Homeage to Jacques Rueff

In a free market, wages eventually ease their way down to levels that allow capitalists to exploit workers again. Always have. But for some reason, in Britain in the 1920s, this didn’t happen. Bill Bonner explains…

Our dollar-based financial system is like a loaded pistol…

Today, we take a summer rest and let a dead man do the talking. Jacques Rueff died 30 years ago. But in a couple of articles written for Le Monde in February 1976, this economic advisor to Charles de Gaulle, explained today’s monetary system and what was likely to become of it. His articles were unusual, in several respects. It is rare for an economist to have any idea what is going on – especially a French one. And on the subject of economics, Le Monde has things worth reading about as often as Leap Years.

To fully appreciate Rueff’s insight – and how it applies to the macro-economic circus circa 2008 – you have to begin by understanding the problem of unemployment. In the world of the ’30s, the triumph of capitalism was no sure thing. Communism, for all its faults, at least put people to work. Capitalism often left them ‘sittin’ on the dock of the bay.’ And here we have our first measure of how far we have come since the ’70s; the average post-Mitterand Frenchman now believes that there are worse things than not working. Such as working, for example. Today, he is eager to pass laws to prevent it.

The real cause of joblessness is obvious, even to an economist. People don’t have jobs when it costs more to employ them than employers can get out of them. And in an economic downturn, the unemployment rate goes up. Because, in a slump, prices for ‘things’ fall quickly. But labor rates tend to be sticky. Workers have contracts. And rights! Employers’ profit margins are soon squeezed between slippery revenue…and stubborn costs for labor. Result: output falls and fewer workers can earn their keep.

In a free market, wages eventually ease their way down to levels that allow capitalists to exploit workers again. Always have. But for some reason, in Britain in the 1920s, this didn’t happen. Rueff identified the culprit even before Milton Friedman did:

"Since 1911, there existed in England a system of unemployment insurance that gave an indemnity to jobless workers, known as the "dole." The consequence of this regime was to establish a minimum salary level, at which workers would prefer to ask for the dole rather than work for less. It appears that in the beginning of 1923 salaries, which had been declining with other prices in England, suddenly hit this new minimum. There, they stopped falling, and since then, they practically ceased to move."

That’s why France runs such high unemployment rates today; its dole is bountiful. When you add up the costs of "charges sociales," paperwork, and the minimum wage, more than one in ten potential workers is not worth the money. But no right thinking politician is about to suggest the obvious solution: get rid of the dole. So, Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for ‘things’ meant that salaries – in real terms – would go down. That was the greasy scam behind Keynes’ General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them.

"Full employment" was soon no longer a wish, but an obligation.

In France, the Constitution of 1946 obliged the government to present year an annual economic plan that achieves the goal of full employment. In the same year, Harry Truman pushed an Employment Act through the US Congress. And today the central bank of the USA has a "dual mission" – to preserve the value of the dollar while assuring full employment.

"No religion spread as fast as the belief in full employment," wrote Rueff. "…and in this roundabout way, allowed governments that had exhausted their tax and borrowing resources to ressort to the phony delights of monetary inflation. >>

This is where the post-’71, dollar-based monetary system comes in. It allowed the US to issue dollars – and never have to redeem them in gold. At first, the inflation caused by the build up of dollars was moderate and agreeable, said Rueff. It reduced the cost of labor. Then, when the tether with gold was hacked off in the early ’70s, inflation began "galloping away." Readers may remember that inflation got the bit between its teeth in the ’70s, racing along at a record speed of 14.8% in the US in March, 1980, and even faster in Britain. The US government was forced to borrow at 15% yields. Britain could barely borrow at all.

Rueff died in 1978. Had he lived, he probably would have been as surprised as we have been by the stamina of the monetary horses. Except for a brief rest while Paul Volcker was managing the stables, they have run from bubble to bubble…delivering more liquidity wherever it would do the most damage. All the while, inflation continued to cut the price of labor. Between ’74 and ’84, real wages fell as much as 30%. Then, more moderate levels of inflation held them down for the next 24 years.

