Pulling Out the Rug

In the wake of last Friday’s jobs report, can anyone yet claim that the U.S. "recovery" is self-sustaining? On the contrary, Dr. Richebächer sees a "variety of accidents" in store for the market…and chief among them, a dollar rout.

Apparently, the consensus economists are still convinced that the growth acceleration in the second half of 2003, and above all a sharp rise in profits, have laid the foundation for sustainable growth. In particular, sustainable growth with sufficient creation of employment.

We disagree.

But we must admit that our own assessment is prejudiced by the postulate of the Austrian school, that "the thing which is needed to secure healthy economic growth is the most speedy and complete return both of demand and production to its sustainable long-term pattern, as determined by voluntary consumer saving and spending."

Friedrich Hayek said in 1931: "If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into the wrong direction and a definite and lasting adjustment is again postponed. And even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises."

We think this precisely describes what has been happening and continues to happen in the United States. The Greenspan Fed has discovered a new, amazingly easy and quick way to create higher consumer spending virtually from thin air – by way of so-called wealth creation through asset bubbles. It began with the stock market bubble, to be followed by bubbles in bonds, house prices and mortgage refinancing.

Dollar Collapse: An Outright Disaster

Measured by real GDP growth, it seems a successful policy. But measured by employment and income growth, it is an outright disaster. The so-called "wealth effects" are not for real, neither for the economy as a whole nor for the individual asset owners. The reality in the long run is only the horrendous mountain of debts that consumers, corporations and financial institutions have piled up.

Given the general euphoria about the U.S. economy and its recovery, there appears to be a general apprehension in the markets that the Federal Reserve will be forced to raise interest rates in the foreseeable future. The Fed is clearly anxious to dispel any such fears – and this, in our view, is for a compelling reason. U.S. economic and financial stability have become inexorably dependent on the existence of a steep yield curve allowing and fostering unlimited carry trade in long-term bonds. Any major rise at its short or long end would shatter this artificial stability and send the economy and financial system crashing.

Considering all the imbalances impairing U.S. economic growth, we are unable to see the sustained, strong recovery. A closer look at the recent economic data [and last Friday’s jobs report] confirms this skepticism. Possibly, if not probably, economic growth has already peaked. For us, the question rather is when general disappointment will gain the upper hand.

That, of course, is sure to soothe the bond market, allowing moreover the Fed to maintain low interest rates. But it will conjure up another, even greater risk at the currency front. It will pull the rug out from under the dollar.

Dollar Collapse: Saved by Perception, and Asia

In our view, the U.S. trade deficit is big enough to cause a true tailspin of the dollar against all currencies. So far, two things have prevented this threatening dollar collapse: the gargantuan dollar purchases by Asian central banks and the still rather positive perception around the world of the U.S. economy. In our view, few people realize its true weakness and vulnerability.

There is widespread hope that the falling dollar will go a long way to lower the U.S. trade deficit. It takes a lot of wishful thinking to believe that. Its persistent growth has various reasons. One of them is that the gap between exports and imports has simply become too big to be reversible. Last year, exports amounted to $1,018.6 billion and imports to $1,507.9 billion. Just to prevent a further rise of the deficit, exports would have to rise 50% faster than imports.

Principally, the trade flows of a country are exposed to three major influences: first, relative prices and the exchange rate; second, relative demand conditions; and third, relative supply conditions.

Empirical experience suggests that exchange rate changes by themselves have very little effect on trade flows. One obvious reason is that Asian as well as European exporters readily adjust their prices to maintain their market shares.

For years, the United States has been top in the world with its domestic demand growth propelled by the loosest monetary policy in the world. For sure, lacking demand growth in the rest of the world has played a role in boosting the U.S. trade deficit. Yet what matters most for the trade balance is not U.S. growth in relation to other countries, but U.S. demand growth in relation to U.S. capacity and capital-stock growth. In essence, such a deficit indicates an equivalent excess of domestic spending over domestic output.

More precisely, the U.S. trade deficit reflects gross overspending on consumption on the demand side and a grossly unbalanced investment structure on the supply side. There was gross underinvestment in manufacturing versus gross overinvestment in retail, finance and high-tech.

