Bullish sentiment is riding at 1987 levels; tech stocks are leading the way in the reflation rally. What can we say, dear reader, but "oh là là…look out below!"
Hope and hype are again triumphing over reality.
The primary preoccupation in economics worldwide is the U.S. economy’s ‘recovery’, presently hyping the markets. We note three different views. First, a cocksure bullish consensus; second, doubtful voices, among them the Federal Reserve, stressing the lack of conclusive evidence; and third, a few lonely voices, ours among them, who flatly repudiate the possibility of a full-scale, self-sustaining economic recovery in the United States.
We see years of Japanese-style sluggish growth for America, if not worse.
Yet, the latest American Association of Individual Investors poll showed 71.4% bulls and a miniscule 8.6% bears. The gap between the two is the highest since August 1987, just weeks before the crash. Merrill Lynch surveys show institutional investors more fully invested than at any time in the past two years, and heavily overweight high tech.
The case of the bullish community rests crucially on the assumption that the U.S. economy is basically in excellent shape. Fed Chairman Alan Greenspan, and with him the large bullish community, have actually never seen anything seriously wrong with it.
Tangible Assets: A Series of Exogenous Shocks
In their view, its failure to return to normal economic growth is mainly due to a series of exogenous shocks inflicted one after the other on the economy: the stock market crash, the September 11 terrorist attack, the corporate governance scandals and the Iraq war. Rather, they consider it a sign of health that the economy has not weakened more in the face of this unusual sequence of shocks.
Yet compared to the extraordinary exuberance prevailing in the markets, the Fed has been remarkably hesitant in declaring the economy’s impending recovery. In his testimony to Congress, Greenspan acknowledged that the "economy is not yet showing convincing signs of a sustained pickup in growth." In the same vein, Richmond Fed President Alfred Broaddus said a bit later in an interview, "We still don’t have a critical mass of hard evidence that the economy is accelerating," defining "hard evidence" as increases in employment, production and capital spending.
Now to our own opinion: after careful analysis both of recent economic data and also of basic micro- and macroeconomic conditions for the resumption of strong economic growth, we have come to two conclusions:
* First, the U.S. economy neither improved nor accelerated in the second quarter. The reported GDP growth of 2.4% is grossly misleading. From the perspective of quality, it has distinctly deteriorated.
* Second, as we shall explain in detail, the crucial macro- and microeconomic conditions for a self-sustaining and self-reinforcing economic recovery remain flatly missing. Necessary economic and financial adjustments of past economic and financial excesses implicitly involve pain. But pain is not accepted in the United States. In essence, policymakers are trying to cure past borrowing excesses by more of the same and new excesses.
Tangible Assets: Loosening the Fed’s Shackles
Trying to assess the U.S. economy’s prospects, the first thing to realize is that past cyclical experience offers no guidance to the present downturn because it has completely different causes and also a completely different pattern.
All past recessions had their main cause in monetary tightening. As soon as the Federal Reserve loosened its shackles, the economy promptly took off again, propelled by pent-up demand. For the first time in history, the U.S. economy went into recession against the backdrop of most rampant money and credit growth.
Manifestly, the forces depressing the economy this time are radically different from past experience. The typical, major imbalance in post-war business cycles has usually been in inventories. To correct it, retailers and manufacturers temporarily sold from stock, depressing production. Once the stocks were down to desired levels, production came into its right again. At the heart of the regular V-shaped business cycles was the inventory cycle.
In contrast, the present downturn has its brunt in the combination of a profit and capital-spending crisis. At the same time, there has accumulated an array of economic and financial dislocations that tend to depress the economy in many ways, such as extremely poor profits, badly ravaged balance sheets, a variety of asset bubbles in different stages of development, excessive leverage in the whole financial system and shrinking cash flow. There is nothing normal anymore in the U.S. economy and its financial system.
