THE GREATER DEPRESSION
By James Davidson
With a shaky global economy, a plunging dollar and
deflation casting its dark shadow into many corners, there
are nonetheless some encouraging signs of revival in the
U.S. stock market. Yet, it cannot be denied, we are living
in one of the more challenging periods for investors in
many decades.
During the first few days of June, I spent some time trying
to get an added perspective from about as far from Wall
Street as you can get...in Buenos Aires. My journey was the
first I have taken to Argentina since it slipped into a
devaluation crisis and a 'Greater Depression' in January
2002. I wanted to see first-hand how people there were
coping with an economic collapse even more severe than the
United States suffered in the Great Depression. In 2002
alone, the average income in Argentina plunged by 40%.
The economic history of Argentina provides cautionary
evidence that wealthy countries can rapidly fall to Third
World income levels. This may be more pertinent than it
first appears because the collapse in Argentina occurred
very rapidly, within the span of one long human lifetime.
Even if you have never thought you had any interest in
Argentina, stay tuned.
If you've never been to Argentina, I recommend the trip.
Buenos Aires is a beautiful, cosmopolitan city, the most
European in South America, with lots of Belle Epoque
buildings, and broad avenues lined with cafes, trendy
boutiques and bookshops. Unless you are blinded by
'political correctness,' you are bound to notice after a
few hours that everyone you see is of European descent.
Argentina's demographic mix was frozen generations ago when
it ceased to be one of the world's more dynamic economies.
As Argentina stagnated, it became unattractive as a
destination for later waves of ambitious immigrants from
Africa, the Middle East and Asia. A common caricature of an
Argentine captures this Western European heritage: "An
Argentine is an Italian speaking Spanish who believes he is
an Englishman living in Paris."
In 1950, Argentina was more than twice as rich as Japan on
a per-capita basis. By 1970, the Japanese had caught up and
were 30% richer than Argentines. But while Argentina's
economy contracted at an almost 2% annual rate, Japan's
soared ahead. By 1990, when the Japanese bubble burst,
Japan was almost three times richer than Argentina on a
per-capita basis, reversing the situation at the eve of
World War I, when Argentines were on average almost three
times richer than the Japanese. In three quarters of a
century, Argentines failed to even double their incomes,
while the Japanese multiplied their per-capita incomes by
almost 14-fold.
Many economists believe the negligible population growth in
Argentina through most of the last half-century contributed
to its weak economic performance prior to the 1990s. Per-
capita economic growth was negative from 1970 to 1990. A
contracting economy tends not to attract immigrants, which
makes the economy weaker still.
If Argentine history is any indication, frequently voiced
worries about massive defaults on consumer credit card debt
in North America are probably overstated. Notwithstanding
the fact that poverty rates in Argentina have soared beyond
anything imaginable in North America, given last year's 40%
plunge in per-capita income, credit card debt is the only
valuable asset left in Argentina's banking system.
Business borrowing has come to a halt. Even companies that
are losing money are hoarding piles of cash. The government
has defaulted on its debt, wiping out pension programs that
held 70% of their assets in government bonds, and depriving
the banking system of what is usually one of its strongest
assets. The mortgage market has been devastated by the fall
of personal income, which means that most people who would
need a mortgage to buy a home can't qualify. Yet Visa and
MasterCard accounts are still being paid. Amazing.
A review of the confiscatory policies instituted by the
last four Argentine presidents reads like the driving
record of an alcoholic with a heavy foot. The last half-
century has witnessed one gaudy crackup after another. The
most recent, in January of last year, involved the
abandonment of the currency board, which had successfully
pegged the Argentine peso to the U.S. dollar for eight
years. Because the currency board system really made the
peso worth a dollar, it flatly prohibited the Argentine
government from printing money.
