The Era of Fictitious Capitalism

When ‘real value’ is no longer what seems to matter…you can be sure it matters more than ever…


While doing radio interviews this fall regarding themes in our book, the question invariably arises: "France? Nice place to visit, but why the heck do you live there?"

The short answer is, of course, the wine is cheap and the woman are…um, elegant. The long answer is, we gain perspective. It’s the long answer, because it requires an explanation. One could gain perspective from just about anywhere, of course…but why not do it in a place where the wine is cheap and the women pleasing to look at?

An English reader, who also lives in France, recently passed on an interesting article written by a Chinese bureaucrat, published on a non-profit website hosted in Italy, sponsored by the government of Singapore. The aim of the site is to increase amicable relations between Asia and Europe in a U.S.-centric world. The purpose of the article: a strategic recommendation on how China ought to position itself while the U.S. and Europe – as the major players in the two-bloc international system the author predicts will eventually emerge – gear up for eventual war.

If we were writing our daily missives from our offices in Baltimore, would such a site, and such an article, be interesting? Probably. But we’d likely judge the origin of the site through Murdoch’s lens at Fox News, like so many TV-addled minds do, and dismiss it out of hand. Away from influence, living as foreigners, in a country where they don’t pronounce words as they are spelled, we take to the extraordinary like gnats to a sugar bowl. We are addicted to the taste and go there often to get a buzz going. But we are under no illusions that it has nutritional value.

Wang Jian: Clouds of War

What could possibly interest us about a Chinese bureaucrat’s white paper on impending global war? First of all, his conclusion: "In the last century," writes Wang Jian, "American people were pioneers of system and technology innovation. However, the interests of a few American financial monopolies now lead this country to war. This is such a tragedy for the American people.

"Clouds of war are gathering. Right now, the most important things to do for China are:

1. Remain neutral between two military groups while insisting on an anti-war attitude. 2. Stock up in strategic reserves 3. Get ready for a short supply of oil 4. Strengthen armament power 5. Speed up economic integration with Japan, Hong Kong, Korea and Taiwan…"

It’s a rather unsettling idea. China as the neutral power in a war between the United States and a united Europe. How did Wang get there? That’s the subject of the second part of the article, which we find intriguing…and even more unnerving. Wang’s view is disturbingly similar to our own understanding of the way the global economy works.

"War is the extension of politics and politics is the extension of economic interests," Wang asserts. "America’s wars abroad have always had a clear goal, however, such goals were never made obvious to the public. We need to see through the surface and reach the essence of the matters. In other words, we need to figure out what the fundamental economic interests of America are. Missing this point, we would be misled by American government’s shows and feints."

Wang’s argument in a nutshell: By the mid 1970s, the U.S., the U.K., France, Germany, Italy, Japan and other major capitalist countries had completed the industrialization process now underway in China. In 1971, when Nixon closed the gold window, the Bretton Woods system collapsed, and the dollar – the last major currency to be tethered to gold – came unstuck. Economic growth as measured by GDP was no longer restricted by the growth of material goods production. Toss in a few financial innovations, like derivatives, and the "fictitious" economy assumed the central role in the global monetary system.

Wang Jian: A Plummeting Ratio

"Money transactions related to material goods production," writes Wang, "counted 80% of the total [global] transactions until 1970. However, only 5 years after the collapse of the Bretton Woods the ratio turned upside down – only 20% of money transactions were related material goods production and circulation. The ratio dropped to .7% in 1997."

As we note in our book, since Greenspan assumed the central role at the most powerful central bank in the world, he has expanded the money supply more than all other Fed chairmen combined. From 1985-2000, production of material goods in the U.S. has increased only 50%, while the money supply has grown by a factor 3. Money has been growing more than six times as fast as the rate of goods production. The results? Wang’s research reveals that in 1997, before the blow-off in the U.S. stock market, mind you, global "money" transactions totaled $600 trillion. Goods production was a mere 1% of that.

"People seem to take it for granted that financial values can be created endlessly out of nowhere and pile up to the moon," our friend Robert Prechter writes in his book, Conquer the Crash. "Turn the direction around and mention that financial values can disappear in into nowhere and they insist that it isn’t possible. ‘The money has to go somewhere…It just moves from stocks to bonds to money funds…it never goes away…For every buyer, there is a seller, so the money just changes hands.’ That is true of money, just as it was all the way up, but it’s not true of values, which changed all the way up."

