Dr. Jean-Paul Rodrigue


This page contains a collection of my views concerning contemporary economic and geographical issues. I tend to have a rather contrarian perspective, notably for an academic. Disclaimer: These views in no way reflect those of Hofstra University or those of the Department of Global Studies & Geography. They should not be seen as investment advices but I always put my money where my mouth is. For those who strongly disagree with my views please be comforted by the fact that in give or take a few decades I will be gone.
NOTE: I no longer update this blog.

Bubblenomics: A Misallocation Engine (3/17/2009)

Bubblenomics can be defined as the missing branch of economics investigating the consequences of asset inflation (boom) and deflation (bust) on economic activities. A bubble emerges when the market mechanisms that would have normally corrected undue asset inflation, such as higher interest rates or a decline in demand due to high prices, are disrupted. The most common source of disruption is lax credit, a direct outcome of the policies of central banks. Under normal circumstances, supply and demand tend to be closely related and evolve according to well understood factors linked with demographics, technology, productivity and income. For simplicity, let's assume that this relationship is incremental and linear (see "Normal trend" on figure below).

A bubble creates several distortions between supply and demand, resulting in many misallocations. Several key points must be underlined:

  • A bubble essentially transfers of a share of the future demand into the present. It steals future consumption (and expectations of future consumption) and compress it in a short period of time, leading to what can be called a temporal misallocation ("bubble-derived demand"). The consumption taking place in the present is thus much less likely to take place in the future, particularly since debt is used for consumption. Debt can be defined as present consumption and the expense of future consumption and a bubble results in a large accumulation of debt. On the above figure, the amount for demand A is transferred into bubble demand B. For instance, during a housing bubble the surge in demand, most of it speculative, comes at the expense of much reduced demand for housing once the bubble has busted.
  • Bubbles are linked with dramatic valuations in the asset classes they involve and are always debt funded. As stated before, easy credit (such as margin accounts for stocks or no down payment adjustable rate mortgages for housing) is the catalyst that fuels bubbles. The higher the price, the higher the demand because paradoxically it confirms to the participants that future valuations are to be expected. Lies, misinformation and fraud become common until a point where even the most reckless can no longer obtain credit. The situation is completely reversed in the bust phase where even the most prudent may have difficulties obtaining credit. As abundant as credit was during a bubble, it becomes very scarce during a bust since the default on loans that fueled the bubble result in a financial system unwilling to lend for this asset class.
  • A bubble induces the suppliers (real estate, manufacturing, retailing, shipping, etc.) to misallocate their resources because most do not realize that the future demand has been compressed into the present. They thus over estimate future demand, often providing a level of supply ("bubble-derived supply") significantly above a normal level, fooled by the dramatic change in the "fundamentals". During a bubble, there is an under-capacity since suppliers have difficulties coping with the demand, which commonly results in an increased exchange velocity of assets (speculation). In the following bust there is an over-capacity which cannot be cleared in a short period of time; a large waste in capital. This is likely the most damaging consequence of a bubble as it eventually destroys production and distribution capabilities to an undue extent. Many suppliers cut sharply their output ("bust-derived supply"), but it never seems enough to keep up with the demand destruction taking place. In capital intensive sectors, such as manufacturing and maritime shipping, the new supply can take years to come online and once it does, it is in a situation where the demand has "suddenly" vanished, leaving a substantial over supply. This can be enough to put many suppliers into insolvency.

The temporary benefits of bubbles are more than compensated by the wealth destruction their bust triggers. Far from being a zero-sum game, a bubble steals demand from the future and induces the suppliers (real estate, manufacturing, retailing, shipping, etc.) to misallocate their resources because most do not realize that the future demand has been compressed into the present. Thus, a bubble is one of the most damaging misallocation engine that can be conjured.

Blowing Bubbles: From Technology to Commodities (3/14/2009)

When looking at bubbles, most associate them with housing, which is obviously accurate since it was likely the largest financial mania in history. Still, the housing bubble must be placed into a wider perspective; it was triggered by the unfolding of a previous bubble and the housing bubble also triggered another bubble. Thus, the last decade has seen the unfolding of three major bubbles back to back (see figure below). The tech / stock bubble that peaked in 2000, the housing bubble that peaked in 2005 and the commodities / trade bubble that peaked in 2008.

Click here to download a PDF version of this figure (distribution permitted).

  • The tech bubble (using NASDAQ computers - ^IXK - as an index) can be seen as unrealistic expectations (at least on the short term) about the economic potential of the information technologies sector, a mania which was also accommodated by lax credit. However, its bust did not have a significant impact on consumption since only a relatively small segment of the population participated. However, it was concomitant (or maybe a triggering factor) to a recession that began in 2000. It is the consequences of this bust on the monetary policy of the Federal Reserve that had long lasting impacts. By lowering interest rates to 1% it sowed the seeds of the housing bubble.
  • The housing bubble (using the residential home builder Toll Brothers - TOL - as in index) was the most damaging of them all because a very large segment of the population participated by borrowing money to purchase houses at inflated prices or by extracting equity from inflated assets to consume. Such a mania was made possible by lax credit, the securitization of debt as well as the obfuscation of risk by a variety of derivatives. The housing bust triggered a massive wave of defaults in the financial sector, but this was delayed a couple of years by mortgage rate resets. While the stock market value of activities closely related the housing adjusted quickly to lower future expectations (as exemplified by TOL), it took more time for the real estate market and the general population to realize that the boom was over and default on their liabilities accordingly. These defaults created a massive wave of cross-defaulting in the over-leveraged financial sector and precipitated a global recession.
  • The commodities bubble (using the Baltic Dry Index - BDI) had several well publicized components, namely the price of oil that exploded from $35 per barrel to $140 in less than 3 years. The commodities bubble was a global phenomenon since it was related to commodities like food and energy which impact almost all markets. What is less known is that the debt fuelled consumption associated with the housing bubble resulted in a surge in international trade. Major actors involved in international trade and production, from factories in China to maritime shipping companies, saw this growth as enduring and consequently invested in additional capabilities. Once it became clear that the debt derived surge was artificially induced, the commodities sector collapsed, followed by international trade, particularly for export-oriented economies (China, South Korea, Taiwan, etc.).

Each bubble triggered conditions favoring the emergence of the next one and its associated misallocations and mal-investments. The compounding effect of the misallocations of the three bubbles had sharp damaging effects on every sector of the economy, from the balance sheet of financial companies, the net worth of consumers to the assets of maritime shipping companies. What is striking looking at these bubbles is their similar boom and bust structures with a double peak followed by a sharp collapse, which can be figuratively referred as a "Wiley E. Coyote" moment. Then, there are a few "dead cat bounces" with values eventually getting back to their pre-bubble valuations. Interestingly, evidence suggests that a bubble peaks when an index (or an asset) is at 5 times its pre-bubble value. I think that at this point that most who participated in these bubbles now wish that they never took place.

What is despairing is that the lessons of three major bubbles taking place in less than a decade seem not the have been learned by policymakers. Many do no even want to acknowledge that monetary policy was at the root of the problem. The question remains about what is left to inflate?

