The Great 'GDP' Hoax
How many times have you heard the unthinking comment that we need to keep consumption burning brightly because "consumption is two-thirds of GDP"?
If you look up the Gross Domestic Product (GDP) release, you see in black and white that GDP in 2001 was $10 trillion dollars…and personal consumption expenditures were a touch under $7 trillion.
With "consumption" running at two-thirds of the entire US economy, it’s obvious: US consumers must continue spending money they don’t have, lest the whole ball of wax grind to a halt. The "recovery scenario" falls at the feet of the ever-eager US consumer.
Or does it? We here at the Daily Reckoning think not.
Let’s begin by assuming that what makes us rich is not consumption at all. Consumption is merely that fraction of our income and assets that we decide to spend today in pursuits other than those which will either add to greater output in future, or act as a prudential fund against unforeseen needs.
Clearly, it is production that matters, for this is what ultimately lifts us out of savagery. That this should be controversial shows how far we have fallen from the good common sense of our forefathers.
For we can play Oliver Twist all we like, holding up our plates for more, but unless we offer something in return, we are unlikely to be able to rely on our portion being replenished at will.
This simple insight was encapsulated by the forgotten French economist Jean-Baptiste Say, who expressed the idea so clearly they named an economic law after him. Say’s Law states simply: Supply creates its own Demand. Or, to put it in colloquial English, "You want some of these here beans? What you got in yer wagon to trade fer ’em?"
For the best part of the century, Say’s aphorism came to be taken as a truism. Namely, it was accepted that if you worked to produce a saleable good – or to offer a saleable service – you were then entitled to exchange it for the fruits of someone else’s efforts…at a price to be freely negotiated between the two of you.
It was no problem if the wants of vendor and purchaser did not coincide exactly, so long as they felt they could rely upon tokens of exchange that equitably reflected the work needed to produce them. But the exchange required "honest money" to be used as a medium.
Sadly, the idea of resorting to work and entrepreneurship as a means to material well-being has historically become a poor second to the idea of acquiring resources through theft. Robbery is a much less arduous task than striving to best serve the capricious tastes of consumers in open competition with one’s fellow entrepreneurs.
And theft is, of course, always most effectively perpetrated when disguised as law and underwritten by the threat of political violence – i.e., when it is committed by the State.
The ‘fiscal-military state’, as John Berger describes it in The Sinews of Power, or what Austrian economists less charitably decry as the ‘warfare-welfare state’, invariably allows those at the pinnacle of political- military power to disrupt commerce by siphoning off a tribute every time goods pass over the shop counter.
Levies used to be exacted by sheer brigandage and the overt threat of physical force; now, the means are more subtle. Laymen call them: Debt, Taxes, and Paper Money.
One of the sad facts of such impositions is that they always lead to undue hardship. The entrepreneurial bourgeois and the diligent artisan alike have to carry to market not just goods for their own utility, but also goods sufficient to support a posse of bureaucrats, court lackeys, armored hooligans, tax gatherers, assessors, monopolists, subsidy-mongers, and welfare dispensers, as well as the power elite and their financiers themselves.
If these parasites sufficiently weave themselves into the social fabric – as nearly a century of fiat money and creeping collectivism has largely accomplished today – the impoverished and bewildered creators of wealth cry out for help. In their anguish they foolishly come to mistake the shaggy pelts of the wolf pack for the robes of a gentle shepherd whom they trust will tenderly deliver them from their miseries.
Thus, Government frustration of the market process inexorably leads to the call for the government to "Do Something"…to counteract its own malfeasance. As an astute 18th-century Briton put it, "Armies beget taxes, taxes beget unrest, unrest begets armies."
In this way, the Great Depression came about. The Great Depression was not caused by the breakdown of free market capitalism, as the state’s apologists have maintained ever since, but by the suppression of the market’s workings throughout a decade of monetary deceit and a consequently unsupportable credit expansion.
And it was made worse by the frustration of the international division of labor through high tariffs. And by the unwillingness to settle inflationary war debt and punitive reparations left over from World War I in a timely and realistic manner.
