Panacea du Jour

It used to be elementary knowledge among economists that rising investment in tangible assets – factories, offices, machinery and other forms of equipment – is paramount for economic growth and general prosperity.

First, it generates demand, employment, incomes and tangible wealth while the factories and the equipment are built and produced. Once the capital goods are installed, they increase supply, employment, incomes and productivity. The key point to see is that investment is the one and only GDP component that adds both to demand and supply.

But mainstream American economic thought seems to overlook this reality. It places, first of all, an unusual emphasis on consumption as the prime mover of economic growth, and there is furthermore a general disregard of what is happening to saving and capital accumulation. Alternatively, the emphasis is on autonomous changes in productivity growth through new technologies as the root cause of economic growth and profitability.

This is a radical departure from the thinking of the old economists. Measured by the rate of productivity growth, the U.S. economy appears to be in excellent shape, definitely better than the whole rest of the world. But measured by its record-low rates of saving and capital accumulation, it is in most miserable shape. What is the right interpretation?

Tangible Assets: That Great Magic

For America’s policymakers and economists, productivity growth seems to be that great magic that solves all problems and that will sustain an economic recovery. It appears to be a widespread view that the measured stellar productivity growth is the main warrant of a mild recession and of an impending recovery.

The crucial point to see about productivity growth is that, by itself, it only means that hours worked have risen less than real GDP. But there is nil economic merit in this effect unless it is accompanied by an improvement in some other kind of the economy’s performance such as growth of output, profits or investment. In the case of the United States, in actual fact, everything else is deteriorating. That is probably the main reason for the general, singular focus on productivity growth.

Looking at the whole postwar period, the United States actually experienced its most vigorous and definitely its most healthy economic performance in the 1960s. Its rates of national saving and of capital investment were then at their highest in the whole postwar period, and so were its rates of business profits. The main purpose of moderate borrowing on the part of the consumer at the time was the financing of new homes, and the main purpose on the part of businesses was the financing of new investment in plant and equipment, that is, in tangible assets. In essence, it was overwhelmingly borrowing for capital formation.

This pattern of borrowing began to change gradually in the 1970s and rather dramatically in the 1980s. From then on, debt growth went exponential. Consumer debts have since skyrocketed by 473% and business debts by 382%. These numbers compare with simultaneous GDP growth by 283%.

Tangible Assets: The Developing Borrowing Binge

A drastic change in the use of the new debts was the other striking new feature of the developing borrowing binge. Exploding credit quantity implied plunging credit quality.

Consumers started to borrow like crazy to finance increased current spending, and businesses borrowed like crazy no longer to invest in plant and equipment, but to finance financial transactions – mainly leveraged stock buyouts, mergers, acquisitions and stock repurchases – that were thought to be more appropriate for quickly raising shareholder value.

Ever since firms and retailers invented consumer installment credit in the 1920s, U.S. economic growth has become heavily geared to consumer spending and borrowing. But this traditional consumption bias took a big leap in the 1980s and in particular in the late 1990s. The most striking characteristic of both periods were exploding consumer debts and collapsing national saving.

In the 1980s, in actual fact, the hemorrhage of national saving had caused great and widespread concern. Many American economists expressed their strong misgivings about the implicit negative effects on capital investment. This time, in diametric contrast, nobody seems to care or even take notice.

There seems to prevail a widely accepted view that credit creation makes old-fashioned saving from current income superfluous. As to the equal utter lack of interest in capital formation, the apparent explanation is a singular focus on productivity growth. Why are saving and investing even necessary, if the U.S. economy is enjoying stellar productivity growth without them?

Tangible Assets: Macroeconomic Nonsense

What’s wrong with this view? In short, everything. It’s macroeconomic nonsense.

Productivity growth is not the panacea for which American policymakers and most economists seem to take it. If there is insufficient demand, as today, increasing productivity can only result in increasing numbers of unemployed workers, declining capacity utilization and, ultimately, slower growth.

What really induced generations of economists of all schools of thought to elevate saving to an indispensable, key condition for economic growth? The basic reason is that it is the limiting factor for capital investment. Short of nirvana, all resources are scarce. Due to this elementary wisdom, new capital investment can only come about to the extent that somebody makes the resources for the production of the capital goods available. That somebody happens to be mainly the consumer. By saving, that is, by spending less than he earns, he effectively releases the necessary productive resources for investment.

