Greenspan's Mortal Sin

Strategic Investment’s Dan Denning heaping opprobrium on the Fed, whose policy of late, he suggests, has encouraged an egregious moral decay in American society. Nowhere is this more explicit than on Wall Street.

Nobody expected a discussion on the morality of lower interest rates…in Las Vegas. But these are strange times for investors. And you never know when you’re going to hear the advice that could save your portfolio.

At the Foundation for Economic Education conference in Las Vegas, Dr. Roger Garrison, an economist of the Austrian persuasion, who plies his trade at Auburn University, addressed the long-term consequences of artificially low interest rates. His discussion highlighted a key economic – and I would add moral – element to interest rate discussions.

From an economic perspective, it amounts to a basic conceptual error by Alan Greenspan. Yes, productivity did improve in the first quarter by 8.6% – the strongest growth since Ollie North was ducking cameras and microphones in Senate hearings on the Iran-Contra affair.

But the real engine behind greater productivity growth, says Dr. Garrison, was layoffs. Unit labor costs fell 5.4% in the first quarter. Compensation costs actually rose 2.7%. In short, when you get fewer people to produce as much as a pre-layoff workforce did, you become more “productive”. In the real world, however, employees don’t actually produce 8.6% more goods and services than they did the quarter before.

Following this trend, “productivity” can spurt higher for a short while, just like it’s possible to saw a log quickly for a couple of minutes. But long-term productivity growth is unlikely.

In short, the first quarter number looks like a fluke.

This formula is not at all mysterious. Still, it’s precisely the reason Greenspan gave for lowering interest rates without causing inflation. Greenspan seems to believe an increase in productivity means you could increase the money supply indefinitely without increasing prices.

Could it have escaped Greenspan’s attention that the increase in productivity was largely a result of: a) lower capital costs because of the Fed’s own interest rate policy and b) falling unit labor costs as a result of higher unemployment?

This single “mistake” has been largely responsible for trillions of dollars in stock market losses, and billions of dollars of capital “consumed.” If, in fact, it’s an oversight, Greenspan’s miscalculation is quite possibly the single largest error any central banker has ever made. And its consequences will weigh on the stock market for years to come.

I know what you’re thinking: how can a Randian central banker fail so miserably at simple Aristotelian logic? I was wondering the exact same thing.

Say’s Law tells us that new wealth is created from the application of technology and ideas to create new goods and services. Production, and not consumption, is the key to new wealth. And new production comes from investment. Yet the Fed continues to do what it does best – encourage consumption by making the currency increasingly worthless.

The great Austrian economist Carl Menger pointed out that ascendant economies are always forward looking, planning for the future, storing up savings to invest later in new wealth creation. Only declining economies consume at the expense of future generations. Delaying consumption, I would argue, is the moral thing to do. If you’re willing to have a little less now, you can invest in productive enterprise and have a little more later.

By removing market forces from the determination of short-term interest rates, the Fed artificially cheapens the cost of capital and encourages uneconomic investment. There are a lot of consequences to tinkering with the market mechanism for determining the price of capital. But the chief consequence we’re concerned with today is the profits crisis in American business and the cannibalization of America’s capital stock.

My favorite Austrian economist (everyone should have at least one), Dr. Kurt Richebacher, highlights this well. Dr. Richebacher points out that profits are essentially value added. Where there is a lack of profits, there is a lack of value being added. If profits are eventual savings, and savings are investable resources for the future, then a chronic lack of profits now indicates America is consuming its capital; eating its seed corn.

Value – wealth – is being consumed, increase in “productivity” or no. Interest rate policies have, in effect, made us appear wealthier today with fat investment profits made by cheaply borrowed money. But corporate America has been systematically impoverishing itself, living a fevered financial existence in search of short-term financial gains.

Dr. Richebacher points out that pre-tax profits of non- financial corporations have slumped to their lowest level in the post-World War II period. In the 1960s, before-tax profits were 9% of GDP. At the nadir of the recession in 1991 they had plummeted to 4%. Currently, profits are less than 3% of GDP.

But there’s an even scarier figure. In 1991, manufacturing pre-tax profits were $93.5 billion. Retail trade profits were $27.7 billion. By 2001, after a decade-long orgy of financial speculation at artificially low interest rates, manufacturing profits had been nearly halved to $50.3 billion while retail trade profits more than tripled to $84.5 billion.

