Phantom Wealth

Strikingly, the late great bubble of 1996-2000 in the U.S. stock markets represents the first time since economic thinking started that this kind of wealth creation – through rising asset prices rather than through capital formation – found overwhelming attraction and admiration. The old economists never gave it any serious consideration. They flatly discarded it as pseudo or phantom wealth.

What the rising asset values effectively create is a corresponding rise in claims on the economy at the expense of those who do not own such assets. But this is wealth redistribution, not wealth creation. More importantly, this kind of wealth creation involves no gain in current incomes and productive capacity. To the extent that it actually boosts consumption at the expense of investment and the foreign trade balance, the net result from a macro perspective is overall impoverishment.

For the first time ever in the history of economic thinking, economists – that is, American economists – are claiming that growing asset prices represent fully valid wealth creation. In 1996, an article in Foreign Policy entitled “Securities: The New Wealth Machine” effectively explained that the financial markets have become the most powerful generator of wealth.

Rising Asset Values: Direct Wealth Creation

Verbatim: “Historically, manufacturing, exporting, and direct investment produced prosperity through income creation. Wealth was created when a portion of income was diverted from consumption into investment in buildings, machinery and technological change. Societies accumulated wealth slowly over generations. Now, many societies, and indeed the entire world, have learned how to create wealth directly. The new approach requires that a state find ways to increase the market value of its stock of productive assets. Several countries have successfully directed their economic policies toward that goal, achieving and sustaining faster growth rates than were once thought possible…”

Nowadays, wealth is created when the managers of a business enterprise give high priority to rewarding the shareholders and bondholders…In such a strategy, “an economic policy that aims to achieve growth by wealth creation therefore does not attempt to increase the production of goods and services, except as a secondary objective.”

We wondered whether we should reprint such ridiculous economics. We choose to do it because this economic nonsense concisely reflects the confused thinking behind the new equity culture that has spread from America to the rest of the world. Economies exist for the securities markets, say the new equity thinkers; the markets, not the producers in the real economies, create the nation’s wealth. Besides, they say, the markets do this much more efficiently by pleasing shareholders and nobody else.

Rising Asset Values: Like Printing Wealth

There is one consideration, however, which makes the transient and ephemeral character of wealth “creation” through the markets poignantly clear – namely, the way it is calculated. Trillions of dollars of new wealth simply arise from the common practice of treating the value of the whole outstanding stock of assets as if it could be calculated based on the last stock trading price…which, as a rule, is of marginal size. It is like printing wealth.

Indisputably, the new imperative to maximize shareholder value induced profound changes in corporate strategies. For better or worse, that is the question. Wall Street’s propaganda machine, greatly assisted by confirmation through Mr. Greenspan, hammered into people’s heads that in America, “unprecedented technological advances in high-tech technology and corporate governance had ushered in a New Era in which businesses were making unprecedented gains in productivity and profitability”. Rapidly spreading belief in this nonsense kindled fantastic profit expectations that, in turn, helped kindle the steep rise in stock prices.

Realizing that the traditional process of profit creation through capital formation was much too tedious to satisfy the new, grossly inflated profit expectations in the market, corporations switched massively to new strategies that seemed to promise much quicker and higher returns. Thus, mergers, acquisitions, restructuring, downsizing, outsourcing, cost-cutting, stock buybacks and creative accounting became the main characteristics of the corporate strategies to expand.

While the consensus has been trumpeting a profit miracle, we have been protesting for years that this is impossible. What led us to this opposite conclusion were simple, compelling macroeconomic considerations. They say that there is ultimately but one single way for businesses to increase their profits in the aggregate, and that is by mutually increasing their revenues through higher investment spending. With this rule in mind, we realized that all those new corporate strategies meant to boost profit creation when taken together could only have the opposite effect of depressing profits.

Rising Asset values: Absurdly Euphoric

In fact, at the height of the boom, executives and firms faced sharply falling profits, while the prices of their shares, reflecting the inflated profit expectations, were soaring. Most importantly, Mr. Greenspan eagerly supported the stock market boom not only with absurdly euphoric statements, but also with record-high money and credit creation.

Confronted with tremendous pressure from the markets to meet the grossly inflated profit expectations, the great corporate account rigging developed for a straightforward reason. It was the need and desire to cover up the increasingly desperate corporate profits picture, contrasting dramatically with the former high-riding promises. Manifestly, the unfolding epidemic of accounting frauds is not just bearing witness to an unprecedented high level of greed. The far more important aspect is its deeper cause: the horrible reality of Corporate America’s worst profit performance in the whole post-war period.

Measured as a share of GDP, profits today are at their lowest level in the whole post-war period. During the last year of the boom, in 2000, before-tax profits of nonfinancial firms were equivalent to 4.3% of GDP. That was down from 6% of GDP in 1997. This plunge of profits has to be seen against the backdrop of 18% GDP growth during this period.