But Rueff’s insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the US to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this "exorbitant privilege" will be "suicidal" for the western economies, he predicted.

Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques .Rueff must look on in amusement to see what happens next.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning

August 08, 2008 — London, England

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.

What surprises us about this market is that anyone finds it surprising.

Lenders lent to people who couldn’t pay the money back. Naturally, the loans went bad; what’s surprising about that?

Consumers spent more than they could afford. Naturally, they ran out of money and have to cut back. Do you see anything unusual about that?

Wall Street partied for years on cheap credit. Now, credit is becoming harder to come by. Is it any wonder that they’ve had to turn off the music and close down the bar?

Yesterday, the Dow slipped 224 points, after the giant insurance company, AIG, announced a bigger-than-expected loss. AIG got taken down more than at any time since the company went public in 1969.

Oil went up yesterday – $1.32. But gold lost another $5…to $877.

And the 10-year T-note rose to yield 3.93%.

And now we read in the paper that Freddie Mac has posted a big loss. What a shocker! Gosh, we thought financing houses at 100% to poor credit risks, who lied on their mortgage applications, was a good business. And it was a great business, until housing prices went down. But, who could have seen that coming?


Prices go up. Then, they go down. That’s the way it’s been going for a long time. Housing prices are "mean reverting," as economists say. In fact, as we pointed out here, they’re about the meanest reverters in the whole financial world. Houses, unlike dotcom stocks or paintings by Lucien Freud, are useful. They’re bought by wage-earners to live in. So, they have to be priced at levels that the buyers can afford them. In fact, the average house-price has to be within the housing budget of the average house buyer; that’s all there is to it.

So don’t bother telling us that the housing decline came as a surprise; we’ve been predicting it ever since it began. (Of course…we’ve predicted many other things that haven’t happened yet…but that’s a different story.)

But here comes the article from Reuters: "Freddie Mac’s negative net worth raises questions." Well…yes. The first question is how a company with a quasi monopoly granted by the U.S. government could make such a mess of its business. And so fast! Hardly 12 months after the biggest bubble in property in the history of the world and it’s already $5.6 billion underwater.

A rumor making its way around Wall Street – started by us – is that Freddie is secretly being run by Robert Mugabe. Of course, a string of bad luck can ruin any business. But Freddie Mac couldn’t be explained by bad luck alone; it took an act of Congress! Or maybe a couple of acts of Congress. The one that created the Federal Reserve System, for example.

But let’s leave that subject for another day. We opined yesterday, that the financial industry has had its season in the sun; it won’t recover its youthful vigor in our lifetimes. Which brings us to the second question: why would investors buy the shares? Freddie is clearly insolvent.

But most investors don’t believe it. Freddie may have a net worth of negative $5.6 billion, but investors buy the stock anyway. These summer forecasters expect the clouds to pass and the sun to come back any day. Ain’t gonna happen is our guess.

The number of unsold houses is at its highest in 26 years. Half of them have to be sold before sellers have any pricing power. That will take a long time. Then too, our bet is that the inventory is understated. We know at least a couple people who have taken houses off the market. Not because they want to own them, but simply because they don’t think they can sell them. When the inventory gets worked off, these houses will be put up for sale again – holding prices down even longer.

But the big change in the economy is not in the housing market itself, but in the change of opinion that it causes. Markets make opinions, say the old-timers. And a drop in housing is about to cause an epochal shift away from debt and towards savings. We report it here, even though it hasn’t happened yet. As we explained yesterday, baby boomers now look to retirement as a condemned man looks to the scaffold. They know they shouldn’t have done what they did…and should’ve done what they didn’t. They regret not saving money – deeply. And now, the poor baby boomer has only one chance for redemption…trying to make up for the last 15 years by saving as if the rest of his life depended on it.

In fact, it does.

