Hayek, the Fed and the Double Dip

To even the most casual observer of the stock market and economy over the past 3 years, the failure of the Keynesian “print-and-spend” approach to curing a business cycle downturn has become glaringly evident.

Regardless, most people will continue to believe in it, of course, but a few are groping for a better explanation of how we got into our current rut, and why we’re having so much trouble getting out of it.

Today we offer an explanation put forth more than 70 years ago by F.A. Hayek, because for the most part, his basic insights hold up as well in today’s market as they did following the Great Crash. Building on the monetary theory of Ludwig von Mises, Hayek would later receive the Nobel Prize. Reason enough, we think, to look for guidance in one of his perhaps forgotten tomes like “Prices and Production,” which Hayek wrote in the depression year of 1931.

Attempts to cope with the Great Depression caused Hayek’s contemporaries to ask: Doesn’t the existence of unused resources in the economy justify the expansion of the money supply? To which Hayek responded “no”, explaining that all monetary expansion distorts the structure of production. Similarly, today, Hayek’s response explains why Fed easing and seemingly strong consumer spending hasn’t gotten us out of the slump.

F A Hayek: The True Savings Preference of Customers

Far from being the answer to our problems, Hayek argued: “[I]t should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect; a relative increase of the demand for consumers’ goods could only make matters worse.” The reason, in brief, is that the structure of production – that is, the economy’s particular use of capital goods – must be adapted to the true savings preferences of consumers, as opposed to the distorted consumption and investment decisions prompted by monetary expansion. In other words, notwithstanding the sage advice of Dallas Fed President Robert McTeer, our economy would not be better off if every American rushed out to buy an SUV.

For those who consider Hayek’s stance too dogmatic, it is interesting to note that he actually acknowledged the theoretical possibility of a beneficial monetary expansion that favored producers (as opposed to consumers), if it occurred at the beginning of a downturn. But the emphasis is on “theoretical”, for such an expansion would have to be so carefully regulated and then withdrawn that Hayek admitted, “Frankly, I do not see how the banks can ever be in a position to keep credit within these limits.” He concluded by arguing against “the well-meaning but dangerous proposals to fight depression by ‘a little inflation.'” Sound familiar? Furthermore, while Mr. Greenspan tells us that nothing could have been done during the boom to prevent the bust, and now all he can do is address its after-effects, Hayek held the exact opposite view: “[W]e arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come.”

Yet, not all the blame for post-boom economic distress should be put on the regulators of the monetary system. Capitol Hill deserves its proper share of blame as well. “[C]ertain kinds of State action,” Hayek said at the end of his book, “by causing a shift in demand from producers’ goods to consumers’ goods, may cause…prolonged stagnation. This may be true of increased public expenditure in general or of particular forms of taxation or particular forms of public expenditure.”

F A Hayek: “Stimulus”

So where does all this leave us? In short, with many investments that still need to be liquidated before a healthy and sustainable expansion can begin. Such a process is difficult in the best of times, and unfortunately war and vastly expanded government spending will only divert resources away from economically productive uses, no matter how much “stimulus” it appears to bring.

The symptoms of the continuing post-bubble adjustment are all around us. There is weakness in retail sales, consumer confidence, business investment and employment, to name but a few areas of malaise. The eternal optimists among us are quick to blame “temporary” factors like oil prices, “geopolitics” and cold weather as the culprits. We would point out, however, that this is merely what happens when growth is weak and the economy is vulnerable to an external shock. It hardly matters which particular event triggers another downturn.

The good news so far is that oil prices have not spiked further – a sustained increase would certainly send us back into recession. But a tour of recent economic indicators makes it clear that we have indeed hit another “soft patch” (to use the soothing words favored by the Fed chairman). First, let’s consider the labor market. As everyone has heard repeatedly, the employment situation is a lagging indicator. But what was a convenient excuse at the beginning of the recession has now become evidence that the recovery never quite got on track after all.

As the Fed’s Beige Book for the first few months of the year puts it: “Business spending remained very soft as geopolitical concerns and uncertainty over the strength of demand continued to constrain spending and hiring plans.”

Stephen Roach, crack Morgan Stanley economist, goes straight for the jugular when he blames the deterioration in the labor market for the “high and rising” odds of recession. Other indicators also bring into sharp relief the recent setback in the economy. For instance, although industrial production growth has rebounded from negative territory, it hardly compares to previous recovery periods, and already appears to be leveling off.

The manufacturing industry will certainly not find it any more comforting to hear that GDP growth is still positive. The Institute for Supply Management’s index tumbled to 46.2 in March, below the expansion level, and down from 50.5 in February and 53.9 in January – now the lowest since right after September 11. ISM survey chairman Norbert Ore was correct last month when he observed that the drop seemed to be more than a temporary blip.

