Bubble Anatomy

While the Fed and other economic optimists try to downplay America’s non-existent economic recovery – Dr. Richebächer looks at financial development through a different lens – and sees a more permanent and pronounced softness in the U.S. economy…

Almost half of this year is already behind us. The biggest surprise, certainly, is the suddenly disappointing economic data about the U.S. economy. Whether this will be just another brief soft patch or a longer-lasting, rather serious, slowdown – if not worse – is the most important question for the whole world.

The just-published World Economic Outlook of the International Monetary Fund says this about the U.S. economy: "With incoming data generally robust and business and consumer confidence strong, the outlook for 2005 is encouraging. GDP growth is projected to average 3.6%, somewhat higher than expected… with a moderation in private-consumption growth reflecting the gradual withdrawal of fiscal and monetary stimulus… offset by continued strength in investment. The risks to the forecast appear broadly balanced, with upside risks from the strength of corporate balance sheets, as well as rising housing and equity prices by the possibility of a more pronounced rebound in household savings."

We have quoted this passage for two reasons: first, because the World Economic Outlook is a world authority in economics; and second, because its arguments are typical of the general complacency with which the U.S. economy’s growth performance has been and continues to be judged in the face of unprecedented structural dislocations.

For the "soft-patch" crowd, some recent spots of weakness in the U.S. economy have their main culprit in the jump in energy prices and its temporary impact on inflation rates. Other optimistic arguments are contained inflation expectations and still-considerable slack in the product and labor markets. Last but not least, Fed officials stress the fact that monetary policy is still "accommodative" and, therefore, supportive to economic growth.

Energy and the Housing Bubble: Far Bigger Problems Than High Oil Prices

We must admit to finding the singular focus on higher energy prices as the troublemaker in the U.S. economy more than simplistic. In our view, the world economy – and also the U.S. economy – is struggling with a lot of far bigger problems than higher oil prices. Besides, while these may have overshot, they could still stay high, and even rise further. They might even fall if the world economy, or large parts of it, turns significantly weaker.

We see the economic and financial development through a very different lens, and judging from the behavior of the financial markets, we have the impression that we are by no means alone in assuming more permanent and pronounced economic softness in the United States.

The recovery of the stock markets has stopped dead in its tracks. In June last year, the Dow closed the month at 10,300. Lately, it is hovering around 10,100. Investors of recent months are sitting on losses. Even more conspicuous for sudden changes of market sentiment about the U.S. economy’s outlook seems to be the pronounced decline of the yield on the 10-year Treasury note over the last few months, from 4.6% toward 4%, and that in defiance of rising inflation rates and a trebling of the federal funds rate, from 1% to 3%.

While the U.S. economy has clearly slowed, the more relevant questions are, of course, the severity and duration of this slowdown. In the last letter, we described in some detail how the sudden stock market crash and the collapse of business fixed investment in 2000 took everybody, including the Federal Reserve, completely by surprise.

It goes without saying that it was not just by accident that we recalled this episode. We had our reason. At the time, the sky over the U.S. economy seemed cloudless. The stock market soared to new highs until March, and then, all of a sudden, the economy and the stock market slumped.

Energy and the Housing Bubble: Disagreeing with Greenspan’s Complacency

In hindsight, Federal Reserve Chairman Alan Greenspan and his consorts take pride in having managed the U.S. economy’s mildest recession in the whole postwar period with their prompt policy responses, even though the stock market collapsed.

For sure, this was another incident that immensely enhanced Mr. Greenspan’s reputation as the world’s greatest central banker. Two years ago, he summed up the Fed view about this policy by declaring, "Our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful." (See his Jan. 3, 2003, speech "Risk and Uncertainty in Monetary Policy," delivered to the annual meeting of the American Economic Association in San Diego.)

We have never agreed with this complacent assessment. What remains manifestly missing in this scenario is the V-shaped recovery that has been typical of all postwar recoveries but that has grossly failed to materialize this time. The final judgment has to weigh the earlier gains from the milder recession against the comparative later losses in the growth of GDP, employment and income from the unusually weak recovery over the three years since 2001. For sure, the latter losses vastly outweigh the earlier, minor gains.

However, that is only one reason why we have always regarded the story of the "mildest recession" as a great delusion. But this raises a second crucial question: Why has the unusually aggressive combination of monetary and fiscal policy so lamentably failed to generate a recovery of the vigor that had been standard in postwar periods?