The Positive Feedback of Malware (12/20/2008)

For many it is quite obvious that the assortment of computer malware that plague our inboxes and the internet are a nuisance at best and can have serious financial consequences in some cases where confidential information such as social security or credit card numbers is stolen. There are plenty of horror stories where the fool, the naive or the unaware is separated with his money through various and often quite imaginative scams. There are however some good news. Like Spam, these strategies are facing the problem where each campaign leads to lower returns (response rate) as the market gets more crowded with copycats and as the general public develop an awareness, at least to the most blatant scams. I think at this point that anyone receiving a letter from a Nigerian Banker promising untold millions and believing it deserves to be separated from their money, simply from a Darwinian perspective. In their attempt to exploit technological and human flaws, the scamsters are indirectly destroying their business model, or at least marginalizing it. The main reasons are twofold:

  • Diminishing returns may reach a point where the rewards are no longer worth the efforts. Even if the internet offers low entry costs, organizing and benefiting from a spam and/or scam campaign is far from being easy in the current context. For instance, an advance fees scam is very labor intensive and it involves developing trust with the bait through correspondence. This is a reason why many low level scams have moved to developing countries (e.g. Nigeria) where labor and opportunity costs are lower. Yet, in spite of large numbers of scammers working around the clock to reel suckers in, the share of the pie is getting smaller. Same issue with Spam. After a period of trial and error (thanks to the imagination of spammers), email spam filters have become quite effective. I still receive a few spam emails per day (I assume hundreds do not make it to my inbox), but to avoid detection they are almost gibberish and immediately deleted by the junk filter of my email management program. "Phishing" appears to be still a fairly active endeavor where through various forms of entrapment, mainly a fake web site replicating a real one, where people are tricked to volunteer personal information, but I would not be surprised to see the beginning of a phase of diminishing returns in this arena.
  • Paradigm shifts, meaning coming up with an entirely new scam that will trick the software and the people, requires an increasing level of expertise. While almost everyone can run an advance fees fraud, spreading an effective malware is an increasingly challenging task in terms of programming it to perform something "useful" and finding a way to spread it around. Each successful round of infestation, brings countermeasures (OS and web browser "patches") making the next round more challenging, until the marginal utility in terms of what can be achieved and how the malware will spread gets close to zero. There is still a risk that on occasion an entirely new threat emerge, which can wreak havoc, but the probability of such an event gets smaller with each iteration between the scammers and the web browser and OS designers.

Thus, through unintended consequences, those involved in electronic crime are creating a set of conditions (positive feedback) which will seriously undermine future revenue streams. In many ways, it is reassuring that the great majority of malware threats are basic con schemes (browser hijacking towards porn sites, advertisement pop up windows, stealing passwords, or slaving a computer to spread spam). The parasite certainly does not want to kill the host and as the host develops an immunity, real and serious threats (such as viruses purposely designed to damage IT hardware and software) are getting easier to mitigate. Thus, unwillingly, scammers are making the electronic landscape safer from intended disruption. While there will always been "a sucker born every minute" squeezing that sucker electronically will be increasingly difficult.

Margin Calling (10/3/2008)

We have reached the "deer in the headlights" moment where the reality starts to be acknowledged. A large share of the global financial system is insolvent, which is no surprise considering it was built on leverage and asset inflation.

Deleveraging is possibly one of the worst financial situation one can find itself in. It is more than a liquidity issue, it is an insolvency issue. It can happen very quickly (it always does) and a financial institution that weeks prior was seen as solid can essentially cease to exist. It is often triggered by a forced "re-pricing" of the underlying assets.

To understand deleveraging it is a good idea to understand the process that has created it; leverage, asset inflation and fractional reserve banking. Say you have $100 and you use it to buy an asset (stock, bond, real estate...) worth $1000 by borrowing $900 from a financial institution which is more than happy to oblige since it will earn interest on the money being lent while the asset acts as a collateral. You essentially have in this case a 10% "down payment". Say the value of this asset goes to $1,200 and you then sell it. You pay back the bank the $900 you owe (plus interest) and you thus have $300 for yourself. Your $100 investment became $300; a return of 200%. Is this great or what? No wonder why leverage is so popular and savvy investors know how to use it well.

Now lets say that the asset drop to $900 (this is just a 10% drop). You are essentially wiped out (100% loss) since once you pay back the debt you owe ($900) you are left with nothing. Lets go a bit further. The asset drops to $800 (which is still a rather small drop; 20%). In addition of being wiped out, you are now 100% in the red since you owe double the value of your initial investment. So what do you do? If you have some cash reserves you simply pay your debt and call it a day. Most do not have these reserves (this is why they used leverage in the first place). They are now "deleveraging"; they are forced to sell some of their other assets to cover the losses, which of course creates deflationary pressures on the value of this asset class and may force others to sell (margin call). What happen when no one wants to buy your asset (at least at the price you think it is worth) because like you they realize that the asset class is worth much less? Think real estate, Bear Stearns, Indymac, Fannie and Freddie; as long as the asset was inflating things were fantastic. Now everyone is forced to re-price their assets and many realize that they cannot pay back their debts, so they default and bring down with them those who have providing financing. The impacts of deleveraging can be devastating on the value of a variety of unrelated assets as many are forced to sell and start to cross-default. We now have an idea of what is currently happening; the mother of all margin calls. Central bankers do not deserve any respect.

Real Estate and Impoverishment (6/26/2008)

The wealth effect of real estate has often been underlined, particularly within the "ownership society" framework. The assumption is that home ownership provides financial stability and an asset that can be borrowed against in time of needs (e.g. medical emergency, funding college, etc.) or to cash out and fund retirement. However, it can be argued that in the current context real estate is more a cause of impoverishment than of wealth since the asset has essentially been tapped out. For many, homeownership has become a very relative term as they "own" a huge liability instead of an asset. The main impoverishment effects caused by homeownership are:

  • Income diversion. A large share of the family income is diverted to sustain a non-performing asset that has limited utility and, outside asset inflation, does not provide any real return. Thus, what is spent to cover a liability is not used for consumption or savings. Another sign of impoverishment is the strategy of many homeowners in view of rising mortgage payments due to rate resets and rising utility bills. Many will keep up the payments as long as they can (reducing their consumption) in the hope of keeping their home, thus exacerbating the income diversion effect.
  • Destruction of savings. Concomitantly with the income diversion effect, many are digging into their savings (if any), their retirement funds or other assets (e.g. jewelry) to keep up with their mortgages. This simply delay the inevitable if the mortgage load is too high comparatively to income. The outcome is even worse; a homeowner (homedebtor) would end up losing the house anyway in addition to severely deplete his existing non-housing assets.
  • Additional debt. In some cases where income diversion is pronounced and where savings are not available, a homeowner will contract additional debt either to keep up with debt obligations and to cover living expenses (food, energy, clothing, etc.).

All these factors are a real source of impoverishment, undermining the financial stability of many families in an illusive attempt to keep up with the "debt is wealth" paradigm. You end up no longer a homeowner, but "homeowned". This impoverishment effect will not stop until home prices are the equivalent of renting.

The Taco Bell Effect (5/16/2008)

I have an horrendous confession to make; I do enjoy a greasy taco. Over the last couple of years I have been patronizing a Taco Bell fast food joint about once a week (my only fast food indulgence). Being a person of habit, I roughly ordered the same items over that time period. A trick is to never order any soft drinks as they are the profit items in the fast food industry. Prices have remained constant for a period of five years and even went down a little bit during the rat infestation scandal. Being a contrarian, I actually took this opportunity to enjoy lower prices and no lines. I have noticed in this time period a gradual decline in quantity and quality of my orders, particularly the amount of grated cheese and stuffing. However, in the last couple of weeks prices went up in conjunction to again a noticeable decline in quantity and quality. I have thus stopped this little indulgence not because I cannot afford it, but simply to replicate normal consumer behavior. I am certainly not blaming Taco Bell as they undertake a normal business practice to cover up inflation (like candy bars getting smaller). In many ways, they are as much a "victim" as I am in this process since contrary to what many believe they do not create inflation (this is the creature of central banks) but simply respond to it. I would thus like to suggest the "Taco Bell Effect" as:

  • The slow and gradual deterioration of the quality of a product while maintaining the price constant. In this case inflation is not reflected in the price, but over the quality. This process goes on until the business is forced to increase prices while at the same time keeping quality low. The joint outcomes of inflation thus become higher prices and lower quality.

Globalization, Deflation and Theft (04/27/2008)

While the ills of inflation are mainly assumed by the general population, the benefits of deflation are captured by governments and central banks.

It is well known that the process of globalization is based on the principle of comparative advantages as well as the expansion of markets (in size and in geography), which leads to higher efficiency levels. With the entry of China many manufacturing activities have been able to substantially reduce their production costs. A visit to any Wal-Mart or major retailer will likely confirm this assertion. The same can be said with the growing involvement of India in many segments of the service sector; a customer service call to a large financial institution or a computer retailer will likely confirm this assertion. What is puzzling is that in spite of significant input cost reductions there have not been significant changes in the costs of living, albeit apparel and electronic goods tend to be cheaper. As a transport geographer, I know quite well that it is not because of higher distribution costs; in many ways transportation, due to economies of scale in containerization and supply chain management, is significantly cheaper today than in the past.