F A Hayek: Jobless Claims Head Higher

The ISM survey also showed that jobs in the manufacturing sector continue to disappear. And after it looked like they might finally be moving in the right direction, jobless claims are heading higher once again.

Indicative of the investment overhang, non-residential private construction remains very weak, down 15% from a year ago, and 30% from its peak in 2000. How long will low interest rates continue to boost the residential market? Not forever is our unhelpful guess. Housing starts are already declining, and the inventory of unsold homes has risen sharply since the beginning of the year.

Of course, all this could change if the removal of Saddam Hussein really is the answer to all of our economic problems. We’re just not betting on it. If there is one benefit to all the troubles we find ourselves in, perhaps it is the learning of some very old lessons.

War is never good for the economy, and when it comes to monetary policy, there still ain’t no free lunch.


Andrew Kashdan
for The Daily Reckoning
April 16, 2003


No clear trend has emerged – neither in the stock market, nor in the economy – since the war ended.

Yesterday, stocks rose slightly…gold rose slightly…bonds rose slightly…and the dollar fell slightly.

We cannot predict the future and cannot say what trend will emerge. But we have no reason to think that stocks will be more expensive tomorrow than they are today. Typically, the third of the year ending in April is the best for stocks. That may or may not be the case this year…stocks may go up, but with a dividend yield of less than 2%, we can’t think of any reason to own them.

Nor do we have any reason to want to own the dollar – or dollar-based investments. U.S. bonds yield less than euro bonds…and may be undermined by a falling dollar. Bonds might rise, of course, as the Fed cuts rates again. As Eric explains, below, the only thing that would bring lower rates…another round of refinancings…and higher bond prices…is a slumping economy, which is not exactly good news for the dollar.

And sooner or later, paper money always declines against gold. We don’t know if this is sooner or if it is later…but sooner or later it is bound to be.

With nothing further to say about it, we turn to Eric Fry for the latest news:


Eric Fry in New York City…

– Lately, Abby Joseph Cohen has been as difficult to track down as Saddam Hussein. But the Goldman strategist finally emerged from her bunker yesterday to reiterate her bullish prognostications. The economy will improve, she predicts, and share prices will move higher. For one day, at least, she was correct. The Dow gained 51 points to 8,402 and the Nasdaq added half a percent to 1,391.

– But even congenitally bullish folks like Cohen would admit that the economy isn’t looking shipshape. Not to worry, however; conditions will improve later this year, they promise. According to Cohen’s prophetic vision, the economy will recover, consumers will begin to “dissave”, coporations will begin to “dislose” money and the stock market will begin to “disfall”.

– Cohen’s optimism may well prove to be correct. But in the here and now, economic conditions leave much to be desired. Industrial production fell 0.5% in March and manufacturing output declined 0.2%. Even more troubling, capacity utilization tumbled 0.5 percentage points to 74.8% – a whopping 6.5 percentage points below its 1972-2002 average.

– Corporations are responding to the sluggish conditions by conserving their cash and shoring up their balance sheets. Poor Richard would be pleased. But the very same thrift, which seems prudent at the individual level, is very unhelpful for the economy as a whole. When everyone saves money at the same time, no one is left to consume and invest.

– “Growth in overall debt owed by nonfinancial corporations in the last two quarters of 2002 slowed to just 0.7% annualized,” observes Morgan Stanley’s Richard Berner, “the slowest pace in a decade.”

– “A trip to the Betty Ford Center for Balance Sheet Repair can make sense from a bottom-up perspective,” says Paul McCulley of the PIMCO funds. “But it’s just not good if you have the entirety of corporate America at the Betty Ford Center for Balance Sheet Repair. And that’s what we have in the economy right now…Everyone wonders why businesses are not investing. Well, for God’s sake, they had a bubble in investment and financed it with a bubble in debt – and they blew up. You’ve got capacity utilization way down here because there is excess capacity out the wazoo…Why would any logical person in this environment go into the boss and say, ‘Let’s ramp up the capital budget?'”

– Consumers are becoming equally thrifty. “Consumers are already feeling the pressure of a low savings rate and record debt,” says Comstock Partners, “and are no longer spending freely without steep discounts and financial incentives that are squeezing corporate profit margins and causing them to cut employment and delay capital spending. This, in turn, leads to further decreases in employment and, therefore, lower growth in personal income. The benefits of continuous mortgage refinancing depend on even lower mortgage rates, and that can happen only if the economy continues to weaken. Since it is this negative feedback loop rather than the war that is causing the economic malaise, the end of the war will not automatically lead to an economic revival.”

