The Crisis of American Capitalism

In these pages, we talk a lot about America’s “we think, they sweat” mentality, and as the events of the past few weeks show, this mindset is the country’s downfall. Chris Mayer points out, below, that finance can no longer be America’s national product… the days of actually producing things we need, rather than things we want, are upon us again. Read on…

The Crisis of American Capitalism

The bell of American finance has cracked. It was a long time coming, as I’ll show you. The biggest change in the American economy in the last generation or so has been the rise of finance at the expense of making things. This seemed to work for a while, but like a boxer who has a habit of dropping his hands, America finally caught one on the chin.

Every crisis, though, brings opportunity. In this one, investors will go back to investing in simpler, more durable things (at least until forgetfulness kicks in). For instance, investing in a company that supplies grains to hungry people looks like a better bet than investing in one that sells mortgages to people who can’t afford them. The focus will shift to things we need, rather than things we want.

As I write these words, I’m in Paris, France, sitting at one of those cafes that spill out onto the sidewalks. The two towers of Notre Dame are visible across the Seine. It is a bright and cool fall afternoon. A blackboard propped up outside the cafe carries the daily fare written in chalk. A typically gruff waiter in rolled shirt sleeves takes my order after what seems like a really long time. I’ve slipped into the Parisian pace of life, in which meals take an especially leisurely turn.

I’m spending a few days in Paris before I head home, after a week at an old chateau in Normandy for a conference. During my stay in this country, the U.S. markets have put on a show that has the feel of a movie climax. Uncle Sam bailed out AIG. Merrill Lynch sold out to Bank of America. The U.S. government hastily arranged a $700 billion bailout. Markets rose and fell hundreds of points per day. Gold and oil enjoyed their biggest one-day rises ever. It was a wild stretch.

The French have a chance to gloat a bit. Even though the crisis in America, the world’s biggest economy, helps no one, the French may have a better shot than most at coming through it with only flesh wounds. The housing market stinks in France, too. Housing sales in France are off 20% in the last 12 months. But the French market is not nearly as leveraged as the U.S. market was.

Financial innovation seems to occur slowly here. Mortgages in France are typically for terms of only 15 years. The French have also not embraced creativity in this field, as most mortgages bear fixed rates of interest. There is no subprime market. And French consumers did not borrow much against the rising prices of their homes. (The savings rate here is 13% of income, versus zero in America.)

The U.S. economy followed a very different path. Sometime over the past few decades, we abandoned the old-world notion of making things. We turned to making shuffling paper our stock in trade. Precisely when and why this happened will be something for historians to debate. But sometime in the 1990s, the percentage of corporate profits from finance passed that from manufacturing.

It was the first time that had happened, and the gap has only grown wider since. Before the great credit crisis hit, profits from financial firms made up nearly half of corporate profits. Only 10% came from the manufacturing sector. As recently as the mid-1960s, it was the other way around.

The French go on and on about their cheeses, wines and breads. For us, mortgages became our national product. Mortgages, before the crisis hit, made up 60% of total bank loans and the financial sector grew to become our biggest sector – bigger than health care, retail or manufacturing.

To a smaller degree, we had a similar crisis in the 1970s, Kevin Phillips tells us in his new book, Bad Money. Mortgage debt doubled from 1960-70. The Dow crashed, losing 36% of its value from 1969-70. Hedge funds blew up. The top 28 funds lost 70% of their assets, and about 100 brokerage and financial firms disappeared – by either acquisition or outright failure. Seems a lot like the outlines of the present day, does it not? The 1970s also had two major oil price spikes. The first in 1973-74 and the second in 1979-80. We’ve already had one oil spike now, and a second one is in the cards.

The neglect of making things is perhaps most evident in the oil business. Phillips says the U.S. has a “dated, ghost-of-glories past petroleum infrastructure.” He writes that the major oil companies “are wealthy, but aging behemoths, hard-pressed to maintain production levels, despite large exploration outlays, and no longer enjoying access to overseas oil fields they once commanded.”

Exxon Mobil, once the largest oil company in the world, now ranks 25th by booked oil reserves. The top 10 are all state-owned national oil companies (NOCs). The top 13 NOCs own four-fifths of the world’s known oil reserves. They don’t share them cheaply.

A look at where we get our oil is not encouraging. Most of these sources of supply are not particularly reliable. As Phillips opines: “Of the eight principal 2007 suppliers of petroleum to the United States as of August, only one, Canada, could be called secure and reliable.” Mexico seems secure, but exports have been falling since 2004, as Mexican production has fallen. It could become an insignificant source of oil by 2012.