But this necessary release of productive resources is true only for saving from current income, coming implicitly from current production. The attendant release of resources is what makes this kind of saving indispensable for investment and economic growth.

In essence, capital formation represents the surplus of production over consumption, and that has to be made possible by saving. To quote Friedrich Hayek on the subject: “Saving is not synonymous with the formation of capital, but merely the most important cause which normally leads to this result.”

A lot of energy has been devoted to whether there will be a double-dip into recession. This is the wrong question. What really matters, instead, is whether capital spending will rebound after its steepest decline in the whole postwar period. This is also a question that can be answered with reasonable foundation from the available data.

If yes, the U.S. economy has a chance for a sustained recovery. If not, it will be Japanese-style near-stagnation and sub-par growth for years to come. We think the prevailing conditions speak overwhelmingly for the latter.


Kurt Richebächer
for the Daily Reckoning
January 21, 2003


“Personal consumption has been going up in the U.S. for the last 20 years. Instead of solving the problems of underinvestment and rebalancing the economy, which would be painful for a while, the central bank just throws money at the system and entices consumers to take on more debt. “

Felix Zulauf had interrupted Barron’s Annual Roundtable discussion to say something important.

“At best,” he continued, “the U.S. is in for a long period of stagflation, very low growth or worse. At some point, the world will begin to understand that the U.S. economy is fundamentally much weaker than generally believed.”

Americans enjoy a level of consumption they cannot really afford. If they had invested more of their money in new plants and equipment – capital improvements that increase income and profits – the situation would be different. But they didn’t; rather than save and invest, they consumed.

And now the world’s only superpower depends on the kindness of strangers in order to keep its citizens living in the style to which they have become accustomed. But the strangers are becoming less kind…or less stupid. Last year, foreigners bought $45 billion of U.S. equities, Zulauf tells us, “but that will change at some point. When people realize there are fundamental problems in the U.S. economy, the dollar will begin to decline in a major way.”

The dollar has already lost 20% of its value against the euro. But Zulauf thinks the biggest drop in the dollar will come against gold.

“Other central banks will at some point then try to support the dollar, because if it declines too much, it hurts their exports. They will be forced to adopt the same policy as the U.S. central bank, and you will have the whole world creating more fiat currencies. That’s when gold will really run.”

How far? In 2000, the ratio of an ounce of gold compared to the Dow stocks was 45 to 1. It took 45 ounces of gold to buy the Dow. Now, the ratio is down to 25 to 1.

“I don’t know exactly how low it will go,” admits Zulauf, taking the words right out of our mouths, “but I’d guess somewhere between 1 to 1 and 1 to 3. We’ll see in 10-12 years.”

Let’s check in on Eric in New York…


Eric Fry, reporting from Manhattan…

– The U.S. financial markets took a break from the action yesterday in honor of Martin Luther King Day. But America’s growing debt burden never takes a break. We Americans can borrow and spend better than anyone. In fact, borrowing money from foreigners and spending it on CD players and all-you-can-eat shrimp dinners is one of our greatest national talents.

– Better still, we get to repay our foreign debts with money that we print ourselves. That’s a pretty sweet deal, all in all. Unfortunately, we don’t always have a lot to show for all of our borrowing and spending. That’s because we tend to spend far more money consuming things than building things.

– This week’s issue of Barron’s quantifies America’s growing debt burden from several different angles. Herewith a sampler:

  • “Total U.S. debt…an aggregate of the borrowings of all households, businesses and governments (federal, state and local), zoomed up from about $4 trillion at the beginning of 1980 to $31 trillion as of 2002’s third quarter.
  • “Credit-market debt now equals 295% of gross domestic product, compared with 160% in 1980 and less than 150% during much of the 1960s.
  • “Debt as a percentage of GDP exceeds the previous record reading of 264% from early in the Great Depression.
  • “Corporate revenues, the raw material of debt service, have fallen to just 113% of corporate debt levels – the second worst reading in debt-repayment capacity since the Great Depression.”

