In spite of Fannie Mae’s $7.9 billion earnings write-off for the years to 2004, and failure to provide accounts for the last 7 quarters, the stock is substantially up during 2006, and analysts are mostly recommending it. This reflects a particularly counterproductive habit of financial analysts and economic commentators: they assume that the future will resemble the past. Time after time, particularly since 1995, that has proved to be a mistake.
This mistake has been made before. In the 1930s, commentators from Treasury Secretary Andrew Mellon down assumed that the post-1929 downturn was an ordinary recession, similar to that of 1920, and that similar policies would pull the United States through it quickly. In practice, policymakers, led by President Herbert Hoover, didn’t follow the policies that had been so successful in getting out of the 1920 recession. Instead they raised tariffs, increased business subsidies, raised taxes and (largely accidentally) contracted the money supply – all counterproductive. Whether the recession would have followed previous patterns if left to develop alone is unclear; in any case, with those extra burdens, it didn’t.
After 1995, there is in retrospect no doubt that the Internet and its associated telecom revolution caused a step change in the world economy. Contrary to much excited commentary at the time, however, it did not revolutionize U.S. productivity. When corrected for statistical bias and looked at over the long term, this showed no significant increase around 1995 from the already fairly robust growth that it had enjoyed since the early ‘80s recovery from the 1973 oil shock. Instead, Internet/telecoms greatly increased the efficiency with which products and services could be outsourced to the Third World, particularly India and China (coincidentally both at this time receptive to a huge increase in connectivity to the world economy.)
The result of the changes that happened around 1995 is only gradually becoming clear. Like many commentators, my analysis for several years was incorrect, in that I assumed that valuation levels and interest rates that had prevailed before 1995 remained appropriate, so that a prolonged period of below-normal interest rates would quickly lead to an upsurge in inflation. In reality, U.S., European and Japanese inflation since 1995 has been effectively suppressed to the tune of probably 1.5-2% a year by the inflow of new products and services from China and India. Thus a monetary policy far easier than seemed appropriate, with M3 money supply growing by 10% per annum or close to it, produced no surge in consumer price inflation but simply a series of fantastic increases in asset prices.
However Federal Reserve Chairman Alan Greenspan also got it wrong. On December 5, 1996, ten years ago last Tuesday, he denounced “irrational exuberance” in the stock market. That was a reasonable extrapolation from past history; the Dow, at 6,400, was well above what before 1995 would have been considered a sustainable level and had risen by more than 50% in less than two years.
Had he proceeded with the normal next step of a responsible Fed Chairman, he would have raised interest rates in order to choke off the developing stock market bubble. In that case, economic expansion would have continued vigorously, while inflation would have dropped to below zero, as new products and services from China and India would have lowered overall price levels. In essence, the U.S. economy would have returned to its position of 1873-96, in which expansion and productivity growth were rapid, but consumer prices had a steadily falling trend.
Instead, in July 1997, Greenspan, possibly seeking reasons to justify the continued effortless elevation of Wall Street, compounded his error by professing to find a productivity miracle in the U.S. economy, which justified stock prices far higher than would previously have been thought appropriate. This was wrong. There was no productivity miracle in the U.S. economy. Nor should the Internet have been thought likely to have produced one, except in the minor areas of writing term papers and lightly researched journalism, which had been made much easier. More than a decade after its introduction, the Internet’s effect on retailing, for example is still significant but minor, because the United States had efficient retailing and distribution systems already.
The great advantage of the Internet (and its associated telecom revolution) was to make instantaneous communication with the other side of the world cheap, and simultaneously make both public and private information accessible to those without easy physical access to mass media and good libraries. This does not on the whole include Americans or Western Europeans, although it used to surprise me how difficult it was to get a worthwhile national newspaper in, say Portland Oregon (no, USA Today does NOT count!)
Thus Indian software engineers could access the latest technical periodicals and the gossip columns and job listings appropriate to their trade, provided they had a cell-phone or a decent landline connection, without worrying that the nearest town was 4 hours away on a muddy, boulder-strewn road. Chinese manufacturers, too, could communicate with their customers and take immediate orders for shipment across the globe subject only to the vagaries of the world’s shipping lanes but no longer to those of the mail system.
It was Indian and Chinese productivity and output, not American, which were revolutionized by the Internet. Other countries could share in the new wealth, to the extent that they were open to the new global economy. Those countries that resisted globalization, notably in Latin America, fell rapidly behind.
By recognizing a U.S. productivity miracle that did not exist, Greenspan left monetary policy far too loose, as it has remained ever since. This produced an excessive level of investment, first in dot-coms then in housing, depressed U.S. saving to an unsustainable level, and by artificially increasing U.S. consumption produced a dangerous and unhealthy trade deficit. Since 1995, or at least since 1997, the United States has been living beyond its means.
