A Grotesque Misnomer
Wealth creation used to be a factor of sweat, blisters, and clock-time. Not in Greenspan’s new world order…to get rich nowadays, you simply have to use your credit card and refinance your house occasionally.
Economic growth now depends crucially on the strength of wealth and profit creation. Mr. Greenspan and the bullish consensus economists claim that America is enjoying its highest rate of wealth creation in history – through rising asset prices.
Fed members are claiming that this is a perfectly normal transmission mechanism of monetary policy. This is an outright lie. Never before have inflating asset prices been a key driver of real economic activity.
To be sure, asset prices have always risen in the early stages of a cyclical economic recovery in response to monetary easing. But such increases do little or nothing to boost economic growth.
First of all, in past recoveries, price rises were generally very limited in size, particularly for housing; and secondly, there was no way to convert the asset inflation into cash, because the reckless lenders of today did not exist. Besides, Americans of the 1960 – 1970s would have been too proud to practice inflated-asset liquidation and too intelligent to mistake it for wealth creation. There is no precedent for such profligate behavior of private households.
Asset Price Inflation: True Wealth Creation
Worst of all, asset-price inflation is not wealth at all. That is strikingly obvious from the macro perspective. The best way to realize this, we think, is a comparison against the true wealth creation that generations before us have experienced and that generations of economists have regarded as the one and only way to greater, lasting prosperity. It comes from investment spending on income-creating buildings, plant and equipment.
Investment spending creates demand, employment and incomes in the first instance through the production of the necessary capital goods. When finished and installed, the new capital goods go into production, creating further employment, incomes and demand. And most importantly, debts incurred in connection with this wealth creation are self-liquidating through the underlying income creation.
And what really happens to incomes and debts in the case of so-called wealth creation through appreciating asset prices? Nothing at all. Generations before us never thought of it as wealth creation. This new attitude arises principally from a general convention to consider total outstanding assets of a certain category as being worth the price of the last trade, however small that trade may have been. Clearly, small trades have tremendous capitalization effects. For good reasons, such so-called wealth creation is not practiced in most countries.
In Japan’s case, the principal beneficiaries of the asset bubbles in the late 1980s were industrial and real estate businesses. In the U.S. case, it is the consumer. But in order to enjoy the wealth effects of rising stock and housing prices, the American consumer had to encumber himself with soaring debts in order to afford the price-driving asset purchases.
For Mr. Greenspan and the bullish consensus it is a virtuous circle, as the overall gains in capitalized asset prices have outpaced the rise in debt levels. Implicitly, the big net gain in asset values can be used as collateral for borrowing, which funds higher spending for consumption.
Asset Price Inflation: Nothing in Common
In their economic effects, these two patterns of wealth creation have nothing in common. The key feature of the capital investment model is correlated increases in current and future incomes. It boosts economic growth both in the short and long run. What’s more, the associated initial rise in corporate debt amortizes itself through the following depreciations.
The striking key feature of so-called wealth creation through asset bubbles in favor of the consumer is, first of all, the associated record production of debt, set against the total absence of income creation. To maintain demand creation through this kind of wealth creation, ever more debt creation is needed – first, to keep the asset prices inflating; and second, to fund the spending on consumption.
Thinking it over, one realizes that "wealth creation" is really a grotesque misnomer for asset prices that are rising out of proportion to current income. The economic reality is not wealth creation, but impoverishment. We repeatedly hear from Americans that they are living in houses or apartments they cannot afford to buy with their present incomes. But many years ago, with incomes and prices as they were at the time, they could afford the houses. That says it all.
The writing has been on the wall for years. In 1996 the American consumer increased his spending on current goods and services by $281 billion, with debt growth of $345.7 billion. In 2000 he spent $456.9 and borrowed $566.9 billion. And in 2003 spending of $367.9 compared with debt growth of $879.9 billion.
Asset Price Inflation: Government Borrowing Soars
But consumer borrowing was not alone in escalating to unprecedented extremes. Government borrowing also soared, in particular borrowing for boundless financial speculation.
In 1997, the U.S. economy grew by $487.4 billion in current dollars, with an overall credit expansion of $1,406.8 billion. That was already an unusually high borrowing ratio. In 2003, it took $2,717.5 billion of new credit to generate nominal GDP growth of $504.7 billion.
Credit excess – always due to artificially low interest rates – implicitly means spending excess. But the problem is that these spending excesses tend to distribute very unevenly across the economy. In the United States, for years, the spending excesses have been overwhelmingly directed towards the whole range of asset markets – stocks, bonds, housing – and in the economy towards consumption.
Given the enormity of these credit and spending excesses, it goes without saying that they have involved tremendous distortions in the economy’s whole structure, being typically located in three areas: first, they misdirect output; second, they distort relative prices, costs and profits; and third, they strain balance sheets.
It used to be true among policymakers and economists that for an economy ailing from such structural distortions, a return to sustained growth is only possible after these have been significantly moderated, if not removed. Mr. Greenspan has plainly opted for the diametrically opposite strategy of fighting economic weakness, regardless of existing maladjustments, through more and more credit excess.