Nothing could more clearly illustrate the shift away from production (manufacturing) and toward consumption (retail). In the 1990s, the substructure of the economy changed entirely. Corporate America and the American consumer became infatuated with consuming now instead of saving for later.

The structural damage to the U.S. economy is far more serious than the Federal Reserve is willing to say, especially given their current bias for keeping rates low. When you spend ten years consuming your own capital stock – and borrowing from foreigners to finance it – chances are likely you’ve done serious long-term damage to your economy.

You’ve drawn down the pool of investable savings and squandered capital on projects that don’t grow wealth. You’ve sacrificed the future for a new couch from Pottery Barn or percale sheets from Bed, Bath and Beyond.

Not exactly a good trade, even by Vegas standards.

Dan Denning,
for The Daily Reckoning
May 22, 2002

P.S. Nowhere is the moral rot caused by the Fed’s policy more explicit than on Wall Street; speculative excess having run rampant for years. As yesterday’s ruling against Merrill Lynch reveals, the biggest financial scandal in history has just begun.

Trust me, it won’t stop here. Millions of investors have already lost trillions of dollars. They’re about to lose a lot more. But you don’t have be among the losers.

Someone has to pull all the strings together. For the team at Strategic Investment, that man is Daniel Denning. You may remember Dan from his earlier investment advisory service. Especially since his focus on little-known stocks – predominately small caps – led investors to profits as high as 5,182%…as well as over 570% on Isle of Capri Casinos, 457% on Big Entertainment, 411% on Gentner Communications and 130% on Total Research Corporation. Today, Denning is the architect of Strategic’s winning portfolio up across the board, while Wall Street’s finest take it on the chin.

Hey, hey, hey…gold settled yesterday above $316.

And why not? The second most powerful man in the world says another terrorist attack is coming. And the second richest man in the world says we should expect a “nuclear event” sometime.

And then, there’s the economic news – which makes it look less and less like a strong recovery is in the bag. Profits are still down…unemployment is still up…and consumers are still boosting their spending at nearly twice the rate of their incomes.

And then, there’s the dollar!

In January-February 2001 foreign investors bought about $100 billion of U.S. dollar assets. In the most recent period, foreign buying declined to just $26.7 billion. It doesn’t take a genius to see why that trend might continue. U.S. stocks are down so far this year – for the 3rd year in a row. European and Asian stocks are cheaper than their U.S. rivals…their stocks are rising and so are their currencies. From a foreigner’s point of view, U.S. assets represent risk without much reward.

“I have no doubt that the demise of the U.S. Dollar, which seems to be inevitable,” writes Alf Field, “will unleash a bull market in gold bullion that even the most avid gold bull cannot now imagine. This is not something that we can contemplate with any degree of comfort because the world that we now know will have changed beyond recognition.”

Here at the Daily Reckoning, we’re less confident. We try never to leave the house without our doubts and an umbrella. You just never know. And we’re getting a little worried about all the attention gold is attracting. Great bull markets tend to begin when no one is looking.

Still, we were encouraged by a headline in the NY TIMES: “Despite Year of Upheavals, Economic Optimism High.” The TIMES article reassures us that the mass of investing yahoos is still long the dollar and long the stock market. Which means that, so far, it’s only the smart money behind the price of gold. When the yahoos and patsies enter the gold market – oh la la!

For reference, we remind you, dear reader, that a single ounce of gold was priced at about the same level as the DJIA back in 1980. Now, it takes 32 of them to equal the Dow. We do not claim to be able to see clearly into the future. Heck, we’re not even sure we see the present clearly.

But if you wanted a guess about what might turn out to be the Trade of the Decade…this might be it: sell the Dow/buy gold. Gold might not go to 10,000. The Dow might not go to 316. But that the two will somehow belly up towards one another seems a good bet.

Eric, what’s the latest from the Temple of Capitalism?


Eric Fry on Wall Street…

– Terrorism grabbed the headlines and seemed to spread a bit of terror amongst investors. The Dow dropped 124 points yesterday to 10,106, while the Nasdaq tumbled another 2% to 1,664.

– The stock market – which had been drifting south all day – dropped even lower in the afternoon on word that terrorists might attack our Liberty…the statue, that is. According to the NYPD, no New York landmark will be safe over Memorial Day weekend. For us New Yorkers, these vague warnings are as unnerving as they are pointless.