Contrary to the superficial impressions of some critics,
however, the currency board did not fail. It could have
continued to peg the peso to the dollar indefinitely. It
was abandoned because of ideological conviction. A large
number of economists - and others meddlers such as former
U.S. Treasury Secretary Paul O'Neill - loudly complained to
Argentine authorities that sound money was hampering their
economy. The local political establishment eagerly grasped
the advice to return to easy money as a tonic for weak
exports, unemployment and the unfairness of life. But
contrary to expectations, the economy did not prosper. Real
wages plunged by 40% following the devaluation. And the
official poverty rate, which had seemed high at 38.5% in
December 2001, skyrocketed to 58.5%. Ouch.
The experts were wrong. They had forgotten the history of
Argentine political dysfunction, impressed cruelly on the
Argentine population in the second half of the 20th
century. These include the most disastrous peace-time
inflation in all of modern history - an annual average
inflation rate of 127% between 1960 and 1994. Unless you
have an instinctive facility for compounding interest and
the numerical gifts of an astrophysicist, you may not
immediately grasp how devastating an annual average
inflation of 127% is over 34 years. To put it in better
perspective, consider that an Argentine with a fortune of
$1 billion in 1960 who kept his savings in pesos through
1994 would have the equivalent of 1/13th of a penny left.
Why?
How did a wealthy country careen to such a disaster? That
is an important puzzle if you have money to invest or
expect to have it in your lifetime. I can't pretend to be
more than a voyeur where the history of Argentina is
concerned. Still, I have my theories. I see the repeated
crackup of the Argentine economy and its long-term decline
from the ranks of the world's richest countries as the
unintended consequences of continuing efforts at income
redistribution.
You will note that income redistribution is hardly an
Argentine invention. The United States and all the high-
income economies have democratic political processes that
guarantee gestures at subsidizing the underachievers. The
logic is simple. Votes are equally distributed. Money and
the other good things of life are not. Hence, the vivid
appeal of income redistribution. But the question remains,
why did these policies have so much more disastrous
consequences in Argentina than apparently similar programs
elsewhere?
I suspect that the answer may lie with the peculiar fact
that there were relatively more rich people in Argentina
than in the United States or Canada, but fewer in the
middle class in the mid-19th century. Unlike the United
States or Canada, Argentina does not have a strong
tradition of yeoman farming. And not because of a lack of
fertile land. The Argentine Pampas, an area 50% larger than
France, contains some of the most marvelously fertile
farmland on earth. Even today there are places in the
Pampas where the topsoil is 10-feet deep. Little wonder
Argentina was once known as "the world's bakery." Yet
unlike North America, where land suitable for cereal
farming was divided into small plots, land tenure in the
vast Argentine Pampas was concentrated into larger holdings
that predated the Argentine Republic.
A century ago, it was not modernist irony to say that
someone was 'as rich as an Argentine.' Lots of Argentines
were rich. You can divide an area 50% larger than France
into quite a few large holdings. Consequently, by the late
19th century the rich in Argentina were a relatively
numerous group, far larger, for example, than the
percentage of Americans who became industrial tycoons like
Rockefeller or Carnegie.
I have no doubt that it is preferable in political terms to
have a larger middle class than Argentina had when the 20th
century began. In 1900, per-capita income in Argentina and
Canada were at an equal level, as they had been since 1870.
Both were not far below the United States. As you will
probably remember from your history studies, most Western
democracies initially had limited franchise, which
restricted the ballot to property owners. So long as the
franchise was limited in Argentina, the elected governments
followed sound, free-market policies, and Argentine per-
capita income rose smartly. Indeed, the growth of
Argentina's economy accelerated in the early years of the
20th century, rising 37.8% in real terms from 1900 to 1913.
Notwithstanding unequal capital holdings, free-market
policies raised Argentine per-capita income by more in the
first 13 years of the 20th century than statist policies of
income redistribution did in the 53-year period since 1950.
What can you learn from Argentina's experience? Probably
the most urgent lesson is that while a larger middle class
may be politically stabilizing and desirable, it does not
follow that efforts to artificially enlarge the middle
class through income redistribution are economically
stabilizing and desirable. Indeed, the record shows that
Argentina's economic crashes have been repeatedly
occasioned by political efforts to cultivate and subsidize
a bigger middle class.
More lessons to come, tomorrow...
