Housing is at the root of many of the rich world’s problems

Since the second world war, governments across the rich world have made three big mistakes, says Callum Williams

The financial crisis of 2008-10 illustrated the immense dangers of a mismanaged housing market. In America during the early to mid-2000s irresponsible, sometimes illegal, mortgage lending led many households to accumulate more debt than they could sustain.

Between 2000 and 2007 America’s household debt rose from 104% of household income to 144%. House prices rose by 50% in real terms. The ensuing wave of defaults led to a global recession and nearly brought down the financial system.

From the 1960s to the 2000s a quarter of recessions in the rich world were associated with steep declines in house prices. Recessions associated with credit crunches and house-price busts were deeper and lasted longer than other recessions did. Yet the damage caused by poorly managed housing markets goes much deeper than financial crises and recessions, as harmful as they are.

In rich countries, and especially in the English-speaking world, housing is too expensive, damaging the economy and poisoning politics. And it is becoming ever more so: from their post-crisis low, global real house prices have since risen by 15%, taking them well past their pre-crisis peak.

Traditionally politicians like it when house prices rise. People feel richer and therefore borrow and spend more, giving the economy a nice boost, they think. When everyone is feeling good about their financial situation, incumbent politicians have a higher chance of re-election.

But there is another side. Costly housing is unambiguously bad for the rich world’s growing population of renters, forcing them to trim spending on other goods and services. And an economic policy which relies on homebuyers taking on large debts is not sustainable. In the short term, finds a study by the imf, rising household debt boosts economic growth and employment.

But households then need to rein in spending to repay their loans, so in three to five years, those effects are reversed: growth becomes slower than it would have been otherwise, and the odds of a financial crisis increase.

Malfunctioning housing markets also hit the supply side of the economy. The rich world’s most productive cities do not build enough new houses, constraining their growth and making them more expensive than they would otherwise be. People who would like to move to London, San Francisco or Sydney cannot afford to do so. Since productivity and wages are much higher in cities than outside, that reduces overall GDP.

So it is bad news that, in recent decades, the rich world has got worse at building new homes. A recent paper by Kyle Herkenhoff, Lee Ohanian and Edward Prescott argues that in America this process has “slowed interstate migration, reduced factor reallocation, and depressed output and productivity relative to historical trends”.

Constraints on urban growth also make it harder to reduce carbon-dioxide emissions, since big cities are the most efficient built forms. In America there are more building restrictions in places which have lower emissions per household.

Housing is also a big reason why many people across the rich world feel that the economy does not work for them. Whereas baby-boomers tend to own big, expensive houses, youngsters must increasingly rent somewhere cramped with their friends, fomenting millennials’ resentment of their elders.

Thomas Piketty, an economist, has claimed that in recent decades the return to capital has exceeded what is paid to labour in the form of wages, raising inequality. But others have critiqued Mr Piketty’s findings, pointing out that what truly explains the rise in the capital share is growing returns on housing.

Other research, meanwhile, has found that housing is behind some of the biggest political shocks of recent years. Housing markets and populism are closely linked. Britons living in areas where house prices are stagnant were more likely to vote for Brexit in 2016, and French people for the far-right National Front in the presidential elections of 2017, according to research from Ben Ansell of Oxford University and David Adler of the European University Institute. Political disputes sparked the protests in Hong Kong, but the outrageous cost of accommodation in the city-state has added economic fuel to the political flames.

This special report will argue that since the second world war, governments across the rich world have made three big mistakes. They have made it too difficult to build the accommodation that their populations require; they have created unwise economic incentives for households to funnel more money into the housing market; and they have failed to design a regulatory infrastructure to constrain housing bubbles.

Happily, they are at last starting to recognise the damage caused by these policies. In Britain the government now openly says that the housing market is “broken”. Scott Morrison, Australia’s prime minister, has pledged to make housing more affordable. Canada’s recent election was fought partly on who would do more to rein in the country’s spiralling housing costs. Carrie Lam, Hong Kong’s chief executive, has put housing front and centre in her response to the protesters.

They need to learn from places where the housing market broadly works—and those places do exist. As this report shows, flexible planning systems, appropriate taxation and financial regulation can turn housing into a force for social and economic stability.

Singapore’s public-housing system helps improve social inclusion; mortgage finance in Germany helped the country avoid the worst of the 2008-10 crisis; Switzerland’s planning system goes a long way to explaining why populism has so far not taken off there.

