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By Vikram Mansharamani, PhD
A steady stream of Lincoln town cars delivering confident executives. Unbridled enthusiasm in the air, record attendance, and eager attendees seeking pictures with the keynote speakers. An assassinated former president was reincarnated with impressive accuracy to provide for audience entertainment. Professional videos were prepared to tout the industry’s successes.
Mortgage bankers convening in 2007? Nope, the scene I describe was from the USDA’s Agricultural Outlook Forum in late February in the Washington DC area. Attendance at last week’s event exceeded two thousand, and included farmers, politicians, regulators, agribusiness executives, bankers, and academics from around the world.
Might the collective confidence of the event’s attendees indicate an irrational exuberance that is destined to reverse? Was the widespread enthusiasm and economic success (farm income exceeded $100bn in 2011) sustainable? Was the “life is good” attitude indicative of a bubble before it bursts?
I have been a student of booms and busts over the past 20 years and have developed a set of indicators for identifying bubbles. Two in particular seem relevant to the study of agricultural conditions today. First, there is a always a believable story of how “it’s different this time” and the inevitable (over)confidence and invincibility that accompanies such a feeling. Second, moral hazard (via government guarantees or downside price protection) makes for a “heads I win, tails you lose” risk environment. With respect to agriculture, both of these indicators suggest the situation is not sustainable.
It was hard not to notice the celebratory tone that hailed the many impressive accomplishments of US agriculture. In many ways, the success of agriculture has generated a sense that good times will continue indefinitely. I was gently (and regularly) reminded that the USDA touches every American since we all eat food. It was repeatedly mentioned that Lincoln referred to the department as the “People’s Department” and that while 50% of Americans lived on farms in 1862 (the year Lincoln established the USDA), today 2% of Americans live on farms that produce a surplus that is exported to a hungry world. Record land prices drew some discussion of bubbly dynamics – but rationalizations of how “it’s different this time” seemed to win the day. Demand from emerging middle classes in the developing world provided strong support for the belief that we are in a new era of agricultural prosperity (i.e. that it’s “different this time”).
As is typical of most bubbles, past trends are extrapolated into the future to paint a picture of continuing good times ahead. The pinnacle of last week’s events was a plenary session moderated by Secretary of Agriculture Vilsack that included 7 former Secretary’s of Agriculture discussing the future of agriculture in America. It was noteworthy that the 8 members on stage included republican and democratic appointees, lawyers, farmers, and legislators. While the event was truly a “love-fest” in that everyone was praising everyone else about how great a job everyone was doing, there were some noteworthy exceptions from former secretaries who commented on the sustainability of US agriculture and implied heavily that the current good times were unlikely to continue indefinitely.
Clayton Yuetter, Secretary of Agriculture from 1989-1991, noted “the antidote to high prices is high prices; the antidote for low prices is low prices.” While an appealing intellectual construct, USDA supports policies that contradict this perspective. The counter-cyclical and marketing loan programs both allow for farmers to not consider prices when making planting decisions. Lower prices don’t deter production as government subsidies effectively create the moral hazard-induced asymmetric risk-reward trade-off.
Given these two very concerning dynamics, it is not surprising that John Block, Secretary of Agriculture from 1981-1986, suggested the USDA’s “strength and power and influence in the halls of government and in the nation” are at risk in a time of budget cuts. He even suggested the USDA change its name to the “Department of Food, Agriculture, and Forestry” in order to maintain control of the food programs (~70% of the annual budget, includes food stamps, school lunches, and other nutrition programs) and the forest service (manages ~193 million acres and employs more people than any other group within the USDA). His specific rationale: USDA would be at risk of losing its cabinet level status without the size and breadth of these two programs.
Why should cabinet status drive inappropriate organizational structure? Birthdays are wonderful times to celebrate the past, but they are also appropriate times to reconsider plans for the future. As the USDA turns 150 this year, we should consider if the food and nutrition programs actually belong in it. Might these programs be more appropriately placed in the Department of Health and Human Services? Or, as mentioned by Secretary Block as a risk, perhaps the Forest Service should be relocated to the Department of the Interior. Frankly, even the underlying agricultural subsidy programs should be reconsidered. Should American taxpayers be providing subsidies to an industry that posted record profits in 2011? The time to reduce or remove subsidies is now, while prices are high and pain of removing them minimal. Further, the Farm Bill should be rewritten from scratch, not modified incrementally from Depression-era policies that in many cases are no longer relevant.
Reorganizing the USDA and rewriting the Farm Bill might remove some of the hot air supporting the bubble dynamics in agriculture today. The USDA has inadvertently contributed to overconfidence and moral hazard, much to the detriment of taxpayer resources. The fiscal tightening that appears necessary might best begin by grabbing the “low-hanging fruit” (pun intended!) at the USDA. The time has come to return the People’s Department to the people.
Vikram Mansharamani is a Lecturer at Yale University, a TIGER 21 Scholar, and author of Boombustology: Spotting Financial Bubbles Before They Burst.
Food Bubble Is Expanding U.S. Waistlines: Vikram Mansharamani
Illustration by Russell Weekes
In the housing boom that lasted from 2001 to 2007, highly motivated investment bankers capitalized on historically low interest rates, abundant liquidity, government- sponsored housing finance, political encouragement to make housing accessible to all, and mortgage-interest tax policies to create a securitization party of unrivaled scale and scope.
The hangover from this toxic cocktail continues to plague the global economy: The world still struggles with too much debt, the threat of deflation and the painful prospect of more deleveraging.
