The Trouble with the Whole World
How runaway credit fed the bubble in Japan…and, with a ten-year time lag, in the U.S. too. This Classique, originally aired on 20 September 2000, gave rise to themes in Chapter 4 of Financial Reckoning Day.
"Kim An Wu, a 55-year-old housewife," says a report in William Fleckenstein’s SiliconInvestor.com column yesterday, "believed the [South Korean] government’s vow last year that it would foster technology stocks. She spent more than $250,000 to buy shares listed on the Kosdaq index.
"Instead of profiting from the Kosdaq’s Internet and mobile phone stocks, Kim posted a loss. No longer able to afford the home she hoped to buy for her soon-to-be-married son, Kim is so incensed that she phoned the presidential palace yesterday to complain. ‘The only way I can make up for my losses is through the stock market,’ she said, standing amid a grimfaced group of retirees at a Seoul brokerage today, as stocks slipped yet again. ‘So I want the government to do something fast.’"
The article went on to say, "housewives and retirees watched, dazed, yesterday and today as screens on broking floors quickly filled with green, that in many parts of Asia marks declines."
Ms. Wu may not know exactly what she wants the government to do. But the central bankers who work for the world’s governments know. Another dose of ‘liquidity’…of cash…of credit…usually sends equities higher.
"Look at this," said Addison to me yesterday, pointing excitedly to a group of charts. "Credit expansion and stock market growth go together."
Economic Downturn: Credit Growth Boom
Sure enough, the group of charts, from a study done in 1996 – produced by the Japanese central bank – showed that credit growth paralleled stock price movements. When stocks were in a boom – credit growth was, too. (None of the parallel lines, I noted, went up forever.)
Japanese monetary officials made a reasonable inference: looser credit policies must CAUSE stock market increases.
In 1996, Tokyo was looking for a way to boost its economy and stock market. Lower interest rates – lowering the cost of borrowing – looked like a decent bet. Besides, it was about all central bankers could do. So, interest rates came down. By 1999 they had reached what the Financial Times called "effectively zero." Yet, even free money failed to revive the Japanese economy or its stock market. Why?
Digital Man is stumped. To him, everything works by simple cause and effect logic. When the cost of borrowing goes down, the demand should increase. And yet, not even giving money away could persuade Japanese business and consumers back into the credit market.
But Analog Man, more heart than brain, understands. He knows it is his fault. He knows that, were it not for him, the world would be a different place.
Economic Downturn: The Fed Saves the Day
Paul Erdman, former analog gloom-and-doomer, explains [via Gary North] how monetary officials reacted to the Long Term Capital Management crisis of 1998. The LTCM geniuses had gotten themselves into multi-billion-dollar dry hole…into which the entire world’s financial system threatened to slide.
But the Fed, according to Erdman, "pushed immense liquidity into that system within hours and saved the day."
Erdman, reborn a digital man, does not believe night follows day: "In this information age," he says, "we live in a new world in which decision makers are immeasurably better informed…"
Daily Reckoning readers who have endured my letters on the value of information will be tempted to click off at this point. Let me reassure you…my point in today’s letter has nothing to do with the value of information. It is not the nature of information that interests me today, but the nature of man.
Whatever technological improvement the ‘Information Age’ represents, it is neither the first nor the last to get investors noticeably aroused. The railroads, internal combustion engines, electricity – all of these were seen in the same light as we see information technology today. And each time, investors "under-reacted…and over-reacted" in what has become a predictable fashion. They got excited…they bid up prices to outrageous levels…and then there came a bust.
But, Erdman continues: "The business cycle may not be dead. But there are increasing grounds to believe that the boom- and-bust phenomenon is. Which reinforces the view that the place to keep your money is in index funds, not in gold."
In short, if the central bankers were able to ‘save the day’ in 1998 – why not now? Why not forever?
A boom is accompanied by an expansion of credit…a bust, by a contraction of credit. The Japanese tried to create a boom by reducing interest rates – making credit more affordable. But, it didn’t work. They were not able to get their own people to borrow yen.
Economic Downturn: A Zero-Sum Game
But animal spirits still ran high in the western world. The ‘yen carry trade’ developed. Speculators borrowed yen and then invested the money in U.S. stocks and bonds.
Speculation is, however, a zero-sum game. (Actually, taking into account the friction costs…it is a minus-sum game.) So there have to be some losers as well as winners. And with trillions of dollars at stake, it was only a matter of time until a there was a big, big loser. LTCM would have been that big loser – had not the Fed stepped in.
A little later, the Fed and other central bankers stepped in to save the world from the Asian currency meltdown. Then, two years later, they protected the system from a Y2K shock.
These efforts at rescue, resuscitation and protection have produced a moral hazard of grotesque proportions. The amount of derivatives outstanding today [in September of 2000] is estimated to be as high as $100 trillion. And the debt in the U.S. economy has reached $26 trillion.
