Tuesday, 17 February 2015

Is Europe catching up to the US in MLM/Pyramid schemes?

Today I am happy to host a prominent figure in the anti-pyramid scheme movement, Rogier Fentener van Vlissingen. In the text which follows, Rogier gives both a novice introduction as well as a deeper understanding of the most recent developments in the area, pointing the way forward for legislation on the subject. Obviously, any opinions expressed are the sole responsibility of the author.

Clearly, the world needed a refresher on Ponzi-schemes, and it got Bernard Madoff. The question will be if the SEC, the USA, or the world, learned anything. Certainly, Harry Markopolos' book, No One Would Listen: A True Financial Thriller, highlighted the risks of regulatory capture. Madoff was smooth and seemingly respectable, and the SEC was not equipped to be looking for an operation like his, even though in retrospect the red flags were all over. So the problem becomes that the regulators protect the crooks from the public, and not the other way around, as Markopolos observes so succinctly. That is the problem of regulatory capture in a nutshell. The practical point, from the standpoint of law enforcement is to see that the appearance of respectability is no guarantee of anything, and a good fraudster will always try to create an aura of respectability. Madoff mastered the art, it was all smoke and mirrors.

Pyramid schemes are somewhat akin to Ponzi-schemes from an economic point of view. In a Ponzi, the underlying business is either non-existent or dysfunctional, and cannot produce the returns on capital raised, so that older investors are being pacified with good returns poached from the funds of new investors, not business profits, and the venture ultimately hits the wall, when at some point withdrawals overwhelm the rate of new investment. Recruiting may or may not play a role, as in the case of the feeder funds for Madoff, but most business tends to come from referrals. The argument for regulation stems from the predictability of the bad outcome, so that intervention by law-enforcement could limit losses. 

In pyramid schemes the business is recruiting for a venture that is either yet to be launched, or non-viable, or simply a hoax, and the payments for recruiting are merely a way of syphoning money from money hungry prospects to the pockets of the organizers. Classic cases include Galaxy foods, Koscot, Omnitrition, Holiday Magic, and recently Fortune High Tech Marketing and BurnLounge. Until the fateful Amway '79 decision, the courts were very clear on the nature of a pyramid scheme, and why they were illegal. With the Amway '79 case the lines began to blur.

In Amway '79, instead of dealing with the finding of fact - pyramid scheme or not - the court allowed itself to get drawn into a negotiation of conditions what would presumably make Amway not a pyramid scheme, without even noticing that the conditions it agreed to were utterly unenforceable, and nobody had the intention of ever enforcing them. It was pure make believe. If a burglar or a rapist were to negotiate with the court over how many free passes they should get before they could be convicted for burglary or rape, the public would be outraged at the stupidity of the judge, but in the Amway '79 case the commercial equivalent of that negotiation succeeded. Then FTC Chair Robert Pitofsky, and Commissioner Elizabeth Dole, accepted the ruling as law.

The MLM-"industry" took flight from then on, and Herbalife became the first most memorable child-prodigy offspring from that illicit liaison of courts and criminals, in the form of the judicial error of the Amway'79 court. The culmination of that hubris came when Herbalife was taken private after that death of its founder, Mark Hughes, from a multiple drug overdose, for a short time (think legitimizing a scam) its interim CEO was one Frank Tirelli, now Chairman and CEO of Deloitte Italy. He held the operation together with an agreement (the "Tirelli agreement") with top distributors that is very likely illegal, but at least highly problematic, and was the basis for the company subsequently going public, with Michael O. Johnson as their CEO, and the new pied piper, showing that in America, crime does pay, and very handsomely. The secret to a successful crime, is to do it in plain view, right in front of the cops.

Most succinctly, in economic terms, the problem of MLM is that unlimited recruiting is substituted for sales by dint of the fact that recruiting incentives are greater than sales incentives in MLM marketing/compensation programs. The resulting behavior predictably is that people will recruit, not sell, and only conscripted consumption ("personal volume" required to qualify for commissions) will ensure a minimum of cash flow to keep up appearances for the sake of the regulators. The befuddled participants who even try to sell, will soon find that if they don't recruit their customers as distributors, that somebody else will, for the money is in recruiting not selling. Very soon therefore, retail margins will tend to collapse to zero, and ultimately product will even be given away as free samples in order to recruit the next prospect, and the wholesale cost of the product becomes another tax-deduction, and tax-deductions are the major product of an industry that produces 99% loss rates among participants.