Similar dynamics are at work in the global food system: Forces are combining to create another dangerous bubble. This food bubble, like the housing one, has grown from a system that is focused on generating efficiencies through high volumes, which generate lower prices and increased consumption. The commoditization of loans and crops, supported by government policies to keep prices low, has led to overconsumption of credit and food — resulting in a highly leveraged society, and a national obesity epidemic.
Just as bankers created loans for standardized mortgage pools, most farmers now produce predominantly for commodity markets. And just as bankers stopped caring about their customers’ financial health, or even their ability to repay loans, farmers, under the heavy influence of government programs, have increasingly stopped growing food for the benefit of the people who eat it. In fact, industrial farming is generally not even producing “food,” but rather inputs for what author Michael Pollan calls “edible food-like substances” — processed foods.
Bushels of Corn
Consider corn. While some of it is actually consumed as food (for example, “on the cob”), most is converted into animal feed, ingredients for processed food or feedstock for ethanol. The price of most corn grown in the world is based on qualitative variations from the benchmark No. 2 grade corn. By the U.S. Department of Agriculture’s definition, a bushel of No. 2 grade corn weighs about 54 pounds and contains no more than 5 percent damaged kernels and less than 3 percent broken corn and foreign materials. Just as unsophisticated buyers blindly bought AAA rated mortgage securities, so does the corn industrial complex readily accept all No. 2 grade corn. Similar dynamics exist for other commoditized crops, such as wheat and soybeans.
U.S. government policies have promoted the production of high-volume commodity foods. These policies date to the early 1970s, when poor harvests in the Soviet Union and bad weather in the American farm belt caused crop prices to skyrocket. U.S. News & World Report and Time magazines dedicated cover stories to food inflation and its social impact.
To prevent grocery prices from soaring 20 percent or more, Earl Butz, the secretary of agriculture in the Nixon and Ford administrations, made a series of policy changes designed to lower food prices. He did away with some loans to farmers, government grain purchases and incentives for leaving land idle during times of low crop prices. And he replaced them with direct payments to farmers to make up any difference between the market price and an artificial price floor.
Rather than discourage farmers from growing more crops when market prices were low, the new policy motivated them to produce more, regardless of price. The floor, which has been regularly adjusted, set a price at which farmers could effectively sell an infinite supply. Ballooning crop volumes drove prices lower, which, in turn, increased consumption.
Similarly, in 2001, when the Federal Reserve lowered short- term interest rates — to fight the deflationary forces from the popping Internet bubble — the price of money was driven lower, and that increased the use of debt.
Price of Calories
In the past 30 years, food prices have fallen, on average, 1 percent per year, according to an analysis from the Department of Agriculture’s Economic Research Service. During the same period, the daily average calorie consumption in the U.S. has risen about by an average of about 400 calories, or about 18 percent.
There’s reason to think that the low price of food has led people to eat more of it, and especially the kinds of foods that are subsidized by U.S. agricultural policy. Consider that overconsumption is not spread evenly across food groups, but rather predominates among processed foods containing ingredients such as corn, wheat and soybeans, whose prices are heavily influenced by government policies.
Flour and cereal products account for 39 percent of the total increase in average American food consumption since 1980 – - about 155 additional calories — while whole foods not supported by agricultural subsidies are not being eaten much more today than before: The average American’s intake of fruit rose by a mere 6 calories over the past three decades, and calories from vegetables were flat.
In 2004, a dollar could buy more than 1,000 calories of cookies or potato chips, or 875 calories of soda, but only 250 calories of carrots or 170 calories of fruit juice, according to Adam Drewnowski, a professor of epidemiology at the University of Washington and director of the Center for Public Health Nutrition in Seattle. In other words, agricultural subsidies cause the least healthy calories to be the cheapest.
Given that about 3,500 calories is equivalent to a pound of body weight, it is easy to see that extra calories are a major contributor to our obesity epidemic — alongside inadequate exercise and a poor diet. Furthermore, given the strong linkages between obesity and cardiovascular disease, diabetes and other illnesses, our industrial food system appears to be no more sustainable than our pre-2008 housing-finance system.
Another unintended consequence of producing food in such large volume is that the bigger the yields per acre, the fewer nutrients the crops contain. Donald R. Davis of the Biochemical Institute at the University of Texas in Austin has looked at the evidence regarding the relationship between yield and nutrient content. The studies comparing high-yield and low-yield varieties of corn, wheat and broccoli show, in his words, “uniformly inverse associations between yield and nutrient concentrations.”
Food and Health
In a time of strained budgets and rising medical costs, we must think more broadly about the health effects of our food system. To ignore the connection between agricultural policy and public health would be as wrong as to ignore the link between housing policy and financial regulation. Presidential campaign debates and the renewal of the farm bill in 2012 may offer a platform for the conversation. Let us begin by redesigning agricultural policy to minimize incentives for overproduction and encourage the production of healthy calories.
Two agricultural subsidies, in particular, should be greatly reduced or eliminated: the marketing-loan program and the countercyclical-payments program. The marketing-loan program, which allows farmers to borrow using their crops as collateral, effectively enables farmers to lock in a minimum price via non-recourse loans. If market prices are lower than the government-set target price, farmers are not required to pay back the full loan amount. Yet if prices are higher than the target price, they keep the difference. Countercyclical payments act as their name suggests: When prices are lower, subsidy payments are higher — enabling farmers to again lock in minimum prices. Both subsidies focus disproportionately on commodity crops.
