Ominous Parallels

To lead a recovery of the economy, US consumer spending has to rise by 3-4%. But in reality, during the second quarter consumer spending fell to an annual rate of 1.9%. Today the inimitable Dr. Richebacher asks: Will it be long before Johnnie Q. in his minivan capitulates altogether?

For the first time in the more than 50 years since World War II, the world is in the grips of a synchronized global economic downturn. This has but one precedent in history: the Great Depression of the 1930s. The most striking common feature of both periods is the dominant role of the U.S. economy in the prior boom as well as in the following downturn.

Yet there exists a conspicuous difference between the two cases of American global economic predominance. During the 1920s, America flooded the world with credit, acting as the world’s lender of last resort, while in the 1990s it became the world’s consumer of last resort, flooding the world with unprecedented excesses in consumer spending.

Remarkably, the two U.S. boom episodes were alike in their heavy disposition towards consumer spending. However, the borrowing and spending excesses of the 1990s vastly exceeded those of the 1920s. Another difference of crucial importance is in the state of the balance of payments. During the 1920s, America was the world’s leading creditor country, running a chronic current surplus. Today, it’s the world’s greatest debtor, running a monstrous deficit in current account and piling up trillions of foreign debts.

An old bone of contention between American and European economists is at what time the American Federal Reserve made its decisive policy mistakes that determined the protracted depression of the 1930s. Was it the excessive monetary looseness before the stock exchange crash? That is the opinion in Europe, strongly influenced by Austrian theory. Or was it excessive monetary tightness after the crash, during the 1930s? That is American opinion, as indoctrinated since the 1960s by Milton Friedman.

I am a great believer in the logic of Austrian theory. It says that the severity and length of depressions depends critically on the kind and the magnitude of the maladjustments and dislocations that have developed in the economy and its financial system during the preceding boom.

This seems to be exceedingly straightforward logic. Moreover, it has historical experience on its side.

Assessing the present economic situation in the United States, the key point to realize is that for years it has been exposed to the most inordinate credit excesses in history. It has been crystal-clear for a long time that it was a typical bubble economy, being defined as an economy where unusually sharp rises in asset prices fuel extraordinary borrowing and spending binges, either by businesses (Japan) or by consumers (America).

Established economic theory, by the way, has a strict measure for "excess" credit – all credit in excess of available savings from current income that is not spent for consumption. The essential economic effect of such saving is to release productive resources that a borrower may use for capital investment. Traditionally, the credit cycle has been associated with the investment cycle.

Credit expansion in the last three years in the United States has been running at an annual rate of around $2 trillion, accounting thus for about 20% of GDP. Never mind that combined personal and business savings plunged in 2001 to barely 2% of GDP. The discrepancy between the two defies the wildest imagination of a reasonable economist.

Today’s American policymakers and economists apparently find nothing wrong with this pattern. Least of all do they understand that such a runaway credit expansion could do any damage to the economy and the financial system. Doesn’t it boost economic growth and financial markets? The only serious economic damage they can think of is rising inflation rates, and their absence in the past few years testified in their view to the U.S. economy’s excellent health. Another inherent logic is that this justifies virtually unlimited credit expansion.

We subscribe to the opposite view – which may be called classical European economics – that credit creation in excess of available savings is by itself an evil. It tends to harm the economy far more than consumer-price inflation by encouraging reckless spending that essentially distorts the allocation of real resources.

Of course, the consumer-spending boom of the last few years in the United States was crucial in propelling the economy’s growth. As a share of GDP, it shot up to an average of 82.6% between 1995-2001, as against a long- term ratio of about two-thirds. But it essentially did so at the expense of saving, capital investment and the balance of payments.

As domestic demand grew persistently in excess of domestic output, the deficit in the current account ballooned from $139.8 billion in 1998 to $417.4 billion, running lately even at an annual rate of $450 billion. A large part, if not the greater part, of the rapidly swelling consumption demand was actually met by foreign producers possessing the necessary idle capacities. Since the early 1980s, the nation has moved from a net creditor position of 13% of GDP to a net debtor position of 25%. Altogether, this adds up to almost 40% of GDP.

The inevitable domestic result has been a badly split economy. The part exclusively serving the consumer and also being sheltered from foreign competition boomed with strong profit growth, while the sectors that serve capital investments and are also exposed to foreign competition have been badly withering with collapsing profits.

