The 'OK' [Unbalanced and at Risk] Economy
by James J Puplava CFP, President & CEO, PFS Group. October 3, 2003
The easiest way to gain an understanding of the U.S. economy is to think in terms of four words: debt, consumption, speculation, and illusion. When looking at the U.S. economy from the perspective of these four words, it becomes easier to understand why the recovery isn't shaping up like the cyclical recoveries of the past.
It has become a start and stop economy for the last two years. The economy picks up steam after stimulus is applied, then it begins to fizzle once that stimulus has been exhausted. Without the constant input of new stimulus, either through interest rate or tax cuts or deficit spending, the economy rolls over. It is a bubble economy where real economic growth has been anemic, job growth has been nonexistent, and business fixed investment has been absent.
This sputtering economy requires an ongoing stream of new stimulus just in order to keep it afloat. Compared to past recoveries, economic growth has been half of what it has averaged over the last half century. It is also the first time in history that the economy went into recession against a backdrop of rabid money and credit growth. Fed stimulus failed to keep the economy out of recession.
What makes this situation more worrisome is that it has taken 13 rate cuts, three tax cuts, massive government deficits, and record growth in money and credit just to keep the economy growing. In economic terms, it is the largest fiscal and monetary stimulus the world has ever seen. What does the Fed have to show for its efforts other than multiple bubbles and the return of speculation to the financial markets?
All the Fed has been able to accomplish is the creation of a series of bubbles leading to widespread economic distortions and serious imbalances. This can be viewed from these graphs of durable good orders, debt levels and housing sales.
There are areas of the economy that have been influenced by cheap and abundant credit that have responded to Fed stimulus. This is visible in retail sales and motor vehicle sales reflecting an over-stimulated consumption sector. Real estate has done well as a result of minimum down payments, lower credit standards, and record low mortgage rates. However, the manufacturing sector remains plagued by low capacity utilization rates, stop and go production and flat durable good orders. Not a week goes by that one company after another closes down plants, announces more layoffs or transfers manufacturing jobs and facilities overseas.
During the week this Update was being written, Verizon offered voluntary severance packages to 74,000 nonunion management employees, Ford announced it would lay off 12,000 workers in the U.S. and in Europe, and IBM will lay off 700 workers in its service division. On the economic front, the ISM Manufacturing Index is falling again along with factory orders, which fell last month by 0.8%. Consumer confidence is also heading south and retail sales are starting to soften from their torrid pace during July and August. Nonresidential private construction fell 2.7%; while construction spending rose 0.2% thanks to a strong residential housing sector.
Given this massive stimulus, the question that has to be asked is why hasn't the economy gained traction? The answer is simple. Today's U.S. economy is made up of a series of bubbles and excesses left over from the 90's that have grown even larger as a result of monetary and fiscal stimulus. Through their actions, policymakers have injected more money and credit, which have only exacerbated existing imbalances in the economic and financial system. Like a drug dealer dispensing heroin to addicted junkies, the Fed continues to pump even larger amounts of credit and liquidity into the economy and the financial system. Instead of allowing the credit bubble to deflate, the Fed has chosen a path of monetary inflation in order to keep asset bubbles from collapsing. It has now become a matter of inflate or die. The U.S. debt imbalances and liabilities have become so large that the only way out of this credit predicament will be partial default through dollar depreciation. The U.S. will do what other third world countries have always done. It will debase its currency. It remains only a question of how this debasement will take place. Will it be orderly or will it be chaotic and abrupt? I believe the latter is more likely.
These large credit balances have not only impaired the economy's health, but they have also led to even greater imbalances. Building and production have been replaced by consumption. Savings have been diminished and replaced by debt and speculation has taken the place of investment. The result is that corporate profits are depressed as workers transfer their wages to foreign producers through our trade deficit.
Companies are saddled with excess debt and capacity preventing a rebound in business. In short, by failing to properly diagnose the root problem correctly, policy prescriptions have created further imbalances.
Policies aimed at curing the economy's ills are being driven by Keynesian prescriptions that in the past have shown to be ineffective in creating economic growth. In the minds of policymakers, the problem with the U.S. economy is that there isn't enough consumption. In fact, it is the other way around. The essential root of our problems is too much consumption driven by debt and not enough savings and investment. The United States is a high consumption, low savings and investment economy.
