The Verge of Ruin

In a hard-hitting address first given to the American Statistical Society back in 1934, Fritz Machlup laid out the crucial concept of capital consumption for his audience.

Machlup looked at what factors might induce entrepreneurs to divert funds normally earmarked for the replacement, or expansion of their holdings of materials, plant and equipment, into consumptive uses. This list – enumerated at the height of the Great Depression – is depressingly familiar to one we could compile today.

Fritz Machlup: Miscalculation due to Inflation…

It’s something everyone buying into the stock market this year must watch closely, as must those speculating in the housing bubble and gearing up against its inflationary gains by taking out notional “equity” to spend.

It is not only Americans who are proving adept at this game: what we call in the U.K. “mortgage equity withdrawal” has amounted to undefined 77 billion in the past 3 years. This not only accounts for the aggregate trade deficit of undefined 66 billion over that time (a measure of how overtaxed domestic productive resources are), but also for three-quarters of the concomitant increase in aggregate household spending.

Machlup himself gives the example of a commodity speculator who invests in an initial tonnage of, say, copper, and who keeps making money as it appreciates in price, repeatedly spending half on fine living and reinvesting the balance.

As the price of the material progressively rises, the speculator is able only to buy a correspondingly lower weight of metal each time he does so, until the spiral leaves him at last with the means to purchase only a few pounds of it. He has no doubt enjoyed the ride tremendously, but he has also now exhausted his capital.

Summing up, Machlup tells us that: “profits due to an increasing price level are only fictitious. If they are consumed, capital is consumed.”

Bear this in mind as today’s corrosive monetary overhang continues to eat its way through the girders of the productive structure, inevitably boosting at least some income streams – in nominal terms – along the way.

Fritz Machlup: Overtaxation of Incomes

It might seem a little irrelevant in the face of the overblown fuss about the Bush administration’s much-vaunted tax cuts, but that would be to lose sight of the fact that state and municipal tax rises may well more than offset any immediate benefit accruing from the lightening of the Federal burden. Ask property owners (and, soon, commuters) in the Big Apple, or stay tuned for California’s coming Gray’s of Wrath program.

In the U.K., of course, we know all about tax increases under New Labour, and we are bracing ourselves not only for a round of payroll tax hikes in April, but also a potentially novel scheme of redistributive property taxes to further penalize the suburban Middle Classes in the South of England.

Nor would this seem alien to our German friends, famously asked to give Schroeder’s hapless coalition the very shirts off their backs in order to pay for the failing corporatist welfare structure of post-Erhard Deutschland.

Fritz Machlup: Overtaxation of Production

As Machlup put it: “While income tax snatches the profits after they have come into existence, other kinds of taxation increase costs of production and, therefore, may prevent profits from coming into existence”

This is the downside to the wave of collectivist spending being perpetrated almost without exception across the globe. Dimly aware of the looming dangers to the budget in the U.S., the press is now suddenly awash with stories of a prospective $350 billion deficit this year – blithely ignoring the fact that public debt outstanding has already risen by 13.3%, or $750 billion, in the past nineteen months, a rate of nearly $12 per household per day!

Furthermore, since the cycle maximum (which occurred just before the profits collapse of 1998), almost one in eight manufacturing jobs has since disappeared, for a total loss of 2.4 million – equivalent to displacing the total population of Pittsburgh – while, simultaneously, nearly one in twelve of the current total of government jobs came into being, for a gain of 1.7 million new drones in the hive.

Consider, too, the U.K., where the ratio of government expenditures to the gross operating surplus of non- financial corporates has risen from 57% to 62% in just two years, and where the relative size of the public sector payroll has ballooned 30% from 141 per 100 manufacturing workers to 183 since RobespiBlaire [the U.K. Prime minister] moved into No. 10.

In Australia, a government budget recently forecast to be in surplus of A$890 million at the end of November actually registered a deficit of $1.43 billion, mirroring an external position which has swung from a surplus of A$655 million to a deficit of A$1.1 billion in 16 months. This deterioration, amid a familiar housing- and auto-led credit boom, is comparable in scale and pace to that experienced in the aftermath of the Asian Contagion.

