The Great Wealth Deception

The U.S.’s economic recovery since 2001, despite what others may say, is practically non-existent. Dr. Richebächer wonders if this quest for an economic rebound has been abandoned – or simply delayed…

This is the most important economic question in and for the world: Has the U.S. economy’s rebound since 2001 been aborted, or is it only delayed? Our rigorous disagreement with the global optimistic consensus over this question begins with four observations that we regard as crucial:

1. In the past four years, the U.S. economy has received the most prodigious monetary and fiscal stimulus in history. Yet by any measure, its rebound from the 2001 recession is by far the weakest on record in the post-World War II period.

2. Record-low interest rates boosted asset prices and, in their wake, an unprecedented debt-and-spending binge on the part of the consumer.

3. What resulted was a badly structured economic recovery, which – due to grossly lacking growth in capital investment, employment and wage and salary income – never gained the necessary traction to become self-sustainable.

4. Sustained and sufficiently strong economic growth implicitly requires a return to strong business fixed capital spending. We see no chance of this happening. Above all, the outlook for business profits is dismal from the macro perspective.

Bubble Economy: Enormous Structural Changes

This takes us to the enormous structural changes that the Fed’s new monetary “bubble policy” has imparted to the U.S. economy over the years. While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy – record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.

None of these shortfalls is a typical feature of the business cycle. Instead, they are all of unusual structural nature. Yet the bullish U.S. consensus simply ignores them, bragging instead about the U.S. economy’s resilience and its ability to outperform most industrialized countries.

To be sure, all these structural deformations tend to impede economic growth. Some, like the trade deficit and slumping investment, do so with immediate effect; others become repressive only gradually and in the longer run. Budget deficits stimulate demand as long as they rise. An existing budget deficit, however large, loses this effect. Rather, it tends to become a drag on the economy. In the past few years, clearly, the massive monetary and fiscal pump-priming policies have more than offset all these growth-impairing influences.

Assessing the U.S. economy’s future performance, it is necessary to distinguish between two opposite macro forces: One is the drag on the economy exerted by the various structural distortions; the other is the enormous demand-pull fostered by the housing bubble and the associated rampant credit creation.

Measured by real GDP growth, the demand-pull driven by the housing bubble has, so far, overpowered the structural drags, provided you believe in the accuracy of the GDP numbers. We do not. Yet even by this measure, as repeatedly explained, it is actually by far the U.S. economy’s weakest recovery on record in the postwar period. In fact, measuring the growth of employment and wage and salary income, there has been no recovery at all.

Our stance has always been and remains simple. Asset bubbles and their demand effects invariably fade over time; structural effects invariably worsen over time if not attended to. It is our strong assumption that the negative structural effects are overtaking the positive bubble effects.

Bubble Economy: Rewriting the Rules of the Business Cycle

We come to another feature of economic recoveries that American policymakers and economists flatly ignore. That is its pattern or composition.

Past cyclical recoveries were spearheaded by three demand components: durable consumer goods, residential building and business fixed investment, regularly following prior sharp downturns caused by tight money during the recession. Importantly, the tight money had always created pent-up demand in these three categories, which promptly catapulted the economy upward when monetary policy eased. For sure, the pent-up demand played a key role in the recovery dynamics.

With its rapid and drastic rate cuts, the Fed rewrote the rules of the traditional business cycle and related policies. It managed a seamless transition from equity bubble to housing bubble. Consumer spending on durable goods continued to forge ahead during the 2001 recession at an annual rate of 4.3%. Residential building never retreated, while business fixed investment took an unusual plunge.

From 2000-04, consumer spending soared by 27.3% on durable goods and 25.4% on residential building. Government spending, too, rose sharply, by 13.9%. Together, the three components accounted for 123% of real GDP growth.

But in the rest of the economy, it was all misery. Despite a modest rebound, business nonfinancial fixed investment in 2004 was still down 0.2% from 2000. Exports of goods posted a minimal gain of 0.1%, whereas imports of goods shot up by 16.5%.

Thanks to the sharp decline in interest rates over the last few years, sharply inflating house prices have been a rather common feature around the world. Still, there is one crucial difference among the countries concerned. There are countries in which the rising house prices have fueled borrowing-and-spending binges by private households, and there are others where these binges are completely absent. Typical for the first pattern are all Anglo-Saxon countries; typical for the latter are most eurozone countries.

Bubble Economy: Why the US Is Unique

Even among the Anglo-Saxon bubble economies – meaning countries where the house-price inflation led to borrowing-and-spending sprees – the United States is a unique case. It concerns the official and public attitude to such bubble-driven economic growth.

The United States is the one and only country in the world where monetary policy was systematically designed toward the goal of inflating the market value of assets – stocks, houses and bonds – virtually making wealth creation through inflating asset prices their explicit goal.

In Britain and Australia, the associated borrowing-and-spending binges are even worse than in the United States. Yet there is a general apparent reluctance to embrace this growth model as an unmixed blessing. Central bankers who celebrate this as “wealth creation” and even explicitly animate people to exploit the possibilities of easy credit to lift their spending on consumption are unique to America.

