Das Phony Kapital

Today we continue with the last installment of our trilogy. We render unto the Caesars of Wall Street, the Commoduses of the Central Banks, and Neros in Washington what is properly theirs – that is, not earnest criticism – just idle mockery. Bill Bonner explains…March 28, 2008

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.

"My bills are all due
And the kids all need shoes
And I’m busted

"Coffee is down
To a quarter a pound
And I’m busted.

"I went to my brother to ask for a loan
‘Cause I was busted
I took the bait like a dog takes a bone
‘Cause I was busted

"My brother said there ain’t a thing I can do
My wife and my kids are all down with the flu
And I was just thinkin’ ’bout callin’ on you
‘Cause I’m busted…"

The old Ray Charles song might be coming back in style. During the boom years of the ’90s and the ’00s, it made no sense to people. ‘Why not just take out a credit card?’ they wondered. ‘Or, refinance the house?’

But now credit is becoming scarce and busted is becoming plentiful. At least, that is what we expect.

Yesterday brought mixed news. The Dow dropped 120 points. The dollar rose slightly, leaving the euro above $1.57. Gold remained a little below $950.

The Wall Street Journal calls the last ten years a "lost decade" for stockholders. The S&P is now about where it was in 1999. Stock market investors are ten years older and wiser; but not a penny richer.

And now they’re beginning to wonder about the whole scheme of things. The stock market was supposed to make them rich. "Stocks for the long run," was the mantra of the late ’90s. Buy…hold…you can’t go wrong. But 10 years seems like a long time. If they don’t go up in a one decade, what makes buyers think they’ll go up in the next? Plus, even now, the S&P still trades at a P/E over 18 – which isn’t cheap. It seems as likely that stocks will go down in the next 10 years as up.

And, of course, there’s the housing market. Ten years ago few people doubted that if they just put money into property and left it there, they would make a good profit. For quite a while, it seemed to be true. But now, for the first time in U.S. history, housing prices are falling nationwide. They’re down about 11% from the peak…and leading economists think they have another 20% – 30% to go. What’s worse, Americans are realizing that it costs a lot of money to hold onto a position in property. There are bills to pay – taxes, utilities, maintenance…all of which seem to be going up.

You could add to those things the growing realization that wages in the United States are not going up. This inconvenient truth was masked – for more than 30 years – by rising household incomes and increasing debt. Real wages per hour didn’t go up, but more Americans worked and put in more hours. Then, they turned to credit cards and housing finance to increase their spending power. Both of those avenues have come to dead ends recently.

But here’s a little bright spot. According to a Bloomberg report, the Fed’s efforts to loosen credit really have done the job. Mortgage resets have been much less of a problem than anticipated – because the resets are linked to Libor, which has been pushed down by central bank action.

Of course, people are still losing their homes in record numbers – but it’s not necessarily because of the mortgage resets.

Also, the feds are looking at various plans to bail out homeowners in advance of the upcoming elections. Neither party wants long lines of angry, homeless voters lining up at the polls in November.

But the malaise that is spreading over America is more than just a matter of numbers. Ten years ago, America seemed invulnerable. Its money was on top of the world. Its military could take on the entire rest of the planet, if necessary. Its stocks were flying. Its houses were rising. Its financial institutions were the most dynamic, innovative and solid on earth. Nothing could stop it.

We argued then that when nothing can stop you, everything will. And, in the event, everything did. Ten years later, stocks have gone nowhere…housing is on its way down…the Pentagon is gummed up in a trillion-dollar war it can never win…and Wall Street has revealed itself not as cunningly cupid, but as blunderingly stupid.

More than that, the fantasy failed. Americans permitted themselves such an extravagant conceit that they practically begged the gods to punish them. "They sweat; we think," was the gist of it. They allowed themselves the illusion that their new, post-Reagan, Internet-savvy capitalism would make them rich without saving money…and without actually producing anything. They thought the rest of the world would extend them boundless credit – forever. Now the scales are falling from their eyes…they’re beginning to see things more clearly. As a result, consumer confidence has dropped to the lowest level more than 30 years. Most people think things are bad…and few think they will get better. In the history of such surveys, never have so few people expected their incomes to increase over the next six months – less than 15% of those polled.

But here at The Daily Reckoning headquarters, we are always optimistic. Yes, Americans will be busted and broken by the realities of the real world in the 21st century. But they will eventually be bent into a better shape.

*** Now, we look at the Bear Stearns of the North Atlantic – Iceland.

From Ambrose Evans-Pritchard in the Telegraph:

"Fitch said countries that run current account deficits above 10pc of GDP for any length time almost always come to grief. East Asia’s debt crisis in 1997 erupted before any state reached double digits. Iceland’s deficit is now 16pc of GDP. Latvia is at 25pc, Bulgaria 19pc, Georgia 18pc, Estonia 16pc, Lithuania 14pc, Romania 14pc and Serbia 13pc. The region will need $337bn in foreign loans this year.

