The Monetisation of the American Economy
Marc Faber reminds the Fed, prior to their next meeting on January 22nd, that faced with an explosion of credit, one of the worst possible monetary policy decisions is, of course, to make additional credit available.
Although there are a number of different "business cycle" theories, it has always been my view that economic expansion and contraction phases are caused by a number of different factors, and that their durations can vary considerably, depending, again, on many different social, economic, and political conditions. That said, I’ll try to explain what I believe is happening today in the U.S. Economy.
In the 19th-century, the U.S. economy was still a predominantly agrarian economy. In 1900, despite America’s rapid industrialization, agriculture still employed twice as many people as did manufacturing, with farm workers making up close to 40% of the U.S. labor force, down from 70% in 1840. Today, farm workers account for less than 3% of the labor force.
The relative importance of agriculture versus manufacturing in the 19th century is also evident from American export figures, which show that in 1850 over 83%, and in 1890, 75%, of exports were agriculture- based. It is thus easy to see that, in the 19th century, agriculture was by far the most important sector of the U.S. economy and that, therefore, movements in agricultural prices were the dominant factor for the entire economy. When, for whatever reason, farm prices rose (poor harvests, droughts, wars, etc), the agricultural sector thrived because farmers’ incomes would rise.
When agricultural prices fell, farm incomes would decline. Declining farm incomes would then reduce the purchasing power of farmers and lead to less demand for manufactured goods. Periods of weak growth or recessions followed. But to explain 19th-century American business cycles purely as a function of agricultural price movements is an oversimplification.
During times of rapidly rising agrarian prices, what was the incentive for farmers to innovate and to lower costs by producing more efficiently with new production methods?
In periods of falling commodity prices we find all the great waves of innovations in periods. The reason? During such times the only way to increase one’s income was to produce more cost-effectively through the application of new inventions and innovations. The canal boom in the 1830s, the railroad boom of the 1870s, and the 1920s’ electricity, chemistry, and motor booms all occurred during times in which commodity prices fell.
All these periods of great innovations were, however, driven not only by the desire to cut costs and improve productivity in order to boost profits, but also by a favorable environment for financial assets.
Declining commodity prices led to falling interest rates and, therefore, rising bond and stock prices. In turn, the combination of declining interest rates and rising equity prices lowered the cost of capital and improved the profits of the manufacturing sector. Hence, all major financial manias, such as the canal and railroad booms, and the 1920s’ and 1990s’ U.S. stock market manias, also occurred in a weak pricing environment! But at the same time, each innovation and stock market boom period preceded financial busts, which led to recessions or depressions. Why?
During periods of weak prices, monetary conditions remain very accommodative, since there is no inflation. Moreover, the combination of new inventions, rising corporate profits, vibrant financial markets, and easy money is a powerful tonic for capital spending. Both rising stock prices and declining interest rates are obviously reducing the cost of capital and, by themselves, lead to more capital investments.
Easy-money monetary policies bring about, through a combination of a wave of innovations and booming financial markets, massive over-investments and a gross misallocation of capital because the profit opportunity expected to arise from the innovation is so great that it leads to excessive borrowings by consumers as well as businesses. The downturn or bust is ushered in when the over-investments lead to excess capacity and a collapse in prices, which in turn drive down profits and, along with them, stock prices, which then weaken the economy even more. Thus, you have negative wealth effect and cutbacks in capital spending due to rising capital costs.
This is where we stand today. The weak pricing and easy money environment of the 1990s led to a huge stock market and capital-spending boom, which was largely financed by debt and foreigners who bought U.S. real assets, equities, and bonds.
However, today the situation is more complex because we are faced with a fundamentally totally different set of economic and financial, and now suddenly also geopolitical, conditions than ever before in economic history. Why? Every economy has a dominant driving force. I explained above that in the U.S. economy of the 19th century, agriculture was the dominant sector, which would largely drive economic activity according to rising or falling prices for agricultural commodities.
In the Middle East, since the 1970s, rising or falling oil prices bring about, in the absence of an important and efficient manufacturing or service sector, vibrant or sluggish economic conditions. For countries like Taiwan and South Korea, exports are the engine of economic expansions and contractions. So, what is now the driver of the U.S. economy? Certainly, it is no longer agriculture!