When the Albanian economy tanked in 1996/1997 because of pyramid schemes, the IMF did some very helpful work in warning the rest of the world about the obvious dangers of pyramid schemes, only to see their work filed away for reference, and ignored in practice. After all, "we" don't have a pyramid problem. That was just those dumb Albanians who did not know any better. They just escaped communism, and they mistook pyramid schemes for capitalism. And the world went back to sleep.

Then, in December 2012, there was a wake-up call, in the form of a short position initiated by Pershing Square Capital Management, against Herbalife (HLF), and made very public with a 300+ Power Point presentation at the Sohn investment conference. PSCM even created two websites to document their thesis, Facts about Herbalife, and  Herbalife Pyramid Scheme. At the time when I read it, my first thought was: "It's a dirty job, but somebody had to do it," and I felt sort of grateful that the public listing of Herbalife and the opportunity to short the stock provided the market incentive to get the ball rolling. What happened next defies the imagination. In obvious reliance on the idea that Herbalife was actually a real business, actually an exchange-listed company, with ostenstibly $5bn in sales, Carl Icahn took the opposing view, and that is when I took notice, and in my first article on this spectacle on Seeking Alpha (free registration), here, I promptly assumed that Carl Icahn, would soon be facing substantial losses on the position, and I compared his position to Wil E. Coyote hanging over the ravine, and realizing he had no ground under foot. Little did I realize how long it would take for this episode to play out. I thought at the time my first article on the matter would be my last, but we're now at thirty and counting. I know now that my last article won't be my last, for when Herbalife finally collapses or gets shut down, a post mortem will be in order.  

For those who are interested, Seeking Alpha has, for better or for worse, become the locus of some of the best research and analysis on the issue outside of the astounding material produced by Pershing Square on the two websites listed above, and by Christine Richard (who did much of the original research leading up to the Pershing Square short), explained in part in her own articles on Seeking Alpha, here, and here.  It should be noted that a short position is a difficult investment decision, unless you have a very clear trigger mechanism that you can identify. Government action is not one of those. And, to a degree, Bill Ackman counted on such action, based in part on his MBIA short (and it should be noted that Christine Richard wrote the book, Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street's Bluff). Other important contributors on Seeking Alpha regarding the Herbalife developments include:

