Pompous Claims vs. Poor Reality

Pompous claims of the superiority of the U.S. economy throughout the 90s, contends Kurt Richebächer, contrast grotesquely with the miserable economic reality. Haven’t we seen this picture before? Why, of course, we have: the Reagan years.

Considering the horrible backdrop of accounting scandals, crashing stock prices, plunging profits, a yawning budget deficit and even an unprecedented negative interest-rate differential against the euro, the dollar has certainly been performing astoundingly well. Yet let’s not overlook that against the euro, it is down almost 20%.

Inertia of exchange rate expectations is a familiar experience. Basic to the dollar’s relative strength is obviously a general perception that the U.S. economy will continue to outperform the economies in Europe and Asia.

Somehow in the past few years a perception has taken hold in the currency markets that exchange rates are mainly determined by differences in economic growth. There have, indeed, been striking examples of this kind, but more often it has not been vindicated. All the lessons of history say that in the long run, it is the state of the balance of payments that determines the strength of a currency.

Recent 90s history in the U.S. is reminiscent of the 1980s ‘Reagan’ era. Then, too, the dollar astounded the world by soaring against the European currencies in flat defiance of an exploding U.S. trade deficit. It was a completely new experience for the currency markets.

While the U.S. current account between 1981-85 went from a small surplus of $5,000 billion to a deficit of $121 billion, the dollar skyrocketed against the D-Mark from DM 1.74 to DM 3.42. From then on, however, the dollar fell sharply, although the growth of the deficit slowed sharply as well. The dollar’s slump ended in 1995 at DM 1.25.

Let us peruse the figures of the recent past for comparison: since 1997, the rise in the U.S. current- account deficit has grown exponentially from $128 billion to almost $500 billion. But this time, in addition to the mammoth deficit, there looms a negative interest rate differential of 2% against the dollar at the short end. During its bull run in the first half of the 1980s, the dollar enjoyed a big interest advantage against the other major currencies.

Currency strength under such extremely negative conditions is definitely unprecedented in history. There is only one possible explanation for this extraordinary experience, and that is phenomenal faith in the U.S. economy’s inherent strength and health.

Apparently, it was mainly two influences that drove the dollar’s bull run of 1981-85. Probably the most important one was worldwide admiration for America’s new "supply- side" Reaganomics, against pronounced pessimism about the European economies. (Eurosclerosis became the catchword of the time.) A big interest-rate advantage for the dollar was the other influence. The dollar’s long decline began in 1985 when, in the face of a weakening economy, the Fed accelerated its interest rate cuts.

It is still widely believed that Reagan’s supply-side strategies worked, although nothing could be further from the truth.

Looking only at the increases in aggregate real GDP and employment, they were indeed a great success. Economic growth, which had stumbled in the early 1980s, began to surge in 1983, compiling a more durable recovery than at any time since the 1960s. For more than five years, real GDP kept growing at an annual rate of more than 3%. America’s unemployment rate fell from 11% to 6%.

But looking at the pattern of economic growth and the changes in the allocation of resources, Reaganomics has been a total flop. The crux of economic policy is always its impact on capital formation and profits. What happened to the U.S. economy in the 1980s, in actual fact, was the precise opposite of what the supply-siders had expected and predicted. Soaring government and consumer borrowing ravaged capital formation to unprecedented lows, and business profits showed no improvement as a share of national income or GDP.

The net national savings rate – the average rate of business and consumer saving minus the government deficit – virtually collapsed from about 6.5% from 1968-82 to 2% of GDP, due both to sharply higher government and consumer borrowing. Net capital investment as a ratio of GDP fell to 5% of GDP, nearly two percentage points below the post-war average. Manufacturing net investment was flat for years.

Ultimately, "supply-side" Reaganomics grossly failed by all accounts. Three bull years for the dollar were followed by 10 bear years.

We have recalled this experience of the 1980s because of its stunning resemblance in virtually every detail to what has happened in the past few years.

It begins with the bogus New Era. In the 1980s, it was newly fashioned supply-side policies that would work miracles for the economy. In the 1990s, it was a new paradigm economy with miraculous efficiency gains through massive investments in the new information technology and a revolutionary improvement in corporate governance, guided by the goal of increasing shareholder value.

What’s more, in both periods, there was exactly the same American derision of Europe’s inflexible economies, and on the part of the Europeans, there was exactly the same inferiority complex. Even more stunning are the parallels on the domestic side. In both periods, the pompous claims of superior, new government and corporate strategies contrasted grotesquely with the miserable economic reality.

Looking at what effectively happened to resource allocation between capital formation and consumption, as well as to profits – the policies in both periods were an outright disaster. However, the macroeconomic damages of the 1990s are worse…and have yet to be reckoned with.


Kurt Richebächer,
for The Daily Reckoning
December 4, 2002

Editor’s note: Dr. Kurt Richebächer’s articles appear regularly in The Wall Street Journal, the U.S. edition of The Fleet Street Letter, Strategic Investment, and other respected financial publications. France’s Le Figaro magazine did a feature story on him as "the man who predicted the Asian crisis."

