The Greater Depression, Part II

The increasing bitterness and polarization of politics in the United States today is partly a consequence of soaring economic inequality. With the advent of the Information Economy, income for persons with high skills in every field of endeavor has increased dramatically, while wages for unskilled workers have fallen. In 1998, for example, 47.3% of ‘net financial assets’ of all American households were owned by the top 1% of Americans.

The holding of wealth in the U.S. is even more concentrated than it was in Argentina in the first half of the 20th century. But it does not follow that the U.S. will necessarily go the way of Argentina.

If you recall in yesterday’s Daily Reckoning, we pointed out that the initial downturn in Argentina’s fortunes corresponded with an enlargement of the franchise around the time of World War I. This brought the Radical Party to power, with a policy of consciously cultivating a larger middle class. The Radical policies tended to punish the rich and inhibit investment. Consequently, Argentina was one of the countries that failed to enjoy a postwar boom in the Roaring ’20s.

When the Great Depression began after 1929, Argentina was a deeply polarized country. It was evident to most of the educated elite that President Hipolito Yrigoyen was old, senile and incapable. It was widely known that public offices were being sold, and that Yrigoyen was creating new, unnecessary offices “to have a steady supply of product to sell.”

Argentine Economy: Nobody Cares

Although he had been re-elected in a landslide in 1928, Yrigoyen lacked public support. No one seemed to care deeply about what he was doing. There were no thundering editorials in support of Yrigoyen’s government, no mass of impassioned demonstrators prepared to go to the barricades for their belief in Yrigoyen. Certainly he did not command the devotion, even among a few, of the suicide bombers who now so unpleasantly remind us of the depth of their support for the cause of Hamas or al Qaeda.

On Sept. 5, 1930, the respected dean of the law school in Buenos Aires called for Yrigoyen’s resignation. The next day, cadets from the military academy led a coup that overthrew his government. In short order, the Argentine Supreme Court ratified the overthrow of Yrigoyen. This set the stage for more disasters to come, although the conservative governments that ruled Argentina in the 1930s coped with the Depression well. The ’30s were one of the few decades after World War I during which Argentina outperformed other rich economies.

The trouble was that the relatively strong economic performance was achieved by governments widely believed to have won election by fraud. Given that the expansion of the franchise had created an apparently permanent majority for income redistribution, many among the rich felt that the only way to maintain sound government was to fudge election results.

In particular, it was widely known that tenant farmers in Buenos Aires province were bribed or intimidated into casting their ballots for conservative candidates supported by the large landholders. The fact that conservatives repeatedly won what were thought to be rigged elections caused bitterness and polarization, not just against the rich, but against the courts that certified the rigged elections. The Supreme Court, in particular, was considered to be nothing but a mouthpiece for the interests of the rich.

Argentine Economy: Juan Peron

For a sense of how this can poison politics, consider some of the more exaggerated blather about the presidency of George W. Bush from diehard Democrats who believe the 2000 presidential election was “stolen” from Al Gore by the Supreme Court’s ruling in the Florida recount case.

In any event, resentments simmered until 1943, when another military coup seized control of the Argentine government. One of the leaders of the 1943 coup was Juan Peron, who was eager to be seen as a leader who could punish the upper class. A centerpiece of the counterproductive policies instituted at the time was rent control on tenant farming. Rents were rolled back and frozen at 1940 levels, minus 20%. Not surprisingly, this was popular among tenant farmers, but not with the large landholders. Popularity aside, it had a devastating impact on Argentine grain exports at a time when Argentina could have garnered a larger share of world markets. But rather than expanding production and increasing export earnings, the policies cost Argentina dearly. Before long, large areas of cereal production previously worked by tenant farmers were converted to pastoral use because raising cattle was more profitable under the new rules. Growth was retarded to prevent the rich from becoming richer.

Peron compounded this perverse policy when he became president by requiring that grain for export had to be sold to the state. He paid farmers a pittance and used the profits from foreign sale of mostly stolen grain to build nationalized industries to “create middle class jobs” for urban workers. Peron also began a tradition of impeaching Supreme Court justices in order to prevent his attacks on property rights from being overturned in the courts. All but one of the sitting justices on the Argentine Supreme Court was thrown out after Peron’s first election.

