Structural Drags

Many economists are still convinced of the United States’ economic strength…but the Good Doctor shows us that the U.S economy’s famous resilience is due to clever statistics and monetary looseness…

From the macro perspective, U.S. business profits received their main boost from two flows in recent years. One was the phenomenal decline of personal saving, and the other was the soaring budget deficit accruing from tax cuts and higher spending.

Saving is the unspent part of personal income. To this extent, wage earners reduce total business receipts in relation to total expenses incurred. The net result is a corresponding fall in profits. Conversely, when households run down their saving, business revenues rise in relation to expenses incurred. The net result is higher profits.

In this way, the phenomenal collapse of personal saving in the past few years has been Corporate America’s main profit bonanza. This was far more important than the direct and indirect revenue flows from the soaring budget deficit.

But the trouble is that the soaring U.S. trade deficit in recent years has been diverting a rapidly growing share of such spending and its inherent profit creation to foreign producers. In essence, the trade deficit directly transfers spending and profits from domestic to foreign producers, leaving American producers with the wage expenses, which their employees spend on foreign goods. As we have stressed many times, the trade deficit is the greatest profit killer in the U.S. economy.

Macroeconomics and Net Capital Investment: Two Streams of Money

We come to the most important macroeconomic profit source in a healthy economy. Apparently unknown to most American economists, this is net capital investment. John M. Keynes expressed it with great simplicity and precision: There are two streams of money flowing to the entrepreneurs, namely, the part of their incomes that the public spends on consumption and the expenditures of businesses on net capital investment.

Economists, in general, are completely unaware of the crucial importance of business investment for business revenues and profits. This has a particular and peculiar reason. From the perspective of the business sector as a whole, investment spending creates business revenue without generating business expense.

What seems mysterious has, in reality, a simple explanation. Investing firms capitalize their investment expenditures. No expense is incurred until the first depreciation charge is recorded. For the producers of the capital goods, on the other hand, it involves a sale, producing immediate revenue.

Due to this particular treatment in accounting, net fixed investment is typically the business sector’s most important profit source. But in the United States, this profit source has dramatically collapsed in the past few years, as rising depreciations have overtaken gross new investment.

In 2003, net fixed investment amounted to $154.5 billion, after $404.8 billion in 2000. This implies, first of all, a rapidly shrinking capital stock; and second, a disastrous drag on business profits, because depreciations are expensive.

Answering the question of aggregate profit prospects for the U.S. economy in 2005 requires a macro perspective focusing on changes in four aggregates: personal saving, budget deficit, trade deficit and net business investment.

Our crucial assumption is that negative profit influences will grossly outweigh positive influences, suggesting in their wake lower business investment. If the consumer starts to save out of current income, the U.S. economy will slump.

We have characterized the U.S. economy as a bubble economy in the sense that asset appreciation has become its main engine of growth. Courtesy of the prolonged sharp rise in house prices, the American consumer has been willing and able to maintain his spending despite a protracted recession in employment and wage incomes.

But we see a variety of influences tempering the bubble climate. For the time being, the whole set of asset bubbles finds strong support from still exceptionally low short-term rates, still extremely loose money and credit, and high-riding expectations about strong U.S. economic growth and low inflation rates in 2005. Much economic data warn of impending strong disappointment on both counts that will prick the bubbles. Not to ignore, moreover, the Fed’s commitment to further rate hikes.

Yet the refusal of long-term rates to rise in response to the Fed’s serial exertions to raise short-term rates further is perplexing. Mr. Greenspan himself spoke of a "conundrum." A reported inflation rate above 3% would, by past experience, imply a federal funds rate of at least 5%. But a rate of 3.5% would already be enough to wreck the bond bubble, and in its wake, the stock and housing bubbles.

Macroeconomics and Net Capital Investment: An Immense Policy Risk

For sure, the financial community is fully aware of this immense policy risk, strictly limiting the Fed’s scope for further rate hikes. The amazing stability of long-term rates suggests the financial community has not only refused to unwind, but has even continued to add to existing carry-trade positions. They are still far too profitable to be abandoned before the Fed makes them unsustainable.