And we are not alone in competing for these oil reserves. China became a net oil exporter in 1993, and its appetite grows every year. It is now the world’s second largest consumer of oil, behind only the U.S. China actually imports more oil from Saudi Arabia than the U.S. This partnership is not surprising, given the dynamics of the New Silk Road.

The “New Silk Road” is a term I use for the boom in trade between countries from the Middle East to China. In matters of energy, you see a lot deals inked on the New Silk Road. Saudi Arabia and China get together regularly like newfound pals. Sinopec, a Chinese oil company, recently got the OK to explore the Saudis’ Empty Quarter for oil and gas. Saudi Aramco, the big oil company, put $750 million toward a huge plant in China.

Just as interesting to me is what I like to call the “New Burma Road” – after the road of World War II fame that linked China and India via Burma. The New Burma Road identifies the booming trade between India and China. As Phillips writes, “China has already made a six-lane highway out of its portion of the road from Chinese Kunming to India’s state of Assam… The demographics of a Sino-Indian entente would make it especially momentous.” Yeah, I’d say so, given the strengthened ties between more than 2 billion people.

As you know, there is an awful lot going on in the world today, and it’s all far more complex than I can get into here. But this is where we are, in brief: The U.S. economy faces a crisis in its biggest sector – finance. The neglect of making things is finally taking its toll, a fact most apparent in the oil and gas world, but also apparent in infrastructure across the spectrum. And the world is less U.S.-centric than it has been in a long time. We see this, too, in the oil and gas sector and in the flurry of deal making along the New Silk Road (and its “momentous” segment, the New Burma Road.)

The implication of this post-finance U.S. economy is a theme we’ll explore more in this letter. As an early conclusion, though, I believe the spread between finance and manufacturing has reached millennial extremes, like a rubber band at its limits. Now begins the snap back.


Chris Mayer
for The Daily Reckoning

Chris Mayer — October 14, 2008

P.S. As I said, the trend is going to have to go back to investing in things we actually need – tangible assets. I have two ideas for investing in the post-financial world in the latest issue of Capital & Crisis, including a new idea – a family-owned conglomerate that combines operations in pork, grains, shipping and more. It’s a stock you can sock away for a long time. And if the post-financial world develops as I think it will, you’ll be glad you parked some money in this sector…

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Finally, leadership! Every commentator has whined for it. Every investor has pined for it. Every politician has inclined towards it. And now they’re going to get it, as we say here at The Daily Reckoning – good and hard!

The world’s power elite have gotten behind the plan. We’re saved! They are striding boldly into the market – like J.P. Morgan in 1907 – with cash in hand.

Only…it’s not their cash.

(Whose cash is it? Is it the ‘taxpayers money?’ Not exactly. Is it from savers and investors? Uh…some of it. More on where this money comes from…later…)

Britain has nationalized its banks. America is up to its familiar Rooseveltian tricks (Barack Obama quotes him in every speech: “The only thing we have to fear is fear itself,” – as if it were all just in our heads). Yesterday, Paulson said he wanted to take over the banks “as soon as possible.” Today, Bloomberg says the U.S. government has already bought into 9 major U.S. banks.

Hundreds of billions in loans, giveaways, bribes and trash collection has been dispersed. And now Europe has come out with its own bailout plan.

The front page of today’s Le Monde says it will cost 1.3 trillion euros to save Europe’s banks. Over at Liberation, the price is 1.7 trillion. And the Financial Times announces it as “Europe’s 1.873 trillion bail-out boost.”

How come it costs so much more to save Europe’s banks than our own? The numbers don’t jibe, but the math is a little funny anyway. France is putting up 360 billion euros. Germany tossed a half-trillion in the bailout pot. But who’s counting, anyway? This is war…

In war…as in love…you never count the cost until the shooting is over. Then, of course, you regret the whole thing…

But yesterday, at least, the world celebrated what it considered a major victory. German stocks went up 11%. Up 11% in Paris too. Hong Kong rose 10%. London 8%. And the Dow? Up 936 points.

So, let us have some fun. Let’s drive by and moon the partiers.

We begin by pointing out the obvious. A bounce in a bear market does not give cause for celebration. It gives cause for selling. Sell the rallies, buy the dips. Buy low, sell high, in other words. We’re selling stocks, generally. And this bounce is a good occasion to do so…because we think this market could go a lot lower. Dow 5,000 is our target. When the Dow gets below 5,000 we might be tempted to buy. Until then, it’s sell…sell…sell.

