From the March 2005 Idaho Observer:
U.S. Flow of Funds Data signal imminent $ crisis
There is little question among those of us who have been monitoring world world events that, both domestically and globally, things are beginning to happen very fast. The number of outrages, catastrophies and tragedies we must endure as compassionate and caring people are piling up, one on top of another, so quickly now that it’s becoming difficult for activists to maintain an effective list of priorities. Do we coordinate relief efforts for tsunami victims or try to prevent police brutality here at home? Do we spend all of our time trying to alert our countrymen to the New World Order agenda or show our neighbors how corrupt local officials are destroying their community? When it comes to global finance, it is true that there is not much we can do except be intelligent consumers, minimize our personal indebtedness, teach people about the money system and use Federal Reserve Accounting Unit Dollars (FRAUDs) as little as possible in our purchases of goods and services.
With that said, the following story describes issues quite beyond our control. It is developing fast as global political and economic indicators are foreshadowing a dollar crash of unprecedented proportions. The purpose of this page is not to frighten, but to give our readers advance warning that a storm is coming. Of course, the weatherman can be wrong, but it makes good sense to do what we can to prepare for a predicted storm, ride it out if it comes—and pray for sunnier skies.
by William Engdahl
On March 10, 2005, the Federal Reserve released its quarterly "Flow of Funds Data series, Z1," for the U.S. economy. The data confirm why bond markets reacted with such alarm when Japan’s Prime Minister Koizumi hinted earlier in March that his nation’s Ministry of Finance might seek assets other than dollars and diversify Japan’s current estimated 850 billion in U.S. dollar reserves.
The large Asian economies seem to be attempting to pressure Washington on its deficits by gently hinting they might diversify reserves (a nice way of saying "sell off some U.S. dollars").
The quarterly Z1 report revealed that, in the period through December 31, 2004, foreigners absorbed a shocking 102 percent of all U.S. Treasury debt issued. That means U.S. funds were net sellers. Foreigners also bought 87 percent all U.S. government-sponsored enterprises (GSE) debt—Fannie Mae, Freddie Mac etc.—and 47 percent of all U.S. corporate bonds issued. By comparison, in 1994 foreigners held only 18 percent of U.S. Treasury debt.
The same time the Fed increased its own holdings of Treasuries by $51 billion. This combination of foreign and Fed buying was what sustained the real estate bubble in particular, the U.S. economy in general and maintained low interest rate levels in the face of otherwise strong selling pressure.
Who owns U.S.?
According to the Fed data series, foreign investors, public and private now hold an impressive $9.29 trillion of U.S. financial assets, of which $2.67 trillion is U.S. government securities and $1.8 trillion U.S. corporate bonds.
Interesting figure to note, total net U.S. liabilities to foreigners, according to the Z1 data, rose to a net indebtedness of $5.17 trillion. Two years ago it was some $3 trillion. Since 1995, the dollar rise in value has been directly tied to foreign willingness to hold dollar liabilities in the form of bonds.
Now, factor in the near-record January U.S. trade deficit of $58 billion (over $700 billion annualized) and a deficit increase of $2.5 billion in December, combined with the rising NYMEX crude price hovering at $54 a barrel for near futures. The situation is beginning to create an extreme degree of global financial instability not seen since 2000-1.
Americans’ private debt
Z1 data also reveals that U.S. Household Liabilities rose by 13 percent in the fourth quarter (Q4) of 2004 to $10.7 trillion, though assets rose even more, to $59 trillion, driven by housing price inflation. U.S. home real estate assets are up 24 percent in two years and 92 percent last seven years. In 2004, real estate rose alone by a record $2.12 trillion to a record total $18.7 trillion.
Total credit market debt in the U.S. is now $36.9 trillion—double the rate of debt growth of the 1990s—and a level now of 315 percent of gross domestic production (GDP). In 2000 it was 275 percent of GDP.
U.S. household debt grew last year to a record 11 percent, or $1 trillion. Home mortgage debt grew a record 11.2 percent for Q4 alone. The last three years mortgage debt has grown in the U.S. by more than $1 trillion a year. Mortgage debt annually rose by an average $270 billion in the 1990s by comparison.