Governments across the world need to act decisively, and without delay.

Nothing less than the world’s economic and political stability is at stake.

Viral injections

Companies warn of economic crisis as China fights the coronavirus

The government steps up support, not to boost growth but to ensure social stability

RARELY HAVE plans in China fallen apart so swiftly, so publicly. On January 12th the leaders of Hubei declared that the province’s GDP would grow by 7.5% this year. They also vowed to make the province a stronger link in high-tech supply chains. They made no mention of a mysterious new virus that was causing pneumonia and spreading fast through the cities and towns under their watch.

But less than two weeks later its scale was too big to ignore. Under intense pressure to act, they placed the entire province under quarantine, hemming in 60m people and rendering their flashy economic targets almost certainly unreachable this year. Their focus instead shifted to stopping the illness and keeping people supplied with necessities.

The lurch from confidence to anxiety has echoed throughout China. In the months leading up to the coronavirus outbreak, the stockmarket had rallied. Businesses were upbeat about their prospects this year, not least because China and America had finally reached a deal in their long-running trade war. But over the past two weeks, as the government has begun a full-scale fight against the epidemic, optimism has crumbled.

Share prices in mainland China have fallen by 10% since January 20th. Factories and offices, already shut for the new-year holiday, were supposed to reopen in recent days but many have stayed shut. Most provinces have ordered them to remain idle until February 10th, if not longer. Poultry farmers have warned that their chickens might starve because roadblocks have snarled their feed supplies.

Businesses have started dipping into their cash reserves. Restaurants and hotels have been hit especially hard because few people anywhere in China, not just Hubei, dare venture out. In one interview that was shared widely on social media before being censored, Jia Guolong, founder of Xibei, a popular restaurant chain, said that if the lockdown persisted for a few more months, vast numbers could lose their jobs. “Wouldn’t that be an economic crisis?” he asked.

Analysts have rushed to cut their forecasts for economic growth. The consensus had previously been that GDP would expand by about 6% year-on-year in the first quarter. Now several think that 4%, the slowest since China started publishing quarterly figures in 1992, is more likely, with risks firmly tilted to the downside. As with past epidemics, there is sure to be a strong recovery when the virus is eventually contained.

But there is much uncertainty about when that might be. Three unknowns will dictate the recovery’s timing: how long it takes to bring the virus under control; how long after that the government relaxes its heavy-handed restrictions on daily life; and how long after that people resume the whirl of activity that normally makes the Chinese economy so vibrant.

For economic policy, this presents a challenge. Usually, the further into the future you peer, the greater the uncertainty. But China’s officials can be reasonably confident in assuming that growth will return to its pre-virus trajectory next year.

It is the next couple of months that are the black hole. In this environment flexible measures to help people and companies through a difficult patch are most sensible. These can be pared back when the rebound arrives. Getting them right, though, is not easy.

It is worth noting what China is avoiding, so far at least. Some have speculated that officials will unleash a big stimulus, perhaps a vast new array of infrastructure projects, to get growth back up to speed. But it is too soon for that. The government does not want people on building sites or in factories at the moment.

Much of its efforts are aimed at keeping them in their homes, in order to prevent the virus spreading. Moreover, there is a lag between unveiling infrastructure plans and breaking ground. The boost from projects announced today could start as the economy is gathering steam on its own, leading to overheating.

Instead, China is using a combination of temporary cash support, market interventions and forbearance to get through the crisis. On February 3rd the central bank made headlines by injecting 1.2trn yuan ($172bn) into the financial system (it bought treasury bonds from banks which promised to buy them back within 14 days).

Banks will probably suffer from rising loan defaults in the coming weeks, and this gives them more cash to work with. When the repurchase agreements come due, the central bank could choose, in effect, to extend them if needed.

Officials are meddling in the market (or, as they would say, managing it) out of concern that investors may be too pessimistic in the near term. Because many companies have pledged their equity as collateral for loans, they would need to sell assets as share prices fall, only adding to the downward pressure. So regulators, having already delayed the reopening of the stockmarket after the new-year holiday, told brokerages to bar clients from short-selling, according to Reuters.

Chinese shares still dropped by 8% on February 3rd, their steepest one-day fall since 2015, but they were largely catching up with the Hong Kong market, which had been open the previous week. On February 4th, shares rose a little more than 1%, suggesting that the stabilisation tactics were working.

