Perspectives: The Perfect Financial Storm?
Financial Storms Heading Towards the U.S. Economy
August 16,2001 © Copyright 2001 James J. Puplava

I. Where We Are Today

The Bubble is Still With Us

The boom that grew into a bubble is still being fed by a constant infusion of credit. We've seen the money recycled between the stock and bond markets with derivatives and day trading steroids adding volatility to the mix. It is also visible in real estate where new home sales, sales of existing homes, mortgage refinancing, and credit expansion continues unabated. Americans persist in spending money as they expand their balance sheets with debt. Consumers want to borrow more money and credit card companies are only too willing to lend it to them. Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac are still expanding their balance sheets providing ready credit to the housing market.

“Political Correctness” Enters The Financial World

No one mentions the R- or B-word. We’re still talking summer here. The mantra may have changed from second-half recovery to fourth quarter, but even the fourth quarter mantra is subtlety changing to recovery next year. Political correctness has invaded the financial world. Words such as bear markets; recessions, unemployment and losses have been replaced by euphemisms. We now refer to these situations as corrections, soft landings, recovery, and restructuring. I’m not sure that the investors who have lost trillions of dollars in the stock market tech bubble or the hundreds of thousands of workers who have lost their jobs would find the words “correction” or “restructuring” to be very comforting. See CBS Marketwatch's "Shadow of Recession".

Rough Weather Lies Ahead

As I wrote in Part 7, 2001 is the last of “The Seven Fat Years” that began in 1995. Right now times are still good with the last remaining pillars of the economy, consumer spending and housing, remaining strong. The Fed’s rate cuts and the tax rebates promise to hold up the economy for a while longer. As these graphs indicate, the housing market still remains strong fed by a constant influx of new mortgage money. Government Sponsored Entities such as Fannie Mae and Freddie Mac continue to expand their balance sheet with new debt issuance. This expansion of credit has fed into the housing market. Housing starts, existing home sales, and the average sales price for existing single-family homes rise unabated. The stock market may be down, but evidence of the credit bubble can clearly be seen in our housing markets.

Credit expansion charges ahead. This year’s domestic debt issuance is expected to top $1 trillion dollars. Asset backed securities are growing at an annual rate of 17 percent and should top $265 billion this year. Credit card borrowing is up 56 percent year-over-year. Personal income for the average American continues to grow at an above-average pace, but personal spending is outrunning it. Each month consumers go deeper into debt to support their lifestyles. The American credit machine is running nonstop. The money may not be going into the stock market like before, but the money has definitely found a home in the real estate market and in consumer spending.

TAX, SPEND & INFLATE

To better understand the course this storm is likely to travel, it is important to understand the storm’s origination. Its epicenter is located in Washington and on Wall Street. The credit creation mechanisms of the Fed and Government Sponsored Entities inflated our nation’s money supply. The result was an abundance of money made available at artificially low rates. This helped corporations to refinance existing debt at much lower interest rates. In addition, cheap credit allowed companies to finance acquisitions and buy back stock. Money was also made available for speculation in the financial markets helping to fuel a boom in stock prices that went well beyond profit fundamentals. At the same time, lower interest rates allowed consumers to refinance mortgages and take on additional debt to finance consumption and speculation in the stock market.

The 90’s – A Decade of Mounting Taxes

While credit creation was feeding a constant flow of money into the financial system and the economy, government taxes were siphoning off a good portion of that excess money in the form of taxes. President Bush increased tax rates in 1990 from 28 to 31%. In addition to an increase in the personal income tax rates, an additional Medicare tax of 2.9% was assessed against earned income. President Clinton followed Bush in 1993 with the largest tax increase in U.S. history. Rates were increased from 31 to 39.6%. The Medicare tax cap was removed. Itemized deductions were reduced through phase-outs. Social Security income subject to taxation was increased from 50 to 85%. At the same time, as shown in the table below, the wage base on which Social Security taxes were assessed went up each year. As personal income increased, the amount of Social Security taxes increased right along with it. Most Americans have felt the squeeze in this last decade. This table dramatically portrays one of the reasons why.

The end result of Fed money pumping and government taxation was the ravaging of household finances of the average American by taxes and inflation. The government, through an increase in the money supply, created inflation. The monthly budget for necessities for the average American went up each month as the cost of daily living rose across the board. Housing prices went up along with rents. Food prices rose. Medical premiums skyrocketed. The cost of a college education grew each year. Automobiles cost more. Utility bills rose each year. About the only thing that was going down was the cost of technology as we saw with personal computers.

Inflation rates would have been much greater had it not been for imports. The excess demand created through cheap credit was offset in part by imports. Foreign imports helped to keep a lid on domestic prices below what they should have been. Even so, the cost of most goods rose. Inflation statistics hid the true cost of living through statistical manipulation. I would challenge the widespread statement by the financial media that the 90’s were a period of moderate inflation. The effects of inflation were everywhere. They were visible in housing prices, food, education, medical, clothing, entertainment, automobiles and finally asset prices. The average household budget – the things people spent money on from Big Macs to movie tickets – went up each year.

Technologically Improved Statistics

Government statisticians massaged these inflation numbers by a “new and improved” accounting method for improvements in technology. The automobile you bought last year may have cost you more money than your last car, but the car was more technologically advanced. It had better safety systems. The car radio sounded better. It may have had a CD player or a GPS system on board. The car cost you more money, but it was technologically a better automobile. Therefore, in the minds of government statisticians, it was a cheaper car because it had been technologically improved. As a result, the price of the car was massaged to account for these improvements adjusting the cost factors lower.

During the 90’s as the cost of living was rising for Main Street’s average American, on Wall Street financial asset prices were also moving up. Inflation has two outlets. The excess money can either go into the economy, inflating the cost of goods, or it can go into financial assets, inflating their prices. They are essentially one and the same. One of the more remarkable aspects of the 90’s is that the outlet for excess money flowed into the financial markets more so than it did the economy. This accounted for the above-average returns of stocks throughout the decade.

While assets and the price of goods went up, Americans we’re taking home less money as a result of taxes. Taxes took a greater bite out of monthly income while the cost of daily living rose. The result was a reduced savings rates. When savings had been exhausted, debt levels increased. I believe the chief reason that the country has a negative savings rate is that household income has been ravaged by the combination of taxes and inflation. As the graphs of household debt and savings illustrate, debt levels are high and savings is negative. These two factors alone make a recovery scenario based on a continuation of consumer spending a precarious one. The consumer-spending bust will soon join the capital-spending bust with devastating consequences for the economy.

The end result is that the boom times of the 90’s weren’t the result of a new economic paradigm, as many Wall Street and Washington spinmeisters would argue. It was the result of a giant credit boom that fed itself through the financial markets and the economy. The 90’s were a result of a return to Keynesian economics: tax, spend and inflate

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