Greenspan's Legacy - Part 2

Kudos to Tim Iacono for his excellent, thought-provoking article on Greenspan and possible political influence in Fed policy. Before you dismiss this as another conspiracy theory, read the article and make up your own mind. I can't help remembering when Senator Harry Reid called Alan Greenspan a "political hack". Read on...

Sin #2 - Bending to the Will of Others

Early last year, Senate Minority Leader Harry M. Reid (D-Nev.) blasted Federal Reserve Chairman Alan Greenspan, calling him "one of the biggest political hacks we have here in Washington." What could possibly have set Senator Reid off so?

Support for private social security accounts? Support for tax cuts?

"I'm not a big Greenspan fan", Reid said.

The outgoing Fed chair has been losing fans at a quickening pace as his retirement edges nearer and signs of a fading housing boom, the economy's life blood in recent years, continue to mount.

Some of the criticism of Mr. Greenspan's tenure at the Fed involves the various opinions that he has offered - opinions generally in support of administration policies, from which he is supposed to be independent.

Surely this was what motivated Senator Reid's objections.

It seems, over the years, Chairman Greenspan has been prone to bending to the will of others.

Founded in 1913 as a financially and politically independent agency, Federal Reserve Board activities were, from the outset, intended to be independent of political influence. Offering views on matters outside of the purview of monetary policy is something unique to Mr. Greenspan.

Serving in the position that many refer to as the second-most powerful in the United States, the views of a long-serving Fed Chairman carry an extraordinary amount of weight and can quickly shape opinions from Wall Street to Main Street to Capitol Hill.

With positions on tax-cuts that have adapted to each administration - in favor during the Reagan and Bush presidencies, opposed during Clinton's, and again in favor during recent years - he has at times sounded like a pitch-man for White House policies, though not nearly as boisterous a pitch-man as his counterpart at the Department of the Treasury, Secretary John Snow.

Alan Greenspan's seal of approval has been much more subtle.

Qualified with an extra key word or two that offer cover - "triggers" for tax cuts or "cautious, gradual" for private accounts - the Fed chair's endorsements of White House policies have been at the same time mildly ambiguous and tremendously powerful.

Long Ago, Before the Fed

Many years ago, shortly after Paul Volcker had hiked interest rates to near 20 percent to stave off roaring inflation (which at the time included actual home prices and not owner's equivalent rent), and after Mr. Volcker had received hundreds of sawed up two-by-fours from irate builders whose livelihoods he had affected, Alan Greenspan set out to save social security.

The Greenspan Commission on Social Security Reform resulted in the near doubling of the Social Security tax on working individuals. It resulted in a huge surplus in the Social Security Trust Fund as baby boomers were just entering their prime working years.

While ostensibly shoring up the system for future retirees, this move provided the added benefit of making available an annual stream of funds that could be borrowed as inter-governmental transfers, rather than via public debt offerings.

Borrowing from the Social Security Trust Fund, a practice that continues to this day, does not appear as part of the federal government's annual budget deficit.

This helped make Ronald Reagan's massive tax cuts for the wealthy much less noticeable than they would otherwise have been, and began the process of rapidly rising public debt.

Reagan appointed Alan Greenspan as Federal Reserve Chairman a few years later.

Charles Keating and Long Term Capital Management

Other examples of the malleable Mr. Greenspan are known - two more are recounted here, with some help from Devil Take the Hindmost, by Edward Chancellor (see this previous post for lengthier excerpts).

Before taking over for Paul Volcker in 1987, there was an intriguing crossing of paths between Charles Keating and Alan Greenspan in the mid-1980s. Recall that the last national real estate boom/bust occurred in the late 1980s, culminating in the Savings and Loan crisis a decade and a half ago.

He [Keating] hired the economist Alan Greenspan, later Chairman of the Federal Reserve, to support Lincoln's application to increase its "direct investments" to more than 10 percent of assets. In a letter he must have come to regret deeply, Greenspan wrote to the California bank regulator that the management of Lincoln and American Continental was "seasoned and expert ... with a long and continuous track record of outstanding success in making sound and profitable direct investments."

In another letter dated 13 February 1985, Greenspan claimed that Keating's management had turned Lincoln into "a financially strong institution" which would not pose any risk of loss to the federal insurer "for the foreseeable future." Greenspan was paid $40,000 for writing the two letters and testifying on Keating's behalf.

And, after helping to save the world on a number of occasions in his first ten years on the job as Federal Reserve Chairman, when Long Term Capital Management wound up on the wrong side of an interest rate bet, Alan Greenspan was there once again.

Among John Meriwether's partners was a former vice-chairman of the Federal Reserve named David Mullins.

Mullin's friend and former colleague Alan Greenspan was also embarrassed by events at LTCM. For several years, Greenspan had vigorously resisted calls to regulate both the derivatives markets and hedge fund activities. Only a couple of weeks before the bailout, Greenspan had insisted to Congress that hedge funds were, in his words, "strongly regulated by those who lend them money." Yet the leverage at LTCM showed clearly that this was not the case.
...
Shortly after the bailout of Long-Term Capital Management, Paul Volcker, Greenspan's predecessor as Federal Reserve Chairman, asked, "Why should the weight of the federal government be brought to bear to help out a private investor?"
...
A few years earlier, the Federal Reserve had passively stood by while Drexel Burnham Lambert, an investment bank with some five thousand employees and a history stretching back into the nineteenth century, was deserted by its envious Wall Street competitors and collapsed because of liquidity problems.

Long-Term Capital Management, on the other hand, a mere four-year-old upstart with only two hundred employees but partners and investors drawn from a cabal of finance professors, central bankers, and the cream of Wall Street, was considered more important than Drexel and simply "too big to fail".

In recent years, as the number of hedge funds has exploded and the notional amounts of derivatives has reached astronomical levels, Mr. Greenspan has continued to resist the regulation of hedge funds and derivative products.

On more than one occasion, he has marveled at their "risk spreading" qualities, integral to global finance today. Many wonder if another derivative crisis, similar to the LTCM melt down, is waiting for a precipitating event to set it off.

The White House Visits

Although it will likely never be known with any certainty what Alan Greenspan talked about during his visits to the White House during the first few years of the George W. Bush administration, it will not stop people from wondering about the possibilities.

A casual visitor during the Clinton years, both the frequency of visits and the choice of White House officials with whom he spoke, take on added significance when viewed through the lens of monetary policy actions in a struggling economy with a U.S. President clearly having set his sights on re-election.

Kenneth H. Thomas compiled the following data and additional commentary is provided about the Fed Chairman's White House visits from this post last year, over at The Big Picture.




















In light of the tragic events of September 11th, surely increased coordination between the executive branch and the nation's central bank would seem warranted. Ensuring the stability of financial markets goes a long way in explaining the 2001 and 2002 visits, but the trend not only continued, but accelerated in 2003 and 2004.

Occurring at about the same frequency as during the Clinton years, visits to the White House Counsel of Economic Advisers were routine during the first few years of the Bush administration.

But the other visits were anything but routine.

Vice President Cheney tops the list with seventeen face-to-face sessions during this time, followed by 11 visits with Defense Secretary Donald H. Rumsfeld, another 12 visits with Condoleeza Rice, and a few with Andy Card, Colin Powell, Paul Wolfowitz, and Scooter Libby.

It makes you wonder what they could possibly have talked about.

It makes you wonder if there could have been any impact on monetary policy. Maybe this chart will help to explore the possibilities:

Click on Chart to enlarge.

















