The Coming Internet Depression

Paul O’Neill notes that the Great Depression resulted from doing all the wrong things. This is the view made popular by Milton Friedman.

As historian Sean Cashman described the situation in the late ’20s and early ’30s:

“The people running the economic machinery simply did not fully understand the system they were operating. Official dependence on outdated cliches – such as maintaining the gold standard, balancing the budget, and opposing inflation – all posed insuperable barriers to an early solution to the crisis.”

“But after a while,” as Friedman observed, people “stop making the same mistakes.” What he forgot to say is that they begin to make new ones.

An historian, looking back on the boom of the late 90s, to which we have already borne witness, and its resolution in the early 2000s, which we await, is likely to notice both kinds of errors. That is, he will see the classic errors made by investors and policy makers – ignoring the business cycle….allowing themselves to get swept off their feet by greed and hubris…and believing that they could get something for nothing. Plus, he will see some entirely new errors too – products of the unique set of circumstances at the end of the 2nd millennium and the beginning of the next.

“Every economic era is afflicted with its own unique curse,” announces the opening sentence of Michael Mandel’s book, “The Coming Internet Depression.”

“Agricultural economies were tied to the rhythms of the harvests,” he continues. “Villages would prosper when crops were good, and suffer, when drought or pests withered the fields. A long enough drought could devastate a region or even a civilization.”

“Up until the business cycle of 1857, or perhaps 1866,” Mandel quotes Charles Kindleberger, “the harvest was the measure of business conditions. A bumper crop lowered the price of bread…crop failure, on the other hand, led to depression.”

In the long period pre-dating the industrial revolution, most of the economy of all nations was the farm economy. There was not much more than that. A bad harvest was bad news. But at least it was local bad news. People in the affected area suffered a decline in their standards of living. Economic slumps meant reduced rations. This affected all agricultural economies – even those in the New World. Skeletal remains of colonists in Maryland during the 1600s, for example, show that they suffered from periodic malnutrition.

If the economic crisis was particularly bad, and people had not saved enough in coin or grain, they starved to death.

But the Industrial Revolution changed things. It virtually eliminated the threat of starvation, by vastly boosting farm productivity…and by reducing the cost and time of transporting food. It compressed space – so that people in London could enjoy bananas from Latin America and people in New York could eat lamb raised in New Zealand.

Mandel: “The gradual shift to an industrial economy seemingly made growth more controllable and predictable. No longer was prosperity tied to the harvest… The new source of wealth was systematic investment in capital goods – machinery, factories, railroads, electrical and telephone systems – which could be used to multiply human productivity. At the same time the rise of the modern stock and bond markets in the second half of the 1800s provided financing for large capital projects on a scale never before dreamed of. The dawn of mass production permitted industrial economies to achieve unprecedented growth rates and living standards.

“It soon became clear, however, that industrial economies were prone to new types of economic fluctuations. Worse, these shocks were broader, more pervasive, and in many ways more violent than any country had experienced before. Starting in the middle of the 19th century, national and global capital markets opened up the door, for the first time, to national and global economic crises – the boom- and-bust cycles in business investment and labor markets that we now recognize as the familiar business cycle.”

After more than 200 years of observation, the business cycle should come as no surprise. Yet, each generation of investors and businessmen seems condemned to rediscover it on its own…at least once, and often several times.

As recalled in these letters, the railroad industry of the 19th century saw several full turns of the boom/bust cycle. Fortunes were invested in the belief that you couldn’t overspend on such a promising new technology – only to discover that too much had been spent. Investors went broke episodically, right up into the 20th century, as if each one was the Adam, the Alpha Man, of the investment world. “The total investment in American railroads came to roughly $10 billion in 1890,” Mandel tells us, “an enormous sum at a time when the entire annual output of the economy was on the order of $13 billion.”

