Consequences of Housing Inflation Policy in the U.S.

From OECD 

The above chart compares the types of countries' 2015 financial assets.  More specifically, it shows the percentage of cash (currency and deposits) held by households as a percentage of overall wealth.  You'll notice the U.S. is an outlier, because most Americans have their life savings in their home equity. From the Federal Reserve, on housing before the 2009 financial crisis:

[H]ousing wealth of U.S. households at the end of 2008 was 25.4 trillion dollars. Housing wealth is about one half of total household net worth (which is 52.9 trillion dollars), and is larger than the Gross Domestic Product (14.4 trillion dollars). Moreover, since financial wealth is more unequally distributed than housing wealth, housing wealth accounts for almost two thirds of the total wealth of the median household.

Housing as the driver of America's savings vehicle is no accident.  Tax policy guarantees housing prices will always increase absent extraordinary circumstances. In fact, tax policy is so potent in this regard, what brought about the 2008-2009 financial crisis wasn't some unexpected event but the overuse of this magical money-making machine.  (Like most sure things, the main threat is overloading and overextension of the thing itself.)

The issue isn't just the well-known mortgage tax deduction, which cost the government about $70 billion in 2013--it's the way it favors banking dependency and excessive borrowing.  You can deduct all of your mortgage interest up to $1 million in principal on the home in which you live, which means banks and buyers are incentivized to borrow as much as they can up to that limit.  By setting a limit by fiat, the government has encouraged everyone to game the system up to that limit (a corollary to Goodhart's Law).  What's worse is the government compounds the problem by guaranteeing the borrowed money indirectly through agencies like Fannie Mae and Ginnie Mae.  Meanwhile, homeownership rates in the U.K. and Canada are similar to the United States, even though the first two countries don't allow such a tax loophole, er, deduction.  (Anything that allows you to minimize your taxes is a "loophole," but if the government likes a loophole, it'll call it a deduction to make it sound nicer and to encourage its use.)  Why set up tax policy that confers so much power to the banking system?

First, in theory, it makes sense to support home ownership.  Owning a home is usually a long-term decision that creates more interest in sustaining your surroundings.  The reality, however, is different--as cities have become larger, community becomes difficult to achieve, and most Americans tend to be private folks anyway--they may bring an apple pie to a new neighbor, but unlike many other countries, an invite into one's home is rare.

Second, by having so much wealth held illiquid and therefore captive and subject to fees (broker fees, closing costs, etc.), which discourages impulse moves, the government can manipulate its citizens' financial freedom and also its currency strength.  In contrast, in other countries, especially China, residents can remove their wealth--such as stock market gains--and transfer it elsewhere, such as Canada (Vancouver) or the United States (Cupertino, CA).  Such options can create havoc for governments, because not only do they lose wealth that supports their own currency, but the wealth they helped created is now captive in another country's currency and protected by law, making its return more difficult.

Third, if wealth is illiquid, easily tracked, and tangible, it can provide stable tax revenue.  How does this help the average resident?  Under a cost-benefit analysis, it doesn't.  In California, even after passage of a proposition that limited the government's ability to raise property taxes, some local governments still tried to over-estimate housing prices for purposes of increasing the applicable tax revenue or granted more developer permits than usual, harming quality of life by not accounting for public transportation or improved roads or new highway lanes.

At the end of the day, globalization requires more flexibility, more consumer disposable income, and more individual labor mobility.  Meanwhile, America's tax code continues to prioritize the exact opposite.  What could possibly go wrong? (Again?)

Bonus: the key to currency strength is reserves, and when your non-gold and non-natural-resource reserves are guaranteed to grow as well as be held captive, the (financial) world is a reserve bank's oyster.  In normal economic circumstances, if you want to make your exports more attractive, you can weaken your currency by issuing more debt; if you want your currency to remain strong, you issue less debt or debt at ultra-low interest rates.  In America, however, you can have the best of both worlds--you can issue more debt, keep it captive in housing, and create tax policies that ensure the debt becomes an asset at some point.  How does this captive wealth, which allows greater government manipulation of both currency and exports/imports, help sustain a growing middle class? Well, it doesn't.  It actually leads to more boom-bust cycles and debacles like the 2003 Cancun WTO trade failure and its continuation. Rendering the sale of essential items like housing and education on the financial sector's willingness to issue debt is a recipe for short-term gains and long-term disaster.

Worse, by ensuring both private and public banking entities have disproportionate influence over the economy, you cede power to the financial sector in the absence of almost perfect regulation and enforcement.  What does the financial sector do in exchange for such power, given that it doesn't make anything?  In theory, it exists to encourage stability, predictability, and the integrity of economic transactions.  Unfortunately, with pro forma accounting and conflicts of interest within banks, it doesn't even do accounting or valuation well.  In short, America's current tax system takes a sector that should be the designated driver in the economy and makes him or her into a Formula One fan itching to get into the driver's seat.  Given the global nature of finance, it's not just America that falls prey to such problems--google "Deutsche Bank hidden losses swaps" for more. 

