The Ultimate Debacle

The other day, I received a three-page email from Klaus Bockstaller, who runs the Baring Emerging Europe Trust. I have to say that while I get at least 100 emails a day, the issues that Klaus raised, his thoughts, and the resulting questions, were some of the most interesting and challenging that I have ever encountered. They have driven me along an illuminating path of reflection, and given rise to some interesting conclusions.

In essence, Klaus has the following theory. When, in the future, Western political leaders realize that the Bernanke- type monetary policies don’t really work (or are doomed to fail, as I would put it), but lead to inflation and a depreciation of the dollar, they will increasingly pursue a policy of protectionism, which will buy the developed countries of the West some time and keep jobs from migrating to low-cost service providers, such as India, and more competitive manufacturing centers, such as we find in China, Vietnam, and Eastern European countries, among many others. A sharply depreciating dollar and import duties will lift the price level in the U.S., but the disadvantage of higher domestic inflation could be partially offset if production and tradable services shifted back to the U.S..

The only remaining problem in this scenario (of depreciating dollars) would be oil. But, according to Klaus Bockstaller, the U.S. has wisely already taken steps to ensure that it will have sufficient supplies at reasonable prices in the future – by occupying Iraq.

Protectionism: ein böses Ende

Klaus concludes that while he agrees with me that the U.S. is headed towards ‘ein böses Ende’ (disastrous eventual outcome), he nevertheless feels that a country like the U.S., whose money is ‘the’ reserve currency of the world, can, as Bernanke suggested not long ago, print money at practically no cost.

If this policy does not work, however, Klaus suggests that the U.S. can simply implement protectionist policies in order to postpone for quite some time the ‘ultimate debacle’. If the U.S. succeeds in putting off its problems for quite some time, then the equity markets could perform very well for a while.

While I fully agree with Klaus Bockstaller’s basic presuppositions, I believe that the lease of life of economic policies that are designed to postpone problems, rather than to solve them – and to hurt competitors through competitive devaluations and protectionist measures – is far shorter than is generally accepted. As Mao Tse Tung wrote during the revolutionary struggle to ‘liberate’ China, “a single spark can start a prairie fire.” Let me explain the reasons for my somewhat less sanguine views.

More than two years after the Fed began to ease aggressively, it is now becoming more obvious that the policy of aggressively driving down short-term rates has failed to produce any meaningful recovery. Consider, for instance, the booming housing industry. Given the red-hot conditions in this sector of the economy (don’t forget that it is excessive credit growth that drives residential house inflation), one would assume that the furniture manufacturing industry would also be thriving.

But, not so! Industrial production for furniture and related products has been declining since 2000, while employment in this sector has totally collapsed. Why? Easy money has led to new capacities in the furniture industry – not in the U.S., but in Vietnam and in China, two countries from which furniture imports into the U.S. are soaring.

Protectionism: Stimulating Borrowing, Not Production

So, it should already be obvious to U.S. economic policymakers that in an environment of free trade and free capital flows, monetary policies can stimulate borrowings and spending in a high-cost country, but not capital spending and production, which, given the highly competitive situation we have, will naturally shift to the lowest-cost producers and lead to the ongoing wealth transfer to Asia via the U.S. current account deficit.

But what about protective duties, quotas, and regulatory measures that would prevent service jobs from migrating overseas? It is on this point that I disagree with Klaus Bockstaller. Import duties and quotas will make matters worse, not just in the long term but also immediately. Let me explain.

First of all, import tariffs and quotas on a large scale would increase prices for manufactured goods in the U.S. and, combined with the ongoing inflation for services, would lead to higher inflation rates across the board and, therefore, depress bond prices further. In turn, rising interest rates would bring the refinancing boom, which has kept consumption up, to an abrupt end. In addition, selective tariffs, such as were imposed on steel imports, will not create jobs.

Because of the steel tariffs, U.S. steel prices are now far above steel prices in Asia, Russia, and Brazil. So, what is the result? Manufacturers of goods with a heavy steel content (such as car-part manufacturers) are shifting their production overseas, where not only labor but also now steel prices are lower. And if across-the-board import duties were levied, such duties would not only hurt foreign manufacturers, but also U.S. companies, which in the last few years have set up production capacities overseas and import their products back to the U.S. (I understand that about 50% of U.S. imports originate from U.S. companies overseas).