As further recalled in these letters, the auto industry repeated the experience of the railroads – again, as if no one had ever before invested in a new transportation boom. Into this new investment Eden, billions of dollars were devoted to competing for the automobile ‘space.’ Five hundred separate companies were created.

But the business cycle still operated, in the 20th century as in the 19th. What went up so magnificently, fell with equal flamboyance.

“The depths of the collapse,” Mandel writes, “were staggering. In the twelve months prior to October 1929, America’s automobile factories produced over 4.7 million cars. In the year after the crash, automobile factories production fell by 40%, as consumers simply stopped buying. By 1932, production had fallen to only 1.12 million cars, 75% BELOW ITS PEAK. Over the stretch from 1929 to 1932, the number of automobile production workers fell by 45%, a decline that traumatized whole states. And that drop underestimates the economic impact: auto company payroll expenses actually dropped by 65%.”

More recently, the classic error and cause of the business cycle has been repeated in the go-go industry of our time: Information Technology. Fortunes have been spent on computers, the Internet, and telecommunications. So much excess capacity has been created that it will take years to work it off.

Mandel cites the example of Toys R Us, which in 1999 felt compelled to spend $86 million to set up a website in order to meet the challenge posed by eToys. EToys went public in May of ’99. The stock rose 200% in the first day of trading. It looked as though the toys online space was going to be worth billions. Toys R Us couldn’t let eToys get it all.

But a year later, online toy sales didn’t look so good. In fact, it appeared that eToys had spent too much on too small a market. The shares, which had traded at $76 on the first day of trading, closed on Friday at 15 cents. The company has gone bust.

“Like most failed e-tailers,” reports Forbes, “eToys overspent, building out infrastructure and floating an expensive marketing campaign in anticipation of a market that didn’t materialize fast enough to support the business.”

Among other evidence of overbuilding, eToys is left with a 1.2 million-square-foot distribution center in Blairs, Va., which opened in August 2000. “They built a great distribution center, but the volume you would have to do to make the place profitable is astronomical,” Forbes quotes an analyst, “No one’s e-commerce activities could even come close.”

Of course, these are merely the classic, traditional errors of the business cycle. In the present case, they have been permitted to go to greater excess than usual, thanks to the credit industry and the Fed…but the mistakes are the same as those made by the financiers of the railroads or the stock buyers of the ’20s or the Japanese real estate investors of the 1980s.

Tomorrow, we will look at what is really new about the New Economy…and why it threatens an even more calamitous correction.

Your correspondent….

Bill Bonner Ouzilly, France February 20, 2001

*** The dead presidents were honored yesterday with a holiday on Wall Street. So, things are pretty much as we left them on Friday. Wholesale prices are increasing at 13% per year – annualized from the latest month’s data. And tech companies are announcing that they either have no idea what the last part of the year will bring (Dell) or don’t like what they see (Nortel).

*** This week should be interesting too. The giant retailers – Nordstrom, J.C.Penny, Liz Claiborne, to name a few – will post their results. And on Wednesday, the Consumer Price Index for January will be revealed.

*** The trouble with recession is that people get laid off, lose income, and don’t buy as much stuff. Then, the people who sell stuff notice that their earnings are falling and they stop investing in the machines and people that make the stuff. The supply of stuff goes down until consumers begin to notice that they need stuff again.

*** What I have just described is, of course, the business cycle – which was declared dead in 1998…but is suddenly looking rather un-dead. Like it or not, the U.S. economy is now cursed with this ghoulish specter.

*** It is commonly believed that the beast can be put off, simply by waving a dollar bill in front of its face. Like making the sign of the cross in front of a werewolf, the dollar sign is supposed to cause a recession to shrink back into the shadows.

*** On this trick does Mr. Greenspan, the most celebrated recession-slayer of all time, rest his faith and his policy. Will it work? Not forever, certainly, but maybe one more time, allowing the Fed to puff up the bubble to an even greater extreme. That is what makes this all so interesting, don’t you think? When the bubble finally blows, now or later, the demons of economic hell will be loosed upon the world.