For the old economists, investment in tangible assets – factories, commercial buildings and machinery – was paramount in creating both economic growth and wealth. It creates demand, employment and income as the capital goods are produced. And with their installment, all these new buildings, plant and equipment create increased supply along with increasing employment and income with increased productivity.
Tangible Assets: A High-Consumption Economy
The United States has always been a low-savings and low- investment economy. Putting it in reverse: a high- consumption economy. But all three went to unprecedented extremes over the past several years. Savings and investment have been run down to atrociously low levels that are typical for underdeveloped countries.
To repeat: Investment in tangible assets is paramount in creating everything that is decisive in generating our wealth and raising our living standards. Given the low levels of saving and investment in the United States, American policymakers and economists in recent years have elevated productivity growth to the single most important achievement of an economy. But just by itself, productivity growth creates only unemployment. It is the normally associated capital spending that makes for the necessary, simultaneous demand and employment growth.
This simple recognition – gross lack of saving and capital formation – is really at the root of our controversial and highly critical view of the U.S. economy’s sanity and vitality. True, its growth rate has been the highest among the industrial countries for years. But it has all the time been economic growth of the most miserable quality. The striking hallmarks of this extremely poor quality were collapsing savings, low rates of business fixed investment, a profit carnage that began at the height of the boom, exploding consumer and business debts and an exploding trade deficit.
Today’s economists have at their disposal information in quantity and speed as never before. But reading numerous reports, we have the impression that very few are making use of it.
Particularly shocking in this respect were the immediate euphoric reports about growth acceleration in the second quarter.
During the 1960-70s, by the way, the U.S. accumulated on average about 1.5 dollars of additional debt for each dollar of additional GDP. Just extrapolate this escalating relationship between the use of debt and economic activity. And think of it: the GDP growth of today is tomorrow a thing of the past, while the debts incurred remain.
Plainly, Greenspan’s policy has collapsed into uncontrolled money and debt creation that has rapidly diminishing returns on economic activity. The late economist Hyman P. Mynsky would call this a Ponzi economy, where debt payments on outstanding and soaring indebtedness are no longer met out of current income, but through new borrowing. Soaring unpaid interests become capitalized.
For The Daily Reckoning
September 09, 2003
P.S. We keep asking the question of the American economists: Are they providing deliberate misinformation or simply performing slipshod work? In our view, as usual, the latter rings true.
The whole economic discussion today is fixated on the next economic data with one single question in mind: is it better than expected? Careful, more detailed analysis with a longer-term perspective is completely missing. Obviously, most economists and journalists read no more than the brief summaries provided by agencies, like Bloomberg and Reuters, that only rehash the summaries preceding the official releases.
Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."
We now understand, more or less, how we got into this mess. We are waiting to find out how we get out.
Or, maybe we should say ‘messes’: one economic…the other political. One tragic…the other pathetic.
Debt and war start off with high expectations. But, like love affairs and camping trips, things usually begin to go wrong almost from the get-go. Finally, the campers return, looking as though it must have rained all weekend, and are almost always happy to be back home.
Sunday, the American president delivered some depressing news: we will be in Iraq for a very long time, and it will cost much more money than we thought. According to today’s Figaro, the U.S. deficit will rise even higher than we projected – to $600 billion.
What historians will make of the war, we cannot know. Perhaps it will be written off as an errant folly perpetrated by a pack of imbeciles – Bush, Rice, Rumsfeld, Rove, Perle and the rest of them. Or, maybe the adventure will have an unexpected twist, which miraculously transforms the neo-cons into geniuses and heros. More below…
But what of the economic mess? You understand how it developed. Once the U.S. no longer had to settle its accounts in gold…it could spend, spend, spend…
…which lit a fire under foreign producers, who realized they could sell, sell, sell…
While protesters railed against ‘globalization’ and deregulation…worrying on the one hand that they were stealing jobs from the developed world, and on the other that they were exploiting people in poor countries…they missed the cause: Nixon’s Dollar Standard system.