Today consumption makes up almost 90% of GDP. Wall Street and Washington believe if consumption can increase, business spending and investment will follow. In effect they have put the cart in front of the horse. It is business spending on capital plant and equipment that drives real economic growth. Investment in new plant and equipment creates demand and jobs as capital goods are produced. Once capital investments have been made, the capacity is then in place to satisfy demand.
Contrast this savings and investment scenario with what is currently being pursued in the U.S. and it becomes clear why the economy is creating no new jobs and why business is reluctant to spend money on capital investments. U.S. workers spend more of their wages on foreign-made goods. This is visible by the graph of America's huge trade deficits. When an American worker spends his wages on foreign-made goods, those wages are transferred outside the U.S. economy and into the pockets of foreign manufacturers. The money spent on foreign-made goods is money that is not going back into the U.S. economy. U.S. businesses are deprived of these sales and are therefore reluctant to spend money on new plant and equipment or hire new workers. In fact, as companies come under attack by new regulations, new taxes and frivolous law suits, more companies have chosen to close up shop and transfer manufacturing facilities overseas where the regulatory environment is more favorable, tax rates are lower and labor is cheaper.
Very little is being done to make doing business in the U.S. more favorable. Regulations are increasing, tax burdens are rising through new state tax levies and frivolous lawsuits continue to multiply. This is driving more companies to transfer manufacturing and service facilities overseas resulting in the loss of more U.S. jobs. Nothing has been done to remove regulatory impediments or to remove the threat of frivolous lawsuits. Taxes have been lowered, but lower federal taxes have been offset by higher state taxes. Even then there is constant talk of repealing the President's tax cuts and imposing even higher taxes. The message to businesses and entrepreneurs is that the government is going to regulate and tax you. Businesses are getting this message and are choosing to pack up their bags and move offshore.
In the United States over the last three decades economic policy has emphasized consumption at the expense of savings and investment. Debt has replaced savings and consumption has replaced investment. The U.S. has not maintained investments in its infrastructure from roads, bridges, airports and water systems to energy. This is no more evident than our failure to invest in our energy infrastructure where we seem to be going from one energy crisis to another in quick succession. This is obvious by the high price of energy and the power blackouts of this past summer. On the corporate front, companies have chosen to grow their businesses by merger and acquisition rather than invest in new plant and equipment to grow the business internally. If there are new plants and equipment being built or purchased, it is being done overseas and not in the U.S. Companies are relocating their manufacturing facilities to Asia and Latin America while they move their service functions to India. Once again is it any surprise why new job growth has been nonexistent? How do more credit, more taxes and new entitlement programs rectify this process?
The Vicious Cycle
Once the consumption fallacy is understood, it is much easier to see why the economy is breaking down. Businesses are trying desperately to conserve cash and maintain profits by slashing payrolls and cutting capital spending. Workers are losing their jobs and going deeper into debt in order to maintain living standards. Consumer spending increasingly goes towards the purchase of foreign made goods. The money spent on consumption is then transferred to foreign producers. These foreign producers then take those dollars and deposit them in their own domestic banks. Central banks in those countries then take those dollars and recycle them back into the U.S. by buying up our financial assets.
This represents the largest wealth transfer in history. The U.S. is trading all of its accumulated wealth and savings for consumable goods. Our monstrous size trade and current account deficits are a reflection of this fact.
To put this into perspective from December 1999 to June of this year, world dollar currency reserves grew by $870 billion of which $665 billion is held in Asia.These large dollar reserves overseas represent a clear and present danger for the U.S. economy. Asia now holds $1,000 billion of foreign exchange reserves out of a global total of $2,500 billion. Most of these reserves are held in U.S. dollars that come from trade imbalances between Asia and the U.S. Asian dollar reserves are part of a deliberate policy of Asian central banks intervening into the foreign currency markets selling their own currencies and buying U.S. dollars in order to keep their own currencies from rising. In the last month alone Japan has spent over $38 billion in order to contain the yen's rise against the greenback. Last year according to the Bank of International Settlement, central bank reserves of dollars rose by $220 billion. This represents almost half of last year's U.S. current account deficit.