The de-legitimization of the Argentine judiciary has had continuing ill effects to this day. The lack of a juridical defense for property rights and contract enforcement facilitated the chronic hyperinflation from 1960 through 1994. In their continuing attempts to enlarge the middle class, governments pressured Argentine companies to overstaff and to borrow vast sums to meet payroll obligations.

Argentine Economy: Hyperinflation

In return, Argentine firms were protected from foreign competition. When, as frequently happened, these companies could not repay their loans, the central bank printed money to retire the loans and cover up holes in balance sheets. Thus, hyperinflation.

When President Carlos Menem finally restored sound money in 1994, monetary reform was undertaken in conjunction with widespread privatization of industries and the reduction of barriers to imports. Consequently, with Argentine firms suddenly exposed to competition, they had no choice but to become more productive. They did. Large numbers of make- work jobs in formerly nationalized firms were eliminated. Argentine industry quickly became competitive again. Indeed, Argentina was second only to China in economic growth through 1997.

However, as unemployment rose due to improved productivity, the elimination of make-work jobs and the consolidation or bankruptcy of uncompetitive firms, politicians once again attempted to artificially enlarge the middle class. Government spending grew like wild. Attempts to raise taxes to finance the new spending met stout resistance. Argentines simply refused to pay.

The only way to finance new spending was through borrowing rather than by the printing press. President Fernando de la Rua lacked the conviction to cut spending. And other players in the political process catered only to the demands of their constituents for more spending. Under the circumstances, default and devaluation changed the economy for the worse, but reopened scope for the politicians to redistribute income. President Eduardo Duhalde began a giveaway program to 20% of the work force, which continues under his successor, Nestor Kirchner.

Argentine Economy: Martha Stewart

You might think that my reflections on the misgovernment of Argentina have little bearing on investment today in North America. But Martha Stewart probably wouldn’t agree with you. She is just one of the many scapegoats among the rich now being persecuted as part of a general recrimination following the bursting of the 1990s bubble. Ms. Stewart has been forced out of her company, Martha Stewart Limited Omnimedia, under the weight of Security and Exchange Commission charges, which remarkably claim she conspired to lie about an activity that itself was not a crime. The alleged kernel of her wrongdoing is that she sold her ImClone stock after hearing a rumor that ImClone founder Sam Waksal was dumping his. An entirely rational reaction, if you ask me. But one which may not have been “proper” given the vague and stylized securities regulations promulgated by the SEC in the attempt to quarantine investment information.

In any event, bureaucracies such as the SEC tend to undertake reckless enforcement efforts when there is a public demand for blood. There is such a demand today. Those who appeared to succeed in the 1990s are under suspicion, and large numbers of people appear to believe, for no good reason that I can grasp, that the incarceration and financial ruin of highfliers from the 1990s would be bullish for the economy. What rubbish.

Over 100 corporate executives in the United States, I have heard, are negotiating plea bargains with the Justice Department over various supposed infractions of securities law. It is a negative omen for U.S. economic growth when vague and possibly bad laws that impose staggering liabilities are aggressively enforced against business leaders. This is a recipe for timidity and mediocre performance, like promising to make success a tort punishable by class action lawyers.

Another worrying suggestion from Argentina’s tribulations is that the negative effects of income redistribution intensify when there is a larger percentage of rich people in a given country. The larger percentage may polarize the electorate and lead to destabilization and delegitimization of the government. Certainly, political discourse in the United States has recently highlighted a number of themes redolent of politics in the last century in Argentina. Widespread resentment of day traders and dot-com millionaires, as well as billionaire celebrities such as Martha Stewart, augurs ill. When an electorate is so polarized that election results tend to fall within the margin of error in counting, as Florida’s ‘hanging chad’ election underscored, politicization of the courts could follow leading to seriously perverse economic results.