– By steering clear of the Statue of Liberty, for example, I might just as easily step into harm’s way elsewhere in Manhattan. Or let’s imagine that – fearing for my safety in any New York City locale – I escape to the countryside for the weekend. Feeling safe and secure in my bucolic setting, I might nevertheless choke to death on a barbequed hotdog…One never knows.

– When it comes to the stock market, investors have plenty to fear, even without any new threats from Osama and his buddies. The poor prospects for corporate earnings growth, coupled with the stock market’s high valuations, are more than enough to terrorize investors.

– And even more terrifying, Standard & Poor’s has decided to start classifying as “earnings” only what a company actually EARNS. Why didn’t we think of that? S&P announced that from now on it will produce what it calls “core earnings,” which it defines as, “after-tax earnings generated from a corporation’s primary business or businesses.”

– This concept is so old that it only seems new. Back in the days before investors began eagerly (or gullibly) embracing New Era concoctions known as “pro forma earnings,” companies used to report something known simply as “earnings.” S&P now returns us to that bygone era.

– “Investors are going to be terribly confused,” Alan Abelson quips, “when they look back at the dehydrated versions of past years’ reported results and wonder where in the world earnings went. We sympathize with the aggrieved corporate brass who spent years getting advanced degrees in financial engineering and see it all going to waste.”

– According to David Blitzer, S&P’s chief investment strategist, reported operating earnings in recent years have been exaggerated by at least 20% and perhaps a lot more. “So ask not why we needed a new way to measure earnings,” says Abelson, “ask rather, why it was so long in coming. Under the old definition of earnings, the S&P 500 sports a P/E of 22. Under the new, that ratchets up to around 30…It’s not exactly a stretch, obviously, to suspect that as S&P puts its core earnings approach into effect and…the overvaluation of the market becomes inescapably evident, stock prices will suffer, perhaps severely.” Just because stocks have suffered a lot already doesn’t mean that they couldn’t suffer a bit more still.

– Abelson continues: “But whatever the short-term pain, over the long haul anything that makes corporate reporting clear, more consistent and more true has got to be an enormous plus, for the market, for investors, and most certainly for corporations…There’s simply no substitute for honest numbers.”

– True enough, and yet, in order to arrive at the equity Promised Land that Abelson anticipates, we may need to let a little more air out of the stock market bubble… and that won’t be much fun.

– As the stock market continues to deflate, a number of related mini-bubbles will likely lose air as well. Foremost among them, the US dollar bubble. Is the housing bubble next in line to suffer at the hands of a deflating stock market? And what about the “tax revenue bubble?” Yes, it’s true; the falling stock market is sucking the air out of state and federal tax revenues.

– It’s like this: No bull market = no capital gains = no capital gains tax windfall.

– “New York has had a serious shortfall in revenue,” the New York Times reports, “largely because weakness in the stock market has resulted in smaller receipts from the capital gains tax…Circumstances in Indiana are more severe, and more typical. Just three years ago, the state was sitting on a $2 billion surplus…But times changed almost overnight. Indiana’s deficit is now more than $1 billion, and the figure seems to grow with each recalculation.”

– Not to worry…that’s nothing that a few tax hikes can’t cure.


Back in Paris…

*** It’s a rainy day. The streets are quiet.

*** Yesterday, though, our local oracle – a strange little dipsomaniac of a man with oriental antecedents – was “en forme.” He bellowed in front of the Paradis bar: “We’re all going to paradise…” Standing in the middle of the street in a pair of baggy pants, shirtless, with a scarf wrapped around his head, he looked like a dirty elf with a toothache.

*** This morning, walking to work, I spied him sitting on a doorstep.

*** “Monsieur…Monsieur…” he beckoned me over.

*** I would normally pay no attention to him…for he is as mad as a Democrat. But I felt sorry for him; I could see he had sobered up.

*** “Do you have some spare change for a poor man?” he asked me. “Could you give me a franc?”

*** “Give and ye shall receive,” popped into my head. “Okay, I’ll give you a euro…we don’t have francs anymore… but only if you’ll tell me which way the price of gold is going.”


“No, I mean over the next few months…”

“Which way do you want it to go?”

“I don’t care…I just want to know…”

“Do you really want to know? You want to know what it will really do?

“Yes, of course…”

“Then I’ll tell you the truth…it will go up…and down…”


The Daily Reckoning