"White Elephants" and Other Monetary Ailments
There is a fundamental difference between a “real economy” and a “financial economy.” Understanding it could help you navigate the stormy decade that no doubt lies ahead. Ignoring the difference could be disastrous.
In a “real economy,” the debt and equity markets as a percentage of GDP are small and are principally designed to channel savings into investments. In a “financial” or “monetary-driven economy,” the capital market is far larger than GDP and not only channels savings into investments but also continuously into colossal speculative bubbles.
This isn’t to say that bubbles don’t occur in a real economy, but they are infrequent and usually small compared to the size of the total economy. So, when these bubbles burst, they tend to inflict only limited damage on the economy. In a financial economy, however, investment manias and stock market bubbles are so large that, when they burst, considerable economic damage follows.
Every investment bubble brings with it some major economic benefits. A bubble generally leads either to a quantum jump in the rate of progress or to rising production capacities, which, once the bubble bursts, drive down prices and allow more consumers to benefit from the increased supplies. In the 19th century, for example, the canal and railroad booms led to far lower transportation costs, from which the economy greatly benefited. The 1920s’ and 1990s’ innovation-driven booms led to significant capacity expansions and productivity improvements, which in the latter boom drove down the prices of new products such as PCs, cellular phones, servers, and so on, and made them affordable to millions of additional consumers.
Economic Bubbles: Capital Spending Booms
My view is that capital spending booms like these, which inevitably lead to minor or major investment manias, are a necessary and integral part of the capitalistic system. They drive progress and development, lower production costs, and increase productivity, even if there is inevitably some pain in the bust that follows every boom.
The point is, however, that in the real economy (with a small capital market), bubbles tend to be contained by the availability of savings and credit…whereas in the financial economy (with a disproportionately large capital market, compared to the economy), the unlimited availability of credit leads to speculative bubbles, which get totally out of hand.
In other words, whereas every bubble will create some “white elephant” investments – investments that don’t make any economic sense under any circumstances – in financial economies’ bubbles, the quantity and aggregate size of “white elephant” investments is of such a colossal magnitude that the economic benefits arising from every investment boom can be more than offset by the money and wealth destruction that arise during the bust.
This is so because, in a financial economy, far too much speculative and leveraged capital becomes immobilised in totally unproductive “white elephant” investments. In this respect, I should like to point out that in the early 1980s, the US resembled far more a “real economy” than at the present, which I would definitely characterise as a “financial economy”. In 1981, stock market capitalisation as a percentage of GDP was less than 40% and total credit market debt as a percentage of GDP was 130%. By contrast, at present, the stock market capitalization and total credit market debt have risen to more than 100% and 300% of GDP, respectively.
Economic Bubbles: Paul Volcker
It is not wise to base today’s monetary machinations on those performed in the early ’80s. Consider the tight monetary policies of former Fed chief Paul Volcker. In the 1970s, the rate of inflation accelerated – partly because of easy monetary policies, partly because of genuine shortages in a number of commodity markets, and partly because OPEC successfully managed to squeeze up oil prices. But by the late 1970s, the rise in commodity prices led to additional supplies and several commodities began to decline in price even before Paul Volcker tightened monetary conditions.
At the same time, the U.S. consumption boom engineered by Ronald Reagan in the early 1980s (driven by exploding budget deficits) began to attract a growing volume of cheap Asian imports, first from Japan, Taiwan, and South Korea, and then, in the late 1980s, also from China.
I would argue that even if Paul Volcker hadn’t pursued an active monetary policy designed to curb inflation by pushing up interest rates dramatically in 1980/81, the rate of inflation around the world would have slowed down very considerably in the course of the 1980s, as commodity markets became glutted and highly competitive imports from Asia and Mexico began to put pressure on consumer product prices in the U.S.. So, with or without Paul Volcker’s tight monetary policies, disinflation in the 1980s would have followed the highly inflationary 1970s.
Nevertheless, after the 1980 monetary experiment, many people – especially Mr. Greenspan – began to believe that an active monetary policy could steer economic activity on a non-inflationary steady growth course and eliminate inflationary pressures through tight monetary policies, and cyclical and structural economic downturns through easing moves! This belief in the omnipotence of central banks was further enhanced by the easing moves in 1990/91, which were implemented to save the banking system and the Savings & Loan Associations, by similar policy moves in 1994 in order to bail out Mexico and in 1998 to avoid more severe repercussions from the LTCM crisis, by an easing move in 1999, ahead of Y2K, which proved to be totally unnecessary but which led to another 30% rise in the Nasdaq to its March 2000 peak, and by the most recent aggressive lowering of interest rates, which fueled the housing refinancing boom.