Our short answer: The Greenspan Fed deliberately pursued a policy to instantly replace the bursting equity bubble with another, even greater, housing bubble. By rapidly slashing interest rates to rock-bottom levels, it succeeded in generating the housing bubble and also in provoking the consumer to sustain and accelerate his borrowing-and-spending binge, now against the soaring collateral of rising house prices.

Energy and the Housing Bubble: Weak Recovery

The consensus sees a tremendous success. In reality, it was by far the U.S. economy’s weakest recovery in the whole postwar period, with grossly lacking employment and income growth. That is a decisive failure. Moreover, at the same time, the aggressive policies and the resulting unbalanced recovery vastly aggravated the existing imbalances in the economy.

Recessions are intrinsically the phase in the business cycle in which businesses and consumers exert restraint by unwinding some of the borrowing-and-spending excesses of the prior boom. In the United States, the exact opposite happened this time.

While businesses restrained their spending and hiring, private households and the government stepped up their borrowing and spending. Economic growth recovered, but it should not be overlooked that this "success" had its flip side in an unprecedented escalation of economic and financial imbalances.

In 2000, national savings – the compound savings of the government, businesses and private households – amounted to $817.6 billion, or 8.3% of GDP. The profligate policies of the following years slashed them to $212.7 billion, or 1.8% of GDP, by 2004. The U.S. current account deficit in 2000 came to $413.4 billion and in 2004, to $665.9 billion. In 2000, the federal government ran a surplus of $295.9 billion. In 2004, it had a deficit of $362.6 billion. In 2000, private household debt equaled 97% of disposable income; in 2004, this ratio was up to 120%.

Could it be that these imbalances are damaging to economic growth and general prosperity? You bet they are. The greatest and most obvious damage derives from the escalating trade deficit in the U.S. manufacturing sector. The U.S. economy is being virtually deindustrialized. The sector has lost 3 million jobs since 2000 and keeps losing them month after month.

Yet American policymakers and most economists do not appear to be worrying about any damages to the economy. From their public talk, we must presume a complete lack of grasp. Recently, a Fed governor spoke of the minimal savings rate as a sign of optimism. The soaring trade deficit, on the other hand, is generally put into a positive light with the argument that the flood of imports of both foreign capital and foreign goods reflects America’s dynamism.

The truth, rather, is that at 15% (measured as a share of GDP), U.S. import penetration of goods and services is unusually low in comparison to other major industrialized countries. For instance, it is 33% for Germany and 28% for the United Kingdom. In reality, what America grossly lacks compared to other major industrialized countries is competitive export capacity, and this, for sure, is primarily a problem of underinvestment in manufacturing.


Kurt Richebächer
for The Daily Reckoning

July 07, 2005

Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

The citizens of London had quite the rude awakening this morning, to say the very least.

Between 8:30 and 9:30 this morning, explosions went off in three London subway stations, and one went off on a double-decker bus. Timed with the kickoff of the G-8 summit in Scotland, and yesterday’s announcement that London was awarded the 2012 summer Olympics, this is adding up to what Tony Blair called a series of terrorist attacks. As of late afternoon in London, there have been 33 people confirmed dead from the subway blast and an undetermined number of people have been injured from both the subway and the bus incidents.

This hit especially close to home for your editor, as we have friends and colleagues in London. Luckily, we are all safe and accounted for, but that doesn’t mean that we aren’t shaken up. The U.K. Daily Reckoning’s managing editor, Adrian Ash, sends us this note:

"Yeah, we’re all fine. But the tannoy says we have to stay inside the building. Don’t breathe too deep, eh?

"No buses in Zone 1, no Tube, and all mainline stations evacuated. Phone lines intermittent. Word is, the mobile phone network’s just been shut down by the authorities.

"Six explosions in total. Parliament meeting to discuss…what exactly? Initial news from London Underground and the police said the four Tube blasts caused by a power surge. Then news came in of a bus being ripped in two. At least one dead at Russell Square.

"Did anyone walk away from this?

"FTSE down 1.8% on news, gilts up strongly, London Clearing House evacuated, so too a quarter-mile zone around Liverpool Street station. Guess we’re all walking home tonight. Quickly."