A Twofold Risk
The risk to the U.S. and to Asia is twofold. Asian countries are experiencing higher interest rates on their own debt, while the loans they make to the U.S. by buying our debt is at a lower interest rate. This is done to sterilize their own intervention by neutralizing the excess supply of money into their own domestic money markets. Essentially what Asian central banks are doing is trying to keep their own currencies from rising against the dollar. This necessitates constant buying of dollar assets in order to keep their own currencies from appreciating. This is creating a financial anomaly. Asia is experiencing faster economic growth rates, rising trade and current account surpluses, and higher returns on capital. By investing in the U.S., Asia gets a lower rate of return than it would by being invested in their own countries.
This imbalance in global trade and investments cannot persist forever. The U.S. current account deficit, which is the broadest measure of international transactions, is now running at 5% of GDP. This means that the U.S. must attract $50 billion of foreign capital a month just to balance its books. The need to import capital doesn't end with the trade deficit. The U.S. budget deficit, which will rise to $455 billion in fiscal 2003, is projected to balloon to $600 billion next year. The projected trade deficit is also expected to rise. The United States will require $1.2 trillion of new capital just to pay its bills. The combination of these twin deficits could have a major impact on dollar depreciation producing more of an abrupt adjustment rather than a smooth transition to a lower rate of exchange. When this process of adjustment begins, interest rates in the U.S. will begin to rise. It will wreak havoc on debt-laden consumers and heavily leveraged companies and the American economy overall.
In essence, interest rates here in the United States will be determined more by the actions of foreign central banks and currency traders than decisions by the Fed or the U.S. Treasury. The U.S. may be a global superpower, but it is a superpower that is totally financed by foreign capital. Asian central banks keep 80-90 percent of their foreign currency reserves in dollars. It is those foreign currency reserves that finance the U.S. economy. During the 80's Japan financed the bulk of America's deficits. Subordinating their monetary policy to support the U.S. dollar led to Japan's bubble economy from which it has yet to recover. The Japanese are still financing our deficits, but they have now been joined by China and other Asian countries that run large trade balances with the U.S. China's support of the dollar is producing monetary growth of 20 percent a year and hyperactive economic growth of almost 8% a year. This kind of monetary growth could create the same kind of misallocation of capital as the money boom did in Japan in the 1980s.
These large trade imbalances and the U.S. twin deficits pose a major risk to the global economy. Foreign heads of state now face an issue of how to bring down the dollar without creating havoc in the global economy. At the recent Dubai summit, the Group of Seven leading countries called for greater exchange rate flexibility. (That is diplomatic talk for dollar depreciation.) However, how do the major G7 countries do this without creating major dislocations in the global economy? The economies of Europe and Japan are fragile and barely growing. If the yen continues to rise further, it would already jeopardize Japan's anemic recovery. The same holds true for Europe. Both economies are dependent on exports to the U.S. and the American consumer�s appetite for debt-based consumption.
Controlling the Dollar's Descent
It is a circuitous problem that offers no easy solutions. If foreign central banks stopped their dollar purchases, interest rates in the U.S. would immediately rise. A rise in interest rates would threaten the U.S. recovery, bond investments would depreciate, and the dollar would fall precipitously. A sudden drop in the dollar would undermine foreign willingness to finance U.S. deficits. America's twin deficits represent an unhealthy imbalance that cannot be corrected without pain for the global economy, especially here in the U.S. and for the financial markets. There is no easy way out of this mess. How the dollar's adjustment unfolds will determine whether we experience The Perfect Financial Storm or just another hurricane or nor�easter. It is doubtful whether policymakers can supervise and direct a smooth transition. The last time it was tried back in 1985-87, it led to a severe dislocation in the financial markets. Ultimately the adjustment process gave way to a plunging dollar, rising interest rates and major stock market crashes in the U.S. and around the globe. Therefore, controlling the dollar's descent will need handling with kid gloves. How policymakers maneuver this descent could determine whether we experience an abrupt crisis leading to system risks imploding all at once or an orderly and gradual transition. History gives us little hope of a smooth transition. Fiat currency systems always end tragically for all of the participants.
Foreign exchange markets depend on policymakers in the short-run more so than they do economic fundamentals. This has been the rule of the foreign exchange markets for the past 30 years ever since the world abandoned the Bretton Woods system and gold-backing of the U.S. dollar. Fundamentals may determine what happens to a currency over the long run, but it is the policy of the state, backed by intervention and monetary policy, that often moves the markets in the intermediate term. The markets often look for direction as to which fundamentals matter. The reason that policy decisions matter is that exchange rates often reflect the political responses to economic fundamentals. In the long run, it is economic fundamentals. But in the short-term, policy response determines who gets the greatest slice of today's economic pie.
