverse.

According to the Fed’s Flow of Funds Accounts of the United States, new mortgage borrowing by private households peaked in the third quarter of 2005 to an annual rate of US$1,223.6 billion. One year later, its growth sharply slumped to US$672.7 billion, marking a decline by 45% within just one year. Retrenchment in mortgage borrowing and lending over this brief period has been dramatic.

Without rising home values, and continuing access to new credit, the American economy will slide into recession.

The US economy is one of the very cases in the world in which all three main sectors - government, businesses and private households - keep borrowing and spending heavily in excess of their current income growth. In 2005, they together borrowed US$3.35 trillion, of which the nonfinancial sector borrowed US$2.3 trillion and the financial sector another US$1 trillion. This compared with a total credit expansion by US$1.6 trillion in 2000. This coincided with a collapse in national saving from US$582.7 billion to US$7.2 billion.

Therefore, arguments between bulls and bears about the further prospects of the economy and the financial markets are focused more than ever before on one aggregate: excess liquidity and credit growth. Long ago, until the late 1960s, credit growth was closely tied to economic growth, as measured by gross national product. But this formerly close relationship between the two aggregates went completely bust in the 1980s. Ever since, credit has been expanding in excess of GDP growth.

During 2005, total credit grew in that single year by US$3.35 trillion. Compared with nominal GDP growth by US$0.74 billion. In other words, it required US$4.50 of new credit to add US$1 to GDP. Clearly, this is excessive liquidity and credit growth.

It is a fact that each major economic and financial crisis has been preceded by “excess” liquidity. Just think of America’s New Era during the 1920s and of Japan’s famous bubble years in the late 1980s. In both cases, prior excess liquidity vanished in no time when the existing asset bubbles began to burst. If growing asset bubbles are the channels to excess liquidity, bursting asset bubbles are the channels to liquidity destruction and excess debt.

Therefore, we observe with a very critical eye the balance sheets of private households. According to the consensus of economists, American balance sheets are in excellent shape because asset values, mainly equity and housing, have soared in value for years, altogether by about US$19 trillion - or almost 40% - since recession year 2001.

But the bulk of these gains has been entirely in illiquid assets, mainly equity and housing. Liquidity, measuring existing cash against overall liabilities, is at its lowest ratio in postwar history. To us, consumer balance sheets in the aggregate look more like a house of cards.

The great question is whether there is anything in the pipeline that might shake this house of cards. Clearly, we do not want to be standing near this house of cards when the macro-economic trembler finally arrives.

Dr Kurt Richebacher
for The Daily Reckoning Australia

Editor’s note: Noted economist Dr. Kurt Richebacher died recently in Cannes, aged 88. He was the editor of the Richebacher Letter. Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebacher’s insightful analysis stemmed from the Austrian School of economics. France’s Le Figaro magazine once featured a story on him, describing him as “the man who predicted the Asian crisis”.

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"Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth. The serious costs of financial repression around the world have been well documented. But financial liberalization has also greatly facilitated the access to credit... more than just metaphorically. We have shifted from a cash flow-constrained to an asset-backed economy."

Though we basically agree with the analysis and the conclusions of the study, we radically disagree with the one sentence that "Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth." The indispensable first condition for proper resource allocation at a national as well as global scale is avoidance of excessive money and credit creation. In many countries, and in particular in the United States, they are excessive as never before.

If Mr. Bernanke complains about irregularities of M2, this is nothing in comparison with the fact that credit and debt growth in the United States has exploded for more than two decades. When Mr. Greenspan took over at the helm of the Fed in 1987, outstanding debt in the United States totaled $10.5 billion. In less than 20 years, this sum has quadrupled to $41.9 billion. In reality, this significantly understates the rise in debts because, for example, highly leveraged hedge funds with trillions of outstanding debts are not captured. In 1987, indebtedness was equivalent to 223% of GDP, which was already pretty high. Lately, it is up to 317% of GDP.

In actual fact, there used to be a very stable relationship between money or credit growth and GDP or income growth until the early 1980s. Growth of aggregate outstanding indebtedness of all nonfinancial borrowers - private households, businesses and government - had narrowly hovered around $1.40 for each $1 of the economy's gross national product. Debt growth of the financial sector was minimal.

