What Ails Our Economy
The Big Squeeze
By James J Puplava CFP, January 29, 2003
On Main Street, the average Joe wants a job, if he has lost one. If he has a job, he wants better pay, better health care, and pension benefits. On Wall Street, job cuts are the largest they have been in 25 years with 78,500 highly paid investment bankers, analysts, and brokers losing their jobs. Wall Street wants lower interest rates and the Fed to reliquefy the markets by printing more money. In retirement communities, seniors want prescription drug benefits and higher interest rates. The message from Main Street and Wall Street is that they want Washington to take away the economic pain and make the economy better. Nobody wants to experience the pain of a hangover. Everyone wants to feel good again, so they are turning to Washington for answers. It is unfortunate, but that is the last place to go if you want answers to economic problems. The average politician and bureaucrat has little understanding of what makes an economy run. In Washington, they haven't balanced the books in over 30 years. If revenues run short or if expenses exceed budget, they simply raise taxes or print money. Businesses and households don't have this luxury.
What is not understood here is that sometimes when you get a common cold or the flu, there is very little that can be done but get plenty of rest, drink plenty of liquids and tough it out. Politicians can’tsay that. They feel their job is to make their constituents, especially those who have donated the most money to their campaign, feel better by passing laws that directly benefit particular constituencies. There is also the misguided belief that governments can run the economy much better than the markets. The believe in the "invisible hand" has given way to the "hand of intervention." The only thing that the government can do now is to make things worse. The best alternative would be to get out of the way and let the economy heal itself naturally.
Looking Back to Look Forward
To understand where our problems originate, it is necessary to look at money supply, debt creation, savings, and investment. In the 1990s, the US went on a debt and consumption orgy. Consumers went into debt to buy bigger homes, bigger cars, luxury goods, and other consumable items. Instead of saving and investing, consumers cut back on savings because of the stock market bubble. With the major averages going up double-digits each year from 1995-1999 it was no longer necessary to save anymore.
Why save money when the stock market was going up 20% a year? Savings rates in this country plunged to zero. With rising stock prices, even corporations stopped contributing to their pension plans to fund employee retirement benefits. In fact, rising pension plan assets became a source of profit as companies were able to count the excess in the plan towards profits.
As the graphs below indicate, debt at all levels of society went up exponentially during the 1990s. The Total American Debt graph above from Grandfather Economic Report shows total US debt rose to over $32 trillion. The government borrowed money, states borrowed money, municipalities went deeper into debt, and households and corporations joined them.
The next set of graphs below shows the US savings rate, debt service payments for consumers, corporate debt, and the trade deficit. In just six years, debt levels doubled. To put this into perspective, at the beginning of the 80's, this country had total outstanding debt of around $4 trillion and was the world's largest creditor nation. Today we have net foreign liabilities of over $2 trillion and the US has become the world's largest debtor nation.
Since taking over the Chairmanship of the Fed, the Greenspan Fed has embarked on the largest creation of money and credit this nation has ever known. The annual supply of credit went ballistic after 1994 as the Clinton Administration embarked on a grand experiment to bring down interest rates, expand credit, and stimulate the economy. The net result of this expansion was that the money supply began to grow at double-digit rates throughout the rest of the decade as shown in this graph of M3 from 1991 to the present. Credit expanded, the financial community became highly geared and we went from one financial crisis to the next from the peso and derivative crisis of 1994, the Asian crisis in 1997, the LTM and Russian crisis of 1998, Y2K in 1999, to the recession and the aftershocks of 9-11. The standard prescription was to print more money, flood the financial system with liquidity, and expand credit.
This is where we are today. We are very dependent on foreign capital to fund our consumption. The US needs to borrow between $1.5-2.5 billion every day to fund its budget, trade, and investment deficits. The government's budget deficit could get as high as $300 billion this year; while our trade and current account deficits are annualizing over half a trillion a year. Despite these difficulties, credit expansion in the US goes on unabated as the Fed embarks on a grand experiment to fight debt-based deflation in an effort to avoid another depression. In this effort, they are adding more fuel to the fire with perilous consequences.
Adding Fuel to the Fire
In Washington politicians are talking about more ways to encourage more consumption by consumers and spend more money in an effort to stimulate the economy. Many programs that are being proposed are nothing more than fiscal stimulus programs and transfer payments designed to increase consumption. Inadequate consumption is believed to be the big problem, so politicians of both parties want to pass legislation designed to encourage more consumption. Outside the President's program to give tax incentives for investing in plant and equipment, lower tax rates on consumers, and end the unfair double taxation of dividends, most programs being proposed are transfer payments and new spending initiatives. Lowering tax rates at all levels of society is criticized as a handout to the rich. The rich would only save and invest the tax savings, which is considered a bad thing for the economy. What politicians favor is more debt and consumption. [See What Taxes Really Mean]
Politicians are afraid of what they see. They understand very little about economics, for if they did, they would understand we are making the same mistakes that turned a stock market crash and recession into a full-fledged depression. Monetarists believe that if the Fed acts by increasing the money supply, another 1930's style depression can be avoided. Keynesians believe that if fiscal stimulus is applied, deflation and a recession can be avoided. The US is currently applying both measures to avoid another depression. The Fed is increasing the supply of money and credit in the system while the government is spending more money. Apparently we have learned nothing from the past so we are doomed to repeat and experience the painful lessons of history once again with another depression.