These programs create de facto price floors, allow farmers to ignore crop prices when deciding how to allocate land, and effectively encourage overproduction. From 1995 to 2010, the Department of Agriculture spent more than $50 billion on these programs. Eliminating them would save enough money not only to subsidize the farming of fruit, vegetables and other healthy foods, but also to sponsor education programs on how careful eating and exercise can reduce or prevent obesity. Acting now could help keep today’s cheap food and expanding waistlines from adding to tomorrow’s high health-care costs.
(Vikram Mansharamani, who teaches a seminar on financial booms and busts at Yale University, is the author of “Boombustology: Spotting Financial Bubbles Before They Burst.” The opinions expressed are his own.)
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(Originally published in Bloomberg View 2012. Reprinted with permission. The opinions expressed are those of the author)
Gold: A Boombustology Perspective
by Vikram Mansharamani, PhD
As gold has been one of the most volatile assets in the past several weeks, with some analysts arguing for a $10,000/ounce fair value, many in the media and investment communities have asked me if gold is a bubble. To answer this very difficult question, I have chosen to apply the five-lens framework from my book Boombustology to gold today.
Let’s begin with my first lens, micro-economics. Most mainstream economic theories utilize a supply and demand driven price determination model that generally results in prices tending towards equilibrium. I say “tending” because most serious scholars admit that behavioral and informational issues can distort the price at any one point in time, but there exists an overarching philosophical belief that such distortions are rapidly ironed out. Markets are, according to this view, efficient. Higher prices dampen demand, and lower prices dis-incentivize supply.
Let us suppose for a minute, however, that higher prices increase demand. Such a dynamic might arise for many reasons, but one eloquent explanation for such an outcome in asset markets is the Theory of Reflexivity, as proposed by George Soros. Although the theory has many subtleties beyond the simplified “self-fulfilling” logic that many ascribe to it, the underlying implication of this perspective is that prices can and do tend away from equilibrium. In this case, boom and bust dynamics appear highly likely.
Turning to gold, it appears higher prices are indeed generating more demand. Might his indicate that a reflexive dynamic is underway? Are prices tending towards or away from an equilibrium level? Evidence from the Gold ETF (GLD) indicates that higher prices have correlated with higher demand for gold. The chart below shows the number of shares outstanding (i.e. a reasonable proxy for “demand”) and the price per share of GLD. The fact that these two metrics correlate indicates that both price and demand are aligning, a classic sign of bubbly conditions. Lens 1: check.
My second lens is macroeconomics, with special attention to credit. In Chapter 11 of my book, I state that financial innovation that embeds or enables leverage can often provide fuel to a bubble. Indeed, rapidly rising leverage of any sort (direct or indirect) is cause for concern.
Consider the above-mentioned GLD, the gold ETF that enables individuals to purchase Gold directly in a brokerage account. Unfortunately, however, because I do not have access to aggregated brokerage account information, it’s hard to determine if GLD has been purchased on margin or financed with equity. Combine this with the double, triple and other leveraged ETFs that promise multiples of daily price moves. For good measure, add on a bit of small margin, high effective-leverage futures…and what you get is evidence of a credit fueled asset price dynamic. Consider the fact that I can today (as an individual) buy 100 ounces of gold exposure (>$150,000 at the time of this writing) through futures market by putting down less than $10,000. This enables me to have more than 15x financial leverage! Clearly, embedded and indirect leverage are clearly supporting the gold market. Lens 2: check.
Overconfidence and new era thinking are the hallmarks of my third lens, psychology. Whenever individuals develop a devout belief that “its different this time,” buyers beware. It is rarely different and asset prices generally go up and down and in this regard, gold prices too go both up and down.
So, is there a belief that gold is a “store of value” like no other? Absolutely. Is it deemed a commodity that is different than others? Perhaps it is considered protection against inflation…but others insist it is the only thing to own when facing deflation. The reality is that gold is a risk-asset like any other. Its price rises and falls. In fact, the fall is generally more frequent followed by an occasional but spectacular rise. For a concise analysis of historical gold price dynamics, read Ken Fisher’s Debunkery Bunk 35: “With Gold You’re Golden” which ends with an eloquent recommendation: “Feel free to buy gold – for earrings, necklaces, and electrical wires. But for your portfolio, gold has less luster unless you’re a super-duper timer.” Lens 3: Check.
The fourth lens of my bubble-spotting framework is politics. I tend to focus on government intervention and the distortions such actions have on market prices. This a complicated topic when it comes to gold, and one I will revisit after addressing my fifth lens.
An application of epidemic thinking to the study of financial bubbles has proven very useful in gauging the relative maturity of manias. Let us analogize an investment hysteria to a fever or flu spreading through a population. To an epidemiologist, the variables of concern include the infection rate, the removal rate, and perhaps most importantly, the percentage of the population not (yet) affected. The population of “yet to be infected” participants can be thought of as fuel that is available to keep the fire burning. Once we run out of fuel, the party’s over. Prices will fall. The investing implications of this logic can be illustrated with a simple piece of advice: Don’t buy whatever your taxicab driver is talking about. It’s too late. Widespread amateur investor participation is tell-tale sign that a bubble is in its last innings.
One way to gauge amateur participation in a financial bubble is observe media targeting everyday audiences. In this regard, gold is very concerning. While walking through the streets of NYC one recent afternoon, I saw no fewer than 14 signs offering to buy my gold, 18 signs indicated there was a willingness to sell me gold…and if I veered several blocks in the wrong direction, I’m sure there are eager individuals that would simply take my gold. Other confirmatory indicators include TV commercials, billboards, dinner party conversations, and the fact that everyone under the sun now has an opinion about gold. Gold is, in many ways, the ultimate greater fool asset. To make money investing in gold, you need someone with a belief more money is to be made to take it off your hands. Lens 5: Check.