The substantial benefits of globalization should have resulted in a strong deflationary process in a broad range of sectors. Instead, prices remained relatively similar and a look at the consumer price index (CPI) indicate that from an aggregate perspective there has not been a decline in more than half a century. In recent years, and in spite of globalization, the CPI has remained in the 2-4% range (let's leave the relevance of CPI as a measure of inflation for another day...). What is peculiar is that this pattern is not even being questioned. It could be argued that many corporations have taken advantage of globalization to increase their profit margins and keep consumers paying a similar price. This is not accurate as competitive forces would have prevented such a strategy to be truly effective. In short, a good share of the deflationary benefits of globalization have been stolen by the inflationary policies of central banks and governments. Larger amounts of credits have been issued than it would have been otherwise possible while maintaining relatively low CPI figures and thus keep the market and general public relatively unaware. However, this was linked with the largest asset bubble in human history, known as the real estate bubble. It is tragic that much of the criticism about globalization is actually pointing fingers in the wrong direction. The current trend is however changing. There is not much benefit left to be derived from globalization as a good share of the economic activities that could be off shored already have been. It could even been argued that the recent surge in commodity prices may be indicative that the over-issuance of credit can no longer be effectively masked by the deflationary forces of globalization.

An Advice to FBs (09/17/2007)

(B stands for Borrower; I will leave F to your imagination). At this stage of the real estate collapse, many are now technically under water, owing more than the value of their homes. Additionally, many are having the unpleasant surprise of seeing their adjustable rate mortgage reset to an higher rate, making the "howmuchamonth" more difficult to handle. Considering the current prospects, a plethora of FBs are actually following this strategy; they are defaulting on their mortgages and simply walking away. This is the main reason behind the current global credit crunch since financial institutions are getting increasingly reluctant to lend, uncertain about who is likely to default next. My advice for those unable to meet their crushing debt obligations is the following; stop paying your mortgage. Continue to meet any other financial obligation such as municipal taxes, utility bills, and credit card debt. Since your mortgage has been collateralized and sold on global financial markets, your default will punish to most reckless, clueless and leveraged players first. This will go a long way in enforcing discipline in a market that in recent years forgot about the concept of risk, or has obfuscated it in exotic debt products. You may also benefit from a long time lapse between the date you stopped paying your mortgage and the moment you will receive your notice of default and then your notice of foreclosure. In between, you will be able to stay in the bank's house (who has now become a FL; L standing for lender) for quite a while, rent free. This is what you get when relying on fiat currencies and fractional reserve banking.

Watch Them Cross-Defaulting... (08/02/2007)

The power of leverage. Leverage amplifies upwards movements, but also the way down, and this very quickly. Leverage is thus a tool where returns can be boosted but once this tool turns against you, financial suicide is almost guaranteed. We call that a margin call. This is the nature of the current financial fiasco where risk was assumed to be a known entity. The problem is that leverage was based on debt to be serviced by the most financially frail debtors ever concocted; the sub-prime (and even up to the prime) mortgage holder. As many homedebtors and other real estate geniuses see their "howmuchamonth" increase substantially and their "paper equity" vanish, they are simply walking away, triggering waves of defaults and forcing a repricing of every investment product based on mortgage. Fraud also appears to have been rampant; this is what you get with easy fiat money. A few weeks ago, when a new price discovery was forced on a couple of Bear Stearns hedge funds, only an abyss could be contemplated and that new price was virtually zero as no one wanted to become a bag holder of toxic waste (aka collateralized debt obligation). There is an interesting reciprocity; the Fed creates money out of thin air and hedge funds destroy it. So lets watch the slicers and dicers cross-defaulting and hope that they will not bring down too much of the economy with them. Another interesting point is that a lot of those debt instruments was purchased by foreign investors and central banks. The rest of the world has become a bag holder so the damage to the American economy may proportionally be reduced.

The Fundamental Difference between the State and the Market (05/08/2007)

Coercion versus persuasion, plain and simple. The market, represented by the interaction between sellers and buyers, has the difficult task of convincing buyers that a good or a service being offered is what they need (or want). So each transaction is an exercise in the freedom of choice, which is carefully pondered based upon the comparative merits of what is being offered. In a market, everyone can elect to buy or not to, or to substitute to another product or another seller. Trust is a core foundation of the system and if this trust is broken (like a manufacturer selling a defective product), the penalty is often steep. A dishonest business does not stay in the market very long, but dishonesty by the State commonly goes unpunished.

The State forces its constituents to use its "service" and taxation is coerced out to pay for them. In time, there can only be more and more "services". Some, like road construction and maintenance, are generally well accepted because they are perceived as a societal benefit, while others, like warfare (war on terrorism, war on drugs, war on poverty; I never though there would be so many "wars" that need to be fought...), can be controversial to say the least. In between, there is a whole range of welfare practices where the population is made to believe that the State is indispensable. In any instance, the government (central planners) is supposed to know better and all its decisions are for "the common good". Thus, these decisions must be enforced on the masses. While a person can change his consumption preferences any time for any reason, the "services" offered by governments tend to remain even if they prove to be inefficient or even counter-productive. On the long run, this process has the potential to create substantial economic hardship and can work against freedom.

If the Housing Bubble was a Movie... (06/30/2006)

A bit of a comic relief. Lets come up with some potential housing bubble movies.

  • Raiders of the Lost Equity. Starring Joe Sixpack and Sally Boobjob. A group of teenage mortgage brokers put a neighborhood under siege armed with Helocs and Neg ARMs. By the time people start realizing what is happening, the neighborhood is littered with Hummers, Escalades, flat screen TVs and exotic vacations. Homeowners are left upside down, chained with debt, but with inflated egos and mammary glands. The raider brokers escape unnoticed. Rated: Low IQ (warning, viewing this may alter your perception of economic reality and make you feel richer than you really are).
  • Honey I shrunk the Equity. Starring: Suzanne “researched this”. A gullible couple follows the advice of their realtwhore (Suzanne) and buys a condo in San Diego in July 2005 with the anticipation of becoming multi-millionaires in 3 years. Meanwhile, we follow the struggle of Suzanne to complete her high school diploma as she fails arithmetic because she can only add, but not subtract and can only multiply, but not divide. In this historical drama the producer skillfully explores all possible ranges of human emotions from hope, euphoria, greed and “keeping up with the Joneses” to denial, delusion, anger and despair. The mob lynching scene of Suzanne is a classic and thankfully her poodle escape unharmed. Rated: GP (Guaranteed Disappointment).
  • Night of the Living Debt. Starring: David Lereah. The sudden reset of ARMs wrecks havoc among the population of a small town as most see their payments double. “Mortgage zombies” are seen roaming the streets, ruthlessly attacking renters, who appear to be immune to the epidemic, while mumbling gibberish such as “real estate only goes up”, “they don’t make any more land”, “everyone wants to live here” and “buy now before you are priced out forever”. Autopsies reveal that the morbid appearance of mortgage zombies was caused by overwork, stress, lack of sleep, and selling their hair, blood and kidneys. The epidemic is finally stopped when the master mortgage zombie, David Lereah, is killed by a group of surviving renters holed up in an apartment complex. Rated: SCD (Strong Cognitive Dissonance; warning not suitable for most ARM holders).
  • Independence Day. Starring: Joe Homedebtor. After 40 years of struggle a lucky homedebtor finally pays back the mortgage he contracted in 2004. Unfortunately, he dies the next day from an indigestion caused by eating something other than ramen noodles for the first time in 40 years. Rated: CDA (Continuous Depreciating Asset).
  • 1984. Starring: Lawrence "Fun" Yun. A gruesome alternate future where the world is controlled by different factions of the NAR (National Association of Realtwhores). The entire economy is based on building and selling houses under the everlasting vigilance of "Big Broker" whose mottos are "Debt is Wealth" and "Homedebtorship is Freedom". The world is kept in a constant state of war which sole purpose is to destroy housing stocks and keep prices going up. The story follows a civil slave of the Department of Housing Truth whose tasks is to conjure up housing sale figures and reset days-on-market data for the renting masses. In the background is the perpetual war between Countrywidestan and New Centuria with weekly reports about how many housing units have been destroyed or condo buildings captured. Rated: NS (NewSpeak).