In the midst of the Depression, the ever-opportunistic Keynes stepped forward, seeking to persuade people that Say had it all wrong. In fact, Keynes said, it was Demand that created its own Supply ("Please, sir, may I have some more?"), and that all we needed was to give people extra money, unbacked by anything, and prosperity would be restored simply through spending.
Keynes was wrong.
The fact is, GDP can give us only a very partial insight into the mechanisms at work. Consider the BEA’s Input- Output data. For 1998, when these were last compiled, GDP stood at $8.8 trillion, and personal consumption was $5.9 trillion.
Manufacturing seemed to be fairly inconsequential at $1.5 trillion in the GDP numbers and made a smaller contribution than either finance ($1.7 trillion) or services ($2.1 trillion).
If you look at what was actually being made and sweated over within the economy…what provided the jobs, on the one hand, and the opportunity of profits, on the other…then the picture is quite different from the less than perfect one you hear blathered by "experts" on CNBC.
In fact, the total gross output of the economy now comes to $15.4 trillion in turnover. And manufacturing – at $3.9 trillion – suddenly swells to being the largest constituent of them all. 55% greater than finance, and 10% larger even than the much-vaunted service sector.
Manufacturing emphatically does matter. It now becomes responsible for fully a quarter of all productive activity. And here is the crucial point: 60% of that provides an input for other industries, and 60% of that fraction goes back into the other stages of manufacturing itself. Only 25% is destined straight for consumption and a lowly 15% to the GDP-defined "fixed- investment" category.
Armed with this fresh perspective, ask yourself whether you are ready to continue to accept blindly that we are living in a "service economy"…or that all will be well "as long as the consumer keeps spending"…or that businesses merely have an "inventory problem," not a fixed-capital problem to overcome.
Under the Keynes version – espoused uncritically by central banks, Wall Street "analysts", and politicians everywhere – if business falters, do not be alarmed! We can simply send people to the shops waving their new Federal Reserve purchasing coupons, and urge them to Spend, Spend, Spend!
We are told by the Inflationists that currently there is overproduction and that prices are falling. If we do not take care, consumption will falter unless we induce the Fed to prop up demand by expanding the supply of money.
Granted, there is possibly specific overproduction. Distortions of the credit system have seen to that (thank you, Sir Alan)… so there may be a surplus of automobiles and disk drives and broadband capacity, among many others. But do we really have everything else we want for the asking?
Do we have the best shoes, the finest clothes, limitless energy with no harmful waste products, instant medical treatment, the highest standards of education for our children, delay-free means of transport – in fact, all the delights of an earthly Paradise? Of course not.
Extra fiat money can do little to substitute the time- consuming recuperative process. It cannot give the outfoxed chessmaster two moves to his opponent’s one to avoid a mate, nor can it teach infantrymen instantly to ride cavalry chargers to repel the foe. It cannot create wealth – for wealth is only minimally coincident with today’s mockery of money.
It can, however, arbitrarily transfer ownership of what wealth still exists. It can lock sub-par businesses in place and suck their creditors deeper into the mire alongside them. It can foster an unwelcome competition for resources which elevates their costs beyond the reach of truly productive businesses. It can choke the garden with the weeds of those undertakings which are only able to flourish under these highly artificial conditions – the "housing boom" springs to mind.
Unfortunately for the legions of Inflationists, there are no shortcuts to betterment, but there are all too many diversions, distractions, and dead ends.
The most misleading road map in the world is the one printed at 20th Street and Constitution Avenue in Washington, deep inside the Marriner S. Eccles building: The GDP.
for The Daily Reckoning
September 10, 2002
Editor’s Note: Sean Corrigan is the founder of Capital Insight, a London-based consultancy firm which provides key technical analysis of stock, bond and commodities markets to major US, UK and European banks. Corrigan is a graduate of Cambridge University and a veteran bond and derivatives trader from the City. Corrigan serves with distinction as The Daily Reckoning’s ‘man on the scene’ in London’s financial district.
"Still Bullish" headlined a Barron’s article that caught our eyes (Eric has more comments, below…)
The group of Wall Street strategists interviewed by Barron’s at the beginning of each year were wrong about 2000 and then wrong again in January 2001. Unless there is a major rally in stocks in the last 3 months of the year, they’ll be wrong again this year.
But Barron’s still asks their opinions as if they had a clue.