Before concluding that gold is bubble (which I tend to believe is more likely than not), let’s revisit lens #4. While I generally do not subscribe to the many conspiracy theories arguing that governments are manipulating gold markets, the primary linkage with politics over long periods of time has been through the currency. Thus, we can ask if today’s policies are affecting currencies in a way that might be affecting gold. Given that gold is effectively an “anti-asset,” by which I mean it is the flip-side of fiat currencies, we need to evaluate what is happening in the market for fiat currencies…and in this regard, the upside pressure on gold remains. In many senses, I am therefore agreeing with Jim Grant’s point that gold’s price is an inverse indicator of investor confidence in central banks. Lens 4: half-check.
Thus, given that four and a half of my five indicators are flashing “bubble,” it is my view that gold is very bubbly. But as many bubble-watchers know all too well, the final innings of a bubble can be extremely profitable. Combine this potentially lucrative opportunity with a bit of career risk (from not-participating) and you get a very volatile situation. The gold game is not in the first innings, and in fact may be well beyond the seventh-inning stretch. When one considers the fat that gold does not generate any cash flow, costs money to protect, and is generally not consumed (i.e. 99%+ of the gold taken out of the ground in the history of the world is still around today), one must use extreme caution when dabbling in this market today.
Miss the last gains, but avoid potentially devastating losses? Or capture potentially very dramatic gains rapidly, with a known and elevated risk of big losses? Given investors are all prone to making errors, it may be more prudent at this juncture to make the error of omission (miss gains, avoid losses) than to make the error of commission (ride gains, capture losses).
Vikram Mansharamani, a Lecturer at Yale University, is the author of Boombustology: Spotting Financial Bubble Before They Burst, published by John Wiley & Sons. The book presents a multi-disciplinary method for identifying unsustainable booms in financial markets.
China: The Urgent Need for Speed…
by Vikram Mansharamani, PhD
Recent social unrest in the Middle East has spurred speculation that similar uprisings may take place in China. Is there any reason to believe that social instability (or revolution) is possible in China? While the immediate threat of an uprising in China appears limited due to the government’s iron grip on media and communications, China faces very different dynamics than those that have recently struck Middle Eastern countries. In particular, the source of legitimacy for the Chinese authorities over the past 20+ years has been economic opportunity. At least historically, such an implicit social contract was not the basis of the regimes in the Middle East. By creating jobs and the potential for a better life, Beijing has dampened desires for political reform or representative government.
Unfortunately for Beijing, signs of increasingly difficult and less-hospitable economic conditions are increasingly apparent to the ordinary citizen. Increasingly unaffordable housing. Rampant food price inflation. Inadequate employment opportunities. Rising inequality. Forced relocations. Environmental pollution. Widespread corruption. While each of these is by itself enough to generate resentment among a populace, the combination of these factors creates explosive potential for social unrest and possibly even (gasp!) revolution. It should come as no surprise that Chinese leaders – facing this potentially lethal cocktail of issues – are concerned.
The stakes are high, and not just for Beijing. China continues to be one of the world’s fastest growing economies and has had a tremendous impact the global economy. Its voracious appetite for commodities has generated growth throughout the global commodity complex, and many industrial markets continue to be driven by Chinese demand. Any disruption to the Chinese development story will surely have global ramifications.
Author and money manager Vitaliy Katsenelson has analogized the Chinese economy to the movie Speed, in which the bus must maintain a certain speed or an onboard bomb will detonate. There seems to be good reason for such an analogy. Consider the recent boom in education. In 1998, China had less than 1 million students graduating from college each year. Estimates today suggest that number may be close to 7 million, and rising. Despite healthy economic growth, the pace at which new white-collar, professional jobs are created has not kept pace with the surge in college graduates. Between 2002 and 2009, wages for college graduates remained essentially flat (negative if you consider inflation). During the same time, unskilled laborer had their wages rise by more than 80%. In a cruel twist of fate, it seems Beijing’s spectacular accomplishment in education may threaten the regime’s very foundation.
Aside from a mismatch between the supply and demand of college-educated workers, the problem is exacerbated by the inflexibility of the typical Chinese curriculum. In most cases, students tend to spend their college years developing expertise in a particular subject (engineering, computer science, accounting, etc.) by focusing almost exclusively on the topic for four years. As a result, students lack the flexibility to adapt to China’s changing labor markets. The mismatch is likely to get worse as China migrates from an agricultural economy to a manufacturing economy and eventually on to a services economy.
Deng Xiaoping’s declaration “to be rich is glorious” unleashed significant entrepreneurial energy; what China needs today is a similar battle cry for a more flexible education policy. Labor markets for skilled and educated workers need to become more dynamic, and one way to do so is to encourage the Western model of liberal arts education. Yale University President Richard Levin has noted that the most important characteristic of a well-educated person “is not subject-specific knowledge, but rather the ability to assimilate new information and solve problems.” Education reform is needed…and soon.
The clock is ticking. China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity. Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption galloping forward. Moral hazard runs rampant, and national-provincial dynamics are generating GDP growth through unnecessary and low ROI activity. Finally, amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state.
All of these indicators point to the fact that the Chinese economic bus is running low on fuel. A financial bust or even economic slowdown may just detonate the onboard bomb, resulting not only in an elevated risk of social unrest or possible revolution within China, but also a meaningful slowdown in global economic growth.