A comprehensive list of such instances would become exhausting, long before it became exhaustive. So, to sum up the damaging Keynesian orthodoxy all too prevalent at present, let us conclude with the case of France where, in a GOP-style display of economic illiteracy, President Jacques Chirac popped up to give his New Year address to journalists:

“When growth is slow, it isn’t the time to enter into restrictive budgetary policies. The economic outlook requires, by contrast, that we support growth, to continue reducing taxes and charges in order to stimulate activity,” he said, though he paid lip service to the need for spending control.

This last was, in fact, little more than a sop, aimed at an increasingly irate EU Commission, which warned only on Wednesday that France’s deficit risks topping 3% of gross domestic product in 2003 – the limit set by European budget rules.

Giving the lie to their intent to exercise any degree of real abstinence, government spokesman Jean-Francois Cope reiterated that while France intends to adhere “scrupulously” to its European commitments, the government has to reconcile those commitments “with the pledges it has made to the French people.” Or, in plain language: “Mais, certainement, mes amis, we’ll stick by the rules – just as soon as we’ve finished using taxpayers’ money to buy us enough votes to stay in power.”

Machlup summarized this ineluctable process of increasing the costs of production with mordant wit: “The numerous friends of public expenditures…reiterated every day the high productivity of these…public works. I doubt by which indexes one should measure this productivity; by the increase in unemployment; by the decrease in profits; or by the steady decline in the capital stock…”

Fritz Machlup: Forcing up Wage Rates & Social Benefits

Again, it may seem at odds with mainstream perceptions, but it is evident that today’s labor market is not clearing in a worrisome number of countries and we must ascribe this at least partly to wage costs, as well as to the ongoing imposition of regulatory burdens in the name of ‘workers’ rights’, all of which impinge, of course, upon the property rights of the owners and employers of capital.

Thus, even in the U.S., while aggregate manufacturing hours have plunged 14.8% from the July 2000 level, hourly earnings have risen 7.1% there, and by 9.6% in the service sector. Back to Machlup: “Forcing up wage rates forced up unemployment, but why should it lead to capital consumption? Because of the simple fact that industries do not shut down before the losses from operations considerably exceed the losses from non-operation. This means industry goes on producing at a loss, consuming its capital by borrowing or by omitting renewals (of depreciation).”

Ford and UAL spring very much to mind today, as do all those mishandled Delaware Chapter 11 ‘Return of the Living Dead’ cases.

Fritz Machlup: Paying Unearned Dividends

Double taxation or no, U.S. non-financial corporates have shelled out 118% of after-tax profits in the past seven quarters, amounting to a $116 billion diversion of their depreciation allowances to more consumptive ends.

Why, in such difficult times, are they dissipating their resources in this manner? To keep Wall Street happy, of course, as well as to maintain the existing boards of directors and claques of executives in the Lear Jet luxury to which they have become accustomed.

Fritz Machlup: Keeping Industries Going

Government bail-outs, subsidies, and protective measures are as rife today as they have ever been, while bank support is being extended across the globe from Asia, through Europe and the U.K. and into the Americas – whether overtly, as in the case of Japan, or by implication, as in the case of firms (and individuals) able to borrow for survival at patently artificial, low rates of interest.

That none of this helps promote a necessary re-ordering of human and physical resources, but rather prolongs the agonies of the market, is a lesson that should not need repeating here.

Fritz Machlup: Consumer Demand

Here we return briefly to what is still perhaps the most contentious issue of the day, but we can only re-emphasize that diverting resources away from higher-order producers towards consumers – indeed, to credit-empowered overconsumers – does not magically drag products out of the ground, off the assembly line and down from the warehouse shelf sustainably and profitably, as standard macro- economics tries to persuade us.

Rather, it diverts resources away from any possible reproductive use – where they might give rise to a steady diet of nourishment over time – and towards their dissolution in an unrepeatable, if immediately gratifying, nose-first plunge into the trough.

A rough idea of the scale of the losses in Machlup’s day was estimated by Oskar Morgenstern (of Game Theory fame) by taking the market capitalization of Austrian companies before the war and adding their ensuing equity issuance, adjusting for inflation (hyperinflation at one point) and comparing the sum with its value at the peak of the crisis of the Continental collapse in 1931. Since, we have learned to be suspicious of stock market valuations as representing any rational yardstick of worth and productive capability.