Long Death through Inflation (05/10/2006)

"A government that can spend all it wants is a tyranny in waiting. A government that can destroy a currency on a whim is despotic." Llewellyn H. Rockwell, Jr.

Inflation is fraud, plain and simple. It is one of the most insidious forms of wealth confiscation used by governments and central banks. In simple terms, inflation is the over issuance of money in relation to available goods and services, implying that more money is "chasing after" a similar quantity of goods and services. The value of each monetary unit is thus reduced accordingly. Since most of the population are unaware of the true source of inflation, governments have effectively relied on inflation to stealthily confiscate the wealth of their constituents. To be frank, inflation is not always the outcome of central bank policies but the inflation that has been observed in recent decades is almost entirely monetary inflation as opposed to the real commodity inflation:

  • Monetary Inflation: Occurs when monetary creation causes a surplus of cash chasing the same amount of goods.
  • Monetary Deflation: Occurs when fiscal responsibility or a lack of monetary creation causes a decline in total cash chasing the same amount of goods.
  • Commodity Inflation: Occurs when a group of commodities in general are declining in supply relative to a monetary pool, with or without monetary inflation.
  • Commodity Deflation: Occurs when an excess number of commodities hit the market relative to a monetary pool, with or without monetary deflation.

Value of a 2005 $100 Dollar, 1800 - 2005
Source: Robert C. Sahr, Political Science Department, Oregon State University, Corvallis, OR 97331-6206. http://oregonstate.edu/Dept/pol_sci/fac/sahr/sahr.htm

The above graph clearly indicates the systematic debasement of the US dollar that took place in the 20th century, particularly after the establishment of the Federal Reserve in 1913. Prior to this event, the value of the US dollar was kept relatively constant through the 19th century. Wars were the major inflationary events, such as 1812 and 1860, but afterwards the dollar quickly gained back its value, an indication of a remarkable period of prosperity in the American economy where the population was benefiting of the multiplying effects of higher incomes as well as the higher purchasing power of the dollar. This cycle was broken after World War I, so instead of having the US dollar resume its former value, the Federal Reserve went on into a period of over issuance of money. The dislocations and misallocations this created led to the stock market crash of 1929 and the issuing Great Depression (most people are unaware that the cycles of booms and busts are the outcome of monetary policies of central banks). The deflation of the 1930s was thus the outcome of the Great Depression. After World War II, inflation became systematic and officially part of government policies of "deficit spending". The final restraint on the US dollar was broken in 1971 when its convertibility with gold was stopped. It lead to one of the most inflationary period in US history. This means that $100 in 2005 was worth the equivalent of $500 of purchasing power in 1970. Today, the world economy is under a regime of fiat currencies that are only backed by the confidence and faith people may have in their value.

There is a significant problem in the making for the money printers who were able to issue a substantial amount of "thin air" money in recent years rather unnoticed. They benefited until recently from commodity deflation brought by productivity gains related to globalization. For instance, there was a strong downward pressure on the prices of many manufactured goods as production refocused in low costs countries (e.g. China). We are now facing a real process of commodity inflation which is the outcome of resource shortages brought by surging demand. Petroleum is the most eloquent example of commodity inflation with peak oil; even with growing demand additional supply cannot be brought online. The outcome is likely to be a multiplying effect compounding the impacts of monetary and commodity inflation, somewhat reminiscent of what happened in the 1970s, but potentially much worse. This is likely to take central bankers by surprise as they know the rules of the monetary inflation game very well, but are pretty much clueless on the issue of resources. They see resources strictly from an economic standpoint where if the price goes up due to greater demand, additional supply will immediately been brought in and eventually a new equilibrium will be reached, hopefully at a very similar price. The reality is that additional resources, particularly non-renewable resources, are very difficult to gather, even if prices go up substantially. This misconception is likely to become a trap that will trigger the realization of the general public that something is really wrong with the nature of our monetary system. Very little will be done except printing even more money and inflation will thus goes on unabated until the fiat US dollar (and all other fiat currencies) will reach its intrinsic value, which is zero, in a period of hyperinflationary collapse. This is what I call long death through inflation as every fiat currency system results in the same destructive outcome. Is this reason enough to buy gold?

Straight to Foreclosures and Bankruptcies (04/10/2006)

Now that the real estate bubble is showing clear signs of wavering with inventories skyrocketing (e.g. California, Florida and Arizona), I suspect that the collapse will come much faster and deeper than expected. The scenario that I discussed in my January blog appears to be materializing. We are now at a turning point; a phase of acceleration where a gigantic wave of foreclosures and bankruptcies will sweep across the United States. The argument of price "stickiness" in housing endures and this behavioral trait will cost "specuvestors" dearly. However, what came to my attention are the strategies of builders that appear to have a wide margin from which they can price down their housing output. They have become weapons of "mass equity destruction", which will accelerate the downfall. Already, several stories of builders unloading their projects with large discounts have popped out, leaving buyers in previous phases with instant equity destruction. Those who bought over the last two years may now already be upside down in their mortgages. Builders will continue to play this game because they can and they must. The margin call is now very strong and less "homedebtors" are able to unload their properties. The buyers left will ask themselves, "why should I buy an overpriced used product when I can get a new one at a discount?". This is the reason why I believe that the next major step is simply foreclosures and bankruptcies. Most upside down homeowners cannot and will not sell their houses because they simply cannot afford to bring at closing the difference between the sale value and the amount owed on the mortgage. Many have overstretched themselves to access homeownership to the point where they have limited if any saving. Some will simply try to stay put and wait this out, but the carry costs (mortgage, taxes, insurance, utilities, etc.) will eventually sink them, particularly if meanwhile their exotic (aka toxic) interest only mortgages reset to a higher rate. Holding more than one property as an "investment" becomes an heavy burden in the absence of asset inflation. The negative cash flow will eat them alive, one painful bite at a time, even if the property is rented. For many, the move will be straight from homeownership to foreclosure. Trying to sell will become useless and they will simply walk away (or squat in their former property for as long as they can). Once this process begins and accelerates, there will be no turning back and no way out. It will consume those who cannot wait or cannot afford to wait.

The Fed has Stolen one more Month of my Income (02/26/2006)

For most Americans it is a dreadful time of the year. When last year's incomes, already withhold taxes and deductions are tallied up, there is hope that the balance will be neutral and hopefully positive. The process itself is as esoteric as alchemy and requires complex computer programs and probably the wisdom of a professional to guide you through the maze of forms, rules, regulations and all the possible shortcuts in between. Neutrality means that you and the government have settled your scores and no one owes to the other more than what was already deducted. A positive balance means that the government got from you a one year interest free loan to be paid back with an additional 4 to 8% discount due to inflation, mostly with freshly printed money.

My wife and myself were not too lucky this year as our incomes have increased enough to place us in a higher tax bracket. This is a mixed blessing. Although our incomes may have gone up, it does not appear that our quality of life has improved accordingly. The problem is that we know why; inflation. Our rent, groceries, utilities, gasoline and insurance costs went up at a rate much higher that the dishonest core rate. What standard of living my father was able to maintain with a single income and four children, two good incomes and only one child do not even match in the current context. So we ended up owing to the Fed the equivalent of one additional month of our respective incomes (we have approximately the same income). This is after we have decided to take a portion of our current savings and place them as an additional contribution to an IRA in order to reduce our taxable income.

I know that this additional taxation serves no useful purpose. What do we get for our taxes? A multitude of socialist undertakings doing a fantastic job at misallocating the resources of our economy; our Empire. There is very little more despairing in life than to have an additional month of one's labor taken away to be swallowed by the black hole that governments have become. Governments do not contribute to wealth creation, only to wealth diversion. They reduce our standards of living through taxation and through inflation. The question is how much they can drain away from an economy before chocking it to death. I suspect we will find out in the coming years. As far as we are concerned, my spending power for 2006 was reduced by the equivalent of one month of income plus the equivalent of one month of deferred consumption (which has been placed as additional contribution to an IRA). Although the IRA is only a deferred consumption, I wonder how the dollars we have set aside today will be worth in the future. My hunch is that they will be worth much, much less than today. The Fed thus stole two months of my family's labor in exchange of absolutely nothing.