Pointing to the U.S. economy’s rates of real GDP growth, Mr. Greenspan claims full success for his policy. Compared with the far higher rates of growth of past cyclical recoveries, his policy has grossly failed, even by that measure. But considering the horrible development of employment, it has been a policy disaster.
for The Daily Reckoning
May 25, 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."
"Stay the course."
The President’s plan for America in Iraq is America’s plan for everything.
The consumer intends to stay the course – spending more than he can afford for as long as he can get away with it.
The investor plans to remain in stocks – keeping his eye on the north star of ‘stocks for the long haul’ – until he finally crashes into the rocks of a bear market.
Alan Greenspan and his merry band of central bankers have no intention of changing course. Greenspan has just been reappointed for a 4-year term…with the tacit understanding that he keep his hand on the tiller, as blank and unyielding as a dead man.
And so, the whole nation stays the course. Too bad. For "the course is headed over Niagara Falls," said Gen. Anthony Zinni, USMC ret.
Gen. Zinni was speaking about the administration’s war efforts in Iraq. In the general’s view, Bush ought simply to admit the truth: that he made one of the biggest blunders in American military history…and move on.
We do not expect it.
Nor do we expect consumers suddenly to wake up and realize that they are ruining themselves; or investors suddenly to realize that they have been deceived; or Alan Greenspan to stand before Congress and tell the drooling solons that he regrets creating the biggest bubbles in history.
On the evidence, the present course has not been a good one. Americans are further in debt than ever before – financed at the lowest rates of interest in 2 generations.
Nor are they especially well equipped to carry this debt. We keep pointing out that the modern consumer economy is a fraud. Here’s our proof: real wages of the average man have actually gone down for the last quarter of a century. In the year 2002, the typical American man earned 6% less than he earned in 1977. He could only make ends meet by resorting to two desperate measures: he sent his wife, girlfriend and daughters to work…and he went into debt.
Americans believe they are getting richer because their assets rise in value. But stocks are no higher today than they were 6 years ago. And houses? House prices are rising…but this is a curse, not a blessing. It only encourages homeowners to go further into debt, by tapping the ‘equity’ in their houses as collateral.
But there is little chance they will wise up.
Error is rarely cast out. More often, it must be crushed out. That is the majesty and symmetry of nature, dear reader. It is what makes our daily reckoning so beguiling: for every bit of truth and justice…a thousand hearts are broken.
We approach the 60th anniversary of D-Day. Old men are already gathering in Normandy. In England, the TV specials have already begun. We are meant to remember the heroism and glory of it all…the sacrifice…and the victory. Even on the German side, the old men are interviewed and tell their tales. They do not mention that they were on a fool’s errand that would likely get them killed. They seem to have forgotten that they were the fools. Instead, they recall that they were engaged in some great battle…that they were participants in something magnificent…some episode in history that we can all look back upon in shock, awe and wonder.
Here at the Daily Reckoning, what we wonder is why they did it. What possessed the poor grunts on either side to want to do something so grandly mad?
On this day, 60 years ago, 150,000 men…6,000 ships…and untold numbers of planes, tanks, guns and other materiel mobilized for an assault on France.
On the continent, the Germans could not mistake the movement in Southwest England. The roads were full of troops…the ships were gathering and loading…already, there was a buzz in the air. An attack was coming, there was no doubt about it.
But here, again, we pause to wonder at it all. Why did not the Germans recognize their error? On the eastern front, they were already being rolled back by the Russians. On the Italian front, the Americans were kicking their behinds. Wasn’t it obvious that they could not withstand another major front? Wasn’t it obvious that they should admit their error, retreat to their own borders and renounce their plan of global domination?
And what was it to the poor German soldier, anyway? What did he care if Germany controlled France? What did it matter to him whether the Third Reich was in power, or the fourth? Would his beer and sausages taste any different? Would his frau be more fetching one way or the other?
And yet, the Germans stayed the course. They stood their ground…and fought a losing battle for a sordid reason. Today, we marvel at their bravery…and their stupidity.
Grave error begets grave punishment. Niagara Falls, here we come…
And now, over to Eric Fry in N.Y., with an up-to-date, eyewitness report on grave error.
Eric Fry, reporting from The Big Apple…
– Up here in New York, most of us care more about finance than politics. Our voting record proves the point (with all due respect to Senator Clinton). But sometimes, a political headline catches our attention.
– For example, we couldn’t help but notice that the President’s popularity is tumbling almost as rapidly as the bond market’s. According to a recent CBS News poll, 52% of Americans disapprove of the way President Bush is doing his job – the lowest approval rating of his term…so far. Sixty-five percent of respondents also believe the United States is on the "wrong track," up sharply from 55 percent in April and 36 percent a year earlier.
– The declining approval numbers aren’t hard to figure; the Iraqi conflict-cum-public-relations-debacle is undermining the public’s confidence in their Commander-in-Chief. If Bush had halted his militaristic adventures in Afghanistan – and not proceeded through the alphabet of Middle Eastern nations – the Republicans would have already locked up four more years in the White House by now.
