They Had it in Their Guts

Plunging personal savings rates…a soaring trade deficit…a return to Federal deficits…and outright denial from American economists. For a country that once took pride in its frugality and pragmatism – how did we get here? The trend, says Dr. Richebächer, find its roots back in the ’80s with an unprecedented binge in private and public borrowing…

Worldwide, the economic news is going from bad to worse. Never before has the world experienced such massive destruction of stock market wealth; never before have business profits and business capital spending suffered such steep declines. Yet there remains, particularly in the United States, a general flat refusal to see anything foreboding in these developments.

Blind faith is overwhelming bad and worsening facts. This faith has two main objects: first, Fed Chairman Alan Greenspan creating money and credit with reckless abandon; and second, the consumer borrowing and spending with equally reckless abandon.

This faith is utterly amazing. But it confirms our long- held suspicion that the American consensus remains at a complete loss to appreciate and understand that the extraordinary excesses of these two, Mr. Greenspan and the consumer, have been crucially responsible for the present economic and financial mess. Even more of the same excesses are hardly the solution. While postponing the day of reckoning, the consumer is ever-worsening his position by loading himself with more debt that he is unable to repay.

We continue to track the chief causes of this developing American economic and financial crisis. Our finding is that they keep worsening. There is nothing in sight that might be regarded as healthy readjustment.

In his book Crises and Cycles, published in 1936, Wilhelm Röpke, Germany’s leading economist at the time, lamented about the general posture of American economists to indulge in the collection of detailed statistics about the economy, simply looking for regular sequences in the business cycle while grossly neglecting analytical research about underlying causes and conditions.

For the great European economists, economics was in essence a branch of logic with minimal statistics; for American economists, it is traditionally a branch of statistics with minimal research and logic.

The main concerns of the European economists were the need for sufficient rates of saving and capital investment as the key sources of wealth creation and productivity growth. For them, capital formation was the future. Under the dominating influence of Professor Wesley Mitchell (1874-1948), economic thinking in America took a diametrically different route. He had no interest in the conditions of long-term economic growth. His whole attention centered on the recurrent oscillations in economic activity.

His primary thesis was that each phase of the cyclical oscillations grows out of the preceding phase. Under his influence, the business cycle became a fad with American economists and the business community, and forecasting became a national sport.

With the change in the target of research came a radical change in the kind of research. While the European economists emphasized the need for a theoretical concept to properly assess economic policies and prospects, Mr. Mitchell discarded such abstract theorizing as a useless exercise.

Pointing out that business cycles generally follow the same pattern, Mr. Mitchell advocated that economists should therefore contend themselves in their studies with purely empirical, descriptive analysis. Instead of trying to search with theoretical concepts for causes and conditions, they should look for regular sequences and leads and lags of the significant economic and financial variables, trying to trace unfolding fluctuations.

Putting it briefly and bluntly: while the European economists searched for causes and conditions that determine long-term economic growth and its repeated upheavals, Mr. Mitchell practically turned American economics into a science of statistical symptomatology, refuting the necessity to identify underlying causes and conditions.

Still, although very skeptical of any theory, he emphasized in his writings that the quest for profits is the central factor controlling economic activity. Accordingly, he said the whole discussion must center on the prospects for profits, which is really the theoretical assumption of crucial importance about the workings of the capitalistic economy.

Looking back over the five decades since World War II, it is true that the industrial economies developed very smoothly and that cyclical fluctuations showed, indeed, the very same pattern as presumed by Mr. Mitchell. There appeared to be no need for a theoretical concept.

But we think that this interpretation is grossly misguided. With the Great Depression in their memory, policymakers, economists, entrepreneurs and the public worldwide entered the postwar period with strict views about what is sound and what is unsound in economics.

They didn’t need a theory; they had it in their guts that saving and investment were needed to increase living standards and wealth. Americans were proud of repaying the mortgages on their houses. They would have thought it irresponsible to increase an existing mortgage. In the same vein, deficits in government budgets as well as deficits in the balance of payments were generally abhorred. Minor deteriorations tended to cause prompt and heavy adverse market reactions in the markets, forcing governments to undertake quick, corrective action.

What prevented prolonged spending excesses was, clearly, not only prompt monetary tightening, but rapid, adverse market reactions and a general sense of responsibility and unwanted consequences among the public. This kind of thinking went completely out the window in the United States in the 1980s with unprecedented private and public borrowing binges.

Whether plunging personal saving, a soaring budget deficit or a soaring trade deficit, none of it mattered anymore for the economy’s health in the eyes of American consensus economists. For the first time in history, national and international lenders and investors readily financed extreme American borrowing and spending excesses.