More news, from our team at The Rude Awakening…


Chris Mayer, reporting from Gaithersburg, Maryland

"The average American consumer may be cash-poor, but the average American corporation is not. A few of these cash-rich corporations are spending their money very wisely…by investing in their own shares."


Bill Bonner, with more opinions…

*** The price of oil rose through the $60 barrier yesterday. The world is using so much of the stuff, supplies can’t keep up.

"Saudis warn on shortfall in oil output," says a page-one headline in today’s Financial Times: "The Organization of the Petroleum Exporting Countries will be unable to meet projected western demand in 10 to 13 years Saudi officials have warned."

Meanwhile, from the Lone Star State, via the Guardian newspaper, oil analyst Matt Simmons says oil "will hit $100 by winter."

"We could be at $100 by this winter. We have the biggest risk we have ever had of demand exceeding supply. We are now just about to face up to the biggest crisis we have ever had," he said.

Simmons intends to publish a hard-hitting book this week in which he argues that Saudi Arabia, the world’s largest producer, is running out of oil. The chase for oil, he maintains, could lead to war.

Who knows? The Economist Intelligence Unit takes a different view, predicting that oil prices will peak by the end of this year, and decline by 10 percent in 2006. We have no way of knowing who is right. But we have opinions.

*** The Chinese are using more and more oil. But they’re using it in an economy that is based partly on fantasy – producing things for Americans, who don’t have the money to pay for them. It is just a matter of time (we will keep saying this until the time actually arrives…or we go to our graves…whichever comes first) until Americans stop buying. No people can run up debts forever – even people who have the world’s reserve currency. Americans’ debt binge is collateralized by rising property prices. Someday, that must end too. When it does, demand for Chinese-made goods will fall, and so will China’s consumption of oil.

But the fall in U.S. consumption will have other consequences. In the Anglo-Saxon world’s high debt culture, a credit contraction – or a cut back in consumer spending – should be devastating. Too many people owe too much money. When they can’t pay, the whole system is threatened by collapse. This is, of course, the last thing the dissemblers at the Federal Reserve, Congress or the Bush administration want. Former Fed governor Ben Bernanke announced that would take extreme measures to prevent it – "we have a technology," said he, "called a printing press." You can imagine the howl that will come up from lumpenhomeowners when they begin losing their houses. And you can imagine how eager public officials will be to repeat the miracles of the past – the LTCM rescue operation…the post-’87 crash recovery…the turnaround of the 2001 recession. Each one was dealt with in the same way – with more cash and credit!

From every angle we look at it, we see the same picture – the picture we have been watching since the tech crash of 1999-2002. The U.S. economy continues to sink into a long malaise – a soft, slow slump, a la Japan. Our major corporations slip and slide. Wages go nowhere. Growth figures are positive, but they are phony; they record the rate at which Americans ruin themselves with excess consumption, not the rate at which the economy grows stronger and richer.

"There’s good growth and bad growth," writes Stephen Roach. "The former is well supported by internal income generation and saving. The latter is driven by asset bubbles and debt. The United States, in my opinion, has been on a bad-growth binge for nearly a decade, but especially over the past five years. In a US-centric global economy, that means the rest of the world has also become overly dependent on bad growth as the sustenance of a false prosperity."

Eventually, but not necessarily soon, this picture will give way to another one – when desperate officials destroy the imperial currency in order to try to save homeland consumer spending. That is when oil, copper – and especially gold – really begin to fly. Ultimately, the supply of dollars is unlimited. The world’s supply of oil, on the other hand, grows smaller every day.

*** We found in one paper that George W. Bush "admitted" that human activity affected the world’s climate. How could he know? As a theoretical, marginal matter everything affects earth’s climate. Every single blade of grass…every single baby’s burp…and every single light bulb…has its effect. The earth is a big place, with nearly an infinite number and variety of climatic influences. Even climatologists cannot figure out how all of it works itself out. Elaborate computer models produce conflicting, and often suspiciously self-serving, results. If I turn off a light bulb will it have a good effect or a bad one? For whom? Global warming may be a nuisance for the Sahara…but perhaps it is an advantage to Siberia. What will happen…when…how…at what net cost? Scientists guess at the answers, but no one really knows. Posing the question to George W. Bush is a little like asking a truck driver about the mysteries of transubstantiation; you’re not likely to get a helpful answer, just one you can make fun