Dollar Collapse: A Task Too Herculean to Be Tried

Our assumption is that there is no intention or will on the American side to correct any of these maladjustments. Given their enormous size, it is a Herculean task, too Herculean, in fact, to be seriously addressed.

Principally, American policymakers and economists take only two economic problems seriously: high rates of inflation; and, in particular, slow growth and rising unemployment. They could not care less about the dollar. The low inflation rate is the excuse for more of the same extreme monetary looseness.

There is quite a variety of accidents waiting to happen in the markets, but the most predictable and biggest risk is a dollar crisis. In addition to the gargantuan trade deficit, looming in the background are existing foreign holdings of dollar assets in the amount of $9 trillion.

As explained, the tremendous vulnerability of the U.S. bond market due to its underlying heavy leveraging prohibits any defense of the dollar through tightening.

Instead, the plunging dollar will pull the rug out from under the bond and the stock markets.


Kurt Richebächer
for The Daily Reckoning
March 9, 2004

Editor’s note: Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

It is the great circle of life, dear reader.

People start off with nothing; they work hard, save their money, and gradually – if they are in the right time and the right place – they get rich. Then, they get older. As they acquire a taste for silks and SUVs, their attention shifts from making money to spending it. Their economy changes with them…switching from steel mills and the smell of diesel fuel to shopping malls that sell Diesel jeans.

Then come the lies and illusions. They are rich, they come to believe, not because they (or their parents) worked hard and saved their money, but because they have some special gift that guarantees they will be lucky forever. Let someone else do the hard work of making things, they tell each other…we’re so smart, we don’t have to schlep and save anymore – we can borrow and innovate!

Finally, the lies give way in a bear market of falling asset prices…recession…and collapsing living standards…studded with entertaining lawsuits, bankruptcies, work-outs, and Martha Stewart-type show trials.

No people were in a better place or a better time than America after WWII. The baby boomers were delivered into Eden itself. They had barely to stand on two legs and the low-hanging fruit fell into their mouths. For not only did they have the world’s most advanced factories…they owned most of the world’s gold. And every day, they got richer, because they sold more things to the rest of the world than they bought from it.

But they also had the astonishingly good fortune to control the world’s money. In 1971, Richard Nixon cut the link between the dollar and gold. From then on, America could pay its debts in a currency of whatever value it chose. This was a stroke of luck so puissant it must have caused brain damage, for they began to believe the most incredible things: that they could spend their way to wealth…that the rest of the world would lend them money forever, and never ask for it back…that ‘things’ no longer mattered in the modern, globalized economy…and that their new post-modern economy was based on ‘information and innovation.’

By the time the oldest baby boomers were in their mid- and late-30s, the U.S. economy was already rolling over from being focused on production to concentrating on consumer spending.

By the time they were 42 years old, Alan Greenspan was already at the Fed, and their nation crossed the threshold from its position as net-creditor for the rest of the world to net-debtor status. Instead of building factories…America was building malls and condos. [Ed note: And soon, real estate will be the only asset holding up the economy…or so suggests Robert Blumen in an article on the Daily Reckoning website:

Signs The Housing Economy Is About To Crash: A Satire ]

By the time these same boomers reached their 50s, the country was putting up new retail space at a rate 5 times greater than the increase in population.

Now, the most decrepit of the baby boomers are nearing 60…and what’s this? After a long summer in the sun…the boomers are facing some cold winter arithmetic.

Currently, they are more likely to go bankrupt than get divorced. Their homes went up about 10% last year. But the Fed says total debt in the U.S. went up at about the same rate – 10%, the fastest growth in 15 years.

And if they lose their jobs, they are likely to wait 20.3 weeks before getting a new one – the longest in 20 years. The average length of joblessness is not far from the record of 20.8 weeks – set in 1948, before most baby boomers were born. But the worst is yet to come.

"Recovery Built on Retirees’ Backs," begins an article in TheStreet.com. A boomer couple retiring in 2011 are expected to cost taxpayers $700,000 in Social Security and Medicare. The Bush administration estimates the cost of Medicare alone at $10 trillion over 75 years. But economist Laurence Kotlikoff says current estimates are much too low. The real shortfall between Social Security and Medicare obligations and expected revenues is more like $51 trillion. This leaves only two choices: either raise taxes immediately 69%…or cut benefits 45%.

Either way, the boomers are more likely to get what they deserve than what they expect.

