An Even Better Trade of the Decade, Part III
The final installment of our speech in Las Vegas…on why you can’t engineer a genuine recovery…and why GDP is just a number…and why China will blow up…
The problem with trying to engineer a ‘recovery’ is the same problem with all central planning – it substitutes the honest signals from the marketplace with imposters. For example, instead of getting the message that they need to conduct their business in a different way, the banks get the idea that the feds will always bail them out…and automakers – thanks to the Cash for Clunkers program – may get the idea that there is more demand than there really is…and everyone could get the idea that the economy is healthier than it really is, thanks to the feds $1.5 trillion deficits.
The authorities are trying to force the economy back into the shape it was in before the crash. They’re preventing it from taking a new, better shape…and preventing the correction from doing its work. A correction is supposed to cleanse out the mistakes from the 50-year credit expansion. But it’s hard to do so when you don’t know what is really going on.
Markets – when they are allowed to do their work – are always in the process of discovering what assets are worth. They were doing a good job of it in the fall of 2008. They were discovering that the US had too many houses, and too many shopping malls, (the US has 10 times as much retail space per person as France…) We also had too many derivatives backed by real estate, and too many private equity deals based on too many optimistic assumptions about the future.
[Anyway you look at it, we have, as Paul Volcker puts it, a “long period of economic adjustment” ahead of us. The feds are just getting in the way…and making it even longer.]
The market was in the process of discovering what assets were worth when the feds stepped in. They stopped the process of discovery. Instead, they forced the market into a process of Price Hiding.
Probably the most dramatic example of price hiding has been in the financial sector itself. There, the feds took away the risks of bad debt from the bankers and put it on the general public. The Fed bought the toxic loans, transferring hundreds of billions of losses from the banks’ balance sheets onto the balance sheet of the Fed.
The Fed also lent the banks money at near zero percent…and then the federal government borrowed it back. The banks were able to make profits without doing any work or taking any risks. No wonder they didn’t lend money to private businesses or consumers. It was too much trouble. And they didn’t have to.
If you look at the latest figures from the Fed you will see that private credit is still falling. Commercial and industrial loans in March fell 16%. Asset backed commercial paper fell 20%. This correction, by the way, marks the first major reversal of commercial and consumer credit since WWII.
And now the Treasury has the gall to tell the public that it made money from its ‘investments’ in the banking sector. If so, those were the most expensive profits in the history of finance. They cost the nation about $4 trillion in fiscal stimulus deficits – added to the national debt. And another $1.8 trillion worth of dodgy debt on the FED balance sheet. And about $6 trillion more worth of financial guarantees of various sorts.
If the SEC wants to redeem itself, it should forget about the small fry. It should get off Fabulous Fab’s case and go after the real frauds in this case…Ben Bernanke and Tim Geithner.
That won’t happen. But everything regresses to the mean. That’s the work of a correction – to bring things back to normal, back in balance. First, the private sector is corrected. And then, the public sector.
When something is out of balance on one end, you can be sure it’s out of balance on the other side too. Americans consumed too much during the Bubble Epoch. Now, they need to save and produce more. But who was on the other side of this trade…?
Let’s begin by going back to the 1920s. Back then, the USA was the industrial powerhouse of the world and its number one exporter. In those boom years, America had the largest trade SURPLUS on the planet. At the time, trade balances were settled in gold. So, the US built up the world’s largest reserves – in gold. It still has them.
But that pile of gold didn’t keep the US from financial trouble. The stock market crashed in ‘29 and the following two years cut the US GDP in half.
It took the stock market 27 years to recover.
In the 1980s, Japan had the biggest trade surplus in the world. You remember Japan, Inc? It was such an export success story that people worried that the Japanese would take over the world. But in 1989, Japan, Inc. peaked out. Its stocks have been going down ever since – 20 years already.
Now, it’s China’s turn. China has the world’s largest trade surplus and its largest pile of reserves. (Unfortunately for China, after 1971, treasuries switched to using paper dollars for reserves. So China has one enormous pile of paper…not gold.)
Thomas Friedman wrote that he wouldn’t bet against a country with more than $2 trillion in reserves. But does this pile of paper money guarantee that China cannot fail? To the contrary, history tells us that China is most likely to fail – spectacularly – even though, over the longer run, like the US after the ‘30s, China may turn out to be a great success story.
Everything regresses to the mean. Everything tends to go back to normal.
Corrections are normal. They help things get back in balance.
Now, here’s the interesting thing. While Japan’s government tried to prevent it, the Japanese private sector de-leveraged. Over a long period of adjustment – 20 years – the household, business and financial debt went down by about 40%, in GDP terms.
And now, in the US, even though the government tries to hide prices and delay the correction, the private economy is still de-leveraging. The latest figures suggest that households took a little pause in the first quarter of this year. Savings actually went down as consumption went up. But if we continue to follow the Japanese example the de-leveraging should resume soon.
We know from the Japanese history too – if we had any doubt about it – that price hiding doesn’t work. First, they tried fiscal stimulus. That didn’t do anything. The banks took the monetary stimulus and held onto it, just as US banks are doing now.
Then, they tried fiscal stimulus. Now, this deserves a little discussion. Because Richard Koo among others argues that the fiscal stimulus did work in Japan. He points out that Japanese GDP did not drop significantly – thanks to massive doses of fiscal stimulus. And now, Paul Krugman and others are saying that fiscal stimulus has worked in the US too…because our GDP only went down less than 3% in what they call the Great Recession.
Here is where we see the claptrap theories at work. Fab Finance turned the economic profession from historians and philosophers into mathematicians and engineers. Dozens of these fellows won Nobel Prizes for elaborate mathematical proof of what were essentially bogus or inconsequential ideas.
And now they turn to GDP as proof that fiscal stimulus works, without bothering to think about what is really going on. GDP measures economic activity. Like everything else in modern finance, it is sensitive to quantity and completely ignorant about quality. To borrow from Oscar Wilde, it knows the price of everything but the value of nothing.
Yet, here again, as the Soviet Union showed us, you can summon up all the GDP you want. Just divide the country at the Mississippi. Get half the population to dig a big hole in Tennessee…and get the other half of the population to fill it up. Imagine the trucks…the fuel…the machinery…the labor…the housing you’d need… GDP would go up. You’d have full employment. Modern economists would be content with themselves. They’d sit by the phone, waiting for the Nobel committee to call.
But what would you really have?
You’d have Japan! That’s what the Japanese did. Well, not quite like that… They put people to work building roads and bridges…pouring concrete on a massive scale. Until then, Japan had the healthiest government finances in the world. Now, it has more government debt/GDP than any other nation – approaching 200%..
And think about what really happened. Japan’s population is getting older. These are people who lent the government money so that it would be safe. They wanted to be sure they’d have the money they needed when they retired.
But where is that money? It has literally been poured into a hole in the ground. The savings of an entire generation have been turned into bridge abutments and canals – most of them unnecessary and many of them unwanted.
That is what is happening in the US too. Except we don’t have enough savings to finance our own holes in the ground. We’re more like Greece.
And like Greece, we will pay a high price when the final correction comes.