The Coming Internet Depression Part II

“What nobody saw, though some people may have felt it, was that those fundamental data from which diagnoses and prognoses were made, were themselves in a state of flux and that they would be swamped by the torrents of a process of readjustment corresponding in magnitude to the extent of the industrial revolution of the preceding 30 years. People, for the most part, stood their ground firmly. But that ground itself was about to give way.”

Joseph A. Schumpeter, Business Cycles, 1939

When I returned from Paris to the little town of Montmorillon last Friday night, a cloud of black smoke arose from the center of town.

“We had better take the back roads,” said Elizabeth as she picked me up at the station.

In the center of town, a sleepy little burg whose last role on the stage of world events was performed during the Hundred Years’ War with Britain in the 14th century, when an angry mob had formed. And there, where the two principal roads meet, a pile of tires burned – sending black smoke up over the church spire and Mayor’s office.

The point of controversy was the subsidies paid to farmers. Most unhappy are the beef producers, who have been caught on the horns of the ‘mad cow’ dilemma. Though only a handful of people have come down with the disease, fear is widespread…so that the price of beef has fallen.

And then, last week, a relative of ‘mad cow’ disease was reported in sheep. There is no evidence that anyone was ever made sick by the sheep disease, but it was enough to throw another panic into the farm community. So, all over France, last week, farmers demonstrated for higher subsidies.

“Where you stand depends upon where you sit,” goes the expression. My neighbor, Pierre, is in favor of more subsidies for farmers. Catholic, conservative…he nevertheless sits on a tractor a good portion of the day and believes the state has the responsibility to make sure he gets a fair price for his beef. Already, about half his income comes from government subsidies, but he wants more.

“Farmers always complain,” said Maitre Boulzaguet at Saturday’s party…dismissing the demonstrations.

Yes, they always complain about the weather….and about farm prices. What is unique to our age is that they also expect their success or failure to be a collective responsibility.

Governments never tire of trying to rig prices. Politicians always try to favor their friends and destroy their enemies…interfering in the market as much as they can in order to bring about some unnatural result. But never before have the markets been so jimmied on such a grand scale and at such colossal risk.

What my neighbor Pierre expects from the European Union, the average American investor and householder expects from the United States Congress…and the Federal Reserve – protection from the crises of capitalism and from the consequences of a free market.

“In effect,” according to economist Paul Krugman, “capitalism and its economists made a deal with the public; it will be okay to have free markets from now on, because we know enough to prevent any more Great Depressions.”

The presumption is that while the economists and policy makers of 1931 did “everything wrong,” those of 2001 will do everything right.

I will put the question to you: Will the same Euro-policy makers who react to farmers’ demand for higher subsidies with promises of more taxpayers’ money do ‘everything right’ in a financial crisis? Will the same U.S. policy makers who react to every financial threat with promises of more cash do ‘everything right’ when a debt crisis reveals itself? Will Japanese officials, who – on the advice of American economists – have dropped interest rates to zero and taken on more public debt per capita than any nation in history…do the ‘right thing’ in a real pinch?

The question answers itself.

Farmers will act like farmers and politicians like poltroons…which has always been the case; but what is new?

What is new is the extent to which the farmer’s plight and the investor’s risk has been globalized, securitized and derivativized.

Progress, as I’ve opined in these letters, depends on an increasing division of labor. More and more, people specialize…and improve both the quality and quantity of their output. They also develop specialized tools and equipment that make further productivity gains possible.

In the Agricultural Economy, few people specialized. Local economies were small and relatively self-contained. A gardener, like Mr. Deshais, might produce the vegetables for a hamlet…while someone else produced the dairy products, but that was about as far as it went.

Thus, an economic crisis was fairly small too. A drought might affect all of Europe, for example, but the pain would be local – each village and farm suffering according to its unique situation and how much of previous harvests it had managed to save. Little help was expected from the larger community.

But the division of labor got a big boost from the Industrial Revolution. Factories, machines, railroads, and communications made it possible for people to specialize on a grander scale. Just a few shoe factories in New England, for example, might provide footwear for thousands of people. And just a handful of farmers could feed entire cities.