Vikram Mansharamani is the author of Boombustology: Spotting Financial Bubble Before They Burst, published by John Wiley & Sons. The book presents a multi-disciplinary method for identifying unsustainable booms in financial markets.
BUBBLY BOOKS: Is Education Overvalued?
by Vikram Mansharamani, PhD
College graduation is a time of great joy, of optimism, of forward-looking enthusiasm. Indeed, the very term “commencement” implies a positive new beginning. Unfortunately, this is not universally the case in America. Many students this year will graduate with questionable educations and mountains of debt; as more students go off to college and borrow money to do so, student loan debt in the United States is likely to top $1 trillion this year, exceeding credit card debt for the first time in history.
Might our strong belief in the value of an education be misguided? Is higher education in America a bubble about to burst? As a student of booms and busts, I have developed a framework for identifying unsustainable price dynamics, which are as applicable to higher education as they are to tulips, Japanese real estate, and Internet stocks.
Two primary dynamics seem to telegraph bubbly price action regularly through history’s great speculative eras. First, an unquestioning faith in the asset’s value leads to an ever-increasing universe of buyers, despite price increases. Second, the availability of “easy money” or “loose credit” is often driven by policies that generate significant moral hazard. Higher education in America today exhibits both of these warning signs.
The argument in favor of education is based on average salaries for differing education levels, and on the surface, the numbers are compelling. According to data from the U.S. Census Bureau, average earnings in 2008 for those with an advanced degree were ~$83,000, compared to ~$58,500 for those with a bachelor’s degree. This compares to high school graduates’ average salaries of ~$31,250.
Recent research from the Pew Research Center provides confirmatory data in the unquestioning faith in the value of an education: 94% of parents with children under the age of 17 indicate they expect their children to go to college. There is a broad universality of this view, with 93% of parents who did not graduate from college and 97% of those who did subscribing to this aspiration.
Despite these responses, only 5% of those surveyed by Pew indicated higher education provided excellent value for the money (57% say it does not even provide “good” value). Further, a college degree ranks fourth (work ethic, social skills, and technical skills all rank higher) in terms of perceived life success factors. Enrollment data does not reflect this concern.
The number of American college students has risen from approximately 9 million in 2009 to approximately 13 million over the past ten years. Enrollment in the for-profit education sector has been particularly brisk, rising at multiples of the overall higher education growth rate, with 2009 enrollment growth in the 20%-25% range. Marginal students have been wooed by this sector and have sought education in droves.
TOTAL FALL FULL-TIME COLLEGE ENROLLMENT IN AMERICA
(Source: College Board, Trends in College Pricing 2010, Figure 17a)
During that same time period, the price of a college education (i.e. tuition) has risen faster than inflation. Tuition and fees at public, four-year institutions have risen on average at 5.6% per year more than inflation over the past decade. While private college tuition has risen at a less dramatic rate (~2.5%-3.0% more than inflation), it was significantly more expensive to begin with.
Increasing participation of price- and value-insensitive buyers, check.
In its noble quest to provide educational opportunities to all Americans, the Department of Education has administered over $500bn in federal financial aid to students seeking post-secondary education over the last five years. For the academic year 2009-2010, the College Board estimated that total federal aid was approximately $147bn, a 136% increase over the past ten years, a growth rate faster than either enrollment or price increases might explain.
TOTAL FEDERAL FINANCIAL AID ($MM)
(Source: College Board, Trends in Student Aid 2010, Table 1)
The securitization market has fueled this development. Just as mortgage backed securities enabled rapid growth in housing finance, so too have student-loan asset backed securities (SLABS) enabled rapid growth in education finance. The dollar value of SLABS grew from approximately $76mm in 1990 to over $2.6 trillion by 2007. SLABS are deemed by some investors to be government sponsored securities (Sallie Mae played a major role in enabling this market) and due to the full recourse nature of student loans (i.e., filing bankruptcy does not eliminate them), many investors believe the risk of loss to be small. The rapid and brisk lending pace has enabled even marginal borrowers to obtain education loans without question.
Evidence from the for-profit sector is particularly concerning. Despite low completion rates (less than half of students who start finish their program), many for-profits receive close to 90% of their revenues from government financial aid sources. From 1987 through 2000, the industry received federal financial aid (Title IV funding) of between $2 and $4 billion per annum. In 2009, the industry received over $21 billion.
Easy money supported by moral hazard, check
One of the philosophical underpinnings behind the US housing bubble was the belief that all Americans should own their homes, even if they borrowed to do so. A similar philosophical belief has taken hold in higher education.
An increasing percentage of graduates are finding themselves burdened with student loans upon graduation; less than half of the graduates in 1993 received loan repayment coupons with their degrees. In 2008, more than two-thirds graduated with loans, having borrowed double what their 1996 counterparts did. Almost 50% of those with student loans indicate repayment makes it hard to make ends meet, and around 25% indicate student loans impact career choices and delay the purchasing of a home.
Parents, students, bankers, investors, and policymakers alike should reconsider the value of education and ask the uncomfortable but critical question: Is higher education an overvalued asset? Much of America has come to question the value of $1,000 per square foot homes. The time has come to reconsider the value of $1,000 per week education.
Vikram Mansharamani, Lecturer at Yale University, is the author of the recently released Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011). He has been an active participant in the education bubble, having acquired a bachelors degree from Yale University, two masters degrees from MIT, and a PhD from the Sloan School of Management.
Boombustology and Value Investing: Why Context Matters
As one who has fought with global equity markets during the past 20+ years, I remain confused by the typical value investor’s belief that “top-down” issues are not worth contemplating. Why is it that Graham and Dodd investing (as practiced by many value investors) downplays the role of context in the investment process? Wouldn’t the prudent investor want to understand risks and uncertainties relating to the environment in which he/she is investing?