In the fictitious economy, the values for paper assets are only derived from the perceptions of the buyer and seller. A man may believe he is worth a million dollars, because he holds stocks or bonds generally agreed in the market to hold that value. When he presents his net worth to a lender, a mortgage banker for example, and wishes to use the financial assets as collateral for a loan, his million dollars is now miraculously worth two. If the market drops, the lender, now nervous about his own assets, calls in the note…the borrower once thought to be worth two million discovers he is broke.

"The dynamics of value expansion and contraction explain why a bear market can bankrupt millions of people," Prechter explains. "When the market turns down, [value expansion] goes into reverse. Only a very few owners of a collapsing financial asset trade it for money at 90 percent of peak value. Some others may get out at 80 percent, 50 percent or 30 percent of peak value. In each case, sellers are simply transforming the remaining future value losses to someone else."

Wang Jian: Deer in Headlights

As we saw in the 2000-2002 bear market, in such situations, most investors act as if they were deer being approached by a speeding truck at night. They do nothing. And get stuck holding financial assets at lower – or worse, non-existant – values. Anyone suffering glances at their pension statements over the past few years knows their prior "value" was a figment of their imagination.

Back to Wang: "In the era of fictitious capitalism, a fictitious capital transaction itself can increase the ‘book value’ of monetary capital; therefore monetary capital no longer has to go through material goods production before it returns to more monetary capital. Capitalists no longer need to do the ‘painful’ thing – material goods production."

Real-life owners of stocks, bonds, foreign currency and real estate have increasingly taken advantage of historically low interest rates and applied for mortgages backed by the value of these financial assets. Especially since the rally began 8 months ago, they then turn around and trade the new capital on the markets. "During this process," writes Wang, "the demand of money no longer comes from the expansion of material goods production, instead it comes from the inflation of capital price. The process repeats itself."

Derivatives instruments, themselves a form of fictitious capital, help investors bet on the direction of capital prices. And central banks, unfettered by the tedious foundation set by the gold standard, can print as much money as is required by the demands of the fictitious economy. You can, of course, trade the marginal values of these fictitious instruments and do quite well for yourself.

But Wang sees a darker side to the equation. "Fictitious capital is no more than a piece of paper, or an electric signal in a computer disk. Theoretically, such capital cannot feed anyone no matter how much its value increases in the marketplace. So why is it so enthusiastically pursued by the major capitalist countries?"

The reason, at least until recently, is that the "major capitalist countries" have been using their fictitious capital to finance consumption of "other countries’" material goods. Thus far, the most major of the capitalist countries, the U.S., has been able to profit from the system because since the establishment of the Bretton Woods system, and increasingly since its demise, the world has balanced its accounts in dollars.

Wang Jian: The Fictitious Economy

"Until now," writes Wang, "U.S. dollars [have counted] for 60-70% in settlement transactions and currency reserves. However, before the ‘fictitious capital’ era, more exactly, before the fictitious economy began inflating insanely in the 1990s, America could not possibly capture surplus products from other countries on such a large scale simply by taking advantage of the dollar’s special status in the world…Lured by the concept of the ‘new economy’, international capital flew into the American securities market and purchased American capital, thus resulting in the great performance of U.S. dollar and abnormal exuberance in the American security market."

And here we arrive at the crux of Wang’s argument that a war is brewing. "While [fictitious capital] has been bringing to America economic prosperity and hegemonic power over money," he suggests, "it has its own inborn weakness. In order to sustain such prosperity and hegemonic power, America has to keep unilateral inflow of international capital to the American market…If America loses its hegemonic power over money, its domestic consumption level will plunge 30-40%. Such an outcome would be devastating for the US economy. It could be more harmful to the economy than the Great Depression of 1929 to 1933."

Japan’s example suggests, as your editors have oft reminded you, that a collapse in asset values in a fictitious economy can adversely affect the real economy for a long time.

In the era of fictitious capital, Wang surmises, America must keep its hegemonic power over money in order to keep feeding the enormous yaw in its consumerist belly. Hegemonic power over money requires that international capital keep flowing into the market from all participating economies. Should the financial market collapse, the economy would sink into depression.