There was still a lively, critical public debate inside America about the negative effects of the soaring budget deficit and lower personal saving on national saving and the pace of domestic capital investment. Net national saving as a percent of GDP declined from around 7% to almost 2% during the 1980s, while net private investment (gross investment minus depreciations) shrank over the same period as a share of GDP from a little over 7% to 5% of GDP. Clearly, this reflected a consumption boom, not a supply-side boom.

We have recalled this episode and the notorious American disregard of economic theory because these negative trends in saving and capital formation that started in the 1980s have dramatically deteriorated in recent years.

Measured by the new slide of net saving and net capital investment, consumers and businesses have ravaged the economy’s capital structure in the past few years as never before. Yet this time there is zero discussion, zero research and zero worry.

Net national saving has slumped again to around 2% of GDP, and continues to shrink as minimal personal and business saving is being joined by a soaring budget deficit. Net capital investment still accounts for about 5% of GDP, about half-and-half nonresidential and residential investment.

Manifestly, this is not a garden-variety type of economic downturn; that is, one triggered by rising inflation and monetary tightening. Rather, collapsing profits induced businesses to slash employment, fixed capital investment and inventories. The profit slump is the one very unusual feature. The fact that it occurred against the backdrop of the most rampant money and credit growth in history is the other one.

During 2001, broad money growth (M3) accelerated to $912.5 billion, from $573.7 billion in the year before, while GDP growth, measured from fourth quarter to fourth quarter, decelerated to $5 billion. To put this into perspective: Broad money (M3) grew by $468 billion overall, from 1990 to 1995 or $94 billion per year.

Worst of all are the credit figures. In 1991, borrowings of the non-financial sector soared by $1,108 billion and those of the financial sector by $916 billion. During the second quarter of 2002, the debt explosion went astronomic. Total non-financial debts exploded by $1,531.4 billion (government $451.3 billion, consumers $705.5 billion and businesses $201.1 billion) and financial debt by $916.3 billion, all at annual rate. Altogether, this produced an abysmal increase in GDP of $58 billion, also at annual rate.

One would think that such a horror picture of grossly ineffective record money and credit growth would provoke some critical questions about underlying causes. But we see nothing of that kind. Few, if any, people seem to have noticed.

The past U.S. boom was anything but normal, and so is the downturn. The question to examine in the face of the obvious, massively abnormal features of boom and bust is how, and to what extent, they condition the future, either for better or for worse.


Kurt Richebächer,
for The Daily Reckoning
October 28, 2002

Editor’s note: Dr. Kurt Richebächer’s articles appear regularly in The Wall Street Journal, Strategic Investment and other respected financial publications. France’s Le Figaro magazine did a feature story on him as "the man who predicted the Asian crisis." Dr. Richebächer is currently warning readers to remain cautious in the face of The Bogus Recovery.

For advice on protecting your money during the coming economic mayhem, click here:

The Richebächer Letter

Another winning week on Wall Street – making three in a row. The Dow was up 1.5%. But gold was up too – 2.7%. (Of the two trends, we expect only the latter to continue.)

Meanwhile, durable orders were off almost 6% in September – the biggest decline in 10 months. Car sales are moving into the slow lane, says the Financial Times. Recent figures show new sales 30% below the same period a year ago.

Buyers typically finance 96% of the purchase price, we learned in the weekend news, versus 95% of new homes. The ‘veil of money’ has gotten so thick in these industries that the buyer barely ever sees the transaction for what it is meant to be: an exchange of savings for a product. Sellers have come up with new ways to drape the real costs in financial chiffon. Lower interest rates, for example, make him feel as though he has just married an heiress. Sooner or later, as we judge it, the veil will have to come off and he will see his bride for what she really is. About which, Eric explains more below…

"Mortgage Rates Rise Sharply," is today’s news. In the Denver area, house prices have been falling for 3 months in a row. Denver could be a trendsetter. Then again, it might not. We don’t know.



Eric Fry from New York City…

– Bad news, it seems, has been banished from Wall Street…All news is good, no matter how bad it may be. Last Friday morning, the news crossed the wires that durable goods orders plunged 5.9% in September. Then, on Friday afternoon, the stock market rallied once again, to put the finishing touches on its third straight winning week. It seems that the lower our economy sinks, the higher the stock market soars. Maybe if we all quit our jobs on Monday, the Dow will hit 64,000 by Christmas.