"Borrowing in foreign currencies was all the rage in the heady days of the credit bubble. Most mortgages in Hungary over the last two years have been in Swiss francs, with the Balkans and Poland not far behind. This is now turning into slow torture. The franc has risen 5pc against the euro since October. The real level of the debt is ratcheting up.

"The foreign debts have reached 122pc of GDP in Latvia, 101pc in Estonia and 73pc in Lithuania, mostly in euros. For now the debtors are shielded by fixed exchange rates in Europe’s ERM system, but this could make the shock even worse should the currency pegs start to snap."

And this from our old friend, Steve Sjuggerud. "Is it time to buy Icelandic bonds?" we wondered.

"Well, the bonds sure should be a good buy…

"I haven’t watched this too closely… But I think this is the basic story over the last week…

"Carry traders got margin calls from their banks. That forced a large amount of money out of a small currency (Iceland’s krona), which caused it to depreciate.

"Short sellers caught on, knowing that the carry traders had to close out their positions, causing the currency to fall faster… then SURPRISE…

"The central bank caught everyone off guard and raised short rates to 15%(!) and took other drastic measures.

"So now…you’ve got short rates at 15%. You’ve got a currency that is significantly oversold (cheap) now relative to its history (it’s always expensive), in a country with a triple-A credit rating and no risk to government finances. (The only risk is they’re the perceived lender of last resort to Iceland’s leveraged local banks)

"The currency is always volatile. But buying short-dated paper, with a 15% ‘tailwind’ in a triple-A rated country, when the currency has backed off so much, ought to be a good trade.

"As you probably know, I prefer the inflation-indexed long-dated bonds to t-bills, because the capital gains potential could be huge…

"Icelandic TIPS pay 4.5% now, plus inflation (which should be 6% this year). So that’s a double-digit yield. But the TIPS go out as far as 2044… so the capital gains on those long dated bonds would be huge if the real yield fell from 4.5% to 3.5% or lower.

"A real yield of 4.5% is ridiculous. My thesis all along is the capital gains portion of the trade… but one thing after another has kept that real yield high.

"The currency is the big risk. Its volatility can’t be taken lightly. But when you think about it, it’s foolish to short a AAA currency yielding 15%. So now should be a good time to put the trade on…"

*** Meanwhile, this from a Dear Reader in Australia:

"You have been talking about your ‘Trade of the Decade’ to buy gold for a long time. Do we have to hear about it for the rest of the decade?"

‘Yes,’ is the answer – unless gold goes down and stocks go up. Then, we’ll forget we ever mentioned it.

But we judge that rather unlikely.

Still, Melbourne-based colleague, Dan Denning, thinks we have a problem here at The Daily Reckoning headquarters.

"Most of what the DR franchise (now itself nearly ten years old) has predicted has come to pass," he writes. "So now what?"

"… readers are tired of the themes…they want an endgame. But the endgame is going to take a while. So while we still have to cover that from day to day, I think we need to offer them a preview of the NEXT game. That is, if you follow the chain of dominoes in the credit crisis…it leads all the way to the nation state itself.

"This sets off a whole chain of interesting geopolitical consequences that are rich ore for us to mine…"

Now what?

The easy milestones have been hit – gold at $1,000; oil at $100. Stocks have gone down (though the Dow is still about where it was; in nominal terms stocks have gone nowhere). And the dollar has gone down decisively against the euro.

What is ahead now? We don’t know. But our view of things has not changed. Nor has it played it itself out.

In our view, markets make opinions, not the other way around. In other words, people come to think what they must think in order to play their roles in the great drama. America has become a huge empire. All empires are extraordinary things…fragile and doomed to failure. When the Soviet Union threw in the towel, America was left without any major competition. Since empires cannot last, and since she had no competitors worthy of the name, the Empire of Debt had to find a way to destroy herself.

In that sense, it was no accident that the financial industry invented subprime debt…and then put it in its own coffers. Nor was it any accident that households spent more than they could afford. Nor that Congress went on the biggest spending spree in history. Nor that George W. Bush took the nation into an unbelievably pointless and expensive war, effectively squandering not only the nation’s credit…but also its military advantage.

Meanwhile, Americans’ eagerness to spend money they didn’t have on things they didn’t need caused a huge boom in places they’d never been. Asians built factories, roads and entire cities with money gotten from selling gadgets to Americans. Arabs built ski-slopes in the desert…and constructed towns on manmade islands. And even their former enemies – the Russians – created one of the world’s largest piles of U.S. dollar reserves, and saw their own wages rise 6 times in the last eight years. These foreign competitors have been adding to their skills, their savings, and their capital bases – just while the United States has been running its own down.