Thomas Jefferson on Banks

From Thomas Jefferson, paraphrased:

If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their Fathers conquered...I believe that banking institutions are more dangerous to our liberties than standing armies... The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

President Jefferson's modern-day equivalent would have to be Mr. Ron Paul.

Note: the Jefferson quotation cited above has no credible source. It is apparently a paraphrasing of two separate Jefferson statements:

And I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale...Bank-paper must be suppressed, and the circulating medium must be restored to the nation to whom it belongs.

From Thomas Jefferson to John Taylor, Monticello, 28 May 1816. [Ford 11:533] and Thomas Jefferson to John Wayles Eppes, Monticello, 24 June 1813. [Ford 11:303]

Ford = Ford, Paul Leicester, ed. The Writings of Thomas Jefferson. New York: G.P. Putnam’s Sons, 1892-99. 10 vols.

Currencies

You can now buy almost all the major foreign currencies through a U.S. brokerage account: 

FXE: Euro 

FXC: Canadian dollar 

FXF: Swiss franc 

FXM: Mexican peso 

FXY: Japanese yen 

XRU: Russian ruble 

BZF: Brazilian real 

CYB, CNY: Chinese yuan 

ICN, INR: Indian rupee 

Although you can trade currencies, it doesn't mean you should. Personally, I own some FXC and FXF, but my positions may change at any time, and I am *not* qualified to give investment advice.

I view the Canadian dollar as a diversification tool because it is indirectly linked to commodity prices. The U.S. imports most of its oil through Canada, Mexico, and Venezuela. 

The Swiss franc should do relatively well, despite Swiss banking problems, because war is the #1 destroyer of economies, and the Swiss have historically avoided war. In contrast, the U.S. has Iraq; China has Taiwan; Russian has Georgia; India has Pakistan (over Kashmir); and Mexico has internal corruption so terrible, it may lead to civil war. Brazil's egregious income inequality makes it difficult for me to invest too much of my money in the country, despite its independence from OPEC and recent economic growth. 

I have heard several Southeast Asians say that Malaysia is doing better than its neighbors Cambodia and Vietnam primarily because Malaysia avoided war and Cambodia and Vietnam did not. The general theory makes sense. Aggression and war destroy economies because they lead to a lack of stability, which drives away investment. Thus, peacenik Americans who crave stability are left with the Euro, which is going to be devalued because of future expected interest rate cuts; the Canadian dollar; the Japanese yen; and the Swiss franc. 

If Tyranny and Oppression come to this land, it will be in the guise of fighting a foreign enemy. -- James Madison

The American Dollar and the Currency Carry Trade

You would think that after Bernanke talked up the American dollar and the Saudis agreed to boost oil production, the U.S. dollar would go up. You would be correct. See chart for currency ETFs and look at June 10, 2008 chart:

http://finance.yahoo.com/q/cq?d=v1&s=fxc+fxf+fxm+fxy+fxe

But for American investors still shell-shocked by the dollar’s decline, is now a good time to jump into the foreign currency pool? Probably not. While I own some shares of FXF, a Swiss francs ETF, I will not buy any more. There are so many other ways to get foreign currency exposure it makes no sense now, after the dollar’s steep decline, to buy other currencies directly. The U.S. dollar might keep increasing, or it might decrease in value–there is no sure way to determine which way the trend is going now that the federalis have finally awoken and removed their muzzles.

So what’s an investor to do? My pick is DBV, the PowerShares DB G10 Currency Harvest. (Disclosure: I own some shares of this unique ETF as a currency hedge, along with my FXF.) Basically, DBV is one manifestation of the “currency carry trade.” DBV borrows low-yielding currencies and lends (buys) high-yielding currencies; theoretically, returns should be automatic, assuming only slight variations in interest rates (and yes, that's a major assumption). Making these kinds of trades in a personal FOREX account would be too complicated and time-consuming, and that’s why DBV is an interesting product–as an ETF, it carries a low fee, and it further hedges its risks by using only ten fairly stable currencies, including the Euro. Any diversified currency product with ample exposure to the Euro is beneficial, at least to hedge a personal portfolio. As Dallas Fed Reserve President Richard Fisher told me at the Commonwealth Club, the ECB has only one mandate–to fight inflation, which makes it more politically palatable to maintain higher interest rates, leading to a more stable currency.

DBV is selling for 26.78, and FXF is selling for 95.93 as of the close of business on June 10, 2008. But if you don’t like DBV and you don't like the idea of dabbling in currency products, you’re in luck. Almost every major DJIA-listed company derives much of its revenue from overseas. Even Pfizer (PFE) has substantial currency exposure because of how much cash it has abroad. But General Electric (GE) would be my pick of the bunch if you are looking to buy a multi-national conglomerate with overseas exposure–it is at a five year low, and as of June 10, 2008, yields around 4%. That’s hard to beat when money market yields are around 2%. (Disclosure: I own GE and PFE.)

I hope that the federal government soon heeds President Eisenhower’s prescient words: “to support progress in our country, and indeed throughout the free world, we must make certain that there is no cheapening, no debasement of our currency” (Presidential Reflections, 1960). Until the Federal Reserve starts raising interest rates, I will keep looking for ways to protect myself from a government that seems to openly disrespect savers.