– But let’s assume that the perma-bears at Comstock Partners are out to lunch and that the perma-bulls like Cohen are on target. Let’s assume that the economy recovers smartly, thereby boosting corporate profits. Even so, the stock market still ain’t cheap.

– “The continuing bubble is evident in the stubbornly high valuations still being accorded the technology stocks,” says Comstock. “We examined the 16 technology stocks that are part of the top 50 capitalizations in Nasdaq, and found that they are selling at an average of 41 times estimated fiscal 2003 earnings. Nine of those stocks were in existence and had positive earnings in 1991. During that year their average P/E ratio was only 19, compared to 35 today when their prospects for rapid growth are much less than they were at that time. In our view the bear market is far from over.”


William Bonner, back in Rome…

*** “It’s just a rumble in the jungle,” for now, says our South African correspondent, Evan Pickworth, but from Nigeria comes news that Muslims are urging one another to dump the dollar in favor of the euro.

“European countries,” preached Sheik Ibrahim Umar Kabo, the head of Nigeria’s Council of Muslim Scholars, “have refused to be fooled by America…we should therefore encourage transactions with the euro and stop patronizing the American dollar.” “It would be a great mistake not to treat the threat seriously,” said Nobel prizing-winning economist Robert Mundell.

Iraq began selling its oil in euros about 4 years ago. We haven’t heard the latest news, but it seems likely that the entire economy will become the first country to be dollarized at the point of a gun. Too bad the dollar’s value can’t be guaranteed by Abrams tanks too.

*** “After a year of scandal and fraud allegations at Merrill Lynch & Co., not to mention a battered stock, investors might reasonably have expected the Wall Street giant’s top brass to feel some pain in their paychecks,” begins an article in the Boston Globe. “Instead, the chairman and chief executive of the nation’s largest brokerage each took home a $7 million cash bonus – seven times the sum each had received in the prior year. At EMC Corp., the state’s largest technology company, chief executive Joseph Tucci failed to meet the profit goals his board of directors had set for him. But that didn’t stop the board from awarding him $7.1 million last year, even as shareholders saw the stock price plunge 76 percent. Tucci’s cash bonus suffered a mere scratch, falling $25,000, to $675,000. In January, he received 75,000 options to buy shares at just a penny each.”

We keep noticing…and now we remember why…that American capitalism no longer rewards capitalists. Instead, they wait at the end of a long line – behind tort lawyers, tax collectors, and employees, both current and retired. But in the ’80s and ’90s while this was happening – that is to say, while more and more hands were slipping into the corporate till – the prices capitalists were willing to pay for corporate earnings rose. It made no sense. The golden age of capitalism had not arrived, as they thought; it had departed.

And even today, three years after the bear market in stocks began, stocks are still valued as if a dollar’s worth of corporate earnings in 2003 were worth as much as 5 times more than it was worth in 20 years before.

*** Yesterday, your editor and his entourage journeyed to the city of the dead – the necropole deep beneath the Vatican. The visits are by appointment only and carefully guided. No English guide was available, so we joined a small group of French people, led by a nun with calluses on her hands from years of smacking children with a ruler.

We descended a narrow stairway and passed through the main brick wall, about 6-ft. thick, built perhaps in Nero’s reign. There, we halted and received the first part of our lecture. We were in a graveyard of sorts…where people built their own family mausoleums. The whole place had been out in the open….but was filled with dirt in about 320 A.D. in order to build St. Peter’s basilica on top.

We could read the inscriptions above the doors, explaining a little about the family and the gods it worshipped. There were elaborately carved sarcophagi for the bodies…and urns for ashes. Some of the burial houses had more than one floor…with stone staircases leading to the second level. Among the cult of the Etruscans, the nun explained, it was customary for the family to visit the mausoleum often and to eat meals there…while paying homage to the dead.

We recalled why we like the French. The Sister of Everlasting Severity reminded us of the qualities we like so much – excess rationalism, authoritarianism and a pathological inability to follow the rules. Hardly had she begun her discourse then she turned it into a dialectical exercise.

“Look now, then I will give you the synthesis and a conclusion,” she ordered.

Later, after peeking at the tomb of St. Peter, the small group followed her down a further narrow defile…

“We’re not supposed to come in here…it’s off limits to the public…but I like to see it myself…

We thought we might be sneaking a look at some Vatican secret…its hoard of gold…the arc of the covenant…or the holy grail… But there before us was the marble sarcophagus of Pope Pius 12th…with his image carved on the top. Why it was out-of- bounds we never found out.

At the end of our tour, we stopped again near where we began. The nun led us in the Lord’s Prayer…and ended with a final plea to St. Peter himself…