Though still subject to distortion through the trickery of modern accounting practice and all manner of off-balance sheet chicanery, using U.S. aggregate net worth might be a better gauge, therefore. We can attempt to adjust for changes in the dollar itself either using the Median CPI, or via a more traditional yardstick – the capital’s gold weight equivalent.

On the first of these measures, the past seven quarters has seen a 10% depletion – the worst for a decade. But it is in terms if gold that the losses look even more stark, dropping 29%, the steepest fall since 1980, or by 10 billion ounces…the worst since the first Oil Shock of 1973.

Sadly, few of the incentives to this wastefulness have been even mitigated, much less removed. Entrepreneurs everywhere continue to face an uphill battle to create more wealth than Finance Ministers and Fiat Bankers can simultaneously destroy.

Let’s leave the final say on the matter to Machlup, as he reveals from the vantage point of seven decades ago what might be our fate if we persist in our present folly. Check off his points for their relevance today as you read his sardonic conclusion.

“Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures; she increased wages; she increased social benefits; she increased bank credits; she increased consumption…

“After all these achievements, she was on the verge of ruin.”


Sean Corrigan,
for The Daily Reckoning
January 17, 2003


Gold hit $358 yesterday. It seems overbought…it has gone up too far, too fast. The Chinese are buying. The Japanese are buying. Daily Reckoning readers are buying.

We like gold because we cannot predict the future. Eventually and always, paper currencies disappear while gold remains.

Unusually and unnaturally, the world’s most ubiquitous paper currency – the dollar – rose against gold for the last 20 years of the 20th century. It is not likely to do the same for another 20.

Illinois announced a budget deficit of almost $5 billion, while the federal deficit might go above $300 billion – not including the cost of a war with Iraq.

“Dimly aware of the looming dangers to the budget in the U.S.,” writes our London correspondent, Sean Corrigan (more below), “the press is now suddenly awash with stories of a prospective $350 billion deficit this year – blithely ignoring the fact that public debt outstanding has already risen by 13.3%, or $750 billion, in the past nineteen months, a rate of nearly $12 per household per day!”

Tax revenues are falling – because taxpayers have less income to tax. Meanwhile, expenditures are rising – as government’s safety nets get stretched a bit…and its counter-cyclical fiscal policies begin stimulating.

There is a smell of sushi about the whole stimulus effort. Japan poured concrete from one end of the island to the other; fat lot of good it did. But what fiscal stimulus reliably does do is absorb the nation’s savings – away from capital investments that might actually make people better off.

At least the Japanese had a lot of savings to waste; Americans do not.

Meanwhile, the “deterioration in the government’s fiscal balance accounted for fully 85% of the depletion in overall national savings since early 2000,” writes Stephen Roach.

The U.S. savings rate – 1.6% in 2002 – is too low to finance its own consumption habits, let alone big government deficits.

America is trapped in what Roach calls “a fool’s game.” It buys foreign goods, giving the foreigners dollars…which are lent back to Americans so they can continue buying! As time goes by, Americans’ TVs and SUVs wear out – but their debts to the rest of the world are bigger than ever. And, any time they choose, foreigners can decide to stop buying America’s stocks, bonds and real estate…and to cease financing its deficits. Whatever else can be said about it, the trend cannot go on forever.

What a strange position for the world’s only super-power! It sits on top of the world…but like Humpty Dumpty on a wall, it awaits a push.

Eric, more news from Wall Street, please…


Eric Fry, reporting from New York:

– The U.N. weapons inspectors finally tracked down the smoking gun they’ve been seeking for the last few weeks. But there wasn’t any smoke; just eleven “empty chemical warheads.” News of the chilling discovery spooked stock market investors and warmed the hearts of gold investors. The Dow slipped 24 points to 8,699, while the Nasdaq fell 1% to 1,424. But the gold market relished the troubling news from Iraq. Gold for February delivery soared $7 to $358.10.

