BUBBLE ANATOMY
by Dr. Kurt Richebächer
Almost half of this year is already behind us. The biggest surprise, certainly, is the suddenly disappointing economic data about the U.S. economy. Whether this will be just another brief soft patch or a longer-lasting, rather serious, slowdown - if not worse - is the most important question for the whole world.
The just-published World Economic Outlook of the International Monetary Fund says this about the U.S. economy: "With incoming data generally robust and business and consumer confidence strong, the outlook for 2005 is encouraging. GDP growth is projected to average 3.6%, somewhat higher than expected... with a moderation in private-consumption growth reflecting the gradual withdrawal of fiscal and monetary stimulus... offset by continued strength in investment. The risks to the forecast appear broadly balanced, with upside risks from the strength of corporate balance sheets, as well as rising housing and equity prices by the possibility of a more pronounced rebound in household savings."
We have quoted this passage for two reasons: first, because the World Economic Outlook is a world authority in economics; and second, because its arguments are typical of the general complacency with which the U.S. economy's growth performance has been and continues to be judged in the face of unprecedented structural dislocations.
For the "soft-patch" crowd, some recent spots of weakness in the U.S. economy have their main culprit in the jump in energy prices and its temporary impact on inflation rates. Other optimistic arguments are contained inflation expectations and still-considerable slack in the product and labor markets. Last but not least, Fed officials stress the fact that monetary policy is still "accommodative" and, therefore, supportive to economic growth.
We must admit to finding the singular focus on higher energy prices as the troublemaker in the U.S. economy more than simplistic. In our view, the world economy - and also the U.S. economy - is struggling with a lot of far bigger problems than higher oil prices. Besides, while these may have overshot, they could still stay high, and even rise further. They might even fall if the world economy, or large parts of it, turns significantly weaker.
We see the economic and financial development through a very different lens, and judging from the behavior of the financial markets, we have the impression that we are by no means alone in assuming more permanent and pronounced economic softness in the United States.
The recovery of the stock markets has stopped dead in its tracks. In June last year, the Dow closed the month at 10,300. Lately, it is hovering around 10,100. Investors of recent months are sitting on losses. Even more conspicuous for sudden changes of market sentiment about the U.S. economy's outlook seems to be the pronounced decline of the yield on the 10-year Treasury note over the last few months, from 4.6% toward 4%, and that in defiance of rising inflation rates and a trebling of the federal funds rate, from 1% to 3%.
While the U.S. economy has clearly slowed, the more relevant questions are, of course, the severity and duration of this slowdown. In the last letter, we described in some detail how the sudden stock market crash and the collapse of business fixed investment in 2000 took everybody, including the Federal Reserve, completely by surprise.
It goes without saying that it was not just by accident that we recalled this episode. We had our reason. At the time, the sky over the U.S. economy seemed cloudless. The stock market soared to new highs until March, and then, all of a sudden, the economy and the stock market slumped.
In hindsight, Federal Reserve Chairman Alan Greenspan and his consorts take pride in having managed the U.S. economy's mildest recession in the whole postwar period with their prompt policy responses, even though the stock market collapsed.
For sure, this was another incident that immensely enhanced Mr. Greenspan's reputation as the world's greatest central banker. Two years ago, he summed up the Fed view about this policy by declaring, "Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." (See his Jan. 3, 2003, speech "Risk and Uncertainty in Monetary Policy," delivered to the annual meeting of the American Economic Association in San Diego.)
We have never agreed with this complacent assessment. What remains manifestly missing in this scenario is the V-shaped recovery that has been typical of all postwar recoveries but that has grossly failed to materialize this time. The final judgment has to weigh the earlier gains from the milder recession against the comparative later losses in the growth of GDP, employment and income from the unusually weak recovery over the three years since 2001. For sure, the latter losses vastly outweigh the earlier, minor gains.
However, that is only one reason why we have always regarded the story of the "mildest recession" as a great delusion. But this raises a second crucial question: Why has the unusually aggressive combination of monetary and fiscal policy so lamentably failed to generate a recovery of the vigor that had been standard in postwar periods?
Our short answer: The Greenspan Fed deliberately pursued a policy to instantly replace the bursting equity bubble with another, even greater, housing bubble. By rapidly slashing interest rates to rock-bottom levels, it succeeded in generating the housing bubble and also in provoking the consumer to sustain and accelerate his borrowing-and-spending binge, now against the soaring collateral of rising house prices.
The consensus sees a tremendous success. In reality, it was by far the U.S. economy's weakest recovery in the whole postwar period, with grossly lacking employment and income growth. That is a decisive failure. Moreover, at the same time, the aggressive policies and the resulting unbalanced recovery vastly aggravated the existing imbalances in the economy.
Recessions are intrinsically the phase in the business cycle in which businesses and consumers exert restraint by unwinding some of the borrowing-and-spending excesses of the prior boom. In the United States, the exact opposite happened this time.
While businesses restrained their spending and hiring, private households and the government stepped up their borrowing and spending. Economic growth recovered, but it should not be overlooked that this "success" had its flip side in an unprecedented escalation of economic and financial imbalances.
In 2000, national savings - the compound savings of the government, businesses and private households - amounted to $817.6 billion, or 8.3% of GDP. The profligate policies of the following years slashed them to $212.7 billion, or 1.8% of GDP, by 2004. The U.S. current account deficit in 2000 came to $413.4 billion and in 2004, to $665.9 billion. In 2000, the federal government ran a surplus of $295.9 billion. In 2004, it had a deficit of $362.6 billion. In 2000, private household debt equaled 97% of disposable income; in 2004, this ratio was up to 120%.
Could it be that these imbalances are damaging to economic growth and general prosperity? You bet they are. The greatest and most obvious damage derives from the escalating trade deficit in the U.S. manufacturing sector. The U.S. economy is being virtually deindustrialized. The sector has lost 3 million jobs since 2000 and keeps losing them month after month.
Yet American policymakers and most economists do not appear to be worrying about any damages to the economy. From their public talk, we must presume a complete lack of grasp. Recently, a Fed governor spoke of the minimal savings rate as a sign of optimism. The soaring trade deficit, on the other hand, is generally put into a positive light with the argument that the flood of imports of both foreign capital and foreign goods reflects America's dynamism.
The truth, rather, is that at 15% (measured as a share of GDP), U.S. import penetration of goods and services is unusually low in comparison to other major industrialized countries. For instance, it is 33% for Germany and 28% for the United Kingdom. In reality, what America grossly lacks compared to other major industrialized countries is competitive export capacity, and this, for sure, is primarily a problem of underinvestment in manufacturing.
Regards,
Kurt Richebächer
for The Daily Reckoning
Editor's Note: Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."
The above essay was taken from the most recent issue of
The Richebächer Letter