  • Matt Stewart, Quoth the Raven and Matthew Handley, all of whom have short positions, and collectively they have produced an astounding body of research and analysis, highlighting both legal issues and financial analysis.
  • On the legal front there have been contributions from attorney Douglas Brooks (of Omnitirition fame), and former Wisconsin Assistant Attorney General Bruce Craig, who notable won a case against Amway in 1980, just after the fateful Amway '79 decision that would cripple the FTC for the next 35 years. In the discovery phase Bruce Craig found that of 20,000 Amway distributors in Wisconsin at that time, the top 200 lost $900 per year.
  • As far as business and economic analysis, as well as some of the more in-depth aspects of the cult-like appeal of pyramid schemes, there have been important contributions from Bill Keep, Dean of the College of New Jersey, and Robert FitzPatrick, who runs Pyramid Scheme Alert, as well as some connecting commentary from myself.
  • On the tax front, there is the fascinating research of Dave Ritchie, here, who confirms the tax research of Jon M. Taylor from IRS records. Loss rates are typically close to 99%. Tax deductions is the major product of the industry.
  • As an additional angle to both the cult aspect of MLM, and its apparent business/investment promises, there was Kay Herbert, an MIT-educated mechanical engineer, who drew a statistical analogy between MLMs and the propagation of epidemics, to explain the "pop and drop" behavior when opening new markets or introducing new products, that even Herbalife management acknowledges in their public filings.    
There have certainly been other contributions, but the above are probably the main ones. Outside of Seeking Alpha, a few of the sources that should be mentioned include the following:
  • Blog by investor Tom Salvatore, which has shown very astute analysis and profound comprehension of the legal, business, and criminological elements that have made up the story of MLM/pyramid schemes.
  • Blog by British MLM-critic David Brear, whose own family was torn apart by the Amway cult, and who has put forth the most comprehensive body of historical analysis of thought control with fake "opportunity," going all the way back to beguiling misrepresentations and advance fee fraud of Hitler in his Volkswagen program, basing himself firmly on the razor sharp insights of George Orwell.
  • The classic sources include Jon M. Taylor's site www.mlm-thetruth.com which includes such gems as his analysis of the tax losses of MLM-participants, as well as his documentation of regulatory capture of the FTC, that are masterpieces in themselves. Taylor has researched over 500 MLM companies, and found the structure to be always the same in effectively syphoning moneys from a multitude of losers to a few at the top. Robert FitzPatrick's sites are www.pyramidschemealert.org and www.falseprofits.com. A newer voice is that of E. Robert Smith, author of the book Downline... an intolerable potential to deceive, with his website www.amway79challenged.com. The title of his book was a statement of Paul Rand Dixon, a former FTC commissioner, which he made in one of his own MLM-rulings. The author's own conclusion, after five years of 6-figure earnings in MLM was that he had become a professional liar. He did not like it, and he chose to write the book instead.
  • The mainstream press has mostly missed the story, or failed to cover more than the headlines, but some highly competent coverage should be mentioned, including a five article series on Al Jazeera, which included some powerful commentary by William K. Black, he of S&L fame (The Best Way To Rob A Bank Is To Own One), excellent coverage in Rolling Stone of MLM-company Vemma, and somewhat older but very worthwhile coverage in a four-part series in The Nation, here (part 4, and you'll find the links to parts 1, 2, and 3 referenced at the start of the article). The Nation does a very good job on the regulatory capture and political corruption aspects of the issue, including how the GWB-administration put the fox in charge of the hen house in the form of making Amway-lawyer Timothy Muris head of the FTC, promptly stopping all MLM-prosecutions, and starting an FTC tradition of obfuscation in their public policy statements, that misled the public into thinking there is such a thing as a 'legitimate MLM.'
  • Finally, there is the incomparable Salty Droid, whose material provides rich documentation of various scams, including extensive material on MLM in general and Herbalife in particular.
One of the issues that has gone nearly unnoticed is this matter of regulatory capture, although it has been well documented. Rationally, it is the first and most obvious problem in dealing with crime. Only the latest example is the Dodd-Frank Act in the US, and its offspring, the Consumer Financial Protection Bureau (CFPB). Effectively, it was a way of blaming the banks for the political corruption of vote-getting with the lure of 'low income' home ownership under the Clinton administration, but with plenty of Republican believers as well. This issue was recently documented by Peter J. Wallison in a new book, Hidden In Plain Sight. Personally, I tend to think that the abolition of Glass-Steagal was the beginning of the problem, but the cynical view of the whole matter is that the CFPB today is a captive regulator from the outset, to justify why the root causes of the sub prime scandal were never dealt with. As William Black put it, Financial Frauds Had A Friend In Eric Holder, and instead of thousands of criminal prosecutions, as we saw in the S&L scandal, nobody went to jail. The USA laughed in the 90's about Japan's inability to deal with the financial engineering by its biggest corporations, and its failure to deal with the bad banks in a forthright manner. The US has now officially taken that title. Japan bought itself two lost decades, sofar. The US has set itself up for two lost centuries. As author Gore Vidal, the unofficial biographer of the USA, put it so succinctly, the US has become a country not of laws, but of lawyers.

The SEC and the FTC have been asleep at the wheel in relation to MLM/Pyramid schemes, taking only occasional action, by culling some minnows from the oceans of fraud, but it is a travesty that pension money should be invested in a complete scam like Herbalife, or that it should be allowed to be publicly listed in the first place. This 'industry' has now grown into an international $150 billion dollar fraud. The FTC has only intermittently pursued a few smaller operations, such as Fortune High Tech Marketing. In the case of Fortune High Tech case ran  for 10 years and had at least 200,000 victims before it was stopped. Herbalife makes 2 million victims a year, and some of the stories are heart-rending, such as one I learned of recently of a 72-year old woman who operated Herbalife 'nutrition clubs,' which are a pyramid within a pyramid, and losing $150,000 doing it.

