Forget Iraq

From what we read about the U.S. economy, we have to conclude that its enormous bubble-related, structural problems are still little understood.

Too many economists in America possess an extraordinary ingenuity to discard the greatest imbalances in the economy as irrelevant. Record-high trade deficits, record-low savings and record-low profits do not matter in their eyes. It is, by definition, an economy that cannot have serious problems.

We like the statement that Rep. Bernard Sanders recently made to Fed Chairman Alan Greenspan after a testimony: “Mr. Greenspan, I always enjoy your presentation because, frankly, I wonder what world you live in.” It is a question that we would like to ask numerous Wall Street economists and analysts.

Not only Mr. Greenspan, but indeed most economists are clearly overstating the role of the Iraq “jitters” in slowing the economy. In the same vein, they flatly ignore the implications of the severe economic and financial maladjustments that the bubble-related borrowing and spending excesses have inflicted on the economy, among them in particular the profit implosion. There is no debate, no discussion, no questioning about this unprecedented profit calamity – just lamenting that increasing oil prices and the looming war with Iraq are causing companies and consumers to postpone big spending decisions. This explanation has, of course, the great virtue to make believe that the economy and the markets will resume booming as soon as this uncertainty is lifted, war or no war.

Bubble Economy: Zero for Three

For the great economic thinkers of the past, it was uniformly apodictic that healthy economic growth depends on three key attributes: a high share of saving, a high share of investment and a high share of profits. But the U.S. economy’s strong growth during last year badly lacked all three attributes.

Looking for the effective quality of the U.S. economy’s strong growth in recent years, we noted the following facts: In 2002, consumption accounted for 87% and government spending for 32% of GDP growth in current dollars. On the other hand, business fixed investment diminished GDP growth by 23.6%. Another sizable cut by 20.2% derived from the further worsening trade deficit. In the fourth quarter of 2002, by the way, government spending accounted for 39.4% of GDP growth. If this was a recovery, it was a very sick one that lacked everything for sustainability.

During the preceding four years, 1997-2001, nominal GDP grew altogether by $1,763.8 billion, or 21%. Consumption accounted for $1,457.7 billion, or 82.6%, of the total. That share was about 15 percentage points above the long- term average. Government spending provided $370 billion, or 20.9%. An unusually small contribution came from business fixed investment, with $202.2 billion, or 11.4%, of the total. The soaring import surplus diverted a huge $259.6 billion of domestic spending abroad.

According to official interpretation and general perception, the U.S. economy’s growth during these years was led by strong investment and productivity growth. The ugly reality was that growth was consumption-led growth as usual, with one important difference: this time, the consumer borrowing binge went to an unprecedented extreme. Just as clear was its decisive propellant: the skyrocketing wealth effects of the booming stock market.

Bubble Economy: The Essence of a Bubble Economy

By definition, it is the essence of a bubble economy that rising asset prices fuel specific borrowing and spending excesses. In the case of Japan, these went mainly into commercial construction and business fixed investment. America’s bubble economy had its decisive, big structural distortion in the borrowing and spending orgy of the consumer.

Consumption’s steeply rising share in GDP was the manifest hallmark of the U.S. bubble economy that developed in the late 1990s. Essentially, a sharp rise in one GDP component implies the looting of other components. In the U.S. case, these victims were fixed investment and foreign trade.

There is a widespread, hopeful view that the bubble-related imbalances and distortions are being rapidly corrected. In this view, the U.S. economy’s main problem from the past boom years has been a protracted excess in business spending on fixed investment that has resulted in vastly excessive production capacity. Boosting potential supply in relation to slower demand growth, it is also supposed to be the main cause behind the profit carnage by destroying pricing power. From this perspective, the drastic retrenchment of business fixed investment represents a highly desirable correction of the prior investment excesses.

It is the consensus view. Yet it is absolutely ludicrous.

Bubble Economy: Overconsumption, Not Overinvestment

Overinvestment may, indeed, be true for Asia, but definitely not for the United States. As explained and documented, America’s overwhelming structural maladjustment in the past few years has been bubble-driven overconsumption that plainly bombed out business investment and the trade balance.

What the slide in business fixed investment truly reflects from this perspective – our perspective – is not at all a desirable and necessary correction of a prior maladjustment, but a dramatic worsening of chronic corporate underinvestment in the United States. The profit carnage is the obvious culprit.