Professional Plagiarism at Work from a Government Official (01/25/2006)

Since I am an university professor, I am exposed from time to time to the problem of plagiarism. The great majority of cases concern students who lift information from the Internet and paste it in their assignments. Plagiarism detection products, such as Turnitin.com have substantially reduced such occurrences in recent years. I post most of my work, including articles and conference presentations, on my web site. I find this strategy an excessively useful tool of diffusion and promotion. It is always pleasing to see some of it (particularly material from my transport geography site) been used by other scholars and professionals. In the majority of cases the source of the work is clearly specified and proper credits are given. Some even request my approval before using my figures or maps (I say yes virtually on every occasion). Sometimes, the situation is a bit more shady as figures are not properly referenced and used for purposes that were not permitted, but I never make a bit fuss about it. Being copied from is flattering for an author.

However, a colleague recently forwarded me a PDF document he found on the web site of the Maputo Corridor Logistics Initiative (http://www.mcli.co.za). The presentation by Mr. Elvin Harris, Chief Director: Transport, Corporate Strategy and Structure Unit, Government of South Africa (email: elvin.harris@dpe.gov.za), was titled "Freight and Development Corridors: Various Perspectives". Immediately, I recognized the real author of this presentation: me.

  • Here is the presentation by Mr. Harris.
  • Here is my paper titled "Freight Gateways, Corridors and Distribution Centers: The Logistical Integration of BostWash" presented at the 2003 conference of the Association of American Geographers.

What strikes as quite obvious is that the presentation by Mr. Harris is an exact copy of mine, except the last slides which were probably lifted from somewhere else. Even the PowerPoint template was not changed, but the institutional icon of the original has conveniently been removed. However, the formal proof is in the document's digital signature. Our plagiarist botched his job (or more likely was unfamiliar with the feature) as if one loads the presentation in Adobe Reader and request to see the properties of the document (File, Document Properties... or CTRL-D) it becomes quite clear who the author really is. Try it for yourself.

So there you have it. A South African government official from the Department of Public Enterprises shamelessly using my work for his credit and without attribution. I would not be surprised that he received an honorarium to present "his" paper, including food and accommodation (the seminar took place in a $120 a night hotel in Maputo, Mozambique). I perceive this as a form of theft as Mr. Harris received a compensation for the "work" but did not do much outside downloading from the internet and changing the title. His employer should keep a closer eye on his work (especially the material he portrays as his), as his ethics (lack of) reflect poorly on his department.

When I noticed this issue to the Maputo Corridor Logistics Initiative, they were quick to apologize and to remove the document. They behaved in a very professional manner. A cc of the apology was sent to Mr. Harris' email address, encouraging him to also issue an apology, especially since he his the real culprit in this matter. A few days later, Mr. Harris issued such an apology, obviously embarrassed by the turn of events. What strikes me is the vast array of reasons that were provided, including the lack of time, too much work, pressures to perform and deliver, crises, and in view of all of this he forgot to dully acknowledge sources; it was his "intention" to do so but because of some unforeseen event it did not happen. This left me with a sense of deja vu as it rimes with the reasons most students give me when I catch them plagiarizing. I think that the career of Mr. Harris could be facing bumpy times, but he has a government job so his incompetence could be well protected.

Bubbles, Manias and Bears, oh my... (01/18/2006)

Business cycles are a well understood concept commonly linked with technological innovations which often trigger a phase of investment and new opportunities in terms of market and employment. The outcome is economic expansion and as the technology matures and markets are saturated, expansion slows down. A phase of recession is then a likely possibility as a correction is required to clear the excess investment or capacity. The bottom line is that recessions are a normal condition to a market economy as they are regulating any excess, bankrupting the weakest players or those with the highest leverage. What appears peculiar in the current context is that one of the mandates behind the creation of central banks is to fight a process that occurs "naturally". The interference of central banks such as the Federal Reserve appear to be exaggerating the amplitude of bubbles and manias that fuel them. It could be argued that business cycles are being replaced by phases of booms and busts, which are still displaying a cyclic behavior, but subject to much more volatility. Although manias and bubbles have appeared many times before in history under very specific circumstances (Tulip Mania, South Sea Company, Mississippi Company, etc.), central banks appear to make matters worst by providing too much credit and being unable or unwilling to stop the process with things are getting out of control. Instead of economic stability regulated by market forces, monetary intervention creates long term instability for the sake of short term stability. Are we now condemned to live in a world where fiat money constantly shifts from one bubble to the other? This remains to be seen, but I would argue that the destructive effects of a bubble's blow off, like the current real estate bubble, could become strong enough to shake the foundations of a fractional reserve banking system, even one as large and as sophisticated as in the United States. Understanding how bubbles and their manias are created would certainly help.

Click here to download a PDF version of this figure (distribution permitted).

The different phases in a bubble are backed up by 500 years of economic history. Each time the situation is obviously different, but there are always a lot of similarities. The situation applies pretty well to the current real estate bubble, which is rapidly unfolding as these lines are written. Simplistically four phases can be identified:

1) Stealth. Those who understand the new fundamentals realize an emerging opportunity for substantial future appreciation, but at a substantial risk since their assumptions are so far unproven. So the "smart money" gets in, often quietly and cautiously. This category of investor tends to have better access to information and a higher capacity to understand it. Prices gradually increase, but often completely unnoticed by the general population. Larger and larger positions are established as the smart money start to better understand that the fundamentals are well grounded and that this asset is likely to experience significant future valuations.

2) Awareness. Many investors start to realize the momentum, bringing additional money in and pushing prices higher. There can be a short-lived sell off phase taking place as a few investors cash in their first profits (there could also be several sell off phases, each beginning at an higher level than the previous one). The smart money takes this opportunity to reinforce its existing positions. In the later stages of this phase the media starts to notice and those getting in are increasingly "unsophisticated".

3) Mania. Everyone is noticing that prices are going up and the public jumps in for this "investment opportunity of a lifetime". The expectation of future appreciation becomes a "no brainer" and a linear inference mentality sets in; future prices are a "guaranteed" extrapolation of past price appreciation, which of course goes against any conventional wisdom. This phase is however not about logic. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets to eager future bag holders. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep the appreciation - "the game" - going. The market gradually becomes more exuberant as "paper fortunes" are made and greed sets in. Everyone tries to jump in and new investors have absolutely no understanding of the market, its dynamic and fundamentals. Prices are simply bid up with all financial means possible, particularly leverage and debt. If the bubble is linked with lax sources of credit, then it will endure far longer than many observers would expect. At some point statements are made about entirely new fundamentals implying that a "permanent high plateau" has been reached to justify future price increases; the bubble is about to collapse.

4) Blow-off. A moment of epiphany (a trigger) arrives and everyone roughly at the same time realize that the situation has changed (like the Road Runner Coyote realizing he is about to fall after walking on thin air for a few seconds). Confidence and expectations encounter a paradigm shift, call it a reality check, not without a phase of denial where many try to reassure the public that this is just a temporary setback and that anyone saying otherwise does not know what he is talking about. Some are fooled, but not for long. Like a directionless herd many try to unload their assets to a greater fool, but takers are few; everyone is expecting further price declines. The house of cards collapses under its own weight and late comers (commonly the general public) are left to hold the bag while the smart money has pulled out a long time ago. Prices plummet at a rate much faster than the one that inflated the bubble. Many over-leveraged bag holders go bankrupt, triggering additional waves of sales. There is even the possibility that the valuation undershoots the long term mean, implying a significant buying opportunity. However, the general public at this point considers this sector as "the worst possible investment one can make in his life". This is the time when the smart money starts acquiring assets at bargain bottom prices.

Bubbles can be very damaging, especially for those who arrived late with the hope of getting something for nothing. Even if they are inflationary events, the outcome of a bubble's blow off is very deflationary as large quantities of capital vanish in the wave of bankruptcies they trigger. Historically, they tended to be far in-between, but over the last decade we have experienced the largest bubbles in human history back-to-back; the stock market (which deflated in 2000) and the real estate (which is likely to deflate in 2006).

