Bubble Aftermath

The length and severity of a bust depends partly on the magnitude of the ‘real’ maladjustments which developed during the boom…and partly on aggravating monetary and credit factors. We’ve got both in spades.

"Encouragement of consumption is no benefit to commerce, for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption."

Jean-Baptiste Say,
"A Treatise on Political Economy", 1803

Since World War II, all recessions in the United States, as well as in the rest of the world, had their main cause in monetary tightening by the central bank, implemented in response to rising inflation rates. As soon as the central banks loosened their shackles, economies promptly took off again.

Also important, the business cycles in America and Europe never used to coincide and cumulate, but instead used to follow each other. The fortunate effect of this regular sequence was that it stabilized the world economy.

Now, for the first time in the whole postwar period, the U.S. economy has slumped against a backdrop of the most aggressive rate cuts by the Federal Reserve and the most rampant money and credit growth ever. Implicitly, the forces depressing the U.S. economy this time are radically different from those that fueled past recessions. It is the goal of this essay to explore and identify the unusual causes of this economic downturn.

Among these causes, the profit implosion is the most obvious and also the most important. Essentially, it must have its own specific causes. Searching for them, we identified three major profit killers: first, a surging share of depreciation charges in gross investment; second, inflexible, record-high interest charges; and third, the gaping trade deficit.

Widespread hopes of an early rebound in U.S. corporate earnings are doomed.

But there is another crucial novelty to this economic downturn: its global synchronization. The problem is that the global economic upturn of the past few years was equally synchronized, as economies around the world adjusted to the roaring U.S. asset and spending bubble. During 1997-2001, American spending on imported goods and services exceeded earnings from exports by altogether $1,428.8 billion. To put this into perspective, U.S. GDP growth during these four years was $1,055 billion in real terms and $1,763.8 billion in nominal terms.

It is a familiar postulate of Austrian theory that the extent of the bust following a boom tends to be rather proportional to the scope of the excesses and the adherent economic and financial imbalances that accumulated during the boom. Gottfried Haberler’s ‘Prosperity and Depression’ (1937) says: "The length and severity of depressions depend partly on the magnitude of the ‘real’ maladjustments which developed during the preceding boom and partly on aggravating monetary and credit factors."

This postulate of the proportionality between boom and bust has convinced us from earliest times. Manifestly, it is diametrically opposite to conventional thinking in America that, under the influence of Milton Friedman, discards past boom excesses as things of the past. Past is past, and the only thing that counts for the present and the future is current monetary policy.

In this view, the Depression of the 1930s owed nothing to any credit excesses and related maladjustments in the economy and the financial system during the boom years, but resulted exclusively from the Fed’s flawed policies after the stock market crash. Common to this opinion is furthermore the conviction that proper monetary policy is capable under all circumstances of preventing recession and depression.

It goes without saying that this kind of thinking is prone to foster illusions about what monetary policy can do. What we generally hear and read from American sources reveals that there is, in fact, a widespread, inordinate complacency about the U.S. economy’s woes, even though troubling economic data abound lately.

A strong, preconceived view appears to hold sway that everything is bound to come up roses in the end. We stick to our view that the world economic prospects are significantly more bleak than most people realize.


Kurt Richebächer,
for The Daily Reckoning
November 13, 2002

P.S. The existing imbalances and structural distortions are too big and the room to cut interests far too small to fight the spreading weakness. But as to prevailing illusions, America is apparently on top. The rest of the world clearly lacks the dynamics for self-made economic growth. But Europe, above all, has no prior excesses to cope with. Our particular concern about the U.S. economy arises from the recognition that the world’s greatest bubble in history has in many ways grossly imbalanced it, hampering growth for a long time to come.

The decline of profits is already the worst since the 1930s. What’s more, it started long before the economy began to slow down.

Editor’s Note: Dr. Kurt Richebächer’s articles appear regularly in The Wall Street Journal, Strategic Investment and other respected financial publications. France’s Le Figaro magazine did a feature story on him as "the man who predicted the Asian crisis."

Philip Morris is a contrarian’s stock. Its main product is something that nearly everyone seems not to like.

Baltimore used to call itself "the city that reads." Now, "Welcome to Baltimore," say billboards as you enter the city, "the city that doesn’t smoke." Neither advertisement is truthful.

When something has gotten so out-of-favor that the city fathers make a motto out of it, we think, it has to be a good investment. But yesterday was not a good day for Big Mo. It fell 14% – on news that sales were slowing. Two years ago, we liked the company because it was cheap when others were expensive. Then, we liked it even more as the rest of the stock market fell and Big Mo actually went up. Yesterday, it got cheaper even as most stocks went up. But we liked it just because we like it.

Smoking is not the only bad habit a man can take up. USA Today reports that homeowners have been taking out about half the amount of the increase in value of their homes in ‘cash-out’ refinancings.

"They’re selling their homes one brick at a time," said Ian McAvity in New Orleans, "and using the money to buy groceries."

Well, not just groceries, it turns out. The USA Today article tells us that more and more homeowners are refinancing their homes in order to buy a second one. The second home market is even hotter than the market for primary houses. In California, for example, houses in vacation areas grew at a 27% annual rate in the last quarter. Overall, real estate went up by only 16%.