*** Asked if capitalism can exist without crisis, Paul O’Neill, U.S. secretary of the treasury, responded, “why not?” Well, that’s what we try to chronicle for you, dear reader, in these daily reckonings. It can’t exist without crisis, because crisis is what you inevitably get when people get carried away with one idea or another.

*** But O’Neill seems to believe in the perfectibility of capitalism. He said he thought the Great Depression was the result of bad policies – monetary, trade and fiscal. “We did everything wrong,” he said.

*** Will we do everything right this time? I don’t think so, dear reader, I don’t think so. Capitalism is inherently unstable. It is a system of booms and busts. Government policy cannot stop the boom/bust cycle…it can only make them worse.

*** O’Neill says he thinks the economy is growing at between plus 0.5% and minus 0.5%.

*** “The American middle class is full of families that could not write a check for the rent, utilities, insurance and car payment at the same time,” writes Lynn Carpenter. Lynn’s convinced that the true barometer of the economy comes not from the major indexes, or the Fed funds rate, but from the balance sheet of the average family.

*** “Families need to put a new television on their credit card…” Lynn points out. “Yet, since 1974, rent and utilities have fallen from 23% of an average family’s spending to 17%-in real terms, after inflation. Food has gone from 19% of the budget to under 14%. What’s going on here? For one thing, that 26% reduction in housing costs is offset by a 600% increase in the portion of the budget spent on recreation! Families are also tripling the amount they devote to apparel and shoes, and doubling what they spend on transportation…”

*** A number of class action suits against Nortel have been set in motion. Plaintiffs charge that the company misled investors…and note that company executives sold $7 million of Nortel shares within 3 weeks of the profit warning announcement. Nortel, once at C124.50 is now around C30. The shares rose C2.25 yesterday in Toronto.

*** The 9 major tobacco companies are up an average of 90% so far this year. But, uh oh, analysts have turned bullish on tobacco. Philip Morris, which we suggested to you a year ago, now trades at $47.

*** A friend sent me a remarkable exhibit from the ‘practice random acts of kindness’ school of marketing. “We can’t make your tuna salad just the way you like it,” says the letter. But can send customers 10 1-cent stamps to help them adjust to the postal rate increase in January, which is what it did. In big ways in and small ones, Amazon continues to redistribute shareholder’s money to customers. “Short Amazon” says the accompanying message from my friend.

*** “Everything is out of phase,” said our gardener, Mr. Deshais, this morning. A week ago, we were outdoors in our shirtsleeves telling each other that winter was over. Today, I am sitting so close to the fire I can smell my sweater burning – and looking out the window at the plum trees already in bloom. It has turned very cold. Snow has been forecast for later in the week.

*** “I’m going to kill the goose,” Mr. Deshais added.

“Why,” I asked naively, “what did it do?”

“No, no, Monsieur Bonner,” said the ever-practical gardener, “we now have room in the freezer, so there’s no reason to continue feeding it.”

Later, I went out to the woodshed to see what he was up to. The goose was strung up by his feet. The white feathers of its neck had turned red…and were dripping. Not quite dead. I wondered what it must have thought. The poor thing watched Mr. Deshais’s little dog, Tina, drink the pooled blood on the ground. Mother nature is no sentimentalist.

*** “Live Large,” urges a headline at I imagined the scene…a fat person, finally liberated from the restraint of embarrassment, rises triumphantly at a meeting and tells his fellow weight watchers: “Stuff it! I’ve had it with starving myself. I’m going to Live Large!”

But no, the Forbes message – which might be better phrased, “Live Grandly,” offers readers a chance to win 3 nights at the Forbes chateau, which I believe is in the Loire Valley not too far from here.

*** Not to be outdone, I will offer DR readers a similar contest. First-place winners will get 3 nights free in my chateau d’Ouzilly. Losers will get 4 nights. Details to follow.