*** You may be wondering what is happening in Europe…

Here in England, it has been raining for the last week. "What happened to summer?" we wanted to know.

"Oh…it was over in May," came the reply.

The summer season seems to have left Britain’s economy too. A report in the newspaper tells us that food prices are rising at almost 10% per year. Meanwhile, housing prices are falling – at the fastest pace in 24 years.

So you see, the typical Brit, like the typical American, is caught in no-man’s-land…with inflation destroying his purchasing power on the one hand, and deflation undermining his assets on the other. At the end of the day, he has less money…and it goes less far.

Here’s the latest from our colleagues at MoneyMorning, here in London:

"There seems to have been more or less a straight fight between the States and us as to who actually plunges into a recession first. [But] within the last few weeks another strong contender for this dubious prize has emerged. The eurozone now looks like it could get a dose of recession before either the US or the UK.

"Anyone who has been keeping an eye on Spain’s troubled economy won’t be too surprised to see that the eurozone is really struggling. The Hispanic housing market is collapsing – sales are down 34% from the peak, say the latest official figures – and the banking system is on the brink, according to Morgan Stanley.

"A momentous economic slowdown in Spain is now under way… though just in the beginning stages, with the bulk of the pain to be suffered in 2009", says the investment bank, going on to warn that "the probability of a crisis scenario similar to the early 1990s is increasing".

Meanwhile unemployment has already reached 10.4% and the country’s finance minister recently admitted that: "the economic situation is worse than we all predicted…we thought it would happen slowly but it has hit fast".

It’s not just Spain. In Ireland too, house prices are tumbling, with Dublin seeing double-digit falls. New housebuilding has hit a five-year low. And over in Italy, things aren’t so hot on the economic front either. Last weekend Prime Minister Berlusconi said he would now be slashing government spending as tax revenues have slumped.

But let’s be fair here. Trouble in these countries isn’t exactly a surprise – Ireland was heading for trouble from the moment it joined the eurozone, as low interest rates poured petrol on an already blazing economy. Spain was the same. And as for Italy, it’s rarely far from economic strife.

Surely the countries at the real core of the eurozone – France and Germany, in other words – are looking a bit more stable? Well, it seems not. After holding out pretty well during the first half, by mid-July, business confidence was declining abruptly, as the German ZEW economic sentiment indicator suddenly plunged, unexpectedly, to a record low. French business confidence has also dropped away.

Then last week, the overall eurozone activity survey plummeted much more sharply than the ‘experts’ had expected, to its lowest point since March 2003.

What’s more, European companies are starting to default on their debts, says Dresdner Kleinwort, which believes that as many as 6-7% of corporate borrowers may fail to pay their debts on time within the next year. That’s a tenfold increase in the estimate since June and, says Moody’s Investors Service, the highest default rate since July 2003. Add in Tuesday’s 0.6% drop in retail sales for the region, and the picture we’re seeing emerge isn’t at all pretty. Because things have got worse so fast that the eurozone now looks like a racing certainty to beat us Brits into recession.

It all points to a sell-off in the euro. Sure, the alternatives may not be great, with both the US and the UK apparently competing to see which can prove the bigger basket case, but to quote one of the oldest market truisms around, currencies are a ‘zero sum’ game.

If one falls, another has to rise. And while it’s very hard to make a convincing case for the dollar, or indeed the pound, all the signs from the continent are that the euro faces even more problems.

Pimco bond fund manager Bill Gross recently said he sees no reason for "the euro’s 25% to 30% overvaluation against the US dollar", while BNP Paribas also declared: "we’re turning incredibly bearish on the euro." It’s starting to feel like the dollar, currently trading at around $1.55 to the euro, might just be bottoming out against its continental European cousin. And maybe sterling, which over the last five years has tended to move more or less in line with the buck, could get a ride on its coat tails.

*** And don’t bother to cry for Argentina. Of course, the country is a mess. But that’s the way the Argentines like it. But that story will have to wait until Monday.

More below…