Almost too Wonderful
A little chart…and the end of the world.
In a recent issue of Barron’s, a little chart, tucked away at the bottom of the page, and printed with little accompanying comment, must have gone unnoticed by most readers. But I bring it to your attention, dear reader. Because it reveals one of the deepest patterns in the economy…one which surges directly from the human heart – like red blood from an open artery…It shows something that should never, never, never happen. But it does.
We have spent many letters discussing how "light thinking" (leicht denken) leads to huge errors – especially when someone else’s life or money is at stake. Economic mumbo-jumbo or geopolitical double-talk rises off of the editorial pages…and wafts from Congressional hearing rooms…as though it were a rank odor – blowing this way and that on the hot air of popular opinion. People become intoxicated by it. "Everyone knows" this…or "Everyone knows" that… Except that…as the saying goes, when everyone thinks the same thing, no one is really thinking.
No one was thinking when they thought war impossible in 1910…nor were they thinking when they thought the war would be over quickly in 1914…or when they thought the Germans would pick up the whole tab in 1919. One error led to the next like subway stops…until the train finally crashed into an abutment.
But that was the beginning of the century. By the end of it, people had boarded another train. This one, too, was bound for glory, but on a different route.
You will recall that Norman Angell had declared Universal Credit to be the savior of mankind. Trade required credit. And credit required peace and trust. Ergo: war no longer made sense.
"Like fire and sex," wrote Jim Grant recently, "credit is almost too wonderful." True, credit proved no bulwark against war, but it is still widely believed to have banished depression forever. Even Philippe Simonnot, working his way through the major economic mistakes of the last century, believes the Fed made a big error in 1930. Relying on the work of Milton Friedman and Anna Schwartz, Simonnot says the Fed needed to get more cash and credit into circulation.
It is still thought that credit is the key to prosperity. But it is the key to prosperity in the same sense that military spending is the key to security: it all depends what you do with it.
More military spending in 1910 did not make the world a safer place. Nor did the extra credit of the late ’90s make it a richer one. But that idea is so much at odds with what people believe, the burden is on us to prove it.
First, we offer the theoretical argument by reductio ad absurdum. If credit were such a panacea, why not offer more of it? If a Fed funds rate of 4.75% works such wonders as have been lately credited to it (producing the softest landing in history)…why not lower rates another point or two? Why not pay people to take the money…if you could really get richer that way?
Why not? Because it doesn’t really work that way. Anyone who cares to think about it will soon realize that credit is only valuable insofar as it represents real resources that can be used in a productive fashion. Argentina, or the Fed for the that matter, can print all the pesos it wants; people won’t get richer unless the currency has real value behind it, and the investments they make with it turn a profit. Unprofitable investments waste capital…making people poorer, not richer.
What causes people to make unprofitable investments? Loose credit!
Imagine that you invest in a new bakery. Other bakers sell bread at $1 a loaf and make a profit of 7 cents. But your new bakery has higher costs. It only makes a profit of 5 cents. In a world of cheap credit – where interest rates are under 5% – it may make sense to begin the bakery, because the cost of capital is lower than the expected rate of return.
But imagine that the 5% rate was set, not by the market – matching up borrowers with available resources at the going rate – but by officials at the central bank! The real rate of interest may be 8% or 9%. Which means, your investment is unprofitable.
Now, the world has more bread…which will force prices lower, putting even more pressure on profit margins. And, sooner or later, you will have an investment that is worth less than you paid for it.
"It has been the excessive creation of [credit]," Jim Grant quotes Antony P. Mueller, "in the first place that has brought forth the misallocation that is revealed when liquidity gets tight. It is not the outflow of monetary capital that produces these distortion, but it is the massive inflow that makes mal-investment happen." Too much credit is not such a good thing, after all.
People don’t really get rich by spending and consuming. They get rich by saving and investing. Yet, the popular mythology of the late 20th century…and the creed of virtually the entire economics profession…is that consumer-led, credit-enhanced economies are the wonders of the world!
Turning to the second part of today’s polemic, we offer the experience of the last few years. If more credit really could make people wealthier, what has gone wrong? "For the first time in history," writes Dr. Kurt Richebacher, "a major economy has slumped against the background of rampant money and credit expansion."