Specialization produced economies of scale – allowing yet further improvements in output per unit of investment. It also made it possible for most people to forget about storing grain for lean years. Henceforth, savings would be of a more abstract form – deposits in banks, stocks, bonds, and cash.

But “every economic era is afflicted with its own unique curse,” as Michael Mandel puts it in “The Coming Internet Depression.”

The grander scale of commerce, labor, and production created by the Industrial Revolution produced problems of a grander scale too.

The most costly of these was WWI. Before 1914, wars came and went in Europe. Armies marched hither and yon…fighting, dying, and generally making life miserable for everyone.

But the damage was limited. The economy of the pre- industrial era would only support a limited number of people not involved in farming. And part-time soldiers could not stay in the field for long. As in ancient Greece, wars were often conducted between planting and harvesting, guaranteeing that conflicts would be fairly short.

With the Industrial Revolution came the capacity for warfare on of a larger magnitude. Not that anyone wanted bloodier and more costly wars. But that is the point, people do not get what the want. And even if it were possible to correct the errors of the past, there are still plenty of new ones that can be made.

Not long after WWI came a crisis of capitalism, which, thanks to the errors of politicians, developed into the Great Depression. This, too, was a depression that couldn’t have happened in the agricultural age. It was made possible by an extended division of labor…which suddenly broke down and created an economic collapse on a grander scale than had ever been seen before. There had been many period panics in the capital markets, of course. But they affected relatively few people and tended to be short-lived.

In the Great Depression, as in previous economic crises, savings proved indispensable. And the savings that worked best were those of the least abstract form – food, shelter, gold, and cash in hand. Stocks and deposits in banks proved, very often, ineffective.

And now, 6 decades later, information technology has permitted a further extension of the division of labor. The whole world economy operates on a much vaster scale than it did in 1929. Labor is much more specialized. Wealth has become even more abstract – often existing only as ‘information’ in electronic form – and savings are few. Securitization, derivatization and globalization have changed things greatly – but we still don’t know to what effect.

What will the next crisis bring?

More tomorrow…

Bill Bonner Ouzilly, France February 21, 2001

*** Reuters reports that the IMF expects the US economy to grow at 1.7% this year.

*** The Philadelphia Fed estimates growth at 2.2% – down from 3.3% just 2 months ago.

*** Both of these estimates could turn out to be high. But even if they are accurate they leave no doubt that the U.S. economy has lost its miraculous vitality…and the New Economy is not much different from the old one. The business cycle lives. But what is new? More below…

*** After investing too much in the latest tech wonders, investors are now discovering that their investments are worth less than they thought. Not that Mr. Market was wrong about when the stock was at $200…and the Nasdaq was over 5,000. Mr. Market is never wrong. But he changes his mind about things. Yesterday, he took the Nasdaq down 4.4% – or 106 points. And he repriced at $12.50.

*** The story was similar throughout the Big Tech sector. Companies on which investors had spent billions of dollars slipped down to the point where they are worth only a few million.

*** Cisco, for example, is a “must own” New Economy stock that sits in almost every institution portfolio like a lump of old French cheese in a warm room. The aroma was good when it was fresh – but now, it stinks to high heaven. Billions have been lost on Cisco, whose shares sank yesterday to $26.50. The stock has lost 68% of its value since it hit a high of $81 last year.

*** Cisco was singled out for rough handling because its CEO dared to speak the truth in Europe over the weekend. “It makes no difference what the Federal Reserve or the latest statistics say,” Mr. Chambers told a Swedish newspaper, “What we see now is absolutely not a soft landing. Ask anyone in American manufacturing industry and they will say that we are in a recession. If the situation does not change before the half year stage there is a risk of a domino effect whereby the rest of the world will be imminently affected.” Again, more below…

*** Cisco, Amazon, GE all suffer from what Richard Thaler described as the “winner’s curse.” Thaler noticed that the winning bidder for oil drilling rights almost always paid too much. Estimates of the value of the rights varied greatly, he pointed out. The winner was the one with the most optimistic view. But, the most optimistic view was rarely the correct one.