Mr. Market is a decent chap, after all. He always gives you opportunities to get out…or get yourself in deeper. After the market crashed in ’29 for example, prices gained 18.8% over the next two days. Investors should have hit Mr. Market’s bid. Instead, many were convinced that the bottom was in. They took advantage of an opportunity to buy shares at ‘bargain’ prices – only to see them cut in half…and cut in half again. And then, they had to live with their mistake for a long, long time. Prices did not return to the ’29 high until the 1950s.

There was a rally after the crash of Black Monday in ’87 too. Stocks rose 16.6% over the next two days. This time, buying turned out to be only a short-term mistake; stocks rose for the next 12 years.

The bunkum behind this bounce is that the pyromaniacs who caused this conflagration…and then fanned the flames…are now going to put it out. We recall, for provocation, that Goldman Sachs was a leader in developing mortgage backed securities and swaps – the dry tinder that set off this blaze. We recall too that Henry Paulson was not only at the head of Goldman while this was going on, but actually pushing the company in that direction. We recall also that that the U.S. central bank – the Fed – has kept its key lending rate at below the rate of consumer price inflation for most of the last six years. As for the rest of the world’s leaders – they are little more than careless gawkers…people who drove out to see the woods on fire…and then got caught by the backburn… Now, they’re lost in the smoke and feeling the heat.

Yet, we are supposed to believe that they are creating a new world financial order…and that it will be stable and prosper. As to the former, we have no doubt. Governments are using this financial meltdown in the same way they used the meltdown of the twin towers in 2001 – to grab a little more power. The dumb fist of politics now pushes aside the greedy little ‘invisible’ hand of Mr. Market. Subtle swindles give way to heavy-handed larceny.

Whatever happens, now the financial industry will have to stand in line for pat-downs and strip searches. More people of low intelligence and low self-esteem will find employment protecting the homeland’s financial security. And those who didst ride so high on Wall Street will lie in the dust of Congressional hearings…or lie low in some offshore hideaway. We take all that – as nasty as it is – for granted.

But the second part of the bunkum is probably dead wrong. Government control of an economy has never led to stability or prosperity. In fact, the record is fairly clear – the more the state meddles, the worse the economic results. In extreme cases, such as the Soviet’s 70-year experiment with a command economy, the results were so spectacularly bad that – at the end of it – Soviet industry had become ‘value subtracting.’ That is, it mobilized an entire economy to extract valuable resources…to ship them… to refine and process them…and to turn them into finished goods. And at the end of the day, the finished products were so badly made and so out-of-touch with what the market wanted that they were worth less than the resources that went into them!

No one is planning to recreate the Soviet system. Instead, they’re thinking that maybe a little political supervision would be a good thing. And who knows; maybe they’re right. We just don’t know of any theory or experience that leads us to think so.

But the fix is in and who are we to argue with it? Paulson is busily giving $700 billion of the taxpayers’ money away to his friends on Wall Street. The English are trying to save the City. And the French? What they don’t know about crony capitalism – at the public’s expense – is not worth knowing.

To return to a key question: where will the money come from? There are only three sources. Taxes can be raised; you can forget about that right away. No one is going to raise taxes – except symbolically, to punish the rich – in the face of a depression. Or, the money can be borrowed.

“But where is the 360 billion euros coming from?” Liberation repeats our question.

“The government is going to borrow on the capital markets to finance the banks,” comes the answer.

But from whom? And at what rate? Borrowing money adds nothing to the world’s total financial resources; it only takes money from one pocket and moves it to another. That is, it deprives (we presume) worthy borrowers of capital so it can stuff the pockets of cronies and insiders. Overall, there is no increase in purchasing power or available credit. What’s more, as the feds borrow more and more money, it should – logically – drive up interest rates. This should further depress economic activity, making the situation worse.

That leaves the third possibility: print more money.

Hit the bid, dear reader. Hit the bid.

*** Well, the hypothesis, as you know, is that capitalism has failed. And now the politicians have to bail it out. Rather than let Mr. Market express himself fully, Mr. Politician will have his say. And he will say: ‘Hold on…we will put in a bid.”