Following a few quarters of negative real GDP growth and job losses in 2000-2001, the federal funds rate was moved below two percent in early 2002, where it remained for nearly three years - 2002, 2003, and 2004.

Given talk of deflation, and a clearly struggling labor market in 2002, this certainly seemed to be prudent action to take. The rationale for monetary policy during 2003 and 2004, however, is less clear.

Clearly, GDP growth rebounded in a big way during 2003, and the labor market was improving albeit slowly. The unemployment rate during 2003 averaged six percent, not far from the historical average, but it did begin declining rapidly at mid-year.

Inflation, as measured by the CPI-All Items index was above two percent again, and the housing market was appreciating at an annual six percent rate. What was the monetary policy response in 2003?

Rates were lowered from 1.25 percent to 1 percent.

Toward the end of 2003 and into early 2004, housing began to take off in a big way. Inflation was rising, employment was rising, and GDP growth was steady. What was the monetary policy response in early 2004?

Rates were held steady - the pedal was held firmly against the metal with short-term rates of one percent.

It was not until mid-2004, a mere six months before the 2004 Presidential election, that rates were nudged off of their rock-bottom position with the beginning of a long series of quarter-point baby steps.

By this time, home prices were rising at 8, 10, and 12 percent year-over-year, reported inflation had cleared three percent and was headed toward four, jobs were being created at a healthy clip, and Americans were discovering the joys of real estate speculation and home-equity withdrawal amidst the nirvana of rapidly rising real estate prices.

Then came the election.

It is likely that no one will ever know if or how the White House visits affected monetary policy during 2003 and 2004, but it won't stop people from wondering.

Greenspan's Legacy - Part 1

Much has been written about the legacy of Alan Greenspan. Throughout his retirement party, which has been painfully dragged out over the last year, politicians, analysts, economists, and the press have been singing Alan Greenspan's praises and gushing over his accomplishments. The Fed Chairman has presided over an economy that has seen impressive job and economic growth through two minor recessions while maintaining low inflation throughout the majority of his tenure as Fed Chairman.

He has accomplished much in the last 18 years as Fed Chairman but critics have been quick to note that there are many fundamental problems that Mr. Greenspan has created, that are being passed on to the new Fed Chairman, Ben Bernanke. These problems and his legacy are at great risk depending on how things unfold in the coming years.

An excellent 4-part series of articles has been written on "The Mess That Greenspan Made" that highlight the potential problems that Mr. Greenspan will have with his legacy:

Sin #1 - Ignoring Asset Prices

The legacy of Alan Greenspan is now inextricably intertwined with, and will likely suffer the same fate as, the over-inflated American real estate market.

If housing cools painlessly over the next few years reverting to more normal levels of growth that are sustainable into the next decade, and if over-extended homeowners successfully adjust to a changing world of reduced expectations, then, and only then, will current criticism of the outgoing Fed Chair have been proved both premature and ill-advised.

If, over time, the citizenry maintain much of their currently elevated standard of living, as they have been led to believe is nearly an inalienable right, then the departing chairman will have demonstrated that his detractors were wrong, and will have rightfully earned the praise that accompanies being universally regarded as the greatest central banker in history.

Many believe these rosy scenarios are unlikely and that ignoring asset prices has been sinful.

Today, on the surface, the American economy is the model for the rest of the western world - robust GDP growth, low unemployment, and low inflation.

By most statistical measures emanating from Washington, we are living in a "goldilocks" economy - a sort of dream world where no shocks to the system can derail growth or prosperity - wars, hurricanes, deficits, political intrigue - none of it matters.

But where would we be without rising home prices?

Rising home prices, following historically low interest rates held far too low for over two years, have enabled home equity withdrawal at unheard of rates. This has supported personal consumption which now contributes to GDP growth as never before in history, and has resulted in the creation of millions of housing related jobs.

This has seemingly worked wonders in response to the bursting of the stock market bubble at the turn of the century, but with housing now beginning to cool, the natural question to ask is, "Where do we go from here?"

Like stocks in the late 1990s, why were home prices allowed to rise at many times the rate of inflation, leading all to believe that prosperity would be eternal?

The Economist asks the same questions.

The Economist's long-running quarrel with Mr Greenspan is that he chose not to restrain the stockmarket bubble in the late 1990s or to curb today's housing bubble. He has declared himself vindicated in not pricking the equity bubble with higher interest rates, but instead to let it burst and then cut rates sharply to “mop up” the damage. The economy has fared better than we expected since share prices slumped, with only a mild recession in 2001. But a better test of Mr Greenspan's policies is not whether America escaped a deep recession, but whether the economy would today be on firmer foundations if the Fed had acted against that bubble.

How monetary policy should respond to increases in the prices of assets such as houses or shares is the biggest dilemma facing central banks everywhere. The Fed takes account of rising asset prices to the extent that they boost spending and hence future inflation. But the burning question is: should it respond to asset prices even if inflation seems under control? Three main arguments are given by Mr Greenspan and his colleagues for why central banks should ignore asset prices other than their impact on inflation. First, that monetary policy focused on inflation and growth is the best way to achieve economic stability. Second, that one can never be sure that what looks like a bubble really is a bubble. And third, that interest rates affect the economy more like a sledgehammer than a scalpel. A modest rise in rates is unlikely to halt rising share prices, but an increase sufficient to pop the bubble would slow the whole economy and could even cause a recession. Mr Greenspan thus concludes that it is safer to wait for a bubble to burst by itself and then to ease monetary policy to soften a downturn.

Consider each of these arguments in turn. First, the job of a central bank is not just to prevent inflation, but also to ensure financial stability. Yet the three biggest stockmarket bubbles in the past century—America's in the 1920s and 1990s and Japan's in the 1980s—all developed when inflation was low. Arguably, Mr Greenspan has defined the role of monetary policy too narrowly. Inflation is often described as too much money chasing too few goods. But in a world awash with cheap money and with potent new sources of supply, such as China, to hold prices down, inflation will remain low and so fail to signal if an economy is overheating. Increased central-bank credibility also helps to anchor inflation. If central banks hold interest rates low, this will encourage risk-taking in financial markets and excess liquidity will spill over into asset prices rather than traditional inflation.

Asset-price inflation can be as harmful as conventional inflation. A sudden collapse in share or house prices can trigger a deep downturn. And surging asset prices also distort price signals and cause a misallocation of resources—by encouraging too little saving, or too much investment in housing, so reducing future growth. This is why central banks need to pay closer attention to asset prices.

Second, it is not, as Mr Greenspan argues, impossible to identify bubbles. When prices have lost touch with fundamentals and there are other signs of excess, such as rapid credit growth, alarm bells should ring. Mr Greenspan's “irrational exuberance” speech in December 1996 shows he was concerned about a bubble inflating long before the bubble reached its full extent. And transcripts of meetings of the Federal Open Market Committee (FOMC, which meets to set interest rates) now make clear that several Fed officials were fretting about the bubble in 1998 and 1999. At the December 1999 meeting, when discussing the stockmarket, Mr Greenspan said: “It is only a question of how much of a bubble there is.”

Moreover, central banks do not have to be certain they have identified a bubble before they act. Monetary policy has constantly to deal with uncertainty—such as the size of the output gap. Uncertainty is a reason for responding cautiously, but not for doing nothing.