– But who knew? Invading Iraq seemed like a good idea to our Secretary of Defense…So what the heck. Perhaps, in the fullness of time, the Bush-Rumsfeld doctrine of pre-emptive anti-terrorism will prove its wisdom. But said wisdom might not become evident to the masses by Election Day.
– The surging oil price might also be eroding the president’s popularity. Voters don’t know for certain if the rising price of oil is his fault, but they know for darn sure that they don’t like spending $50 to fill up their cars…And didn’t that nice man John Kerry promise to help lower oil prices?
– Truth be told, Bush probably doesn’t have any more control over the oil price than he does over the share price of Halliburton, but voters might hold him accountable anyway. Yesterday, crude oil and gasoline futures both soared to new all-time highs on the New York Mercantile exchange. Oil for July delivery jumped $1.79, or 4.5 percent, to $41.72 a barrel. Likewise, gasoline gained 4.1 cents, or 2.9 percent, to an all-time high of $1.458 a gallon.
– This probably isn’t the reaction the OPEC ministers anticipated when they promised over the weekend to begin pumping more oil into world markets. Even though the Saudis, in particular, pledged to ramp up production, the oil price rocketed higher.
– In earlier financial epochs, investors would have turned tail and run at the sight of $40 oil. But in this post-bubble era, investors protect themselves from the inflationary effects of rising oil prices by dumping gold and buying the shares of mortgage lenders. Year-to-date, the oil price has jumped 28%, while gold has fallen 7.5%. Meanwhile, the interest-rate sensitive – and theoretically inflation-phobic – shares of mortgage lender Countrywide Financial have gained nearly as much as the oil price.
– It seems odd – to us anyway – that the gold price would fall sharply while crude oil is gushing to record prices. And it seems doubly odd that the shares of mortgage lenders would rise sharply while oil and interest rates are both soaring…But we don’t make the rules; we just try to remember them.
– Financial stocks rallied again yesterday, but not by enough to lift the Dow into positive territory. The blue-chip index sagged 8 points to 9,958, while the Nasdaq added 13 points to 1,923. At least Mr. Bush still has the stock market on his side…
– The President may also console himself that he is not nearly as unpopular as the 10-year bonds his government issues. These reviled financial assets have fallen for nine straight weeks – the first time that’s happened in 24 years. Almost no one likes bonds, observes Jay Shartsis, a professional options trader at R.F. Lafferty in New York. Shartsis points out that the bullish sentiment toward bonds has fallen to a 17-year low, according to the MBH Commodity survey.
– The paucity of bond bulls also shows up in the CFTC’s Commitment of Traders Report, where the so-called Large Speculators have amassed one of their biggest bearish bets ever on the 10-year bond. From a contrarian perspective, the pervasive negative sentiment toward bonds suggests that a rally may be just around the corner.
– "A rally for bonds should be assigned a high probability," Shartsis concludes. Adding credence to this notion is the fact the so-called Commercial Traders – considered the "smart money" – have amassed one of their biggest ever "long" positions in bonds. In other words, they’re positioning for a bond rally.
– Given these extreme sentiment readings, a bond rally would not be surprising. But given the rapidly mounting inflationary pressures in the economy, any bond rally is likely to be very short-lived.
Bill Bonner, back in London…
*** "Inflation seen as picking up this year," says an AP headline. Everyone believes it. As Eric reports, above, bond investors are sure of it.
We’re sure we don’t want to buy bonds, but we’re not at all sure they are going down. Au contraire, the ‘inflation going up’ theory seems too easy…too predictable…too accommodating.
We recall that in 1994 inflation rose from 2.9% to 3.1% and, similarly, everyone was sure we were at the beginning of a new inflationary cycle. Not so. Inflation then went down…and bonds went up. We wouldn’t be surprised to see a replay.
*** Gold is inching back up. But it is not signaling a major turn in inflation levels. We remind readers, too, that Greenspan’s easy money policies have had two major effects: they have increased the capacity of the Chinese and other low-wage producers to make things…and they have put the American consumer deeply in debt from buying them.
These are the consequences of Alan "Bubbles" Greenspan’s policies. But consequences have consequences of their own. Bubbles do not expand forever. They contract, too. And the contraction phase is a destruction of credit phase…a phase in which American consumers realize they have less money to spend than they thought. It comes at almost exactly the same time that the Chinese realize that they have more capacity than they need. The result, dear reader, is not inflation; it is deflation.
*** We were curious. What really is going on in China and India? Are they just more of Alan Greenspan’s bubbles…ready to burst? We do not trust the financial media, so we sent an intrepid reporter of our own, Dan Denning, to go and look for himself. His first report:
"The business section of the Shanghai daily has some interesting stories. Jack Welch is getting paid $400,000 to give a speech to the Shanghai business community on June 23rd and 24th. For 30,000 yuan, a VIP can get a picture with Welch, admission to two seminars, and a one-night stay at a five-star hotel.
"Seemed to me like the Chinese were being taken for a ride here. But a Mr. Gu Qing says, ‘The majority of the participants only want to spend 4,800 yuan since luxurious hotel charges are considered unnecessary.’