Finally, officials have been advocating and orchestrating forbearance on various fronts. Shanghai was due to increase companies’ social-security contributions on April 1st. The city has delayed that by three months, saving firms an estimated 10bn yuan.

In Beijing, the municipal government has encouraged landlords to cut their commercial tenants’ rents; in exchange, it will provide them with subsidies. And regulators have called on banks throughout the country to roll over loans to companies, such as small manufacturers, which would otherwise lack the cash buffers to survive the work stoppage.

Even as the death toll continues to mount, some officials are already thinking about economic distortions that have arisen in the course of the battle against the epidemic. Hospitals have faced shortages of protective equipment such as masks, gowns and gloves.

So the government has called on companies to increase production. Many, feeling a sense of duty, have heeded the call. But as Liu Shangxi, an adviser to the finance ministry, has noted, this means that medical-equipment firms will suffer from severe overcapacity after the crisis passes. The government should thus be ready, he argues, to compensate them.
Such proposals are a far cry from the bold growth-and-investment plans that Hubei’s provincial leaders laid out less than a month ago. Yet the priority now is not to stimulate the economy or climb the technology ladder but to ensure that society remains stable as the quarantines and controls drag on. China’s grim new reality is that everything, economic policy included, revolves around the question of how to beat the virus.

The Fed Won't Avert The Next 'Crisis,' They Will Cause It


- The ultra-low interest rate policy administered by the Federal Reserve is responsible for the "yield chase," and the massive surge in debt since the "financial crisis."

- Rising levels of non-productive debt has negative long-term economic consequences.

- Despite the best of intentions, lowering interest rates to zero did not spark a "bank lending spree" throughout the economy.

- Instead, the excess liquidity flowed directly back into the financial system, creating a global wealth gap, rather than supporting stronger economic growth.
John Mauldin recently penned an interesting piece:
"Ignoring problems rarely solves them. You need to deal with them - not just the effects, but the underlying causes, or else they usually get worse. In the developed world, and especially the US, and even in China, our economic challenges are rapidly approaching that point. Things that would have been easily fixed a decade ago, or even five years ago, will soon be unsolvable by conventional means.Yes, we did indeed need the Federal Reserve to provide liquidity during the initial crisis. But after that, the Fed kept rates too low for too long, reinforcing the wealth and income disparities and creating new bubbles we will have to deal with in the not-too-distant future.

This wasn't a 'beautiful deleveraging' as you call it. It was the ugly creation of bubbles and misallocation of capital. The Fed shouldn't have blown these bubbles in the first place."
John is correct. The problem with low interest rates for so long is they have encouraged the misallocation of capital.
We see it everywhere throughout the entirety of the financial system from consumer debt, to subprime auto-loans, to corporate leverage, and speculative greed.
Misallocation Of Capital - Everywhere
Debt, if used for productive purposes, can be beneficial. However, as discussed in "The Economy Should Grow Faster Than Debt":
"Since the bulk of the debt issued by the U.S. has been squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments."
Currently, throughout the entire monetary ecosystem, there is a rising consensus that "debt doesn't matter" as long as interest rates and inflation remain low.
Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the "yield chase," and the massive surge in debt since the "financial crisis."
Yes, current economic growth is good, but not great. Inflation, and interest rates, remain low, which creates an illusion that using debt remains opportunistic. However, as stated, rising levels of non-productive debt has negative long-term economic consequences.
Before the deregulation of the financial industry under President Reagan, which led to an explosion in consumer credit issuance, it required just $1.00 of total system-wide debt to create $1.00 of economic growth.
Today, it requires $3.97 to create the same $1 of economic growth.
This shouldn't be surprising, given that "debt" detracts from economic growth as the "debt service" diverts income from productive investments and leads to a "diminishing rate of return" for each new dollar of debt.
The irony is that while it appears the economy is growing, akin to the analogy of "boiling a frog," we accept 2% economic growth as "strong," whereas such growth rates were previously considered near-recessionary.

Another conundrum is that corporations and financial institutions appear to be healthier, not to mention wealthier than ever. If such is indeed the case, then why is the Federal Reserve still needing to engage in "emergency monetary measures" to support the financial markets and economy after more than a decade?
As John stated above, the Fed's actions are only "ignoring the problems," which, combined, is a problem too large for the Federal Reserve to fix.
The Dark Side Of Stock Buybacks
While many argue that "share buybacks" are just a method by which corporations can return cash to shareholders, there is a dark side. In moderation, repurchases can be a beneficial method for a company to deploy capital when no better options are available. (It's the least best use of cash.)
But as with everything in life, when taken to "excess," the beneficial effects can become detrimental.
"The rules now reward management, not for generating revenue, but to drive up the price of the share price, thus making their options and stock grants more valuable."