THE GREATER DEPRESSION, Part II
By James Davidson
The increasing bitterness and polarization of politics in
the United States today is partly a consequence of soaring
economic inequality. With the advent of the Information
Economy, income for persons with high skills in every field
of endeavor has increased dramatically, while wages for
unskilled workers have fallen. In 1998, for example, 47.3%
of 'net financial assets' of all American households were
owned by the top 1% of Americans.
The holding of wealth in the U.S. is even more concentrated
than it was in Argentina in the first half of the 20th
century. But it does not follow that the U.S. will
necessarily go the way of Argentina.
If you recall in yesterday's Daily Reckoning, we pointed
out that the initial downturn in Argentina's fortunes
corresponded with an enlargement of the franchise around
the time of World War I. This brought the Radical Party to
power, with a policy of consciously cultivating a larger
middle class. The Radical policies tended to punish the
rich and inhibit investment. Consequently, Argentina was
one of the countries that failed to enjoy a postwar boom in
the Roaring '20s.
When the Great Depression began after 1929, Argentina was a
deeply polarized country. It was evident to most of the
educated elite that President Hipolito Yrigoyen was old,
senile and incapable. It was widely known that public
offices were being sold, and that Yrigoyen was creating
new, unnecessary offices "to have a steady supply of
product to sell."
Although he had been re-elected in a landslide in 1928,
Yrigoyen lacked public support. No one seemed to care
deeply about what he was doing. There were no thundering
editorials in support of Yrigoyen's government, no mass of
impassioned demonstrators prepared to go to the barricades
for their belief in Yrigoyen. Certainly he did not command
the devotion, even among a few, of the suicide bombers who
now so unpleasantly remind us of the depth of their support
for the cause of Hamas or al Qaeda.
On Sept. 5, 1930, the respected dean of the law school in
Buenos Aires called for Yrigoyen's resignation. The next
day, cadets from the military academy led a coup that
overthrew his government. In short order, the Argentine
Supreme Court ratified the overthrow of Yrigoyen. This set
the stage for more disasters to come, although the
conservative governments that ruled Argentina in the 1930s
coped with the Depression well. The '30s were one of the
few decades after World War I during which Argentina
outperformed other rich economies.
The trouble was that the relatively strong economic
performance was achieved by governments widely believed to
have won election by fraud. Given that the expansion of the
franchise had created an apparently permanent majority for
income redistribution, many among the rich felt that the
only way to maintain sound government was to fudge election
results.
In particular, it was widely known that tenant farmers in
Buenos Aires province were bribed or intimidated into
casting their ballots for conservative candidates supported
by the large landholders. The fact that conservatives
repeatedly won what were thought to be rigged elections
caused bitterness and polarization, not just against the
rich, but against the courts that certified the rigged
elections. The Supreme Court, in particular, was considered
to be nothing but a mouthpiece for the interests of the
rich.
For a sense of how this can poison politics, consider some
of the more exaggerated blather about the presidency of
George W. Bush from diehard Democrats who believe the 2000
presidential election was "stolen" from Al Gore by the
Supreme Court's ruling in the Florida recount case.
In any event, resentments simmered until 1943, when another
military coup seized control of the Argentine government.
One of the leaders of the 1943 coup was Juan Peron, who was
eager to be seen as a leader who could punish the upper
class. A centerpiece of the counterproductive policies
instituted at the time was rent control on tenant farming.
Rents were rolled back and frozen at 1940 levels, minus
20%. Not surprisingly, this was popular among tenant
farmers, but not with the large landholders. Popularity
aside, it had a devastating impact on Argentine grain
exports at a time when Argentina could have garnered a
larger share of world markets. But rather than expanding
production and increasing export earnings, the policies
cost Argentina dearly. Before long, large areas of cereal
production previously worked by tenant farmers were
converted to pastoral use because raising cattle was more
profitable under the new rules. Growth was retarded to
prevent the rich from becoming richer.