This drama is far from over. We are only at the beginning of it. The next scenes should be even more interesting. The dollar will lose its status as the world’s reserve currency (possibly with episodes of hyper-inflation)…China and Russia will greatly increase military spending (with some dangerous moments, as the US still tries to throw its weight around)…U.S. stocks will work their way down to real values – with P/Es below 10…and the average American household will find itself no better off, financially, than the average family in, say, Latvia or Malaysia. Then, Asian manufacturers will outsource production to an area where wages are low and productivity is high – Arkansas, maybe.

So stay tuned!


A good flim flam needs a good mountebank and a good mark. Two weeks ago, we pointed out that Wall Street was full of bright cads and dull sharks. Then, last week, we showed that conceited humbuggers run the central banks. Today, it is the politicians we come, not to bury, but to praise. They did their work well; they set up the marks.

The two great political figures of the last thirty years were Mrs. Thatcher and Mr. Reagan. These titans from the two sides of the Atlantic led the way to a new idea of how the world should work. Thenceforth, capitalism was king. But it was a new kind of capitalism they had crowned, one with a strange, unnatural face. It was not the old free enterprise, king of the jungle, red in tooth and claw. This new capitalism was more like the owner of a pet shop, where all the animals were cute and cuddly — and didn’t eat the customers.

Mrs. Thatcher and Mr. Reagan and their followers had seen how centrally planned economies worked; the Chinese and Russians showed what happened when bureaucrats ran an economy. The free market seemed like the best alternative. But the trouble was, these new ‘conservatives’ had no real respect for it. Instead of quaking before it in genuine fear and awe, like Moses before the burning bush, they began to believe that they could be its master. Then, they developed a whole host of fantasies about what this tamed beast could do for them.

Not only could the free market solve the problem of poverty, it could solve almost every other problem too. It was a social panacea. Just look at the wealthy countries, they said. Switzerland is clean and prosperous. By contrast, communist China is a dump. People are healthier and happier in capitalist countries, where they have better automobiles and lower birthrates. Science, supported by the free market, would find cures to diseases too…and even help people live longer. The logic was simple enough: free enterprise made people rich. And with their money, they could do wonders — cleaning up the factories, building hospitals and clinics, organizing public day care and Pilates classes…even getting rid of smoking!

Nothing was too absurd or contradictory for the True Believers. Gradually, they began to confuse the fruit with the tree…and then mistake the tree for a lamppost. Financial incentives were thought to be the key to everything. If an executive failed to maximize shareholder value, it was because his bonus was not large enough. If students showed poor test results, it was because teachers were paid by the job, not by the outcome. And if terrorists attacked a building in New York, it was because they lacked financial opportunities in Cairo. (Later, people were dumbfounded when doctors who had worked for the National Health Service tried to blow up cars in Glasgow and London.)

The ideas were slippery but they greased the skids. Soon, the marks were ready to go along with anything. Shareholders consented to hundreds of millions in bonuses and stock options for key executives. Investors signed up for hedge funds, willingly giving managers "2% and 20%" for putting quarters in the slot machine for them. Taxpayers allowed huge tax cuts – widely believed to be aiding the wealthy – because they looked forward to the day when they would be wealthy too. And almost everyone, everywhere eagerly went on a spending spree, in the belief that this new, kindler, gentler capitalism would add wealth faster than they could get rid of it. And if they overspent, hyper-capitalism would soon catch up.

In public finance, this delusion led to Dick Cheney’s famous quip: "Deficits don’t matter." This, in turn, led to the greatest explosion of government red ink the planet had ever seen. During the first seven years of the George W. Bush administration, about $20 trillion was added to the U.S. ‘financing gap’ – more than under all America’s other presidents put together.

What was good for the top was good for the bottom. Private households, too, ran deficits of their own. Savings rates fell close to zero while U.S. household debt rose from less than $2 trillion in the first year of the Reagan administration to nearly $13 trillion in the 6th year of the present administration.

In Britain the story is about the same. Before the Thatcher revolution, household debt was about 65% of household income. By 1988, it had reached 100%. And by 2007, it was more than 150%.

When a consumer spends a dollar he earned, it is taken in as income to the businesses that receive it. But it offset by a cost too – a wage expense. But if the consumer spends a borrowed dollar, it comes to business like manna from heaven, with no balancing wage cost. Higher profits, greater leverage, more debt – it was all catnip to Wall Street. Financial assets were only 4.5 times GDP in 1980. Now they are 10 times as large. But that is nothing compared to the sugary confections of the credit industry. Credit default swaps, alone, are said to be worth $45 trillion.

The earnings of the financial sector equaled only 10% of total corporate earnings in 1980. By 2007, they made up 40% of the total, even though they still only employed 5% of the workforce.

But, "that game is now up," says the Economist. The "new" capitalism was a fraud. It didn’t make people rich. It only allowed them to get rich – or poor – depending on what they did with it. Americans used their economic freedom to ruin themselves. But that’s just the way capitalism really works. You don’t get what you expect…or what you want; you get what you deserve.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning
March 28, 2008

The Daily Reckoning