- John Mauldin
The problem for the Fed was, despite the best of intentions, lowering interest rates to zero did not spark a "bank lending spree" throughout the economy. Instead, the excess liquidity flowed directly back into the financial system, creating a global wealth gap, rather than supporting stronger economic growth.
The most vivid example of this "closed loop" was in corporate share repurchases. Corporations, able to borrow cheaply due to low rates, used debt and cash to repurchase shares to increase earnings per share. This was the easiest route to create "executive wealth," rather than deploying capital in more risky endeavors. As the Financial Times penned:
"Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices."
Importantly, as noted by the Securities & Exchange Commission:
"SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks."
Again, buybacks may not be an issue, but when taken to excess, such can have the negative side effects of inflating asset bubbles. As John Authers pointed out:
"For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve's spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices."
"Stock buybacks" are only a short-term benefit. With liquid cash - or worse, debt - used for a one-time benefit, there is a long-term negative return on uses of capital for non-productive investments.
All Levered Up
Currently, total corporate debt has surged to $10.1 trillion - its highest level relative to U.S. GDP (47%) since the financial crisis.
In just the last two years, corporations have issued another $1.2 trillion of new debt not for expansion, but primarily used for share buybacks.
For the last 10 years, the Fed's "zero interest rate policy" has left investors chasing yield, and corporations were glad to oblige.
The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historical lows, and debt has allowed many "zombie companies" to remain alive.
During the next market reversion, the 10-year rate will fall towards "zero" as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds will be decimated.
When "high yield," or "junk bonds," begin to default in large numbers, as they always do in a recession, which is why they are called "junk bonds," investors will face sharp losses on the one side of their portfolio they "thought" was safe.
As the credit market falls into crisis, the Fed will have to ramp up additional stimulus to bail out the financial institutions caught long with an exceeding amount of poor-quality debt.
As shown below, Treasuries will gain a bid as yields fall to zero, while corporate bonds lose value.

"In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion-an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality Ladder.
And there's a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis."
- John Mauldin
As noted previously, there is a large tranche of BBB bonds on the verge of being downgraded to "junk."
When this occurs, there will be an avalanche of selling as pension, mutual, and hedge fund managers dump bonds simultaneously into what will be an illiquid market.
Pensions Are Broke
But it is not just "share buybacks" and debt, which are problems hiding in plain sight.
"Moody's Investor Service estimated last year that the total pension funding gap in the U.S. is $4.4 trillion. A few months ago, the American Legislative Exchange Council estimated it at nearly $6 trillion."
With pension funds already wrestling with largely underfunded liabilities, the aging demographics are further complicating funding problems.
The $6 Trillion "Pension Crisis" is just one sharp market downturn away from imploding. As I wrote in "The Next Financial Crisis Will Be The Last":
"The real crisis comes when there is a 'run on pensions.' With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the 'fear' that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are declining, will cause a debacle of mass proportions. It will require a massive government bailout to resolve it."
This $6 trillion hit is going to come at a time where the Federal Reserve will already be at "full tilt" monetizing debt to stabilize declining financial markets to keep a "debt crisis" from spreading.
Strike Three, You're Out
While investors have become extremely complacent over the last decade that Central Banks have gained control of the financial markets, this is likely an illusion. There are numerous catalysts which could pressure a downturn in the equity markets:
  • An exogenous geopolitical event
  • A credit-related event
  • Failure of a major financial institution
  • Recession
  • Falling profits and earnings
  • A loss of confidence by corporations, which contracts share buybacks
Whatever the event is, which is currently unexpected and unanticipated, the decline in asset prices will initiate a "chain reaction."
  • Investors will begin to panic as asset prices drop, curtailing economic activity and further pressuring economic growth.
  • The pressure on asset prices and weaker economic growth, which impairs corporate earnings, shifts corporate views from "share repurchases" to "liquidity preservation." This removes a major support of asset prices.
  • As asset prices decline further and economic growth deteriorates, credit defaults begin triggering a near-$5 trillion corporate bond market problem.
  • The bond market decline will pressure asset prices lower, which triggers an aging demographic who fears the loss of pension benefits, which sparks the $6 trillion pension problem.
  • As the market continues to cascade lower at this point, the Fed is monetizing nearly 100% of all debt issuance and has to resort to even more drastic measures to stem selling and defaults.
  • Those actions lead to a further loss of confidence and pressure markets even further.
The Federal Reserve can not fix this problem, and the next "bear market" will not be like that last.
It will be worse.
As John concluded:
Coordinated monetary policy is the problem, not the solution. And while I have little hope for change in that regard, I have no hope that monetary policy will rescue us from the next crisis.