Protectionism: Reducing Competitive Pressure

In fact, under careful analysis, it should be obvious that the lack of competitiveness of U.S. companies has led to the shift overseas of goods production and the provision of services. Import duties or restrictions will ‘protect’ unproductive and uncompetitive industries and make them even less competitive, since duties will now diminish the competitive pressures.

For the U.S. economy, rising protectionism would also mean far higher inflation rates, as well as a huge competitive disadvantage on the global markets for U.S. corporations. Sure, the lowest-cost providers of services and producers of goods would temporarily be hurt, but the world’s economic geography is now mutating rapidly. Already, the Asian markets combined are far larger than the U.S. economy in a number of sectors. Consequently, American protectionism would merely redirect trade flows, but not eliminate them. (As an example, Thailand’s exports were up in May year-on-year by 13.5%, but exports to China soared by 82%.) I might add that the threat of protectionism will actually make exporters in Asia and India stronger, because they would then direct their efforts to lowering their dependence on the U.S. market by looking for customers elsewhere.

Lastly, rising protectionism in the U.S., which is already evident in a number of industries where foreign firms are accused of dumping, will probably mean the end of the WTO and lead to retaliatory measures by foreign governments. This is hardly a picture that would be very beneficial for economic growth and financial markets, not to mention the negative geopolitical consequences for the U.S.!

In sum, I suppose that American protectionism will be bad for everyone, but especially so for the U.S., as it would not cure the cause of job losses and the trade deficit problem but, rather, would address only the symptoms of these problems.


Marc Faber,
for the Daily Reckoning
July24, 2003

P.S. I also doubt that the financial markets would take a rising tide of protectionism in their stride. As already mentioned above, the U.S. bond market and the dollar would likely react negatively because of rising inflationary expectations and the fear that the Asian central banks would dump their dollar holdings. Stocks would suffer because of the damage that protectionism would do to the multinationals.

P.P.S. A last point that I am compelled to address is Klaus Bockstaller’s remark that the U.S. has, cleverly, already taken steps to ensure that in future it will have sufficient oil supplies at reasonable prices by having occupied Iraq. But, isn’t it highly uncertain how much oil from Iraq will ever reach the world’s markets? The occupation is going very badly, and it increasingly looks as if the U.S. is bogged down in a vicious guerrilla war that will be hard to win.

Just consider the arithmetic of the war. Let us be optimistic and assume that only 5% of the Iraqi population wants the U.S. to leave or has some grudge against the coalition forces. In a population of more than 20 million, this amounts to at least one million potential enemies, or at least supporters of the guerrilla fighters, or ‘terrorists’, as some may call them. One million invisible enemies, who can only be identified as enemies during very brief acts of sabotage and ambushes, is a huge numerical superiority against a highly visible (uniforms) occupying armed force of 160,000.

I would not be surprised, therefore, if at some point the financial markets were unsettled by the lack of progress of the coalition forces in establishing law and order in Iraq.


Yesterday, we wondered.

On what day will the U.S. economy change course? It has been following Japan…with a 10-year lag…since the mid- ’90s. Stocks boomed up, then bubbled up, then blew up…just as they had in Tokyo 10 years before.

And then Greenspan, Bernanke, McTeer and Bush came along. Vowing not to repeat Japan’s mistakes – they did almost exactly the same thing Sakakibara, Mieno, and Murayama did – they cut rates and increased government spending. Is it any wonder they got the same results?

Like Japan before it, the U.S. economy has slipped, slumped, and slid for the past 3 years. It cannot seem to find a firm footing. So much ‘liquidity’ has been hosed on the ground that it is now too sloppy to give a man any traction. Instead of making progress, he slips and falls. Prices drop. Jobs are lost. The economy sinks.

More than 2.5 million jobs have been lost since the beginning of the millennium. At first, no one seemed to care. Assembly-line workers are a dying breed. Their incomes have been falling for the last 30 years. But now, it is white-collar working stiffs who are feeling the pain.