But now we see even the ‘anti-globablization’ intellectuals catching on:
"[G]lobalization was triggered by elected politicians, and central bankers, in both the U.S. and the U.K.," says a report from the New Economic Foundation. "In the post- Vietnam war era, led by Richard Nixon and later Ronald Reagan, these politicians sought ways to avoid making the ‘structural adjustments’ necessary to the American economy if debts incurred by foreign wars were to be repaid by U.S. taxpayers. Rather, these politicians preferred to disband the existing system of paying off debts by exchanging gold, and opening up capital markets, so that the U.S. could borrow to pay off its debts.
"This new arrangement also allowed them to print the money in which they paid off those debts (unlike poor countries which have to repay debts in foreign currencies like dollars or sterling). British politicians and central bankers were only too happy to act as U.S. intermediaries in the capital markets. Together they constructed a new financial architecture that effectively obliges central banks of both rich and poor countries to lend to the U.S. – by buying U.S. Treasury bills (debt).
"It is US treasury bills that have now effectively become the world’s reserve currency – where once that reserve currency was neutral (gold)…It is this international financial system that makes the U.S. administration so arrogant in its refusal to ‘adjust’ its economy by cutting spending and paying its way…It is this financial system which makes U.S. financiers so confident that the rest of the world will continue to finance their nation’s extravagant spending binge. In the words of David Goldman, head of debt research at Bank of America Securities: ‘America is at little risk for the foreseeable future, simply because the world’s capital has nowhere else to go'(Wall Street Journal, 13 August 2003).
"The Real World Economic Outlook challenges that view. There is now a growing consensus that the vast build-up of household, corporate, state and foreign debts of the U.S. is not sustainable. Some central banks are already switching out of U.S. dollars and into euros. When capital flows shift away from the U.S., and there are recent signs of this happening, Alan Greenspan may have to raise interest rates to attract capital back into the U.S. to fund the growing federal, state and foreign deficits. Indeed, the bond markets seem to be signalling that they expect this to happen quite soon.
"When interest rates begin to rise again, when debt costs soar both for corporates and households, when defaults and bankruptcies increase more rapidly than now – then the ‘tipping point’ will be reached."
When that happens…Americans will go bankrupt, their standards of living will be reduced…they will have to save, save, save…and the greatest credit bubble in history will deflate.
Eric Fry in the city that never sleeps…
– So many, many wonderful things are happening in the world today that it is impossible to determine precisely which wonderful thing is responsible for making stocks go up. Is it the fact that President Bush would like to ship another $87 billion dollars over to Iraq for immediate disposal? Or is it the fact that our economic recovery is producing steady job losses instead of steady job gains? Or is it, maybe, the fact that bond yields are climbing faster than they did during the months leading up to the 1987 crash?
– Whatever the reason, investors keep showing up every day to buy stocks, especially tech stocks. Yesterday, tech and biotech stocks powered the Nasdaq to an 18-month high. The ‘techy’ index jumped 1.5% to 1,887. The Dow advanced 90 points to 9,593, as it continued trudging toward 10,000. But the Dow is merely a follower; it is the Nasdaq that leads the way. The marvelous Nasdaq Composite has racked up an astounding 41% gain year-to-date.
– One distinguishing trait of the Nasdaq’s ‘echo bubble’ of 2003 is that investors, once again, are heeding the advice of Wall Street analysts, as if the analysts really knew something. When the analysts say "Buy," the lumps buy, just like they used to do in 1999. And when the analysts say "Sell"…Gotcha! Analysts don’t ever say "sell."
– Interestingly, Wall Street analysts are much more confident about the U.S. technology sector’s ‘recovery’ than are the tech industry insiders themselves. Yesterday, CS First Boston upgraded IBM to an ‘outperform’ rating from a ‘neutral,’ and also raised its 2004 earnings forecast for Big Blue.