The Perpetual Motion Machine (01/06/2006)

I will make a daring announcement that Allan Greenspan, as a parting gift from his chairmanship of the Federal Reserve, should be awarded the Nobel prize, not in economics, but in physics. His remarkable accomplishment is related to the invention of the world’s first perpetual motion machine which works on the following principle (see figure).

When the United States (individuals or corporations) purchase goods made in Asia, the transaction involves dollars in exchange for goods. So there are flows of capital in one direction and flows of goods in the other. In theory, this unbalanced flow should put strong downward pressures on the US dollar, making Asian exports less competitive. The accumulation of foreign reserves, mainly USD, in China provides a large capital pool that can be used for investing in additional production capacities. The outcome is the creation of jobs, badly needed for the Chinese transition to an industrial society. In addition, China realize the importance of the American market as the outlet of its export-oriented growth model, so favorable conditions must be maintained for this paradigm to continue. The huge trade imbalance with the US places pressures on the Yuan. To accommodate this pressure China, Japan and Korea (countries having substantial trade surpluses with the United States) have established the largest buyer financing scheme in human history. By buying American liabilities (mainly bonds and treasuries) the flow of capital from Asia has helped maintain the value of the USD. This in conjunction with low interest rates pushed by the Federal Reserve has helped a significant inflation of American assets, mainly real estate. Consumers, in view of the growing paper value of their asset, have been encouraged to borrow against it and the great share of this borrowed money went into consumption. Bluntly, home equity loans were taken to pay credit cards used to pay for cheap (Chinese) imports. Thus the perpetual motion machine continues.

The US attracts more than $2 billion per day, about 80% of the world’s savings. The idea of a “global savings glut” is fallacious; it is a global money printing glut taking the shape of American asset inflation which is recycled in foreign (Asian) markets and comes back as purchases of bonds, treasuries and other equities. More money (debt) has been created in the US during the past five years than in the preceding one hundred years combined. It makes me wonder who is the greater fool. The one that produces tangible goods in exchange of promises to pay or the one accumulating debt that is unlikely to be ever paid back in exchange of tangible goods. The more dollars China holds, the more the Chinese economy loses by exporting real wealth in exchange of promises to pay. The dependence of China on foreign trade has reached excessive levels with international trade accounting for 90% of its GDP in 2004. This distorts China’s economic growth as much as asset inflation distorts America’s economic growth. As an economist recently stated: “The economy in 24 words: East makes. West takes. East lends. West spends. East saves. West consumes. East creates deflation. West creates inflation. East buys gold. West sells gold.”

The US is the consumer of last resort and several strategies were undertaken to keep American consumption going, mainly through the housing ATM. The savings rate of Americans is now negative implying that the only factor that keeps the American economy growing is further borrowing. As Addison Wiggin and Bill Bonner observed in a recently published book, America has become an “Empire of Debt”. This system appears unsustainable as there is an over-accumulation of debt on one side and over-production on the other. The fact that China’s stock markets (notably Shanghai and Shenzhen) are among the worst performing in the world is an indication that despite all this growth the profit margins of most Chinese enterprises are very low (if not negative). How will this perpetual motion machine comes to a grinding halt remains to be seen, probably a conjunction of events related to a diversification of foreign holdings by China (and other Asian countries) and a decline of consumption in the US as consumers are overburdened by debt obligations. A re-equilibrium in such a system is likely to have very serious consequences in international trade and as a transport geographer I would say that we are living in interesting times.

How would Real Estate Collapse (01/02/2006)

As we begin a new year, among the many questions that come to mind the fate of the asset inflation in real estate is certainly one that warrants a lot of "interest". There are signs of change that may indicate a significant shift in this sector (in my opinion the market is screaming but not many are listening). Inventories of unsold units are rising quickly and there are indications that price appreciation is stalling and has reversed in some markets. Since it appears that we are now at the top of the bubble, what's next? Many pundits with self interests (realtors) argue that we have reached a "permanent high plateau" and that now property values will appreciate at a more "modest" range of about 5% per year. I will argue that we are going to see substantial declines in real estate prices to the level of a collapse (25% to 50% decline) in the coming years. Both economic and psychological factors are at play. The goal here is not to try to time when real estate would tank, but to discuss the causes and consequences of this mania (it is difficult to label the situation otherwise).

A core argument against significant declines in real estate values is that homeowners will not put their houses on the market as people need a place to live. If prices decline, some would simply refuse to sell and "wait it out", especially for those who bought recently and would be very reluctant to sell at a price lower than they paid for. Being down under in a mortgage (owing more than the asset is currently worth) is certainly a homeowner's worst nightmare. So, the conventional belief asserts that real estate cannot go down by a significant amount as properties are pulled out of the market until a new equilibrium is reached (less sellers for a similar quantity of buyers). Although this argument makes a lot of sense, it discounts some very basic economic rules as well as the strong speculative positions already established in the housing sector. One such rule that many forget concerns the arbitrage of price setting which is based on the margin. In a market, value is determined by the price the marginal buyer is willing to pay. So to understand the trigger of the real estate collapse, one has to look at the margin which is much bigger than one would expect. There could be 1,000 houses in a neighborhood for which homeowners have an expectation about the value of their respective properties. There is no way to know the current value of a property until is put for sale on the market. Once this transaction takes place, then the value of all comparable properties is set by this new price and everyone is adjusting their expectations accordingly. As long as prices go up everybody is happy, and when prices go up quickly, so do expectations. Banks have found a way to take advantage of these expectations through home equity loans and home equity lines of credit where a homeowner can use his/her house as an ATM.

On par with the real estate market, there are several types of buyers. However, the market has become dependant on the marginal buyer willing to enter at ever higher prices. It appears that we are running out of fools. A good deal of those new buyers are either investors who see real estate as a tool to achieve higher returns on their investments or marginal buyers that have to resort to unconventional, not to say exotic measures (e.g. interest only adjustable rate mortgages with no down payment) and extreme hardship to be able to afford a house. They are excessively vulnerable to anything but significant valuations. The recent investors (who also tend to be inexperienced and quite greedy) are particularly vulnerable since they came late in the game where seasoned investors may have already pulled out. It appears that we have reached an inflection point that will surprise more than one about the rapidity and extent of the shift.

So lets ponder about what may happen from now on. Again the exact timing remains to be seen and the situation may unfold in ways that could not have been foretold, particularly since real estate is so embedded in the economy. The most volatile buyer is the speculator (the flipper) whose game is a fast entry and exit, counting on short term appreciation to "make a killing". They tended to focus on large markets (Southern California, Florida, East Coast, Las Vegas), notably pre-construction condominiums which have seen a surge in supply in recent years. These buyers and the legions of copycats they have spawned have now overflowed almost everywhere in search of a bargain. As soon as asset inflation slows down, speculators are very likely to pull out as fast as they can. They have no choice since property for them is a speculative investment that can be held with substantial leverage as long as it is appreciating. Once price inflation stops, the game is over. Unlike stocks, housing incurs substantial recurring costs (mortgage, maintenance, taxes, utilities, insurance, etc.). The outcome would be a sudden growth of units for sale and a lengthening of the average sell time. There would however be very few takers as everyone at the same time would realize that future asset inflation will be unlikely. Why buy now when if you wait a few months (or years) to see even lower prices? We can expect a rather sudden shift in confidence if this mentality of expecting future lower prices sets in. Price decline would at start be modest and a few incentives would thrown in (appliances, furniture, TV, and why not a car) in a last ditch attempt to reel buyers in. The "what can I do to get you in this condo today?" mentality would set in as builders try to unload huge amounts of units built during the later stages of the bubble when everyone and their mother-in-law thought that "if you build it they will come". This would also place strong pressures on investors having unoccupied properties to sell as the sole factor behind the rationale of acquiring was appreciation. Investors were willing to hold non-performing assets (empty properties) as long as that the price appreciation was higher than the recurring expenses. Once this process stops (or just slows down), an additional glut of properties will be put on the market with urgency. Even if the great majority of homeowners will be sitting tight, paying their mortgage and be relatively unconcerned about this denouement, it is important to state again that market price is dictated by the marginal buyer, not by the mainstream (those not buying or selling). Someone may have bought those nice Google shares at $400, but if one morning somebody else decides to sell at $300 (or $50), then this marginal transaction becomes the new share value is spite of all what other think their shares may be worth and even if 99.9% of the shareholders are not selling.