Peron compounded this perverse policy when he became
president by requiring that grain for export had to be sold
to the state. He paid farmers a pittance and used the
profits from foreign sale of mostly stolen grain to build
nationalized industries to "create middle class jobs" for
urban workers. Peron also began a tradition of impeaching
Supreme Court justices in order to prevent his attacks on
property rights from being overturned in the courts. All
but one of the sitting justices on the Argentine Supreme
Court was thrown out after Peron's first election.
The de-legitimization of the Argentine judiciary has had
continuing ill effects to this day. The lack of a juridical
defense for property rights and contract enforcement
facilitated the chronic hyperinflation from 1960 through
1994. In their continuing attempts to enlarge the middle
class, governments pressured Argentine companies to
overstaff and to borrow vast sums to meet payroll
obligations.
In return, Argentine firms were protected from foreign
competition. When, as frequently happened, these companies
could not repay their loans, the central bank printed money
to retire the loans and cover up holes in balance sheets.
Thus, hyperinflation.
When President Carlos Menem finally restored sound money in
1994, monetary reform was undertaken in conjunction with
widespread privatization of industries and the reduction of
barriers to imports. Consequently, with Argentine firms
suddenly exposed to competition, they had no choice but to
become more productive. They did. Large numbers of make-
work jobs in formerly nationalized firms were eliminated.
Argentine industry quickly became competitive again.
Indeed, Argentina was second only to China in economic
growth through 1997.
However, as unemployment rose due to improved productivity,
the elimination of make-work jobs and the consolidation or
bankruptcy of uncompetitive firms, politicians once again
attempted to artificially enlarge the middle class.
Government spending grew like wild. Attempts to raise taxes
to finance the new spending met stout resistance.
Argentines simply refused to pay.
The only way to finance new spending was through borrowing
rather than by the printing press. President Fernando de la
Rua lacked the conviction to cut spending. And other
players in the political process catered only to the
demands of their constituents for more spending. Under the
circumstances, default and devaluation changed the economy
for the worse, but reopened scope for the politicians to
redistribute income. President Eduardo Duhalde began a
giveaway program to 20% of the work force, which continues
under his successor, Nestor Kirchner.
You might think that my reflections on the misgovernment of
Argentina have little bearing on investment today in North
America. But Martha Stewart probably wouldn't agree with
you. She is just one of the many scapegoats among the rich
now being persecuted as part of a general recrimination
following the bursting of the 1990s bubble. Ms. Stewart has
been forced out of her company, Martha Stewart Limited
Omnimedia, under the weight of Security and Exchange
Commission charges, which remarkably claim she conspired to
lie about an activity that itself was not a crime. The
alleged kernel of her wrongdoing is that she sold her
ImClone stock after hearing a rumor that ImClone founder
Sam Waksal was dumping his. An entirely rational reaction,
if you ask me. But one which may not have been "proper"
given the vague and stylized securities regulations
promulgated by the SEC in the attempt to quarantine
investment information.
In any event, bureaucracies such as the SEC tend to
undertake reckless enforcement efforts when there is a
public demand for blood. There is such a demand today.
Those who appeared to succeed in the 1990s are under
suspicion, and large numbers of people appear to believe,
for no good reason that I can grasp, that the incarceration
and financial ruin of highfliers from the 1990s would be
bullish for the economy. What rubbish.
Over 100 corporate executives in the United States, I have
heard, are negotiating plea bargains with the Justice
Department over various supposed infractions of securities
law. It is a negative omen for U.S. economic growth when
vague and possibly bad laws that impose staggering
liabilities are aggressively enforced against business
leaders. This is a recipe for timidity and mediocre
performance, like promising to make success a tort
punishable by class action lawyers.
Another worrying suggestion from Argentina's tribulations
is that the negative effects of income redistribution
intensify when there is a larger percentage of rich people
in a given country. The larger percentage may polarize the
electorate and lead to destabilization and delegitimization
of the government. Certainly, political discourse in the
United States has recently highlighted a number of themes
redolent of politics in the last century in Argentina.
Widespread resentment of day traders and dot-com
millionaires, as well as billionaire celebrities such as
Martha Stewart, augurs ill. When an electorate is so
polarized that election results tend to fall within the
margin of error in counting, as Florida's 'hanging chad'
election underscored, politicization of the courts could
follow leading to seriously perverse economic results.