The eventual solution will be that the U.S. will be forced to cut back on its consumption and start saving, investing and producing again. That would be a painful adjustment for politicians to weather here in the U.S. and for American consumers who are used to borrowing money and spending it on cheap foreign goods. Foreign trading powers will have to depend more on their own domestic economies for growth. If policymakers choose to achieve this process by one-upping their neighbor, either through currency debasement or expanding their money supply to lower interest rates, we will see the inflation demon return.
The Perversity of Yields
If the collapse of the dollar represents a major risk to the U.S., then the global economy speculation in the financial markets represents the other major risk. (Another terrorist attack in the U.S. is also a major risk, but won't be addressed in this Update.) The U.S. economy runs on debt. Without more credit, the U.S. economy would collapse of its own weight. Without foreign credit, America's borrowing and consumption binge would soon end. Yet, there is another side to America's endless supply of money and credit creation. It is fueling speculation in the financial markets again.
During the first phase of the bear market in equities, money gravitated towards bonds and real estate. Record half-century lows in interest rates have created a desperate hunt for yields globally. This has forced investors� from large institutions, pension plans and sophisticated hedge funds to the ordinary investor� to invest in riskier and more illiquid assets. This is evident in viewing the decline in interest rates across a broad spectrum of debt from governments to emerging market debt and junk bonds.
While economists have been extolling the benefits of low interest rates in support of consumer spending and debt refinance of consumer and business balance sheets, they fail to mention the perverse relationship that lower rates have on investments. Institutional and individual investors have been forced to seek yields in places they would normally avoid. The message from the Greenspan Fed is that the U.S. central bank will keep interest rates low in the U.S. for as long as it takes to get a sustainable U.S. recovery. It has been two years and there is still no sign that the recovery has planted deep roots.
The bear market in stocks from 2000-2002 forced investors to seek the safety of fixed income investments. Unlike the last recession where investors could find high single-digit yields, this time there is no such refuge. Both long and short-term rates have been falling sharply for the last five years as the Fed placed a heavy foot on the monetary pedal. This is evident from looking at today's interest rates here in the U.S. The Fed funds rate has fallen from 1.69% a year ago to 1% today. Two year T-notes only yield 1.625%. Five-year and ten-year notes have fallen to 3% and 4% respectively. With rates this low, investors have had to go elsewhere to fund a decent return. The search for higher yields has led investors into areas of investing that they may not understand. Substantial amounts of investor money is going into junk bond funds, emerging market, mezzanine funds and hedge funds that are not only more risky, but also are less liquid.
No Concern for Credit Risk
Investors are doing exactly what the Fed wants them to do by pouring money into high-risk investments. This helps marginal borrowers who would otherwise have difficulty getting funding due to large credit risk. In the process of searching out yields, money inflows into higher risk investments have caused them to appreciate in value because of high demand and lower interest rates. Credit spreads have narrowed considerably. A few experts feel investors are no longer compensated for taking on additional risk through higher rates of return. Whereas a 7-10% yield on an investment would have been conservative a few years ago, today anything yielding 7-8% entails high risk.
Today credit risk is no longer adequately priced into the market. The search for returns has driven yields down on all classes of debt especially high-risk bonds. Furthermore, investors are exposed to the additional risk of rising interest rates. Bond investors got their first interest rate shock last June and July when interest rates backed up more than a full percentage point in less than six weeks.
The one event that bond investors aren't prepared for is a major rate shock which could be triggered unexpectedly by a sudden plunge in the dollar or a planned rate rise by a reversal of Fed policy. The last time the Fed implemented a major rate policy change was back in 1994. The Fed funds rate rose 1.25% in less than two months. The rate increase was a jolt to the financial system causing bond prices to crash and derivatives to implode. The bond markets are more highly geared today than they were back then. Debt levels have doubled and tripled and derivative growth has been parabolic. As reported in the latest OCC report, the total notional value of derivative contracts has gone from just over $10 trillion in 1994 to $65 trillion today. The bulk of this amount is held by just three banks, J.P. Morgan Chase, Citigroup and Bank America. The concentration of so much risk in just a few hands heightens systemic risk. Like dominoes, everything is interconnected. If problems develop in one banking house, it could spread like a wildfire throughout the financial system. (Source: OCC Derivative/Notional graph)
The Fed is orchestrating a high wire act. Any mistakes or missteps could cause the whole system to implode. The June and July bond debacle is just a precursor of what might happen if the Fed miscues the markets again. It may find itself in a situation beyond its ability to control. A sudden collapse of the dollar could be such an event. Central banks have not been good at avoiding crises. Their real forte has been in fighting them once they erupt. So far they have been lucky in avoiding a systemic meltdown. This means as inflation rates heat up, the Fed will have to tread carefully with the financial markets when it plans to reverse course. The markets are heavily geared and any rate rise would truly be a seismic event.