So we have reached a point when fear starts to set in the real estate market. Prices have not went down a lot and few appears to be buying (maybe a small spike of investors who think that this is a small downturn and would like to buy the dip). Factual evidence that we are at this juncture abounds. I can give an example which is as good as many others. Nearby where I live there is a mid size condo complex built in the late 1980s of about 270 units; nothing fancy and average quality. An average 2 bedroom unit was being sold at $280K in 2003. The same unit is now about $400K, a 30% increase in about two years. 15 units are currently officially listed on MLS (multiple listing systems) which is the largest number I recall (who knows how many more are for sale through other means). An educated guess would be that about 10% of the complex is currently for sale and an annualized estimate would place this figure in the 20% ballpark; an amazing fact for a complex that is now 15 years old. Is anyone buying? Not very likely. Even investors that have bought and rented their property are vulnerable as rent often does not cover the real cost of ownership (you can rent a house worth $650K for $2,400 a month in my neighborhood; a mortgage for such a property would be about $4,000 plus hefty municipal taxes). What better proof about a real estate bubble then booming real estate prices and stable (and even declining) rents? Thus, investors would represent another group of potential mass sellers that would add to the misery of the collapse.

Another nail in the coffin, and quite a big one, concerns a class of homeowners that is in a very precarious situation, and like investors, is quite dependent on price inflation. Even if they do not want to sell, they may be forced to sell as their expectations do not materialize. A whole new class of homeowners have entered the market over the last 2-3 years at considerable risk but with breathtaking confidence (bubble mentality). They have resorted to forms of financing that were virtually unheard of a decade ago. The financing focuses on the capacity to meet temporary low monthly payment requirements; ARMs (adjustable rate mortgages) with no down payments. These homeowners/investors are expecting a miracle to occur by the time the new rate sets in (within 2 to 7 years), notably being able to cash out with a substantial profit or lock in with a new fixed low rate. This class of homeowners is likely to trigger a tsunami of foreclosures (many will simply walk away since they have no stakes in their property) and price deflation as they find themselves with negative equity and a surging monthly payment. A lot of ARMs are expected to reset in 2006 and 2007, but I expect that as real estate prices stagnate and decline, many ARM owners will not wait until the reset time, will do their math, realize they are down under and try to unload their property (or walk away) as they will see no advantages in keeping paying the "mortgage" (rent) of a property they will lose anyway. We can also think about the "equity extractors" who have counted on asset inflation to borrow to maintain a lifestyle (or to invest in real estate) which they would not have been able to afford otherwise. Many may also find themselves down under with their mortgages with debt obligations they are unable to meet in addition to see the interest rate of their home equity line of credit increase on a monthly basis.

Accounting for all the above we can expect of lot of "margin calls" that will damage the perceived equity of mainstream homeowners. One can just imagine the complex economic consequences of the popping of the real estate bubble in terms of employment, consumption and distress of the global financial system. However, in making such predictions one has to acknowledge that things may work differently. If I am wrong in my analysis, I would be curious to see which factors enabled for the situation to play out otherwise. There would be much to learn from this.

Debt (Fiat) is Slavery; Gold is Freedom (10/17/2005)

We are getting towards the last mile (or 1.6 kilometer) of an experiment that began for the United States in 1913 with the creation of the Federal Reserve. To put a complex story simple, the dollar was gradually moved away from an asset (gold) based currency to a faith (fiat) based promise to pay which is likely not to be fulfilled. The last strike was done in 1971 when the dollar was finally disconnected from any restraint except the whims, greed and fears of a cabal of individuals operating obscurely, answering to just a few. Not many realize that placing the control of a currency in the hands of governments and Central Banks, which are simply tools of the State, is a process that is the cause of much distress for the average citizen even if the promise is always "price stability". Instead of having money being subject to market forces reconciling the interests of savers and borrowers, money is created out of "thin air", by dictat (this is where I think the creationist theory applies the most), and pumped into the economy by truckloads (and soon by helicopters). Where the money ends is often difficult to predict, but the outcome is always the same; inflation. The dirty little secret in front of everyone to see is that inflation is mostly the outcome of government policies of deficit spending (you will not find this in the great majority of economics textbooks). See inflation as the ultimate stealth confiscation of your wealth; the cleptocratic government is spending the newly created money first, which then seeps through the system. By the time it gets to you, your purchasing power has been reduced accordingly at the rate of 2 to 6% per year. It is a very old trick played by governments since they existed; the Romans and the Chinese emperors resorted to inflation to finance their bread and circus policies as do the fascist and socialist regimes of today. The outcome of such a game was always the same; the currency and often the empire eventually died as people lost trust in the promise to pay and saw the emperor as he truly was; naked. The challenge is to fool the population as long as possible in the vain hope that its faith in the fiat currency will endure. So why not "massage" inflation with a few hedonistic measures and account it in such a way that consumers are assumed not to be bothered by the constraints of eating, driving or paying a huge interest only adjustable rate mortgage.

Not entirely out of thin air however money comes from because fiat can only be created by debt, so the issue is to find ways to create debt that is sound enough to be repaid. Otherwise, your house of cards collapse and you fall victim to the horror of central bankers; deflation. This is where the potentially phantasmagoric financial world clashes with the economic reality; there must be some real economic output to pay back debt plus interest. Quite a system of checks and balances, like having two 500 pounds gorillas, one named asset and the other liability, balancing on a pole supported by a needle. Actually, you would like the pole to be very long so that the two gorillas do not see one another, scare the hell out of themselves on how unrealistically big they are and lose balance. With a very long pole, you could have one gorilla weighting only one pound and the other 1,000 pounds and still be in balance; we call this a fractional reserve system. Since one's asset is another liability in a fiat system, the rate of interest is the profit that financial institutions make by lending money issued by Central Banks at the dictated core rate. Thus taking money from the Central Bank at lets say 4% and lending it at 7% is a great carry trade as you get a profit of 3% for virtually doing nothing, except of having the privilege of being an intermediary that cannot be bypassed. You should thus not be surprised to receive so many credit card offers and pleas, if you own a house, to borrow against it, or if you go to any retail outlet, an amazing array of e-z financing. Corporations, such as GM, Ford or GE are more financial institutions than manufacturers these days. Get the house / car / vacation / flat screen TV you "deserve" now; you are entitled to it so they say. We are being flooded with liquidity and we live in an era of hyperinflation; the Greenspan Economy where the fruits of labor are virtually stolen. It is truly unbelievable that most people do not even realize it. We have asset bubbles all over (as the 1929 crash was, an outcome of the Federal Reserve monetary policies) and now the largest asset inflation in human history; the real estate bubble. Words and paradigms are invented to explain them, to hide their true source. Technology is a new paradigms justifying such high and "permanent" valuations (even if they have no assets or profits); you cannot lose investing in real estate.

Is there a way out of this spiral of devaluation and our constant strife to pull ourselves out of it? For most families, both spouses need to work to keep the balance sheet afloat. It is a sad realization that as long as money will be solely controlled by governments, the population will be held hostage to the fiscal (ir)responsibility of those who in theory should be protecting the fruits of our labors and savings. Even in a democratic society, the government cannot be trusted for such an honor system, even the best intentioned ones; they all eventually succumb to the temptation of spending more than they earn by using inflation to hide their Ponzi schemes. Democratic regimes may even be more vulnerable as the time span of elected officials is quite short, so decisions that can be seen damageable on the long term but perceived as beneficial (buying votes, approval, photo ops and names in concrete) on the short run will be made. It is however fascist regimes that have relied on fiat the most as democracy implies a level of accountability. A fiat currency system eventually creates a social dependency on debt which is a form of slavery. People become dependant on fiat generated handouts; the welfare state. The economy gradually hooks itself to government fiat-fed contracts allocated to the well connected first, which leads to misallocations of resources and even more government control like communism did not taught us an economic lesson on the horrors of central planning. The consumer, being fooled by asset inflation (especially in real estate), feels paper-wealthy and stop saving and contracts debt obligations that will likely take decades of lowered standards of living to pay back. The asset may deflate, but the debt remains the same (plus interest); you can be sure that this obligation will be well protected by law. Our monetary system thus needs an anchor more solid than the promise of governments and their central banks and far less corruptible and / or fallible. This anchor has always been there since the beginning of our monetary history.