The most striking feature and testimony of this split in the economy is an extreme divergence in the profit performance of two sectors – manufacturing and retail trade. In 1997, manufacturing earned $195.5 billion, comparing with retail trade earnings of $63.9 billion. After five years, this relationship has been turned completely on its head. In the first quarter of 2002, manufacturing profits had slumped to $68.9 billion, while retail trade profits were up to $81.4 billion, both figures at annual rate.

It should be self-evident that this dramatic diversion in profitability between the two sectors had far- reaching implications for their investment policies. While the profitable retail trade sector has grossly overinvested in relation to sustainable consumer demand, the unprofitable manufacturing sector has just as grossly underinvested in plant and equipment. These are the kind of structural distortions that Austrian theory emphasizes as the recession-breeding consequence of major credit excesses.

Assessing the prospects of the American economy, this big split between consumer-related and investment- related activity is, certainly, of greatest relevance. Considering furthermore that it has developed over years, it cannot be discarded as cyclical. Clearly, the overall poor profit and capital spending performance is structural. And with the economy’s slowdown it has dramatically worsened.

For the same reasons, there is clearly no chance under these circumstances for business investment to lead an economic recovery. This would have to come almost single-handedly from the consumer. But for that to happen, he must do more than keep spending at a high level. To lead a recovery, consumer spending has to rise by 3-4%. But in reality, in the second quarter it was down to an annual rate of 1.9%. Before long, he will capitulate altogether.

In the end, all questions about the U.S. economy boil down to one: whether or not business investment will return with sufficient vigor. But for that to happen, it needs both a luring profit outlook and accommodating financial markets.

Neither is in sight.

Though monetary policy could hardly be looser, the financial markets are nevertheless tightening up against business financing…and consumer financing is sure to be next.


Kurt Richebacher,
for The Daily Reckoning
September 17, 2002

Editor’s note: Dr. Kurt Richebacher is the world’s foremost Austrian economist. His articles appear regularly in The Wall Street Journal, Barron’s, The Fleet Street Letter and other respected financial publications. France’s Le Figaro magazine did a feature story on him as ‘the man who predicted the Asian crisis.’

It’s the end of the world as we have known it.

We’re not joking. But we’re not complaining either. We were never fans of the Information Age, the New Economy or the bubble on Wall Street. They were all mountebanks and shysters and we’re glad to be rid of them.

But here we are almost 2 years into the 3rd millennium and it looks like there might be more to this next phase than a few dead dot.coms and a handful of business executives in prison outfits.

Bankruptcies in Hong Kong are rising. Small businesses in Russia are going belly up at an alarming rate. Just read the headlines from around the world; they are a litany of woe – slowdowns, debts, bankruptcies, and deflation…not to mention war.

The entire world economy seems to be cooling off.

Everywhere, economists are revising their targets downward. America, Europe and Japan are still growing…but barely. European GDP rose at only 1.4% annual rate in the 2nd quarter. The Japanese economy grew faster than the U.S. – but neither gave cause for celebration.

Japan is still in deflation. Wages fell 5.6% in the second quarter. In America, prices are still rising, but not by much. And prices in the business sector – according to the Bureau of Economic Analysis – are actually falling for the first time since WWII…down 0.6% in the second quarter.

"Before the end of 2003," adds the Economist, "the rich world’s three biggest economies – America’s, Japan’s and Germany’s – could all have negative inflation rates."

The Economist believes that no recession would be necessary to push down prices. All that is required is a continued economic slowdown. What counts is the ‘output gap,’ says the Economist, the difference between how fast the economy could grow and its actual rate of growth. Large unused potential has the effect of driving down prices. At such low current rates of inflation, an increase in the ‘output gap’ equal to that of the early ’90s would be enough to turn inflation rates negative.

In Japan, the banks wait to go bust. In America, it is the ordinary householders who are in trouble. But American consumers are the world’s ‘consumers of last resort.’ What happens when the consumers of last resort stop consuming?

We hold our breath and wait to find out…


Eric Fry reporting from New York City (sort of)…

– The market turned in a mixed performance yesterday; the Dow rose a bit and the Nasdaq fell a bit. The trading activity was very light due to the Jewish holidays…at least that’s what CNBC reported. I don’t have my finger on the pulse of the NYSE exactly, because I’m en route to Colorado Springs for the latest gathering of the Supper Club.

– You may have heard us mention the Supper Club on occasion. The group gets together once every three months to examine various venture capital opportunities. To be sure, venture capital is risky. But that’s part of the game. By contrast, most of the folks who bought stocks like Lucent and Tyco and Nortel and Corning and Worldcom probably had no idea how much risk they were taking on. Taking on unknown risks is the riskiest kind of venture capital.