"Deflation menaces the planet" says a headline in the French financial magazine, L’Expansion.

Your editor had picked up the magazine to read the cover story, "How America Aims to Control the World," and got distracted.

"More than half the world is in deflation," the article explains. "Five of the world’s seven biggest economies, those that produce more than $1 trillion per year in output, are experiencing a decline in producer prices: the U.S., Japan, Britain, Germany, France and China. In the two Asian giants – China and Japan – consumer prices are falling too. Global stock markets are falling too. They’re down 20% over the last year, 45% since the spring of 2000. Only property prices have managed to resist the trend."

This is pretty exciting, don’t you think? Something big is happening…and people don’t know what it is, do they? We don’t know either, but we have a few ideas.

The world as we have known it ends not with a bang, but with a whimper, we believe…about which, more below.

"Production is increasing worldwide at hardly 1% annually," continues L’Expansion.

Curiously, while producer prices collapse, the raw materials the producers use have risen 20% in the last 6 months. How come? Well, partly because China is buying so much of them. It takes raw materials in order to make finished goods. China buys resources – thus driving up prices – and produces immense quantities of finished goods – which drives down producer prices. Year over year, Chinese industrial output has risen at an astonishing 13.8% rate.

A barrel of oil is up about 50% in the last year, while Chinese-made garden tractors, toaster ovens and office supplies have fallen in price. Thanks to globalization, about which, more below too, these cheap Chinese goods force down prices on domestic manufacturers also – down 1.9% in the U.S., 0.2% in France and 0.9% in Japan over the last year.

For many people, deflation really is a menace. People borrowed heavily during the boom years. In the middle of this year, business debt passed a milestone – more than $7 trillion, almost twice what it was 10 years ago. Are U.S. businesses so much more profitable today that twice the debt of a decade ago will be no problem? Alas, no. Profits for U.S. corporations peaked out in 1997; they are scarcely higher today than they were in 1993.

And individuals? They, too, have much more debt than they did 10 years ago. And they, too, have no more income with which to pay it; at least on the crowded lower steps of the economic staircase, incomes haven’t budged.

Businesses and consumers will have a hard time staying afloat in deflation; many will sink as they struggle against it.

But here at the Daily Reckoning, we always look on the bright side of things. No one would lend us money during the boom years, so we’re free from debt during the bust. Unburdened by responsibility, we welcome deflation as a 10- year-old welcomes a blizzard; instead of going to school, we’ll go outside and throw snow balls at tottering old people.

As we have been saying, we’re a little suspicious of all this ‘getting and spending’ anyway, and wonder if the world wouldn’t be a better place if people took a break from it once in a while. If we’re right, we’ll soon find out…people may get a holiday, whether they’re ready for it or not.

Over to you, Eric…with your report from the world capital of Getting and Spending…


Eric Fry in New York…

– Day two of the "pause that refreshes" on Wall Street featured the Dow Jones Industrial Average falling 120 points to 8,742 and the Nasdaq dropping 2 1/2% to 1,449. Gold, the ultimate anti-stock, responded to the stock market weakness by climbing $2.70 to $321.20.

– Isn’t it funny how quickly gloom has turned into boom? The two-month stock market rally seems to have restored an air of "normalcy" to life in the U.S. Maybe we shouldn’t judge an economy by its cover, but from all outward appearances, the U.S. economy seems healthy – almost boom- like. Consumers are spending a bit of money (at Wal-Mart anyway), businesses are making a dollar here and there and the commuter train I ride to Manhattan is as packed as ever.

– While happy to see signs of economic vitality, we disbelieve them. That said, we have greater confidence in the recuperative powers of the U.S. economy than we do in the "strength" of the overvalued U.S. stock market. Stocks are, quite simply, too expensive, and seem to be discounting not only the upcoming, hoped-for recovery, but also many future recoveries.

– Curiously, and somewhat ominously, the U.S. dollar has failed to "catch a thermal" from the steeply ascending stock market. The dollar’s feeble action is no great surprise to Jim Grant, editor of Grant’s Interest Rate Observer. He considers the dollar a doomed currency, at least relative to the world’s oldest money: gold.

– "Your editor trusts in the capacity of sovereign governments to bring about the depreciation of the money they sponsor," Grant writes. "Governments have few enough fields of competence…Governments can still do to money what they have usually been able to do to it, starting with the first clipped coins."

– Therefore, says Grant, "We prefer the euro for vacations in France, the yen for trips to Tokyo and the Swissie for idylls by Lake Geneva without the children. However, as a store of value, we favor none of the above. Our best idea is to hedge one’s dollars with gold or the shares of the companies that own and produce it…"

– Speaking of gold, Bob Moriarty from 321gold.com, an erstwhile Daily Reckoning reader, took issue with my recent comments about JP Morgan’s gold-derivatives exposure. "JPM has problems and they are real," Mr. Moriarty writes. "[Morgan’s] $26-trillion-dollar derivatives book is simply beyond understanding the level of risk they have assumed. But you didn’t write about that. Instead you wrote about a gold derivatives ‘RUMOR’ which is pure nonsense. Writing about a ‘RUMOR’…is totally irresponsible, you are shouting fire in a crowded theatre when a simple question or two in advance might show you the rumor couldn’t be true.