The hollowing out of U.S. manufacturing has proceeded further than it needed to, as foreign capital has propped up the dollar artificially, being attracted by the U.S. asset bubble. Since 2001, interest cost differentials between low risk and high risk credits have been artificially reduced, producing a wave of investment in doubtfully creditworthy Third World countries and an acceleration of outsourcing from the American heartland. Profits have been artificially raised, as asset price increases and operating cost reductions have flowed to corporate income statements, further boosted by the artificially low cost of capital.
This has been enormously beneficial to some within the United States, and has hurt others. Most obviously, it has benefited Wall Street, rentiers and top corporate management. High asset prices, low interest rates and an ever increasing speculative flow of capital round the world all act to boost Wall Street profits and bonuses. Conversely, it has damaged Middle America, whose jobs have been outsourced, it has damaged savers, who have been unable to get a decent return on their money except by speculation and it has damaged the asset-poor, who have been priced out of the housing market.
Those who expect current conditions to continue, money to remain loose, asset prices to remain inflated or even inflate further, and inflation to remain quiescent are equally deluded today. (This group would include most of Wall Street, Fed Chairman Ben Bernanke and the Chief Executive of luxury homebuilder Toll Brothers, who announced Thursday that the housing market had definitely bottomed out.) They are expecting the future to be like the past, and for continuing outsourcing of goods and services to Asia to keep suppressing prices in the West, allowing cheap money speculation to continue.
At some stage, however, outsourcing’s artificial suppression of price inflation will stop. The enabling of outsourcing by telecoms and the Internet is a step change. It has already happened, no further major improvements are in store, and the remaining difficulties of international sourcing, primarily language/cultural barriers and transportation logistics, will remain in place and not enjoy more than modest improvement. Like the manufacturing revolution produced by electric power, or the transportation revolution produced by the automobile, it will continue to increase efficiency at a gradually reducing pace, but its enormous effect on the prices of outsourced goods will no longer dominate the world economy and suppress Western inflation. Wage rates are rising rapidly in China and India, a sure sign that the workers in those countries are gaining the bargaining power they deserve, in turn pushing up the prices of their output and reducing the exceptional cost gains achievable through outsourcing.
Once this happens, either inflation will reappear or, in the unlikely event that money creation is held back to prevent inflation reappearing, the Western economies will decline and asset prices, in particular, will collapse. Probably both. In either case, the U.S. trade deficit will reverse, the dollar will decline sharply, U.S. consumers will start saving again and U.S. demand will go into a multi-year slowdown.
This may currently be happening. Long term bond yields have dropped unexpectedly in the past few months, signaling a sharp slowdown in domestic demand. While factory output remains buoyant, retail sales are weak. Labor productivity had been propped up by cheap money which has produced capital investment bubbles, first in tech then in housing, thus increasing the capital to labor ratio. Labor productivity growth has now fallen back sharply, as demonstrated by Friday’s employment figures, which showed good jobs growth in an economy that is barely expanding.
Far from a “soft landing” the U.S. economy appears to be about to dive headfirst below the water, only to emerge after several years of negative growth and high unemployment. The Japanese malaise of the 1990s (but probably not the Great Depression) will thus repeat itself in the United States, albeit with a different pattern, as asset values return to normal.
And what of Fannie Mae? It has enjoyed 25 years of declining interest rates, which have boosted house prices (thereby reducing loan defaults), while allowing it to benefit from borrowing cheap short term money and investing in long term home mortgages. Analysts and its own management therefore forecast its future by extrapolating its past, assuming continuation of the exceptionally favorable environment it has enjoyed.
That environment is about to become much darker — house prices will decline and long term interest rates will rise. The result will be far greater loan losses than Fannie Mae is used to, “gapping” losses between old low mortgage yields and suddenly more expensive funding and a sudden lengthening in the maturity of its mortgage portfolio, as consumers stop refinancing. That in turn will cause Fannie’s derivative portfolio to stop working as a hedge again – just when they thought they had got it in order. The savings and loan industry went bust in the 1970s because of rising interest rates; Fannie Mae will have to show unanticipated bursts of management intelligence and good luck to avoid that industry’s fate.
Watch Fannie Mae’s 2005 and 2006 results, if and when it produces any. If they are unexpectedly poor, you will know that the world has changed – Fannie Mae, in this case, can act as the canary in the US economic coal mine, telling you when the air has become un-breathable.
If Fannie’s auditors don’t move fast, however, economic asphyxiation will have arrived in other sectors before Fannie can report its distress. That would be a pity. Fannie Mae would otherwise for the first time in its existence have served a genuinely useful purpose.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)