Real estate dangers in U.S.
We have known for some time that Fed policies deliberately boosted U.S. consumption levels since the dot.com crash in 2001. The politically-motivated Chinese and Japanese buying of U.S. Treasury debt in the past three years has been the key factor keeping the U.S. economy from experiencing a debt "implosion" which would rock global markets. In the 15 months ending March 31, 2004, the Bank of Japan bought $320 billion of U.S. treasuries and GSE paper to stabilize the yen/dollar.
Now we see the earliest hints that the unprecedented real estate inflation in the U.S. might have turned. In January, 2005, according to the Mortgage Bankers Association, median home prices fell by 13 percent—the largest one-month fall on record. Data for February will be most important to indicate whether this is a true market turn. If so, buckle your seatbelts, the financial system is in for a bumpy ride.
In the period since the Enron and dot.com collapse in 2001, millions of Americans have turned to investing in a second home as an alternative to the stock market for their savings, according to the National Association of Realtors.
In 2004, second home purchases were up 20 percent over 2003. Given loose bank credit conditions for granting home loans, this is a development which has even triggered recent Fed concern. Banks argue their risk is now minimal as they simply bundle and sell the mortgages on to Fannie Mae or Freddie Mac, semi-government enterprises.
On March 2, the mortgage regulator, Office of Federal Housing Enterprise Oversight (OFHEO), issued its quarterly House Price Index report in which it is reported that home price rises slowed from annual 11.1 percent rate in 2004 to 6.8 percent in Q4. This suggests, as OFHEO states, a "leak in the housing bubble."
Interesting to note is that the official government agency with oversight on Fannie Mae and Freddie Mac admits openly to a housing bubble even as Federal Reserve Chairman Alan Greenspan continues to deny that such a bubble exists.
More, new home sales were down sharply in January with home inventory up 17 percent—the highest level since 1996, when the U.S. home market was just recovering from a severe downturn of the early 1990s.
Many homes are being sold on an interest-only loan basis where ownership begins only after 15 years, something being pushed by Fannie Mae to push home buying into the lowest income layers. This tactic is not intended to expand home "ownership" as official rhetoric claims, but to keep the bubble growing a bit longer.
Typical of any bubble, home quality sinks as prices rise with people desperately jumping on the price-rise bandwagon of the past two years.
Now, if we see interest rates continue to rise; if foreign central banks even moderately reduce their rates of U.S. Treasury note purchases for reserves, during a time when the stock market and U.S. bonds are not attractive to foreign investors, the prospect is that, suddenly, millions of ordinary Americans who had bet their bankbooks and futures on the endless rise of home prices, will suddenly face a market with sharply falling home values, high mortgage payments and illiquid assets on their hands in the form of a second home which no one is willing to buy at pre-burst-bubble prices.
Homes bought with a $600,000 mortgage will then come on the market at $450,000 or lower. When that happens, the entire debt pyramid faces collapse. Adding to the looming problem is that, in the past two years, some 30 percent of all new home mortgages have been adjustable rate mortgages, so these buyers face grueling rises in monthly payments amid a falling market.
An orderly return to sustainable economics
Chances of an orderly global financial rebalancing rest on three elements: 1) A significant fiscal adjustment in the U.S. that requires—at the very least—a reversal of unsustainable tax cuts (as spending controls will not be sufficient), and giving up a budget-busting plan to privatize Social Security; 2) a revaluation of the Chinese and other Asian currencies and; 3) policies leading to higher growth in Europe and Japan.
The problem is that there are no plans to implement any of the three adjustments indicated. To the contrary, the Bush administration is proposing yet more tax cuts and the privatization of Social Security—both of which, while sounding good in the headlines, effectively clash with the need for meaningful fiscal deficit reduction. Low U.S. private and public savings and the lack of currency adjustment in large parts of Asia are increasing the likelihood that a hard-landing outcome is inevitable.
An economic crash landing
Brad Setser and Nouriel Roubini at New York University’s Stern School of Business suggest in 2005, or latest 2006, the unsustainable buildup of U.S. deficits and debt dynamics, plus dollar vulnerability, will trigger a hard-landing scenario in the U.S. and world.