What of Mr Greenspan's third claim that, even if a central banker is pretty sure there is a bubble, there is little he can do about it because interest rates are a blunt tool? In August 2005 Mr Greenspan said: “Given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon.” But he was setting up a straw man. Nobody is seriously arguing that central banks should “target” a particular level of asset prices. Most economists accept that aggressive action to “prick” bubbles could also be risky. Instead, the debate today is whether central banks should “lean against the wind” when asset prices appear dangerously out of line with fundamentals, raising interest rates by a bit more than inflation alone would call for.

While quarreling with the use of the word "inflation" to casually exclude the cost of housing, there is little else to object to here. These are the same points made on a number of occasions in these pages.

1. Asset prices affect long-term stability
2. The formation of asset bubbles can be detected
3. Monetary policy can be used to combat rising asset prices

Regarding the last point, it seems reasonable that regulation of mortgage lending should work alongside monetary policy to do what is in the best long-term interests of an economy, impinging as little as possible on the operation of free markets.

The role of the Federal Reserve and other government agencies in this area has been much too little and far too late to have any meaningful effect on the consequences that are likely to arise as a result of credit that has already been extended.

The horse has long since left the barn, as they say.

Fittingly, Monetary Myopia concludes with a drinking analogy that refers to today's economy as a "mess". We are humbled and gratified that The Economist shares our view, and find it impossible to resist closing with these words as well.

In December Mr Greenspan was made a Freeman of the City of London. One of the traditional perks of this honour is that he can be drunk and disorderly without fear of arrest. The snag is that his policies have also encouraged drunk and disorderly asset markets and intoxicated consumers. When the party ends, Mr Greenspan will not be there to clean up the mess. But end it surely will.

The new risk from China: deflation

Most investors are becoming increasingly aware of the China Miracle! The economy that grows by 10% a year, with no signs of slowing, is becoming increasingly srutinized for the risks that have been a historical norm. Recently, the Chinese Government purposely deflated a Real Estate Boom in Beijing, and now there are concerns that the underlying economy is facing deflation risks that could cause a "Japan-sized" bust. Jim Jubak has written an excellent article that highlights these risks:

Wildly rapid growth has made China the world's fourth-largest economy. But burdened with industrial overcapacity and corruption, it's in danger of a Japan-sized bust.

By Jim Jubak

Could China, the driver of global inflation in commodities such as crude oil and iron ore, be looking at domestic deflation in 2006?

Deflation effectively took Japan out of the global economy for more than a decade, slowing global growth and increasing global economic volatility. Serious deflation in China has the potential to be a lot more dangerous. At its least damaging, it would flood the world's markets with even cheaper Chinese goods. At the worst it could stall the Chinese economy, a major driver of global growth, and even send the country into one of its traditional periods of instability.

All that from a change in prices? You betcha.

A Chinese economic think tank at the country's top economic agency, the National Development and Reform Commission, raised the red flag on deflation on Jan. 12. Since then, Chinese officials have repeatedly gone out of their way to pooh-pooh the danger. So much effort spent on denial, of course, means that it’s a problem that the communist regime takes seriously.

The urban advantage
I know I would if I were in their shoes. Deflation in the domestic Chinese economy would pressure companies to cut wages to keep up with falling prices. That, of course, would depress demand. Chinese consumers would have less money for purchases, which would depress prices further, which would lead to further wage cuts. Once a deflationary cycle like that gets started, it can be terribly hard to reverse. Just ask the Japanese, now emerging from years of deflation and no economic growth.

China wouldn't survive a bout of deflation anywhere nearly as well as Japan. Japan is an amazingly cohesive society; China, even in the midst of an economic boom, is deeply fissured. Deflation would strike hardest at precisely those in the countryside who have been left behind in the current boom. The richest 10% of Chinese control 45% of the country's wealth, according to Chinese government figures, and the poorest 10% hold about 1%. About 250 million people in the country still earn less than $1 a day -- the official definition of poverty in China -- and 700 million live on less than $2 a day. Incomes among rural Chinese have actually declined in the last four years, the World Bank reports. This rural 70% of China's population has an average income of just $318 a year. If benefits like superior schools and medical care are included in the calculation, the average urban income is a huge seven times greater than the average rural income, the Chinese Academy of Social Sciences has calculated.

Rising income inequality has led to a rising tide of protest. There were, officially, 87,000 public disturbances in 2005, up 6% from 74,000 disturbances in 2004, according to the Ministry of Public Security. (And you know that if that's the official number, the actual level of protest is much higher.) That's brought the typical response from security forces: beatings of protesters and mass arrests. China will strike "hard" against rising unrest, a senior official of the ministry told the Xinhua news agency this week. "For a considerable time to come, our country will be in a period of pronounced contradictions within the people, high crime rates and complex struggle against enemies," the official said.

No. 4, with a bullet
All this, mind you, while the economy is booming and deflation is just a story told to scare naughty economists at bedtime. How did China get into this mess?

Start with an economy built around export growth and feed it with lots and lots of cheap money. And then ignore any signals that the rudimentary, somewhat free market might be sending you about overinvestment or overcapacity.

On the one hand, this works really, really well. China's GDP grew 9.9% last year, according to Chinese government figures. That's after 10.1% growth in 2004 and 10% in 2003. When the final data is in, China's economy is expected to jump over France and Britain to rank as No. 4 in the world behind the United States, Japan and Germany.

And there's no doubt that growth like that has raised average incomes in China. Real disposable income in urban areas rose 9.6% in 2005. Rural incomes grew by 6.2%.

On the other hand, China has achieved this kind of growth only through massive overinvestment in the export sector. Even after a yearlong campaign to rein in investment in fixed assets -- you know, things like steel mills and aluminum foundries -- investments like these grew by 25.7% in 2005.

2 million cars too many
The result has been massive overcapacity in fixed assets. Look at coke producers -- capacity of 242 million tons exceeded demand in 2005 by 100 million tons. Or steel makers -- capacity exceeded demand by 120 million tons. Production capacity in China's auto industry now exceeds annual sales in China by 2 million vehicles. The government has identified 10 sectors -- including aluminum, autos, cement, coke, steel and textiles -- with capacity problems.

Of course, this excess capacity hasn't ended plans to add even more capacity in these sectors. About 120 million tons of new coke capacity is under construction. New steel mills with capacity of 70 million tons are being built.

Companies can raise money to build clearly unnecessary and unprofitable factories because all too many Chinese banks continue to make loans on the basis of political connections rather than market forecasts. Put a local entrepreneur and his local political patrons from the district government in the same room with a banker, and a loan pops out.

How do you make a profit if you're doing business in an industry with 100 million tons of spare capacity? Export, export, export -- to any international market that will buy your product. And cut your prices until the buyers can't resist. At home, cut prices and cut them again.

See how a system like this might produce both higher global prices for raw materials and lower prices for finished goods abroad and at home? Global commodity inflation and domestic price deflation.

China hasn't seen domestic deflation yet. But the trends are enough to worry Beijing's economists. Consumer price inflation fell to 1.8% in 2005 from 3.9% in 2004. (Like all other Chinese statistics, regard this one with extreme skepticism.) Prices, according to the National Development and Reform Commission, could start to fall in the second half of 2006.