– The blue chips gained 121 points last week to 8,443, while the Nasdaq jumped 3.3% to 1,331. Somehow – thanks to the marvels of mob psychology – the Nasdaq has managed to climb more than 20% from its early October nadir. "At the lower extremity of the market’s recent sell-off, on Oct. 10, the Nasdaq touched a midday low of 1,108," Barron’s reminisces.

– "In addition to being 4,000 points, or 78%, below its March 2000 peak, that level was less than 100 points above where the Nasdaq finished on Aug. 10, 1995. That was the day Netscape shares made their debut with a stunning and provocative one-day ascent, to launch the era of financial promiscuity that created the Internet bubble."

– Financial promiscuity – not unlike the carnal sort – can be fun while it lasts (or so I am told), but the consequences are often painful and long-lasting. To hazard a guess, investors have not finished paying their dues for the financial promiscuity of the 1990s. But the fact that they’re still paying for past mistakes is no guarantee that they won’t keep making new ones. In fact, at this very moment, investors are throwing themselves into another ill-advised dalliance with expensive stocks. This, too, will end badly.

– Investors are in a see-no-evil frame of mind. They are turning a blind eye to the very same financial flaws that troubled them only three weeks ago…But the flaws are out there nonetheless. "One characteristic of the recent rebound in stocks," says Barrons, "has been investors’ tendency to sidestep, ignore or explain away consistently unimpressive economic data." In addition to the aforementioned drop in durable goods orders, the index of leading indicators fell for a fourth straight month and the University of Michigan’s consumer-sentiment reading tumbled to a nine-year low.

– And yet, despite this catalogue of bleak economic reports, investors are racing into the market to "buy the dip." Somehow, despite a brutal 3-year bloodletting on Wall Street, many investors still cling to the delusion that paying 30 times earnings for a stock that only yields 1.5% is a good idea. We think it is a bad idea.

– As Mark Hulbert, founder of Hulbert Financial Digest, sees it, greed has taken the lead over fear once again. He bases his assessment on a visit to last week’s "New York Money Show."

– "Based on my informal survey of the dozens of exhibit hall booths and myriad seminars, greed is selling far better than fear," says Hulbert. "In fact, the word ‘risk’ appears in the title of just two of the more than 200 workshops being offered during this three-day event to the more than 8,000 investors who reportedly have signed up…

– "This is yet another straw in the wind that the bear market has yet to breathe its last breath. At the ultimate low of this bear market…the mood will be markedly different. At that time, investors’ pre-eminent concern will be risk management and capital preservation rather than finding the next stock that will double in value.

– "For example, [Marty] Zweig reports that, for a number of weeks in the latter stages of the 1973-74 bear market, he could find no bullish newsletter ads at all in Barron’s. Not one.

– "That’s the hallmark of a bear market bottom," Hulbert concludes. "We’re not there yet."


Back in Ouzilly…

*** "Signs of a Credit Crunch", says the Economist.

Businesses aren’t borrowing. Lenders aren’t lending. Junk bond debt issues have fallen to only about 1/8 the levels of a year ago. There are few new share offers. Commercial borrowing has collapsed. That’s what happens when credit gets crunched.

Here at the Daily Reckoning, we have been no fans of the growth in credit of the past 5 years. We think it’s about time credit got crunched a little. But contracting credit is a very bad sign for an economy. It means less business activity, fewer jobs, less investment.

Businesses are no fools. They’re not going to borrow money unless than can make money on it. Consumers, on the other hand, don’t seem to know when to stop. And the industries operating behind the ‘veil of money’ come up with new and more enticing ways to lead them on…

"You go into a car dealership with cash," said a friend recently, "they barely want to talk to you. They don’t make their money selling cars, they make their money financing them."

How they make money financing cars at zero percent interest is beyond our ken. But the housing industry seems to like the idea as much as the car dealers. More and more, loans seem calculated to avoid forcing the consumer to look at his debt. Borrowers can now skip payments if they want. They can pay interest only…at initial rates as low as 3%. Or they can finance a house over 40 years – a remarkable innovation in a society where the average family moves every 5 years or so.

Wells Fargo Home Mortgage goes even further. It recalculates your equity annually and automatically increases your line of credit. "Homes are a source of wealth to be managed," explained a Wells Fargo executive.

Anything that can be managed, we observe cheerfully, will be mismanaged.

*** It is the "All Saints" holiday. Your editor is trying to work on his new book from the calm of his country house. He says "trying" because the countryside is full of distractions. Hardly a half-hour goes by without some disaster.

"The pump seems to be broken," Pierre reported this morning.

"The geese are loose," added my mother, on the lookout.

"Dad, how did all those windows get broken," Henry wanted to know.

"Did anyone feed the horses?" my mother asked.

The Daily Reckoning