For generations of economists, it used to be a truism that “wealth creation” implies capital formation in terms of generating income-creating tangible assets. The emphasis was on capital formation and the associated income creation. To indiscriminately put this label of “wealth creation” on rising asset prices in the absence of any income creation is plainly a novel usurpation of this concept. It is in essence wealth creation through a stroke of the pen.

Measured by their net worth (market value of household assets minus debts), American households have amassed unprecedented riches in the past few years, despite spending in excess of their current income as never before.

Bubble Economy: “Wealth Miracle”

The first question springing to mind in the face of this “wealth miracle” is its cause or causes, leading immediately to the next question: whether or not this drastic increase of house prices relative to the consumer price index has to be seen as a “bubble,” which sooner or later have the habit of bursting.

In old textbooks, you would read that higher saving increases capital value. But in the U.S. case, capital values have soared while personal and national saving has collapsed. What else, then, has the power to lift asset prices?

Everybody knows the answer, but few want to admit it: Lured by artificially low interest rates and easily available credit, private households have stampeded as never before into the purchase of homes, boosting their prices. Artificially low interest rates and easily available credit are, actually, the key features that specifically qualify an asset bubble.

The growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. This equates with simultaneous nominal GDP growth of $1.9 trillion. America’s financial system is really one gigantic credit-and-debt bubble.

Our general misgivings about “wealth creation” simply through rising house prices has still another reason, however, and that is the way housing values are calculated. The conventional practice in America is to treat the whole existing housing stock as being worth the last trade. We do not think this makes sense, considering that current sales are always marginal to the whole capital stock.

This way of calculating wealth creation naturally explains the extraordinary rapidity with which it can deluge an economy, creating trillions of dollars of such wealth in no time. For sure, this contrasts wondrously with the tedious process of generating prosperity through saving, investment and production.

In earlier studies published by the International Monetary Fund about asset bubbles in general, and Japan’s bubble economy in particular, the authors repeatedly asked why policymakers failed to recognize the rising prices in the asset markets as asset inflation. Their general answer was that the absence of conventional inflation in consumer and producer prices confused most people, traditionally accustomed to taking rises in the CPI as the decisive token for inflation.

It seems to us that today this very same confusion is blinding policymakers and citizens in the United States and other bubble economies, like England and Australia, to the unmistakable circumstance of existing rampant housing bubbles in their countries.

Thinking about inflation, it is necessary to separate its cause and its effects or symptoms. There is always one and the same cause, and that is credit creation in excess of current saving leading to demand growth in excess of output. But this common cause may produce an extremely different pattern of effects in the economy and its financial system. This pattern of effects is entirely contingent upon the use of the credit excess – whether it primarily finances consumption, investment, imports or asset purchases.

A credit expansion in the United States of close to $10 trillion – in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000 – definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation.

In other words, there is tremendous inflationary pressure at work, but it has impacted the economy and the price system very unevenly. The credit deluge has three obvious main outlets: imports, housing and the carry trade in bonds. On the other hand, the absence of strong consumer price inflation is taken as evidence that inflationary pressures are generally absent. Everybody feels comfortable with this (mis)judgment.


Kurt Richebächer
for The Daily Reckoning

April 19, 2005

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.”

Do you see what we see, dear reader?

Minus 104, – 125, -191…then, yesterday, down another 16 points. The Dow is breaking down. It is due for a bounce at this point. But its direction is down. Negative. Towards gloom, doom and economic destruction.

The Dow will probably sink below its October 2002 low under 8,000. Why? Because the hole is there…it must fall in sooner or later.

All over the world, stock markets are in retreat. Last week, the Nikkie saw its biggest drop in 11 weeks. In Europe, recent declines have wiped out all of this year’s gains. The profits aren’t coming in as expected, say analysts. They found ready “reasons” for stocks to go up when they needed them. Now, they have no trouble finding “reasons” for the sell-off.

But stocks do what they want. The reasons only appear after the fact, like a social disease after a wild party.

What really happens is that stocks go up and down, without anyone really understanding why. At the bottom of the cycle, investors will only pay $5-10 for one dollar’s worth of earnings. At the top, the price rises to over $20. Why would the same revenue be prized so differently at different times? Ask me something harder! Because the mood of the market changes. When people are optimistic and expansive, they think things will get better and better, forever and ever, amen. But when the mood of the market turns gloomy, people think the sky will fall at any moment; they are willing to wait for the long-term. They want a good return on their investment, right now.

Okay then, why does the mood of the market change? Ah…a tough question. But we have an easy answer: because they do. Why is it sometimes sunny and sometimes dark? Why are we sometimes young and sometimes old? Why are we sometimes happy and sometimes sad? We can’t be in an average mood all the time. Instead, we’re in an average mood almost none of the time. Most of the time, we’re either happier than average, or sadder than average.