The plan: Pry open wallets
The government has several alternatives to make sure that doesn't happen.
• It could juice up the money supply. That would cut the value of money, sending prices upwards. And cheaper money would increase demand. Of course, with China's current financial system, much of that extra money would wind up going into investments in more capacity in already money-losing industries.
• It could juice up exports. That would soak up some capacity -- but it would also get China in hot water with trading partners that want China to cut its trade surplus. It would certainly increase pressure on the country to revalue the yuan, China's currency.
• It could increase domestic demand. Chinese consumers simply save too much and spend too little. The Chinese savings rate was about 40% of annual gross domestic product in 2005. (For contrast, the U.S. savings rate was negative in 2005.) Result: At the end of 2005, personal savings in China totaled $1.8 trillion -- a good piece of change in an economy where total GDP was $2.3 trillion. If Chinese workers saved less and spent more -- like us -- it would soak up a lot of that excess capacity.
That last is, apparently, the solution the government has adopted. The Central Economic Work Conference held at the end of 2005 called "expansion of domestic demand" key to economic growth in 2006.

Easier said than done, especially when you look at why so many Chinese save so much and spend so little. It will take more than a propaganda campaign to get the average Chinese to spend more.

Over the last decade or more, the Chinese government has failed to put in place or has actually dismantled the kind of social programs that cut saving and encourage consumption. Chinese workers don't have retirement plans of any sort -- the government just hasn't got around to setting up meaningful plans. So even if they make just $2 a day, workers struggle to put something aside.

Same with health care. No national health insurance. No company health insurance. And the government system of free hospitals and clinics has been largely dismantled. Many of these have been privatized and now make a profit by taking in only patients who can pay. So it's either save or do without medical care.

The Olympics loom
And finally, there's the issue of property ownership. Chinese farmers don't own the land they farm: they lease it for, at the most, 25 to 30 years. And that lease is only good until local authorities decide they want to take the land for a factory or some other investment. Just imagine how economically secure you'd feel knowing that your land is yours only at the pleasure of some official. More reason to save.

I don't have a lot of hope that the central authorities in Beijing will be able to implement the changes needed to make the average Chinese secure enough to spend more. Historically, dynasty after dynasty, the weakness of the Chinese system has been the inability of the central government to get local officials to implement its decrees. The evidence right now is that local officials are pretty much flouting national policy on anything, from environmental rules to policies on land rights, that might cost the local elite a yuan of profit.

I don't know if we'll ever see a number that shows deflation in China. One advantage the Chinese government has over the U.S. Federal Reserve is that they control all the data. Admitting to deflation is simply too damaging.

Watch instead the news on domestic protest. If the tide of protest keeps rising, if the repression gets more violent, you'll have a pretty good idea that the poorest of the Chinese are feeling the bite of deflation. The big danger is that the regime will feel so much pressure to restore order before the 2008 Beijing Olympics, meant as a national showcase, that it will resort to teaching the protesters some large-scale lesson like that imposed by the tanks of the Red Army in Tiananmen Square in 1989.

Actually makes you root for inflation, doesn't it?

Understanding Petrodollars

A client recently asked me about Oil trade and Petrodollars and I thought that it was a concept that would be interesting to others who have never considered the issues of oil and its importance to the worldwide economy. I will be posting a series of articles on Peak Oil for the dissemination of information on this topic.

From Wikipedia, the free encyclopedia.

A petrodollar is a dollar earned by a country through the sale of oil. The term was coined by Ibrahim Oweiss, a professor of economics at Georgetown University, in 1973. Oweiss felt there was a need for a word to describe the situation which was occurring in the OPEC countries, where it was entirely the sale of crude oil which allowed these nations to prosper economically and to invest in the economies of the nations which purchased their oil.

In the West, the word has been used to reference the large financial leverage the OPEC countries held until the turn of the century, and has been seen by some Arab politicians as offensive because it stereotyped OPEC producers as crude nouveau-riche nations interested in purchasing political goodwill. Considerable concern was being expressed at the time, particularly by the American media, that the American economy was in danger of being held hostage by the interests of some OPEC countries.

More recently, speculation has arisen that OPEC may switch from the US dollar to the Euro, inaugurating the Petroeuro. So far, OPEC has resisted this move although some OPEC members (such as Iran and Venezuela) have been pushing for a switch to the Euro. During Iraq's Oil-for-Food Programme, Saddam Hussein did switch to the Euro and some commentators claim this switch was another factor contributing to the 2003 Invasion of Iraq. As noted by Cóilín Nunan, "A move away from the dollar towards the euro could have a disastrous effect on the US economy" because the US's negative balance of trade is largely offset by its role as a reserve currency.

Warren Buffet Wisdom

When the world's "most successful investor" speaks, people listen. Here are some recent words of wisdom from Warren Buffet that I feel are worth noting:

“‘Right now, the rest of the world owns $3 trillion more of us than we own of them,’ (Warren) Buffett told business students and faculty Tuesday at the University of Nevada, Reno. “In my view, it will create political turmoil at some point. ... Pretty soon, I think there will be a big adjustment…’ The U.S. trade deficit soared to a record $665.9 billion in 2004, and Buffett said he expects it to top $700 billion this year. ‘That’s $2 billion a day. We are like a super rich family that owns a farm the size of Texas. You sell off a little bit of the farm and you don’t see it.’ Fifteen years ago, the U.S. had no trade deficit with China, he said. ‘Now it’s $200 billion. If we don’t change the course, the rest of the world could own $15 trillion of us. That’s pretty substantial. That’s equal to the value of all American stock. That’s the big danger.’”

What is Inflation?

What is the Real Definition of Inflation?

Webster's 1983 Definition of Inflation

According to Webster's New Universal Unabridged Dictionary published in 1983 the second definition of "inflation" after "the act of inflating or the condition of being inflated" is:

"An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand."

This definition includes some of the basic economics of inflation and would seem to indicate that inflation is not defined as the increase in prices but as the increase in the supply of money that causes the increase in prices i.e. inflation is a cause rather than an effect.

Webster's 2000 Definition of Inflation

However, The American Heritage® Dictionary of the English Language, Fourth Edition, Copyright © 2000 Published by Houghton Mifflin Company says:

Inflation: 2) A persistent increase in the level of consumer prices or a
persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

In this definition, inflation would appear to be the consequence or result (rising prices) rather than the cause.

Shifty Words

So between 1983 and 2000 the definition appears to have shifted from the cause to the result. Also note that the cause could be either an increase in money supply or a decrease in available goods and services.

Other Definitions

Webster's Revised Unabridged Dictionary, © 1996, 1998 MICRA, Inc., Relegates Price Inflation to number 3. and says:

Undue expansion or increase, from overissue; -- said of currency. [U.S.]

WordNet ® 1.6, © 1997 Princeton University, has a witty definition that says:

inflation 1: a general and progressive increase in prices; "in inflation everything gets more valuable except money" [syn: rising prices] [ant: deflation, disinflation]

According to investorwords.com

The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index; opposite of deflation.

From this page we can see that even Dictionaries don't agree on the definition of inflation and economists continue to argue over its primary cause. Although it is generally agreed that economic inflation may be caused by either an increase in the money supply or a decrease in the quantity of goods.

Therefore it should be equally obvious that falling prices will result from a decrease in the money supply or a rapid increase in the quantity of available goods. Recent years have seen a virtual explosion of inexpensive goods produced in China and other former Communist Countries. So it is no wonder that we in the United States see falling prices rather than the effects of inflating the money supply in our economy.

The Irony of Complacency

Morgan Stanley Chief Economist Steven Roach offers a sobering look at the potential pitfalls in the economy in 2006:

So far, so good, for an unbalanced world -- the sky has yet to fall. And the longer a lopsided global economy continues to chug along with impunity, the more the broad consensus of opinion becomes convinced that this is a sustainable outcome. This increasingly complacent mindset may be about to meet its toughest challenge: A likely turn in the liquidity cycle appears to be on a collision course with ever-widening global imbalances. This could well be a lethal combination that triggers the long-awaited capitulation of the American consumer -- heretofore the mainstay of a US-centric world.