Economic Bubbles: Loose Monetary Policies
But consider for a minute what actually caused the 1990 S&L mess, the 1994 tequila crisis, the Asian crisis, the LTCM problems in 1998, and the current economic stagnation. In each of these cases, the problems arose from loose monetary policies and the excessive use of credit.
In other words, the economy – the patient – gets sick because the virus – the downward adjustments that necessary in a free market – develops an immunity to the medicine, which then prompts the good doctor, who read somewhere in the Wall Street Journal that easy monetary policies and budget deficits stimulate economic activity, to increase the dose of medication. The ever-larger and more potent doses of medicine relieve the temporary symptoms of the patient’s illness, but not its fundamental causes…which, in time, inevitably lead to a relapse and a new crisis, which grows in severity, since the causes of the sickness were neither identified nor treated.
Karl Marx might prove to have been right in his contention that crises become more and more destructive as the capitalistic system matures (and as the “financial economy” grows like a cancer). If Marx’s conjectures hold, the ultimate breakdown will occur in a final crisis that will be so disastrous as to set fire to the framework of our capitalistic society.
Economic Bubbles: Extraordinary Measures
“Not so,” Bernanke & Co. will argue, since central banks can print an unlimited amount of money and take extraordinary measures, which would, by intervening directly in the markets, support asset prices such as bonds, equities and homes, and therefore avoid economic downturns, especially deflationary ones. There is some truth to this view. If a central bank prints a sufficient quantity of money and is prepared to extend an unlimited amount of credit (and to bail out troubled government- sponsored enterprises, such as will have to happen in future with Freddie Mac and Fannie Mae, the same way that China keeps its money-losing state-owned enterprises alive), then deflation in the domestic price level can easily be avoided, but only at a considerable cost.
First, it is clear that such policies do lead to a depreciation of the currency, either against currencies of countries that resist following the same policies of massive monetization and state bailouts, or against gold, commodities, and hard assets in general. The rise in domestic prices then leads at some point to a “scarcity of circulating medium,” which necessitates the creation of even more credit and paper money.
If the inflationists, who are now, under the leadership of the Fed, in control of central banks around the world, have their way, this vicious cycle will continue and a very dangerous economic policy course will be followed. Never- ending credit creation will eventually result in sharply rising inflation rates and a much lower U.S. exchange rate. It will also bring about a disastrous global recession, which could threaten the capitalistic system as we know it today.
for the Daily Reckoning
June 26, 2003
P.S. I’m not sure about the timing of the inflation lift- off (the kind that would be reflected in the CPI), but I am certain that, given the irresponsible current credit expansion, it will happen eventually. When it does, it will usher in the crisis I have just referred to.
Fannie Mae is the perfect example of today’s reckless excess of credit. The GSE mortgage lender just raised its projection of mortgage originations for 2003 to a record $3.7 trillion – this in a $10 trillion U.S. economy and compared to an increase of total mortgage borrowing of just $1 trillion between 1990 and 1996!
Do you remember Ed Yardeni, dear reader?
He was the man who popularized the Y2K scare…and then the “Fed model” for mis-pricing stocks…and then thought he saw an evolved race of super-humans during the Tech Bubble: “those who get it.”
That new species finally got it, good and hard, when the bubble burst, but Yardeni was unconcerned. The Fed would fix things, and fast.
“There are 600 basis points between here and zero,” said he. As far as we know, Yardeni has never been right about anything. But in this remark, he managed to be wrong twice. For it implied that that the Fed could easily reflate the bubble, just by taking basis points off the Fed Funds rate…and that it had only 600 of them to work with.
Yesterday, two…no three…no four…fascinating things happened. First, in the 32nd year of the Dollar Standard, the U.S. central bank decreed that its key lending rate would be reduced to 1%…only 100 basis points were left on the way to zero. Second, did the investment markets leap for joy? Did businessmen sign up for new spending projects in anticipation of the boom? No. Investors sold off stocks and a poll of CFOs said they were still cutting expenses, not adding to them. Then came word not of inflation…but of deflation…in fact, the unkindest price cut of all: Reuters reported that the New York Time’s best-seller lauding Alan Greenspan, albeit in simpleminded fashion, had been marked down to just 99 cents by Amazon.com’s used-book affiliate.
Last, but not least, it turns out that the Fed has more than 600 points to work with after all. Yesterday, the interest rate on overnight loans in Japan fell below zero to minus 0.001%. Meaning, borrowers paid back less than they borrowed. Talk about something for nothing; wait until America’s auto dealers, homebuilders and mortgage brokers hear about this!
Zero percent financing? Forget it…we’ll pay you!