The breakdown of this relationship started in the early 1980s. Financial liberalization and innovation certainly played a role. But the most important change definitely occurred in the link between money and credit growth to asset markets. Money and credit began to pour into asset markets, boosting their prices, while the traditional inflation rates of goods and services declined. The worst case of this kind at the time was, of course, Japan.

Do not be fooled by the sharp decline in consumer borrowing into the belief that money and credit has been tightened in the United States. Instead, borrowing for leveraged securities purchases (in particular, carry trade and merger and acquisition financings) has been outright rocketing, with security brokers and dealers playing a key role. Over the three quarters of 2006, their net acquisitions of financial assets have been running at an annual rate of more than $600 billion, more than double their expansion in the past.

Federal funds and repurchase agreements expanded in the third quarter at an annual rate of $606.3 billion, or an annual 26%. The main borrowers were brokers and dealers. During the first three quarters of the year, their assets increased $427 billion, or 27% annualized, to $2.57 billion. A large part of the money came from the highly liquid corporations. There is no reason to wonder about low and falling long-term interest rates.

All this confirms that financial conditions remain extraordinarily loose. Even that is a gross understatement. Credit for financial speculation is available at liberty. Expectations for weaker economic activity only foster greater financial sector leverage. Why such unusually aggressive speculative expansion in the face of a slowing economy?

The apparent explanation is that the financial sector intends to make the greatest possible profit from the coming decline of interest rates, promising further rises in asset prices against falling interest rates. While the real economy slows, the leveraged speculation by the financial fraternity goes into overdrive. Principally, there is nothing new about such speculation. New, however, is its exorbitant scale.

Before leading his jumbo-sized delegation to Beijing, Henry Paulson, U.S. Treasury secretary, cautioned against expecting any big breakthroughs from the visit. And so it has turned out. The meeting produced plenty of statements about the desirability of improving relations, but nothing concrete to do so.

Of course, the Chinese are in a very strong position with the central bank holding more than $1 trillion of bonds in its portfolio, mostly denominated in dollars. According to reports, the American visit was initiated by Mr. Paulson in an effort to contain rising Sinophobia in the U.S. Congress, which increasingly blames China for America's economic problems, from its huge current account deficit to stagnating real incomes. In other words, those troublemakers, not the trade deficit, are the problem.

One cannot say that U.S. policymakers and economists have been preoccupied with worries about possible harmful effects of the exploding trade deficit. They appear obsessed with the conventional wisdom that free trade is good and must always be good under any and all circumstances, as postulated in the early 19th century by David Ricardo.

Ricardo exemplified this by comparing trade in wine and cloth between Portugal and England. Portugal was cheaper in both products, but its comparative advantage was greater in wine. As a result, according to Ricardo, Portugal boosted its production and exports of wine. In contrast, England gave up its wine production and could produce more sophisticated goods. In both countries, living standards rose.

For sure, it appears highly plausible that American policymakers feel they are following Ricardo's logic. Only they are disregarding some caveats of Ricardo's. For equal benefit, first of all, balanced foreign trade is required. "Exports pay for imports" was a dogma of classical economic theory. Ricardo, furthermore, disapproved of foreign investment, with the argument that it slows down the home economy.

With an annual current account deficit of more than $800 billion, the U.S. economy is definitely a big loser in foreign trade. To offset this loss of domestic spending and income, alternative additional demand creation is needed. Essentially, all job losses are in high-wage manufacturing, and most gains are in low-wage services. In essence, the U.S. economy is restructuring downward, while the Chinese economy is restructuring upward.

Considering that Chinese wages are just a fraction of U.S. or European wages, it appears absurd that the Chinese authorities deem it necessary to additionally subsidize their booming exports by a grossly undervalued currency, held down by pegging the yuan to the dollar.

In the U.S. financial sphere, the year 2006 has set new records everywhere: records in stock prices, records in mergers and acquisitions, records in private equity deals, record-low spreads, record-low volatility. Manifestly, there is not the slightest check on borrowing for financial speculation. There is epic inflation in Wall Street profits.

One wonders what can stop this unprecedented speculative binge. Pondering this question, we note in the first place that the gains in asset prices - look at equities, commodities and bonds - have been rather moderate. To make super-sized profits, immense leverage is needed. We think the speculation is unmatched for its scope, intensity and peril. Plainly, it assumes absence of any serious risk in the financial system and the economy. The surest thing to predict is that the next interest move by the Fed will be downward.

