Quantum Pranx


Pockets of Rot

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by Martin Hutchinson
Originally posted November 30, 2009

THE COLLAPSE OF DUBAI WORLD is pretty unsurprising; when examined closely, the Dubai real estate market was always likely to prove a gigantic bubble. It does, however, raise the question: how many other pockets of rot are around globally, left over from the cheap money boom of 2003-07 and likely to plunge the world’s markets into gloom by their collapse?

Even at the peak of its fashion allure in 2007-8, Dubai was clearly a market that had got ahead of itself. Residential mortgages were available at a cost of 7% below the local inflation rate, and were eagerly snapped up by ignorant expatriates in a sure sign that the local construction industry was running way ahead of genuine demand.

Bizarre relocation decisions were being taken worldwide. It may have made sense for Halliburton, the giant oilfield services company, to relocate its CEO and headquarters staff to Dubai in March 2007 (though Texas, its original home, produces a lot more oil). However, it made no sense whatever for the International Cricket Council (ICC) to move to Dubai in 2005 – a country in which cricket is played very little, and which, however much it spends on fancy cricket grounds, lacks the essential of a successful cricket match – spectators cheering on the local team. The move was undertaken for unsavory tax reasons; its result however has been that the ICC is now completely removed from the bedrock support of the game, either in Britain, Australia, India or anywhere else, and so is prone to making increasingly eccentric and damaging decisions which it imposes on the world’s cricketers.

Thus the collapse of the Dubai real estate market is little if any loss to the global economy, although it causes one to raise further eyebrows at the amounts of money the world’s banks committed to the bubble. HSBC shareholders, in particular, should ask some tough questions of the bank’s management, while British taxpayers can groan once more in the knowledge that RBS management was as capable of running into gigantic losses in real estate lending abroad as at home.

Dubai’s problem, and that of several other hidden pockets of rot in the world economy, was the 14 years and counting of excessively loose monetary policy, initially in the United States and from 2000 worldwide. This stimulated investment in fixed assets far beyond the level required by the world economy. It also prolonged the life of many uneconomic operations that could be propped up with easily available money from compliant banks. It allowed the less productive areas of the investment banking/brokerage business to grow to immense size, to the enormous profit of their senior employees, largely at the expense of everybody else. Finally, it allowed the establishment of innumerable entrepreneurial ventures, initially in dot-coms but more recently in clean-tech, that lacked a solid economic basis and attracted capital purely because of their fashionable sector and capital’s infinite availability.

These artificial constructs won’t last forever. An unneeded building constructed with cheap money never attracts sufficient tenants and so is permanently a drain on its owners. An uneconomic business kept open with cheap money does not generally recover, but becomes more uneconomic, multiplying the losses when it eventually fails. A trading operation built with cheap money flourishes fine while money remains cheap, but is forced into enormous losses and rapid disappearance (like the subprime mortgage securitization business in 2007) once the cheap money dries up. An entrepreneurial business that is founded primarily with cheap money does not grow into a self-sustaining, employment-providing venture, but instead limps along sucking in more resources, always one deal away from viability.

Beyond Dubai, therefore, there are a number of other areas that on closer inspection appear to be patches of rot that will eventually collapse, causing immense losses to those involved in them.

One such pocket of rot is undoubtedly China. People have been writing this for at least a decade, and have lost credibility because collapse never happens. Nevertheless, China, while big enough and opaque enough to hide problems, is NOT immune to the normal laws of economics. It now bears every sign of a gigantic jerry-built economic edifice waiting to crumble. China has had money supply growth in the past year at 28.7%, with the government now doing 50-year bond issues at 4.4%, far less than the rate of inflation – both signs of a market in extreme bubble mode. It also has a mass of uneconomic state industries that have been propped up by the banking system, a gigantic portfolio of real estate investment financed by cheap loans that has been built far ahead of demand, casinos in its stock exchanges that are supporting immensely lucrative but fragile trading operations, and innumerable entrepreneurial ventures in all sectors of the economy, at least a substantial percentage of which have to be non-viable.

Having all four types of bubble-created rot (albeit in different degrees), China must eventually undergo the collapse that is necessary to remove the rot and restore its long-term growth prospects. That’s not to say China isn’t the great growth economy of the 21st century – it probably is – but it has to go through a truly gigantic financial crash first, before resuming its growth on a healthier basis, probably at least 5-10 years later.

A second “pocket of rot,” quite localized but nevertheless involving a lot of capital, is the London housing market. U.S. house prices have declined from their overvalued state in 2006 by about 25% to somewhere near their long-term average in terms of national earnings (but still have further to go before finally bottoming, as interest rates rise to a more normal level and subsidies are removed). However, the British housing market, which was far more overvalued, with the average dwelling price being about 6 times average earnings at the peak compared to about 4.5 times in the United States, has declined by only about 10% from the peak and has recently rebounded. There is thus no question that London housing in particular is still far into bubble mode. At some point, the rot will make itself evident, prices will collapse by close to 50% and huge losses will result for foolish lenders and speculators, as well as for many unfortunate over-extended homeowners.

A third “pocket of rot” is Wall Street and the other global trading operations. These were created partly by misguided financial theories, but more especially by the ready availability of cheap money for over a decade. Had they been allowed to collapse in 2008, the world would have been the better for it. As it was, they were bailed out by unfortunate taxpayers, and have proceeded to make even more money in 2009, as finance has become even cheaper and more available – at least for rent-seeking trading. Their collapse will probably have to await the rise in interest rates and withdrawal of liquidity that is the inevitable denouement of the current commodities bubble.

At that point, the Wall Street houses will demand yet another bailout, claiming that their tangle of mutual obligations makes them systemically essential and that they play a vital role in the U.S. and global economies. The answer this time should be NO; their role has for the last decade been a negative one, and the parts of it that are genuinely essential can quickly be replicated by boutique operations staffed by those of their ex-employees that aren’t under indictment.

Finally, there is undoubtedly rot in the green-tech bubble of the past few years. Quite apart from the question of whether the entire global warming extravaganza was a gigantic hoax, as now seems possible (probably not entirely, but its over-inflation certainly was), the companies set up using readily available pools of over-excited venture capital don’t look like ordinary youthful tech ventures. Instead of their “footprint” expanding inexorably like Google’s until it seems about to take over the world, it has remained stubbornly modest, with their margins remaining slender and their revenues heavily dependent on new research grants from various government “stimuli” and other non-market sources. That suggests that the oxygen of genuine and explosively expanding demand for their products and services simply is not there; they will limp along at marginal profitability as long as the money lasts, but will then collapse altogether leaving no permanent results other than investor losses and the wrecked career prospects of their unfortunate ex-employees.

As was the case in 2001-02, the recession of 2008-09, painful though it was, has been prevented by artificial means from cleansing the rot in the global economic system. New healthy growth will be very limited indeed until the cleansing happens, because the rot, being powerful and well-connected, will tend to suck up the great majority of available capital and other resources. Its eventual decay and collapse will thus be immensely painful, but is wholly necessary before healthy economic growth can resume.

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005). Details can be found on the Web site www.greatconservatives.com

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