With the benefit of hindsight, the hows and whys of a benign outcome for the world economy in 2005 are crystal-clear. Basically, it was another year of “follow the leader,” as a US-centric world continued to draw sustenance from the seemingly unflappable American consumer. Sure, there were a number of other factors that came into play elsewhere around the world -- namely, the apparent healing of the Japanese economy, an improvement in Euroland late in the year, and the ongoing boom in China. But suffice it to say, were it not for another year of solid support from US consumer demand -- our latest estimates put real consumption growth at an impressive 3.5% in 2005 -- the rest of a largely externally dependent world would have been in big trouble.

What did it take for the American consumer to deliver yet again? It certainly didn’t come from the traditional income-generating capacity of the US labor market. Private sector compensation outlays expanded only 2.5% in real terms over the 12 months ending November 2005 -- a full percentage point below trend and an especially disappointing outcome following the anemic pace of labor income generation in the first three years of this expansion. In fact, by our reckoning, in November 2005, private compensation remained nearly $390 billion below the composite trajectory of the past four US business cycles. With America’s internal income-generating capacity continuing to lag, US consumers once again tapped the home equity till to draw support from the Asset Economy. According to Federal Reserve estimates, equity extraction by US households topped $600 billion in 2005 -- more than enough to compensate for the shortfall of earned labor income. Comforted by this asset-based injection of purchasing power, consumers had little compunction in stretching traditional income-based constraints to the max. The personal saving rate fell deeper into negative territory that at any point since 1933, and outstanding household sector indebtedness -- as well as debt service burdens -- hit new record highs.

So much for what happened in 2005. The big question for the outlook -- and quite possibly the most important macro issue for world financial markets in 2006 -- is whether the American consumer can keep on delivering. My answer is an unequivocal “no.” Three factors lead to me to this conclusion, the first being the distinct likelihood that a shortfall in internal labor income generation persists. Specifically, I do not expect the US labor market to break the shackles of globalization and unwind the increasingly powerful global labor arbitrage that has played a key role in restraining employment and real wage growth over the past four years. Second, I believe that asset effects will be far less supportive to the American consumer in 2006 than has been the case in recent years. This reflects the likelihood of a distinct slowing in home equity extraction -- driven by the combination of moderating house price inflation and a sharp deceleration in home mortgage refinancing. Third, in an environment of subpar income generation, in conjunction with diminished wealth effects from the Asset Economy, the saving-short, overly indebted American consumer will instantly become more vulnerable to ever-present shocks. Look no further than 4Q05 for validation of the “vulnerability factor” -- a likely “zero” growth rate for real personal consumption expenditures in the immediate aftermath of a Katrina-related supply shock to the energy complex.

Of those three factors, the asset effect is most likely to be the swing factor for the US consumption outlook. This is precisely where the liquidity cycle comes into play. In my view, the froth in asset markets -- first equities in the late 1990s and, more recently, property -- is a direct by-product of a powerful surge in global liquidity. In 2005, our global liquidity proxy -- the ratio of the narrow money supply to nominal GDP for the G-5 (US, Euroland, the UK, Japan, and Canada) plus China -- rose to a level that we estimate to be nearly 60% higher than that prevailing in 1995. That may now be about to change. Courtesy of central bank policy normalization -- led by America’s Federal Reserve -- in conjunction with an important shift in the mix of global saving, there is good reason to look for a much slower flow from the global liquidity spigot in 2006.

A turn in the global liquidity cycle is likely to affect the American consumer through domestic and international channels. The domestic angle comes from a dramatic flattening -- and periodic inversion -- in the slope of the US yield curve. In my view, the slope of the curve matters a great deal in driving the equity-extraction effects of the Asset Economy. From the standpoint of financial intermediaries, a flatter curve alters the economics of the cut-rate lending programs that have been supporting such activities. A sharp recent deceleration of home mortgage refinancing activity -- down 45% from the mid-2005 peak -- is a perfect example of this development.

The international angle arises from a likely reduction in non-US saving, a natural outgrowth of increasingly successful efforts to stimulate domestic demand in the world’s major surplus saving economies -- Japan, Germany, and China. That would tend to absorb saving and, therefore, reduce the flows of private sector excess liquidity that have been recycled into dollar-denominated assets in recent years. That, in turn, would draw into question the overseas subsidy to domestic US interest rates, as well as the equity extraction fueled by such an abnormally low rate structure. Foreign central banks, of course, have the option to fill the void through official purchases of dollar-denominated assets. But, as recent public statements from monetary authorities in China and Korea suggest, the pendulum is swinging more toward increased diversification in the mix of foreign exchange reserve portfolios.

All this points to a shift in the non-US liquidity cycle -- a development that could have important implications for America’s massive current-account financing needs. That would then heighten pressure on the dollar and US real interest rates, thereby putting America’s equity extraction cycle under even greater pressure. That does not bode well for the income-short US consumer. Experience tells us it is usually unwise to bet against the American consumer. While I think there are compelling reasons to go against the grain in 2006, I do so with great trepidation.

Excess domestic liquidity is the high-octane fuel of the Asset Economy and the consumer-led growth dynamic it fosters. Excess global liquidity is also responsible for the funding of America’s massive current-account deficit. Yet as the liquidity cycle now turns, the rules of engagement in the Asset Economy are likely to meet their sternest challenge. That’s a big deal for the income-short US consumer, leaving households with little choice other than to cut back discretionary spending. From the start, that’s been the only real option for meaningful progress on the road to global rebalancing. The irony of complacency is about to strike again. The day of reckoning for an unbalanced world could be close at hand.

Danger time for America

Jan 12th 2006
From The Economist print edition

The economy that Alan Greenspan is about to hand over is in a much less healthy state than is popularly assumed

DESPITE his rather appealing personal humility, the tributes lavished upon Alan Greenspan, the chairman of the Federal Reserve, become more exuberant by the day. Ahead of his retirement on January 31st, he has been widely and extravagantly acclaimed by economic commentators, politicians and investors. After all, during much of his 18½ years in office America enjoyed rapid growth with low inflation, and he successfully steered the economy around a series of financial hazards. In his final days of glory, it may therefore seem churlish to question his record. However, Mr Greenspan's departure could well mark a high point for America's economy, with a period of sluggish growth ahead. This is not so much because he is leaving, but because of what he is leaving behind: the biggest economic imbalances in American history.

One should not exaggerate Mr Greenspan's influence—both good and bad—over the economy. Like all central bankers he is constrained by huge uncertainties about how the economy works, and by the limits of what monetary policy can do (it can affect inflation, but it cannot increase the long-term rate of growth). He controls only short-term interest rates, not bond yields, taxes or regulation. Yet for all these constraints, Mr Greenspan has long been the world's most important economic policy maker—and during an exceptional period when globalisation and information technology have been transforming the world economy. His reign has coincided with the opening up to trade and global capital flows of China, India, the former Soviet Union and many other previously closed economies. And Mr Greenspan's policies have helped to support globalisation: the robust American demand and huge appetite for imports that he facilitated made it easier for these economies to emerge and embrace open markets. The benefits to poorer nations have been huge.