Moreover, whereas the manufacturing sector may have been the engine of the U.S. economy in the 1920s and probably still was in the 1950s, today it only accounts for slightly more than 20% of GDP and, therefore, it doesn’t have a very meaningful impact on the economy as a whole.
Compare manufacturing to, say, the U.S. financial markets and you will realize that it is the financial markets, and financial transactions, that are the key driver of the economy.
Just think of the U.S. stock market capitalization, which at its peak in March 2000 reached a stunning 183% of GDP, more than twice the level prior to the crash in 1929 when it reached 81%, and significantly higher than the Japanese stock market capitalization as a percentage of GDP in late 1989.
Prior to the vicious bear markets that followed the speculative excesses leading to both the 1968 and early 1973 tops, stock market capitalization as a percentage of GDP stood at 78%. Compare this to major market lows, when stock market capitalization as a percentage of GDP stood at 16% in 1942, 34% in September 1974, and 34% in July 1982. Even after its decline over the last 18 months, the U.S. stock market capitalization as a percentage of GDP – at present amounting to more than 130% of GDP, compared to an average of 50% since 1926 – is still extremely high and supports my view that the equity market, along with the credit market, is the economy’s largest, albeit certainly not "strongest", lever for the economy.
The rising importance of the financial sector in the U.S. economy has also been reflected in the strong performance of U.S. financial stocks. The performance of the S&P 500 Financial (Diversified) Index – which includes stocks such as American Express, American General, Fed Home Loan Mortgage, Federal National Mortgage Association, MBIA, MGIC Investment Corp, Morgan Stanley Dean Witter, DSCVR&C, and SunAmerica – reveals that their resilience in an otherwise rather weak market – at least until last fall – is striking.
On the debt side, the evidence also points to a disproportionately large debt market compared to the real economy. Total U.S. market debt which does not include loans by financial and non-financial institutions) currently amounts to about 270% of GDP, compared to an average of approximately 145% of GDP between 1950 and 1980.
At the stock market’s peak in 1929, total market debt reached 160% of GDP!
If, indeed, a substantial part of economic growth over the last 20 years or so, not only in the U.S. but all over the world, was driven by an expansion of the financial markets – most notably the credit market – then it follows that this disproportionate financial expansion must go on at all costs in order to sustain further economic growth.
The almost endless supply of money available for the corporate and household sectors leads to poor investments by corporations – projects that don’t make any sense – and to personal consumption growth that outpaces income growth declining savings rate.
The turning point of this financial pyramid then occurs when it becomes evident that the corporate sector over- invested. Competition then drives down prices as a result of the additional supplies, which in turn bring about the profit deflation in the corporate sector we are presently witnessing among industrialized countries. The profit deflation subsequently leads to a reduction in employment and lowers the value of equities, which brings about a deterioration of the consumers’ leveraged balance sheet.
When the economy weakens, this increased leverage on the part of the consumer leads to a substantial rise in the number of personal bankruptcies, as happened recently.
Faced with these conditions, the consumer has two choices. He will either be forced to borrow even more in order to maintain his consumption, thus leveraging his already shaky balance sheet even further, or he will cut back on his spending.
The strong, and in the long term unsustainable, growth in consumer finance may sound alarming, but when you consider that in the first seven months of 2001 the credit card industry mailed out more than 2 billion solicitations, an increase of 61% over a year ago, this expansion of credit should come as no surprise. Capital One was responsible for 29% of all solicitations. (Note that for every man, woman, and child in the U.S., seven credit card solicitations were sent out in just seven months, with an average response rate of only 0.4%!)
Another disaster in waiting concerns other government- sponsored enterprises such as Fannie Mae and Freddie Mac, which are currently benefiting from a deluge of mortgage refinancing. According to the Prudent Bear’s Doug Noland, over the last three years, Freddie Mac’s assets grew by US$308 billion (134%), while shareholders’ equity only increased by US$5.6 billion.