In our view, the obvious major risk for speculation is in the economy - that is, in the impending bust of the gigantic housing bubble. Homeownership is broadly spread among the population, in contrast to owning stocks. So the breaking of the housing bubble will hurt the American people far more than did the collapse in stock prices in 2000-02. For sure, the U.S. economy is incomparably more vulnerable than in 2001. Another big risk is in the dollar.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning Australia

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During the five years 1995-2000, nonfinancial debt growth by 32.4% went together with 22.2% real GDP growth. In the following five years 2000-05, nonfinancial debt grew by 47.3% and real GDP by 13.4%. There has been an atrocious deterioration in the relationship between debt growth and economic growth.

In his speech on the Economic Outlook on Nov. 28, Chairman Ben S. Bernanke said:

"A reasonable projection is that economic growth will be modestly below trend in the near term but that, over the course of the coming year, it will return to a rate that is roughly in line with the growth rate of the economy's underlying productive capacity.

"This scenario envisions that consumer spending - supported by rising incomes and the recent decline in energy prices - will continue to grow near its trend rate, and that the drag on the economy from the motor vehicle and housing sectors will gradually diminish."

To everybody's surprise, Mr. Bernanke indicated he was more afraid of inflation than of an economic slowdown. What, actually, would happen if he expressed some fears about an economic slowdown? He would unleash an undesirable torrent of speculation anticipating the coming rate cuts. It is one of the many bad ideas of Mr. Greenspan that central banks should foreshadow to the public their next policy moves. It only plays into the hands of speculators.

While admitting that "the correction in the housing market could turn out to be more severe and widespread than seems most likely at present," Mr. Bernanke added:

"Economic growth could rebound more vigorously than now expected. The solid rate of job growth, the decline in the unemployment rate and the healthy pace of capital investment could be signals that underlying fundamentals are stronger than generally recognized. Moreover, to date, there is little evidence that the weakness in housing markets is spilling over more broadly to consumer spending or aggregate employment. If these trends continue, growth in real activity might return to a pace that could intensify upward pressures on resource allocation."

Pondering the U.S. economy's performance in 2007 ultimately boils down to two main questions:

1. Will the housing downturn will seriously hurt consumer spending
2. Will capital spending by Corporate America will promptly come to the rescue when consumer spending slows

In our view, the first eventuality is highly probable, and the second is highly improbable. The first of the two assumptions is simply commanded by the recognition that the housing bubble over the last few years has been the economy's main driving motor, against pronounced weakness in business capital investment. Sharply rising house prices provided the collateral, which enabled private households to embark on their greatest borrowing-and-spending binge of all time.

Those "wealth effects" from house price inflation, manifestly, played the key role in fueling the soaring home equity withdrawals. But the thing to see now is that to stop this easy credit source, it is enough for house prices to flatten. In fact, the curb to this borrowing-and-spending binge has started with a vengeance.

The fact is that private households have drastically curbed their mortgage borrowing. It amounted to $672.7 billion in the third quarter 2006, sharply down from $1,223.6 billion in the same quarter of last year. That is, consumer borrowing almost halved. It amazes us how little attention this fact finds.

It means that the most important credit source for spending in the economy is rapidly drying up, even though money and credit remain, in general, as loose as ever. It is drying up because the decisive lever of this borrowing binge, rising house prices, has broken down; most importantly, this lever is not under the control of the Federal Reserve.

A sharp decline or even cessation of such borrowing essentially indicates an impending sharp retrenchment in consumer spending. Mortgage equity withdrawal peaked at an annual rate of about $730 billion, or 8.1% of GDP, in the third quarter 2005. One year later, in the third quarter 2006, it was sharply down to $214 billion.

This, too, represents a pretty steep decline. Yet it seems to have had little effect on consumer spending, which rose 3.9% in 2004, 3.5% in 2005 and 2.9% in the third quarter of 2006. For the bullish consensus, this is instant proof of its prior assumption that the downturn in the housing market will not spill over more broadly to consumer spending or aggregate employment. The truth is that consumer spending has been squarely hit.