“U.S. Jobs Jump Ship,” says a CNN headline. IBM and Microsoft are moving their work overseas. “You can get two heads for the price of one,” says an executive.

And people like Donna Bradley, an unemployed IT specialist from Mesa, Arizona, are in a tight spot. “They won’t hire Americans,” she says, missing the point. What they don’t want to do is pay $45 per hour for something they can get for less than half that amount in India.

Ms. Bradley has been forced to sell her home.

And here, once again, we stop dead in our tracks. Stepping back, we take a look…in awe. How elegant, how exquisite, how unrelenting and unforgiving the whole thing is…! Who was supposed to get rich from the information revolution? From globalization? From the Dollar Standard…the trade deficit…Wall Street? Americans! But who will be ruined by these very same trends? Ah…more below…

There will come a time, of course, when there are too many Donna Bradleys. At that point, if not before, the U.S. will stop its drift to sushi-land. Unlike Japan, America is a nation of debtors. It can’t tolerate as much slump; its Donna Bradleys go broke too fast.

But that day may still be a long time in the future.

In the meantime, we turn to Eric Fry with the latest update from Wall Street:


Eric Fry in the Big Apple…

– Stocks and bonds both gained ground yesterday, but investors don’t seem to be brimming with confidence. The Dow gained a meager 36 points to 9,194 and the Nasdaq drifted 13 points higher to 1,719.

– Perhaps the stock buyers were feeling a little nervous while looking over their shoulders at the newly falling dollar, which tumbled more than 1% yesterday to $1.147 per euro. Or maybe the stock buyers felt a twinge of anxiety while watching the gold price surge more than $8.00 to $358.70 an ounce. What troubling trend or event, these nervous investors may be asking themselves, might such a substantial gold rally portend? Inexplicable rallies are the most unnerving sort of financial market phenomena. Whatever the gold market may know, we suspect that it is not a good thing for the stock market.

– The strongest evidence in support of reincarnation may be the uncanny resemblance between the bubble stock market of 1929 and its re-emergence in 2000. Was the bubble market of 2000 nothing more than 1929 returned in the flesh? And therefore, is the stock market’s awesome rally since last October something that we have seen before? Will the 2003- vintage Dow rally perish as suddenly as the bear market rally of 1931-1932? Constrained by a kind of déjà vu, is the stock market predestined to tumble anew and to drop below the lows of last October?

– We don’t know the answer to these “meta-financial” questions, of course. But we can take our cues from history and see if the modern market rhymes with the markets of yore.

– Let’s consider the evidence. In 1929, the U.S. stock market was booming, selling for the formerly lavish P/E ratio of 33 times earnings, well above the historical fair- value average of 14 times earnings. Then came the bust.

– For the next three years, stocks cascaded lower, until they finally bottomed in June of 1932. Along the way from peak to trough, the Dow mounted six major rallies, the last of which lifted the blue-chip index about 35% before exhausting itself. On six separate occasions, the stock market bulls of 70 years ago believed that “the bottom was in.” And on six separate occasions their optimism proved to be woefully misguided.

– Fast forward to 2000, when a two-decade stock market boomed flourished, then mutated into one of the greatest investment manias of all time. Stocks soared to ridiculous valuations, with the best-performing stocks soaring to “infinity times” their non-existent earnings. Then came the bust.

– Like any self-respecting bear market, the 2000-2003 edition has made stocks much cheaper, if not absolutely cheap. The Nasdaq’s valuation has tumbled from well over 100 times earnings to a still-plump 40 times trailing earnings.

– Unfortunately, as accurately points out, “A post-bubble bust cannot and will not end until valuations are once again undervalued by historical standards…The Nasdaq is up an impressive 38% from its March lows and an incredible 58% from its October lows…But unfortunately, as this valuation data reveals, there is simply no fundamental foundation to this powerful bear-market rally. Like the 35%, 25%, 41%, 45%, and 34% major bear-market rallies since 2000 before it, this 38% specimen today is built on a weak foundation of speculative sand and will fail. One way or another, before this Great Bear ends, the S&P 500 will trade under 14x earnings and yield over 6% in dividends and will be undervalued by historical standard.”