Not only do the buyers think they will enjoy their second home, they believe they are making a safer investment than putting their money in stocks. "What will happen when real estate prices go down?" one was asked.

"The cycle will come back," he replied. "If you weather the storm for 2 or 3 years, things will work out."

Whatever they are smoking, we wonder to ourselves, it may not be made by Philip Morris. Houses in Japan have fallen for the last 10 years – and are now down to just half what they were at the peak.

Could it happen in the U.S. too? We’ll see.

Addison has made his way back to Paris from New Orleans…he’s covering the markets from there.



Addison Wiggin, writing in Paris…

– "I hope you’re all looking after the $24,240 you are each responsible for," wrote Sean Corrigan, our London correspondent yesterday, referring to the $128 trillion derivatives market. According to a November 8th report issued by the Bank for International Settlements (BIS), the central bankers’ central bank, we’ve now managed to ‘hedge’ the full median income of your average Anglo- American breadwinner.

– To put things in perspective, that figure is about 16 times the market cap of the entire S&P 500.

– The BIS report specifically indicates a sharp 37% rise in gold futures over the past year…to $279 billion; a number that is roughly equivalent to the current market value of 27,000 tons of the metal itself. At this rate, it’ll only be a few months before every ounce of the world’s above ground gold reserves (c. 29,000 tons) are covered against any "evil speculative price fluctuations."

– "The ‘gross market value’ [the bit left over after all the contracts have been cancelled out] of gold derivatives is some $28 billion," says Corrigan, "which means the Big Boys in the market could sell the 12-member Amex Goldbugs index and still come up $3 billion short."

– Isn’t it nice to know that your paper money has been so protected against any change in the value of its hardest, if most residual, backing?

– Meanwhile, in another room of the casino…following encouraging words about the prospects of the U.S. economy from the Fed Vice Chair Roger Ferguson, all the major U.S. indexes starting selling off early gains. The Dow gave back about 100 points to close up a measly 27 at 8386. The S&P 500 ended 6 points higher at 882…while the Nasdaq gained 30 and finished its session at 1349.

– According to USA Today, Vice Chair Ferguson told a conference in Pittsburgh that "the Fed still has firepower left should the economy need additional stimulus." How comforting, really, given the effect of the last 12 volleys.

– The ‘overnight rate’ is mighty close to rock bottom at 1.25 percent, but "the central bank has…room to maneuver should a shock hit the economy." Ferguson added that one of the biggest risks to recovery is geopolitical uncertainty, but expressed optimism that the Fed’s latest rate cut would stoke a recovery in the coming year and called the risk of deflation remote.

– Greenspan speaks before the Joint Economic Committee today. Perhaps, he’ll be even more effective as his No. 2 in talking down the markets.

– We here at the Daily Reckoning have been speculating for some time that given the deteriorating investment environment in the US, foreign investors will soon enough tire of financing local consumption. But if a report in The Sydney Morning Herald can be believed, U.S. consumers can do nothing if not count on their staunchest allies to chip in when called upon.

– "Australian investors are being lured to the U.S. like moths to a flame," the opening lines of the article read, "fund managers are picking the worst bear market in 70 years to send record levels of portfolio investment to the US."

– "Australia’s appetite for badly performing U.S. assets appeared to be unrivalled," says National Australia Bank strategist Greg McKenna. "Of the first-world investment market, it does seem we are the only ones who are continuing with gusto to buy U.S. assets. Australians have burnt a lot of cash investing in the U.S. over the past couple of years.

– "Privately, some fund managers and equity strategists blamed the accelerating push into U.S. markets on the ‘tyranny’ of asset consultants, who they say are pushing managers to increase exposure to [U.S.] assets, but denying them the flexibility to deviate from weighting indices." (Think those boys were trained on Wall Street?)

– By August 31, the U.S. had received a total of $US482 billion in net portfolio investment inflows, of which only $65 billion went into equities…the rest financed government and corporate debt. Now that we’ve consumed all of our own savings, doesn’t it feel good to be snacking on our friends’ from down under?

– Harvinder Kalirai, an economist for State Street in Boston, warns: "the ‘deteriorating quality’ of U.S. capital inflows would trigger a major US dollar adjustment…When the dollar falls it’s going to be very rapid." What then, mate?


Back in Baltimore…

*** While yesterday stocks went up a little, gold went up a lot. December gold rose $3.24.

*** Is the stock market signaling a stronger recovery? "Tracking the developments in the economy and the financial markets, both stocks and credit," writes Dr. Kurt Richebächer, "we see nothing but aggravating conditions. Renewed drastic weakness of the US economy is the great shock waiting to happen to the world. A slumping dollar will turn it into a nightmare."

*** Bad dreams haunt us all, at one time or another.

Last night, coming out of a restaurant in mid-town, a colleague tripped on a step, fell, hit her face on the curb, and knocked herself out. Your editor rushed to her assistance.

"Sit her up," said one helpful passer-by.

"Lay her down," said another.

"We’ll take care of this," said the paramedic. "We know what we’re doing."

Your editor spent much of the night in the Johns Hopkins emergency ward with his colleague. He was surprised by how young and pretty the nurses and doctors were. Not enough to make you want to get hit by a truck, he thought to himself, but something to look forward to if ever you are.