Nor do we often get “average returns” from our investments. What we get is some periods of above-average performance followed by other periods of below-average performance. In periods of above-average performance, investors’ moods rise – until they are very confident, very bullish, and very sure that their performance will continue to be above average for a long, long time. This mood has a momentum that often causes it to persist long after the investments themselves have failed to perform. “Virtue is what used to pay,” said Gordon Tullock. Investors still think it is a good idea to leave money in stocks – for the long run – even though the market probably entered one of those periods of below-average performance in 2000. Buying stocks used to pay. It will pay again, but probably not for another 10 years.

Investors are beginning to wise up to stocks. They seem to be wondering…hesitating…and drifting away. But the cocksure mood still dominates the nation’s markets and its economy. Now, people think: “you can’t lose money in real estate.” Their mood is so buoyant and hopeful that they will spend $500,000 on a house that they deemed worth only $200,000 in 1995. What’s more, they’re confident that an even bigger dope will come along next year and offer them $750,000 for the place.

But even in housing, prices are subject to change without notice…and moods swing there too.

More news …


Our Rude Awakening team has scattered to the four corners of the Earth…or at least to opposite sides of the country. Tom Dyson is in Myrtle Beach, going to head-to-head with our very own small-cap superstar, James Boric…on the golf course. And with Eric Fry off surfing in California, there won’t be a Rude Awakening today…but never fear; they’ll both be back from their spring break tomorrow…


Bill Bonner, back in London…

*** Another study of CEO compensation confirms what everyone already knows – CEOs are paid a lot more than they’re worth. Pearl Meyer & Partners looked at 180 large companies. They found the average CEO made $9.97 million last year – up 12.6% from the year before.

Why pay these guys so much? Would they be less motivated with $8 million? Would they be able to quit their second job…or allow their spouse to stay home with the kids…if they only earned $7 million? Would companies be unable to find qualified candidates if they offered only $6 million?

We’ve been running a company for a quarter of a century. We’ll let you in on a secret, dear reader. The larger a company becomes, the less important the CEO really is. As the business grows, other people take over the important jobs. The CEO becomes a figurehead – someone who cozies up to Wall Street financiers and reassures lumpeninvestors. The job is so mindless even a U.S. Senator could do it. And he’d be a lot cheaper. Trouble is, everyone knows politicians are hopelessly incompetent. What they don’t realize is that many CEO’s are hopelessly incompetent too.

*** Chris Mayer, reporting from Gaithersburg, Maryland:

“I’m planning a trip to China in November. China’s emergence as an economic force is changing the patterns of world finance and trade in numerous ways – particularly the consumption of numerous commodities and basic materials. The development of the Chinese economy looks to be one of the biggest financial stories of the decade, perhaps of the century.

“So I’ve been spending some time trying to learn as much about China as I can. I’ve been clipping interesting news pieces on China, and I’ve ordered a few books as well. In writing about China from an investment perspective, I would like emphasize the experiences of people who have actually worked and lived there, people who have tried to make a go of it in China – as opposed to relying on professors and media-types writing about China from afar.”

*** And here’s an item from today’s International Herald Tribune that caught our attention: “A radical in the White House,” is the headline on an editorial from Bob Herbert at the New York Times. Ah-ha! Finally, someone has caught on to Bush’s activist agenda, we thought. But not at all. Instead, the column refers to a different radical – Franklin Roosevelt. Herbert approvingly recalls Roosevelt’s “Second Bill of Rights,” announced in the form of a fireside chat after WWII. Roosevelt promised:

“The right to a useful and remunerative job…

“The right to earn enough to provide adequate food and clothing and recreation…[we wonder what he meant by ‘adequate’ recreation]

“The right of every farmer…[to earn a living]

“The right of every family to a decent home…

“The right to a good education…

“The right to adequate medical care…”

…and so forth. Herbert said he mentioned the list to a 30-year-old acquaintance that was impressed. “Wow,” she is reported to have said, “I can’t believe a president would say that.”

Yes, it’s hard to believe a president would be say anything so absurd and hollow. There is no way a person can have a right to a decent house…without obliging some other person to build it for him. Nor can anyone have the right to adequate medical care, without some other poor schmuck being forced to change his bedpan. What the chief executive should have said, if he were honest, was that they should have, “The right to seek a decent house or adequate medical care or a knowledge of Latin verbs…without asking anyone else’s say-so.”

For comic relief, Roosevelt should have added, ‘The right of every man to marry a woman who is prettier than average…” It’s probably a good thing he didn’t. Otherwise, earnest rock heads like Herbert would be urging Congress to pass a law.

*** Jules had his first gig on Saturday night. He sang “House of the Rising Sun,” at a bar in central Paris. The boy could be a French teen idol, if he put his mind to it. Instead, he’s going to college.

*** We went to hear another fat lady sing last night at the Opera Garnier, Paris’ magnificent opera house. Well, we thought she would sing. Instead, we only saw skinny ladies dancing. It was Nureyev’s version of Cinderella. Happily, we fell asleep before the poor girl laid eyes on the prince.

“How did you like it?” asked our friends who had accompanied us to the show.

“It was marvelous,” we replied, honestly.

The Daily Reckoning