Dr. Richebacher is referring to the U.S., where "plunging business capital spending progressively slashed the growth of consumer incomes form $404.7 billion in 2000 to barely $40 billion, annualized in the second half of 2001. Yet, the consumer was willing and able to largely offset the dramatic income loss by heavier borrowing. While business fixed investment plummeted by $134.1 billion in 2001, consumer spending rose $293.6 billion. Thanks to this spending spree, the U.S. consumer prevented America’s deepest and longest recession – for the time being."
The slump in the U.S. was unusual in many ways – almost in every way.
"While economic activity was virtually stagnating, households, business and financial institutions piled up another $2 trillion in new debts…for every single dollar of additional GDP, the U.S. economy incurred $65 of additional debt…"
The Fed cuts rates 11 times…which encouraged 7.5 million homeowners to refinance in 2001, taking out more than $100 billion dollars in "equity."
"During the [last quarter of 2001]," Dr. Richebacher concludes, "the U.S. consumer saw his income shrink by $3 billion while he increased his indebtedness by $609 billion. Yet at the same time, consumption rose by $94.6 billion. This means the U.S. consumer borrowed more than 6 times the amount he spent! (All figures are annualized.)"
And business profits? They’ve been dropping sharply ever since 1999 – "the worst profit performance during the whole post-war period," says Richebacher.
On the chart described at the beginning of this letter, the debt binge of 2001 doesn’t even appear. The chart traces the growth of credit throughout the 20th century…ending in the year 2000. By that final year, total credit market debt as a percentage of GDP had risen to nearly 300%. If the chart were a topographical drawing, you might think the final year, 2000, was the crest of a huge mountain range. Going backwards, the ground falls away and comes to a plane in about 1980. The ground is more or less flat, with total credit market debt of about 130% of GDP for 40 years…all the way to 1940. There, another, smaller range rises… peaking out at 260% in, what a surprise, 1929.
Did the explosion of credit make people rich in ’29? Did it make people rich in the late ’90s? We don’t think so. Instead, it created a kind of phantom wealth – and binge of consumption, based on the flimsiest pretenses. Everyone was sure he was getting rich…why not spend some of the loot?
Normally, an economy seems to function perfectly well with debt equal to less than 150% of GDP. But occasionally, according to some deep currents of madness, men seem to want twice as much. The chart reveals only two such binges in the entire 20th century. The first wrung itself out in the 1930s. The second bleeds off the chart, it’s denouement still ahead of us.
Your editor, calling it quits for the week,
April 12, 2002 — Paris, France
Have a good day!
Despite our wishes, Wall Street did not have a good day yesterday. Yahoo! fell 16%. AT&T down 8%. Microsoft down to $55. GE – would you believe it – down to $33 and change.
We have long wondered about GE. In fact, we suggested – almost exactly a year ago, when the stock was trading at $50 – that you might want to sell it.
How was it possible, we wondered, for a huge conglomerate to be priced so much more richly than the industries it owns? Is the whole really worth so much more than its component parts?
Was it reasonable for a company that has been around since before The Flood, that is so big its revenues equal more than 1% of the entire U.S. GDP, to be priced like a growth stock, we wondered?
Could the "most admired company in America" (according to Fortune magazine) become even more admired? Could the "world’s most respected company" (according to the Financial Times) become even more respected? Might the company that held the No. 1 position on Forbes’ list of the Super 100 companies and on Business Week’s ranking of American corporate boards move further up the list…perhaps beyond this earthly pale altogether? The Arabic number system permits no improvement on the Number One position…and yet, at 30 times earnings, the market seemed to think it imminent.
"If you could buy one stock to keep for the next 20 years, what would it be?" asked James K. Glassman in his "World of Investing" column a year ago. "General Electric, no doubt about it."
We had our doubts. Now that it has had time to see the post-Enron numbers at GE, the market is starting to have doubts too. In the last few days alone, investors have lost as much on GE and IBM as they did on Enron.
Eric has more details…
Eric Fry in New York…
– Yesterday, the stock market crumbled under the unbearable weight of full disclosure…or at least, less incomplete disclosure. General Electric stripped bare its disappointing first-quarter earnings – holding a conference call for the first time in its century-plus history – and the stock got hammered. So did the rest of the stock market.
– GE shares tumbled 9%, helping to weigh the Dow down 205 points to 10,176. The Nasdaq sank more than 2% to 1,725.
