Over the course of the past several years, the ?wealth? of many people in the Western English-speaking countries (mainly the US, Australia and Britain) had increased, thanks to the real estate price boom. Consequently, the economies of those countries had been growing and expanding over that period. This type of economic growth is what the IMF called the ?asset-driven growth.? One manifestation of this kind of growth is the rise of ?wealth-creation? fades, which advocate the attainment of riches through property ?investments.?
As contrarians, we see that such growth should be more appropriately called ?bubble-driven growth.? For the economists trained in the Austrian School of economic thought, such kind of growth is unsustainable. Furthermore, they believe that the severity of the following eventual bursting of the bubble is related to the preceding inflation of the bubble.
It is good if we could learn from our own mistake. We would be wiser if we learn from the mistake of others. But if we repeat the same mistake of others, we are indeed fools. It is amazing to see that the US, Australia and Britain (for convenience?s sake, let?s call those countries the ?UBA countries? from now on) are not only not learning from the mistake of Japan, but even worse, following the same path. The collapse of the Japanese property bubble in the 1990s led to a downward recessional spiral of the Japanese economy for more than a decade. Property prices have been falling (at least not rising) for 16 years since. At least the Japanese have their savings to count on. But what about those UBA countries, whose savings rates are below zero (that is, they are already deep in debt)? What will happen when the property bubble burst in these countries?
Illusions of ?wealth?
Sydney?s housing property market was the epitome of the great amount of ?wealth? generated by the housing boom in the UBA countries. It started in the mid-1990s, accelerated after the 2000 Olympics and reached its apex in 2003 when house prices were rising at staggering rate of more than 20 per cent a year!
Yes, you heard it right. More than 20 per cent a year!
Where can you find other financial investments that can pay more than 20 per cent return except for the ones that are highly risky in nature? The belief that housing property investment was the way to great wealth was highly delusional. Surprisingly, the mob believed that. At that time (in 2003) there were proliferations of seminars that taught attendees how to be rich through property investments. A cursory glance at the investment sections of bookshops yields titles upon titles of wealth attainment through real estates.
In reality, such ?wealth? was and always is an illusion.
First, let?s see the ludicrousness of the idea that a nation?s general rise in asset value equals a rise in wealth. In a nation?s stock of real estate, only a tiny fraction of it got sold and changed hands in any given year. Those sale prices were imputed into the values of the vast majority of the other properties that never got traded in the market. Therefore, in a rising market, the vast majority of un-traded properties have rising imputed values, which is commonly described as ?rising asset values.?
Theoretically, an economy with only (a very important qualifier) rising asset prices does not produce a single extra widget. That is, there is no real growth. Rising asset prices are illusionary in nature because they are basically imputed values, which are rising fast during the bubble period of exceptionally low interest rates. Meanwhile, the real economy is theoretically no better than before, regardless of the movements of asset prices.
In the case of what is happening in those UBA countries, rising property values merely created higher valued collaterals for which money can be borrowed. With the introduction of equity redraw facilities, borrowers could even extract the ?values? in their properties as cash. As long as property prices kept rising, borrowers needed not worry about repaying back the loans – the increase in the ?value? of their property would take care of that. Meanwhile, some ?investors? (more accurately, speculators) used a sophisticated sounding financial strategy called ?negative gearing? to bet on continuing rise in house prices. Thus, with the economy awash with plenty of borrowed money, there was little wonder why people felt rich! With such feelings of wealth, people tended to spend more. This effect is what the economists call the ?wealth effect.?
Today, with the benefit of hindsight, we could see what a great spectacle it was!
Source of the ?wealth?
Now, the question is: where is the source of all these ?wealth??
For the answer to this question, we will take the case of Australia for example. Over the past 5 years, Australia?s money supply (M3) grew (that is, printing of money) by 10.1% per annum, which is much faster than the rate of economic growth. In other words, the growth of the amount of money circulating in the economy exceeded the growth in the production of goods and services. The natural consequence of this is inflation as there are now more money chasing fewer goods and services.