– Smith Barney also did some cheerleading by raising its rating on the semiconductor equipment group to ‘overweight’ from ‘market weight’ on the hope that an improving economic will trigger a revival in the sector. Smith Barney expects industry sales to grow 20 percent in 2004 and 30 percent in 2005. But if the sales fail to materialize, the brokerage firm may be forced to change its rating on the industry group to ‘lead weight.’
– Merrill Lynch’s Richard Bernstein offered a bold contrary call on the tech sector yesterday – calling it "devoid of value by any reasonable valuation method." In the current market environment, however, ‘devoid of value’ is another way of saying ‘great-performing stock.’
– We are happy that our stock-buying brethren are enjoying this best of all possible worlds, and that buying richly priced stocks is once again a fruitful activity…assuming that one does not forget to sell them before they become cheaply priced stocks. We would not know when to sell an overpriced stock if we owned one, because we would not know when to buy it in the first place. So, instead, we will stand aside while the intrepid stock-buying lumpeninvestoriat becomes rich together… and then poor together.
– The dollar attempted to rally yesterday morning, but squandered its early gains. Ditto the bond market. Treasury bonds broke a three-day winning streak yesterday, as the 10-year Treasury note’s yield jumped to 4.41 percent from 4.35 percent at the previous close.
– Maybe a few of the folks out in Investorland are beginning to wonder where the United States will find all of the billions of dollars required to pay for the Iraqi occupation, while still paying for all the other swell stuff that our tax dollars support, like maintaining Yellowstone Park, paving roads, dispensing welfare checks and bankrolling the New York Attorney General’s posse.
– Where will the U.S. government (and the state governments) find the money for all of these things? Will it print the stuff, borrow money from foreigners, or both?
– Even before President Bush declared the need to spend an additional $87 billion in Iraq and Afghanistan, the Congressional Budget Office was projecting a record $455 billion budget shortfall this year. A $480 billion funding gap is expected to follow next fiscal year.
– Treasury-bond holders and dollar holders are becoming understandably antsy about America’s soaring federal deficit…and understandably reluctant to continue holding dollars and bonds. But stock holders don’t care about such matters. Let bond investors worry about such things. They know that all is well, as long as Cisco’s earnings will be higher next quarter and as long as consumers continue spending money they don’t have on things they don’t need.
Bill Bonner, back in Paris…
*** The news is all over the frog papers; the French love it. We mean, the spectacle of George W. Bush asking for their help.
Who was it…Rumsfeld? Perle? You remember, dear reader, we quoted him here. "Why would anyone bother going to lobby Jacques Chirac," he asked, "except if you wanted to change the cheese or something."
Well, now the American president is asking the ‘chocolate- making countries’ to help bail him out in Iraq. Well, that’s how the French press is reporting it. Columnists are wallowing in a delicious schadenfreude; headlines practically smirk: ‘I told you so.’
"We might ask a few questions," before coming to America’s aid, suggests Renaud Girard on the front page of the Figaro.
Such as why America refused to give us air support when our troops were surrounded by communists at Dien Bien Phu in 1954?
Or, why America failed to support a joint Anglo-French campaign, in 1956, against an Arab dictator, Nasser, who had clearly violated international law, by seizing the Suez Canal?
Or, why the U.S. continuously harassed and criticized the French for the way they tried to hold onto Algeria between 1954 and 1962?
On this last point, the French claim superior experience. They too tried to hold onto to a predominantly Moslem country, futilely as it turned out.
But the Pentagon is not above trying to learn from the experience of others. Recently, the Defense Department showed a 1965 film, The Battle of Algiers. The movie was made by Gillo Portecorvo, who was then a member of the communist party, and banned from visiting America. But now, 38 years later, his flick has made it to the Pentagon theatre where military leaders are studying it to try to understand what the French did wrong.
Of course, no one asked our advice – then or now. But had we been asked, we would have given the same counsel to DeGaulle as to Bush…as to Gustavos Adoplhus, Bonaparte or Hitler…as to stock market investors…bond buyers…debtors…campers and lovers everywhere: watch out…the beginning is always more fun than the end.