Ah, what a wonderful, dizzy world we live in…When people suffer from too much debt – give them more. Lure them in deeper with easier credit terms…keep the printing presses turning…what could go wrong?
But what’s this?? A response to our “Dead Men Talking” column of last week…An email from the nether world…a dead letter…from the Great Beyond: “Ha, ha, ha…” it begins, “you puffed-up fools. You thought we had nothing to teach you. You thought you invented the printing press…and paper money…
“Well, we’re waiting for you…there’s special little corner of Hell reserved for central bankers. We’re stoking the fires for you…so that they may scorch your fat, arrogant derrières…”
Is the letter authentic? Here at the Daily Reckoning, we’re optimistic enough to believe it. (We will give you the full text of this remarkable message…tomorrow…)
Meanwhile…Eric Fry, our man in the citadel of modern capitalism:
Eric Fry in New York City…
– The Fed trimmed interest rates again yesterday, then investors trimmed about 100 points off of the Dow Jones Industrial Average. The Dow, which had been hovering in positive territory most of the trading session, plunged after the Fed news came out and closed down 98 points at 9,011. The Nasdaq Composite fell 2 points to 1,602, eliminating its earlier 2% gain.
– Bond prices also tumbled, as the benchmark 10-year Treasury note fell 22/32, lifting its yield to 3.33 percent from 3.25 percent in the previous session. Now that bond prices are plummeting from the Olympian heights they reached earlier this month, the bull market in bonds is looking increasingly vulnerable. Is the seemingly immortal bond bull merely mortal after all?
– “The bond market rally has gone too far, too fast in our opinion,” says Donald H. Straszheim of Straszheim Global Advisors. “It looks a lot like the Nasdaq run-up of the late 1990s – early 2000…The February 2000 to June 2003 decline, from 6.76% to 2.08%, was a stunning 68%…When investor sentiment turns against bonds, there will be a stampede for the door and many investors will get trampled.”
– Like a bad punch line, Alan Greenspan’s rate cuts can’t seem to produce the desired effect. The economy just shrugs its shoulders and stares back vacantly at the chairman’s one-man monetary show. 13 times since January 2001, Greenspan has reduced the Fed Funds rate. 13 times the rate cuts have produced – ta daaa! – NOTHING…except for a runaway housing market. Economic growth is nowhere to be seen.
– Yesterday, Greenspan trimmed the fed funds rate from 1.25 percent to 1 percent. Short-term rates have not been this low since 1958 and, arguably, interest rate cuts have not been this ineffectual since 1958, or maybe not since 1858. What good have all of these rate cuts achieved? Is the economy any stronger? Are TV sitcoms any funnier? Are American tourists any leaner?
– About the only thing that we can say for certain about the 13 interest rate cuts is that the interest rates are lower than they were 13 rate cuts ago. But the macroeconomic results are dubious at best.
– Not that anyone needs a fresh reason to sell the overpriced shares of companies with no earnings growth, but the Federal Open Market Committee (FOMC) provided one solid reason yesterday: “The economy…has yet to exhibit sustainable growth.” The FOMC then displayed its peerless command of macro-economics by predicting, “The upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal.”
– The economy may lack sustainable growth, but it does not lack for unsustainable growth. Take a look at the housing market. New home sales rocketed 12.5% in May – the biggest one-month jump since September 1993. It seems that folks are still buying houses and tech stocks, even though most American corporations still refuse to spend the money to replenish their pencil supply.
– Government spending, too, at least appears to be in the unsustainable category (although one never knows with those jackals). “The lion’s share of the government’s budget is spent meeting its domestic obligations. In 2003, Washington will spend $2 trillion!” writes John Myers, the driving force behind Resource Trader Alert. “Of that, about $1.1 trillion will be spent meeting the federal government’s social agenda (Social Security, Medicare, Medicaid). That leaves roughly $900 billion for everything else, but after interest expenses of $300 billion, Washington spends roughly $600 billion, or just under a third of its entire budget on defense and foreign aid.”
– Mr. Myers “fully expects [that, to meet these obligations,] the U.S. Treasury and the Federal Reserve will continue – like the empires before them – to grow the number of dollars in circulation. Add that to a rapid divestment of foreign-held Treasuries or other U.S. assets held by foreigners, which could be catastrophic for the dollar, as well as the U.S. stock and bond markets.”
– “And, oh yes,” Myers adds “it would send precious metals and other real asset prices into the stratosphere.”
– Shipments and orders for U.S. durable goods fell 0.3 percent in May, the third decline in the past four months. But let’s not worry too much about durable goods sales. We must remember that Alan Greenspan had reduced rates only 12 times prior to this particular durable goods report. The 13th cut, which is the one that should really take care of things, hadn’t occurred yet.