Gold cannot be created out of thin air (only mined at great effort), cannot be faked, has no political ambitions; it does not care who owns it and for what purpose it is used for. It forces an efficient allocation of resources and accountability, because otherwise its owner gradually or suddenly loses his wealth. It is a store of value that is geographically and temporarily transmissible (try to use Yens to shop in Manhattan or try to spend some Confederate money in Atlanta). So, what one can do in the current situation? Fiat and its support structure are well established and will not go away. As the maxims say, you cannot fight the Fed and markets will remain illogical for longer than you can remain solvent. However, you can move away from fiat by getting rid of large quantities of it before its value whimpers away. The devaluation game will go on until its end, an unavoidable financial crisis that will not be inflated away which will mark the moment where fiat money will reach its intrinsic value; zero. It would be a good idea to own some gold (and silver); it is your ticket to freedom. It is an insurance against the short-sightedness of our ruling aristocracy, even those with the best of intentions (or at least full of promises for a better world for all of us if only they could have more power and money). Debt is the enemy of freedom.

Real Estate is Not an Industry (05/25/2005)

The recent years have been interesting times for the housing market to say the least. Living near the Hudson within a stone throwing distance of Manhattan I have been in the front row of a raging insanity I am convinced will be remembered with contempt in two decades. In view of the fast growth of real estate values in many markets around the United States with also a global contagion (UK, Australia, Canada, et al.), there have been fallacious statements made by kingpins of this sector that real estate is one of the pillars driving the economy and should thus be considered an industry. The mogul Donald Trump (I think he will go down in history, but not the way he expected) was even recently lauding at a Los Angeles real estate fair that real estate was dwarfing industries such as the automobile. After all, half the employment created in hot markets such California in the last few years is directly or indirectly related to real estate. Welcome to the era of asset inflation where everyone is getting rich simply by being a homeowner and seeing their equity inflate to infinity and beyond; the Buzz Lightyeartm economy. Few realize that the snake is feeding on its own tail. This dangerous perspective perpetuates and expands a speculative popular belief that rising home prices generates wealth for homeowners and thus for the economy. Shall we see flippers and speculators as venture capitalists and captains of industry? It would be like stating that a marine ecosystem is based on sharks instead of phytoplankton. Although each component has a role to play in an ecosystem, including the useful role of sharks as predators feeding on the excesses of others, the order of nature should not be reversed to understand what the real bottom line is. If sharks were getting bigger and more numerous while the ecological base remained the same, the only possible outcome is an ecological collapse through an unsustainable misallocation of resources. Hungry sharks would wreak havoc down the food chain until there is little left to eat. It would be then the sharks’ turn to face oblivion. A similar process is taking place in real estate as the top of the economic food chain – wealth diversion – inflates while the base – wealth creation – gets depleted. Thus, continuing asset inflation in real estate does not create wealth, but actually destroys it, partially by fixing greater quantities of capital in a non-productive asset which is then inflated when the next marginal buyer comes about (mix, flip, and repeat). The more asset inflation goes on, the more wealth will be destroyed when reality check knocks on the door as stretched homeowners realize that they have little if any equity and a jumbo liability. The main reasons of such an assertion are quite straightforward:

1) Real estate is a non-basic sector, not a driving force of the economy. Many theories of regional development divide a regional economy in basic (export creating or wealth creating) and non-basic (derived or wealth diversion) sectors. Real estate, like retail, is thus derived from the wealth generated from the basic sectors of the economy. It would be an healthy sign to see real estate values appreciate when a regional economy goes well as hard earned profits are accumulated in a stable asset and as homeowners transpose a part their growing wealth in the quality of their homes (renovations, furniture, landscaping, etc.). However, it is a sign of decadence and misallocation when real estate assets inflates in a situation where wages remain unchanged.

2) Real estate has little marginal utility. The economic function of a house is to provide shelter. Rent is thus the price someone is willing to pay to satisfy this basic need at a specific location. It becomes an allocated portion of an income. Housing size tends to be a direct function of a family size. Once basic requirements such as protecting against outside weather conditions and amenities such as running water, electricity and sewage are provided, the utility of housing is satisfied. Any additional assets, such as more rooms and marble countertops, are conveniences (or social status statements) that do not add to the utility of a house. The productivity of an individual remains the same even if the size of the house he inhabits quadruples and is equipped with all the conceivable amenities. Thus, any inflation to the value of existing real estate assets does not add to the productivity of an economy, but contributes to the misallocation of wealth towards real estate.

3) Real estate involves a transfer, not a creation of wealth. Each transaction involves a transfer of wealth from one individual (the purchaser) to another (the owner). A growth in sale prices thus involves a greater transfer of wealth that must either come from additional savings and/or additional debt. This money, which is now fixed in an asset, cannot be used for current savings, investment or consumption and also comes at the expense of future consumption. If debt is used to finance a housing purchase, then future consumption is even more reduced and can only be redeemed by additional debt.

4) Real estate is not a form of savings, but the amortization of a liability. The equity in a house can be extracted when it is sold (pending market conditions which could be radically different from the time when the house was purchased) or through debt using equity as collateral (aka home equity loans). So, the buildup of real estate equity is done at the price of capital plus interest, implying that this equity comes at a price superior than its initial purchase price if debt is contracted (which is most of time these days). Even if the equity of that real estate appreciates, it can only be extracted using debt as an instrument.

At this point the only possible outcome of the housing bubble is additional disruptions and misallocations of capital, a guaranteed source of future economic hardship as paper wealth gets destroyed, especially if it has been used for debt collateral. Thus, real estate is not an industry; it does not create wealth, it siphons it away. Here are some contrarian strategies for such a context:

1) Rent instead of paying a mortgage (plus taxes, maintenance, insurance, utilities and the infinite number of related expenses) and save a lot of money (thousands of dollars per year can be saved compared with ownership of a similar unit; especially in hot markets).

2) Consume as little as possible and put yourself in a saving and/or debt repudiation mode. If you have the cash reserves and the discipline, you can play the 0% interest credit card game to your advantage. Build a cash reserve as much as you can.

3) Stay clear of stocks and bonds, especially those related to housing. Treasuries and money market have lame returns but will not likely lose their value on the medium term. You may consider gold mines, commodities and energy stocks, but be prepared to handle volatility.

4) Buy some gold, in bullion and electronic form (e.g. Goldmoney) as well as some foreign currencies. The only direction the fiat US dollar will take is depreciation (as it did for the last 90 years), both nationally and in regard to other currencies. You have to protect yourself against the systematic debasement of money by the Federal Reserve and the Federal Government as well as the confiscation of your savings through inflation.

5) When the real estate market starts to be distressed (I wish I knew when), wait 6 months to a year to see it become very distressed, if not in a panic mode. Once deflation is firmly established, come in guns blazing with cash and ruthlessly negotiate a lower price by praying on a desperate speculator or a foreclosure; take your time, you will have a lot of choices. Secure, if you have to, a 30 year mortgage even if interest rates are higher (7 to 9% range in all likelihood), and see the Fed in the following years initiate a wave of hyperinflation by printing money like there is no tomorrow. Have the pleasure to pay back your fixed mortgage in depreciating dollars and see the value of your housing asset follow whatever level of (hyper)inflation.

Dr. Jean-Paul Rodrigue

Dr. Rodrigue's research interests mainly cover the fields of transportation and economics as they relate to logistics and global freight distribution. Specific topics over which he has published extensively cover maritime transport systems and logistics, global supply chains, gateways and transport corridors. Current projects involve:

  • The Governance of Intermodal Transportation Assets
  • Geography of Logistics and Global Production Networks
  • Gateways, Corridors and Inland Freight Distribution
  • Globalization and Transport Terminals
  • City Logistics
  • Cruise Shipping