America’s reigning financial monopolies, he believes, (whoever they may be), would not stand for it.

Addison Wiggin,
The Daily Reckoning

December 02, 2003 — Paris, France

P.S. Wang writes that he was disturbed to draw these conclusions. And as noted above, he recommends that the Chinese government plan accordingly.

He could not be any more disturbed than your editors here in the Paris office. We’ve grown to like the perspective we’ve developed while enjoying carafes at the Paradis and watching passersby pass by. Trouble is, if Wang’s conclusions are correct, then the currency most suited to challenge the hegemony of the U.S. dollar has just this week closed at a historic high of $1.20.

Addison Wiggin is the editorial director of the Daily Reckoning. He is also the author, with Bill Bonner, of the New York Times Business best-seller Financial Reckoning Day: Surviving The Soft Depression of the 21st Century, (John Wiley & Sons).

Fools rush in…watch out.

Do you laugh, dear reader? Or cry?

We got news this morning of a woman in Orange City, Florida, who was trampled while waiting to get into a Wal- Mart Super Center for a 5-hour ‘Blitz’ sale. There are so many fools rushing into so many traps…you risk getting stomped by them.

Investors are rushing to buy stocks with hardly a prayer of getting their money back…(See Christopher Byron’s note, below…)

Foreigner central bankers are rushing to buy U.S. dollar bonds – even as the U.S. dollar itself slides lower every day.

And consumers keep the illusion of prosperity alive…by buying things they don’t need with money they don’t have…and counting on the kindness of strangers to make up the difference.

We keep saying that everything has its limits…and that even the kindness of strangers eventually runs out. But who listens? And who cares?

Of course, we give a hearty laugh when we see central bankers blowing themselves up…and a schadenfreudian chuckle at investors generally. (Isn’t the whole idea of the stock market to separate them from their money?) But consumers? Ah…the poor lumps are fools, no doubt about that. But they are such pathetic fools…you can’t help but feel a little sorry for them.

"It’s not about people deciding to celebrate at the malls following a job loss," Elizabeth Warren explained to our old friend, Scott Burns. "It’s about people using short- term, high-interest debt to manage the mortgage payment, utilities and food at the same time.

"It means bankruptcies will continue to rise, home foreclosures will continue to go up. The signs of economic distress are everywhere around us. It breaks my heart and makes me furious." Guess which group of Americans is going bankrupt at the fastest rate? People over 65, said Ms. Warren. And the second-fastest pace is among people 55 to 65.

These are not reckless kids who don’t know any better, she went on to say. They are people lured by economists and trapped by the credit industry. ‘Go out and buy a new SUV,’ we recall Robert McTeer urging consumers, ‘preferably a Navigator.’ And why not? If you’re going to blow yourself up, you might as well do it in the comfort of a luxury road hog.

Who can help feel a little sympathy for them? The little lambs have been led to the slaughter by their own shepherds at the Federal Reserve. Now, the wolves over at E-Z Credit Lending Center have their chompers into them.

Never before have conditions been so perfect for turning consumers into dead meat. As interest rates came down, they were able to take money out of their houses…and still make lower mortgage payments. Car companies helped out, offering bigger guzzlers at higher prices – while also lowering monthly carrying costs.

And then along came the Bush Administration with its own contribution to consumer insolvency: wars and tax cuts. The wars silenced conservative critiques, distracted the public from its balance sheets and gave the nation a sense of collective purpose. As for the tax cuts, we never met one we didn’t like, but we’re having doubts about this one. Evidence coming in from recent months suggests that consumers took the money as though it was a gift from heaven. So buoyed were their spirits that they spent it all…and borrowed more! Take out the effects of the tax cuts and extraordinary auto incentives and the GDP grew only 2.2% in the 3rd quarter, says yesterday’s news. But credit card, non-revolving and other consumer debt rose at about 10% – or 4 times as fast.

As Addison reported yesterday, a New York Times article tells us "Why Americans Must Continue to Spend." Why? Because they want things, says the august journal. And because, the economy depends on them.

"People in Hell want ice-water," your editor’s father used to remark. "But that doesn’t mean they’ll get it."