If investors have been venturesome in their attitude towards risk in the bond market, they have become careless when it comes to investing in stocks. The bubble has been re-inflated in the stock market thanks to a rise in equities since March. Like the previous stock mania, investors are going overboard again driving up prices with reckless abandon. The percentage of household assets in equities is on the rise as is margin debt. Like the previous mania, ordinary people, wealthy individuals, and large sophisticated institutions have begun chasing stocks again. The excitement is back along with the gambling fever. The Wall Street Journal reports that day trading is in vogue again as are bullish tactics of speculation. This includes not only day trading, but also high risk-taking such as buying stocks on margin.
The markets operate under the rules of speculation today more than they do investing. Short-term trading tactics, rapid forays into and out of sectors, and use of leverage are the modus operandi of today's markets just as they were in the late 90's. Investment psychologists attribute this behavior to the devastating losses suffered by investors during the first phase of the bear market. When people have had devastating losses in their portfolios, they become more desperate to make up for the losses. They become more inclined towards risk and less inclined to be careful with investing their money.
It is not surprising that investors would chase the same stocks of the last bull market hoping they will make them rich again. Investors are once again bidding up technology shares. In the process, prices have risen well beyond company fundamentals. Financial publications are full of stories of investors who (having lost hundreds of thousands of dollars) are coming back into the market chasing Internet stocks, tech-component manufacturers, telecomm stocks and the usual suspects such as Cisco, Intel, PMC-Sierra and Amazon. In the mad dash to make up for losses, investors are buying almost anything associated with technology. A share of Equinix that has never made any money is up almost 400% this year. Other tech companies like Amazon (which has yet to make a real GAAP profit) and PMC-Sierra (an unprofitable communications chip manufacturer) have seen their shares quadruple or triple in value. The result is that the tech-laden NASDAQ is up over 40% this year and is currently selling at close to 40 times next year's projected earnings.
Industry executives from software manufactures to the semiconductor industry say that the business has matured. Each earnings quarter, the Semiconductor Association ways that its business has matured. The 17% average growth rates it has enjoyed for the last three decades are a thing of the past. The industry is not likely to enjoy more than 10% a year, if that. Competition has increased across the whole spectrum of the industry from hardware manufacturers to software companies. Industry gross margins are contracting driven lower by fierce competition. Investors keep ignoring industry fundamentals, believing that what happened in the past will come alive again. They are ignoring the warnings signs of record insider selling. Investors pay no heed and continue to pour money into stocks that offer very little hope of actually making a profit. Stocks of money-losing companies have been rising twice as fast as stocks of companies that actually make a profit.
Despite the general giddiness of the markets, experts believe that this rally has much further to go. The reason for this optimism is a myopic belief in a second-half recovery that will bring with it robust economic conditions and a steady stream of rising quarterly earnings. It is just not ingrained in any investor�s belief system right now that economic fundamentals may be deteriorating again or that corporate profits may disappoint. Standard & Poor's has projected falling profits for the S&P 500 companies since the beginning of the year as shown in the table below.
|S & P 500 Index Quarterly Earnings|
The best thing the market has going for it at the moment is John Q and Herbie Homeowner. They have come back into the stock market. Mutual fund inflows have risen consecutively for the last four months.
Mutual fund flows are also expected to be positive for September. Another positive factor is that most investors aren't reading the financial statements or perusing the economic numbers to find out if they are real or what is driving them. It is a great time to be investing, if you don't understand financial statements or know how to read. In this market all you need is a rising stock price and investors are all over it.
Meanwhile, insider selling continues at a record pace. It is currently running at a rate of 34:1. Insider selling has always been considered a leading indicator. The fact that it is this prolific is telling us that something is wrong with this rally. At some point in the near future, it will be time to fish or cut bait with the economic and earnings numbers. You can only drive stock prices so high on hope and hype before the real fundamentals have to start kicking in.