But to realize this, it is necessary to look at total spending by the consumer on consumption and residential investment. The latter was down 11.1% in the second quarter and 18% in the third quarter 2006, both at annual rate. Combined, the two components of consumer spending in the third quarter had slowed to an annual rate of 2%, the slowest growth rate since the past recession, against a 3.8% increase in 2005.

In 2005, real GDP rose $345.1 billion, or 3.2%. Private households increased their total spending by $312.2 billion, of which $264.1 billion was on consumption and $48.1 billion was on residential building. Together, the two components accounted for 91.8% of GDP growth. This spending boom compared with current income growth by just $93.8 billion, or 1.2%. Thus, less than one-third of the rise in consumer spending was funded by current income growth and more than two-thirds was derived from additional borrowing. To us, this seems an unsustainable pattern.

Considering the dramatic reversal in the housing bubble, a virtual collapse of consumer borrowing is definitely in the cards for the United States. Compensating for this big loss in spending power will require a sharp surge in employment and income growth. Some recent employment numbers have been somewhat better than expected. But they are not nearly as good as would be necessary to offset the impending further sharp decline in consumer borrowing. Importantly, there is no acceleration in comparison with last year.

The median price of a new single-family home fell 9.7% year over year in September - the largest percentage decline since December 1970. The median price of an existing single-family home fell 2.5% year over year - the largest decline in the history of the series.

How likely is it that this housing downturn will be milder than average, as the consensus assumes? A rule of thumb says that the fierceness of a downturn tends to be rather proportionate to that of the prior upturn. By any measure, this was America's wildest housing boom. We owe the following chart to Paul Kasriel of Northern Trust. It measures the dollar volume of single-family home sales to GDP. In 2005, it reached a record high of 16.3%, almost double the median percentage of the entire series dating back to 1968.

For us, the most obvious, and also most simple, measure of spending excess is associated increases in credit and debt. Between 2000 and third quarter 2006, the mortgage debt of U.S. private households soared from $4,801.7 billion to $9,497.4 billion. In barely six years, it has, thus, almost doubled.

We have been reading with utter amazement that stronger employment and income growth will offset the negative effects of the downturn in homebuilding. By available official numbers, the housing bubble - including directly related businesses such as furniture, mortgage finance and real estate - has created about 850,000 new jobs, about 30% of total job growth. Most of these jobs are sure to disappear.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning Australia

Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

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A minority of economists, in contrast, keeps just as stubbornly stressing that the economy's famous gross imbalances and structural distortions and the associated debt explosion are inexorably undermining economic growth. In this view, the ongoing housing downturn will finally abort U.S. growth and drive the economy into recession, with major adverse spillover effects on consumer borrowing and spending.

Generally, however, optimism distinctly prevails about the U.S. economy. It is not the old buoyant optimism. Yet it is optimism in the sense that some true malaise, like a crash in the asset markets and a recession, let alone a deep and prolonged recession, are absolutely out of the question. Thanks to its superior dynamism and flexibility, the U.S. economy has time and again bounced back smartly from periodic downshifts, and so it will again.

Let us start with the hard facts. For six, seven and more months, U.S. economic data are overwhelmingly surprising on the downside, and moreover, the surprises have been going from bad to worse. Real GDP has successively fallen from 5.6% in the first quarter of 2006 to 2.5% in the second and 1.6% in the third.

That's bad enough, but what rescued the latter quarter from total disaster was a rather quixotic statistical event. While auto firms slashed their output, it soared in the real GDP account, owing to sharp price cuts on gas guzzlers. In this way, falling vehicle output contributed fully 0.72 percentage points to third-quarter real GDP growth, after subtracting 0.31 percentage points. The price index for gross domestic purchases increased 2% in the third quarter, compared with an increase of 4% in the prior quarter.

It is an old wisdom that the scale of the boom excesses essentially determines the severity of the following process of economic and financial readjustment. It has been comfortingly argued that the U.S. housing boom of the last few years has been less fierce than prior booms, which all ended without steep price declines.

Certainly, there are different possibilities of measurement. For us, the most important, and also easiest, measure of excess is the associated credit expansion. The use of credit in the wake of this housing bubble has been simply bizarre, outpacing all past experiences by far. Over decades until 2000, outstanding total mortgages accumulated to $4.8 trillion. In the second quarter of 2006, they amounted to $9.3 trillion. Mortgage growth over the last five years was almost equivalent to its growth over the prior five decades.

