The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (42 page)

There are more engineers in the city of Bangalore, in India, than there are in the state of California. They work well and cheaply, taking home an average annual pay of about $6,000. And they seem to be just as innovative as their American counterparts. The software for DVDs was developed in Bangalore, not in SiliconValley, says the French newspaper,
Libération.
In the seven short years of its existence in Bangalore, the Philips research center alone has come up with 1,500 new inventions.

Foreign workers have been cutting into American salaries for many years. Assembly line workers in Taiwan, Mexico, and other places have undermined factory wage growth in the United States. Over the past 30 years, real hourly earnings on the shop floor have gone nowhere. No one particularly cared—because America’s economy was shifting to service and consumption anyway. Factory workers were out of fashion and out of luck. But now it is the accountants, architects, and paper shufflers whose jobs are threatened. Even lawyers are worried; law firms are outsourcing routine legal work to India.

These trends might not have worried Democrat economists any more than they troubled the Republicans, but 2004 was an election year, so they couldn’t pass up an opportunity to get their names in the paper. Pandering to the lumpen masses, the Democrats offered to “do something” to “protect American jobs.”

A lot of dopey things are said to voters with the cameras running. But no one is going to look the American worker in the face and tell him that he earns too much money for what he does.A politician might as well pour gasoline over his head and light a match; the media would scorch him in a matter of minutes; his career in politics would be in cinders.

Every empire begins with a humbug. Later it develops into mass illusion, self-congratulation, hallucination, farce, and finally disaster. Until the disaster comes, you never know quite where you are. Because for every imbecility that comes along, there are dozens of eager intellectuals ready to promote it and at least half the population is ready to believe it.

So it was that almost every day, we saw a piece in the
Wall Street Journal
explaining that trade deficits were no trouble. And at a certain level, they were no trouble at all. It does not matter to God who owes what to whom. Or even if it does, he keeps quiet about it.

Some kibitzers pointed out that the United States ran trade deficits for much of its early history and that fast-growing countries always have current account deficits. After all, they are building something for the future—factories, plants, machines—that takes capital. Then, when the factories are built, they produce earnings and profits, which are used to pay back the debt. In this instance, the debtor comes out ahead.

Oh, the reverie of it! But when did you last see a factory, refinery, or mine under construction in America? The last one we recall was a shiny new brewery outside Baltimore—and that must have been 40 years ago. Since then, it has gone out of business.

Many economists believed we no longer needed factories.They thought the information revolution had many more good things to give us.We’re not aware of any benefits,yet, from the information revolution, but we’re prepared to believe there might eventually be some. But information is notoriously light on its feet. More and more U.S. tax forms—which are nothing more than information—are being processed in India. And American companies are actually outsourcing more and more of the “information” component of modern products.They no longer go to Taiwan and ask the locals to “make this.” Now, they go to Taiwan to see what the locals are making that they can sell back home. More and more, U.S. companies don’t even participate at the design stage.

“What we are seeing,” wrote Paul Craig Roberts, is the “rapid transformation of America into a 3rd world economy.”
⁵
American firms are increasingly left with only brands to market. But even those won’t last forever, after customers realize that the real innovation, design, and manufacture genius is overseas. Just as car buyers took up new brands as quality increased in Japan, so will they soon take up new brands in other industries. Soon, Americans will not only want to spend on foreign-made goods, they will have to.

The cycle is typical of empires in their mature stages. Even in decline, people still look to the homeland for fashion cues. Music, education, theater, dress, architecture, and manners are exported from the center to the periphery long after commerce in more practical goods has reversed direction. Even today,Vienna remains a regional cultural center—as do Paris and Rome. Parents from former colonies still dream of sending their children to Cambridge and Oxford.

Meanwhile, the Newman brothers, Dan and Frank, also in the
Wall Street Journal,
pointed out that the outflow of dollars was no cause for concern, because the dollars just came back to us. But they didn’t come back as the same good-natured working stiffs they were when they left. Instead they came back from abroad in finer clothes, with finer manners, and with a better accent. They came back as rentiers. They went out as a credit and came back as a liability. The next thing we knew, they were putting their feet on the furniture and acting as if they owned the place. Instead of helping the average man earn a living, they made it harder for him. Interest must be paid on debt or compounded into more debt. Either way, day by day, the burden just grew heavier.

We know from experience that our moods can change for no apparent reason. One day, we are happier than usual.The next, on exactly the same set of “facts,” we are gloomy. One day, we are prepared to start a war. The next, trouble is the last thing we want. One day we think $20 is a fair price to pay for $1 of earnings.The next, even $10 seems too much. One day, we see the facts, and they are awful.The next, the very same facts don’t seem so bad.

These moods happen to individuals on a day-to-day basis and to whole groups of people over long periods. One generation is bullish. The next is bearish. One generation wants war. The next wants peace. One generation is lost.The next is found.

As prices fall, our opinions fall too; we become gloomy. But sometimes, the opposite happens; opinions make markets. Gloominess sets in, for no particular or apparent reason, and then prices fall. Moods and facts, sometimes in harmony, but often in opposition, struggle to dominate our generation’s zeitgeist.

Until 2007, both were in harmony. The public’s mood was ridiculous. But so were the “facts.” Never before had people been expected to believe so many impossible things. But, perhaps, never before had so many impossible things seemed true.

There’s something funny going on over there at the bank.

—Jimmy Stewart
It’s a Wonderful Life

13

Welcome to Squanderville

The citizens of Squanderville, as Warren Buffett called the United States, were a happy bunch. They believed happy things; it didn’t bother them that the things they believed were impossible.

