What difference a year makes, huh? 363 days and 75 basis points later, earnings and the economy are still looking beleaguered. This DR Classique was originally broadcast on November 16, 2001.
"Economists say America is unlikely to follow into Japanese-style deflation," said a recent Wall Street Journal article, "because U.S. leaders reacted to their slowing economy much more quickly than Japanese leaders did…"
The question bores most people. But here at the Daily Reckoning, it haunts us like an unsolved crime. Spectators, we sit on the edge of our chairs to see what will happen next.
The U.S. economy seems to us to be following a script written in Japanese. With only an occasional improvisation, and a broad allowance for cultural differences, the essential dialog in America 1995-2001 has been very much that of Japan 1985-1991.
The plot was much the same – hotshot new era meets cold realities of marketplace.
The love interest was identical – investors fell head over heels for financial assets, and abandoned all sense of reason or dignity, and made fools of themselves… The first couple of acts were similar…with rising action in the investment markets and a climactic sell-off.
But now, the curtain has gone up on Act III…and our American audience expects a twist. Unlike the dumb Japanese, U.S. investors and consumers will be saved by the prompt action of the hero, Alan Greenspan, they believe.
Greenspan, wielding his rate-cutting sword, has chopped off 450 basis points in 10 months, while it took the Japanese central bank more than 4 years to do so.
Bullish economists think his speed will be decisive. We are less sure. But then, we see an economy that suffers from too much credit, not a shortage of it. So we doubt that giving it more credit, more quickly than the Japanese did, will make any difference.
Anything could happen, of course. But the Japanese analogy has worked well enough so far. We’ll stick with it.
Most economists, says Dr. Kurt Richebächer in his latest letter, reject the idea that America might follow Japan with a prolonged period of economic stagnation. But these are the same economists who saw no downturn coming the first place…and who expected lower rates to have already perked up the U.S. economy by the 2nd quarter.
Each month, they push back their estimate of when the upturn will happen.
Now that short-term rates have hit 2%, stocks have rallied for a couple weeks, new unemployment claims are down for 3 weeks in a row, and bonds are turning down…these economists, analysts and investors think the worst is behind us.
But, "in April 1992, as the Nikkei appeared to be hitting bottom at 17,000 [from a high of 39,000 a year and a half earlier]" the Wall Street Journal reminds us, "a consensus of a dozen top forecasters still foresaw Japanese economic growth for the following year at between 2% and 3%. It ended up growing at 0.4%. Today, the Nikkei hovers around 10,000 and the Japanese economy is back in its fourth recession of the past decade."
Most economists have no idea when the market will turn up, because they have no idea why it turned down. They believe lower rates can restore economic activity to former levels. But as pointed out yesterday, rates are already below zero in real, inflation-adjusted terms.
And, as mentioned here many times, while it took the Japanese longer to get there, short term rates in Japan have been "effectively zero" for more than 5 years.
Does ineffective medicine work better because it is administered faster?
There are 3 possible effects from lower rates:
They could do the economy some good. They could do it some harm. Or, they could do nothing at all.
In Japan, lower rates seem to have done as much harm as good. "Plentiful credit is financing stagnation," reports the Wall Street Journal, "banks use cheap credit to keep ailing companies on life support."
That’s why, even 12 years after a stock crash, bankruptcies are hitting record highs in Japan. These companies should have given up the ghost long ago. Easy credit has not cured what ailed them…it merely stretched out the period of suffering.
Ignoring the actual experience, economists turn to theory. Since the Hoover administration, they have counted on lowering interest rates and cutting taxes to boost economic activity, thus putting more dollars in the hands of people who would spend them.
But consumer spending does not really make people richer. Consumption is the end result of getting richer…not the means to it. Real prosperity results not from consumption, but from its opposite – forbearance. It is the capital that is not consumed – the savings – that determine how quickly a society gets rich.
Savings can be invested in capital improvements that produce more and better products…and give investors a profit. These profits are the key to everything. They tell us that the effort was worthwhile – that the investment is paying off, making people wealthier. They encourage the business to hire more workers…and spend more on new plant and equipment.
The "old economists", says Dr. Richebächer, knew this. But the new ones seem to have forgotten.
"Ever since Adam Smith published his ‘Inquiry into the Nature and Causes of the Wealth of Nations’ more than 200 years ago," he writes, "it was undisputed doctrine that there is but one single route towards economic growth and the creation of wealth – through saving and capital accumulation in tangible, income-yielding assets.
"Rising capital investment is the one and only component in the economy that pulls up with it everything else that matters in the process of creating growth and prosperity: capacity, production, productivity, output and consumer income…"
Of attempts to induce prosperity by making more consumer credit available, he adds, "only in the alphabet does consumption precede production. But that is what every president and every Fed governor has done in America since the Great Depression." The result? "This country’s economy is geared to rising consumption," Richebächer quotes Simon Kuznets from a 1961 book, "and our institutions and patterns of social behavior encourage higher consumption per capita…Unless in the next few years the private sector can generate savings and capital formation in a greater proportion to a rising product, the pressure in the demand for goods upon the supply of savings will persist."
