Peter Boettke and I have a friend, Mr. E., who is a very successful investor who manages hundreds of millions of dollars of a few select clients. Many years ago, Mr. E. took a class in Austrian economics that Peter was offering and he became an assiduous reader of Ludwig von Mises and his Theory of Money and Credit. With perhaps the exception of Steve Hanke and Frank Shostak, Mr. E. is, in my view, the investor who is most knowledgeable in Austrian economics out there.
In the last few years, Mr. E. has alerted us that financial markets were on a dangerous slippery slope. Among the symptoms of a coming credit collapse was the US housing market and the price of gold. Both of them have gone up dramatically over the last five to ten years. The housing market has now started changing course with house prices going south and the number of new houses being built diminishing like ice in the sun. According to Mr. E., what explains the cycle is the (bad) health of the financial system, which generates outcomes best described by the Austrian business cycle theory. In a nutshell, there has been a huge increase in liquidity and debt with no corresponding real activity—except house flipping.
What are the facts?
- First, the burst of the dot-come bubble in 2000 was softened by the Federal Reserve by a massive influx of liquidity (interestingly enough the FED recently decided to stop publishing M3 data).
- Second, some assets in the economy have seen their prices increase way beyond what people should normally be ready to pay. Real estate prices in many places have been out of sync with their returns for almost a decade (the housing affordability index is at a 15-year low and the price-to-rent ratio is off the charts).
- Third, personal debt has now a difference face. Many people have bought houses with no equity collateral of any sort, using interest-only loans. This makes a downturn more problematic.
- Fourth, credit markets are now supposedly able to deal with greater risk. As a result, subprime loans have been offered to many borrowers who would not have qualified for a loan in the past. This was predicated on rising house prices.
What worries Mr. E. is that the systemic risk of financial markets has not gone down, as many have said, but up. This is because financial institutions sell their mortgages (especially subprime loans) onto others. As the rates move up and house prices slow down, the initial borrowers cannot pay back and the loans become more risky. Those who bought the loans want to sell them back to the original mortgage-writers but they can’t because many of them are in financial difficulty or have already gone belly-up. In the old system, mortgage lenders would worry about borrowers repaying their loans in full. In the current situation lenders sell their loans to private investment banks generating cash to make more mortgages. These buyers also go on to resell them as complex mortgage-backed securities with various terms, yields, and level of risk. (See here for an article on this subject in The Economist this week.)
Clearly, real estate is subject to the same forces as any other asset in the economy, and it can’t go up for ever without some artificial inducement. The number of house foreclosures has gone up in the last two years. House inventories are also on the rise. What we are currently witnessing may be the beginning of the final collapse of a boom brought about by an expansion in the super-complex credit derivatives and collateralized debt instruments markets. This may lead to a domino effect whereby many financial institutions default, jeopardizing the whole system. In the worst-case scenario, the Federal Reserve and the FDIC won’t be able to do much to stop the system from collapsing.
It sounds similar to what Mises described in Human Action. As he put it:
The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. (p. 572)
While the nature of the credit expansion has changed, the principle may still be the same. In other words, the Federal Reserve has not been able to manage the impact of its monetary expansion because a lot of what happens is beyond its control. The US economy is now living with a huge amount of liquidity that has little visible impact on the CPI, but has a much higher impact on other asset prices. But the day of reckoning may be coming. We are living under the illusion that central banks have figured out a way to manage the entire money supply well—but they haven’t and they will never do so.
If the Austrian view of (unwarranted) credit expansion applies to the current case (and I believe it does, at least to some extent), the $64 million question is: how big the adjustment is going to be and will it affect the entire economy? There is now a superstructure of debt and derivatives upon which the real estate market has been built. This may have become a house of cards. Merrill Lynch analysts recently said that house prices could tumble 10 percent this year and the stock market could lose as much as 30 percent (see here). I personally don’t have an answer to my question, but I would probably wait before buying a house, and buying gold might not be a bad idea.