What saved the U.S. economy from a crushing recession was the housing and mortgage refinancing bubble that developed with consumer debt growth beating record after record. In the third quarter of 2002, it ran at an annual rate of $770.7 billion, as against $661.3 billion in the same quarter a year ago, and $571.4 billion another year back.

Everybody is hailing this acceleration of the consumer borrowing binge because it has prevented a deeper recession. But in essence, this, too, represents an increasing maladjustment in consumer spending.


Kurt Richebächer,
for The Daily Reckoning
March 17, 2003


“US seen contracting unless Iraq situation resolved soon,” says an MSNBC headline.

“War jitters,” say news reports, are hurting consumer spending and business investment. Instead of beginning new projects, American businesses keep eliminating old ones – and getting rid of the employees who ran them. For their part, consumers are still mortgaging their homes – heroically or desperately – but growing more and more uneasy about spending money. Retail sales just showed the sharpest decline in a year and a half. (More from Kurt Richebächer, below…)

That George Bush is a great statesman, we have no doubt. But neither do we doubt he noticed that it was the recession of ’93 which made his father a one-term president.

Having inspired the war jitters, Bush now has to calm them…by getting the war underway and over with, we would guess. In a matter of days…or maybe weeks…we can reasonably expect ‘regime change’ will be a matter of fact in Iraq. We’re less sure that it will have the desired economic effects on the homeland front. The thing that unites both supporters of Bush’s war and its opponents, we wrote on Friday, is dollars. Both sides have them.

Twenty three percent of U.S. corporate bonds are held overseas…13% of equities and 35% of treasuries. There are also trillions worth of U.S. cash in central bank vaults, merchants’ registers, and individuals’ piggy banks all over the world.

Victory against Saddam may inspire foreigners to hold more of the winners’ currency. Then again, it might not. Even a short, sweet war may not make the world a safer place…nor a happier one. It will not make U.S. goods more competitive on world markets. It will not reduce the supply of dollars…nor the demand for them.

“A costly war could drive more foreign investors away from the U.S.,” explains an article on MSNBC, “hurting living standards and our influence abroad.”

“As risks increase, expenditure declines,” Max Fraad Wolff elaborates on the Prudent Bear website. “Funds advanced shift toward safer havens. We are positioning to receive declining portions of a shrinking pie. The airline industry suffers as Airbus replaces Boeing and Mecca Cola replaces Coke. The dollar slides as foreigners fear reckless spending, military conflict and xenophobic campaigns. U.S. positions are sold as global equity markets plunge and bond prices fall, forcing up rates. There is no lasting recovery in such an environment.

“…Tens of billions will be spent on a lengthy, unpopular occupation. At home and abroad opposition will form and strengthen. Protests, boycotts and whisper campaigns will rage. Conflicts overseas echo at home. Terrorists and competitors seize opportunities to attack. Even if war goes well militarily, it generates massive and enduring costs. The Council on Foreign Relations estimates occupation costs at $20 billion per year. Taxes and revenues are projected to decline. Where will the billions come from? Fear of the answer burdens us. “American-led global cooperation is being displaced by division. ‘Old Europe’ and world opinion impact our exports, treasuries, equities and prosperity. As we struggle with the challenges posed by massive indebtedness, anemic earnings, declining budgetary health – state and federal, negative wealth effects and global economic weakness, unity and cooperation are essential. If the world is to continue to fund our multibillion-dollar current account deficits and budget shortfalls, harmony is required. Our fiat dollar floats, in part, on good will…”

Floating on good will is fine when the tide is running in your favor. But eventually…the tide always turns.

In the meantime, Eric’s back on the job, if not in the office:


Eric Fry, reporting from Sir John Templeton’s backyard…

– Your co-editor is still marooned in the Bahamas. He arrived in this sunny tropical locale late last week to attend a meeting of the Supper Club, an interesting event about which you may learn more in tomorrow’s Daily Reckoning.

– But your co-editor has not yet returned to New York because he is in no hurry to trade a balmy beach for an icy metropolis. Your co-editor fancies himself something of a beach aficionado, and has lounged on many of the world’s finest. He was prepared, therefore, to be underwhelmed by the beach at the Atlantis Resort here in the Bahamas. Instead, it impressed him greatly.

– The resort’s massive, Disneyland-style trappings and swarms of overweight vacationers detract from its natural beauty. (Your co-editor found himself longing for the stark isolation and raw beauty of Rancho Santana in Nicaragua). But, physically, the beach at Atlantis is gorgeous. Less gorgeous by far were the beach-goers. If you spend any time strolling along the beach at Atlantis – or wondering around almost any American resort – one particular observation becomes inescapable: Americans eat…and eat and eat and eat…They never miss a meal, and rarely miss a between- meal snacks. We Americans know how to consume, and nobody does it better.