Let me amplify that last line: Not only is there no hope monetary policy will save us from the next crisis, it will help cause the next crisis.
The process has already begun."
- John Mauldin

How to Invest in China’s Perilous Demographics

Aging and shrinking populations are bad news for productivity and economic growth, but may be good for owners of government bonds.
 By Mike Bird

There were 10.5 new births per thousand Chinese people in 2019, the lowest rate since the Communist Party established the People’s Republic of China in 1949. Photo: Mark Schiefelbein/Associated Press

China’s birthrate fell to its lowest level in modern history in 2019, according to official data.

That is one of the most serious issues for the country’s economic future, but may also be bullish for one asset class: the country’s government bonds.

Just 10.5 new births per thousand Chinese people were recorded last year.

The United Nations expects the country’s population to begin declining before the end of the current decade.

A working paper published by the Federal Reserve Bank of San Francisco in 2016 suggests there are two ways demographic changes can reduce real interest rates, driving down bond yields.

Rising longevity means workers save more for old age, resulting in ample funds available for investment.

At the same time, the amount of existing capital per worker increases as the labor force shrinks.

Higher savings and less demand for investment drives down nominal rates, and lower spending means lower pressure on prices and inflation.

Likewise, a review of the literature by the Society of Actuaries in 2018 generally supported the idea that aging societies can increase bond prices.

And an International Monetary Fund study last year noted similar findings in international research.

Investors should approach these conclusions tentatively: Though the case of Japan provides some real-world support for the theory that aging reduces real rates, economists are still able to say surprisingly little for certain on the effects of aging societies on financial markets.

But demography is just one reason why Chinese government bonds make up an important part of a global portfolio.

The country’s capital controls have proved their ability to withstand stress.

The economy is undoubtedly slowing—which usually means lower rates and higher bond prices—and the asset class is still relatively uncorrelated with developed-market government bonds.

Though many countries world-wide face demographic headwinds, China stands out given its unusually low income levels: Its fertility rate fell below the replacement rate of two per woman almost two decades ago, when the country’s GDP per capita was around $1,000 in 2010 price terms.

South Korea’s per-capita GDP was around five times that high when it reached the same threshold, and Japan’s was more like 20 times as high.

Investments that might actually benefit from the many long-term threats China faces are hard to come by.

Western investors looking for China exposure—without betting on a return to rapid growth—should consider buying government bonds for the ride ahead.

Why banks are bowing out of Europe’s bond markets

Number of primary dealers is around the lowest in data going back to 2006

Philip Stafford in London

A graphic with no description

Ultra-low interest rates and reduced trading profits are taking their toll on the banks that play a pivotal role in Europe’s sovereign debt markets.

At the end of December, UBS withdrew as a “primary dealer” in the Irish debt market, a move that extends a deeper industry decline and leaves the €8.3tn EU market increasingly dependent on a shrinking band of intermediaries.

Primary dealers help governments raise money from investors by pricing and selling debt.

The average number of such dealers in the EU fell to its lowest on record after four banks exited the business between January and November, according to Afme, the trade association.

The number of primary dealers in 11 EU countries is now around the lowest since Afme began collecting data in 2006.

Many European banks are reassessing these divisions after years of poor performance and meagre returns.

Among critical factors identified by Afme: low levels of new supply and investors’ tendency to hang onto their bonds rather than trade them. Issuance of bonds and bills by euro-area governments declined from €1.4tn in the first half of 2009 to €1tn in the first half of 2019.

The European Central Bank’s €2.6tn quantitative easing programme has also meant national central banks mopped up large volumes of debt.

Ireland fell from 16 dealers to 15, in line with the EU average.

But other countries have seen falls too, since the financial crisis.

The Italian sovereign debt market has 16 primary dealers, down one-third since May 2006.