One of the interesting side stories is how the DSA, the Direct Selling Association, was taken over from the inside by MLM companies, displacing the original Direct Selling companies, and so to complete the disguise of MLM, as a direct sales company. (This would make a good definition of MLM: MLM is a pyramid scheme disguised as a direct sales company.) The DSA was instrumental in corrupting the political process and the regulators in the US, and internationally the same has taken place. I received a response to an inquiry to the Dutch Ministry of Justice, in which they maintained that protecting the citizens from fraud was not their business, for limiting the freedom of contract was a priority concern, and the citizens should sort out for themselves which companies were fraudulent. In short this is the police protecting the right of the crooks to defraud the public. This view is only possible if it is assumed that MLM is ever a legitimate business model, but of course any business method that produces 99% losses for its practitioners, is not a business mehtod, but a fraud.

More recently, back in the USA, both Tupperware and Avon have quite publicly quit the DSA, making it clear that they were concerned it was overrun by pyramid schemes. However, neither company has (yet?) taken the next step to seriously reform their business models, and Avon in particular exhibits a deterioration in its financial results that seems strongly correlated to its adoption of an MLM model in 2005, which has predictably cannibalized the traditional sales business of the Avon lady, with the recruiting madness of MLM. Economically it is clear, that if recruiting drives the bus, retail sales is thrown under the bus.

It should be noted that a proliferation of public satire about MLM/pyramid scams is indicative of the fact that the public is getting tired of the scams, so that even if the regulators continue to be slow in acting, the population is so scam weary that enthusiasm of these programs is waning. I am personally involved in some public education in my area, including presentations in the Police precinct council meeting of my precinct in the Bronx, for with fraud, two pennies of crime prevention is certainly worth more than a pound of cure (never mind a dollar's worth) of cure.

Possible Remedies

Clearly, in the US the FTC is supposed to protect consumers, but the only means it currently has to fight MLM is under section 5 of the FTC act, "Unfair and deceptive business acts and practices" (UDAP), which works only to a point, as the FHTM case showed. It makes no sense that these companies should have the opportunity to run, as in the FHTM case for 10 years, and make 200,000 victims, before they can be stopped. In the Herbalife case the total run time up to the present is 35 years, and the victims are in the multiple millions.

Presumably the SEC would know enough not to let a Ponzi scheme become publicly listed, but there is a long list of publicly listed MLM companies, or MLM companies owned by publicly listed companies, including Warren Buffett's Berkshire-Hathaway. This means pension funds also own these illegal rackets directly or indirectly.

The good news is that there still is a strong foundation in US law to pursue these companies, and in a very interesting development AARP just filed an amicus brief for a class-action RICO lawsuit against Ignite/Stream, which is a private MLM/pyramid company in the de-regulated retail energy industry. The company had sought to appeal both the RICO and class-action status of the lawsuit, and AARP is supporting the class-action status. It should be noted that the RICO dimension in a private lawsuit opens the door for triple damage claims. The first use of the RICO laws against MLM was by Prof. Robert Blakey in Amway's case with Procter and Gamble, and the current case against Ignite/Stream will make for an interesting development. He originally drafted the RICO statute to fight the mafia, and the similarities with how the MLM industry operates are eerie. The AARP brief is a masterful summary of the current legal framework in the US, which still provides ample grounds to pursue these frauds. The material would be equally applicable to Herbalife in its entirety.  
Rogier Fentener van Vlissingen lives in Bronx, NY, and is active as a consultant in renewable energy retrofits, and an author on finance, energy, and spirituality. His website is www.vliscony.com.

Sunday, 21 September 2014

Two-Handed Economists

"A sign of a good economist is he or she always has two hands" says John Cochrane. Truth is, there is more to that statements than commonly thought and it is one of the things most forgotten in the economics profession. More often than not, when an economist is asked to provide an opinion on a subject, the assurance of absolute knowledge in his or her words is staggering. It is as if God Himself has come down to earth and bestowed that person with the impeccable ability of perfect foresight. In addition, the economist was also granted with the ability of saying that everybody who disagrees with him is just plain ignorant.