More recently, profits are down further to 3% of GDP. What has hammered the stock market is plainly not a lack of confidence but collapsing profits.


Kurt Richebächer
for the Daily Reckoning
April 1, 2003


Stock prices, and the economy itself, are held up by 2 x 4s. “It is a housing economy,” say commentators…as if such a thing could exist.

But it is not exactly the carpenters who keep stocks trading at 40 times core earnings…nor do plumbers keep consumers spending – even in the face of war, pestilence, joblessness, bankruptcies and foreclosures. Instead, the real work of trying to avoid a correction is done not by those who build houses, but by those who finance them.

For every person who refinanced his home in 1990, there are 93.8 people who did so last year, reports James A. Bianco. That is an increase in refi activity of 9,380%.

Consumers “took out” about $80 billion in “equity” from their homes last year, which allowed them to continue living in the manner to which they had become accustomed – despite the fact they were losing their jobs and incomes, while taxes and fuel costs were rising.

The Fed may cut rates again…and may bring about yet even more refi activity…which may hold up the stock market and the economy for a few more months. But sooner or later, the bull market in refinancings must go the way of the Nasdaq.

Despite all the stimulating, the world’s economies – with the exception of China – seem to be slouching towards recession.

Bank lending declined 25% from a year ago, reports the Financial Times. European consumer confidence dropped to a 9-year low, says another report.

In America, the index of Chicago Purchasing Managers has turned negative for the first time in 5 months. And a new report from the Levy Institute tells us to beware of a long “growth recession”.

“During the 2001 recession,” explains Mark Zandi in Barron’s, “we lost 2 million jobs…And last time we had unprecedented economic stimulus that we can’t…have again.”

We can’t have it again because the Fed has already cut rates 12 times. Maybe they could cut rates once or twice more before hitting zero…but that is all. And without the stimulus of householders continuing to borrow to live beyond their means, what’s left for the economy?

Doug McIntosh offers a guess: “We now see Fannie Mae and Ginnie Mae, with hundreds of billions in sub-par mortgages, are reeling like drunks. All that is left is a bankrupt consumer using home equity loans. The actual value of the homes is a fantasy as recent declines in home prices are beginning to show. The last two legs sustaining the economic illusion are now being hammered by high energy prices, endless war, a savage job market and political anarchy on our streets. So, all you optimists out there in TV land…Once the American consumer stops spending, which is now happening, and stops being able to use home equity loans, what’s left? I say the abyss, but then I’m a doomer. I prefer to say I’m a student of history, a realist and a shrewd judge of human character. The time of death is now upon the planet Earth I call home. If the four horsemen haven’t been released, at least they are pawing the ground at the starting gate. The days ahead will not be pleasant to be sure. We may survive them or we may not. At least it’s going to be interesting.”

Eric, you’re not a doomer…what do you see?


Eric Fry in New York City…

– So far, war is proving to be somewhat less bullish that advertised…for the stock market, that is. War is plenty bullish for oil and gold and all the other sorts of assets that investors seek when they’re terrified of buying stocks.

– The first 13 days of war have brought very little luck to most investors. Yesterday, the Dow tumbled another 154 points to 7,992 and the Nasdaq dropped 2% to 1,341. Meanwhile, gold, oil and bonds continued to power ahead. The safe-haven metal gained $4.50 to $336.90 an ounce; oil gushed 88 cents to $31.04 a barrel; and the 10-year Treasury jumped three quarters of a point, pushing its yield down to 3.82% from 3.90% last Friday.

– Given the considerable national angst that is resulting from the Iraqi campaign, investor demand for safe-haven investments is hardly surprising. But what is at least a little surprising is that any investor could consider a 10- year debt obligation from the U.S. government to be a “safe haven”. Is this not the same government that will borrow about $300 billion this year, just to keep the lights on? And isn’t this the same government that will spend about $100 billion waging war against Iraq, and maybe tens of billions more to clean up the place afterwards?

– Last week, while on the air as guest host of CNNfn’s “Market Call,” your co-editor dubbed the 10-year U.S. Treasury note, “the single best short sale in any financial market”. Whatever the eventual military outcome of the Iraqi conflict, the fiscal campaign back home is already a resounding defeat. And yet, bond buyers somehow believe that victory is theirs.

– Whether the military onslaught against Iraq leads to a fast victory, slow victory or medium-paced victory, the bond market is sure to become a prominent “collateral victim” of the costly campaign. Strictly speaking, the $100 billion or so that it will cost to “liberate Iraq” is not an unbearable burden. But that’s just the tip of the iceberg.

– “The burdens that follow – from occupation, reconstruction, humanitarian aid and checkbook diplomacy – could extend well into the coming decade,” the New York Times predicts. “Taxpayers for Common Sense put the total cost of the world’s engagement with Iraq at $544 billion, spread over 10 years.”