Other negative signs abound. Congress and President Bush
are about to enact a massive new entitlement to
prescription drugs. And neither the White House nor the
Republican majorities in Congress appear able to resist the
blandishments of demagogues on the issue of extending
income tax reductions, in the form of child care credits,
to low-income families who do not pay income taxes. The
Republicans wilted in the face of charges that they were
"giving money to the rich" at the expense of poor children.
All of which bodes ill for the future capacity of the U.S.
government to maintain economic stability and resist the
siren call for destructive income redistribution.
The United States and other governments are not above
imitating Argentina in other respects. They are certainly
all keen to devalue their currencies. This makes holding
gold more attractive. It is also likely that the world's
major currency blocs will continue lowering interest rates
until economies unequivocally rebound in a robust way. With
Germany and much of Europe facing the specter of deflation,
euro interest rates will come down sharply.
Argentina's "Greater Depression" reflects the bankruptcy
and debt default - the ultimate outcomes of malinvestment -
of the Argentine state. Though the monetary history of the
U.S. does not share quite the same degree of turbulence as
Argentina's, it is not inconceivable that Argentina's
example will prove an ominous harbinger of U.S. troubles to
come. The United States is slowly suffocating in a mire of
debt, both on the federal and consumer ends...and like
Argentina before it, it has channeled much of that debt
into investments that should never have been made in the
first place.
The unhappy marriage of easy credit and malinvestment in
the U.S. has created excess capacity in many industries
that are now being painfully restructured. Whether such
'restructuring' will allow the U.S. to circumvent a fate
like Argentina's remains to be seen.
Regards,
James Davidson,
for the Daily Reckoning
P.S. Despite the fact that the general slowdown in world
growth and the investment depression is largely a Hayekian
hangover from malinvestments made in the 1990s, if you were
to ask 100 people on the street to explain the stock market
debacle that cost investors so many trillions since the
spring of 2000, most would probably cite the dot-com mania
as an example of 'irrational exuberance.'
They would be wrong. Contrary to the widespread
misimpression, the Internet has met most of the supposedly
demented forecasts for growth made by stock promoters in
the late 1990s.
Notwithstanding some conspicuous flops, Internet investment
has generally been profitable. Indeed, if you had invested
$1,000 in each and every Internet IPO, including the flops,
you would be ahead by more than 30% today. And those gains
stand to be compounded, given that most of the losers have
already been buried while the winners stand to gain even
more as Internet commerce continues to grow.
P.P.S. Another misconception holds that the cause of the
stock market's malaise is accounting fraud at Enron,
WorldCom, Tyco and other unspecified rogue corporations.
Wrong again. Fraud is fraud, and it is wrong. But the
impact of accounting fraud is much less than people seem to
believe. Accountants and executives who doctored books to
disguise slowing income may have had some impact at the
margin in redirecting stock losses from some earlier
investors who were able to sell to later ones who bought in
at a bad time. This is truly equivalent to shuffling the
deck chairs on the Titanic. Even if you could accurately
reconstruct where everyone was sitting, it would not
explain why the ship went down.
In the case of the stock market, the casualties are more
numerous than the numbers who went down on the Titanic.
Indeed, there were 100,000 fewer millionaires in the United
States and Canada in 2002 as the result of the declining
stock market. The question is, what was the main cause of
this huge loss of wealth? Bad accounting accounts for
little. The bigger cause was malinvestment. If accountants
and executives had merely lied about their claims to have
invested $4 trillion into the construction of fiber optic
cable, for example, and had not actually made the
investments, the markets would be in far better shape than
they are now.
The real problem is not what they lied about. It is what
they told the truth about. A great many people, lured on by
apparently low-cost capital, undertook a huge investment
program to string fiber optic cable around the world like
thread on a spindle. Most of the fiber optic networks built
at such great cost remain dark and unused. This was part of
an even more massive malinvestment and incoherence in the
telephony sector. |