The problem most economists commonly ignore (maybe due to biases than other things) is that there are actually two sides in everything, from the plainest decision to the most intrigue problem the economy faces. The smart thing would be to recognise both but choose the one with less downside. For example, when the Federal Reserve chose to boost the economy by promoting programmes such as the TARP and large-scale QE they were faced with two options: do nothing and watch the whole economy collapse or do something and risk being told off for inducing moral hazard. Obviously the latter was the worse of two evils. (In case you were wondering, even with the total collapse of the economy the top 1% would still be the top 1%; the inequality would have just been greater- see the certainty I was talking about before?).

Take another example: what do you think about the government spending more than now? Most who say that this is a good idea are in danger of being labelled as communists while those who say that it is bad are about to be called Austrians. The problem here is that the question is very vague: when, for example would be a good clarification. In times of crises those labelled Keynesians would respond. But again, it depends on where you spend it and how constrained you are. Greece, Italy, Cyprus and Portugal cannot increase government spending as they are too indebted for that. In addition, moral hazard comes in again. If I am due to spend every time things go bad, why shouldn't everyone just be risky? Again, the lesser of two evils is the wisest choice here.

Probably all issues could be benefited from a two-handedness approach. Even extreme ones such as cartel formation. We all know that cartels are bad, simple because they tend to charge higher prices. Suppose now that we have a situation where a cartel is formed in an industry. In the case where no cartel exists, every firm competes by price and the lowest bidder wins. But in the case where the cartel exists, the firms agree that one of them would win each time and place higher prices. Is this bad for the state? Obviously. Is this bad for the economy? Well, it depends. If, as usual we have returns to scale, it would mean that less people are employed in a single firm than in two similar firms. In this case, the lowest bidder would get all the auctions and everyone else would be left off the market. But, at the same time more unemployment would occur than if all firms were operating as one firm needs less than all the workers! 

As the reader may observe, there is no clear-cut answer to a question. Even in this most extreme of cases such as the one where cartels are involved, what would you prefer if you were a policymaker during a crisis and unemployment was already sky high? High morals and high unemployment with less spending or lower morals and lower unemployment with more spending? My answer is simple: it depends.

Saturday, 2 August 2014

Comments on the PIMCO report for Cyprus

Since the PIMCO report on the Banking System of Cyprus became public information, I've actually noticed much less comments regarding it than when it was still considered confidential. The reason might simply be that it is always much more difficult to speculate on something which is available to everyone than something which is supposed to be a secret. Thus, given the lack of comments on the subject, what follows is my take on the report.

The first thing you notice in the report is that PIMCO did an excellent job in identifying the major features of the Cyprus banking system. The most important of these features are:

1. The prevalence of asset-based lending practices
In essence, Cypriot banks lent out money only if you had some strong collateral to back your loan (in most cases real estate), with less attention given to whether the client had the ability to actually meet payments. If the borrowers got into trouble, they could always sell their property to repay their loans; as real estate prices increased for a very long time, this practice rarely yielded losses for the banks. Most importantly, borrowers who were not able to repay could always pledge more collateral and actually increase the amount of they borrowed.

2. Extended foreclosure and legal resolution timeline
Simply put, if a borrower could not repay his loan, then the whole procedure of obtaining the collateral and making a forced sale of the property ranged between 10 to 12 years. Add this to the previous feature and the reader may easily see that a borrower had no difficulty in pledging more collateral and obtaining more credit as there is almost zero downside on his part. This in its turn artificially increases loans and leads to the concentration of bad loans to few people (see land developers, hoteliers, etc).

3. Different provisioning methodology, impairment recognition and interest income practices
Notably, a fully-secured loan was not considered a non-performing one which makes the value of NPLs depend on the (subjective) valuation of the collateral. In addition, unpaid interest income was also considered to be income as a result of the historically appreciating property prices which made the probability of future losses very few (as also discussed in feature 1).

