Serial Bubble Blowers

Yesterday, our friends at the Everbank trading desk declared, “the dollar rally is done.” Today, The Daily Reckoning’s Addison Wiggin shows why the crack in the rally was inevitable. Where the dollar is concerned? Sell!

According to the consensus view, the U.S. economy is breaking out of its anemic growth pattern.

A few signs of accelerating economic improvement are gleefully cited to support this forecast, such as the 8.2 percent spurt of “real GDP growth” in the third quarter of 2003 and higher investment technology spending, up 22 percent; surging profits, and surging early indicators, among them in particular indicators such as the Institute of Supply Management (ISM) survey for manufacturing.

Various indicators are at their strongest in 20 years. But do we simply accept the popular wisdom? No, because many of the reported indicators are nonrecurring. If they aren’t really signs of a sustained pattern, the results are dubious at best. For example, the impressive third quarter 2003 growth spurt was the direct result of a one-time splurge in federal tax rebates and a flurry of mortgage refinancing caused by low interest rates. As to investment spending, what is really going on? So-called investment in housing is distorted by the housing bubble, and what should matter is the change in total nonresidential investment – business factories and equipment, for example – a trend that has been flat for many years. There is no real growth in business investment.

The U.S. economy’s so-called improvement has one main reason: all the economic growth of the “recovery” years since 2001 is traced to a seemingly endless array of asset and borrowing bubbles. Quoting analyst Stephen Roach, “The Fed, in effect, has become a serial bubble blower” – first the stock market bubble; then the bond bubble; then the housing bubble and the mortgage refinancing bubble. As a result, consumer spending has been surging well in excess of disposable income for years. But we must understand, this is not real growth.

Serial Bubbles: Consumer Spending Has Not Stimulated Investment Spending

The idea behind the bubble economy is that sustained and rising consumer spending would eventually stimulate investment spending. This is like suggesting that overeating will eventually lead to serious dieting. As you might expect, rising consumer spending has not had the desired effect. In fact, consumer spending will slow down when consumer borrowing starts to fade. And that’s just a matter of time.

The dollar is going to continue falling over the long run. It will fall as long as we continue to outspend our investment and production rates. If foreign investors were to slash their investment levels in the U.S. dollar and Treasury securities, that would cause a hard landing. Our credit would dry up rapidly. This would not just send the dollar crashing. A sudden rupture of private capital would also hammer the U.S. bond and stock markets.

Private foreign investment into U.S. assets has slumped. But we are addicted to foreign investment; this is where much of our consumer credit and debt is financed. So we are vulnerable if our credit economy is supported primarily by huge holdings of dollars on the part of foreign private and institutional investors. If the dollar’s fall begins to frighten foreign owners, they will sell from this immense stock of dollar assets.

How big are these foreign holdings? We rarely hear about this problem on the financial news channels, so what’s the big deal? Well, let’s run the numbers. At the end of 2002, foreign holdings of U.S. dollars had a market value of $9.078 trillion. This includes corporate and government bonds held directly and by foreign governments.

It’s a big number. The point here is that these huge foreign dollar holdings are a looming threat to the dollar, perhaps the biggest threat of all. If these foreign investors lose confidence in the U.S. economy and the dollar, they will sell and switch the dollar proceeds into a stronger currency.

That $9.078 trillion is a lot of debt. A lot. How is it going to get repaid? And by whom? The hope in Washington is that declining value of the dollar will reduce the U.S. trade deficit. Past experience shows that this is unlikely.

Serial Bubbles: Hardly Rock Solid

The chronic U.S. trade deficit is caused by exceptionally high levels of consumption, undersaving, and underinvestment. Improving the trade deficit would require a major correction of these imbalances, and cannot be fixed simply by watching the dollar’s value continue to decline. An economic downturn would come as a rude awakening to most Americans, a cataclysmic shock. It would directly affect the other two asset bubbles, housing and stocks, in addition to the dollar value bubble itself. Imagine the uncertainty and turmoil this will create in the financial markets. Rock solid? We think not.