Over to Eric, with more news:


Eric Fry writing from the Big Apple…

– Apparently, these are the good old days…the economy is booming, the stock market is booming and the gold market is booming. What’s not to like? Based on the latest government statistics and the bull market in stocks, we Americans are becoming more prosperous by the day. Unfortunately, our prosperity is denominated in dollars, a currency which tumbles lower by the day.

– Yesterday, the major stock market averages all soared to their highest levels of the year. The Dow charged ahead 117 points to 9,899, while the Nasdaq jumped 1.5%, to 1,990 – its highest level in nearly two years.

– The stock buyers gained confidence from fresh indications of economic revival. The Institute for Supply Management’s November index on U.S. factory activity jumped to 62.8% from 57% in October. The ISM Index had not logged such a sharp monthly gain in 20 years.

– Meanwhile, news from the Consumer Front reveals an insatiable urge to splurge. ShopperTrak, which combines Commerce Department data with reports from 30,000 store traffic monitors across the nation, said retail sales last Friday rose 4.8% over last year. Visa USA reported an even more dramatic increase in debt-financed consumption. Spending on credit and debit cards during the Friday and Saturday following Thanksgiving jumped 12% over the same period a year ago.

– Curiously, the booming economy and stock market are not inspiring a corresponding boom for the U.S. dollar. The greenback hit yet another all-time low against the euro yesterday morning, before strengthening a bit during the New York trading session to $1.197 per euro.

– The gold market, meanwhile, dazzled its growing crowd of admirers by surging $5.80 yesterday to $403.80 an ounce – its first close above $400 in more than seven years!

– After the gold price topped out above $800 an ounce in 1980, gold investors spent the next 20 years wandering around in the bear market wilderness of failed rally attempts and prodigious capital losses. Then, finally, along came a falling dollar to escort the gold price into the Promised Land above $400 an ounce – a land where gold stock profits flow like milk and honey.

– Certainly, it would be no great surprise if gold were to slip back below $400 for a while. On four separate rally attempts during the last 15 years, the gold price stalled in the $400 to $425. In 1989, 1990, 1993, and 1996 gold breached $400 an ounce, only to tumble shortly thereafter. History could repeat itself, but Peter Munk doubts it.

– The Chairman of Barrick Gold thinks the gold price is headed much higher. Should we care what Munk thinks? Well, we probably shouldn’t dismiss his opinion outright. Munk earned himself a large fortune and a small amount of fame by correctly betting against the gold price. For more than a decade, Munk’s Barrick Gold used innovative hedging tactics to lock in high prices for its gold production. Thanks to Barrick’s aggressive hedging strategy, the company breezed through gold’s two-decade bear market.

– "Gold spent much of the 1980s and 1990s in a bear market," Canada’s Financial Post relates, "and Barrick’s gamble on falling gold prices helped the company generate US$2-billion in cash." But the highly successful gold bear is now changing his tune. He says Barrick will begin eliminating its hedge book.

– "Mr. Munk’s decision to move away from hedging indicates that even he believes gold has a bright future," the Financial Post continues. "That’s in line with the forecast from Pierre Lassonde, president of the world’s largest gold miner, Denver-based Newmont Mining Corp. ‘Gold at around US$400 an ounce is probably fairly valued right now. You are very likely to see its price trade around that for the next while, with a US$50 an ounce band on either side of it,’ he said. But, he added, that’s just the beginning."

– Lassonde predicts an epic gold bull market – the sort of bull market that most investors have never seen. It’s been more than three decades since gold soared 2,200% from US$35 an ounce in 1971 to a peak of more than US$800 in the early 1980s. Says the confident Lassonde: "Since gold hit US$250 an ounce in 2001, it is up 55%. We still have a long way to go. This is chapter two of a 20-chapter book."


Bill Bonner, back in Paris…

*** Christopher Byron, with more fools rushing in:

"The idea: Buy shares in an obscure and struggling California outfit called 8×8 Inc. – which plans to take on corporate giants like Verizon, AT&T and many of America’s largest cable companies simultaneously by selling "all you can eat" phone calls over the Internet. Viewed from the north tower of C.A., 8×8 Inc. seems to be emerging less as a real business than as a gambler’s bet that the company will be taken over by a larger rival before the money runs out and the business collapses.