In addition to these, a high reliance on the the international banking operations for income and non-residents for funding was also reported. These features resulted in high cure rates for NPLs as well as high re-default rates (since extra collateral means a "cured" NPL but does not mean that the borrower's ability to repay has increased) and subsequently in high probabilities of borrower default but low loss-given-default rates due to over-collateralization.

The methodology of the exercise, will not be the subject of this article, yet, just simply comment that even though there has been much speculation, PIMCO does not appear to do anything different than standard procedure. The same holds for the base scenario which does not appear unrealistic given the European Commission (EC) forecast in Autumn 2012. Actually, compared to the -2.3%, -1.7% and -0.7% EC forecast for 2013, 2014 and 2015 respectively, the -3%, -0.6% and 0.8% is cumulatively much rosier. The same holds for the unemployment rate forecast.

The finding which most strikes out in the report is that Cyprus banks were unable to meet their capital needs even in the base scenario. In fact, not only would they need additional capital to meet regulatory needs but they would also end up with negative capital in 2015, making an additional case against the validity of the EBA stress test exercises in 2011. Again, I note that this is simply the base scenario. In the adverse scenario, the capital needs increase by more than 3 billion euros for the whole system.

The PIMCO numbers are supposedly the ones on which the decision on the percentage of the deposits haircut of the Bank of Cyprus  relied on. The 3.9 billion shortfall for the bank was very close to the 3.8bn obtained from the haircut. The problem, however, lies somewhere else: as stated in page 8 of the report "Greek loans represented approximately 40% of the defaulted balances. Moreover, in the adverse scenario [..] Greek loans represent 43% of total expected losses on Cyprus and Greek loans". In numbers, out of the total of 6.6 billion expected losses on loans and advances, around 2.8bn were from Greece. For those who have forgotten, MoU in March 2013 also included the forced sale of the banks' subsidiaries in Greece. This means that the banks were cut off from any potential losses in Greece thus lowering their capital needs. Even if we round the number of the PIMCO report to 2bn euros, the capital needs in the adverse scenario reduce to about 1.9 bn, without even taking into account the reduction in risk-weighted-assets which would further decrease needs.

Hence, the question which arises from the PIMCO report is: since the forecasts were made using the Greek branches as well, why was the amount employed in the haircut the same? In fact, since the Bank of Cyprus actually required a further re-capitalisation of close to 1 bn a few days ago, how low have the PIMCO estimates been? The only major difference which could make the actual outcome worse than the predicted is the fact that unemployment was 16% in 2013 rather than 13.8% in the forecast, while the house price forecast was much more pessimistic than the actual result. The change in the NPL definition does not matter at all, as PIMCO, in page 15, defines a non-performing loan as one which is 90 days past due, regardless of its collateral amount. The good Laiki couldn't have impaired the balance sheet by that much either since most of the losses were absorbed by the bad bank. Even in the worst case scenario of BoC obtaining all loans from Laiki, the exclusion of the Greek branches leaves capital needs for the domestic Laiki at less than 1bn. Strangely, the liquidation of Laiki was said to decrease Cyprus's needs by 4.2 billion which is in contrast to the PIMCO report in which the bank required 3.9 billion in total (including the Greek branches).

Concluding, the big question mark here is not if PIMCO over-estimated the capital needs of the banks, but why its numbers when it came to the Cyprus evolution of loans were so far off. If the BoC actually needed 4.8 bn (3.8bn of the haircut plus 1bn from the re-capitalisation) to pass the October stress tests why was the number less than 2 billion (excluding the Greek branches) in the PIMCO report? 

The PIMCO report, even though it did a great job in identifying and analysing the state of the Cyprus banking system did a very peculiar job in forecasting its capital needs. Truth be told, numbers and reports don't really add up.

Saturday, 12 July 2014

A Marriage Made in Hell: Housing and Foreign Demand

In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative balances, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is no solution for the long-run as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. 

The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.

Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:

Yellow line is the price of housing per square meter while the green one is the inflation rate
The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.

The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:
The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments.

So what makes housing so different?

The simple answer is that housing is immovable. You cannot really take a house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.

Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing bubbles have appeared in the Netherlands, Greece, Cyprus and even London as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.