In the present situation, Mr. Greenspan’s accommodative monetary policies will remain largely ineffective for the U.S. economy. Corporate profits will continue to slide and disappoint. Poor corporate profitability and negative cash flows will lead to further cutbacks in capital spending and to additional layoffs in the U.S.
And when it becomes obvious to everyone that further layoffs are on the cards and that the U.S. economy will fail to recover in the next six months, retail and car sales, along with the housing market, will finally cave in as well.
for The Daily Reckoning
January 16, 2002
P.S. In the current scenario, it is difficult to see why the S&P 500 should rise to 1,500 by the first half of this year, as some leading Wall Street strategists are predicting…
Marc Faber has been headquartered in Hong Kong for nearly 20 years, during which time he has specialized in Asian markets. He is the editor of The Gloom, Boom and Doom Report and a major contributor to Strategic Investment. He has recently been named as a member of Barron’s "Round Table."
Treasury Secretary O’Neill explaining why the Bush Administration did not come to Enron’s aid: "Companies come and go. Part of the genius of capitalism is, people get to make good decisions or bad decisions, and they get to pay the consequence or to enjoy the fruits of their decisions."
Ah…that’s it, isn’t it? The difference between market democracy and political democracy…In politics, whether you go along with the mob or not…you suffer the same consequences. You get taxed, drafted, bossed around…
But the genius of the free market is that you, personally, can do what you like. No one puts a gun to your head and forces you to buy stocks that are too expensive. Heck, you can even profit from the mob… "Find the trend whose premise is false, and bet against it," is George Soros’ advice.
The premise of the recent rise in tech stocks must be about as phony as any. Companies with sluggish sales and declining profits are priced at levels not seen since the Nasdaq peak 2 years ago. AOL’s P/E is 427…with sales growing at only 10% per year. Intel’s sales fell at a 20% rate in the last quarter. Net profits were off at a 77% rate. But the stock still changes hands at 64 times earnings.
It’s a free market. You can either buy the techs…or sell them.
And Soros’ principle applies to the entire market, not just the tech stocks. "The American economy is a disaster waiting to happen," says Marc Faber, quoted in this week’s Barron’s. Faber, a regular contributor to the Daily Reckoning, is a member of Barron’s "Roundtable" discussion this year.
"Greenspan’s interest-rate cuts have supported consumption artificially and borrowed from the future. The so-called booms in car sales and housing will come to a very bitter end. Greenspan basically moved the bubble from Nasdaq to other sectors of the economy and these bubbles will also burst…"
The premise of the latest stock buying is that stalwart consumers will keep buying and will pull the U.S. economy out of its slump. Sales will go up. Profits will soar. And equity prices will rise. But it appears to us that most of the buying and selling going on in the last quarter was the sort that is not likely to continue…nor produce much in the way of profits.
"This brilliant approach," says Alan Abelson of auto discounts and incentives last year, "worked wonders in moving cars out of the showroom. It was not, however without its drawbacks. For openers, it absolutely wrecked profits; in other words, it created profitless prosperity, not an enviable condition for anyone hoping to stay in business for very long."
"I think the American consumer is brain-damaged," Faber remarks. "He should be pulling back and increasing his savings rate dramatically. But, no. He’s pushed by CNBC and the authorities, who always talk nicely about the future, into consuming."
Will the great mob of consumers save the economy…or ruin themselves trying? Again, that’s what’s nice about the market…you can bet either way.
Eric, which way did the bet go yesterday?
Eric Fry from New York (formerly New Amsterdam)…
– More joy in Stockville yesterday as retail sales fell "less than expected" in December. Sales decreased 0.1% during the month. The better-than-feared report was enough to "juice" the stock market.
– The Dow put an end to its six straight losing sessions by gaining 33 points to 9,924. The Nasdaq picked up about a 1/2 percent to 2,000.91.
– During the whole of 2001, retail sales increased 3.4%. That’s less than half the sales growth of 2000, and the worst performance since 1991. Consumer, where art thou?
– Investors seemed to be trading stocks yesterday about as enthusiastically as most Americans work on July 3rd. The stock market was open for business alright, but the financial strip tease known as the "Enron debacle" took center stage.