In The End We All Pay The Piper
It wouldn't have mattered who became President in 2001, whether it was Al Gore or George Bush. The 1990s credit bubble wasn't going away. In fact, the Fed's response by making credit cheaper and more available was actually making the problem worse. Instead of just a stock market bubble, we now have three additional bubbles in mortgages, housing, and consumption. Alan Greenspan's Fed is hell-bent on expanding money and credit. The money supply increased at an annual rate of 16% during Q4 of last year. The enormous debt expansion by consumers and corporations, states and municipalities wouldn't have gone away regardless of who won the elections. The problem in Washington is that it is hard for politicians to be honest with the people. They are elected to deliver more benefits to their constituents--not less benefits. Our problems as a country are no different from any household�s problems. What do you tell your kids when they have run up their credit card debts? Do you encourage them to take on more debt and to continue to spend more? That is what most politicians in Washington are now telling most Americans. They are telling us there will be no hangover from the debt binge and credit orgy of the 90's. In fact, they are encouraging even more debt intoxication.
That is why I believe that my Perfect Financial Storm thesis is now gathering force. The Halloween storm of 1991 was one of the worst storms of the 20th century. It became worse by the collision of three-storm fronts uniting to form The Perfect Storm. What made this storm so treacherous was that for three solid days, the winds blew for 24 hours a day, creating some of the biggest waves ever seen by man. It is similar to what we are now seeing develop in the world's financial markets, currency markets, and the economies of most of the major countries around the globe. Like The Perfect Storm, which gathered force with terrific winds constantly gathering force over three days, we now find ourselves with storm fronts in the economy, the currency markets and the financial markets. Government attempts to intervene and control these forces will make them even worse when all storm fronts collide and become one as they appear to be doing now. We live under debt and delusion, and like the Andr�a Gale, are now moving head first into the storm.
On Wall Street today, that illusion continues. There were more scandals with KPMG and four of its partners charged with fraud by the SEC over Xerox accounting. AOL Time Warner posted a $44.9 billion loss after writing down its online and cable business. Inventories of crude oil continue to drop to the lowest levels in 27 years as we head towards war. Companies from blue chips to silicon chips reported lower earnings; while beating lower estimates. And in a single city, New York City projects a $11.5 billion deficit.
It took several rounds of intervention as shown in today's graph of the Dow to keep the markets in positive territory. Wall Street is petrified that this could be the third losing week and the first losing month of the New Year. They worry that John Q may be getting anxious and ready to bail. For the first time in 14 years, the mutual fund industry experienced redemptions last year. What if investors get wise to this game of earnings charade and decide to head for the exit gates? The simple fact that nobody seems to want to discuss it is that earnings and capex spending don't look that great. Even worse, stocks still aren't cheap but more overvalued than where they were in 1929 and 1987. This is something best left unsaid and swept under the carpet. The big question is what happens when the crowd starts slowly heading for the exit gates? Even worse, what happens if they start putting their money into things? The rise in gold, silver, oil, natural gas, food, and all commodities has the Street terrified. The IPO business has collapsed, brokerage and trading revenues are down, and the Street is going through the worst downsizing it has experienced in over 25 years. Besides, it isn't set up to handle the movement from paper to "things" so the only thing it can do is try to prevent it from rising by selling and shorting and discrediting its rise.
Today's flagpole rally was attributed to Merck's earnings, which rose 1.6 percent beating estimates. The markets also got a boost from the useless gibberish coming from the Fed that the economy will strengthen over time. The Fed gave the appearance of great optimism, which surprised most on Wall Street. What do the oracles know that others don't?
Meanwhile, the Dow went through a 200-point swing from major losses to a minor gain of 21 points. The markets recovery from steep losses took place by very large buy orders throughout the day by someone big. Oil stocks rose sharply on news of dwindling inventories and what is expected to be the one bright spot for earnings in the fourth quarter, which is the energy sector. ExxonMobil will report earnings this week. Oil prices headed back over $33 a barrel.
Volume rose to 1.57 billion shares on the NYSE and 1.5 billion on the Nasdaq. Market breadth was positive by 16-15 on the Big Board and 18-13 on the Nasdaq. The VIX fell .30 to 35.22 and the VXN dropped 3.09 to 43.64.
The Dow Jones Stoxx 50 and Stoxx 600 indexes rose for a second day, led by oil stocks, after brokerages raised recommendations for BP Plc and Total Fina Elf SA following share-price slumps. GlaxoSmithKline Plc and Novartis AG climbed after U.S. President George W. Bush pledged to increase spending on health care in the world's largest pharmaceutical market. The Stoxx 50 added 1.2 percent to 2181.09, paring its loss this year to 9.4 percent. The Stoxx 600 climbed 0.4 percent to 184.35, rebounding from a drop of as much as 2.7 percent, with energy and health companies leading gains.
Japanese stocks fell, with the Nikkei 225 Stock Average sliding to a 2 1/2-month low. Machinery makers such as Fanuc Ltd. led the drop after a government report showed that industrial production unexpectedly declined. The Nikkei 225 Stock Average fell 2.3 percent to 8331.08, extending a three-day, 3 percent drop.
© 2003 James Puplava