As no one is taking the Fed seriously, it may have to do more than it wants. The frightening point to see is that, given the U.S. economy’s heavy dependence on consumer spending for the housing bubble, a mere leveling of house prices would be enough to slash consumer spending and economic growth. We expect worse than price stagnation.

It ought to be realized that a rise in long-term rates by only 1-2 percentage points would rapidly play havoc with all existing asset bubbles – bonds, stocks, housing – and in consequence, with economic growth. Within a matter of months, there would be deep recession.

A crucial question is the inherent impact on personal saving. Voluntarily or involuntarily, private households will sharply restrain their borrowing and return to old-fashioned saving out of their current income. That this will badly depress consumer spending needs no explanation. Unfortunately, when consumption declines, fragile business and housing investment will fall as well.

Macroeconomics: Two Things Most People Don’t Know

Most people inside and outside of America have yet to realize two things: First, that among industrial countries, the U.S. economy has by far the worst structural fundamentals; and second, that it is far more vulnerable today than in the first two years of the decade.

Of course, American policymakers and economists have been trumpeting the opposite for years. Having realized their complete disregard of macroeconomics, we are sure that they earnestly believe this fairy tale. With this in mind, we recently, with great interest, read a report from Morgan Stanley about a meeting with customers in late January.

About global economic prospects for 2005, it said: "There was little doubt as to who would take the baton in a post-U.S.-centric world – it would be another encore for America. There was deep conviction that no one comes close to having such an ideal system – especially in terms of technology, the work force and America’s unique risk-taking culture. Market depth and flexibility – in both the financial and the nonfinancial realms – was depicted as the icing on the cake for yet another run of U.S.-centric global growth."

Later, it stated, "Europe, which has none of these qualities, is the last place where productivity could take off."

For us, this is typical Wall Street trash, bare of any serious macroeconomic thought. It used to be an elementary truism among economists that a healthy economy is rich in savings, rich in productive investment and rich in profits. The U.S. economy is extremely poor in all three. But it is extremely rich in financial speculation and corporate malfeasance.

To be sure, the enormous structural deficiencies are increasingly impairing U.S. economic growth. For the past three years, unprecedented monetary and fiscal profligacy has been able to overpower their depressant influence through the bubble-driven consumer borrowing-and-spending spree. Yet the "structural drags" are finally gaining the upper hand over the weakening bubble impetus. The U.S. economy’s famous resilience had more to do with clever statistics and unprecedented monetary looseness than with true economic strength.


Kurt Richebächer
for The Daily Reckoning

March 29, 2005 — Baltimore, Maryland

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."

The moon turns blue more often than we thought.

As you recall, dear reader, "fat tails" are what statisticians call the peculiar bulbs on either end of what is supposed to be a smooth bell-shaped curve. Random events can be represented by a bell curve, the edges of which are supposed to feather out to nothing. But when stock price movements were actually studied – as well as many other phenomena thought to be "random" – the curve looked a little odd. Out on the extremities, where almost nothing is supposed to happen, there is a surprising amount of activity. Things that were thought to happen only once in a blue moon – such as extreme volatility in stock prices – happen more often than expected.

And since they happen more often than people think, you can make money by betting on them – except when they’re in the news. Then, just the opposite happens…people over-price the unlikely event. But what people do most of the time is overestimate the chance of what usually happens, happening again. They overprice the likely events, or in other words, the things they find in the middle of the curve. If you were to plot out stock price movements for the last 25 years, for example, you’d look at the big hump in the middle and see that they tend to go up. People don’t do this themselves, but read about it so often the bell curve of price distribution is practically tattooed on their foreheads. They see it every time they look in a mirror. And every time, they think it’s time to buy.

Since this is what people believe, you can make a business out of selling stocks to people. Whether you can make money by being that business’s customer is another question, to which the answer is probably "no." At more than 20 times earnings, and dividend yields below 2%, stocks are better sold than bought. That can be seen, too, simply by looking at a bell curve with more data points – that is, by going back further and adjusting the numbers for inflation. What you see then is that stocks go up about as much as they go down. And when they are high, the real rates of return fall, punishing investors for paying too much.