– Meanwhile, default rates are on the rise everywhere. Corporations as well as consumers are defaulting in record numbers.

– “At what level does debt turn lethal?” Barron’s asks provocatively. “No one knows for sure.” As long as our foreign creditors eagerly accept the dollars we print, our foreign debts could remain manageable for years to come. Unfortunately, it’s looking like a few foreigners have already become less enthusiastic about accepting our “Benjamins,” “Andrews” and “Abrahams.”

– Many foreign creditors, especially the Japanese, are shifting assets out of dollars into euros. As Barron’s Vito J. Racanelli remarks, “Investors in the Land of the Rising Sun are increasingly disaffected with U.S. assets and have suddenly warmed up to the allures of Europe. Data from Japan’s Ministry of Finance show that Japanese residents invested $9.1 billion in eurozone assets in November, primarily bonds, compared to $5.3 billion in U.S. securities, while selling $600 million in U.K. assets.

– “For the fiscal year (which begins in April in Japan) through November,” Racanelli continues, “[Japanese] investment in the U.S. was double that of [their investment in the] eurozone, but in August, October and particularly November, more cash went to Europe than America.”

– Is it any wonder the dollar is stumbling? If the Japanese stop plugging the foreign exchange leaks springing from America’s massive current account deficit, the dollar’s problems will become very severe very quickly.

– The dollar is but the latest victim of America’s post- bubble economy. Given the fact that our economy is beset by the twin evils of excess capacity and feeble demand for goods and services, the near-term investment prospects aren’t terrific. And that means that foreign capital will flee the U.S. looking for better opportunities elsewhere.

– “The key factor to remember in assessing the economic and stock market outlook is that this is not a typical post-war bear market, but the unwinding of the mania that occurred in the late 1990s,” Comstock Partners reminds us, “and we are now suffering from the consequences. That is why mainstream economists and strategists who ignore the bubble and continue to use the post-war period as their framework are missing the big picture and making so many erroneous forecasts. We believe that the unwinding of the bubble is far from complete and that the market still has a long way to go on the downside.”


Back in Paris…

*** We are unwinding the ’90s mania, as the Comstock Partners remind us. But we can’t help but think that there is more to it. The stock market mania climaxed from a more important spectacle: the information revolution and the democratization (in both markets and politics) of amplified mob sentiments. Suddenly, there was a fool on every TV and computer screen urging people to believe what couldn’t be true – that they could all get rich together in stocks (15% annual returns forever!)…that paper money would go up against real money (gold) until Hell froze…and that consumers could borrow and spend their way to wealth.

The lumpeninvestoriat have been bruised and abused. They’ve lost half their money in stocks…and are deeper in debt than at any time in history. Will they suddenly come to their senses? Or will they cling to their illusions, like die-hard German soldiers defending Berlin in ’45, until they are completely and utterly crushed?

*** “The policy of the U.S. central bank is going to destroy the dollar,” Felix Zulauf continued, speaking to the Barron’s Roundtable. “Confidence in the U.S. currency at some point will collapse, and you’ll have a run on dollars. Money can’t go to other currencies, because they have to support the dollar. Gold will act as a monetary currency – a currency without the liabilities of ill-guided central bankers. Another way of looking at it is to say the U.S. has underinvested in capital investment to supply the goods that U.S. consumers are demanding. You have spent your money by buying on credit instead of investing. The Chinese are investing. They are building an empire.”

*** Oh là là…Elizabeth returned from a parent-teacher meeting with a worried look on her face.

“It was horrible,” she reported. “They said he never pays attention…that he turns around and talks to his friends…that he won’t sit still…that he’s way behind the other children…”

“It sounds like he acts at school just as he does at home,” replied his father. “At least he’s consistent.”

“And he’s going to fail. We’ll have to find another school for him.”

Poor Edward, a failure at age 9. If he is kicked out of the best primary schools, he will not get in the best high schools…and then, no Andover…no Harvard or Yale…What will become of him, his mother wondered?

“He’s pretty good at helping me on the stone walls,” said the father, still trying to look on the bright side, “maybe he could become a stonemason. It’s more fun than sitting at a desk and you can talk all you want.”