Authored by Charles Hugh Smith via DailyReckoning.com,
There are two kinds of prosperity, one fake, one real. Bogus “prosperity” depends on credit-asset bubbles inflating, magically creating “wealth” not from labor, production or improving productivity, but from the values of assets soaring as bubbles inflate.
This bubble-generated “wealth” then fuels a vast expansion of credit and consumption as assets soaring in value increase the collateral available to borrow against, and the occasional sale of soaring assets generate capital gains, stock options, etc., which then fund sharply higher consumption.
When the value of a modest home skyrockets from $200,000 to $1 million in a few years, that $800,000 in gain was not the result of any improvement in utility. The house provides the same shelter it did when it was worth 20% of its current value. The $800,000 gain is the result of the abundance of low-cost credit and the global search for a yield above zero.
Eventually, this vast expansion of “money” chasing yields and seeking places to park all the excess cash trickles into the real economy and the result is inflationary. Consider how soaring home prices affect rents.
Why All Credit-Asset Bubbles Are Self-Liquidating
When an investor bought the modest home for $200,000, the costs of ownership were low due to the costs being linked to the value: The property tax, insurance and mortgage were all based on the valuation. (The costs of maintenance were unrelated to valuation, of course, being based on the age and quality of construction.) Let’s say the modest house rents for $1,500 per month.
The investor who buys the modest home for $1 million has much higher costs, even if they bought the property with cash and didn’t need to borrow money (i.e., obtain a mortgage). The property taxes and insurance are much higher, and the comparable market rent of similar houses reflects the expected yield on investing $1 million: If investors expect a 3% yield after all expenses, then the rents have to rise so the investor/owner nets $30,000 annually.
Due to the valuation increasing in a bubble, the rent is now $4,500 per month, even though the house hasn’t materially gained any utility at all. The rent has to be high to justify the purchase price of $1 million.
This is why all credit-asset bubbles are self-liquidating: Once the cost of credit drops to near-zero, there’s no discipline left: Any loan for any investment can be justified by the “guaranteed” increase in value/collateral. Since everything will rise in value, then it makes sense to leverage up as much debt as possible to gain control of as many assets as possible, as the means to maximize gain.
This leads to marginal borrowers overextending, borrowing more than is prudent.
Free Money, Big Costs
All this nearly free money sloshing around seeps into the real economy, jacking up prices (such as rents) without increasing the production of goods and services or improving productivity. Costs rise solely as a result of the bubble, pressuring wage earners and enterprises.
Central banks are eventually forced to raise interest rates and reduce credit expansion to put the brakes on the bubble’s inevitable offspring, an inflationary spiral. Once credit is no longer expanding rapidly, the air starts leaking out of the asset bubbles.
Marginal borrowers can no longer roll over their debt based on ever-higher collateral (as valuations rise, so does the collateral to support new loans) and default becomes inevitable once markets tighten.
For example, those willing and able to pay outrageous rents thin out, and commercial residential properties are vacant, generating zero income.
But inflation generated by bubbles is “sticky.” Landlords are reluctant to drop rents, as they’ve been trained by central bank bailouts and decades of easy money/credit to expect a prompt resumption of the bubble’s expansion. This mentality permeates the entire economy.
Once valuations stop rising like clockwork, the bubble “prosperity’ is revealed as illusory. All the “wealth” was illusory; it wasn’t generated by improvements in productivity or the production of more goods and services; it was all based on soaring valuations driven by cheap, abundant credit and the bubble-mentality faith that bubbles never pop and so the “wealth” created by soaring stocks, bonds, collectibles and real estate would only continue expanding forever.
The inflation generated by bubbles remains as collateral crashes and credit expansion reverses into contraction. Suddenly, there are fewer greater fools willing to pay bubble prices for assets.
The smart money sold long ago, but the not-so-dumb money finally awakens to the potential downside of bubbles popping: Rather than reaping huge gains, assets might become illiquid (i.e., there are no buyers at any price) or valuations might fall faster than anyone believed possible in the heady bubblicious decades.
The Liquidation Phase
Bubbles liquidate the illusory “wealth” they generated when they pop, and then the bogus “prosperity” dissipates into the air from whence it came. The only source of real prosperity is improvements in productivity that generate more goods and services with fewer inputs of capital, labor, materials and energy.
So here we are: The global credit-asset bubbles are popping, and the illusory “prosperity” generated by the bubbles is about to tumble off a cliff. The $20,000 week at the posh resort was fun, as was the $80 lunch for two (two avocado toasts and two beverages), but it was all fake, phony, a fraud.
Jacking the valuation of a bungalow fivefold doesn’t actually improve productivity or create any new goods and services. It jacked up prices and property taxes, but it didn’t actually create any real wealth.
Alas, the natural order of markets is mean reversion and the collapse of whatever is unsustainable. This includes speculative manias, credit bubbles, asset bubbles and projections of endless expansion of margins, profits, sales, consumption, tax revenues and everything else under the sun.
The Psychology of Collapse
There’s a well-worn psychological path in the collapse of bubbles. This path more or less tracks the Kubler-Ross stages of denial, anger, bargaining, depression and acceptance, though the momentum of speculative frenzy demands extended displays of hubris and overconfidence, i.e., the first wobble “must be the bottom.”
There are also repeated spikes of false hope that “the bottom is in” and the bubble is starting to reflate.
This pattern repeats until the speculative fever finally breaks and all those betting on a resumption of the bubble mania finally give up.
This process often takes about the same length of time that it took for the bubble mania to become ubiquitous. If it took about 2½ years for the bubble to expand, it takes about 2½ years for the bubble to pop and the market to return to its pre-bubble level.
Once again we hear reasonable-sounding claims being used to support predictions of a never-ending rise in stock valuations.
What hasn’t changed is humans are still running Wetware 1.0, which has default settings for extremes of emotion, particularly manic euphoria, running with the herd (aka FOMO, fear of missing out) and panic/fear.
Despite all the assurances to the contrary, all bubbles pop because they are based in human emotions. We attempt to rationalize them by invoking the real world, but the reality is speculative manias are manifestations of human emotions and the feedback of running in a herd of social animals.
It’s a long way to the bottom, but it won’t take as long as many seem to think.