The second highly important point to see is that this housing boom was the first one in the United States to impact the economy at a vastly broader scale than just the building activity. As private households, using the rising house prices as collateral for mortgage equity withdrawals, stampeded as never before into debt to finance additionally other kinds of spending, the whole economy developed into an outright bubble economy. New single-family homes and multifamily homes rose in 2005 from a trough of fewer than 1.5 million units in recession year 2001 to a postwar high of 2.2 million units. Over the same period, the constant quality price index for new homes rose 30%, and the purchase-only price index of existing homes published by the Office of Federal Housing Enterprise Oversight (OFHEO) rose by 50%.

Boosting the net worth and the borrowing facilities of private households, this drove consumer spending to persistent considerable excess over income growth. In correlation, personal saving plummeted into negative territory, unprecedented for an industrialized economy.

It was a boom that plainly went to extraordinary excess in various ways. As a rule, this suggests a very severe aftermath of painful corrections. The first effects of the housing bust have definitely been bigger and more abrupt than most experts had expected. Yet hopes are riding high for a benign adjustment. To quote Federal Reserve Vice Chairman Donald L. Kohn from a recent speech: "The economy will grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then growth will begin to strengthen."

Among his comforting arguments were first, the overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters; second, this situation stands in sharp contrast to some past downturns in the housing markets that followed actions by the Federal Reserve to tighten credit conditions; third, as the inventory overhang in residential building and automobiles are worked off, economic growth should pick up again.

Mr. Kohn does not even mention that through the cash-out refinancing boom, this housing bubble had unprecedented spillover effects on the economy as a whole. In 2005, private households raised $1,080 billion through mortgages. Of this amount, they only spent $95.1 billion on higher residential building. Spending on goods and services rose altogether by $539.9 billion, against an increase in disposable income by $354.5 billion. In other words, about one-third of the increase in consumer spending depended on mortgage borrowing.

Actually, it strikes us how promptly the change in the housing market has impacted mortgage borrowing. It peaked in the third quarter of 2005 at $1,225.9 billion at annual rate. Falling steadily, it was down to $819.6 billion in the second quarter of 2006. This sharp decline was, however, to a small part offset by higher consumer credit. Mr. Kohn stresses that monetary conditions remain quite supportive of borrowing and spending. Clearly, interest rates are so low that they exert zero restraint on borrowing. But more importantly, falling house prices no longer remain supportive for such borrowing. Remarkably, the sharp decline in new mortgage borrowing since the third quarter of last year has occurred even though house prices were still rising, albeit at sharply slowing rates. As the price climate is sure to deteriorate for some time to come, it seems a reasonable assumption that this initial sharp slowdown in mortgage borrowing has some way to go yet.

While this suggests further sharp falls in house prices, this may well take some time to materialize, because the housing market is notoriously sluggish in its reactions. In contrast to financial markets, its initial response to a change in the market situation is not in price, but on how long unsold homes stay on the market until the prices are lowered to realize desired sales. Sellers tend to resist downward price adjustments as long as they can. Instead, the market becomes illiquid. For sure, lenders will notice and adjust their lending conditions.

Mr. Kohn also takes comfort from the fact that the present housing downturn, in sharp contrast to past ones, is not caused by credit tightening. As he rightly stresses, "The Federal Reserve has returned short-term interest rates only to more normal levels and long-term rates are unusually low relative to those short-term rates." We think, though, that he is drawing a totally false conclusion. All downturns caused by tight money were followed by vigorous recoveries. A downturn happening despite low interest rates and loose money seems to us the most worrying kind.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning Australia

Editor of The Richebacher letter and a regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebacher's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis." Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebacher wrong."

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The turn in the bond market started in June with yields of 10-year Treasury notes at 5.25%. A decline to 4.7% generated a 5% return for investors within just three months. Annualized, this comes to a return of 20%. Take further into account that there is generally heavy leverage involved, multiplying this return between 10-20 times.

Considering further that this rate of decline of long-term rates has occurred against the backdrop of a firmly inverted yield curve, implying that expenses of carry trade exceed current yields, the strength of this move seems a bit surprising. The quick capital gains, though, have richly offset these interest expenses - for the time being. But to maintain these highly leveraged positions, it will need at least one of two things: either a further sharp fall in long-term rates providing new capital gains or rate cuts by the Fed reducing the costs of carry trade.

