Corporate Self-Mutilation

To create wealth through rising asset prices is the one great fallacy and folly in America’s shareholder value model. To create business profits through mergers and acquisitions and cost-cutting is the other big fallacy and folly that has done great and lasting damage to the economy. The reality is that Corporate America’s profit performance has persistently gone from bad to worse since the early 1980s.

The thing to see is that this has happened not despite these new strategies, but because of them. Narrow-minded microeconomics, focusing exclusively on shareholder value, clashed with the compelling, opposite laws of macroeconomics. What looked like new, highly sophisticated microeconomics was, from the macro perspective, utter economic nonsense.

By manipulating share prices upward through grossly overpaid mergers and acquisitions, managers satisfied their shareholders and themselves. That is, of course, the aspired, supreme goal of America’s new equity culture.

But unfortunately, the spectacular and highly desired positive effect on market valuations implies a whole variety of macroeconomic effects – on profits, business fixed investment, debt levels, balance sheets, interest expenses, corporate net worth, the current-account deficit – that, on balance, overwhelmingly harm the economy. It is virtual corporate self-mutilation.

Microeconomics: Back to the 1980s

Trying to assess the past, present and future, we have traced and explored the development of these harmful effects in detail back to the 1980s. As to the most recent developments, we have to say that across the board, these features and signs lack any meaningful improvement, suggesting to us that the U.S. economy is close to a relapse into recession.

America’s economy is by long tradition a high-consumption economy, with low rates of saving and investment. Remedying this structural deficiency was the declared primary aim of the much-heralded supply-side Reaganomics. In hindsight, it is evident that this experiment grossly failed on all accounts. Rather, national savings and net capital investment plunged to unprecedented new lows. Profits and net investment, two other key measurements, were virtually flat over the whole period, implying for both a steep fall as a share of GDP.

As promised, the economy was effectively restructured, but exactly opposite to the declared intention. In 1989, personal consumption accounted for 65.5% of GDP, as against 62% in 1979. At the same time, the share of gross fixed investment in the nonfinancial sector shrank from 12.9% to 11.1% of GDP. National saving temporarily fell to 2% of GDP, compared with an average of almost 8% in the 1970s. The current account of the balance of payments exploded between 1981-87 from a small surplus into a deficit equal to 3.5% of GDP.

What propelled the economy’s growth during these years was definitely not booming corporate investment on the economy’s supply side, but soaring credit and debt growth on the part of consumers and the federal government, driving the economy’s recovery from the demand side.

Microeconomics: Casino Capitalism

Corporations, too, stepped up their new borrowing. For the first time, though, it was not for new investment, but mostly for mergers, acquisitions, stock repurchases and leveraged buyouts. As corporate debt soared while new investment lingered, the corporate sector’s net worth suffered a steep decline. It was the obvious beginning of America’s casino capitalism, in which corporations are supposed to make money without any regard to the real economy. Measured by the GDP aggregate, economic growth appeared quite stellar, yet its pattern and structure was grossly imbalanced. After a brief, sharp spurt, business fixed investment faltered again. Business profits went nowhere, while the economy’s current account skyrocketed temporarily into a huge deficit.

Assessing an economy’s development, we focus, first of all, on two aggregates: trends in net investment and profits of the nonfinancial sector. During the 1980s, both went nowhere in the United States. Measured as a percentage of GDP, they ended the decade at record lows.

Far from improving the economy’s supply side, Reaganomics drastically ravaged it.

We come to the 1990s. Actually, they divide into two strikingly different parts. For the consensus, the years until 1996 are the bad part with sub-par economic growth, while the following years became the great, new paradigm years.

Healthy economic growth, as we have stressed many times, shows primarily in high rates of capital formation and profit growth. Both always go together. By these two measures, the U.S. economy performed best in the first half of the 1990s and miserably in the 1980s and the late 1990s.