– The yellow metal is not lacking for friendly influences these days. As noted in yesterday’s Daily Reckoning, the dwindling supply of newly mined gold is helping to squeeze the price higher. At the same time, geopolitical uncertainty – both in North Korea and Iraq – is boosting the gold price.

– The struggling dollar, too, is gold’s best friend in the world. The greenback is weakening against just about everything – gold, as well as most currencies and most commodities. We non-economists would call this phenomenon inflation.

– If there is to be another Great American Inflation, gold certainly will excel. But we’ve covered that ground already. What other asset might excel during an inflationary episode? Commodities, for one, along with other tangible assets like real estate. But there is another asset that is “guaranteed” by the U.S. Government to do well during an inflation: TIPs.

– “TIPs, as every trainee knows, are indexed to the CPI,” James Grant explains. “As the price index rises, their principal value is raised. Interest is paid semiannually on this adjusted principal value. And if the CPI were to fall, the principal value would be marked lower. At maturity, the holder receives the adjusted principal value, but in no case less than par. The difference in yields is known as the break-even inflation rate.” – Remarkably, despite the dollar’s steadily eroding value, the TIPs market is priced for disinflation. Grant believes that that the “dis” prefix will soon disappear as a monetary phenomenon in the U.S. And when it does, we will be left with plain old inflation…Even a little bit of plain old inflation would make TIPs a darn good investment.

– “To be bearish on TIPs on account of a looming deflation, one would have to doubt that the Fed would do what the instantly famous new governor of the Federal Reserve Board, Ben S. Bernanke, has pledged it would do,” Grant argues. “We have every confidence that the Fed can depreciate the value of the dollar (though we don’t doubt that, in a true deflationary spiral, it could be difficult). The Fed has scarcely missed a beat since its founding.”

– Inflation isn’t the only bullish influence operating on the TIPs market. Large institutional investors are just beginning to “discover” the TIPs market. Their buying interest could help to drive prices higher. As Apogee Research’s Andrew Kashdan explains, “TIPs returned more than 16% in 2002. Our best guess is that they will continue to do well, particularly compared to nominal Treasury bonds…According to Joe Quinn at Bridgewater Associates, the total size of the TIPs market is now about $170 billion. About 10% of all Treasury bonds and notes are now inflation-indexed…The bottom line is that large institutional investors can now get involved, which should further increase demand for these bonds.”

– Furthermore, even if institutional investors don’t step up their buying of TIPs, they probably should. These unique Treasury securities are still quite cheap, especially relative to conventional T-bonds. “In other words,” Kashdan explains, “the break-even rate currently priced in by the TIPs market is too low. Ten-year yields on TIPs are about 1.6 percentage points below nominal Treasury yields, which is the break-even inflation rate. This means that if inflation, as measured by the CPI, averages more than 1.6% over the next 10 years, then the TIPs will provide a better return than conventional Treasurys. With inflation currently running at more than 2% a year, a 1.6% average over the next decade seems exceedingly unlikely.”

– Here’s a little food for thought from Strategic Investment editor, Dan Denning: “Here are a few dates to keep in mind. January 27 is the day U.N. weapons inspectors report back to the Security Council about what they’ve found in Iraq. The next day, on the 28th, President Bush delivers the State of the Union address. If I were a betting man, I’d guess the President and his team will use the State of the Union to prepare the country for an imminent war…The new moon arrives on February 1st, an ideal time to launch operations for the U.S., given the huge advantage the American military has not only in conducting nighttime carrier operations, but in fighting at night on the ground.”

– Here’s another date to keep in mind: December 31, 2003. That’s likely to be the final day of the stock market’s fourth straight losing year.


Back in Paris…

*** “The economy remains soft, Fed finds.” The NY TIMES story explains the latest discoveries from the Fed’s Beige Book survey. Most areas of the economy report “soft” or “sluggish” conditions.

*** In Oregon, the foreclosure rate on recent mortgages has gone over 1%. Marginal buyers are having trouble. Sub-prime lenders are finding it hard to collect from auto-buyers, too.

*** In the international news, Argentina defaulted…German growth is at a 9-year low…and Venezuela is on the verge of revolution or ruin.

The Daily Reckoning