War and Inflation
"I don’t care about money really; it just settles my nerves."
"Inasmuch as this is the first full-blown recession in the modern day era of globalization," writes Stephen Roach, "the contractions around the world now seem to be feeding on one another." What could put an end to this vicious circle, he asks.
"Even with a mild recession in America," adds the Economist, "…this could still turn out to be the most severe world recession since the 1930s."
What might head off a ’30s-style recession? You know the answer, dear reader: war.
Why is war supposed to be good for an economy?
We ask the question, not because we don’t know the answer, but because we think it is too seldom posed.
The common answer is simple. ‘War is good for a sluggish economy, because it is inflationary.’
In wartime, governments drop their feeble inhibitions and take up the task of destroying their currencies as though their lives depended on it.
War "is always wasteful, no matter how just the cause," noted James Grant recently. "It is cost without income, destruction financed (more often than not) by credit creation. It is the essence of inflation."
It is what economists call a "deadweight loss," destruction without creativity, a lose-lose situation… a cloud with no silver lining. A tank may be a useful thing to have – at the appropriate moment – in the way a fire extinguisher is useful. But neither adds much to our quality of life – except by preventing an even bigger catastrophe.
Inflation can be described as an abundance of money chasing a scarcity of goods and services. Wars destroy the goods and services we really want – houses, cars, crops, restaurants – thus, they are biased towards inflation. What’s more, in wartime, governments spend as if there were no tomorrow…deficits explode…and central banks do their best to expand the money supply.
But wars also destroy confidence, credit, and trade. Fighting unsettles the nerves of millions of people. It causes consumers to clutch their money just a little bit tighter and hold onto it just a little bit longer. And it causes businessmen to close down unprofitable operations sooner, rather than later…and to forestall new capital investments. It cuts sales, squeezes profits, and quiets the shipyards and truck terminals, as the volume of trade falls.
In the present conflict, the U.S. finds itself fighting on two fronts – against terrorism…and against deflation. On the first front we have the word of the president that the battle is going well. But on the second, the battle against deflation, the news is not good.
The Economist notes a disturbing feature of the world economy. "Margins are at their lowest level at any time in the past half-century." Companies cannot raise prices. "Estimates of the global output gap (the extent to which output is below its potential) suggest that it has increased to its widest since the 1930s. High excess capacity around the world looks likely to push inflation down faster than in past world recessions."
In America, for example, factory output in America fell for the 12th month in a row in September. Capacity utilization is down to its lowest level in 18 years and falling.
When people were flush with confidence, cash and credit, they built new factories. Now they are flush with factories and what factories produce. Not only is there too much of just about everything except Cipro, the world’s factories can turn out a lot more. Credit is still available but lenders are getting worried. People are getting low on cash…and confidence is still strong among na?ve investors…but shaken among people who know what they are doing.
"Let’s put a final nail in the inflationary coffin," suggests my old friend John Mauldin. "Prices are in retreat. The Philadephia Fed reports, "For the fourth consecutive month more firms reported paying lower prices for their purchased inputs (24 percent) than higher prices (2 percent). The current prices paid index fell from -13.2 in September to -22.1, its lowest reading in the history of the survey. With regard to prices of their final manufactured goods, more firms reported decreases (22 percent) than increases (7 percent). The prices received index fell slightly from – 12.2 last month to -14.9."
"This is price deflation," John continues. "There is no other way to interpret it. ‘The lowest reading in the history of the survey.’ Only a few industries have any ability to maintain or raise prices.
"The US has not experienced numbers like the above for over 60 years. That is because we have not been in a deflationary environment for over 60 years.
"There is a global glut of capacity. I predicted this two years ago, and now it is sadly coming to pass. In an optimistic wind the world built more factories to build more things than we can actually buy, much less afford. Now we reap the whirlwind of companies and nations competing on price to keep those factories busy."
By a margin of almost 4 to 1, Americans say they intend to reduce debt levels and increase savings. They are still refinancing their homes – but new home financings have dropped sharply since Osama bin Laden became the most hated man in Christendom since Saladin. People do not trade up in wartime.
"This is major league deflationary," concludes John, who has his office in the Texas Rangers’ stadium. John raises another ominous feature of the slump: "the velocity of money…has dropped to the lowest point for 18 years. (I can find no data from before that time.)"
In a boom, people enjoy the confidence of CNBC and rising portfolio statements. But in a slump, they find themselves on their own…and take a little comfort from the crisp bills in their wallets and the jingle of coins in their pockets. Money circulates less quickly…and prices fall.
Your writer in residence…
October 23, 2001
For more from John Mauldin visit the Millenium Wave
Gold dropped $4.50 yesterday – to $263. The euro fell to 89 cents. Commodities fell to a new low. "For the first time in years, Americans start to give their credit cards a rest…," declares a Houston Chronicle headline.