So far as the American economy is concerned, however, the Fed's policies of the past decade look like having painful long-term costs. It is true that the economy has shown amazing resilience in the face of the bursting in 2000-01 of the biggest stockmarket bubble in history, of terrorist attacks and of a tripling of oil prices. Mr Greenspan's admirers attribute this to the Fed's enhanced credibility under his charge. Others point to flexible wages and prices, rapid immigration, a sounder banking system and globalisation as factors that have made the economy more resilient to shocks.

The economy's greater flexibility may indeed provide a shock-absorber. A spurt in productivity has also boosted growth. But the main reason why America's growth has remained strong in recent years has been a massive monetary stimulus. The Fed held real interest rates negative for several years, and even today real rates remain low. Thanks to globalisation, new technology and that vaunted flexibility, which have all helped to reduce the prices of many goods, cheap money has not spilled into traditional inflation, but into rising asset prices instead—first equities and now housing. The Economist has long criticised Mr Greenspan for not trying to restrain the stockmarket bubble in the late 1990s, and then, after it burst, for inflating a housing bubble by holding interest rates low for so long (see article). The problem is not the rising asset prices themselves but rather their effect on the economy. By borrowing against capital gains on their homes, households have been able to consume more than they earn. Robust consumer spending has boosted GDP growth, but at the cost of a negative personal saving rate, a growing burden of household debt and a huge current-account deficit.

Burning the furniture
Ben Bernanke, Mr Greenspan's successor, likes to explain America's current-account deficit as the inevitable consequence of a saving glut in the rest of the world. Yet a large part of the blame lies with the Fed's own policies, which have allowed growth in domestic demand to outstrip supply for no less than ten years on the trot. Part of America's current prosperity is based not on genuine gains in income, nor on high productivity growth, but on borrowing from the future. The words of Ludwig von Mises, an Austrian economist of the early 20th century, nicely sum up the illusion: “It may sometimes be expedient for a man to heat the stove with his furniture. But he should not delude himself by believing that he has discovered a wonderful new method of heating his premises.”

As a result of weaker job creation than usual and sluggish real wage growth, American incomes have increased much more slowly than in previous recoveries. According to Morgan Stanley, over the past four years total private-sector labour compensation has risen by only 12% in real terms, compared with an average gain of 20% over the comparable period of the previous five expansions. Without strong gains in incomes, the growth in consumer spending has to a large extent been based on increases in house prices and credit. In recent months Mr Greenspan himself has given warnings that house prices may fall, and that this in turn could cause consumer spending to slow. In addition, he suggests that foreigners will eventually become less eager to finance the current-account deficit. Central banks in Asia and oil-producing countries have so far been happy to buy dollar assets in order to hold down their own currencies. However, there is a limit to their willingness to keep accumulating dollar reserves. Chinese officials last week offered hints that they are looking eventually to diversify China's foreign-exchange reserves. Over the next couple of years the dollar is likely to fall and bond yields rise as investors demand higher compensation for risk.

When house-price rises flatten off, and therefore the room for further equity withdrawal dries up, consumer spending will stumble. Given that consumer spending and residential construction have accounted for 90% of GDP growth in recent years, it is hard to see how this can occur without a sharp slowdown in the economy.

Handovers to a new Fed chairman are always tricky moments. They have often been followed by some sort of financial turmoil, such as the 1987 stockmarket crash, only two months after Mr Greenspan took over. This handover takes place with the economy in an unusually vulnerable state, thanks to its imbalances. The interest rates that Mr Bernanke will inherit will be close to neutral, neither restraining nor stimulating the economy. But America's domestic demand needs to grow more slowly in order to bring the saving rate and the current-account deficit back to sustainable levels. If demand fails to slow, he will need to push rates higher. This will be risky, given households' heavy debts. After 13 increases in interest rates, the tide of easy money is now flowing out, and many American households are going to be shockingly exposed. In the words of Warren Buffett, “It's only when the tide goes out that you can see who's swimming naked.”

How should Mr Bernanke respond to falling house prices and a sharp economic slowdown when they come? While he is even more opposed than Mr Greenspan to the idea of restraining asset-price bubbles, he seems just as keen to slash interest rates when bubbles burst to prevent a downturn. He is likely to continue the current asymmetric policy of never raising interest rates to curb rising asset prices, but always cutting rates after prices fall. This is dangerous as it encourages excessive risk taking and allows the imbalances to grow ever larger, making the eventual correction even worse. If the imbalances are to unwind, America needs to accept a period in which domestic demand grows more slowly than output.

The big question is whether the rest of the world will slow too. The good news is that growth is becoming more broadly based, as demand in the euro area and Japan has been picking up, and fears about an imminent hard landing in China have faded. America kept the world going during troubled times. But now it is time for others to take the lead.

How U.S. debt threatens the economy

In 2006, look for a falling dollar and dropping bond prices, along with rising inflation and interest rates, as growing economies in China and India assert themselves.

By Roger Ibbotson

You don't have to invest in China or India to be affected by the dramatic growth of their economies. And you don't have to be a politician to worry about trade and budget deficits. They're all interconnected, and they will all affect your pocketbook in 2006 and beyond.

Yes, the growth of the global economy has created tremendous opportunities for trade and investment -- and helped keep our economy growing at a healthy rate. But certain long-term problems are becoming more apparent as a result of the way goods and dollars flow around the globe. A few: The U.S. dollar, long-term bonds and financial firms may be in for a rough ride.

But my forecast isn't all doom and gloom. The overall stock market looks like a value at current prices, and some sectors -- most notably energy stocks -- should benefit from Asia's continued rise.

A surplus of deficits
A trade deficit simply means that we import more than we export. The net result of this is that more money flows out of the country than flows in. Prior to 1980, the United States was a net exporter, selling more goods overseas than it imported. But over the last 25 years, the situation has reversed. The trade deficit today has grown to record levels (now almost 6% of gross domestic product), with the biggest import-export imbalances coming from China, Japan and Southeast Asian nations.

We're all familiar with a budget deficit. That's where we spend more than we earn and have to borrow to fill the gap. We rely on credit cards to get through a budget deficit; the federal government issues Treasury bonds to finance its shortfall.

The U.S. has run budget deficits over a great deal of its history. The budget deficit today isn't even the highest it's ever been -- we ran larger deficits (as a percentage of GDP) during World War II. But what has changed over the last 25 years is that foreign governments, rather than U.S. citizens, have been buying this U.S. debt (in the form of Treasurys). Now, approximately half of this country's debt is held outside the United States, primarily by China, Japan and Southeast Asian nations.

Until recently, none of this was a problem. These creditor nations, with whom the U.S. also had its largest trade imbalances, were happy to buy up our extra government debt. The system worked. Folks here bought their exports, and they bought our debt. American consumers benefited from the flow of inexpensive goods, and foreign creditors benefited both from their return on investment and the continued consumption of their goods. This global interdependency helped to kept interest rates low and the dollar relatively strong.

Through the ‘90s, as our trade deficit grew, our budget deficits made up only a small percentage of our GDP. We were easily able to service our debt. But war, tax cuts and Hurricane Katrina changed that. And the combination of a weighty budget deficit and a record trade deficit has made these creditor nations nervous about loading up on too much U.S. debt. It's reasonable to think that China, Japan and Southeast Asia may soon choose to diversify their investments and stop buying our debt.