"The prevailing view among the 12 prognosticators…is that the combination of the market drop and the sharp decline in interest rates has created a major buying opportunity in stocks," Barron’s reports.
"It’s not that stocks are so attractive," says Edward Kerschner of UBS Warburg. "It’s just that bond yields are so low."
"The risk premium built into stock prices is the highest in 15 years," adds Abby Joseph Cohen. "We thought investors would be more accepting of risk this year. The stock market is undervalued."
Do they just make this stuff up as they go along? Well, not exactly. Both refer to a theory of stock valuation known as the Fed Model, which compares the yield on 10- year Treasury notes to the "earnings yield" on stocks. If you can get 4% from a T-note and stocks trade at a forward P/E of 25 (or a price of $100 for every $4 of earnings), the Fed Model says stocks are fairly priced.
But stocks are thought to be riskier than bonds, so investors have typically asked for a ‘risk premium’; they were only willing to pay, say, $75 or $60 for $4 worth of stock earnings, giving them a little cushion just in case things go badly in the stock market or the economy.
In "Dow 36,000", author James Glassman argued that the risk premium was unnecessary, since stocks always outperformed bonds over the long run. But after the crash of the Nasdaq, the terrorist attack of 9/11, the collapse of Enron, and so on, investors came to believe that maybe a risk premium wasn’t such a bad idea after all.
And now we discover that not only did many companies exaggerate their earnings forecasts, a few lied about them; in fact, as much as 50% of the entire increase in earnings over the last 40 years may have come from ‘mystical’ sources – ‘operating’ income, pro-forma accounts, employee stock options, and other phony accounting tricks.
But even if the numbers were certified by Warren Buffett, the Fed Model theory is still as defective as an analyst. As interest rates come down, it suggests that stock prices should go up. And they often do, but only in a bull market. Cheaper credit allows businesses and consumers to borrow and spend more freely. Sales go up…and so do corporate profits.
Eventually, as rates sink further, supplies of goods and services increase, price competition weakens margins, and profits are squeezed.
Imagine rates falling so low that the yield on a 10-year Treasury note was just 1%. The Fed Model suggests stocks should then be priced at 100 times earnings. But at that level investors would be taking a huge risk…and for what? A measly 1% earnings yield?
This is, of course, the situation Japanese investors have faced. Rates have been around 1% for years. But instead of bidding up stocks, investors have taken them down to a 20-year low.
When interest and inflation rates fall – as they have been in the U.S. for the last 20 years – the risk of outright deflation increases. When prices deflate, the real yield on a T-note goes up, whatever the nominal yield. And stocks? They typically go down…as deflation sends the economy into a recession. Who wants to spend money when it is becoming more and more valuable every day? And who wants to invest money when sales are falling and unemployment is rising?
In a boom, the Fed Model appears to work. Rates come down and people prefer stocks to cash. But in a bust, the model turns to mush. Interest rates go down, but so do stocks. Cash becomes the asset of choice.
But let’s hear from Eric with the latest news:
Eric Fry, on Wall Street:
– It’s been sad to watch the stock market struggle day after day. It has been like watching an aging superstar athlete vainly attempt to match the feats of his youth. But yesterday, the old financial has-been displayed flashes of his former brilliance and returned to his winning ways, at least for one day. The Dow gained 92 points to 8,519, while the Nasdaq advanced 9 points to 1,305.
– Speaking of aging superstar athletes, a hearty Daily Reckoning congratulations to Pete Sampras for his victory in the U.S. Open over Andre Agassi…Rumor has it that there were fewer well-heeled Wall Street-types on hand for the finals this year than in years past. That’s because Wall Street brokerage firms have become somewhat stingier with expensive perks for their clients – like tickets to U.S. Open finals, for example.
– A retired investment professional told me over the weekend that UBS did not dole out ANY tickets to U.S. Open finals this year, not even to its best clients. "Times must be tough at UBS," he said. "They aren’t springing for tickets to the finals…Not for anybody."
"How much are they?" I asked.
"15,000 for four tickets," he said
"Well I can see why they wouldn’t want to spend that kind of money," I said, "even for their best customers."
"Yeah," he said, "But paying $15,000 never stopped them before. They’ve done it every year."
