A Critical Juncture

Economic downturns are generally caused by monetary tightening responding to rising inflation rates. Clearly, this has not been true for the U.S. economy’s present slowdown. Instead, the current slump happened against the backdrop of runaway money and credit growth and plunging interest rates.

This economic downturn had very different causes. The single most striking cause was the profit carnage, which acted as a savage depressant on business fixed investment.

It is now fully two years since the U.S. economy went into recession. And for the first time ever, business fixed investment – the key to economic growth – has continued to decline through the recession, with the growth of net fixed investment at an historic low.

The mainstream explains today’s persistent investment drought by referring to low demand and existing idle capacities in business inventories. But its obvious, original cause was the profit carnage that started in 1997, at the height of the U.S. economy’s boom.

Economic Downturns: What’s Been Ravaging Profits?

This apparent explanation, however, only raises a subsequent question: what has been ravaging profits?

America’s profit malaise is nothing new; it started in the late 1970s. Until then, profits of non-financial corporations had fluctuated around 8% of GDP. A steep plunge in the following years slashed it to half that level. From then on, there were only feeble recoveries. In hindsight, the 1980s clearly emerge as the critical juncture in the development of the U.S. post-war economy.

But what explains that sudden, drastic rupture in the profit performance? The fact is that the U.S. economy experienced a variety of changes to its structure in the 1980s that significantly altered its whole growth pattern, some of which were highly detrimental to business profits.

The most striking and hotly disputed novelty in the U.S. economy’s new pattern of growth was, of course, the surging trade deficit. It started in 1982 at $11.4 billion, after a surplus of $5 billion in the prior year, and peaked in 1987 at $167.4 billion, equal to 3.5% of GDP.

Just as striking and also hotly disputed was the equally soaring federal budget deficit. After a steep jump in 1982 to $161.3 billion, from $85.5 billion the year before, it peaked in 1985 at $225.7 billion, equal to 5.3% of GDP.

While the twin deficits almost monopolized the public attention, rather dramatic changes occurred simultaneously in the financial behavior of both the consumer and businesses. Both suddenly discovered the joys of unrestrained borrowing. Over the three post-war decades until 1980, the consumer ran up an overall indebtedness of $1,404 billion. He boosted that in the following 10 years by 158% to $3,624 billion. Business debts soared over the same time almost in lockstep by 153% from $1,474 billion to $3,735 billion.

Economic Downturns: Two Macroeconomic Effects

The consumer’s new borrowing binge essentially had two important macroeconomic effects. In the late 1980s, consumption had accounted for 70% of GDP growth, a record high that compared with a share of 63% in the late 1970s. Its flip side was a decline in the consumer savings rate over the decade, from 10% to 7.5% of disposable income. But given the bursting budget deficit, the net national savings rate – domestic funds and resources available for net new investment – dropped to an unprecedented low of a little over 2%, less than one-third of its historical average of 7.5%.

In the case of businesses, the new proclivity to reckless borrowing went together with a drastic change in the use of the proceeds of borrowing. Businesses borrowed increasingly for financial transactions – including mergers, acquisitions, leveraged buyouts and stock repurchases – and decreasingly for growth through investment in new plant and equipment. As net new investment of the nonfinancial corporate sector progressively lagged GDP growth, the economy’s capital stock fell sharply as a percent of GDP.

Nonfinancial profits increased between 1981 (a recession year) and 1991 by 37.6%, from $159.6 billion to $219.6 billion. Measured as a share of GDP, they declined from 5.1% to 3.7%. It was a profitless expansion.

In hindsight, the U.S. economy in the 1980s already had the key features of a bubble economy, though at a much more modest scale than in the late 1990s. While profit margins fell, stock prices on average more than trebled. Yet American economists preferred to focus their attention on the “productivity miracle” and other fictitious explanations for America’s boom-time economy.

It has always utterly amazed us how anybody with some knowledge about the essence of economic prosperity could ever have hailed this pronounced shift in American corporate strategies away from investment in tangible assets towards investment and speculation in financial assets as an expression of superior, new corporate governance.


Kurt Richebächer
for The Daily Reckoning
March 3, 2003

P.S. Cynically, one might say that the changes of the 1980s reflected a managerial revolution. They did, of course, but the changes were all of the worst possible kind from the perspective of long-term growth.