But in Australia?s case, the inflation remained within the Reserve Bank?s target of 2-3%. Where did all those excess money go? Part of the answer to this question, as you would have guessed by now, lies in the inflation of asset (house) prices. The well-known ?inflation? that everyone talks about in the media is the consumer price inflation, which can be seen statistically by the rise in the Consumer Price Index (CPI) and experienced by everyone from the general increase of price levels in everyday life. Unfortunately, the CPI figures do not capture the price behaviour of assets (property, stocks, bonds, etc.). In Australia?s case, the housing boom was contributed by such excess money printing.
Furthermore, another force was at work in curbing Australia?s consumer price inflation – the rise of Chinese manufacturing. In recent years, Chinese productivity had soared, which means overall, the Chinese economy was producing more and more goods at lower and lower costs. In China itself, that had a good deflationary effect – the fall in the consumer price levels. As China exported more and more of its cheaper goods to Australia, the effect on Australia was disinflation (decelerating growth in consumer price inflation). That helped keep a lid on the Australian consumer price inflation.
This phenomenon is an example of what were happening in the UBA countries. It began in the US in 2001 when it suffered the mildest ever recession after the crash in technology stocks. In order to prop up the economy, the US central bank – the Federal Reserve (commonly called the ?Fed?) – embarked on a massive expansionary monetary policy. That is, the Fed printed huge amount of money, which also increased the amount of credit granted (the flip side of granted credit is owed debt) in the economy. When central banks print money, they cannot control how the excess money is being used. In the case of the UBA countries, the excess money and credit fed the housing bubble.
In the US, interest rates consequently had to fall significantly to accommodate the monetary inflation (printing of money). With that, other countries had to follow suit by lowering their interest rates (to prevent their currencies from appreciating too much against the US dollar), resulting in a worldwide trend towards lower interest rates and monetary inflation.
Effects of the rising ‘wealth’
What was the effect of rising house asset prices, which were caused by the increase in money supply and credit in the economy?
When house asset prices rose, house owners felt wealthier. When they felt wealthier, they increased their spending. This is what the economist called the ?wealth effect.? Increased consumer spending in the economy resulted in businesses expanding their production due to their perception of increased demand by the consumers. Ideally, expanding production should in turn lead to increase in hiring and business investments, which in turn increase employment and productive capacity of the economy respectively. That should result in economic growth.
But unfortunately, the reality in the US was not as good as the ideal. The increase in consumer demand resulted in the increase in import of foreign goods. That showed up in the widening current account deficit, which simply meant that the US was spending more than it produced. The implication for this was that the increase in production in the US economy was not keeping up with the increase in consumer demand, which was fuelled by the boom in house asset prices, which in turn was fuelled by the inflation of money supply and credit in the economy.
Meanwhile, the amount of debt owed (its flip side is credit granted) in the US economy ballooned as the rising house asset prices increased the collateral for which money could be borrowed for consumer spending.
Indeed, this was how the UBA countries? economy grew. The IMF called this ?asset-driven growth.? The question is, how sustainable is this kind of growth?
Sustainability of such growth
Is such kind of economic growth sustainable in the long run?
Before we decide on the answer for this question, let us ponder upon this quote:
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
In the case of the US, the side effects of the economic growth manifested itself in the form of ballooning household debt and widening current account deficit. Put it simply, the US, as a nation, was borrowing money not to invest in the betterment of its future, but to consume to the detriment of its future. Since 2001, the economic growth was accompanied ?with unprecedented large and lasting shortfalls in employment, income growth and business fixed investment? (Restructuring the U.S. Economy – Downward). Indeed, such kind of profligacy is the beginning of the transference of wealth from the spend-thrift nations to the prudent nations (see Transference of wealth from West to East).
These are some of the serious questions we would like to ask:
- As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
- Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?