Monday, 7 February 2011

Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth

The illusion of Wealth:

We all know what happened during the financial crisis, a lot of Americans used their house as an ATM. Today the ATM is broken, following the dramatic impact of the crisis on households balance sheet and the collapse of the housing market. Thanks to QE2 and the rise in all asset prices, Ben Bernanke seems to be succeeding in creating the illusion of wealth. It is indeed the year of the rabbit and the magician is clearly Bernanke, pulling the wealth rabbit out of a hat.
THE ILLUSION OF HOUSEHOLD WEALTH - 15th April 2005 - Chris Leithner

"By borrowing against a home whose price is rising, sometimes substantially, households have been able to "extract equity" and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that has greatly exceeded the increase of household income. But all financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households' assets, particularly houses, can continue to rise much more quickly than income. A less immediate but ultimately much more significant risk is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future."

In this excellent article Chris also adds the following:

"Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households' net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household's portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are – and that savings are not – the route to higher net worth."

The Concept of Capital:
In his contribution, Chris Leithner discusses the critical concept of capital, quoting Peter Kasriel, chief economist at Northern Trust.

"Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods – and therefore that they should not be regarded as components of the capital stock."

This is probably one of the most important concept to understand. To some extent, it explains why there was a huge misallocation of capital during the financial crisis which validates the Austrian Business Cycle Theory.

Here is a reminder of the Austrian Business Cycle Theory:

"According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable."

Chris goes on an quotes Kesriel:
"Just because an existing house goes up in [price] does not necessarily mean that the more expensive house 'produces' more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour?
The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce".

The relationship between capital stock and household net worth is a very important one: the more households save the faster the capital stock subsequently grows:
"Two critical insights into the nature and causes of the growth of wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends heavily upon the composition of capital stock."

Chris concluded:
"Policies that encourage saving and investment – and do not sanctify spending and consumption – are required. But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially severe disorders have been bequeathed to the future."
This what Chris Leithner had to say in April 2005.

But back to today's macro environment.
In relation to the latest quarterly publication of the US GDP, it transpires that the reason why Personal Consumer Expenditure (PCE) rose Month to Month 0.7% in December, was because savings rate fell:
In the final quarter of last year, consumers spent more and saved less. Americans saved 5.4 percent of their disposable income, compared with 5.9 percent in the third quarter.

Truth is, continuous fall in home prices in the US will hurt both consumers and banks, counteracting the wealth effect generated by QE2 and the rise of assets prices.

Banks still face unexpected losses from their on-balance sheet mortgages, from commercial and residential mortgages. A slower growth in the US combined with a stable unemployment level could entice the FED to go for QE3.

Although western Central banks, namely the FED, Bank of England and the ECB will remain accomodative in 2011, you can expect further tightening in the emerging market space, due to inflationary pressures growing relentlessly on their economies.

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