Perhaps because I have spent a great deal of time investing outside of the United States, I have never had the luxury of dismissing macroeconomics, politics, or the actions of other investors. Consider Indonesia before and after the Asian Financial Crisis. Investing in the best companies at reasonable prices did not protect you. The utter bloodbath in the currency markets destroyed dollar returns. Likewise, many value investors faced steep losses during the second half of 2008 and the first quarter of 2009. Herd behavior and self-fulfilling dynamics unfortunately drive these dynamics.
Most of the time, Third Avenue’s Marty Whitman is correct that macro-factors are neither predictable nor important. However, this is not always the case, and just as extreme valuations merit attention, so too might macro extremes matter. How can we value investors effectively determine if we are at an extreme, and should therefore worry a bit more about the context? Surely it is worthwhile to know if a particular asset class is a bubble about to burst. Such an insight might allow us to tilt the balance of the errors we inevitably make towards errors of omission, rather than those of commission. While we may miss gains, we might avoid painful losses.
I have developed a five-lens framework for identifying financial bubbles before they burst. The first lens is microeconomics. In direct contrast to established economic theories of equilibrium, there are occasionally times when higher prices generate demand (rather than, or in excess of, additional supply). Such conditions are particularly prone to self-fulfilling dynamics likely to create bubbles.
The second part of my framework focuses upon credit conditions and the cost of money. While First Eagle’s Jean-Marie Eveillard has rightly highlighted the dangers of using leverage for investors, the same concern is valid for an economy in aggregate. If the foundation of prosperity is built on borrowed funds, it is only a matter of time before instability ensues. One of the primary culprits of such excessive borrowing can be found in overcapacity/malinvestment.
The third lens in my framework is psychology. We humans are unfortunately not the strict, economic-optimizing agents that social scientists might model us to be. We are plagued by cognitive biases that manifest themselves in overconfidence and anchoring upon irrelevant numbers. One of the best indicators of hubris is found in the phrase “world record price.” Whether paid for a building or a piece of art or a bottle of wine or a commodity, such prices are usually a sign of speculative juices running wild.
Fourth, political developments matter. Governments (particularly democracies) are subject to popular sentiment and as such, are willing to change the rules and/or generate moral hazard by bailing out the least prudent of market participants. Price distortion and politically motivated subsidies, handouts, and taxes can also alter incentives in a dynamic manner.
Finally, popular sentiment and herd behavior can affect securities prices more dramatically and potentially for longer than fundamental developments might. As such, understanding the actions of others and linkages to relevant markets has the potential to shed insight upon contagion risk.
In aggregate, these five lenses provide a probabilistic framework for increasing the odds of accurately identifying bubbles before they burst. Consider the case of China today. Let’s apply my five-lens framework to China.
China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. Consider property markets in which leverage and prices seem to be rising together in a highly reflexive, self-fulfilling manner. Higher prices are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity. Ghost towns and vacant malls are increasingly visible manifestations of this problem. Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption on the rise. Chinese buyers have set world record prices for art, wine, pigeons, and even dogs! Moral hazard runs rampant, and national-provincial dynamics are generating GDP growth through unnecessary construction. Perfectly usable infrastructure has been destroyed and rebuilt in pursuit of GDP. Finally, amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state.
Clearly, the ramifications of a Chinese slowdown would have material impacts upon commodity markets, emerging markets, and even the S&P 500’s business and earnings mix. In short, how China goes, so goes the world economy. It seems highly imprudent for investors to not consider the possibility of a meaningful slowdown in China’s economy.
I am not suggesting that we value investors abandon our focus upon the analysis of individual securities. We should not. Finding margins of safety from intrinsic values remains the most sensible method of investing. I am merely suggesting that when we do invest, we should be cognizant (rather than dismissive) of the environment and context in which we are operating. As eloquently summarized by Seth Klarman, we should all “invest bottom-up, but worry top-down.”
Vikram Mansharamani, PhD
Global Ripples Ahead
Vikram Mansharamani is the author of “Boombustology: Spotting Financial Bubbles Before They Burst.” He is a lecturer on financial markets at Yale University.
Updated April 15, 2011, 7:05 PM
China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity.
The ripple effects of a real estate slowdown in China will be felt in commodity markets around the world.
Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption galloping forward. Moral hazard runs rampant, and national-provincial dynamics are generating growth in gross domestic product through unnecessary and low return-on-investment activity. Amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state. All of these indicators point to the fact that the Chinese economic story is unsustainable.
The most visible manifestation of the bubbly conditions in China can be found in the property markets of major coastal cities. A deflation of the property bubble plaguing these cities will be accompanied by a material slowdown in demand for commodities.
Consider the impact on steel, a product for which Chinese consumption accounts for almost 50 percent of global production. Approximately half of Chinese steel consumption is in construction, most of which is for property development. Any slowdown in construction would reduce global demand for steel and also for iron ore, which is used in steel production.
Likewise, given that 40 percent of the dry-bulk shipping industry is connected to moving iron ore to China, the property slowdown will be felt in Norway, Hong Kong, Singapore, Greece and other shipping centers. Because the shipyards in Korea, Singapore and China have themselves expanded to meet increased demand for ships, they too will face significant overcapacity. And on it goes. For better or worse, the Chinese property markets have a global value chain. The ripple effects of a real estate slowdown will be felt around the world.