– And if that doesn’t work, wait until you see rate cut #14!!…Eventually, Greenspan will get it right.
Bill Bonner, back in Paris…
*** Other market news: the price of gold rose nearly $3 yesterday. Bonds fell. The dollar fell against the euro.
*** If America really is going to go the way of Zimbabwe…perhaps we ought to check in and see what it will be like. Herewith, a note from that benighted land:
“Zimbabwe is becoming a really interesting place. It’s the only country in the world where your largest note – $500 – can’t buy you a beer, which is $650.
“A roll of 1-ply toilet paper costs $1000. There are about 72 sections on the average roll, so it is cheaper to take your $1000, change it into $10’s, wipe your bum on 72 of them and get $280 change.
“How lucky are we!”
*** And here…a letter from a live reader, in Australia: “I read with interest your essay this morning titled ‘Dead Men Talking’. An excellent essay. I cannot but wonder what future historians will say about this crazy era, and in particular about Bush, Greenspan and Bernanke. Will Greenspan be compared with the German Reichbank President Rudolf Havenstein, who was responsible for the money printing? He and his associates should be.
“I feel that on this subject, President Bush is entirely in the dark. Like The Fuhrer, who was convinced that ‘everything’ could be accomplished by an act of the will, he seems to think that all is well so long as he declares it so. Could he become America’s Fuhrer? Or will it be some equally power-mad Democrat?
“The following may also help bring some understanding of what a rapidly expanding money supply can do:
“In his book, titled ‘Before The Deluge’, Otto Friedrich devoted an entire chapter to the inflation in Germany between 1919 and 1923. He called this chapter ‘A Kind Of Madness’. It is a fascinating study. It is worth repeating a small section of his narrative in order to alert readers to the deleterious effects inflation has upon a population:
“A seventy-five-year-old lady, previously a journalist told him, ‘Yes, the inflation was by far the most important event of this period. It wiped out the savings of the entire middle class, but those are just words. You have to realize what that meant. There was not a single girl in the entire German middle class who could get married without her father paying a dowry. Even the maids – they never spent a penny of their wages. They saved and saved so that they could get married. When the money became worthless, it destroyed the whole system for getting married, and so it destroyed the whole idea of remaining chaste until marriage.
“‘The rich never lived up to their own standards, of course, and the poor had different standards anyway, but the middle class, by and large, obeyed the rules. Not every girl was a virgin when she married, but it was generally accepted that one should be. But what happened from the inflation was that the girls learned that virginity didn’t matter any more. The women were liberated.
“‘A visiting journalist, Louis Lockner, reported in 1923 he got the usual first impression of cafes crowded with stylishly garbed ladies, but soon found a different story on the side streets off the fashionable boulevards. “I visited a typical Youth Welfare Station”, he said later. “Children who looked as though they were eight or nine years old proved to be thirteen. I learned that there were then 15,000 tubercular children in Berlin; that 23% of the children examined by the city health authorities were badly undernourished.” The old were equally helpless. One elderly writer, Maximilian Bern, withdrew all his savings, more than 100,000 marks, and spent them on one subway ticket. He took a ride around Berlin and then locked himself in his apartment and starved to death.
“‘”Barbarism prevailed,” said another old resident, George Grosz. The streets became dangerous….we kept ducking in and out of doorways because restless people, unable to remain in their houses, would go up on the roof tops and shoot indiscriminately at anything they saw. Once when one of these snipers was caught and faced with the man he had shot in the arm, his only explanation was, “But I thought it was a big pigeon”.
“‘The fundamental quality of the disaster was a complete loss of faith in the functioning of society. Money is important not just as a medium of exchange, after all, but as a standard by which society judges our work, and thus ourselves. If all money becomes worthless, then so does all government, and all society, and all standards. In the madness of 1923, a workman’s work was worthless, a widow’s savings were worthless, everything was worthless.
“‘English historian, Alan Bullock, wrote in his book titled “Hitler: A Study In Tyranny”, “The collapse of the currency not only meant the end of trade, bankrupt businesses, food shortage in the big cities and unemployment: it had the effect, which is the unique quality of economic catastrophe, of reaching down to and touching every single member of the community in a way which no political event can. The savings of the middle classes and the working classes were wiped out at a single blow with a ruthlessness which no revolution could ever equal; at the same time the purchasing power of wages was reduced to nothing. Even if a man worked till he dropped it was impossible to buy enough clothes for his family – and work, in any case, was not to be found. The result of the inflation was to undermine the foundations of German society in a way which neither the war nor the revolution of November 1918, nor the Treaty of Versailles had ever done. The real revolution in Germany was the inflation, for it destroyed not only property and money, but faith in property and the meaning of money”.'”