– "OK, let’s look at the rumor: Total derivatives in the world, $128 trillion dollars: big problem. Total derivatives at JPM, $26 trillion dollars: big problem. Total gold derivatives in the world, $289 billion dollars: small problem. Total gold derivatives at JPM, $45 billion dollars: small problem. Net gold derivatives in the world, $28 billion dollars: no problem."

– In general, I agreed with his remarks. That’s why, when I "irresponsibly" mentioned the rumor in the Daily Reckoning, I wrote: "Perhaps Morgan’s outsized gold derivatives exposure is not a MAJOR accident waiting to happen, but we wouldn’t be surprised to see the high-risk bank stub its toe…at least."

– However, since I didn’t completely agree with Mr. Moriarty, I gave him a call. During our cordial, 10-minute conversation, we agreed about most things. But the one stubborn item of contention was mostly a semantic one. He insisted that JPM’s gold derivatives book was "no problem." I said, "Well, I wouldn’t go that far. Don’t you think it COULD be a problem? I don’t think that either one of us can say anything definitive about Morgan’s gold derivatives. We simply don’t have the requisite information."

– Warming to the topic, I continued: "Don’t you think it’s possible that a rapid $100 dollar gold rally could catch Morgan’s trading desk wrong-footed, and end up costing the bank $1 billion or so?…A $1 billion wouldn’t be fatal, but neither would it be no problem."

– He grudgingly conceded that – theoretically anyway – Morgan could lose some money on its gold derivatives. But here in the real world, he insisted to the end, "They are no problem whatsoever."

– "I think you owe your readers an apology," our friend wrote in his original email. "I’m convinced JPM’s derivatives book will bury them. But I’m damned sure isn’t going to be because of any gold derivatives problem."

– Sorry readers, no apology is forthcoming. I am neither convinced that JPM will perish under a mountain of derivatives, as the reader asserts, nor am I convinced that the bank’s gold derivatives book is "no problem." – Rather, I am convinced that the world’s growing stockpile of derivatives – concentrated as they are in the hands of a few large banks – is a potentially destabilizing influence in the world’s financial markets. Investors should be vigilant for adverse outcomes, nothing more and nothing less.


Back in Paris…

*** We’ve been betting that the developed economies would slow down. First, because that’s what economies do after a period of feverish activity. And second, because that’s what people do when they get older. Populations of all the developed countries are getting older. Would it be any surprise if they began to act like old people?

And now comes a report from my old friend, Mark Hulbert, writing in the New York Times:

"A new study of American demographic patterns and the stock market predicts that while the market may rally periodically, its overall direction will be downward until around 2018."

The three professors who did the study "report that their model has done a good job of explaining the bull and bear markets of the last century. But its accuracy as a forecasting tool is untested," Hulbert continues.

The professors’ insight was no different from ours, but they applied it to the stock market rather than to broader economic trends. When the proportion of old people to young people increases, stocks go down, they say.

"Younger adults, from 20 to 39, are generally consumers," Hulbert explains. "Middle-aged people, 40 to 59, tend to invest in stocks. Retirees are more likely to sell stocks than buy them. Market performance is strongly affected by the relative numbers of people in each of these three life stages…"

During the ’90s, America had a very high proportion of people in middle age – just as Japan did during the ’80s. But now, the oldest baby boomers are getting close to retirement age.

"That trend is reversing, according to the model," Hulbert continues, "which predicts a long decline caused by sales by baby boomers, as they approach retirement, outweighing purchases by the smaller group entering middle age."

*** There’s no smarter man than the one who throws our own discarded ideas back at us. By that measure, French historian Emmanuel Todd is a genius.

We wondered why American conservatives during the Reagan years were so eager to eliminate communism from the face of the earth. After all, the doctrine was not only entertaining…it had taken half the world out of competition with American industries, and enfeebled nations which otherwise might have been vigorous opponents. Russia was growing as quickly as the U.S. at the beginning of the 20th century. Had it not been for Bolshevism, it might be equal in power and wealth to the U.S. today. And suppose China had developed at today’s rates for the last 50 years? It would far surpass the U.S. by almost every measure.

The fall of the Berlin Wall – and the end of communism – was hailed as a triumph for America. But it also marked the beginning of America’s decline. For the first time in nearly a century, the U.S. would have to compete with Russia and China.

"That is the great paradox," says Todd, interviewed by L’Expansion, "the victory of American ideas of free trade and globalization [following the collapse of communism] are weakening the U.S. economy. America now confronts the inexorable reduction of her own strength relative to the rest of the world. The major effect of globalization has been to solidify Europe and organize Asia…"

Natural resources now come from Russia…finished products from China. America cannot produce raw materials as cheaply as Russia, nor can it produce finished products as cheaply as China. For the moment, it relies on the kindness of strangers to cover the difference between what it spends and what it earns. Sooner or later, says Todd, the strangers won’t be so accomodating.

The Daily Reckoning