After 20 years of mostly falling interest rates, mostly falling inflation rates, and mostly rising asset prices (stocks and real estate), people had come to believe that this is the way the world works: Interest rates mostly go down, and house prices mostly go up; it goes on forever.

Even the professionals in Squanderville had never been more certain: A 2005 poll of economists working for major brokerage houses found that 100 percent of them expected rising stock prices over the next 12 months. And real estate? Who believed house prices would fall? Almost no one.

While it is all very well to think happy thoughts and spend happy money, it is savings and investments that produce real jobs and real earnings.

As the years go by, Squandervillians make less and less that they can sell abroad, and consume more and more from overseas. So, when they spend money, much of it goes to buy products from Thriftville. (Buffett’s term, perhaps he had Asia in mind.) The industrious people of Thriftville used the money to hire more workers, build more factories, import more technology, and improve their products. Thus, did the authorities in Squanderville find themselves in a remarkable position:They could still use monetary and fiscal policy to create a boom, but the boom happened in Thriftville!

The happy residents of Squanderville hardly knew or cared. The latest job numbers were celebrated; who bothered to notice that the new jobs were not quite as nice as the old ones? While companies laid off relatively highly paid people in the manufacturing sector, other companies hired relatively more cheap employees in the service sector. General Motors declined; Wal-Mart grew.

What would happen if real estate prices actually started to go down? Soon, the homeowners of Squanderville and their lenders might be faced with a brief interval of horrible sanity. They might be unhappy.

As the year 2005 matured, the corpus of the world financial system became even more grotesque than it had been the day before. Connecting the thigh bone of bond yields . . . to the hip bone of Asian purchases of U.S. bonds . . . to the vertebra of credit expansion . . . we stood back in awe and wondered : What kind of monster was this? It looked like a creation of Frankenstein.

Whatever it was, this was no ordinary economy—it had a hunchback and two club feet. Jobs that ought to exist didn’t. Income that should be helping consumers to spend wasn’t there. Savings that were vitally important to economic growth had disappeared.

The best way to understand America’s economic predicament is to look at it as a system of imperial finance.The United States is an odd and reluctant empire. Its body parts fit together, but only in an absurd and comic way; it’s the imperial backbone that gives it shape.

Only an empire can run such a trade deficit for many years. Only an empire can maintain so many expensive outposts all over the world. Only an empire’s money will be accepted by so many people in so many different places. The American empire, circa 2005, still set the trends in fashion, arts, style, and manners—but it neglected engineering, science, and homeland-bound industries. It depended on the periphery states for its savings and its consumer goods.As an empire matures, its center weakens and its backbone bends under the weight. Eventually it either passes off its imperial burden to a friendly power to which it becomes beholden—as England did to America between 1917 and 1950—or its back breaks.

After investors have lost a lot of money in one bubble, they practically can’t wait until the next one comes along. In the 1960s boom, anything with “onics” in the title sold for far more than it was worth. If you added “onics” to your company name, you were almost sure to be a rich man the next day.

In the boom of the 1990s, the magic syllables were “dot-com.” Remember Dr. Koop.com? Furniture.com? Webvan? So many examples come to mind. It is like trying to select the dumbest member of Congress; we don’t know where to start. The dot-coms were so popular with investors—and mining companies so unpopular—that at least one firm that supposedly had been mining gold switched to supposedly becoming a dot-com to take advantage of it.

Near the end of the tech bubble, an e-trading firm ran an arresting advertisement. It showed a doctor peering down at a trader on the operating table; the doctor says, “Why . . . he’s got money coming out the wazoo!”

Five years later, you could replace the e-trader with a house flipper.Whether they were trading houses or stocks, Americans enjoyed the new empire of debt. Coast to coast, money was coming out of wazoos all over the place.

In Paradise Cove, California, even people who lived in mobile homes were getting rich.Trailers doubled in price every year for the first five years of the twenty-first century. Some were selling for more than $1 million. And in another Paradise, this one in Nevada, house prices rose faster than anywhere else in the nation. By mid-2005, in Paradise, Nevada, they were rising at nearly a 50 percent annual rate.

“If you can fog a mirror, you can get a home loan,” said a mortgage analyst to the
Los Angeles (LA) Times.
In the past, being able to fog a mirror was a necessary requirement for credit. Only now had it become sufficient. If the present trend continued, soon lenders would not even bother to hold up the mirror.

There was no particular reason why the dead should be denied mortgage credit; they would probably be at least as good risks as many of the living who were getting it. Maybe better. At least they don’t skip town or wear out the carpet.

“Borrow up to $250,000,” said an advertisement. “Less than perfect credit is okay . . . . No income verification . . . . No Home Equity requirement. . . . 24-hour approval.”

Between 2001 and 2005, the property bubble raised house prices in California by $1.7 trillion. That was equivalent to 35 percent of personal income. The whole economy not only enjoyed a rising real estate market, it depended on it. Coast to coast, people bought big houses they couldn’t afford.They expected to sell them to someone else for more than they paid for them. What they did not expect was to pay for them themselves. How could they? What would they pay for them with?

No one seemed interested in actually owning real estate. Houses had become like futures contracts. People traded on margin and never took delivery. Houses were financial assets to be actively managed, just as though they were stocks or a sailboat. When interest rates dipped, new credit was unfurled; the house was refinanced at a lower rate with the borrower often taking out a little cash to spend. If rates seemed to be going down, more sailcloth was hoisted at an adjustable rate to catch the favorable wind.

What if rates rose? What if the weather turned bad?

The California Association of Realtors reported that only one in five households in the state had enough money to buy the house that one in two of them lived in; in some areas, it was only one in ten.