And…"Virtually all of the world’s major economies have broken decisively to the downside in the past few months," reports Stephen Roach from Tokyo.
Prices are falling in Taiwan, with the CPI down .5% year to year…and wholesale prices down even more. Japan, meanwhile, is in its 4th recession in a decade.
Worldwide deflation…get used to it.
"The glass-half-empty folks might see our country today as a land of frightening terrorist plots, falling corporate earnings and bad TV sitcoms," writes Eric Fry from New York, "but clearly, Mr. Market sees something else altogether – something hopeful, something upbeat, something so positively marvelous that it is worth almost 40 times annual earnings." Though they suffer the torments of Job…investors still believe…
Here’s the rest of Eric’s report:
Mr. Eric Fry in New York:
– The stock market is going up because it is going up. Who are we to quarrel with it? Like pierced tongues and facial tattoos, some things just seem to happen…for no good reason.
– The Dow gained nearly 2% yesterday, rising 173 points to 9,377, while the Nasdaq advanced more than 2%, to 1,708.
– It would be nice if Mr. Market would let us in on what he sees because, to the naked eye, the economy and the stock market don’t look so good.
– Case-in-point: SBC Communications announced yesterday it would cut several thousand jobs, trim next year’s capital budget by 20% in and delay the build-out of its broadband network. The telecom giant is hardly alone in declaring that it plans to save money next year, not spend it. (To refresh: spending is good and saving is bad).
– Company after company has been reporting terrible earnings lately…the market is rallying anyway, which prompts smartmoney.com’s Igor Greenwald to suggest doing away with "reporting season" this quarter. "The hundreds of public companies reporting earnings over the coming week should save their breath, red ink and crocodile tears," he writes. "A single press release will do: ‘The 170-odd S&P 500 companies reporting this week announced a 20%+ drop in third-quarter profits, after subtracting very special charges in a procedure no one should try at home. Those results beat, by a penny a share here and there, forecasts those companies supplied three weeks ago…Business, meanwhile, is still slow.’ No fuss, no muss, no annoying conference calls." Igor’s got a point. Business, indeed, is still slow.
– Many companies are slashing their advertising budgets, along with every other budget they can find. The media executives from across the country who convened at the annual American Magazine Conference in Manhattan yesterday all griped about the grim outlook for ad spending. Frederick Hill, executive vice president of marketing and communication for J.P. Morgan Chase told Crain’s magazine, "Our advertising dollars will be curtailed until the second quarter of 2002."
– As ad budgets fall, so do entertainment budgets, and that’s bad news for the restaurant trade. Many Manhattan restaurants continue to do a steady business in the aftermath of skyscraper bombings and anthrax attacks, although most are not serving "organic mixed greens," "seared tuna steaks" and "tiramisus" the way they used to. According to Crain’s, "some 15,000 jobs have been lost and hundreds of eateries in the highly fragmented industry face the possibility of going out of business by the beginning of next year…"
– But the Big Apple’s loss is the burbs’ gain. I dined Saturday night at a restaurant in Westchester County, about an hour north of Manhattan. The place was packed to its rustic 300-year-old rafters. "Ever since Sept. 11th," the manager explained, "we’ve been very busy. Customers say they don’t want to go into Manhattan. So – I hate to say it – but terrorism has been good for us."
– Terrorism might also be good for the oil market. John Myers, editor of the Resource Trader Alert, is not afraid to say it: "Osama bin Laden and the Taliban are getting the lion’s share of attention, but the most important player in the Middle East is Saudi Arabia. Beneath the Saudi desert sands lie one-third of the world’s oil reserves, much of which can be developed for less than $2 a barrel. The pro-American sheikdom is OPEC’s swing producer, able to dictate prices and make up disruptions to the world’s oil supply.
– "But Saudi Arabia may also be an oil empire on the brink," Myers warns. "The events since September 11 have increased the tension between the U.S.-friendly Saudi government and the radicalized Saudi populace to the point where the stability of the Saudi government is more threatened today than it has been since the last revolution in the 1930s…If Saudi Arabia were to fall into chaos, crude prices would probably spike to more than $80 a barrel – perhaps even higher."
– At the very least, keep a full gas tank at all times.
And back in Paris…
*** It’s a rainy autumn day. The leaves on the linden trees outside my office have turned yellow. But it is still as warm and delightful as a fresh croissant and a cup of tea…as long as you don’t read the paper.
*** The news is dreadful. Germany just registered its 2nd sharpest collapse in business sentiment since WWII. Italy just uncovered a vast network of terrorist cells all over Europe. Argentina is about to default on $132 billion in foreign debt. And the editorial pages are full of the worst drivel I can remember…about which more…sometime…
*** I’m going to see "Irma La Douce" at the theatre tonight. I’ll give you a report.