by Peter Schiff
The Writing is on the Wall
August 31, 2007
Thisweek, Larry Kudlow and others strongly chastised Bernanke for hisfailure to read the writing on the wall and urged the Fed Chairman toquickly slash the Fed Funds rate. Methinks the pundits doth protest toomuch. For years, Kudlow, who practically coined the term “Goldilockseconomy,” has dismissed with scorn suggestions that the Americaneconomy was anything less than ragingly healthy. If our economy isreally so strong, why does he call so loudly for the artificialstimulus of a significant rate cut?
In truth, the writing hasalways been clearly on the wall all along. A credit bubble has beensteadily inflating for at least the last six years, which in its finalfrenzy produced some of the most absurd mortgage funding products theworld has ever seen. To anyone not dependent on the hysteria, a no-doc,no money down, negative amortization, interest only, adjustable ratejumbo mortgage was a just as clear a sign of pending catastrophe as$200 for a share of Pets.com, or 5,000 Dutch guilders for a singletulip bulb.
The one thing all bubbles have in common is thatthey eventually pop, and ours just did. Unlike the popping of the lastbubble in 2000-2001, this one will fall directly to our economy’sbottom line. And this time the Fed can not step up to the plate withunlimited liquidity injections.
A record percentage of our GDPis comprised of consumer spending. The source of this spending was thehousing bubble. Would our savings rate really be negative were it notfor housing related “wealth?” Could consumers really have spent as muchas they did without the benefits of temporarily low teaser rates andthe ability to extract equity from their homes? How many service sectorjobs are directly related to that extra spending? When the low mortgagepayments and home equity disappear, so too will the spending and jobsthey engendered.
Those who feel that the economy will keepgrowing must believe that discretionary consumer spending is unrelatedto wealth or expenses. In other words, they believe that individualswill spend as much with no home equity and $3,000 per month mortgagepayments as they did with $200,000 in home equity $1,500 monthlypayments. Factor in other rising expenses; such as food, energy,insurance, and taxes and discretionary spending will not just slow, itwill completely collapse.
With the ugly truth laid bare, manynow prod Bernanke and Bush for solutions. Unfortunately there are none.Based on absurd assumptions about real estate, we simply borrowed moremoney than we can ever hope to pay back. There is no magic elixir wecan swallow to cure what ails us. The free market is the only forcethat can fix this mess. Unfortunately, the fix won't be pretty. Prudentlending standards will return, guaranteeing that real estate pricescollapse. This is an important connection that very few have made.There is no way the average American can afford to buy the averagehouse at today’s prices with a mortgage he can afford. Assuming thatthe lax standards of 2005-2006 do not return, the only way this canhappen is if real estate prices collapse, which is exactly what ishappening.
The financial institutions that are calling mostloudly for a bailout claim the Government must act to protecthomeowners. However, the most severe losses will not be born byhomeowners but by those who loaned them the money. Therefore anybailouts will ultimately go to lenders not borrowers. Homeowners whooffered no down payment and who have no equity in their homes will inreality lose nothing in foreclosure, except perhaps a debt burden on anoverpriced house. In addition, even those homeowners who made downpayments likely extracted larger sums in subsequent refinancings orhome equity loans. With plenty of available foreclosed homes on themarket to rent it is unlikely that these former homeowners will becomehomeless.
As a result, the only losses for most homeownerswill be psychological, as their dreams of real estate riches vanish.For some paper millionaires, the sudden realization that they are flatbroke will be somewhat disheartening. Also for those who thoughtretirement was simply a function of living in a home and allowing it toappreciate, the sudden realization that they will now have to financetheir retirement the old fashioned way, by saving up, will be quite aneye opener. However, even if misguided government bailouts enable moreborrowers to keep their homes the equity they thought they had willstill be gone.
In the final analysis, though it was WallStreet that served the punch, it was the Greenspan Fed that spiked itin the first place. Just as Fed policy enabled Wall Street to flood theworld with worthless dot.com stocks it enabled an encore performancewith subprime mortgage-backed securities. My guess is the Fed’s bubbleblowing days are over. Once the inebriates sober up this time, thehangover will be so severe that no one will drink a drop of WallStreet’s punch again, meaning any more inflation the Fed creates willgo strait into consumer prices.