China has been a story of investment led growth; capital expenditure as a percentage of G.D.P. remains elevated in comparison to China’s own history as well as that of other rapidly developing countries.
Many commodity markets currently reflect substantial continued investment. If property markets deflate, and overinvestment and excess capacity are revealed, Chinese growth may be 5 percent 6 percent for the next decade, an outcome for which the world and commodity markets are not prepared.
The Next Art Bubble
Last week the prices for Chinese art skyrocketed to their highest levels yet, but comparisons to the Japanese art bubble prove that a crash is near, says Vikram Mansharamani.
by Vikram Mansharamani | April 13, 2011 1:42 PM EDT
New York’s Asian Art Week was spectacular. A delicate pear-shaped Chinese vase was the star of the week, skyrocketing past its pre-sale estimate of $800 to $1,200 to sell for more than $18 million. A carved celadon-glazed ceramic Qianlong vase sold for $7.9 million, double its high presale estimate. Combined, Sotheby’s and Christie’s International took in a record $202 million during the week, 56 percent above the prior 2007 peak.
The electricity transferred over to Europe, where a Beijing collector paid a record $31 million for a Chinese scroll on March 26 at an auction in Toulouse, France. And this week has been equally exciting. Global art collectors descended upon the Hong Kong Convention and Exhibition Centre for Sotheby’s 3,600 lot series of auctions. A painting by Zhang Xiaogang set a new record, selling for more than double pre-auction estimates. The most anticipated auction was Thursday evening’s sale of the Meiyintang collection of imperial Chinese porcelain.
Thursday evening’s auction disappointed. Despite telegraphing an expected auction sales range of between HK$700 million and HK$1 billion ($90 million and $128 million) (with rumors suggesting a significantly higher sales price was probable), Sotheby’s posted auction sales of less than HK$400 million for the collection. Might this be an early warning sign of an art bubble about to burst? What are the implications of an art market slowdown?
From most accounts, China appears to be the most important driver of the art market today…and not just as a source of desired art. Wealthy Chinese buyers are the largest source of incremental demand, with Chinese billionaire buyers as the most confident. Art dealer Andrew Kahane, who specializes in Chinese art, summarized the buying desires: “Chinese buyers want to be seen spending a lot of money. They want to be seen setting world records.”
These developments certainly point to a rising sense of confidence, perhaps even overconfidence, among the Chinese. Might the ups and downs of the art business be a reflection of surging and waning confidence? Is it possible that recent world record art prices are an indication of unsustainable economic conditions? Could China be in the midst of an unsustainable asset bubble?
The recent auction records are not as anomalous as they may appear. Chinese influence on art markets has risen steadily over the past year. In May 2010, the art world was energized by a Chinese buyer paying a world record $106.4 million for a work by Pablo Picasso. Last November, an 18th-century vase from the Qianlong period, which had been found in a dusty old attic, was purchased at auction for $86 million (presale estimates had ranged from $1.3 million to $2 million) by a buyer from mainland China. It was the highest price ever paid at auction for a Chinese antiquity.
Overconfidence and hubris, manifested in world record art prices, should be as disturbing to policymakers and investors as it is exciting to Sotheby’s and Christie’s.
Traditional buyers have noted this newfound buying pressure, finding it frustrating when seeking to purchase art. Morgan Long, head of art services at The Fine Art Fund, noted that funds “have come across frantic bidding from people from the Chinese mainland. We haven’t been able to buy anything we wanted at the prices we were looking for.”
One of the largest asset bubbles ever formed was in Japan during the late 1980s. The bursting of the “Bubble Economy,” as it has since been known, might have seemed, even at the time, almost inevitable when examined through the lens of art markets. Consider the parallels.
In the then-highest price ever paid for a painting, van Gogh’s Still Life: Vase with Fifteen Sunflowers sold in 1987 to a Japanese buyer for almost $40 million, approximately four times the previous record for a painting.
The Japanese art craze possibly peaked (along with its asset markets) when Ryoei Saito, chairman of Daishowa Paper Manufacturing, paid $82.5 million for van Gogh’s Portrait of Dr. Gachet and over $78 million for Renoir’s Le Moulin de la Galette in May 1990. He then proceeded to shock the art world and the sensibilities of collectors worldwide by stating he would cremate the paintings with his body upon his death.
The similarities with Japan suggest that the enormous Chinese influence on the art market is an indicator of a forthcoming bust in China. It reflects a national overconfidence that has been a consistent ingredient in financial bubbles. Prudent investors would take great pride in selling at world record prices. Wanting to buy at world record prices is a spectacular reflection of hubris in action.
The disappointing results from Thursday’s Meiyintang auction might indicate that expectations of continually rising prices are now ahead of themselves, and that overconfidence and hubris are running out of steam. Was this auction revealing the first cracks in what has otherwise been a very positive story? Is this a sign of an imminent bust?
Seductive rationalizations about China’s enormous population, its tremendous wealth generation, or its industrious labor force are hard to transcend. Policymakers, investors, and corporate boardrooms, however, must attempt to do so because the ramifications of a China bust are so large. For example, China’s influence on the commodity markets has been domineering. If China’s appetite for materials were to slow materially, then many commodities would be over-supplied and prices would fall. Commodity markets have at least partially been supporting the emerging markets growth story, and without that story, the world will likely grow at a significantly slower rate.
Despite the allure of seductive rationalizations, healthy skepticism combined with a careful monitoring of the art market can help one realize that it’s unlikely to be different this time. Overconfidence and hubris, manifested in world record art prices, should be as disturbing to policymakers and investors as it is exciting to Sotheby’s and Christie’s, for in today’s increasingly interconnected world, even the slightest disturbance can ripple from China to Iowa.