“Too Much of Everything,” said a Business Week article, pointing out that overcapacity is forcing price cuts, hurting corporate profits, and reducing employment. But if BW has caught on to the deflationary slump, does that mean it’s over?

The prices of most ‘things’ are falling. Televisions fell by 10% last year. New cars were down 2%. Furniture dropped 1%.

But prices for services are rising. Funeral expenses rose 4.3%, according to the Bureau of Labor Statistics. College tuition went up 7%. The cost of filling your car’s tank posted a 25% increase. (Crude oil has nearly doubled in price in the last 14 months.)

Why are services rising while the prices of things are going down? The simple answer: you can’t get your hair cut in China.

(On his recent visit to Granada, Nicaragua, your editor discovered that he could get his hair cut for just $1.35. He liked the price so much he wished he could have his hair cut twice and save two times as much money. But that is the problem with services. You can neither export them easily, nor can the traveler stock up.)

From the Hindu Kush in the West to the Eastern-most Indonesian islands, Asia is home to more than 3 billion people – 60% of whom are below 30 years of age. Almost anything that can be manufactured in America can be built at less expense, and faster, in Asia. That’s why prices on things that can be imported are generally headed down.

But can Asia produce new goods faster than the Fed can produce more dollars? Ah…there’s a question! The U.S. trade deficit is headed towards $600 billion. Government deficits are expected to come in at about $400 billion. Hey…that’s about $1 trillion…or about 10% of the nation’s GDP. The savings rate in the U.S. is only about 3%. Even if every dollar of the nation’s savings were used to fund these deficits, there would still be a huge shortfall. The money has to come from somewhere. Perhaps out of thin air? Foreign lenders have been getting worried; they sold the dollar last year (it fell 18% against the euro)…and may sell even more in 2003.

“The dollar is not just in decline;” writes Jimmy Rogers, “it’s a mess. If something isn’t done soon, I believe the dollar could lose its status as the world’s reserve currency and medium of exchange, something that would lead to a huge decline in the standard of living for U.S. citizens like nothing we’ve seen in nearly a century.”

“Whenever there has been an economic crisis like this,” Rogers continues, “a new player has always emerged on the economic landscape. A century ago, few people would have believed that the dollar was going to emerge out of the 19th century as the dominant world currency. There’s always a phoenix that rises from the ashes. Who will it be for the 21st century? My guess is the Chinese yuan may eventually have its day in sun. The nation has a recipe for a sound currency – a huge population, an enormous balance of payments surplus, and a sizeable GDP to match. China is now the world’s largest importer and the world’s second largest creditor (Japan is first). For the moment, its currency is not convertible, which must change now that it has been admitted to the World Trade Organization. There are still a lot of cultural barriers to get over – rampant xenophobia and fear of capitalist interests – but nothing assuages fears like steady flows of money into your coffers.”

Over to Eric Fry, with this morning’s report from Wall Street:


Eric Fry, reporting from Wall Street…

– “Never sell a dull market short” is one of the many “old saws” on Wall Street. And as old saws go, this one is pretty accurate. The phrase literally means that an investor should not bet against a sleepy market. That’s because, oftentimes, the stock market will become “dull” immediately before an explosive move to the upside.

– For the past few weeks, stocks have been oscillating between dull and comatose. They’ve been drifting in a narrow trading range since late January, while the trading activity has been light and languid.

– “With most long-term investors standing down for lack of confidence,” writes Barron’s Michael Santoli, “the daily activity in the current environment reflects the efforts of agitated traders feinting and sniping for momentary advantage. The major market indexes last week alternated down and up days through Thursday, then went nearly still on Friday.” After all was said and done, the Dow fell 127 points for the week to finish at 7,891, while the Nasdaq Composite dipped less than 1% to 1,337.

– We have no idea what the somnolent trading action on Wall Street might portend, but we love guessing games. So we’ll hazard a guess: the Dow will soon break out of its one- month trading range between 7,700 and 8,100 by rallying a few hundred points…Remember, this is not a prediction, merely a guess.

– Furthermore, our long-term bearish posture toward richly priced U.S. stocks remains an inviolate article of faith. In other words, it’s tough to get rich buying richly priced stocks hoping they will become more richly priced. And the U.S. stock market remains a pretty pricey equity bazaar.

– Like stocks, gold and the dollar both spent most of last week napping. The yellow metal dipped $1.50 to $350.20, while the greenback slipped less than half a percent against the euro to $108.00.

