Long-Term Bear Markets,
Say's Law, and the Bailout Frenzy

by Travis Steward | May 1, 2009

Print

Why does this chart look this way?

This is a 30 year chart of the S&P 500, the top 500 companies in America as judged by Standard and Poor’s. For the last 10 years, the performance of this stock market has been terrible. America is now lower than it was in 2002-2003. Most commentators think this will all be fixed soon, but the reality is that America has some serious structural problems that impair stock market performance going forward.

The best way to understand what is happening is to imagine a business that produces exploding toilet paper. Would this business be profitable? Of course not. However, it would employ people who they themselves are consumers. The consumption of workers, it is theorized, is ultimately what drives demand of other products in an economy. Modern economics tells us that the loss of these workers’ consumption/demand through insolvency and bankruptcy is a net negative to an economy and must be prevented. Unfortunately, this creates a problem due to a very old law of economics that is as real and as truthful as the law of gravity. This law is “Say’s Law.”

Jean-Baptiste, Say was an 18th century economist who coined the phrase:

“Supply creates demand.”

Unfortunately this phrase is very misinterpreted. Say is not telling us that when you supply something that demand will arise and consume it. In the case of exploding toilet paper, what demand will exist? There will be none. What Say is telling us is that if you supply something, you now become a demander of all other products in an economy. Say is telling us that our consumption comes from our production; our ability to demand comes from our ability to supply. This phrase outlines the very fundamental nature of trade.

These workers who create exploding toilet paper do not supply anything of value. If they are to be “bailed out,” they will be given an artificial ability to consume. However, Say’s law still applies: If these workers are to be given the ability to consume, where does this come from if they do not produce anything of value? The short-answer: Someone else’s production.

Let’s take the example of a GM worker. Currently, no one wants GM vehicles at current retail prices. GM workers are then supplying something that no one wants. It might as well be exploding toilet paper. If the government is to step in and bail them out – to keep their ability to consume alive independent of their ability to supply – it must, by the natural laws that govern our world, be taken from someone else. This re-direction of resources from the productive to the unproductive is the paradigm that defines the U.S. economic climate, and much of the entire developed world, for that matter.

The process of redirecting economic resources from the productive to the unproductive is an incredibly detrimental process. The long-term effects of this policy will result in the erosion of productive resources in an economy. The foolish are rewarded, and the prudent are punished. There comes a point when all the productive resources of an economy are exhausted, and all that is left is accumulated capital from previous periods of prudent economic behaviour. What makes an economy great is the extent of its accumulated capital.

A business that is run very efficiently for years will have trucks, machinery, tools, buildings, land, and well trained labour. To maintain this business takes constant re-investment: trucks and machinery break down, tools become rusty, buildings become out-dated, labour requires training, etc. To accomplish these “repairs,” a business must forego current consumption of profits, and instead re-invest them in the future earning capacity of its accumulated capital. If this chain of repairing and re-investing is broken, the future earnings capacity of this accumulated capital will become impaired. If no re-investment occurs and enough time has gone by, a very unavoidable situation will exist: the trucks are broken down, the tools are rusty and broken, the building is falling apart, and the labour isn’t very efficient. Breaking the chain of repair and investment in an effort to exploit the full benefits of current consumption comes at the cost of future impairment of consumption, ultimately resulting in a point when no consumption can occur, as you exhaust all your accumulated capital. In economics, this process of sacrificing the future for the benefit of today – to let all your capital investments become rusty, broken, and ultimately useless – is known as “Capital Erosion.”

The reason why America breached its 2002-2003 lows is because of the long-term effects of capital erosion. So much existing savings in the U.S. economy are being redirected towards unproductive areas. American businesses have been making very poor investments for two decades now, with one of the most blatant examples being the decisions made by major U.S. banks, who invested heavily in people who could not repay their loans. On the aggregate, if the United States itself was a business, it is not properly re-investing in its future. It is embarking on a flawed policy of “now” instead of “tomorrow,” and the damage can be seen on the long-term performance of its stock market.

Capital erosion is heavily exacerbated by the manipulation of interest rates. Inflation is one of the ways that productive resources are re-directed to the unproductive. Manipulating interest rates low enough ensures the poor entrepreneurs of the world can survive – for a while. This new policy of 0% interest rates and quantitative easing is the policy makers’ latest scheme to keep the party going. Unfortunately, it will fail just as the Japanese did enacting similar policies. The Bank of Japan started similar policies long ago, and the effects of their policies are in plain sight for everyone, as they have been in a bear market since 1987 – 22 years. In 1987 the Nikkei Exchange topped out at 37,000; it is now 7000.

Will America share the same fate as Japan through the devastating effects of capital erosion? An economy experiencing capital erosion will result in less and less attractive “investing” opportunities. Simply put, the dividend growth of businesses will decrease, profits will become impaired, and fewer businesses will be around to survive. This is phenomenon is very apparent by simply looking at the general decline of the S&P 500 and Dow Jones Industrials dividend yield since 1930.

It is important for investors to be aware of this phenomenon and position themselves accordingly. China, for instance, is experiencing high-quality capital re-investment, and the performance of their stock market will reflect it accordingly. If you are going to invest in places like the United States, invest in those businesses most exposed to the capital creation occurring in other economies.

Copyright © 2009 Travis Steward
Editorial Archive

Contact Information

Travis Steward | Vancouver, BC | Email