Microeconomics: The first Half of the 1990s

Actually, profits and net capital formation had their most excellent performance in more than two decades in the first half of the 1990s. After their protracted, poor growth in the 1980s, both suddenly took off in steep upward curves.

Before-tax profits of the nonresidential and nonfinancial sector soared from their recession-low of $226.5 billion in 1991 straight towards $504.5 billion in 1997, more than doubling within six years. Even more impressive was an unprecedented steep rise in nonresidential net investment from barely $100 billion in 1991-92 to $407.3 billion in 1997, virtually quadrupling. It was a typical investment- led cyclical recovery.

Now compare what happened to these two crucial aggregates in the following three new-paradigm boom years from 1997 to 2000. Profits abruptly slumped from $504.5 billion to $423. Nonresidential net investment continued to grow from $299.7 billion in 1997 to $407.3 billion in 2000, but it did so at a sharply slower pace than in the seven years before.

We have reviewed this recovery of the U.S. economy in the early 1990s in the hope of finding some clues for the present situation. We did, but these clues are overwhelmingly on the negative side. Considering profit prospects as the single most important condition for a sustained economic recovery, we have focused in particular on the specific causes behind the sharp profit recovery in the early 1990s and found that all of them are presently missing.


Kurt Richebächer,
for The Daily Reckoning
May 5, 2003


“The Bull Is Back,” says the front page of this week’s Barron’s. The paper says that “America’s upbeat portfolio managers…see the Dow rising nearly 10% by year end.”

The paper does not mention that these are the same portfolio managers who saw the Dow rising 10% last year, the year before, and the year before.

Not that they won’t be right about the Dow rising in some year…but whether it is this one is anyone’s guess.

Still, technology stocks are up more than 10% so far this year. It is a little like old times. Microsoft is trading at 9 times sales, just as though we were at the top of a bubble. And investors are once again putting money into equity funds – $1.6 billion in March. Not a lot of money, but better than the $10.6 billion they took out in February.

Stocks rise against a wall of worry, say the old-timers. What bothers us is not the wall of worry…but the open road of complacency running up to it. Even after three years of stock market losses…unemployment at 6%…12 rate cuts…a trade deficit equal to 5% of GDP…soaring federal and state deficits – portfolio managers are still “upbeat.” And investors are still putting their money in these managers’ mutual funds.

And the dollar? It’s just another thing not to worry about. “Like other disaster scenarios that people get worked up about – Y2K, Skylab – the big, bad dollar drop has never happened,” CNN reassures us.

No matter what they say to pollsters, Americans are still a confident race; they still seem to think that bad things only happen to other people, and the rules that govern other people’s markets bend around America like a speeding ticket in the hands of a friendly judge.

In Japan, for example, over the course of a 14-year bear market, investors have gradually, painfully given up on stocks. At the height of their bubble market, Japanese households had half their wealth in stocks, up from less than 10% two decades earlier. Now, the figure is down near 10% again.

Back in 1980, only 6 out of 100 American households counted stocks among their wealth. By 2001, 52% had stocks. Eventually, the number will work its way back down. Then, when portfolio managers are waiting tables, and Barron’s stops announcing a new bull market every month or two, and American households once again have only 10% of their wealth in equities…then, stocks can begin to find a toehold or two in the wall of worry.

Right, Eric…?


Eric Fry in New York City…

– The stock market roared ahead last week, as the Nasdaq gained 5% over the five-day span to 1,503 and the Dow added 3.3% to 8,583. The major averages have now rallied about 16% from their March 11 lows. What is the stock market celebrating? The economy’s endless loss of jobs, or the endless slide of the U.S. dollar?

– As Addison Wiggin reported over the weekend, the U.S. labor market weakened significantly in April, as companies shed jobs for the third straight month and the unemployment rate jumped from 5.8% to 6%. Non-farm payrolls fell by 48,000, following close on the heels of losses totaling 124,000 in March and 353,000 in February. The economy has lost 332,000 jobs over the past 12 months, shed jobs in six of the past eight months, and idled more workers than it employed for the last three months in a row.