We have been wondering what will happen to the dollar. It has gone down, just as we thought it would. If memory serves us, five years ago, you could buy an ounce of gold for just $288. Now, the same ounce costs you $426. And when the euro came out, you could get one for $1.18. In the months following, the dollar rose…taking the price of the euro down to 88 cents. But then, the dollar finally peaked out and has since fallen, coming to rest yesterday at $1.29.

If you read the popular financial press, you would think that the dollar probably has more falling to do. But nowhere is there any real worry about it. So where’s the fat tail, we wonder? Where’s the unlikely event that people have under-appreciated? Is it that the dollar will rise? Or that it will fall much more than people expect? As usual, we wait to find out along with everyone else.

What you see in a bell curve distribution pattern, Nicholas Taleb explained, is not the range of possible outcomes…but only the range of observed ones. The real outlier events aren’t anywhere in the models. And yet, they change everything. They make all the pricing assumptions invalid. We’ve been watching stock prices for a very long time, under a very wide assortment of conditions. The dollar has been around for a long time too…but never under today’s circumstances. It was only in 1971 that the dollar was cut loose from gold backing. Our models for the dollar’s behavior include drops of up to 40%. But never before, has the United States run such huge back-to-back deficits. Never before have savings in America been so low (forcing the United States to rely on the kindness of strangers). Never before has the country faced such a massive "financing gap" – $54 trillion – and never before have several foreign nations announced that they were lightening up on dollar reserves.

At the end of the 19th century, New Yorkers worried that that they would be buried in a mountain of horse manure. There were horse-drawn conveyances everywhere. The manure was piling up. Smart investors were buying shares in manure removal companies. Nothing in their charts or their models provided a clue to what would happen next; all they could do was to extrapolate out from existing trends and see themselves smothered in horse poop.

You always have the "black swan" waiting to be discovered, says Taleb. When you’ve seen only white ones, you assume they’re all white. Then, along comes a black one.

Where is the black swan in the currency markets? Investors look out their windows and they see only white ones – a declining dollar, but no real trouble. But somewhere out there, a big, nasty black swan must be hiding…waiting for that blue moon.

More news, from our team at The Rude Awakening…


Eric Fry, reporting from Manhattan:

"Wall St. is best known for its congenital optimism…but when it comes to the commodity arena, the Street is plain pessimistic! This stubborn streak gives sharp investors a chance to break down the house…"


Bill Bonner, with more views from Baltimore…

*** "The real estate boom is still going on," said a friend yesterday. "It’s just unbelievable. You remember that area in D.C., up on Rhode Island Avenue? It was so rough a few years ago you wouldn’t have dreamed of living there. But my daughter just bought a one-bedroom apartment, with a loft, for – get this – $370,000. She’s not even planning to live there for very long. Instead, she’s going to rent it out. She did the numbers, she figures she’ll make a lot of money."

*** More and more, the numbers are tilting in favor of renting, says the Wall Street Journal. The "cost gap" between renting and buying is at its widest in a decade. So many former renters are deciding to buy. And why not? You can buy with nothing down…and make "minimum payments" that are lower than rental payments. And then your house goes up 10%…20%…30% in price! What a deal…

"House prices go though the roof,’ says a headline from San Mateo, CA. Pretty soon, they will be orbiting the earth.

*** The weather was bad over Washington when our Air France flight arrived. The plane circled the airport, looking for an opening in the clouds, we imagined. All of a sudden, there was a flash of light…and an explosion up near the cockpit. Women screamed. Children cried. "What the #%@*?" said the young man in the adjoining seat.

The plane began to bounce around. No announcement was made. No one spoke.

We thought we should try to calm our fellow passengers.

"Well, at least we won’t have to worry about the trade deficit," we said.

Eventually, we learned that lightning had struck. But no damage had been done.

The Daily Reckoning