– Yesterday, while traveling from New York to Colorado Springs, I observed what I presume to be the latest – and certainly tackiest – business travel phenomenon: using a cell phone while also using a urinal in a public restroom.

– Yes, it’s true. I observed this bizarre behavior on two separate occasions yesterday. Once in a men’s room in the Atlanta airport and then again in a men’s room at the airport in Colorado Springs.

– In Atlanta, some goofball standing in front of the urinal next to me, answered his ringing cell phone and immediately started chatting away, as if he were sitting in his office. "Bizarre," I thought to myself. "But, after all, it was an INCOMING call. So maybe that’s okay. Maybe he was expecting a call from President Bush or the Pope or Abby Joseph Cohen."

– But I scarcely had a moment to shrug off my disdain before I observed him making an OUTGOING call – all the while standing at the urinal. And just like that, he was talking away again, to a female no less! "Hi Sue. This is Jack," says the urinating cell phone user. "What’s going on? Did you get my message…"

– I couldn’t bear to hear any more. I flushed the urinal just so I didn’t have to listen to him.

– "Surely this guy is not representative of corporate America!" I thought to myself. "This must be a fluke." I was wrong. Not three hours later, at the conclusion of my flight from Atlanta to Colorado Springs, I went to the men’s room to "freshen up a bit." And once again, while I was standing at the urinal, a guy walks up to the adjacent urinal, begins his business, and then pulls out his cell phone. Immediately, he’s yacking away at some colleague on the other end. Is this efficiency or absurdity?

– Note to self: Never borrow cell phone from male acquaintance.

– A bearish disposition, like ice cream, comes in a variety of flavors. Your plain vanilla bear hates stocks, but he promises to become a rabid bull just as soon as the Dow dips below 1,000.

– Some bulls seem to dislike only tech stocks, especially semiconductor stocks like Micron. Others don’t think much about stocks at all because they’re so busy heaping scorn on the US dollar and lavishing affection on gold. (Bill and I have both met a couple guys like that). Others harbor a more flexible, matter- of-fact antipathy for stocks. Michael O’Higgins is one such bear, according to RANDALL FORSYTH of Barron’s.

– Thanks to O’Higgins’ brand of bearishness, his fund has gained 27% so far this year – at least that’s what Forsyth reports. So what sayeth Mr. O’Higgins now? He’s still bearish on stocks, while holding a candle for gold.

– "Around the world, people have gotten screwed by holding paper currencies," O’Higgins crassly observes. He sees gold as being where stocks were in 1982. "For nearly 20 years up to that point," writes Forsyth, "the Dow spent virtually all of its time between 750 and 1000, before it broke through that ceiling and never looked back. Gold, after spiking to $800 an ounce in early 1980, steadily declined, and has spent the last five years mostly between $250 and $300."

– It’s time for a reversal, says O’Higgins.


Back in Paris…home of the thinnest women in Europe…

*** Harvey Pitt told the BBC to expect more "high profile indictments" in the days ahead. What Mr. Pitt didn’t mention is that he hopes to see his own name in the paper again too.

*** Even Jack Welch is feeling the heat. The man could do no wrong in the bull market, but everything seems to go a little sour when prices head down. Now, with the SEC looking into his retirement plan, the poor man has vowed to give up his use of the corporate jets, the apartment, and other perks.

But Jack’s got no worries. Think about the poor turnips who can’t pay their mortgages. The FHA was set up by Congress to try to lure poor people into mortgage debt. Now, yesterday’s news brought word that nearly 5% of the borrowers are more than 3 months behind on their payments, twice the level of 1995. Another helpful lender, Fannie Mae, came out with new bait yesterday too…it said it would lend you 8% more than you had expected if you buy a house near public transport. Ever thoughtful, Fannie Mae must want to make it easy for you to leave town, after your house and car have been repossessed.

*** On another note, I have been living and working in France for so long now…some people actually mistake me for an expert on the subject. Thus, I’ve been asked to speak on "the trials and tribulations of home ownership in the countryside of France" at an International Living conference being held in Paris. The conference, aptly titled "Living And Working In France," will be held at a restaurant called Chez Jenny on October 18th, 2002.

If you are interested in moving to France yourself, or are simply in Paris and looking for something to do, by all means join me…

For details on the conference send an e-mail to Adrian Leeds at: Living And Working In France – e-mail