– We’re inclined to agree with, but we don’t wish to pick a fight with Mr. Market.

– “Either stock prices will plunge dramatically in the next couple of years to get valuations back in line,” winds up, or stock prices will trade sideways for a decade or more until earnings catch up. There will be no new Great Bull until stocks are really undervalued, period. Real bull markets are born from the desolate ashes of undervaluation, not from the fiery embers of a mini speculative mania!”

– OK, so now we know what SHOULD happen!


Back in Paris…

*** is back in the news. The company was supposed to make only 6 cents (when you leave out certain things…such as the cost of stock options and depreciation). Instead, it made 10 cents a share, again, leaving out certain things. Of course, when you add back in the things it left out, you find that the big River-of-No- Returns stocks lost 11 cents. Still, investors were so thrilled, they bid up the stock 15%.

And just in time… our book “Financial Reckoning Day” (John Wiley & Sons) debuted in the “Top 5 Future Releases” list last week on their home page. (Just below Krugman… ha, ha, ha)

*** Gold rose $8 yesterday, after Ben Bernanke opened his mouth. “We should be willing to cut the funds rate to zero, should that prove necessary,” said the Fed governor. The dollar also reacted, with a 1% drop, bringing the euro to $1.14 and change. We wish we had followed our own advice.

*** The Tour de France approaches its finale. It has been fun watching the U.S. Post Office team in their zippy red, white and blue uniforms…often leading the pack. Our hearts swelled just a little at the sight of it.

“But why is the Post Office paying $40 million to sponsor a bicycle team?” a kill-joy wanted to know. We have no idea…after all, the USPS has a monopoly. But the Post Office loses about $1 billion per year. What’s another $40 million?

*** Friend and colleague Karim Rahemtulla, director of the Supper Club, sends news of some interesting developments in the heady world of venture capital:

“At the Supper Club, the small group of accredited investors that I head, we have noticed three things in the past few months. First, the caliber of companies that are seeking funds are better today than three years ago. They are further along with their plans, have a modest cost structure (the company execs are actually earning money for work) and much more serious about the amount of effort required to succeed.

“Second, liquidity events are occurring with greater frequency. This means that investors are seeing the light sooner than before. In the past three months, three deals presented to members in the past 18 months have either gone public, been taken over or are in process of merging with public companies.

“Third, the companies that are presenting are getting all or nothing. This is a relatively new phenomenon. Usually, any company that presents to our group can generate meaningful funds…but not anymore. Our membership is getting very selective, investing heavily in ideas that look to have potential and letting other opportunities leave empty-handed. “If the trends I have seen developing in the Supper Club continue, then you should begin seeing more IPOs in the year ahead. That should bode well for the investor with the foresight to get into a situation early enough that a liquidity event could mean the difference between a comfortable future and one that may have been comfortable.”

This November, at its annual meeting, the Supper Club will present between 12 and 15 breaking investment opportunities. Those new to the club will be given the opportunity to get in on them…as well as a few venture capital deals already in progress.

Because you are so special to us, dear reader, we have arranged for 50 discounted preview spots to be made available especially for DR readers. If you would like to win one of them, contact Vickie Beard at

We advise you to hurry; Supper Club meetings tend to fill quickly, and the discounted spots will go fast.

*** Yesterday, our friend and fellow investment writer Marc Faber spontaneously sent us a copy of his book, Tomorrow’s Gold, in the mail. We have not read it yet, but we are enjoying the cover…(more from Marc Faber, below…)

*** “Oh là là…” said our tango teacher. “Put some life into it…”

It may still be years ahead, but we are not going to wait. We’re going to get into the spirit of the next major trend in the U.S. economy. Not only are we taking lessons in Argentine Spanish…we’re learning how to tango.

“You know,” continued Ms. Nanni, “when I give lessons in Buenos Aires, I have to tell people to calm down. But here in Paris, you northern Europeans…and especially you Americans…are so stiff. This is supposed to be sensual, romantic. In fact, it was considered obscene by many people…maybe it still is. And maybe that’s why I like it….Oh là là. Live a little….put some style into it!”

The Daily Reckoning