– That makes it official folks…We’re in a bear market!
– Nevertheless, Wall Street strategists are maintaining their positive attitude, even without their customary allotment of U.S. Open tickets. And when it comes to the stock market, they remain, as always, upbeat. "Bloodied but still bullish," writes Andrew Bary in this week’s Barron’s. "That describes nearly all of the Wall Street strategists Barron’s interviewed at the end of last year, who were overly optimistic about the stock market’s prospects for 2002 – as they had been about the two preceding years. Most saw the Standard & Poor’s 500 rising to a range of 1,200 to as much as 1,570 by the end of this year. Even the low end of that range seems out of reach with index at 893.92."
– Nevertheless, hope springs eternal. "The prevailing view among the 12 prognosticators," says Barron’s, "is that the combination of the market drop and the sharp decline in interest rates has created a major buying opportunity in stocks."
– Folks like Ed Yardeni of Prudential Securities, Ed Kerschner of UBS Warburg, Jeff Applegate of Lehman Brothers and, of course, Abby Joseph Cohen of Goldman Sachs all achieved celebrity status during the late 1990s for their unflinchingly bullish forecasts. Their celebrity soared along with the soaring stock market, as if they actually knew something more about the direction of the market than a broken clock "knows" about the time. (By comparison, we bearish broken clocks know that we don’t know where the market is heading…And we don’t pretend to know. In fact, we don’t care. We just try to buy ’em low and sell ’em high.)
– These perma-bulls, who used to appear routinely on CNBC with their ever-more-bullish forecasts for the stock market, now find themselves greatly discredited. Since well before the market peaked in early 2000, these "seers" have been very bullish and therefore, very wrong. Unfortunately, their "guidance" was not merely wrong, but devastatingly misguided for anyone who trusted in them. Their irresponsible and self-serving forecasts helped to devastate millions of investment portfolios and to ruin millions of financial lives.
– Investors who were told repeatedly that "fair value" on the S&P 500 was 1,600, then 1,350 and then 1,050 (or always about 30% higher than wherever it happened to have been trading at the time) learned to believe that stocks OUGHT to be higher, no matter how richly priced they were. This belief emboldened them to buy overpriced stocks and to continue holding these overpriced stocks, even as they drifted lower.
– So we don’t really care what these overpaid nitwits say, except for the sheer amusement value.
– Ed Kerschner, the perennially bullish strategist at UBS Warburg, has been compelled (by market conditions) to ratchet back his price targets a bit. He currently pegs fair value for the S&P 500 – whatever that means – around 1,050. Some readers may recall that Mr. Kerschner predicted early in 2001 that the S&P 500 would finish that year around 1,715, or about 50% above where it actually wound up. He followed up this humdinger of a forecast with the prediction (made in December of 2001) that the S&P 500 would end 2002 around 1,570 – a mere 76% above current levels.
– Therefore, if Kerschner’s forecast for 1,050 holds true to form, the S&P will be trading somewhere below 700 one year from now.
– Abby Joseph Cohen, is, as usual the most bullish voice in the crowd with a one-year price target on the S&P 500 of 1,300. "One of the ironies about Cohen’s optimism," says Barron’s, "is that she carries one of the lowest earnings estimates among the bulls." Cohen’s explanation? "She doesn’t pay a lot of attention to P/E ratios," says Barron’s.
– Memo to Abby Joseph Cohen: Consider paying attention to PE ratios.
Back in Paris…
*** Ed Yardeni, recognizing that the Fed Model didn’t work in Japan, told Barron’s readers not to worry. The U.S. economy is more ‘dynamic’, he explained. What does that mean? We don’t know, but we wouldn’t count on it. Japan had the most dynamic economy in the world – until it went into a 13-year slump.
*** Maria called yesterday. "I waited where everyone got off the train," she explained with a hint of panic in her voice, "and Grandma didn’t get off. What could have happened to her? I looked all over the station."
For the next half hour, we worried. My mother was lost somewhere between Paris and Milan. Had she gotten on the wrong train? Had she met with foul play? Had she fallen asleep and dozed all the way to Rome?
But she soon turned up, right where she was supposed to be, at the hotel. There were two exits from the train, it turned out.