Argentine Economy: Resisting the Siren Call

Other negative signs abound. Congress and President Bush are about to enact a massive new entitlement to prescription drugs. And neither the White House nor the Republican majorities in Congress appear able to resist the blandishments of demagogues on the issue of extending income tax reductions, in the form of child care credits, to low-income families who do not pay income taxes. The Republicans wilted in the face of charges that they were “giving money to the rich” at the expense of poor children. All of which bodes ill for the future capacity of the U.S. government to maintain economic stability and resist the siren call for destructive income redistribution.

The United States and other governments are not above imitating Argentina in other respects. They are certainly all keen to devalue their currencies. This makes holding gold more attractive. It is also likely that the world’s major currency blocs will continue lowering interest rates until economies unequivocally rebound in a robust way. With Germany and much of Europe facing the specter of deflation, euro interest rates will come down sharply.

Argentina’s “Greater Depression” reflects the bankruptcy and debt default – the ultimate outcomes of malinvestment – of the Argentine state. Though the monetary history of the U.S. does not share quite the same degree of turbulence as Argentina’s, it is not inconceivable that Argentina’s example will prove an ominous harbinger of U.S. troubles to come. The United States is slowly suffocating in a mire of debt, both on the federal and consumer ends…and like Argentina before it, it has channeled much of that debt into investments that should never have been made in the first place.

The unhappy marriage of easy credit and malinvestment in the U.S. has created excess capacity in many industries that are now being painfully restructured. Whether such ‘restructuring’ will allow the U.S. to circumvent a fate like Argentina’s remains to be seen.


James Davidson,
for the Daily Reckoning
July 2, 2003

P.S. Despite the fact that the general slowdown in world growth and the investment depression is largely a Hayekian hangover from malinvestments made in the 1990s, if you were to ask 100 people on the street to explain the stock market debacle that cost investors so many trillions since the spring of 2000, most would probably cite the dot-com mania as an example of ‘irrational exuberance.’

They would be wrong. Contrary to the widespread misimpression, the Internet has met most of the supposedly demented forecasts for growth made by stock promoters in the late 1990s.

Notwithstanding some conspicuous flops, Internet investment has generally been profitable. Indeed, if you had invested $1,000 in each and every Internet IPO, including the flops, you would be ahead by more than 30% today. And those gains stand to be compounded, given that most of the losers have already been buried while the winners stand to gain even more as Internet commerce continues to grow.

P.P.S. Another misconception holds that the cause of the stock market’s malaise is accounting fraud at Enron, WorldCom, Tyco and other unspecified rogue corporations. Wrong again. Fraud is fraud, and it is wrong. But the impact of accounting fraud is much less than people seem to believe. Accountants and executives who doctored books to disguise slowing income may have had some impact at the margin in redirecting stock losses from some earlier investors who were able to sell to later ones who bought in at a bad time. This is truly equivalent to shuffling the deck chairs on the Titanic. Even if you could accurately reconstruct where everyone was sitting, it would not explain why the ship went down. In the case of the stock market, the casualties are more numerous than the numbers who went down on the Titanic. Indeed, there were 100,000 fewer millionaires in the United States and Canada in 2002 as the result of the declining stock market. The question is, what was the main cause of this huge loss of wealth? Bad accounting accounts for little. The bigger cause was malinvestment. If accountants and executives had merely lied about their claims to have invested $4 trillion into the construction of fiber optic cable, for example, and had not actually made the investments, the markets would be in far better shape than they are now.

The real problem is not what they lied about. It is what they told the truth about. A great many people, lured on by apparently low-cost capital, undertook a huge investment program to string fiber optic cable around the world like thread on a spindle. Most of the fiber optic networks built at such great cost remain dark and unused. This was part of an even more massive malinvestment and incoherence in the telephony sector.


“Things cannot go wrong in contradictory directions,” wrote my friend Lord Rees-Mogg recently. “The world cannot simultaneously have an inflationary and a deflationary problem.”

But that is just what the world seems to have.

For the last 30 years, under the shining sun of the Dollar Standard System, the U.S. has exported not only dollars – but jobs, profits, and entire industries. Now, the rest of the world has plenty of all of them. Maybe too much. When it comes to ‘things,’ it is hard to think of any that aren’t being made cheaper today than they were a couple of years ago, thanks to this boom in overseas capacity.