But instead of increasing savings to meet the new capital needs, gross savings plummeted from a 1950s high of nearly 20% of GNP to personal savings rates near zero today. Instead of saving resources, the U.S. economy consumed it.
"Capital has been consumed and misused," writes Sean Corrigan of Capital Insight. "Everyone would surely be forced to concur that the sooner we cease the first and the quicker we attempt to correct the second, the better it will be for all of us.
"Instead, what do we find? Interest rates are slashed, reserves are injected by the central bank, and the mindless chant. ‘The economy depends on the consumer, the economy depends on the consumer’ is repeated over and over again, as if a farm thrives on the crows pecking at the corn…
"Every extra dollar borrowed by a consumer now puts us all a dollar further from recovery, the debtor a dollar closer to default, and his bank a dollar closer to a bigger loan loss provision than it would have had to face by foreclosing while there was still something to be salvaged."
Will feeding more corn to the crows – that is, making more dollars available to borrowers, cheaper and faster – rescue the situation?
We will see, dear reader, as Act III continues…
November 18, 2002
Our eyes lit up when we saw the headline in the weekend International Herald Tribune.
"Get serious about the threat of a credit collapse," says the editorial page article. The secret of editorial writing is to announce a heartfelt opinion about something which is none of your business and about which you know nothing. David Ignatius, listed as the paper’s executive director, is especially good at it…in the sense that his editorials are particularly ridiculous and, therefore, entertaining.
Thanks to the recent election results, opines Mr. Ignatius, "Bush now has the political power to fix important things that are wrong – not just in Iraq, but in the global economy."
Heck, with Congress behind him, he could probably fix a few things here in France, too – such as all the dog poop on the sidewalks…and the crime problem. (About which, more below…)
And maybe with a few more votes, he could do something about the weather, too.
There is no question in our minds about whether the American president can perform the miracle that Ignatius imagines, but what puzzles us is what he thinks Bush was waiting for? Who was there in Congress who didn’t want him to ‘fix’ the global economy? Not even a Democrat would stand in the way of that.
No matter. Whoever was barring the route to worldwide prosperity is now out of the way. Now, the greatest American president since Bill Clinton can "get serious" about the threat of a credit collapse. But what can he do?
Ignatius makes a couple of lame suggestions – such as "finding a serious financial expert to succeed Harvey Pitt." And now "Bush has the clout to impose real regulation on Wall Street and thereby restore confidence in the global financial system."
If only that were all there was to it! Ignatius notes that bond defaults in the last 2 years have exceeded the total of the previous 20 years. Will ‘real regulation’ suddenly make the bad bonds worth something?
"To oversimplify," warns Stephen Roach, "assets are about today. Liabilities are about tomorrow." In the heyday of the bull market, people seemed to care only about assets. They were going up…and it didn’t seem to matter about tomorrow. You could promise anything you wanted…borrow as much as possible…spend like tomorrow would never come.
But, oops, here it is – tomorrow. It’s the post-bubble economy…with a serious case of post-party blues.
The liabilities were based on unrealistic growth expectations, says Roach. Pension funds, insurance companies, stockholders, bondholders, money-market funds, mutual funds – all are suffering.
And not just in America.
Japan has an estimated 47 trillion yen worth of non- performing loans.
In Germany, nearly one out of every three insurance companies is expected to go broke.
And in the U.S., "as bad luck would have it," Roach continues, "the retirement of ‘baby boomers’ has commenced at just the point when the post-bubble mark- down of asset returns has occurred… There can be no escaping the endgame…"
The standard of living will fall in America, Roach believes, while the U.S. government tries to reflate.
Unless Bush can make it yesterday again.
Over to you, Eric…
Eric Fry, reporting from New York…
– The Dow Jones Industrial Average is advancing like a 1950s football team – "three yards and a cloud of dust." The blue chips aren’t gaining ground very quickly or very artfully, but they are gaining ground nonetheless.
– Last week, the Dow added 42 points to 8,579. "[That’s] just 41 points above where it sat on Oct. 21," Barron’s observes. "Since that date, the market has paced between 8,317 and 8,771, a mere 5% range that passes for stasis in a viciously volatile year." The Nasdaq Composite outpaced the Dow last week by jumping 3.8% to 1,411.
– While stocks moved ahead, bonds, gold, oil and the dollar all retreated. Spooked by the faint apparition of a recovering economy, investors dumped long-term Treasury bonds to hide out in short-term T-bills and money market funds. The yield on the 10-year Treasury jumped back above 4% to finish the week yielding 4.02%.