Competition for oil
The U.S. is by far the largest consumer of oil, buying almost a quarter of the total supply. But as China and India emerge as world economic players, they are demanding significantly more oil for autos and industry. In fact, China has become the No. 2 world consumer of oil. And with a population almost four times ours (and yet, only slightly larger than India's), there's increasingly more demand for oil and natural resources.

At the same time, the potential to increase the global oil supply may be more limited than in the past. Saudi Arabia and other oil-exporting countries are already producing close to capacity. Static supply and increased demand will inevitably cause energy prices to rise. Like budget surpluses, cheap energy and natural resources are unlikely to return anytime soon.

What does this mean to me?
If foreign countries stop buying our debt, that will cause long-term bond prices to drop, interest rates to rise and the dollar to fall. Excess demand for energy and natural resources from China and India will likely spur a rise in U.S. inflation rates. Higher interest rates and inflation coupled with a weak dollar make long-term bonds a risky investment with very little upside. Investors looking to invest new money in fixed income will be better off investing in short-term bonds.

The impact on the overall stock market is less clear -- some sectors will benefit while others will struggle. The drop in long-term bond prices may be harmful to certain types of financial firms, for example. Rising oil prices may help energy companies but hurt manufacturing, while a falling dollar may make many of our products more competitive overseas.

Overall, the market is strong and more reasonably priced today than it was a few years ago. Price-to-earnings ratios have come down from highs in the 40s in 2000 to half that today. And that ratio hasn’t come down because prices dropped, but rather because corporate earnings have increased -- a much healthier reason. Today’s lower stock valuations make the market much more attractive and should attract more money to stocks, which should drive their prices higher.

Roger Ibbotson, Ph.D., is chairman and founder of Ibbotson Associates, a Chicago-based financial diversification company, and a professor of finance at the Yale School of Management.

Hybrid Loan Time Bomb

The HeraldTribune is reporting the clock is winding down on the Hybrid Loan and Sub-Prime mortgage time bombs.

Starting in 2006 and accelerating into 2007, as much as $2.5 trillion worth of the fancy mortgages called "hybrids" are coming to the end of the free-lunch part of the deal. Economists are still trying to put numbers on this reset factor, particularly when it comes to the riskiest home loans, referred to as
"sub-prime."

"We don't have enough data to know how big a problem this will be," said David Berson, chief economist at Fannie Mae, the nation's largest mortgage packager.

The ticking clock

Sarasota's John Barron is typical of the new crop of homeowner-investors. He and his wife, Lauren Wood, are sitting on big profits at two 2004 purchases in the up-and-coming Gillespie Park neighborhood, close to downtown Sarasota.

But the couple made their big moves using ARMs that are about to be reset. If they don't act soon, their monthly bills will rise by hundreds of dollars per month. They used two separate three-year, interest-only, adjustable-rate mortgages from SunTrust Bank to buy the homes within the past two years.

"Besides the two ARMs, we also took out a home equity line on the Seventh Street house to put down a deposit on the Fifth Street house. There was no cash that we had in our pockets to put down on the Fifth Street house. All we had was our shining credit record. And the faith that the banks have in this real estate market that allows you to borrow 100 percent."

Barron and Wood have a lot of company, says Paul Kasriel, chief economist at Chicago-based Northern Trust.

With possibly $2.5 trillion in household debt that is going to be repriced higher "the household debt-service ratio is bound to climb to new highs," Kasriel wrote last month. "Asset bubbles are characterized by cheap credit. Usually what bursts a bubble is higher cost of credit, because that is what inflates the bubble, is cheap
credit."

At Sarasota's Integrity Mortgage Group, ARMs have far and away taken over as the most popular. Five years ago, there was only an occasional one-year or five-year ARM. "Out of 200 loans you'd do 10 adjustables," Integrity President Jason Thurber said. "In the last year, I've probably done five fixed-rate loans, 30- or 15-year, out of 150 loans. So all the rest are some kind of hybrid."

The big picture looks similar, says SMR Research of Hackettstown, N.J., which regularly surveys lenders who make 90 percent of America's home loans.

"I can say that the first half of this year, ARM share was 55 percent nationally," said SMR's George Yacik. "For the full year 2004, it was 50 percent." Making matters worse, it is the the sub-prime lenders issuing the most adjustable-rate mortgages. With those who participate in the survey, 80 percent of their loans were ARMs compared to 55 percent in the broader market.

Fannie Mae looked at 2002-2004 loan data to determine what portion of the existing loan pool would be "adjusted," and when. Fewer than 10 percent of the conventional conforming loans will reset in 2006-2007, but nearly two-thirds of sub-prime loans will. That is because a large portion of the sub-prime loans are two-year adjustables, says Berson, the Fannie Mae chief economist.

Berson offered a typical example of what the industry calls a "2-28," an ARM in which the interest rate is fixed for the first two years and then adjusts regularly for the next 28 to whatever index the loan calls for. The average yearly cap on this loan is 2.3 percentage points per year.

Roughly speaking, a consumer's monthly bill could rise from $330 to as much as $1,425 to $1,755.

Fannie Mae expects sub-prime loans to be reset en masse this year with that trend continuing into 2007.

But over at the Mortgage Bankers Association, senior economist Michael Fratantoni is more interested in the five-year adjustables that were issued during the refi craze
of 2002-03. That's a large crop that will sprout in 2007.

"The estimate is that in 2007, more than a trillion dollars worth of hybrids are going to hit their first reset date," he said.

That one chunk of hybrid loans represents 12 percent of the $8.8 trillion in single-family home loans outstanding nationwide.

Like many ARM borrowers, Barron, the Gillespie Park buyer, is not really sure how much his payment will go up when the loans are reset. The new rate is a moving target. "Come year four, they adjust it based on the prime rate," he said. "It is like prime rate plus two, or, I can't remember exactly what the adjustment is."

At Washington Mutual's Bee Ridge Road office in Sarasota, 25 percent of current applications are for option ARMs, says senior loan consultant Mike Bangasser.

For customers with good credit, there is only about a half-percentage point difference between the 5.75 percent rate on an option ARM and the 6.375 percent rate on a 30-year fixed rate mortgage.

So why bother with the ARM?

This is the key: The minimum payment today on a $200,000 option ARM would be only $678, a little more than half the cost on a 30-year, fixed-rate loan. On that $200,000 loan, a 30-year fixed would be $1,248 per month in principal and interest. With the option ARM, there are three other payment choices: $958, $1,167 or $1,661.

The $678 payment doesn't even cover all the interest, Bangasser acknowledged.

He guesstimated that if somebody borrowed $250,000 on a typical option ARM and made minimal payments for five years they would be "going to be in the hole 15 percent to 20 percent of your original balance, meaning $285,000 to $300,000."

"You don't have to have negative am," Grande said. "As long as you make that fully-indexed payment, you're fine. But most folks aren't doing that. They take the easy way out, get themselves in trouble."

There is one more ingredient to add to this layer cake, and it is one that barely occurs to most borrowers today: What if someday, loans were difficult to get?

"Consumers have become so accustomed to very liquid mortgage markets, where credit is available for almost any circumstance, that they are not aware this is unusual in the market," HSH's Gumbinger warned. "Somewhat tighter credit availability and somewhat higher interest rates are much more normal."

"Borrowers think they can always refinance. That is not always a safe bet."

It's hard to know where to start with this kind of nonsense. But people still insist there is no housing bubble in the U.S. That this type of activity occurs routinely is clear evidence of a credit lending bubble. Given that the credit lending bubble has grossly affected home prices, it should be obvious there is a housing bubble as well. Day in and day out however, someone writes an article telling us why this time is different and how affordable housing really is.