The homeland, meanwhile, has gone in a different direction. Shipping trillions of dollars abroad, the U.S. was then obliged to borrow them back. A huge gap had opened between what Americans earned and what they spent; the foreigners’ money filled it.

And now the U.S. is stuck in a contradiction…with things going wrong in both ways. The economy softens under the deflationary pressures of debt and excess world capacity…à la Japan…while the Feds do all they can to lower the value of the dollar and stir up inflation. American policymakers show signs of not merely inconsistency, but schizophrenia, for they tell us on the one hand that the economy is recovering nicely and that there is nothing to fear from deflation…even while they cut interest rates, just in case. They must also reassure foreign investors that the dollar is still sound – for they need more of the foreigners’ money than ever before – while, to domestic investors worried about deflation, they practically guarantee to destroy it.

A drunken Irish economist, lurching into a bar, might offer the following remark:

“This is all a load of malarkey y’re handing us. And y’know it. For everything y’say…y’say just the opposite a minute later. Y’don’t know what y’re doin’. And now all the saints in heaven can’t save you. You’ll roast in hell, all of you. And y’deserve it, y’do. “

We bring the Irish inebriate into the conversation only for dramatic purposes. He changes nothing. What will be, will be. But when he opens the barroom door, he brings in a little fresh air to a stale discussion.

The world of economics has gotten so dizzy that it scarcely makes any sense to a sober man. Or one who cannot tolerate contradictions. The U.S. is now more dependent on foreign lending than any nation ever was. And yet, it offers lenders a rate of interest that is less than the current inflation rate. And still the foreigners lend!

“Interest rates are intended to compensate lenders not only for the use of the money but for the risk of loss,” observed a French colleague this morning. “As rates go down, it signals that lenders see less risk on the horizon. But what does it mean when interest rates are negative? They must believe that the future will turn out even better than their wildest dreams!”

The real rate of inflation in the U.S., calculates Sung Won Sohn at Wells Fargo Bank, is about 2.7%…which puts the real interest rate on Fed Funds at about minus 1.7%, the lowest in twenty years. In effect, the Fed is paying people to borrow.

Well, “what’s wrong with this?” asks the Mercury News.

“For one thing,” begins the answer, “negative interest rates tempt unsophisticated investors to violate prudent investment guidelines and transfer money from safe, short- term investments to more speculative investments with higher yields, such as junk bonds.

“If the economy sours, risky investments are hardest hit.”

We don’t wonder why people borrow at negative interest rates. We wonder why they lend. But both groups are likely to suffer…when things go wrong in contrary directions. When the lenders stop lending, yields will rise. Lenders will find they’ve lost money. And the borrowers will stop borrowing…and discover that they owe more than they thought and more than they can afford.

But let us turn to Eric Fry for the latest contradictory update:


Eric Fry, down on the corner of Wall & Broad…

– Whew!…What a relief! Wall Street brokerage firms aren’t biased and dishonest after all!

– “Merrill Lynch & Co., Goldman Sachs Group Inc., Morgan Stanley, and Credit Suisse Group won dismissal of lawsuits accusing them of misleading investors with biased research tailored to win investment banking business,” reports Bloomberg News. “The rulings by two judges in Manhattan federal court were the first to address the banks’ liability for research since 10 of the largest Wall Street firms agreed in April to pay $1.4 billion to settle similar charges by regulators. U.S. District Judge Milton Pollack said investors who sued Merrill and Henry Blodget, its former top technology analyst, were ‘high-risk speculators’ who ‘now hope to twist the federal securities laws into a scheme of cost-free speculators’ insurance.'”

– The surprising ruling triggered a brokerage stock rally. Shares of the freshly exonerated and certifiably unbiased brokerage firms jumped briskly, lifting the major averages from morning losses to afternoon gains. The Dow Jones Industrial Average gained 55 points to 9,041 and the Nasdaq Composite Index rose 1.1 percent, to 1,640.