Vikram Mansharamani is a lecturer at Yale University where he teaches a popular seminar called “Financial Booms and Busts.” His new book is Boombustology: Spotting Financial Bubbles Before They Burst.
©2011 The Newsweek/Daily Beast Company LLC
(originally published in April 2011 by YaleGlobal Online, picked up by the Khaleej Times, The South China Morning Post, The Korea Times, and numerous others)
Mega malls and empty purses
China is not only a booming country, for years it has been one of the world’s fastest growing economies. Industrialisation, urbanisation, modernisation and entrepreneurship all appear to be on steroids in the world’s most populous nation. There’s relative consensus among global investors that China will continue growing at eight per cent for the foreseeable future, providing much needed support to the global economy.
By almost any metric, economic progress in China over the past several decades has been phenomenal: GDP per capita, literacy rates, health care, infant mortality, life expectancy and national wealth have all improved remarkably.
However, as the famous disclaimer reads on most mutual fund advertisements, “past performance is no guarantee of future performance,” and this appears to be the case with respect to China’s progress. In fact, China today exhibits many of the signs that characterise the great speculative manias throughout history.
Might China slow to a more sustainable GDP growth rate, say five per cent, in the coming years? Significant evidence suggests that such an outcome is not as outlandish as the global investment community currently believes. A Chinese slowdown of this magnitude would have material impacts upon commodity markets, emerging markets and even the S&P 500’s business and earnings mix. In short, how China goes, so goes the world economy. Given this global economic interdependence, it’s highly imprudent for policymakers and investors not to consider the possibility of such a slowdown.
Given the highly uncertain and probabilistic nature of booms, busts and the sustainability of growth, the application of a multidisciplinary framework seems particularly apt in determining various scenarios and their relative probabilities. Consider the approach one takes to identifying animals: You stumble upon an animal and seek to determine what type it is. You might first look at it, followed by listening, and observing its behaviour. So if the animal has feathers and webbed-feet, and “quacks” while waddling, the probability of it being a duck is high.
Likewise, the same method can be used to assess the Chinese economic boom, using multiple lenses to determine the relative likelihood of a forthcoming bust.
From a microeconomic perspective, one method of identifying an asset-price bubble is to spot self-fulfilling or reflexive dynamics underway. In China today, higher prices in many of its asset markets are generating demand more rapidly than supply. Such dynamics are rarely stable and create situations prone to rapid corrections.
Consider property markets in which willingness to lend and prices rise together in a self-fulfilling manner. Chinese bankers have been lending money against collateral, the value of which is in part rising because of the banker’s willingness to lend. As property prices rise, banks’ collateral is worth more; the bankers feel more secure and smart, so they lend more. The cycle repeats. Unfortunately for the bankers, they’ll eventually discover that they themselves created the sense of safety and intelligence that they enjoyed. As happened with the subprime collapse in the West, reality eventually sets in, bankers step back and collateral values fall.
From a macroeconomic perspective, most asset bubbles are associated with “easy” or cheap money that drives overinvestment and overconsumption. Evidence of such easy money can be found in Chinese commercial real estate, where both entire cities – like Kangbashi, in Inner Mongolia – as well as gigantic malls remain virtually empty. ‘Time’ magazine profiled Kangbashi as a modern “ghost town,” and foreign newspapers have referred to the South China Mall in Dongguan as the “mall of misfortune.”
Chinese buyers have also set recent world records in the prices paid for a dog and a pigeon!
From a political perspective, we need to acknowledge the fact that the Chinese government remains communist in spirit, albeit increasingly less so. The party’s structure drives uneconomic activity as provincial leaders aspire to get noticed by producing more jobs and generating more GDP than the other provinces. Anecdotal reports are alarming: Perfectly usable infrastructure is destroyed and rebuilt to generate GDP. Likewise, job creation and economic activity are prioritised over sustainability and profitability.
The ramifications of a meaningful slowdown in Chinese economic activity are profound, ranging from the risk of domestic social instability to a collapse of several commodity markets.
On the global economic front, China’s voracious appetite for commodities has motivated significant expansions throughout the global commodity complex, and many industrial markets, including shipping, capital goods and more, continue to be driven by Chinese demand.
Unfortunately, the forthcoming slowdown may arrive at a particularly inopportune time. Many Australian and Brazilian mines have undertaken massive capacity expansions. Likewise, many Norwegian and Greek dry bulk-shipping companies have expanded their fleets in anticipation of rising demand. To accommodate this need for more ships, many Singaporean and Korean shipyards expanded their capacities. And so the story goes… What happens if the very foundation upon which these expansion stories are built is faulty? Might the emerging-markets tale that’s been the darling of global investors be less compelling than widely believed?
And what happens to multinational companies in a slowing world? Might the demand for US treasuries drop, resulting in higher costs for capital in the United States? Is it conceivable that the consensus belief that the renminbi will appreciate is instead met by depreciation as Beijing grasps at hopes of export-led growth? How might 25 per cent depreciation affect global imbalances?
The stakes are high. Policymakers, investors and corporate boardrooms must consider the risk of a material Chinese slowdown. Despite the allure of “China is different” explanations, there is a reason well-read and seasoned investors claim the four most expensive words in the English language are “it’s different this time.”
Vikram Mansharamani, PhD, is the author of Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011). For the past two years, he has taught the popular undergraduate seminar “Financial Booms and Busts” at Yale University © 2011 Yale Center for the Study of Globalisation