Why There's No Employment Growth in America's Profit Centers

The financial markets seem to have caught a runny nose. But at this point, it’s hard to say if it’s the runny nose that follows a mild allergic reaction or the one that precedes a life-threatening pneumonia.

Despite a chronic case of the sniffles, the stock and bond markets of the world have performed reasonably well for most of the last of the two years. Even though the financial markets are acutely allergic to most strains of credit distress, Dr. Bernanke’s “Liquidity Elixir” has provided an effective antidote so far.

Even so, we suspect the elixir is treating symptoms, rather than the disease itself. Debt liquidation — either by repayment or default — continues to hobble economic growth worldwide, and also to terrify stock market investors.

Economies usually thrive when private-sector credit is expanding, and struggle when private-sector credit is contracting. The latter circumstance is the one that pertains today. To make matters worse, public-sector credit is expanding.

In effect, the US Postal Service and the IRS are increasing their indebtedness, while Apple Computer and ExxonMobil are reducing theirs. Unfortunately, “cost centers” like the IRS do not create employment growth; “profit centers” like Apple Computer do.

Therefore, when a country’s profit centers are retrenching, its job-creating engines will also be retrenching. And when a country’s job-creating engines are retrenching, nothing good can happen. Employment growth stagnates and credit distress accelerates throughout most parts of the economy.

Welcome to America, 2011.

Despite trillions of dollars of federal stimuli, the US economy can’t seem to shake off its hangover. Businesses are slow to invest and slow to hire. As a result, household finances continue to deteriorate…and defaults continue to mount.

Not surprisingly, many of the world’s largest financial institutions are just as sick as they were three years ago. And many of the world’s largest governments are even sicker. Dr. Bernanke’s elixir may be able to work wonders, but it can’t work miracles.

Bad loans go bad…eventually.

Bad loans go bad, no matter whether the borrower is a mortgage-holder who “bought” more house than he could afford or a government that promised more benefits than it could afford.

The only time a bad loan “goes good” is when a central bank or a national treasury or some other “angel investor” intercedes to rescue the lender from his own incompetence.

The problem with this selective intercession is that it alters the course of history for selected institutions or individuals, but not for the economy at large. Selective intercession is a sand castle. It might divert a wave or two. But after three waves, you would never know the thing was ever there.

Three years after the bailouts of 2008, the sand castles of government intervention are gone. Only the pounding surf of debt liquidation remains…and the surf is pounding away, both at European governments and at American households. As such, the signs of credit distress are increasing.

These signs take various forms. But one of the most telling forms is the direction of LIBOR interest rates. LIBOR stands for “London Interbank Offered Rate.” It is the rate at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank lending market).

In most circumstances, LIBOR rates track short-term Treasury rates. But in the midst of crisis conditions, LIBOR rates tend to spike, while Treasury rates fall. That’s exactly what happened during the credit crisis of 2008, as the chart below illustrates.

The Spread of 6-Month LIBOR Rates Over 6-Month T-Bill Rates

In the depths of the crisis, LIBOR rates soared, reflecting the reluctance of banks to lend money to other banks. The more worrisome the crisis seemed to be, the higher LIBOR rates climbed. As such, the LIBOR rate functioned as a kind of “fear gauge.”

And so it remains…

The Spread of 6-Month LIBOR Rates Over 6-Month T-Bill Rates

During the last few weeks, LIBOR rates have been on the rise once again. They have not risen high enough to sound a distress signal, but they have risen high enough to raise an eyebrow.

Let’s call it an early warning sign.

So whatever else you may be watching to guide your investment decisions, don’t forget to watch LIBOR.

Eric Fry
for The Daily Reckoning