Peter Schiff is the President of Euro Pacific Capital and is famed for being the most vocal financial critic who accurately predicted the real estate crash of 2006 and the stock market crash of 2008.
In Schiff's view, mainstream economists still do not understand the fundamentals of the current crisis. He believes that the government's stimulus and bailout policies are misguided and are "sowing the seeds for economic devastation."
What follows is the second in our series which is condensed from a speech he gave on March 13, 2009 to the Austrian Scholars Conference.
The Real Estate Bubble
The internet bubble burst because you had all these companies that were tremendously overvalued. None of these dot.com stocks were paying dividends because none of the companies had a realistic chance of making money. So why would their value go up?
Basically what had happened was the Federal Reserve had been too easy and loose with money in the 1990s. Interest rates were too low and we created too much money. And that facilitated massive investments in the stock market.
So we had all these companies that were able to flourish despite the fact that they weren’t able to make any money. The same thing started to happen in the real estate bubble.
When it comes to real estate, if a property’s asking price or current market valuation bears an unrealistic relationship to what it can be rented for, well, it’s probably not worth what the vendor is asking. If there is no positive cash flow, it’s overvalued.
People began buying property as an investment when rent for the property couldn’t cover the mortgage payments on what was paid for the unit.
Why? Because people were sold on the idea that it didn’t matter that there was negative equity, the property would appreciate in value and that’s where the real money was to be made. Everyone bought into the idea that a property would double in value in a couple of years.
And it made no sense. You couldn’t cash flow the property positive at the value it is currently sitting at now, how is it going to go up in value? It defied the basic law of commerce that says Real Estate is a function of rents.
During the Internet Bubble, if you questioned the wisdom of what was happening, the reply was always, ‘you don’t understand the stock market’.
Now, when anyone questioned the wisdom of what was happening in real estate, the reply was, ‘you don’t understand the real estate market’.
Well... no... I do understand the Real Estate Market, and the values of these properties was grossly overvalued.
People were told rents don’t matter to real estate in the same way they said dividends don’t matter to stocks. What evolved was a rationalization that said all real estate would appreciate, year after year, for no other reason than a belief that real estate appreciates.
Everyone bought into the idea that it was going to go up… year after year… just because.
And it made no sense. Were incomes going up each year? Would you be able to charge 10, 20, 30 percent higher rents each year? No? Then why is the value going to go up 10, 20, 30 percent?
And the answer was… ‘it just will’.
We had the internet bubble because the Fed was too easy with money. And eventually, Alan Greenspan started to raise interest rates, and he burst the stock market bubble. He had seen what had been happening. In 1996 he talked about irrational exuberance and they took him to the woodshed for saying something negative. But he still went ahead and raised interest rates to correct the imbalance.
And, of course, when the stock market bubble burst, a lot of the malinvestments were exposed. A lot of the people working at the dot.com’s had to find real jobs. Because they were wasting their time. Because they were destroying wealth. They weren’t creating anything of value. And so we had a lot of companies who were given a lot of capital who shouldn’t have been given capital and a lot of investors who invested foolishly who were going to loose a lot of money.
It meant that we were going to go through a painful recession, certainly, as we digested and worked off those malinvestments and allowed capital to be reallocated to where it could be productively used: labour, land capital, what ever was involved in these dot.com businesses.
And it would be a necessary recession. As painful as it might be, it is the free market's way of correcting the imbalances.
And, of course, with all the wealth that was squandered from investors who lost real money, real savings, people were going to have to come to terms with the fact they lost money. People were going to have to try and save and replace that money.
That's part of the way recessions and the free market correct imbalances.
So there was going to have to be a big, painful, difficult recession when the dot.com bubble burst and George Bush came to power in 2000.
But rather than admit that the Clinton era had been a fantasy, that it was a boom and now we had to live through a bust, President Bush squandered a chance to correct the economy. It would have been a perfect opportunity to repudiate what had happened under Clinton, to expose that we had a bubble and to have taken the necessary steps clean up the mess.
And it had to be cleaned up. It wouldn’t be easy but Bush could have taken the chance make sure the economy faces the consequences that come after a boom.
But instead of doing that, the Bush Administration came out and said ‘we need to stimulate the economy’. We need to fight off this recession.
Sounds familiar, right?
So he wanted an economic stimulus. And what was the economic stimulus we got out of Bush? Deficit spending. Cut the taxes and increase government spending. And Alan Greenspan cooperated and slashed interest rates down to 1%. So we had massive money and fiscal stimulus. Massive inflation, this time in Real Estate.
And what was the result? Well… we blew up another bubble that was bigger than the one that was just burst. And not only was it bigger, it was worse.
And during that shallow recession that we had – and Bush was so proud of that – we also had record car/auto sales.
But where did Americans get all the money for all these car sales and all these home sales?
It didn't come from savings... they didn't have any. There hadn't been any time to set aside any savings after the dot.com bust.
So... what did they do? Well... Americans borrowed it all. And why wouldn't they? The Bush Administration monetary policy that was designed to lure Americans into borrowing.
And they did.
And we went into debt. Massive debt which was used to fund a massive spending spree, the biggest spending spree in history. We borrowed Trillions which we used to built houses, remodel houses, we bought cars, appliances, furniture, gadgets, ipods, cell phones and plasma TVs. All sorts of things.
That massive amount of easy credit also further fueled the irrational real estate market.
Making it all worse was the fact that we didn’t make any of this stuff we were buying... we didn't produce any of it. We just borrowed money to buy it all.
And our trade deficit skyrocketed. We started running $60 Billion a month trade deficits for years. And our savings rate went negative. And it went negative even after the government doctored the books and recalculated how we assess savings.
So we had this huge bubble that was much bigger than the Internet stock market bubble. And of course, the major difference was the leverage involved.
When people bought stocks in the dot.com bubble, they pretty much used their own money. Maybe they had a leverage account, but they still had to put up 50% of their own money down.
So when the bubble burst, the losses were pretty much confined to the people that made the bad bets.
That wasn't going to be the case with the Real Estate Bubble because of the amount of leverage involved with all this real estate and consumer debt.
And you could see it all building through 2002, 2003, 2004 & 2005. It was all so obvious. But like I have said, when you are living in a bubble, sometimes it is hard to see reality for what it is.
Tomorrow: The Real Estate Bubble morphs into a Financial Bubble.