The best thing going for the market right now is that money continues to pour into stock funds even while insiders continue to sell. That is a positive if you're trying to cash out. If you want to sell and distribute stock, you have to have a willing buyer on the other end of the trade. There is no shortage of willing buyers at the moment. Selling pressure is low and buying pressure remains strong. The market has been resilient and just when the market looks like it is about to roll over, miracles occur in the futures pits. Those late afternoon zutz's as Richard Russell likes to call them or flag poles as I see them keep reappearing. It is enough to keep the stock market's nemesis; the short seller at bay and ready to cover. Short sellers are having a tough time grappling with double-digit losses.
Despite dismal real earnings and sub-par economic growth, stock prices continue their march upward. Corporate and investment banking scandals continue to surface nearly every week, but they have become so commonplace that the news is buried in the back pages of the paper. Most investors simply ignore them. The economic numbers are starting to soften again as mortgage refi money slows its pace and the tax rebates have been spent.
The question remains: What keeps the economy afloat when the stimulus runs dry? Interest rates are now close to zero and very few experts believe another rate cut by the Fed would do anything. In fact, another rate cut would indicate desperation on part of the Fed. Further stimulus outside of government spending such as tax cuts is unlikely. So there will probably be no tax rebates next year. It is unlikely that the President will get another tax cut passed given the size of the deficits. Besides, the competitors for his job are all advocating raising taxes, a policy that would surely be the death knell to this fragile economic recovery.
So what else is left to keep this economy afloat? The Fed could always make another mad dash at driving interest rates lower through persuasion of the bond markets. That seems unlikely given the low current interest rate environment. Foreign central banks could always intervene in our markets supporting the dollar and buying our bonds as they have done all this year. At the moment (outside of dropping money out of helicopters) the Fed has run out of bubbles to inflate, unless the miracles that transpire in the futures pits have become a quiet and unofficial policy. The best hope right now is to keep the stock market bubble alive. It creates tax revenues for government through capital gains taxes and extra spending money for investors. The bubble in stocks just may be the best thing the economy has going for it.
The Turning Point?
As the final words are penned to this essay, the stock market and the dollar are going up and bonds and gold are going down. The euphoria in the markets is based on this Friday's Labor Department report on unemployment. The unemployment rate stayed the same, but non-farm business payrolls rose by 57,000. This is the first positive number in 7 months during which the economy lost 500,000 jobs. Economists are calling today's numbers the key turning point for the economy. Now economists are predicting that employers will be adding 100,000 new jobs a month for the next 8-9 months. Stock bulls believe that the last missing piece for a sustained recovery is now in place.
In the same report the Labor Department announced annual revisions it will make to its payroll numbers. The latest adjustments reflect an upward adjustment of 145,000 jobs lost. The latest revisions indicate that job losses have been much greater than originally reported. In a separate report out today the ISM service sector grew for the 6th consecutive month, but at a slower pace. The index slipped from 65.1 in August to 63.3. New orders went up; while employment went down and inventories decreased.
Outside of today's "managed" unemployment report, the real economic numbers are starting to soften again as the afterburners of mortgage refis and tax rebates burn themselves out. Although today's markets acted euphorically over the projected job numbers, there are lingering doubts on whether an unbalanced economy can plant roots and grow at a sustainable rate. Up until now the economy has experienced only fitful spurts that quickly fizzle once the stimulus wears off. It has been unable to gain traction.
Although this year is looking good from a stock market perspective, it is questionable whether today's growth spurt is sustainable given the underlying problems that remain from the 90's boom. Consumer debt burdens, a low savings rate, lack of business fixed investment, and a burgeoning trade deficit indicate that major problems still exist and are getting worse. All that policymakers have done is postpone the day of reckoning. The imbalances of debt at the consumer and corporate level have not gone away. They have been ameliorated by lower interest rates. While monetary and stimulus measures have had an initial positive effect on the economy and markets in the short-term, it has been unable to generate a durable recovery. Economic growth has come in spurts when stimulus is applied only to roll over once the stimulus has been expended. What is absent is a positive capital investment feedback loop. The greatest threat to the recovery is the unwillingness of companies to make capital investments and expand payrolls before the stimulus runs wears off.