– As intensifying public scrutiny peels away each new layer of financial tomfoolery, we catch ever more titillating glimpses of the spectacular scandal…But there’s nothing pretty about it.
– The first guy who ever told me about possible troubles at Enron was a professional short seller named Jim Chanos. At a gathering of hedge fund managers in Miami almost one year ago, Jim stood up and declared, "There’s something very wrong with this company."
– He provided various details to support his thesis that this New Era idol was standing on feet of clay. Yet, at the time, the stock was priced for perfection, selling for about 70 times its bogus earnings.
– Jim’s view was very much in the minority and was not well received by either Enron management or by the Wall Street analysts with whom he spoke. No one likes a killjoy, especially if he speaks the truth.
– "All that is needed is the right lie at the right time," Bill observed yesterday, "and the great mob of investors rushes to its ruin…" This is the same mob, by the way, that would just as eagerly stone a short- seller for blaspheming against Cisco, figuratively speaking…(I think!)
– Short-sellers are reviled. In the eyes of most Americans, they inhabit a social stratum far below both politicians and pedophiles.
– Ironically, investors should be throwing parades for short-sellers, or sending them champagne, because honesty is the rarest of commodities on Wall Street.
– And most short-sellers are trying to get to the truth, despite the powerful institutional forces that hope to throw them off the scent.
– The honest analyst – corrupted into near-extinction on Wall Street – is the only true friend an investor has. Perhaps the Enron disaster will promote a new appreciation for independent, sometimes skeptical, analysis.
– On CNN earlier this week, former SEC Chairman Arthur Levitt offered some observations about the Enron debacle that were as insightful as they were humorless. (No one would mistake Arthur Levitt for Rodney Dangerfield, even though they’re about the same age).
– Levitt stared straight into the camera, furrowed his brow and said, "It is not merely the accounting firm that was to blame for this [Enron] tragedy. It was the Board of Directors that was seduced. It was the security analysts that simply weren’t doing their job and had their own levels of conflict. It was the rating agencies, which dropped the ball. It was the investment bankers that cooked up this scheme to hide the losses in the subsidiary companies. It was the standard setters, who were too slow to establish standards to prevent this kind of occurrence…
– "I think this is a question of culture. And American companies have drifted close to the edge of the envelope, in terms of using devices to color earnings in ways which deceive the public."
– Levitt wasn’t finished yet: "You know, another element in this was the public’s willingness, at the height of the bull market, unprecedented in U.S. history, to accept numbers that they didn’t understand. They were at fault as well. Part of the process of a capitalistic system is the process of having miscreants, bad actors such as those involved in this scene, called to task. We don’t know who’s going to come out of this as the real villains, but I’ve named a whole cadre."
– Indeed, a cadre that begins with greedy and deceitful management, then follows the greed food chain down to the greedy and gullible investors.
– Better cautious than poor.
Back in Paris (formerly Lutetia…in Roman times, that is…)…
*** The mob doesn’t like dissent. Especially when the trend is false and the dissenters know it.
*** "Eco-heretic beset by hate campaign," said a headline in the Sunday TIMES (of London).
*** "The scientist who dared to challenge the establishment view on climate change has been subjected to a campaign of personal abuse, professional vilification and threats to his safety," says the TIMES.
*** Bjorn Lomborg wrote a book called "The Skeptical Environmentalist," in which he doubted that many of the environmental industry’s greatest fears – mass extinction of species, climate change, and population growth – were worth worrying about. "For years, we have been hearing how the world is deteriorating. I thought that too," said Lomborg over the weekend, "and then I looked for the evidence and it just isn’t there. In fact…things are getting better."
*** So outraged is the industry that poor Lomborg has had to employ bodyguards to protect him. Nature magazine compares him to apologists for the Nazis who claim the Holocaust never happened. He is heckled and booed at booksignings at bookstores. Speaking at Oxford, he was struck by a cream-laden baked Alaska pie.
*** The pie-throwing protester, naturally, felt justified. He may not have had the facts on his side…but he had feelings. "Hitting him with a baked Alaska seemed appropriate," said environmentalist Mark Lynas, "Global warming is destroying one of the Earth’s last wildernesses and Lomborg is trying to pretend it doesn’t matter."