– Adding fuel to the selloff was the surprising news that wholesale prices in October registered their biggest increase in nearly two years. The producer price index spiked 1.1% last month, which temporarily silenced all the chatter about deflation. So far this year, producer prices have risen 2%, more than reversing the 1.6% decline recorded in 2001.
– Earlier this week, Alan Greenspan characterized the prospect of inflation as "remote." Maybe so, but the possibility seems somewhat less remote when producer prices jump 1% in a single month.
– Still, the inflation/deflation debate rages on, and the economy generously offers a little something for both points of view. Those in the deflation camp can point to this week’s industrial production report. Industrial output tumbled 0.8% in October, the third consecutive monthly decline. Meanwhile, capacity utilization dropped 0.6% to 75.2% – its lowest level since March. Not surprisingly, therefore, inventories are once again on the rise.
– These dismal economic reports did little to dissuade the bullish hordes from buying stocks on Friday. "Buy the dip" is back in vogue. The trading pattern in the market these days goes something like this: A major item of bad news crosses the newswires, Dow dives 50 points, more bad news crosses the wires, Dow dives another 50 points, stocks thrash around for a few hours, stocks rally into the close of trading.
– "What’s interesting is [investors’] willingness to buy below a certain price range regardless of bad news," writes Adam Lass, editor of the Q-Wave, the highly successful option-trading service. Such nonsensical buying has created a market with a split-personality.
– "My compadre, Brit Ryle, called the market ‘schizophrenic’ in a recent Taipan Trader alert," Lass writes in a Friday communiqué to subscribers. "This term is frequently used erroneously to describe a person – or in our circle, a market – suffering from a split personality. Schizophrenia actually describes a group of psychotic reactions characterized by withdrawal from reality with accompanying affective, behavioral and intellectual disturbances.
– "However, I do think Dementia Praecox (as Schizophrenia was known in the bad old days) is quite the appropriate term for this market. Surely the past two days’ rally on the news that Iraq was conceding to the UN’s demands was an escape from reality. Think about it: Tariq Azziz has issued that press release so many times over the past decade, all he does now is Xerox it and scratch out the dates."
– Adam and his partner Bryan Bottarelli expect the market to break out of its trading range fairly soon…by heading south. Still, these flexible traders are not hesitant to reverse their outlook, if their indicators suggest a different course of action.
– A heartfelt Daily Reckoning farewell to Jeffrey Applegate, the latest cardboard-cutout strategist to lose his cushy Wall Street job. The perennially bullish Applegate was but one of 500 employees culled from the herd over at Lehman Bros. Last month, as you may recall, Credit Suisse First Boston dismissed its own optimistic market guru, Tom Galvin. And last week, Merrill’s glass- half-full chief economist Richard Steinberg lost his job.
– Applegate, a strategist of no particular distinction, tried to distinguish himself throughout the 1990s by monotonously predicting much higher prices for the stock market, no matter how high the market had already climbed. For a while, of course, he was a "genius." But his genius peaked sometime around March of 2000. Bullish to the bitter end, Applegate currently recommends that investors dedicate 80% of their portfolios to stocks – that’s one of the highest percentages on Wall Street.
– We will miss Applegate’s woefully misguided forecasts. And we will especially miss the smug confidence with which he espoused his views, coupled with the arrogant disdain he cast upon anyone who disagreed with him…Fare thee well, Jeff!
Back in Paris…
*** Paris can be a tough city for a teenaged boy. Jules, 14, grew tall over the summer, but he is as thin as a 10- penny nail. Yesterday, he was mugged on the subway. His report:
"I was with Igor and François. We were on our way to Igor’s house on the RER (one of the subway systems). We got out at the station and these two Arab guys started giving us a hard time. One of them was real big and looked mean.
"We tried to joke with them and get rid of them. But the station was deserted.
"They stopped us and the big one said, ‘Let me have your wallets.’ It was almost as if he were joking, but then he said, ‘You don’t want me to get out my knife.’
"Igor gave him some money. He asked me if I had a cellphone. I said I didn’t.
"The other guy told François to give him some money. But François must have been a little slow to get out his wallet or something, because he punched him in the stomach. Then, they left.
"So, we went to the police station and explained what had happened. The police said something like, ‘Those dirty Arabs are at it again.’
"They put us in the police car and drove around asking us to look for the guys. And, they were such morons; there they were standing right there in front of the métro station waiting for their next victims.
"So, the police stopped and arrested them. The Arabs were really nasty and called the policemen a lot of names, but the police didn’t seem to pay attention. I thought they were going to beat them with their clubs or something. Instead, they just brought them back to the police station and when they got there, one of the policemen recognized them.
"’Hey, this is the guy we arrested yesterday…’ he said. They had caught him on Saturday. Those guys had been arrested 10 times. But they just let them go.
"We filled out our complaints and left.
"Then, when we were on our way home, we saw two Arab guys standing in the métro at Trocadéro. They saw us and started coming towards us. We just turned around and ran in the other direction."