*** Cisco, Amazon, and GE – were the big winners of the late 90s – each one dominating its space, and paying far too much for acquisitions, customers and just about everything else. They are all doomed…

*** One thing for which leading companies paid too much was labor. Not hourly labor – but top talent, which was typically awarded huge bonuses and stock options.

*** This became a feature of ‘late, degenerate American capitalism’ – companies were operated for the benefit of employees and customers, and not for the benefit of the capitalists.

*** Chief executives tended to get multi-million dollar compensation packages – including bonuses – even when they run down a firm’s balance sheet. And employee stock options effectively redistributed capitalists’ money to the working stiffs.

*** “As a clear illustration of the latter point,” writes Marshall Auerback on the Prudent Bear site, “consider the case of Microsoft… An owner of 100 million Microsoft shares (340,000 initial shares split-adjusted) in 1986 would have had a 2.8% share in the company at the time. If the share count had remained unchanged since 1986 the value of this 2.8% holding would have amounted to $8.4 billion if today’s $300 billion is accepted as fair approximation of true market value. However, as a result of the prolific share issues to employees, a holding of 100 million shares today represents a 1.8% ownership interest and is worth approximately $5.4 billion at current market value. Shareholder dilution skimmed 36% of potential appreciation off the top.”

*** “This is the kind of dilution that Warren Buffett, amongst others, has extensively criticised.,” Auerback continues, “But whereas Buffett was a virtual lone wolf in respect of his attacks on the practice, the number of other market participants critical of the impact of this egregiously unfair dilution has multiplied now that the costs of such activities are becoming more readily apparent in the context of a declining Microsoft share price.”

*** But employees, like everyone else, often end up getting what they deserve, not what they expect. The Wall Street Journal: “As the Internet bellwether’s stock has plunged more than 80% this year, many Yahoo! employees are likely holding options that are currently worthless, or have a value that’s a lot lower than when they were awarded. With options having lost much of their appeal, there’s likely to be an increased need at Yahoo! to pay out cash to retain and attract people.”

*** But many of those who were previously attracted now have a problem. The New York Times: “Stock option and tax experts say thousands, if not tens of thousands, of employees are waking up to a real hangover as April 15 approaches. The reason is that investors generally incur taxes when they use their options to buy stock. Even if the stock price plummets, the tax bill remains unchanged. Whether through bad luck, mismanagement, market restrictions, ignorance or greed, many people failed to sell enough stock to cover the bill. They treated paper gains as real and even borrowed against them. And they presumed that when tax time came, the money would be there.”

“Many people have fallen into the trap where they owe more money in taxes than they got out of their stock options,” said Kaye A. Thomas, an authority on stock options, “Some people have basically been bankrupted by their tax liability.”

*** The dollar rose, knocking the euro down to 91 cents yesterday. Gold, always on the other side of a dollar trade, fell $2.20.

*** “Leading energy research firm Cambridge Energy Research Associates said Thursday that world oil production capacity will grow from 79 million barrels per day in 2000 to 92 million barrels per day in 2005,” reports Dan Ferris. Dan reminds us that Information Technology uses a tremendous amount of power. “The Internet’s dirty little secret,” he says, “is that it runs on coal.”

*** “Forget the free-market talk from Curtis Hebert, the new head of the Federal Energy Regulatory Commission,” writes John Myers of Outstanding Investments. “He indicated in a television interview this past week that California had created its problems, and California was going to have to solve them. Then he extended the emergency supply orders that makes gas and electrical suppliers sell to California utilities even though they don’t want to out of fear they won’t be paid.” But there’s still room for investors to make money…

*** What happened to the day traders? We hear nothing about them. “Day Traders go back to day jobs,” says a headline in the Arizona Republic. Day trading was never anything more than gambling. But the odds were much better in Las Vegas than in Manhattan.

*** Maria prepared a delicious dinner last night. I know you don’t care what we had for dinner, but I will tell you anyway: Salad, duck pate, Brussels sprouts, fried potatoes, stewed tomatoes and sausage. Only the sausage was bought…everything else came from our own garden, grown and preserved by Mr. Deshais. I am bucking the trend of the last 2 millennia: I’m going to buy some pigs so we’ll be able to make our own sausage for next winter.