"Meanwhile, investors have been going nuts over the stock. Back in February, the shares were selling for a mere 17 cents, and were still trading for barely 50 cents as recently as August. Yet by Friday they were changing hands at prices as high as $8.06 before ending the day at $7.52.

"At that price, the shares have gained 4,323 percent so far this year, making 8×8 Inc. far and away the hottest Nasdaq stock of 2003, sporting a market value of $232 million for a business with just 53 employees and top-line revenues of less than $10 million per year."

*** "The U.S. is following Japan, more or less, with a 10- year lag."

This idea became such a recurring theme in the Daily Reckoning that not only did it spawn a book, but readers and editors alike got sick of it. Still, we have not abandoned it. The U.S. responded to its crisis faster and more aggressively than the Japanese. For its trouble, it got a weeny of a recession and a recovery only marginally stronger than Japan’s. The serious trouble in Japan didn’t begin until several years after the stock market topped out in January of 1990. America’s serious trouble is still ahead – 10 years following Japan’s.

But at some point, America and Japan must part company. The U.S. is the world’s largest debtor. Japan was always one of the world’s largest creditors. Japan – with mountainous savings and a positive current account balance – could hunker down and ride out a 13-year slump. America – with twin deficits (trade and federal budget) of more than a half-trillion dollars each – cannot. At some point, America’s slump must follow another path.

Some day, perhaps soon, foreigners will stop buying U.S. treasuries, the dollar will fall…and interest rates in the U.S. will rise. All of a sudden, the best conditions for consumers will turn into the worst. Their debts will be harder than ever to carry – with rising monthly payments…and less money to spend. Sales will plummet. Jobs will be lost…and the economy will be a complete disaster. They will have to walk away from their houses…and their expensive land barges.

They will be poorer…and finally realize it. They will be older, and not especially like it. They will be wiser, and angrier, but not necessarily any less happy.

We look to the pampas for a peek into the future, where Argentina’s middle class has been practically obliterated by inflation, joblessness, and depression. Friend Paul Terhorst, who lived for many years in Argentina, sends this note:

"A friend here gave me a graph showing Argentina’s progress over the last hundred years. The graph compares Argentina’s income per capita, adjusted for purchasing power parity, to the average of ten other countries, essentially the developed countries plus Brazil.

"In 1910 and 1925 Argentina, approached the average standard of living of the base countries. However, even in those years Argentina must have been far poorer than the richer countries, Britain and the U.S., for example. I’ve never believed the saying that Americans at one time wanted to be ‘rich as an Argentine,’ and I think this graph supports my case.

"Note, too, that for the past 75 years or so Argentina has been going downhill. If 2001 to 2003 were added to the graph, we’d see a very steep additional decline."

*** Jules, 15, returned yesterday from a class trip to Ghana, wiser…and thin as a piece of plasterboard. He had stayed for two weeks in a boarding school with 200 Ghanian students.

"Everybody was very nice in Ghana. We were supposed to be teaching French, but we could barely understand their English.

"We all got sick," he went on. "I mean all the kids in my group. Dysentery…or just diarrhea. Every day in the cafeteria, they had the same thing…some kind of rice with chicken in it. After a few days, we couldn’t stand it. But there wasn’t anywhere else to go. Wow…when we landed in Amsterdam on the way back! All the kids rushed over to McDonalds in the airport. McDonalds never tasted so good."

"What was it like…what did you learn…what was the point?" His father wanted to know the return on his $1,200 investment.

"Well, it was hot. And they didn’t have air-conditioning. But we got used to that. And they did have a pool. Thank God for that. And they had a gym, too…"

"The school is not bad. But very simple. And a lot of the students are what they call SOS – meaning that they don’t have any money at all or are in some kind of danger…I don’t really know…they all seemed nice to us. And it took a while to understand what they were saying, so I didn’t really find out too much. They were speaking English, but it wasn’t like our English…and they had their own words for things.

"The countryside is pretty. We stayed a couple of days on a lake with crocodiles in it. And we visited the tropical forest and did a canopy walk…where you walk on these rickety bridges that seemed to break all the time.

"What did I learn…well, like, always take a large supply of candy bars and junk food when you go to those places…"

"Have another piece of apple pie," suggested his sister, "you look like a ghost. Mom will be shocked when she sees you."

The Daily Reckoning