More surprising is the new bull run of the stock market in the face of an economic slowdown. Approaching recessions have always tended to depress stock markets in expectation of falling profits. Well, there is a tremendous difference between past and present experience.

Past recessions were all triggered by true monetary tightening, hitting both the economy and the markets. The current economic downturn is unfolding against the backdrop of unmitigated monetary looseness. While the Fed has raised credit costs from unusually low levels, it has done nothing to tighten credit. Its expansion has kept accelerating.

Credit demand has been running wild for consumption, housing and financial speculation. There is just one striking and ominous exception: Corporate credit demand for fixed investment remains zero. Corporations, too, have been borrowing heavily, but for mergers, acquisitions and stock buybacks, not for productive investment.

In 2005, nonfinancial corporations spent $136.8 billion less than their cash flow from retained profits and depreciations on capital expenditures. Simultaneously, they spent $363.6 billion on mergers, acquisitions and stock buybacks. Given their moderate cash surplus, one has to assume that the stock purchases were generally financed with borrowed money.

It is certainly reasonable to regard the strong trend of corporate stock purchases as an early negative indicator of investment intentions. Principally, there are two different ways for corporations to expand and to raise profits. One is the old-fashioned way of organic growth through creating new plant and equipment. The other is to purchase economic growth and higher earnings through mergers and acquisitions by going more deeply into debt.

What, then, has been happening more lately to mergers and acquisitions? In short, they have gone crazy. During the first quarter of 2006, they hit an amount of $558 billion at annual rate, and in the second quarter another $554.8 billion.

This compares with continuously weak capital investment. In the first quarter, it was $2.7 billion below cash flow, and in the second quarter, $43.2 billion above cash flow. There is an interesting comparison with the year 2000. Then, capital expenditures of nonfinancial corporations exceeded their cash flow by $310.8 billion, compared with net stock purchases of $118.2 billion.

We would say that these figures indicate a continuous, rather dramatic change in corporate policies of expansion away from new capital investment and toward “purchasing” growth and earnings. It started in the 1980s. It strongly intensified during the 1990s, and during the last few years has gone to extremes.

Stating this, we primarily have the long-term development in mind. But in the same vein, we are pondering what is going to happen to business investment in the short run, when consumer spending slows, or even slumps, in the wake of the bursting housing bubble. The generally highly optimistic expectations and economic forecasts about investment spending taking over from consumption as the driver of the economy greatly puzzle us.

To stress one important point, which appears to be generally overlooked: Some rise in capital spending is not enough. Given its much smaller share of GDP than consumer spending, it needs a very strong rise to offset even a minor decline in consumer spending.

While the markets seem to reflect highly conflicting views about the U.S. economic forecast, we nevertheless presume one underlying common view, and that is the perception of very little risk of a possible recession because the Fed would, in any case, swiftly act to head off any gathering weakness. What matters from this perspective both in the bond and stock markets are impending rate cuts.

In essence, this is in line with the conventional thinking that the U.S. Great Depression of the 1930s, as well as Japan’s prolonged malaise since the early 1990s, could have been avoided by prompter monetary easing. Whoever believes in this is entitled to be bullish both on stocks and bonds.

U.S. stock prices received their lift since June/July mainly from lower oil prices and lower long-term interest rates. To keep heading higher, it will now need sufficient earnings growth. After an unusually steep rise in profits during 2005, economists are forecasting more of the same. Our focus is on aggregate profits, as calculated and reported by the Bureau of Economic Analysis within the National Income and Product Accounts (NIPA).

The customary way of making economic forecasts is to extrapolate the recent past. Profit growth in the United States during the last two years has been at its best for the whole postwar period. Profits of the nonfinancial sector in 2005 have jumped to $900.1 billion, from $584 billion in 2004 and $411.8 billion in 2003. These figures compare with a profit peak of $508.4 billion for the sector in 1997 and a profit low of $322.0 billion in 2001.