Most interesting, from our point of view, for a boom to continue, it needs an expansion of credit – at a faster and faster rate. A man with a $1000/wk lifestyle and a $100,000 debt needs a lot more new cash than the man who lives on $100/wk and owes only $10,000.
Likewise, it takes a lot more money to move a billion-dollar company up in price than a million-dollar one.
As the boom of the late ’90s continued, reports Dr. Kurt Richebächer, "the rise in indebtedness gathered ever greater speed in relation to economic activity…In 1999, nominal GDP growth of $509 billion compared to aggregate financial and non-financial debt growth of $2.208 billion. For each dollar added to GDP there were 4.3 dollars added to outstanding debt."
"There is something healthy," Grant’s quotes Mike Brosnan, an official at the Office of Comptroller of the Currency, "…about having a little downturn. It reminds you that the world is a risky place."
Thanks to the work of the world’s central bankers – saving the system from the Japanese bust…LTCM…the Asian currency meltdown…and Y2k…the world has become an even more risky place.
October 29, 2003 — Ouzilly, France
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the Wall Street Journal best-seller:"Financial Reckoning Day: Surviving The Soft Depression of The 21st Century"(John Wiley & Sons). See: "The most important investment book I have ever read…"
"Party like it was 1999," says a message from a friend. October is almost over…all that is left of it are the hobgoblins, demons and spooks of Halloween.
So why not enjoy it? The stock market partied yesterday – with the Dow up 140 points on news that the Federal Reserve had decided to do nothing at all.
One percent…not 1.5% nor .75% nor any other number…was deemed the correct level for short-term borrowing by the Federal Open Market Committee. Said the august group: "The committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future."
"Artificially Low Rates Will Cause More Future Grief," warns a headline in the Korea Times.
We don’t know whether they are artificially high or artificially low. But we know they are artificial. And since there are a lot of possible numbers, the one chosen the Fed is more likely to be wrong than right.
We presume that the Korea Times is on the mark with its suggestion that rates are lower than they should be. Rarely do government appointees make it hard to borrow in advance of national elections.
We presume also that the Korea Times is right about the "future grief." Americans are undeniably adding to their debts. Rarely do people borrow in order to spend more…without regretting it. Myvesta, a credit counseling company, reports, for example, that its clients have increased credit card and unsecured debt by 50% over the last 12 months – to an average of $77,036. Mortgage debt has risen by 25% to $207,958.
Still, the prevailing mood is one of optimism, self- delusion and mass hallucination. Yes, Americans are going deeper into debt, say the kibitzers, but consumer spending is powering the U.S. economy to a strong recovery. We’ll be able to work our way out of debt, says practically everybody.
Americans are hard-working people, as everyone knows. But so are the Chinese and the Indians. The problem for a nation working its way out of debt is that it has to do more than just moan and sweat. It has to make something it can sell. And as time goes by, Americans spend more and more money…but make fewer items that they can exchange for ready cash. In the past year, retail sales rose 6.3%, but manufacturing fell 1.6%.
How we will ‘work our way out of debt’ without actually producing anything is yet to be discovered.
We don’t know what will happen, but at some point, if not this year, maybe the next, the zombies and werewolves are likely to be out in force.
Over to you, Addison…
Addison Wiggin, writing in Paris…
– The Sage of Omaha said he never bought foreign currency – until now. Yesterday’s BBC report tells us that Warren Buffett is worried about the dollar. The U.S. government deficit has "greatly worsened," he said, "to the point that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate." The budget deficit this year is nearly twice the previous record.
– "Our country [the U.S.] has been behaving like an extraordinarily rich family that possesses an immense farm," Buffett warned in an interview with Fortune magazine. "In order to consume 4% more than we produce – that’s the trade deficit – we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own." Continuing his analogy, Buffett goes on to explain that, as foreign ownership of the "farm" grows, income flows out of America in the form of dividends and interest payments.
– The U.S. trade deficit with China was a record $11.7 billion in August, according to U.S. government figures cited by Bloomberg. The trade gap with China, which widened to $77 billion in the first 8 months of this year, was a record $103 billion last year. "We have entered the world of negative compounding," laments Warren. "Goodbye pleasure, hello pain."
– Back in the bubble days – when New Era hero George Gilder and his ilk ‘got it’ – Buffett was crying wolf. When it came to investing in Cisco, Yahoo!, or Amazon, Buffett just didn’t ‘get it.’ He couldn’t understand the valuations…so he stayed away. And unlike the thousands – nay millions – of investors with the New Era light flashing in their eyes, Buffet still has his money. In fact, as we pointed out a few days back, Buffet has more money than he has investment ideas.
– "I am crying wolf again," Buffett continues, "and this time, I’m backing it with Berkshire Hathaway money. Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in – and today holds – several currencies."