– Earlier this week, IBM exposed its earnings and revenue forecast for all to see, and the horrifying images caused investors to dump the stock. Is there a pattern developing here?
– As predicted several times in this column over the last few weeks, truth-telling on Wall Street is not a bullish event. In fact, the truth hurts. After all, what investment story doesn’t sound better with a couple of white lies tossed in? And what better way for CEOs to increase the value of their stock options than to pretty-up the company’s earnings a bit? For more than a decade, white lies and beautified earnings have paved the road to rising share prices…or at least one lane of it.
– Now however, the game has gotten a lot more difficult. Truth-telling is in fashion and the consequences are not pretty. Yesterday alone, General Electric shares lost a staggering $34 billion of market capitalization. That’s about the size of the total global market of gold stocks.
– And so far this week, IBM stock and GE stock combined have shed a breathtaking $56 billion of market capitalization. That’s bigger than the entire Enron bankruptcy filing. In other words, that’s a lot of money.
– Even if truth-telling is not so great for share prices over the near term, it is exactly the right medicine for the long-term health of the markets. However, there is a fair amount of cleaning-up still to do in the aftermath of the riotous tech bubble party.
– The SEC’s new chairman, Harvey L. Pitt, made headlines recently by suggesting a sweeping overhaul of the mechanism by which corporate executives receive stock options. To which we say, "Bravo!"
– "If managers can reap profits from their options while shareholders are losing some or all of their equity stake, the options create conflicting, not aligned, interests," Mr. Pitt complained.
– The SEC chairman not only diagnoses the malady, he also proposes a cure. First of all, Pitt suggests that all option plans for senior executives be subject to approval by shareholders. Further, he proposes that a panel of outside directors determine the size of the specific option grants to each officer. Finally, he suggests that "officers be required to demonstrate sustained, long-term growth and success before they can actually exercise any of their options."
– The proposals make eminent sense, which is reason enough why none of them are likely to become law any time soon…if ever.
– "The ideas are good ones," opines Floyd Norris of the New York Times, "but having them adopted will not be easy. The first one, requiring shareholder approval, would seem to be the most obvious. But companies have resisted it furiously."
– Of course they would resist it. Does a bank robber obtain the depositors’ approval before robbing the bank? And what depositor would ever vote in favor of being robbed? Forcing option grants to face a shareholder vote would simply be an indirect and elegant way of condemning the practice to a swift death.
– "To really align the interests of executives and shareholders means that both groups have to face the risk of declining shares," Norris accurately observes. An option, by definition, participates only in the prospective reward with none of the prospective risk.
– Truth be told, there isn’t a lot of value available on Wall Street at the moment, according to Robert Gardiner, manager of the red-hot Wasach Micro Cap fund. He says he’s struggling to find new investment opportunities. By way of background, Gardiner steered his fund to stellar 36.9% average annualized returns over the last five years.
– But unlike most fund managers who get a "hot hand," Gardiner is turning money away. "We’re closed to everybody, including my dad," Gardiner tells the Wall Street Journal. (You have to admire the man’s integrity). Why the closed-door policy? Because, Gardiner explains, "We’re not seeing a ton of value out there." Gardiner said it; we didn’t.
Meanwhile, April in Paris…
*** Ah yes…this is a financial column. But sometimes it’s hard to keep our minds on business. Last night, Maria came by the office and we went out to dinner together. We dined in one of our favorite restaurants. I’m reluctant to tell you about it. It’s very inexpensive and very good – the kind of local little eatery that is almost always full of loyal customers.
*** In fact, the regulars have their own napkins – in the traditional style – tucked into the "cazes" near the bar. Which is why I’m reluctant to tell you about it.
*** Heck, it’s hard enough already to get a table. But if you’ve been long-suffering enough to read these Daily Reckonings, giving you a solid tip every once in a while is the least we can do. So here goes: Au Pied de Fouet on the rue de Babylone in the 7th. Traditional French cuisine at traditional prices.
*** Also, a little housecleaning detail. Addison tells me our "server" in Baltimore crashed a few days ago… and a slew of e-mail messages sent by readers of The Daily Reckoning were lost. If you have yet to receive word from us on an urgent matter, I apologize. Please send your message again, and we’ll get right on it. Thank you…