We have been talking about a possible "credit event" when these loans reset, so I guess we do not have much longer to see. It may not be a "big bang" however, as these loans are scattered throughout 2006 and 2007.

It is amazing to me that people in these loans are nearly clueless as to what their loans might get reset to. Barron's loan adjusts to prime rate +2 or something like that but he "can't remember exactly what the adjustment is." Yikes, that is 9.25%, on three properties! He has three 100% loans based solely on "shining credit" and someone crazy enough to make the loan. Perhaps a better way of stating it is some hedge fund or mortgage player or investor is crazy enough to take that risk for perhaps an extra 1/4 point or 1/2 point over treasuries. Is that a good deal? I think not!

Luxuries you can live without -- and should

$200 jeans? $800 sheets? Paying a premium now for image and brand cuts into our real quality of life down the road.

By MP Dunleavey

Correct me if I'm wrong, but it wasn't that long ago when the mere concept of Williams-Sonoma (or Restoration Hardware, Crate & Barrel, et. al.) would have struck most folks as . . . nutty.

Oh sure, I'll pay a premium price to buy upscale versions of ordinary stuff -- replacing functional things I already own -- because my lifestyle must reek of affluence!

Thirty years ago, people would have scoffed at such vanity. Today, inundated by high-end specialty stores in every corner of the retail market, more and more Americans are succumbing to the siren song of these so-called affordable luxuries. And at what cost?

A case of 'affluenza'.

In his book "Luxury Fever," economist Robert Frank describes the rise of this swankier-is-better mentality -- and the toll it's taking on people's financial lives.

"Although it is the mansions of the super-rich that attract attention -- homes of 15,000, 20,000, even 40,000 square feet -- the far more newsworthy fact is that the area of the average house built in the United States is now more than roughly twice what it was in the '70s," he writes.

The trappings of affluence are no longer limited to those who can afford them. Increasingly, middle-class Americans will pay top dollar just to have the veneer of luxury -- and retailers, wizards that they are, continue to provide the fantasy of wealth, even when all you're buying is a garden trowel.

The things we can't live withoutIn case you have NO idea what I'm talking about, please scroll through this list of once-ordinary goods and services that now come in versions ranging from the merely overpriced to the truly outrageous:

Pots: Now known as "cookware." Please think nothing of paying $125 for an All-Clad omelette pan. Eggs not included.

Jeans: The $200 pair of designer denims is back. Which is good, because that pair of $75 Diesels just isn't cutting it anymore.

Knives: Still called "knives," but a set of prestige Henckels can set you back up to $1,500.

Cosmetics: The switch from Vaseline Intensive Care lotions ($2.49) to skin-sensitive Neutrogena ($7.99) is a slippery slope to Kiehls ($25) -- but then why not go ahead and splurge on La Mer, which starts at $90 for a fraction of an ounce.

Strollers: There's no limit to what you can splurge on baby gear, so I'll just use this brief example: If you invested the $700 you're inclined to spend on the trendy Bugaboo stroller, your child could retire with an extra $100,000.

Sheets: Now called "linens." It's amazing that people can justify paying $800 for 1,000-threadcount Royal Crest sheets when 20 years ago no one had any idea how many threads per inch their sheets had.

Sneakers: Now called "athletic footwear," and they have us paying $150 for a pair of Air Jordans instead of $25 for a pair of Keds. But price isn't the only problem. We also expect to own several pairs for all the sports we do.

Watches: Now they're "timepieces, but it's no longer about telling the time. For about $20, you can buy a watch with a quartz movement that won't lose a minute in the next 10,000 years. But even without the optional encrustation of diamonds, you'll still fork over $7,500 and up for a Rolex President or pay a couple hundred thousand for a Cartier watch. And we're still talking about a plain-looking gold watch -- not something Liberace would have worn.

Chocolates: It was the humble Hershey Bar that won WWII. Then along came Godiva at $16 a pound. But why not spend $84 a pound on Debauve & Gallais chocolates with (note all the place-specific names that make ordinary ingredients sound exotic) Piedmont hazelnuts, Turkish grapes, Bourbon Island vanilla and West Indies rum as ingredients. Now, try saying that list of ingredients without the place names and see if you still want to cough up $84.

Scotch: I can remember when people used to get excited about a bottle of Johnnie Walker Black, which will set you back about $50 these days. How could we have been so pedestrian? Now, nothing less than 30-year-old single malt will do. Price tag: $250 and up.

Bathrobes: You can get a nice flannel for about $50, or one made from Egyptian cotton (what's wrong with Texas cotton, anyway?) for $250. But really, the one we're all secretly lusting after is the $6,000 Daniel Hanson robe constructed (not made) with silk-trimmed pashmina. And where the hell did pashmina come from? Cashmere wasn't good enough anymore?

TV: Sure, you could spend $700 for a 36-inch conventional TV, but that's so '90s. Why not spend $5,000 for a 60-inch plasma screen? It'll only cost you a few thousand more to acquire a house with a living room big enough.

Wine glasses: Now called "wine stems," shelling out $130 for a set of six Riedel glasses is just the beginning. Now you need eight sets, each with a slightly different shape to "enhance individual grape varieties and styles of wine." And to think I used to believe that what was in my 6-for-$6 Ikea glass was all that mattered.

Many of these examples show that no matter how much you're willing to spend for a little luxury, there will always be a newer, better version out there that's beyond reach, taunting you. It's an arms race that pits the middle class against the upper-middle, who in turn are striving with the rich, who are struggling to live like the super-rich.

But it's an arms race all but the wealthiest are destined to lose. In the last five years, "the top 1% of earners have seen their wages shoot up like a rocket," says economist Chuck Collins, senior program developer at United for a Fair Economy, a research group in Boston.

Not so for the rest of us, writes Frank: "Middle- and low-income families have had to finance their higher spending by a lower rate of savings and sharply rising debt.

Retail therapy
If all these upscale purchases put the financial screws to the average Joe, whose dollar is already stretched, why does it continue?

It's tempting to buy into the "quality is worth paying for" rationale some would have you believe. But often the difference in quality is all but undetectable. Can your body really tell the difference between 300 and 1,000 threads per inch? We like to think of ourselves as connoisseurs, but how many people can really taste the difference between 30- and 40-year-old scotch?

Sometimes, the difference in quality is real, but the price you have to pay for it far exceeds whatever you might gain in durability, usefulness or design. A silk-trimmed pashmina bathrobe can be a beautiful thing, but $6,000? Please!

In reality, many of us use these splurges, affordable or not, to make ourselves feel better. Paco Underhill, a retail analyst and author of "The Call of the Mall," says acquiring various high-end lifestyle "accessories" gives a psychological lift to people "who have had to compromise on other things," he says. "They'd like to drive a Jaguar, but can't afford it, so instead they'll carry a Coach bag."

The price we pay
Sadly, this cycle of spending on image and brand tends to escalate. What was once a luxury or a one-time splurge quickly becomes a necessity. Harvard psychologist Daniel Gilbert dubbed it a pattern of "miswanting" -- because what people want (i.e. a life of wealth and luxury) can't be fulfilled just by acquiring the trappings of it.

And what's worse is that trying to buy the appearance of luxury can become a roadblock that stops you from building up your own, true wealth. Because -- as impressed as your friends are by your pricey "stems" or $700 stroller -- that's just money going toward a fantasy, instead of being invested in a way that might truly enhance your quality of life someday.