– Coca Cola announced another layoff yesterday. Nine hundred more people will get pink slips. Coca Cola was one of the companies that helped make Berkshire Hathaway shareholders into millionaires…and Buffett famous for it. Now he regrets not having sold the stock in ’99…he wished he had got going when the going was good.
– Easy Al and his Fed pals decided after breakfast yesterday to further underwrite the rapidly swelling U.S. asset and housing bubbles; they left interest rates unchanged at 50-year lows. And there they will remain for at least another six weeks.
– "Surely it must mean something when U.S. house prices are up nearly 20% in two years," writes our London correspondent, Sean Corrigan, commenting on the Fed’s decision, "pushing up medical costs, tuition fees and insurance premiums by double digits, too? Or that good, old, speculative equities are roaring – with Semiconductors up 136%, Internets up 142% and Networkers up 209%? Or that four major commodities indices – each with a different composition – are up between 37% and 55% from their late- 2001 lows?
– "Doesn’t it matter that long bond yields on U.S. Treasuries have risen 1% from their lows…meaning a 14% drop in T-bill prices? Shouldn’t economists worry that U.S. household credit continues to boom, as current and budget accounts yawn ever-wider to record gaps…?"
– Well, apparently not. The Fed’s official communiqué stated: "The probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period."
– In plain English, the Central Bank of history’s greatest debtor nation thinks it wise to keep on fuelling today’s enormous consumption of capital.
– The lumps loved it…by the market’s close, fools had rushed in to push the Dow up 140 to 9748, the S&P 500 up 15 to 1046, and the Nasdaq up 49 points to 1932. One wonders whether the greater fools will show up when those in question decide that buying stocks at these valuations isn’t such a good idea.
– Select foreign currencies also loved the Fed’s decision. "The Kiwi [New Zealand Dollar]," writes Chuck Butler, our friend over at the Everbank trading desk, "hit a 6-year high overnight, and hasn’t stopped on profit taking! In December 1997, the Kiwi last traded at .6142, and again, it was going in an opposite direction then on the slippery slope down to 39 cents 3 years later! Both the Aussie [Australian Dollar] and Kiwi got a nice kick when the Fed left rates unchanged, which gives the positive interest rate differential that both of these enjoy, new life!"
Chuck also reports that the "Commodity Currencies" of Australia, New Zealand, Canada and South Africa remain the top performing currencies v. the dollar this year…
Back in Ouzilly…
*** Recovery? "We completely fail to see any recovery at all in the United States," writes Kurt Richebächer.
*** Rather than work their way out of debt, our guess is that Americans will default. Their debts are denominated in dollars. Sooner or later, the dollar will fall substantially, wiping out trillions’ worth of obligations. *** The price of gold fell $4.80 yesterday. It is still $100 above its price in 1999.
*** Our correspondent in South Africa, Evan Pickworth, brings us the latest news from the savannah: "I don’t see the Daily Reckoning opening an office in Harare any time soon. The political situation in Zimbabwe is now very bad. On Monday, police arrested four directors of the publishers of the country’s Daily News.
"Only problem was, when they arrived to arrest the Chief Executive, they couldn’t find him. Minor problem for the Zimbabwean gulag. They simply arrested his niece instead as some kind of a hostage.
"The reason for the arrests is that the government has accused the publishers of publishing the Daily News illegally without a license.
"A court, however, nullified the closure of the newspaper on Friday as they felt the commission which refused the license was improperly constituted and had exhibited bias against the paper.
"The government went ahead with their arrests on Monday anyway – what’s a small court order to them? Apparently, in the swoop, they also arrested a retired high court judge – in my opinion probably to send a message to the ‘recalcitrant’ judges who made the ruling against the government-run media commission on the Friday.
"If convicted, the directors – including the CE whose niece was arrested as a hostage – face at least two years in jail."
*** Back in the States, the Financial Reckoning Day Brigade is out in full force.
"Greetings, Addison," begins a reader:
"I visited a local Borders in Tulsa, OK over the weekend and was able to find a single copy of Financial Reckoning Day. Since I am taking advantage of the 35% discount online, my mission was a simple search and rescue from the dark trenches of a bottom shelf in the business/investing section where I found the lone copy tucked ever so snug between various day trading and options investment books. "On a much more appropriate eye level shelf I managed to create my own display by moving aside the previous contents to prepare adequate space for my next move. Being careful not to over-handle the merchandise, I quickly placed the copy face forward on the shelf paying close attention to achieve a proper viewing angle. The book now stands out among all others in its section so I am fully confident my work there was not done in vain! "Until the Day Comes,"
Don Rozanski – FRD Scout
*** And this from the bn.com bestseller page: "Bill Bonner and Addison Wiggin have been garnering big online sales with this treatise on economic tough times. Now, Financial Reckoning Day has hit our weekly chart of top business titles."
The discount Don is referring to is available here:"The most important investment book I have ever read…"