Last week I started to talk about how I believe the stage is being set for a Canadian real estate collapse of historic and massive proportions.
Since the collapse of the dot-com bubble in the late 1990s, western governments have manipulated economic conditions so that we moved quickly from the unwinding of one bubble and into another.
Within a year of the collapse of the Internet Bubble, we moved seamlessly into the Real Estate Bubble. And within a year of the collapse of the Real Estate Bubble we have moved into another bubble… and it’s as if nobody can see that there are any similarities.
The only reason it worked in 2000 (and it didn’t really work then), is because we were able to borrow the money from the rest of the world and spend it. And we were able to live in the delusion that we were getting richer even when we were getting poorer.
We believed this because we looked at our asset prices (real estate and stocks) and we saw the prices going up and we said “hey, were actually getting wealthier”.
But we weren’t getting richer because we were spending money at the same time instead of saving money. We would borrow on the asset value and spend it consuming. And as we spent money, the government counted that money as GDP.
And as long as our GDP was rising then we thought our economy was growing.
But the whole time our GDP was going up, we weren’t measuring how much our wealth was going up. We thought we were okay because some appraiser said that our house was worth more. Or the stock market was still going up.
The 2008 Financial Crisis was simply the inevitable collapse of this ponzi mindset.
But when that collapse happened, it was SO intense…. SO profound... that our political masters panicked.
What happened in September and October 2008 had previously been considered completely impossible and totally unthinkable. We have always been told that the lessons of 1929 and the Great Depression had resulted in changes to the financial system so that NEVER AGAIN could the financial system come close to totally collapsing.
Yet we were within two hours of a complete collapse of our banking system and of our economy... and governments responded with panic measures.
They responded the same way they did each time there was a ‘financial emergency’ over the past several decades... with stimulus money and bailouts. Only this time they did it on a scale that has never been seen in the history of the world.
- In the 1990s the US Federal Reserve had been too easy and loose with money. Interest rates were too low and we created too much money. And that facilitated massive investments in the stock market.
- This created the 1997-1999 NASDAQ bubble. When that market crashed the government responded with even lower interest rates and easier access to stimulus money.
- And the exact thing that had happened with the Internet Bubble... now starts occurring with real estate.
We had the internet bubble because the US Federal Reserve was too easy with money.
Easy money allowed people to invest in companies that were tremendously overvalued. None of the dot.com stocks were paying dividends because none of the companies had a realistic chance of making money. But it didn’t matter. The frenzy was pushing stock prices up so people grabbed all the money they could and kept investing in them.
Recognizing what was going on, Federal Reserve Chairman Alan Greenspan sought to intervene. 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 the bubble burst.
Of course, when the stock market crashed, a lot of the malinvestments were exposed. A lot of the people working at the dot.com’s were going to have to be unemployed. A lot of companies who were given a lot of capital who shouldn’t have been given capital, were going to lose it all. And a lot of investors who invested foolishly who were going to lose a lot of money.
We were destined for a long, painful recession. Those malinvestments were going to have to be worked off. Capital would have to be reallocated to where it could be productively used, and labour would have to be laid off and rehired as that capital found productive uses.
As painful as it might be, it would be a necessary recesiion; the free market's way of correcting the imbalances.
But government intervened in the free market.
Rather than permit the painful process to play out, government would ‘stimulate’ the economy... again.
As always, the stimulus money created a catastrophe. This time in real estate.
During the dot-com, 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’.
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’.
And for the last nine years it has, fueled by easy money which is being invested in something that does not make fiscal sense – other than the value of the ‘asset’ seems to be rising by 10 – 30% each year.
The real estate bubble, and the financial services industry it created, has grown stupendously out of proportion.
The 2008 Financial Crisis is a result of the stimulus that created the dot-com bubble, the stimulus that tried to prevent the correcting of the dot-com bubble and the real estate bubble it all created.
A long, painful recession is needed to correct the imbalances.
But by responding in the same egregious manner to the 2008 Financial crisis, another catastrophe is inevitable.
Not only have we failed to correct the imbalances, western governments have liquefyed the system beyond any rational explanation in response to fears the entire system could collapse.
In the United States, the U.S. money supply has been expanding at an absolutely unprecedented rate (more than doubling the monetary base since the collapse of Lehman Brothers).
Fears of inflation – even hyperinflation – have been propagated throughout the blogosphere.
So why are we not experiencing rampant inflation?
Why is the U.S. dollar not falling through the floor?
Well, the truth is that all of this new money has gotten into the U.S. financial system but it is not getting into the hands of U.S. businesses and consumers. In fact, even though the money supply is exploding, U.S. banks have dramatically decreased lending. This has brought us to a very bizarre financial situation.
What we have seen is the U.S. government shovel massive amounts of cash into the U.S. financial system and then watch as the big banks sit on that cash and refuse to lend it. The biggest banks in the U.S. reduced their collective small business lending balance by another 1 billion dollars in November 2009.
That drop was the seventh monthly decline in a row. In fact, in 2009 as a whole U.S. banks posted their sharpest decline in lending since 1942.
So all of this money that the U.S. government pumped into the financial system has been doing American businesses and consumers very little good. That is why we can have a vastly increased money supply and very little inflation.
So if the banks are not lending the money to the American people, what are they doing with it?
One of the things they are doing with it is buying U.S. government debt. While U.S. banks have cut business lending by approximately 350 billion dollars since early 2009, they have meanwhile been purchasing approximately 300 billion dollars worth of U.S. Treasury securities.
So instead of loaning money to American businesses and consumers who desperately need it, a ton of this new money is being used to pump up yet another bubble. This time the bubble is in U.S. Treasuries. Asia Times recently described how this trillion-dollar carry trade in U.S. government securities works...
- Remarkably, the most aggressive buyers of US government debt during the past several months have been global banks domiciled in London and the Cayman Islands. They borrow at 20 basis points (a fifth of a percentage point) and buy Treasury securities paying 1% to 3%, depending on maturity. This is the famous "carry trade", by which banks or hedge funds borrow short-term at a very low rate and lend medium- or long-term at a higher rate. This works as long as short-tem rates remain extremely low. The moment that borrowing costs begin to rise, the trillion-dollar carry trade in US government securities will collapse.
Anyone who has dealt with carry trades in the past knows that when carry trades unwind they can do so very, very quickly and the results can be nightmarish.
And this one will unwind too, causing the bubble it is supporting (US Treasuries) to collapse.
You’ve heard it said that doctors 'practice' medicine and lawyers 'practice' law?
They say this for a reason. These 'professionals' never really know their craft. They learn about past mistakes and try to utilize tried techniques to address problems. When something goes wrong, they learn from it and ‘tweak’ their responses.
It is no different for economists, even those entrusted with running the Bank of Canada and the US Federal Reserve (recall Saturday’s post of a paper by Alan Greenspan admitting how the Federal Reserve had failed).
The ‘experts’ panicked when the crisis of 2008 hit.
And they responded with tried techniques (plus a few new tricks) to address the problem.
The truth is that the U.S. financial system is a house of cards that could fall at any time. A lot of economic pain is on the horizon - it is only a matter of when it comes and how bad it is going to get.
And when it does come, interest rates are going to shoot up like nothing we have seen in over 30 years.
Tomorrow, the reckoning that Canada faces.
To read the next part of our series, click here.
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