In the meantime, here’s boomer Eric Fry in Boomtown, USA:


Eric Fry from New York City…

– "Intel Inside"…that was the stock market’s biggest problem yesterday. Intel, which represents 6% of the Nasdaq Composite Index, skidded 4.3% to a five-month low of $27.70. The entire stock market followed along. The Nasdaq Composite Index closed at the session low, down 39 points to 2,009, while the Dow fell 66 points to 10,529.

– The stock market’s weakness chased investors into the bond market, where the yield on the benchmark 10-year Treasury note dropped to 3.77% – an eight-month low.

– Meanwhile, the dollar and gold both took a breather from their recent volatile trading action. The dollar dipped slightly against the euro, while gold eased 70 cents to $400.90 an ounce.

– Despite the Nasdaq’s 7% drop over the last 6 weeks, the stock market is still too pricey to entice America’s savviest investor. Warren Buffett, in his annual letter to the shareholders of Berkshire Hathaway, had nothing good to say about U.S. stocks…or about the currency in which they trade: the U.S. dollar.

– "Yesterday’s weeds are today being priced as flowers," lamented Mr. Buffett. "I made a big mistake in not selling several of our larger holdings during ‘The Great Bubble.’ If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I."

– Mr. Buffett, who amassed his billions by buying stocks whenever they are cheap and amassing cash whenever they are not, is now amassing cash inside Berkshire Hathaway. Berkshire’s coffers swelled by $23 billion in 2003 – taking its total cash pile to a record-breaking $36 billion. And Buffett is diversifying much of that cash into foreign currencies.

– Buffett, who owns more dollars than any other human being besides Bill Gates, is becoming increasingly concerned about the future purchasing power of those dollars. The American investment guru-turned-macro-trader warns that the U.S. is deluging the world with dollars to fund its huge trade deficit, the consequences of which could be "troublesome," reaching far beyond the currency markets.

– As a result, Buffett is plowing Berkshire’s massive cash horde into foreign currencies. The foreign exchange purchases, made in five different currencies, represented Buffett’s biggest investment in the last two years. Buffett started betting against the dollar in 2002. Since then, the greenback had lost about one third of its value against the euro.

– "Our capital is under-utilized now," says Mr. Buffett. "It’s a painful condition to be in – but not as painful as doing something stupid." Hmmm…if Buffett is under-utilizing Berkshire’s capital, aren’t most folks OVER-utilizing their capital…(and the capital of others)? Aren’t most folks spending every available cent buying stocks that Warren Buffet wouldn’t touch with a barge pole?

– In a world where most mutual fund managers and professional investors live by the credo, "Use it or lose it," Buffett suspects that investors who use their cash buying today’s overpriced stocks are very likely to lose it. The last time that Buffett "underutilized" his capital, the stock market was only one year away from crashing.

– Cash may not be the very best thing to put in an investment portfolio, but it might turn out to be a whole lot better than putting "Intel inside."


Bill Bonner, back in Paris…

*** Gold is right at our target buying point – $400. We don’t need to remind readers that God does not tell us his Whole Plan. It could be that He has some way of making the dollar go up against gold…

It is true, also, that Americans are likely to be desperate for dollars in the years ahead. Once Zembei Mizoguchi decides to pull the plug, interest rates in the U.S. will pop up – as the dollar collapses on world currency markets. Still, Americans will need dollars to pay their mortgages, their credit card bills, and their bankruptcy lawyers. In a declining economy – with falling asset prices – dollars could be hard to come by.
We cannot know what will happen. We buy gold and keep our fingers crossed…

*** We are continuing our detailed market research into India…

This weekend, we watched two more movies from Bollywood and didn’t quite know what to make of them. As near as we can tell so far, all Pakistanis are stupid and evil. And all Indians are ready to kill almost anyone, anytime, for almost any reason. In fact, in one film the citizens of two villages begin killing each other for no reason at all.

Additionally, we discovered that when Indians are not killing, they are singing and dancing. We have seen them singing and dancing before killing other people…and after killing other people. We await the film in which they sing and dance while killing other people at the same time.

*** Our tango lessons have fallen by the wayside. We left town. Then Elise, our instructor, left town. But recently we found that Democratic presidential candidate John Kerry also likes the tango. We think we may have to give it up for good.