Given the unprecedented order of magnitude of U.S. cumulative deficits and the size of the mortgage bubble, I would suggest the relevant comparison is not a "global recession" as Setster and Roubini suggest, but a process more akin to that of the 1930s deflation commonly referred to as "The Great Depression."
At this point, even if the Fed were to print billions of U.S. dollars and drop them from helicopters to stimulate inflation-driven demand, there would remain the tiny detail: Which foreign central banks would remain willing to accept such worthless U.S. paper?
Fingering the dike
There is belief in the market that U.S. pension policy has been leading to heavy buying at the long end, as large corporations seek to cover unfunded pension liabilities.
Asian central banks, until recently, have more than done their share to help the Fed keep rates abnormally low. There is also a shortage of high-quality, long-dated paper world-wide, which gives insurance companies with long-term liabilities a problem (the UK is the third largest holder of U.S. Treasuries). Combine this with the conviction in bond markets that Greenspan will not raise rates beyond neutral because he wants to reduce liquidity but not tip the economy over the edge—a tremendous feat if he can pull it off.
A study of tightening cycles in the U.S. shows all recent Fed tightenings have ended with a major financial institutional or economic collapses—the savings & loan debacle of the 90s and the Asian economic collapse of 1998, for example.
As well, every major postwar U.S. recession has come with sharply rising oil prices.
The U.S. bond market’s yield curve is not really representative of inflation expectations, especially given recent increases in oil and gasoline prices. Rather it reflects the visible hand of governments manipulating market conditions: 1) Record levels of currency intervention have been ongoing in Asia since the 1998 crash; 2) the decision by the Organization of Petroleum Exporting Counties (OPEC) to increase the cost of oil to $55 a barrel oil and; 3) a determined effort by U.S. firms to reduce under-funded pension liabilities.
These activities suggest that recent comment by Greenspan regarding "surprisingly subdued inflation expectation as reflected in bonds" is so much self-serving rhetoric.
U.S. market rates are probably more distorted today than at anytime in history. The accumulation of dollar reserves by foreign governments/central banks is unprecedented.
The times are changing
On Thursday, March 10, 2005, the U.S. 10-year Treasury plunged and market traders suggest it was due to lack of sufficient buying by Asian central banks.
Whether true or not, it shattered the trend recently to short the short end and long the long end. This, combined with the U.S. real estate price data, could signal a major phase change is imminent in global credit markets in terms of risk pricing.
Now we need to factor in the return of NYMEX oil prices to a range of $50-55 a barrel. While some of this is clearly speculative as prices traditionally rise in the runup to spring driving demand season in the U.S., it is a major tax on U.S. economic growth. Gasoline at the pump has risen by 25 cents in the last two weeks as a delayed effect of the wholesale price rise. This price pressure is not about to abate, rather the opposite is likely true given the increasing oil import needs of China and India. If we add to the equation growing reports from credible Washington circles close to the Pentagon and of respected journalists such as Sy Hersh that a U.S. military strike on Iran will come by June at the latest, we have reason to expect oil prices could explode, given the disastrous events in Iraq to date.
Hints of slowdown in foreign willingness to continue subsidizing dollar deficits, pressures pushing oil further up, and signs of reversal of trend in the U.S. home market bubble, all combined, present a picture of extreme economic fragility.
How can the Maestro at the Fed orchestrate a soft landing now, with U.S. Fed funds still at historic low levels and foreign appetite for U.S. debt clearly at a low? Two weeks ago, Senate Republican Majority Leader Bill Frist announced Bush’s Social Security privatization plan "would not come for a vote this year" as too many members of Congress are opposed to the plan, which is not very well though out at this time. Bush personally intervened with Frist and a day later Frist announced it would, in fact, be voted on later this year afterall. The added deficits that it will cause, in trillions of dollars, will not improve the causes of investor alarm over the U.S. deficit and glut of Treasury notes coming on to markets.
No one can answer when and how fast this will hit, and clearly the Fed is fully aware of the points of concern indicated in this report.
That something is imminent, however, is increasingly clear. Who is the buyer of last resort, willing to purchase U.S. debt in the form of Treasury bonds when the central banks of Asia are no longer willing?
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