The U.S. economy is much weaker and much more vulnerable than official statistics make it seem. The Fed cushioned the impact of the bursting stock market bubble by manipulating new asset bubbles. Ultralow short-term interest rates and the promise to keep them there for a long time have fueled a housing and mortgage borrowing boom, which also extended the consumer borrowing and- spending binge. “Happy days are here again.” Indeed.

While European policy makers and economists worry endlessly about budget deficits and slow growth, their counterparts on this side of the pond continue to boast how wonderfully efficient and flexible the U.S. economy is. Zero or even negative national savings, a growing trade deficit, never-ending budget deficits – all these and any other imbalances and dislocations are nonproblems. The official word is that the exploding credit and ballooning debt in America are not signs of excess, but a testimony of the financial system’s extraordinary efficiency.

Serial Bubbles: The Problem for the “Nonproblem” People

Small prediction: a shock awaits the “nonproblem” crowd when we finally confront our economic realities. The U.S. inflation rate is understated by at least 1.5 percentage points per year through economic/ statistical magic, grossly overstating real GDP and productivity growth. Bond king Bill Gross discovered this fact of life and commented on it in 2004. An active proponent of inflation manipulation was Fed chairman Alan Greenspan, apparently because – and here again we find a recurring theme – “a low inflation rate fosters low interest rates.”

The huge credit and debt bubbles in the United States have created a dislocated and imbalanced economy, so that a sustained recovery is going to be impossible without many painful changes. We suffer from a false sense of optimism, and when the implicit promise of that optimism is not met, experts will no longer be able to argue away the dollar’s weakness.

Under a system of truly free currency markets, the dollar would have collapsed long ago. But the massive dollar purchases by the Asian central banks have prevented this. China’s persistence in pegging its currency to the dollar traps other Asian countries into doing the same. This practice creates a credit bubble that, in turn, distorts economic growth. In contrast, the European Central Bank is firmly opposed to currency intervention. In its view, artificial tinkering in the currency markets tends to fuel credit excess. It could be right, using the U.S. economy as an example.

Those who like currency intervention policy – artificially controlling the value of the dollar, in essence – ignore the beneficial effects of a rising currency. The benefit is twofold. It reduces the trade deficit and makes us more competitive with our trade partners. And it also adds a healthy premium to domestic purchasing power. It’s important, though, to make a distinction here. Under our present system, our purchasing power is based exclusively on borrowed money. Under a system of competitive trade and a higher dollar, our purchasing power would be based on real economic forces, and not on good credit alone.


Addison Wiggin
for The Daily Reckoning

August 02, 2005

Yesterday, our friends at the Everbank trading desk declared, “the dollar rally is done.” Today, The Daily Reckoning’s Addison Wiggin shows why the crack in the rally was inevitable. Where the dollar is concerned? Sell!

“I hear, but I don’t listen,” was what Wim Duisenberg used to say.

The poor man had to hear many people urging him to loosen up Europe’s economy with lower lending rates from the central bank. Except for a handful of crank economists, such as Kurt Richebächer and your editors at The Daily Reckoning, practically everyone thought he was making a mistake. Politicians, business leaders, columnists and kibitzers – all wanted easy credit conditions so that Europe could grow faster, like the United States.

But Wim held his ground… and as a result, the Old World seemed to grow much slower than the New one. Few people bothered to look beyond the headline numbers. If they had, they might have tipped their hats to the ECB chief. European growth was sluggish, but real. At the end of the day, people had more earning power with low levels of household debt. In America, by contrast, higher levels of consumption – caused by the Fed’s low rates, the lending industry’s innovations, and Anglo-Saxons’ natural inclination to bankrupt themselves – brought about a disaster. Americans now owe more money to more people than any people ever did before. And their spending has helped to create such huge new competitors – in Asia, mainly – that they will have a very hard time earning enough money to pay the interest…let alone the principal.

But Duisenberg never got any thanks. Instead, he met his end two days ago in the South of France. While his American colleagues drowned their countrymen in liquidity, old Wim drowned only himself – in his own swimming pool. RIP.