– But are American feeding habits any different than American financial habits? Or is the tendency to over- indulge – whether in credit cards or carbohydrates – simply part of our national DNA? We gorge ourselves on debt and donuts alike. Predictably, our financial profile is as unsightly as our physical profile. And getting back into shape is difficult and “like so un-fun”. We shouldn’t expect either profile to improve any time soon, if ever. To the contrary, the way that our debts are expanding, we’ll soon need to loosen our financial belts several notches.

– “During the fourth quarter, total (Federal and Non-fed, but excluding financial sector) debt increased at an annualized $1.563 Trillion, or 7.7%, to $20.7 Trillion,” the Prudent Bear’s Doug Noland observes, “with Total Household borrowings increasing at a 10.7% annualized rate. The Household sector has not experienced a year of double- digit debt growth since 1987. And we’re now compounding on top of a base that has seen Household sector debt surge 52% in five years.”

– A big part of the reason household debt is soaring is that mortgage borrowings are expanding at a blistering pace and now total more than $6.05 Trillion. “Take a close look at truly historic developments within the Great Mortgage Finance Bubble,” says Noland. “Household Mortgage debt growth is fully 60% greater than 2001’s record $530.9 billion…The fourth quarter saw a lending frenzy at almost four times the pace of only five years ago…Total outstanding Mortgage Debt is up $1.59 Trillion over two years (23%) and $3.3 Trillion (64%) over five years…”

– One of Noland’s most alarming observations is that consumption-based borrowings have been increasing dramatically over the last five years. (Noland refers to consumption-based lending as “cheesecake” – i.e. tastes great, but very unhealthy). To illustrate the unhealthy trend, Noland calculates that the total dollar value of mortgage-backed securities and asset-backed securities, together with the total value of Fannie Mae and Freddie Mac loans outstanding, has soared over the last five years from 48% of GDP to 77% of GDP. In other words, the economy may be slowing, but debt-financed consumption never slows.

– “Could our deranged Credit system offer a less wholesome regimen?” Noland asks rhetorically. We suspect not. Our consumption-driven debt boom seems as unhealthy as…well…a dinner of cheese pizza and French fries…(For a follow-up on the troubles plaguing the U.S. credit system – and notably Fannie and Freddie.

– “Extra cheese on the pizza, please! We’ll all be wearing swim suits in the Bahamas next week!”


Back in Paris…

*** We spent the weekend laying up a stone wall…and cogitating on the nature of things.

Americans “do not go abroad in search of monsters to destroy”, wrote John Adams early in the 19th century. But by early in the 21st, American troops were stationed all over the world, looking for monsters under every rock.

It is progress, of a sort. And perhaps it is inevitable. Now that America is the world’s only super-power, maybe it has responsibilities that it didn’t have when it was merely a decent republic. Some argue that the nation has a duty to throw its weight around – even if it doesn’t want to do so. After all, policing the world may be dirty work, but someone has to do it, right?

But is that the way the world works, dear reader? Do people…and much less, entire nations…respond reasonably to the rational duties and responsibilities thrust upon them? Or do they merely go a little mad from time to time?

Crowds of people develop a particular thought about themselves, which Gustave le Bon called the General Belief. The thought may be harmless…(such as ‘The sun never sets on the British Empire…’) or it may be very dangerous (such as Hitler’s idea that Germans were a superior race needing more lebensraum [living room]!). At certain points in history, people come to think that they are so special…so superior…so firmly in God’s grace…that the usual rules no longer apply to them.

In bubble markets, investors come to believe that “this time it is different”, so they can ignore P/E ratios, the threat of bear markets, dividend yield, and so forth. And in politics, they come to think that they can get away with practically anything.

And maybe they can. History shows that a country can maintain a military advantage and a General Belief about itself for generations.

But nature abhors monopolies and vacuums. When a vacuum develops, she fills it. When a monopoly occurs, she destroys it. And when a bubble appears, it is soon surrounded by sharp objects.

*** A program note: if you’re not too busy boycotting French products, and in fact, would like to get a taste of La Vie Française, while learning a new trade, International Living will soon be conducting it’s annual Travel Writer’s Workshop, right here in gay Paree…