If you look at the profit development of U.S. corporations over the last 10 years, you will see that it is an awkward picture. Profits fared very poorly during the “New Paradigm” years of the late 1990s, presumably a time of excellent economic performance. No less astounding is their sudden steep rise in the course of 2005, from $624.2 billion in the fourth quarter of 2004 to $1,027.7 billion in the first quarter of 2006, happening while the economy distinctly slowed.

The irony is that after a strong rise during the first half of the 1990s, profits abruptly turned down during the “New Paradigm” years of the late 1990s. For six years, from the recession year 1991-97, the nonfinancial sector’s profits had soared from $227.3 billion to $508.4 billion. As a percentage of GDP, these profits had risen from 3.8% to 4.9%.

While “New Paradigm” ballyhoo and stock prices flourished after 1997, business profits, as officially measured, suddenly slumped. As a percentage of GDP, they were a little higher at the height of the dot-com bubble than in the recession year 1991.

Coming to the recent recovery years, we must point to some irritating observations. On the surface, it looks like a fabulous profit development. From recession year 2001 to 2005, profits of businesses in the nonfinancial sector have more than tripled, from $322 billion to almost $1,100 billion. It was the best profit performance of all time.

However, this good-looking total consisted of two extremely different parts. It was in the first quarter of 2004 that profits exceeded their peak of 1997 for the first time. From there, they shot up almost vertically. Typically, it has been inverse that the very first years of recovery were best for profits.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning

Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis.

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The deficit country is absorbing more, taking consumption and investment together, than its own production; in this sense, its economy is drawing on savings made for it abroad. In return, it has a permanent obligation to pay interest or profits to the lender. Whether this is a good bargain or not depends on the nature of the use to which the funds are put. If they merely permit an excess of consumption over production, the economy is on the road to ruin.

- Joan Robinson, Collected Economic Papers, Vol. IV, 1973 

Finally, the greatest boom in American housing history is going bust. The impact on the economy has only just begun to be felt. Demand for homes is sharply down, while the number of vacant dwellings is ballooning - up more than 40% for existing homes and more than 20% for new homes year over year. At issue now is the severity of the impending bubble aftermath.It does not seem, though, that there is a lot of worrying around. There appears to be a widespread belief that the U.S. economy is now out of trouble because the Fed decided not to raise interest rates. We presume the following interpretation:

1. This is not just a pause, but the end of all rate hikes.
2. In the absence of an overheating economy, inflation is yesterday's issue.
3. Steady or lower interest rates will boost the stock market.
4. As the Fed no longer tightens, the possibility of a hard landing can be dismissed.
5. Abundant liquidity continues to underpin the markets.

Treating bad economic news as good for the financial markets, Wall Street is running wild with more aggressive speculation. "The world economy is on track to grow at a 5.1% rate this year, but the risk of a severe global slowdown in 2007 is stronger than at any time since the September 2001 terror attacks on the United States," said the International Monetary Fund in a report to finance ministers, mentioning two possible triggers: a sharp slowdown in the U.S. housing market or surging inflationary expectations that would force central banks to raise interest rates.

Taking this forecast into account, the sudden plunge of commodity prices may not be totally surprising. On the other hand, prices of risky assets and mortgage-backed securities have, despite the obvious problems in U.S. housing and consumer finance, held steady. Stock prices of U.S. lenders up to their necks in subprime, interest-only and negative-amortizing mortgages have been rising 5-10% since late August. Since hitting bottom in June, emerging stock markets have rebounded 20%. Developed international markets have risen by 12%, and U.S. stock markets by around 8%. A vertical slide by the yen since May suggests that yen carry trade is back with a vengeance.

Given the growing talk of impending recession in the United States, all this may appear rather surprising. The underlying rationale seems to be the assumption that this recession will be just another soft patch forcing the Fed to what the speculative community likes most: a return to easier money.

There is talk of recession, but definitely no recession scare. Popular perception appears to trust that the U.S. economy will again prove its outstanding resilience and flexibility. And are the balance sheets of private households not in excellent shape, as rising asset valuations have vastly outpaced the rise in liabilities over the years? The possible scary parts of the new development, a deeper recession and a precipitous decline in economic growth, have not yet come to the fore.

Over the past five years of recovery from the 2001 recession, U.S. economic growth has been "asset driven," according to colloquial language.