There are times, dear reader, when you should think other thoughts. Here at The Daily Reckoning, we have been thinking the same thoughts for a very long time. We tried to explain it to a young woman at a dinner party the other day.

“There are two main branches of the economics profession,” we began…as the woman looked around nervously, searching for an escape. “There is the old, withered branch of ‘moral’ philosophers…who think you can’t get something for nothing. And there are all the rest…the modern economists who spend their lives pretending that you can. They think that if they can just come up with the right policy at just the right time, they can improve the future before it happens. A man may decide to sell his neighbor a bale of hay for $1. The old crank economists would say – ‘so be it.’ But the new ones would find a way to meddle – believing they could make the economy better by controlling the transaction themselves. They’d raise the interest rate, or impose a tax, or prevent the sale altogether.

Inevitably, their interference would make things worse. You see, there are two groups of economists. But one group are a bunch of idiots.”

That summary seems enough for us, dear reader. So we will think about other things for the rest of the summer – or at least whilst we are on vacation.

More news, from our team at The Rude Awakening:


Eric Fry, reporting from Manhattan…

“Buy sunscreen, not Sun Microsystems…Such is the approximate message delivered by several stock market indicators, according to options pro, Jay Shartsis.”


Bill Bonner, with more views:

*** We talked yesterday about Kevin Kerr’s dead-on insights…and apparently we aren’t the only ones who think so. One of Kevin’s Resource Trader Alert subscribers wrote this note to Kevin this morning:

“I read in the Aug. 1 Daily Reckoning about your accurate prediction that BP’s Texas City refinery was just another accident waiting to happen….I’m sure glad I followed your recommendation and got into the Feb. 06 NY Crude trades. Do the recent difficulties at BP, coupled with King Fahd’s death in Saudi Arabia, change our target price and related exit strategy? Also, with the recent activity around the Yuan are you looking at any currency trades? Thank you, and keep up the great work. I’m a relatively new subscriber who did his homework before signing on with you. I’ve been extremely pleased with results to date and have several open trades following your recent recommendations.”

*** What if the property bubble does pop? Already, in both the UK and Australia, property prices seem to be headed down. But there has been no serious economic calamity so far.

Stephen Roach comments:

“To the extent that both the U.K. and Australia seem to have succeeded in gradually taking the excesses out of their residential real estate markets without seriously disrupting their economies, there is hope that the U.S. can pull it off, as well. Anything is possible, but I think those presumptions miss an important and very basic contextual point: The scale of U.S. property holdings dwarfs housing values elsewhere in the Anglo-Saxon world. For example, in 2004, the value of U.S. residential property hit $17.2 trillion – three times the $5.8 trillion value of the U.K. housing stock. But it’s not just the disparities in real estate values that hint at macro vulnerability to post-bubble adjustments. It’s the link between property and consumption that makes for the biggest difference of all.

“For my money, the U.S. has set the global standard insofar as excess consumer demand is concerned – a consumption share that currently tops 70% of GDP. This is well above the U.K. share of 63% and the Australian share at 60%. The excesses of U.S. consumption stand out all the more in a climate of weak labor income generation – with the worker compensation piece of U.S. personal income currently running some $265 billion (in real terms) below the profile of the typical expansion. The juxtaposition of excessive consumption and weak income is manifested in the form of striking disparities in personal saving rates – 4.8% in the U.K. in early 2005 versus 0.9% in the United States.

(Note: Australia ‘s personal saving rate has been in negative territory since 2002; however, given its relatively low consumption share of GDP, the risk of a major post-bubble adjustment is lower than that of the U.S.)

“On balance, the saving-short, asset-dependent American consumer has made a much more aggressive consumption bet than has been the case in either the U.K. or Australia. As a result, there is good reason to believe that the U.S. economy would be much more vulnerable to a bursting of its residential property bubble than might be implied by experiences elsewhere in the Anglo-Saxon world. The United States relies on its property bubble far more than the U.K. or Australia to square the circle of excess consumption and weak internal income generation. This relative desperation of the asset-dependent American consumer should caution us from drawing comfort from the seemingly gentle aftershocks of other post-bubble workouts.”

The Daily Reckoning