Thursday, January 10, 2008

Old-Fashioned Saving Versus Asset Accumulation

10 January 2008

Stephen Roach used to write Morgan Stanley’s headline weekly investment column. However, Mr. Roach persisted in stating that the US was sprouting a series of asset and credit bubbles, and he was “promoted” to head the company’s Asia division – and “disappeared” (that’s a transitive verb) from the Morgan Stanley Global Economic Forum webpage as a perhaps all-too-convenient consequence. (I used to read this page weekly for Mr. Roach's column. I haven't been back since he left.)

All too inconveniently, however, Mr. Roach persists in writing the truth. The Financial Times, who have recently
declared gold the “new” global currency, have also agreed to publish Mr. Roach’s current opinions in a timely article.

Unfortunately for his employer, who, like the other Wall Street investment banks (apart from Goldman Sachs), has recently written down billions of dollars (in this case,
$9.4 billion in the last quarter of 2007 alone) in ill-considered subprime investment products, Mr. Roach speaks the words that give the lie to Morgan Stanley’s participation in the current international debt and asset bubbles.

Most troubling, Mr. Roach makes his case simply – in fact, too simply for the likes of his investment banking colleagues at Morgan Stanley.

Here is the very uncomplicated story, which basically explains all you need to know about global investing in the next ten fairly brief paragraphs.

1. In the “old days,” people saved by spending less than they took home in income. This is a very simple concept, which we shall refer to as “old-fashioned saving.”

2. In the present “new days,” American citizens have simply stopped saving. They now spend more than they take home, year in and year out. This is particularly anomalous when one considers the preponderance of baby boomers in the American demographic melange, who obviously should now be saving vigorously for their collective retirements.

3. What explains this bizarre behaviour?

4. It is actually very simple. Due to excess money supply generation (excess liquidity) and artificially low interest rates, it has become possible to grow assets by borrowing money at low interest rates and investing it in assets – stocks and real estate – which are growing in nominal value at a more rapid rate (reflecting out-of-control money supply growth, or “old-fashioned” money printing).

5. Thus, the more money that Americans can borrow at low rates, the more assets they can buy, which appreciate in value at higher rates than the interest payments on their ever-mounting debts. Thus, those who borrow $1 million make ten times as much on their asset investments as those who borrow only $100,000.

6. Again, this is because the value of the assets has been increasing more rapidly than the amount of the debts that were incurred to purchase the assets.

7. Therefore, there has been a veritable competition – a “horse race” if you will – to determine who can borrow and leverage the most, so as to buy into the most sizable asset gains. Paradoxically, those who are deepest in debt grow richest in the asset appreciation sweepstakes. And perhaps frighteningly, there may be more well-to-do individuals engaged in this very dangerous venture than has yet been realized or disclosed. Time will tell how many players, and at what levels of income, have been playing this high-stakes, high-risk game.


8. What a great system – known as old-fashioned “leverage” – until it doesn't work anymore. It stops working when asset prices for such investment vehicles as stocks and homes (including second and third homes, “spec" homes, etc.) stop increasing. Unfortunately, the time when the game doesn't work anymore – when asset prices stop increasing – has turned out to be now.

9. Why does the asset appreciation game stop working, and why now?

10. For the same reason that bubbles and Ponzi schemes everywhere have always failed. Eventually, there are far too many assets and no buyers left to purchase them with ever more borrowed money, the flow of which cannot continue infinitely without depreciating the value of money itself. The naïve and entirely unqualified subprime borrowers were the last ditch players, and their minimal assets, including their ability to borrow, have now been thoroughly exhausted. In future steps, the exhaustion will work its way upwards to the middle classes, and ultimately, even to the very rich.

The statistics cited by Mr. Roach are very frightening. Here are a few….

“America's massive current account deficit absorbs about 75 per cent of the world's surplus saving. (This deficit has been generated to fund the borrowing that has driven the US asset bubbles in equities and real estate.)

“Private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.

“None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices (a decline in the dollar will not accomplish this) is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.

“It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America's asset and credit bubbles is all about.”

Let me tell you, if Morgan Stanley had listened to Mr. Roach, who used to be their so-called chief investment officer, they wouldn't have lost $9.4 billion in low-quality subprime "investments" in the 4th quarter of 2007.

Mr. Roach remains a voice crying in the wilderness within his own organization.

Mr. Roach's message has been too inconvenient for his employer, so rather than listen to their erstwhile star analyst, and his increasingly prickly pronouncements, Morgan Stanley silenced him by “promoting” him to a less troublesome position in the Asian hinterland. More’s the pity for Morgan Stanley, who, if they had followed Mr. Roach's sage advice many years ago, might well have been the most successful investment bank on Wall Street this year.

Unfortunately for Morgan Stanley, they refused to listen to Mr. Roach's wise words, and joined their fellow lemmings in jumping off the subprime cliff. (Only the folks at Goldman Sachs were smart enough to bail out of the subprime game before it tanked.)

So, in brief, what happens now?

Well, the US dollar isn't going to do well. As US assets decline in value, international investors will grow less interested in owning them. So the US economy will surely slow. That is a given.

As international investment in the US recedes, that will cause the funds available for continued borrowing in the US to decline. So debt-laden American investors will now have to unload their depreciating assets to stanch their losses and revert to a very old-fashioned behaviour – spending less than they earn.

After all these years, Americans will become savers again. This will bode well for the long-term future, but there will be an interim period of economic pain, possibly for many years to come.

This fundamental shift in American consumer behaviour will drive a “sea change” in the American economy, as rising consumer spending will no longer propel the economy ever upwards.

The interesting question will then be to determine if Asian savers shift their behaviour to become consumers of goods and services, rather than of devaluing US assets.


In short, with the inevitable decline of the American consumer, the critical question will be to determine if new consumers do or do not emerge, primarily in Asia. (Europeans, Canadians and Latin Americans do not have enough savings to compensate for the expected American reversion to saving.)

If Asian savers convert their behaviour to consumerism, their purchases of goods and services might keep the global economy moving forward at a fairly strong clip.

The critical point is that Asians can afford to consume much more than they do now while still spending less than they earn, as they remain “old fashioned savers.” But they will assume this new role as drivers of the global economy only if they choose to do so on a collective basis.

However, if Asian savers respond with fear and continued conservatism in the face of a substantial decline in the nominal (currency) value of US assets and an associated diminution in American international purchasing power, then an international retrenchment in consumer spending could provoke a severe global recession, or even a period of economic depression.

Here is the interesting part – it is really a question almost exclusively of human psychology and associated behavioural functioning.

That is, Asian savers probably have enough funds set aside to keep a consumer-led global economic boom surging for years to come. But the choice of saving or spending is strictly personal and psychological. If Asian savers do not increase their spending, they will join their American counterparts in riding the downside of the debt and asset bubbles of the last 2 to 3 decades.

I don't think anyone can forecast accurately what will happen, though those with a firm grasp of Asian psychology will certainly have a predictive edge.

In the end, all will depend on the cumulative decisions of perhaps 3 billion Asian savers. It will be a matter of mass psychology, Asian style.

Perhaps Mr. Roach was assigned to the correct location by his employer after all.

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