– By contrast, the energy markets were as raucous as a fraternity party. Heating oil for March delivery rocketed about 15% to $1.26 a gallon – that’s record-high territory. Natural gas also vaulted to an all-time high of $11.90 per million BTUs, before easing back to “only” $8.10 – a whopping 28% gain for the week. Crude oil soared to nearly $40 a barrel, before settling with a $1.02 gain for the week at $36.60.

– No one knows quite what to make of the energy markets…neither the bulls nor the bears. Are prices spiking higher due to a short-term squeeze, or is there something more serious afoot? For what it’s worth, the stock market crowd seems dubious that the recent pyrotechnics in the energy markets presage a massive bull market in energy products.

– Stock investors greeted last week’s massive rally in the energy complex with a yawn. The XNG Index of natural gas stocks gained little more than half a percent, while the XOI Index of oil stocks ended the week almost exactly where it started. What’s more, both of these energy stock indexes are well below their record highs set two years ago. This is not the sort of action one would expect to see if the energy rally were “for real.” Watch this space.

– U.S. consumer confidence is plunging, but that’s only part of the story. Taking a peek inside the Conference Board Consumer Survey for February shows just how dispirited the consumer has become. The once-sacrosanct summer vacation is now on the chopping block along with most other discretionary spending items. “Only 42.0% of U.S. consumers stated that they intend to take a vacation in the next 6 months,” observes Greg Weldon, eagle-eyed macro-analyst of Weldon’s Money Monitor. “This [percentage] marks a new secular low, surpassing the August 2002 low of 42.2% and down hard from December’s reply of 43.3%.”

– The only traveling some folks will be doing this summer is “hitting the pavement” looking for work. The nation’s job market is becoming increasingly inhospitable, according to the survey.

– Only 11.2% the respondents say that jobs are plentiful, compared to the 18.2% who held that optimistic viewpoint one year ago. On the flipside, 30.1% of respondents say jobs are hard to get, well above the 22.6% reply posted a year ago. “Most tellingly,” says Weldon, “observe that the percentage of U.S. consumers saying a job is hard to get is triple the percentage who say a job is easy to get.”

– Rising unemployment and falling share prices make Mr. Economy a dull boy.


Back in Paris…

*** What will America’s economy look like in the years ahead? We have two models – Japan and Argentina. In Japan, 14 years after its bubble economy popped, unemployment has risen to its highest level since WWII. But Japan’s misery has been relieved by a deep cushion of savings. And even its worst joblessness rate in 50 years is still better than the equivalent in North America or Europe.

Meanwhile, a headline from the New York Times tells us about life on the pampas – “Once secure Argentines now lack food and hope”.

*** My friend Rachel is always cheerful. It is amazing when you think about it. Her sister was killed by Rachel’s brother-in-law…who then shot himself…her parents both died recently…and her son, who must be about 30 years old now, is severely retarded.”

*** Your editor’s 82-year-old mother recently returned from a visit with relatives in America. She took the occasion of a long drive to the country to bring him up-to-date.

“Life is very hard for some people…and yet they don’t show it at all, whereas other people seem to have everything go well, but they are often very unhappy…” she continued.

“I admire your sister so much. Oh…I don’t think I told you about the terrible things that happened at your brother-in-law’s church…

“…well, first there was the deacon who had taken up with, was it the organist…or one of the kindergarten teachers? And he was married…so your poor brother-in-law had to straighten that out…I think both of them left the church…

“…and then he had a couple of kids who were too old for kindergarten, but their mothers would leave them in with the smaller children…and they were causing trouble. You know, they turned off the Bible show on TV and put on cartoons…that sort of thing. Well, he finally had enough and told the kids to leave the nursery and go back to their parents. Of course, this set the mothers off – and they complained, openly – in church – that he was a hypocrite…and they said terrible things…and sent around email messages to everybody….and had everyone up in arms…

“…and all because of a couple of misbehaving children…

“…well, it weighed heavily on your brother-in-law. He is building a big new sanctuary…the church is growing…and now this… Margaret [your editor’s sister, and the minister’s wife] was afraid he was getting an ulcer…So, she called a few of the key people in the congregation to her house. I think she must have read them the riot act or something…because, after that, the whole thing seemed to blow over. I think the women who were causing trouble left. It’s a terrible thing for a church to have to get rid of people…but sometimes, I guess you have to…

“I guess it’s easier to run a business than a church…at least you can fire people…”