– It gets worse…The manufacturing sector shed 95,000 jobs in April – the worst job loss in the factory sector in 15 months. “Manufacturing firms have cut jobs for 33 straight months,” CBS Marketwatch reports, “a carnage that now numbers 2.3 million jobs. Employment in the sector is at its lowest level in 42 years.”

– Meanwhile, the dollar is fairing no better than an unemployed welder. The greenback is sliding against every major currency…and even many of the minor ones.

– “Could this be the beginning of America’s long-awaited current-account adjustment?” wonders Morgan Stanley’s Stephen Roach. “The problem is the gap between nations with current-account deficits (mainly the U.S.) and surpluses (mainly Asia but also Europe) has never been larger. And for a saving-short U.S. economy, a dramatic deterioration of America’s fiscal position points to an ever-wider current account deficit over the next few years – moving from a record 5.2% of GDP in late 2002 into the 6.5% to 7.0% range by late 2004…The only question in my mind is whether the dollar falls quickly or gradually.”

– The dollar made a series of new four-year lows against the euro last week. “The mighty U.S. dollar – against which almost all countries measure their own money – is on the ropes, staggering yet again after two years of waning strength,” the Toronto Globe and Mail reports. “Last week, the greenback suffered a particularly nasty drubbing. The Canadian dollar – which went over 70 cents (U.S.) yesterday for the first time since April, 1998 – is at a five-year high against the U.S. dollar, as is the New Zealand dollar.”

– Maybe Roach is right. Maybe we have finally reached the epic “tipping point” for the U.S. dollar.

– “All of which leads us to the nightmare scenario,” remarks CNN Money. “It comes up every few years, and it goes like this: All those global portfolio managers, worried about the hits they’re taking from the dollar, are going to start selling U.S. assets, which is going t A) send U.S. stocks lower and B) further damage the dollar. Which is only going to make the global investors (and U.S. ones) more twitchy, and beget more selling. Which will beget more selling. Pretty soon you have a massive rush to exit U.S. assets, and a global financial catastrophe.”

– We at the Daily Reckoning have no trouble imagining such a scenario. But nor do we have any trouble imaging that the dollar might lose its value slowly and imperceptibly, like an evaporating puddle. Of course, the speed of a dollar decline does not alter the ultimate outcome. Even a slow, “orderly” devaluation would be costly for those of us who own a few of these distinctive green banknotes…Maybe it’s time to hold fewer of them.


Bill Bonner, back in Paris…

*** Gold backed off a little on Friday, but is still over $340. The free subway daily, “20 Minutes,” tells us that drug dealers are suspected of moving their profits into gold in order to launder it. Two gold dealers from the rue Vivienne were charged with laundering as much as a million euros each week for the last five years. If governments decide to outlaw gold in order to protect their paper currencies from competition – they will probably do so as an anti-drug, anti-terrorism initiative.

*** U.S. executives “don’t care whether their boards are diverse or not diverse,” said Warren Buffett over the weekend, “…they care about how much money they make…”

They don’t care much about making profits either. Profits, as a percent of GDP, have been falling since the ’80s. A remarkable article entitled “Securities: The New Wealth Machine,” published in 1996, explained that profits didn’t really matter, anyway.

“History, manufacturing, exporting, and direct investment produced prosperity through income creation,” begins the Foreign Policy article. But now, “the new approach requires that a state find ways to increase the market value of its stock of productive assets…an economic policy that aims to achieve growth by wealth creation therefore does not attempt to increase the production of goods and services [or profits], except as a secondary objective.”

Of course, this “new wealth machine” slipped a gear in the last three years. But Americans still believe they are heirs to a special bequest from the gods that allows them to escape from the normal, tedious methods of wealth creation. More from the good doctor below…

The Daily Reckoning