More to the point, protracted sharp rises in house prices served private households as the wand providing them with prodigal borrowing facilities to increase their spending. For years, it was the economy's single motor. The Fed estimates that mortgage equity withdrawals exceeded $700 billion, annualized, in the first half of 2006.

In 2005, the last full year for which data are available, new borrowing by private households amounted to $1,241.4 billion. Now compare this with the following spending and income figures. Disposable personal incomes grew $354.5 billion in current dollars and $93.8 billion in inflation-adjusted dollars. Spending increased $530.9 billion in current dollars and $264.1 billion in chained dollars.

We have presented these figures to highlight the paramount importance of the large equity extractions on the part of private households for U.S. economic growth during the U.S. economy's current recovery. Plainly, it prevented a much deeper recession. Absence of any wealth gains could have easily induced private households to do some saving out of current income.

For the consensus, the U.S. economy's shallow recession in 2001 is the most splendid justification of Mr. Greenspan's repeatedly expressed idea that it is better to fight the bubble's aftermath with easy money than to prick it in its prime. This is plainly a gross misjudgment, because America's shallowest recession was followed by five years of the shallowest economic recovery, with unprecedented large and lasting shortfalls in employment, income growth and business fixed investment.

Actually, there have been major changes in the U.S. economy's pattern of employment and resource allocation, but altogether changes for the worse, not for the better. These structural changes are bound to depress U.S. economic growth in the long run.

The striking feature of the housing bubble - distinguishing it diametrically from an equity bubble in this respect - is its extraordinary credit and debt addiction. The reason is that it requires borrowing for two different purposes: first, for driving up house prices; and second, for the cash out of the capital gains. Every single dollar for this purpose has to be borrowed.

Since end-2000, American households have offset their badly lacking income growth with an unprecedented stampede into indebtedness, up so far by $5.3 trillion, or 77%. But as soaring house and stock prices added a total of $15.6 trillion to the asset side of their balance sheets, households miraculously ended up with an unprecedented surge in their net worth from $41.5 trillion to $53.8 trillion in the first quarter of 2006.

Referring to this fact, Fed Chairman Bernanke noted in a speech on June 13 that "U.S. households overall have been managing their personal finances well."

Manifestly, the rapid creation of the housing bubble in 2001 did prevent a deeper recession. But this should raise the further question of how the housing bubble and its financial implications have affected the U.S. economy from a longer perspective. In other words, are they in better or worse shape today than in 2001 to weather the aftermath of the housing bubble? Our answer is categorical: Underlying cyclical and structural conditions have dramatically worsened.

In 2001, the Greenspan Fed could cushion the fallout from the bursting equity bubble with the creation of the housing bubble. This time, manifestly, there is no alternative bubble available to be inflated to cushion the fallout from the housing bubble. Rather, there is a high probability that the popping housing bubble will pull the stock market down with it. That is the first ominous difference between 2001 and today.

The second ominous difference is that the economy and the financial system have accumulated structural imbalances and debts as never before in history. Vastly excessive borrowing for consumption and speculation has turned the U.S. economy into a colossus of debts with a badly impaired capacity of income creation.

And finally, equity and real estate bubbles are very different animals, of which the latter is manifestly the far more dangerous. In its World Economic Outlook of April 2003, the International Monetary Fund published a historical study, titled When Bubbles Burst, and explained differences in the effects between bursting equity and housing bubbles. It stated, in brief, the following:

First, the price corrections during housing price busts averaged 30%, reflecting the lower volatility of housing prices and the lower liquidity in housing markets. Second, housing price crashes lasted about four years, about 1 1/2 years longer than equity price busts. Third, the association between booms and busts was stronger for housing than for equity prices...

Fourth, all major bank crises in industrial countries during the postwar period coincided with housing price busts.

The severe cases of bursting housing bubbles badly affecting the banking systems in the late 1980s were in England, the Nordic countries and Switzerland, not to speak of Japan, where, however, commercial real estate played the key role.

Regards,

Dr. Kurt Richebacher
for The Daily Reckoning

Editor's Note: The Good Doctor has found the only five investments you'll need in 2006 - and one of them is a mighty hedge against the forces of dollar weakness and inevitable inflation. At the very least, it will help protect your money from the boneheaded inflationary policies and programs of the Federal Reserve - especially under new Fed Chief Ben "Printing Press" Bernanke.

Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebacher wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebacher's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

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