– And then there are the substantial “hidden costs” – like high-priced oil. William Nordhaus, a professor of economics at Yale University, calculates that in a worst-case scenario, rising oil prices cost as much as $391 billion over 10 years. The Iraqi war will also speed a regime- change in the bond markets from one of low and falling interest rates to one of high and rising interest rates.

– How much the war in Iraq will ultimately coast – or, for that matter, any of the future wars in the Middle East that the Bush administration may have up its sleeve – is anybody’s guess. “The start of war is like the break in a pool game,” says Jim Grant. “Predictions are out the window. Possibly, President Bush will not allow this country to become overextended in places where the Founding Fathers would not have expected to find U.S. troops on any pretext. However, the presidential rhetoric is messianic – a ‘liberated’ Iraq could ‘show the power of freedom…by bringing hope and progress into the lives of millions,’ he declared in a February 28 speech at the AEI – and the logic of a preemptive foreign policy points to years of full employment for U.S. forces abroad.

– “The Fed and the Defense Department have, in effect, traded places,” Grant continues. “In the 1990s, the Fed policy was preemptive and national security policy was reactive. Now, it’s the Fed that watches and waits, the armed forces that move on a forecast (specifically, on the forecast that Saddam Hussein had the United States in his chemical, biological and nuclear sites and would squeeze the trigger). We, too, have a forecast. It’s that strategic preemption combined with monetary-policy inertia will make the 10-year note priced to yield 4% a dissatisfying investment experience.”


Bill Bonner…back in the Old World…with the old fuddy- duddies in the Paris office…

*** “So how’s your little war going?…I was going to ask them at the American embassy,” said Sylvie with a mischievous smile. “You know, they were all so eager to start the war…and now they all look kind of depressed. I don’t dare bring up the subject…But everywhere else, it’s all anyone talks about…It’s true that you Americans are not very quick to catch on to the subtle nuances of language…and especially those at the embassy, where they tend to be a little, well…dull. But even they would have detected the ironic tone…”

Sylvie is our French teacher. Her only knowledge of war comes from reading a thick Russian novel with war in the title. Thus, she is less well qualified to comment on military strategy than anyone, except perhaps for the commander in chief, who didn’t read the novel, but only the Cliff Notes. [Here at the Daily Reckoning, we know no more about war than Sylvie or George, except that for many years, we waged a battle against the bottle; even there, the best we could do was a draw.]

“All I know about the war is what I see on the evening news, which is probably different from what you Americans are watching. But I don’t understand the strategy at all. You say you are liberating the Iraqis and expected them to throw rose petals in your path. Instead, they don’t seem to want to be liberated; they act as though they were defending their country. And Saddam is now much more popular throughout the whole Arab world than he ever was before. He’s putting up a fight. They must admire him for that. And even if you kill him, he’ll then be a martyr. And his followers will attack you the way they now attack the Israelis. What a mess! Wouldn’t the smart thing to do be to admit you were wrong? Bush could go on TV…announce that he was withdrawing the troops…apologize…and the world go back to its business.

“But, of course, that will never happen. It would have been as if Napoleon had arrived on the steppes of Russia and reconsidered. He might have simply said – “this is just not worth the effort” – and returned to Paris. He probably would have lived happily as Emperor for the rest of his life. But there’s a certain kind of madness that seems to need to go all the way…

“I think you’ve gotten yourselves in a trap. You either have to try to get into Baghdad and seize control…and who knows what kind of fighting that might require? Or you are going to surround the city and starve it out. But do you think Saddam is going to quit when he sees his countrymen starving? And what are you going to do if women and children are dying…the people you said you were liberating? Who’s going to blink first?

“It’s a trap, because you can’t go forward or back down without a big mess…”

*** From Patrick Buchanan: “‘Bush Ideologues Reshape the World Over Breakfast’

“So ran the front-page headline in the Financial Times. The story described a ‘victory celebration’ at the American Enterprise Institute the morning the Marines rolled into Iraq.

“The AEI panelist-celebrants were Bill Kristol of the Weekly Standard, Richard Perle of the Pentagon’s Defense Review Board and Michael Ledeen, author of “The Terror Masters”. Apparently, the boys were yukking it up over what we were going to do to the French, Germans, Iranians, Syrians and Untied Nations, after we polished off the Iraqis.

“Kristol bewailed the failure of Bush’s father to take Baghdad. This resulted in a regrettable ‘lack of awe’ among Arabs, said he. Perle joked that there were more anti-war demonstrators in San Francisco than Iraqis willing to fight for their country. Ledeen said France and Germany had reached ‘new lows of disgustingness’ by ‘shoring up tyrannical regimes’. Then he went into his mantra about the need for ‘a longer war’.

“Kristol urged that we split Germany off from France but noted that such ‘intelligent diplomacy may be too much to hope for from the State Department.’ When Perle declared that ‘Americans are not vindictive,’ Ledeen interrupted to say that, in the case of France, he certainly hoped we would be.

“What was it Burke said? Great empires and small minds go ill together…”