– The ruling seems to support the idea that Wall Street has quietly championed for years: There’s nothing wrong with issuing ‘buy’ recommendations on almost every stock almost all the time, as long as you’re receiving lush investment banking commissions for doing so…

– General Motors would welcome a few ‘buy’ recommendations these days…for its cars. The struggling automaker keeps slipping behind its Asian rivals, no matter how much money it pays folks to buy its cars.

– General Motors’ incentive spending jumped 1.4% to $3,969 last month. But still, its sales only increased 1.4%. By comparison, Toyota spent only $2,238, while its sales jumped 11% on the month. Nissan ,which spent only $1,531 per vehicle in sales incentives, saw its sales jump 22 percent.

– Is there a housing bubble? We put the question yesterday to Robert Tracy of Apogee Research. Robert replied, “It stands to reason that the double-digit price increases in U.S. housing in a time of negative economic growth and rising unemployment levels is an imbalance that is not only unsustainable, but due for a correction. Furthermore, history reveals that all asset bubbles, whether tulips, railroads or telecommunications, are all underpinned with a common assumption that prices will always go up, therefore you had better buy today. Clearly, if there is one comment about the U.S. housing market that we have heard over and over again, it is that real estate prices always appreciate because God isn’t making any more of them. That house you want today will be more expensive tomorrow. So the classical psychology that fuels asset bubbles is alive and well.”

– Ok, so who’s standing in the line of fire, we asked Tracy? “The list of causalities from a busting housing bubble will be long, as the entire economy will feel the jolt,” Tracy predicts. “Via cash-out home equity and refinancing mortgages, consumer spending has remained relatively strong despite declining payrolls and incomes. A crash in housing prices will not only eliminate the rising equity values that consumers have converted into cash, but many consumers will find they owe more on the mortgage than the worth of their homes. In such circumstances, some consumers may be tempted to just walk away from their obligations.

– “As for specific companies that will feel the pain of a bursting housing bubble,” Tracy continues, “the best candidates are those who have ridden the housing bubble for the past few years. Any company that underwrites, services, holds or insures mortgages is vulnerable. Vulnerable mortgage originators and those who service mortgage include: Countrywide (CFC), Washington Mutual (WM), and Greenpoint (GPT). Mortgage insurers who will be hit hard from a housing bust include Radian (RDN) and PMI Group (PMI). Homebuilders like D.R. Horton Inc. (DHI), Lennar Corp. Cl A (LEN) and Centex Corp. (CTX) will feel the pain form a housing bust.”

– [Ed note: While 37 Wall Street firms were saying “buy,” Apogee counseled “sell!” The difference? A 152% gain. Who got it right? Readthisto get the whole story. ]


Bill Bonner, back in Paris…

*** Chain stores’ sales fell last month, reports Reuters. Car sales were flat.

*** Germany is in “crisis,” says the Financial Times, following the collapse of a large life insurer, Mannheimer.

*** The lumps are still buying; the insiders are still selling. Last month, insiders dumped 6.45 shares for every one they bought.

*** Gold rose $5.40 yesterday, to $351.70. One share of the 30 Dow stocks would cost you 25.7 ounces of gold. Twenty- three years ago, a single ounce of gold would have bought the entire Dow. It will again, is our guess. We remind readers…the ‘Trade of the Decade’ is to sell the Dow and buy gold.

*** London real estate prices are coming down. “Wait 6 months,” we were advised – by practically everyone we talked to. So universal was this point of view that we began to have doubts. Either property prices will rise…or fall much more than people think.

*** “Our power is so great, and so unlikely to be challenged for many, many years,” said Admiral Stansfield Turner, former head of the CIA to a British reporter, “that you have to go back to Rome for any kind of parallel. It’s a misnomer to speak of the United States as being merely a super-power. We’re a super-duper power, and I don’t know that the world has seen one of those before.”

“Western Europe is literally a dying continent, demographically and spiritually,” added Father Richard Neuhaus, a neo-conservative theologian with friends in the White House, “whereas in America, people are energetic, vibrant, filled with technical expertise, whistles and bells.”

Can you remind us, dear reader? What was it that cometh before a fall?

The Daily Reckoning