There is a hot debate in the financial press over the terms of the bid. Should the government buy up Wall Street’s mistakes – as Paulson is doing in America? Or should it ‘recapitalize’ – or nationalize – the banks? How can it force the banks to lend? How can it make sure the money doesn’t end up in the bankers’ own pockets?

“The last successful government program was World War II,” as Jimmy Breslin put it. And we’re not even sure about WWII. So, the likelihood that these bailout bids will do the trick – however they are constructed – is slim.

None of the measures taken by the Hoover and Roosevelt administrations to counteract the Depression of the ’30s worked. Most were irrelevant. Some made the situation worse.

Nor did the measures taken by Japan after its crash in ’89 do any good. It wasn’t as if the Japanese didn’t know Keynes’ theory. And it wasn’t as if they didn’t try to apply it; they gave their economy all the stimulus they could. As to monetary policy, they took their key lending rate down to zero. It couldn’t go any lower.

As to fiscal policy, they took their deficit to 6% of GDP – the highest in the developed world.

Yet, the Japanese slump persisted…and continues to persist, 18 years later.

All the policymakers are doing differently now – as near as we can tell – is increasing the bid. The Europeans are throwing out their Maastricht limits on deficits. And if Morgan Stanley’s chief economist is right, the U.S. will soon run a deficit that will take the world’s breath away – at $2 trillion, or more than 12% of GDP. Over at the Fed, meanwhile, they still have 150 basis points to get down to zero. They’ll get there; we don’t doubt it. Look for another 50 basis point cut, coming soon.

But what will these interventions produce? How can you protect yourself? We have some ideas…which we’ll give you this week…and in a Special Emergency Report we’re working on. Stay tuned. And hit the bid.

*** Chris Mayer has been surveying the wreckage – and he’s found two new buys from his Mayer’s Special Situations readers.

In fact, he tells us, they are old favorites we parted with not all that long ago. “On one we [at MSS] tripled our money and on the other we doubled it. But both have come way back off their highs and we have a great chance to do it all over again.”

Now, you know (much to our dear reader’s frustration) that we don’t give specific stock picks in The Daily Reckoning, but we will give you a little teaser with these two stocks. Without naming names, here’s what Chris can tell us:

“Last time we bought this first stock we more than tripled our money over at Mayer’s Special Situations. After we sold, the stock continued to move even higher.

“Incredibly, the stock has come all the way back down. It hit $84 this year. As I write it is about $19 per share. We bought it in April of 2007 for $21.60. We sold our final half at $63.60 – it’s now nearly 70% below that price.

“And you know what? Not much has really changed. In fact, the stock is cheaper on paper because its earnings are higher now. It goes for about 7 times earnings now and about 5 times next year’s guess…and it has huge macro tailwinds.

“So, we’re going to buy it back and look to triple our money again!”

You’ll have to wait until tomorrow to hear about Chris’s second buy – or you could see for yourself right now.

*** Finally, a word of hope and optimism. We walk on the sunny side of the street, here at The Daily Reckoning.

“Why the recession is a blessing in disguise,” says a headline in the TIMES of London.

According to American researchers, economic downturns can be good for people. When times turn tough, people smoke less, eat less, exercise more, spend more time with their families (especially those who are out of work), drink less and take fewer risks.

Yet, despite all that – they are happier! Yes, levels of contentment were higher in the slumpy ’70s than they were in the go-go ’90s or ’00s.

In a downturn, people slow down. They have the time to reflect. To do different things. To enjoy thrift and appreciate poverty.

Here, a former finance professional describes his new life:

“We’ve decided to go downscale and go to Venice for a bit. We’re in a flat on the Grand Canal, the children are learning Italian, the weather is wonderful and it feels like we can finally relax after ten years of madness.”

Ah yes…downsize, dear reader. Enjoy the simple pleasures…the fresh air of Venice. The sunlight on your cappuccino. The language of Dante as the evening settles over the Grand Canal. And a quiet dinner…just the family…at the Cipriani.

*** Newspapers are losing sales, making losses and missing loan payments. Several are in default. But what are lenders to do? Who wants to buy a money-losing newspaper?

How come the government steps in to save the banks…but not the newspapers? Newspapers are as important to our society as banks. They provide indoctrination…ooops…we mean, information. Without newspapers and other mass media, people would have to think for themselves. No one wants that.

While the government is buying bank shares…and maybe newspaper shares…and then, possibly, auto shares…we hope it saves a farthing for shares in small, struggling financial publishers. Go ahead…make us an offer!

Until tomorrow,

Bill Bonner
The Daily Reckoning