I believe the reason that companies have been unwilling to expand their capital budgets and payrolls rests on the assumption that the economic models are flawed and the economic numbers are rigged. To reason why nothing seems to stick, an understanding of the economic model is required. A diagram of this model is shown below.
T he improvement in corporate profits has come mainly through cost cutting. The most significant cost to companies is labor. Therefore, companies continue to shed jobs in order to cut costs and conserve cash. More workers lose their jobs which cuts purchasing power in the economy. Laid off workers along with employed workers go deeper into debt to maintain living standards. The rise in consumer spending is being exclusively supported by heavy borrowing. Consumer purchases outside of essentials have gone almost entirely to foreign producers. The trade deficit increases because almost all new consumption is transferred to foreign manufacturers. These foreign producers then deposit our dollars into their banks. Foreign central banks then sop up those dollars and reinvest them into U.S. financial assets. This further exacerbates the current account deficit. The trade and current account deficit continue to grow as consumption is transferred to overseas producers. Central banks and financial institutions in these countries then take those dollars and buy up more of our assets. This means we have to pay out more in interest and dividends each year as foreign ownership of U.S. assets exceeds U.S. foreign investment holdings.
In summary, Americans have been going deeper into debt, spending more than they earn in income. The increase in consumption has gone almost exclusively to foreign producers. The money spent on foreign goods represents a loss of revenues to American business. It is why business spending isn't increasing. This week we saw major layoffs at Ford with early retirement incentives at Verizon. In addition to transferring all of our assets into the hands of foreign central banks and institutions in exchange for consumable goods, this shift of capital is depleting this nation's wealth. You can't create prosperity through debt and consumption. Real wealth comes from savings and investments and the production of real goods. It doesn't come from financial speculation. Printing money and expanding leveraged financial assets that trade the markets is paper wealth - not real wealth.
The current economic models that emphasize debt and consumption and the transfer of wealth to foreign producers are a prescription for wealth depletion and a roadmap to poverty.
The false illusion created by financial speculation and rising paper asset prices also helps explain why capital investments have been flat and why companies continue to lay off more workers. This stems from the illusion of our economic and earnings numbers, which has been the subject of my two previous essays. In the last essay, I showed how more than half of GDP growth came from hedonic indexing of computer spending which added $32 billion on phony economic growth to the economic numbers. The GDP numbers were also enhanced by lowering the GDP inflation deflator. Also discussed was the widening gulf between GAAP and CRAP earnings and personal income accounts reported to the IRS. When you understand that the economic numbers as well as the earnings numbers are cooked, then the following actions by companies begin to make more sense:
- Companies fail to expand spending on capital investments.
- Job layoffs continue and more plants are closed.
- Company insiders continue to sell their stock at a record pace.
When the economic numbers and the profits aren't real, you can't spend, invest, and hire with money that doesn't exist. I'll say it again. Our economy rests on a thin thread of debt and consumption that is only sustainable as long as stimulus is applied. Once that stimulus wears off, the economy and the markets roll over.
Just before going to press, I finished reading the latest Richebächer letter. Dr. Richebächer summarizes the economic recovery illusion in four key points as follows:
- American economic growth rates are annualized making them look bigger than they actually are. A 4% growth rate during a quarter translates into an actual growth rate of only 1%.
- GDP has been heavily bolstered by government spending accounting for 40.7% in Q1 and 38.2% in Q2.
- There is no evidence of recovery when GDP is viewed in current dollars rather than chain dollars, which are statistically massaged.
- The widely heralded pick up in business fixed investment in the second quarter was pure fiction, a product of statistical tinkering.[ 2]
To Dr. Richebächer's four points, I'll add a fifth. Just as the economic numbers are fictional, so are the profit numbers. There is widespread evidence that companies are using accounting tricks to make their numbers. The two graphs from the previous essays on CRAP versus GAAP and Reported versus Taxed Profits are as wide as the Grand Canyon. The economy and the financial markets are an illusion based on false perceptions. It is just a matter of time before this illusion is discovered to be what it is.
In closing, I would like to include three graphs for study. They are included below. ~ JP
-  Financial Times, "Funding America's recovery is a very dangerous game," by Martin Wolf. October 01, 2003
-  The Richebächer Letter, October 2003, p1
Grateful acknowledgement to various sources for this Update's charts: Sharefin, Carl, Gary, Alan, Bill, Financial Times, Wall Street Journal, Investors Business Daily and of course, Mary, who spent long hours creating their colorful display.
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