OMINOUS PARALLELS, by Dr. Kurt Richebacher (Austria)
For the first time in the more than 50 years since World
War II, the world is in the grips of a synchronized
global economic downturn. This has but one precedent in
history: the Great Depression of the 1930s. The most
striking common feature of both periods is the dominant
role of the U.S. economy in the prior boom as well as in
the following downturn.
Yet there exists a conspicuous difference between the
two cases of American global economic predominance.
During the 1920s, America flooded the world with credit,
acting as the world's lender of last resort, while in
the 1990s it became the world's consumer of last resort,
flooding the world with unprecedented excesses in
consumer spending.
Remarkably, the two U.S. boom episodes were alike in
their heavy disposition towards consumer spending.
However, the borrowing and spending excesses of the
1990s vastly exceeded those of the 1920s. Another
difference of crucial importance is in the state of the
balance of payments. During the 1920s, America was the
world's leading creditor country, running a chronic
current surplus. Today, it's the world's greatest
debtor, running a monstrous deficit in current account
and piling up trillions of foreign debts.
An old bone of contention between American and European
economists is at what time the American Federal Reserve
made its decisive policy mistakes that determined the
protracted depression of the 1930s. Was it the excessive
monetary looseness before the stock exchange crash? That
is the opinion in Europe, strongly influenced by
Austrian theory. Or was it excessive monetary tightness
after the crash, during the 1930s? That is American
opinion, as indoctrinated since the 1960s by Milton
Friedman.
I am a great believer in the logic of Austrian theory.
It says that the severity and length of depressions
depends critically on the kind and the magnitude of the
maladjustments and dislocations that have developed in
the economy and its financial system during the
preceding boom.
This seems to be exceedingly straightforward logic.
Moreover, it has historical experience on its side.
Assessing the present economic situation in the United
States, the key point to realize is that for years it
has been exposed to the most inordinate credit excesses
in history. It has been crystal-clear for a long time
that it was a typical bubble economy, being defined as
an economy where unusually sharp rises in asset prices
fuel extraordinary borrowing and spending binges, either
by businesses (Japan) or by consumers (America).
Established economic theory, by the way, has a strict
measure for "excess" credit - all credit in excess of
available savings from current income that is not spent
for consumption. The essential economic effect of such
saving is to release productive resources that a
borrower may use for capital investment. Traditionally,
the credit cycle has been associated with the investment
cycle.
Credit expansion in the last three years in the United
States has been running at an annual rate of around $2
trillion, accounting thus for about 20% of GDP. Never
mind that combined personal and business savings plunged
in 2001 to barely 2% of GDP. The discrepancy between the
two defies the wildest imagination of a reasonable
economist.
Today's American policymakers and economists apparently
find nothing wrong with this pattern. Least of all do
they understand that such a runaway credit expansion
could do any damage to the economy and the financial
system. Doesn't it boost economic growth and financial
markets? The only serious economic damage they can think
of is rising inflation rates, and their absence in the
past few years testified in their view to the U.S.
economy's excellent health. Another inherent logic is
that this justifies virtually unlimited credit
expansion.
We subscribe to the opposite view - which may be called
classical European economics - that credit creation in
excess of available savings is by itself an evil. It
tends to harm the economy far more than consumer-price
inflation by encouraging reckless spending that
essentially distorts the allocation of real resources.
Of course, the consumer-spending boom of the last few
years in the United States was crucial in propelling the
economy's growth. As a share of GDP, it shot up to an
average of 82.6% between 1995-2001, as against a long-
term ratio of about two-thirds. But it essentially did
so at the expense of saving, capital investment and the
balance of payments.
As domestic demand grew persistently in excess of
domestic output, the deficit in the current account
ballooned from $139.8 billion in 1998 to $417.4 billion,
running lately even at an annual rate of $450 billion. A
large part, if not the greater part, of the rapidly
swelling consumption demand was actually met by foreign
producers possessing the necessary idle capacities.
Since the early 1980s, the nation has moved from a net
creditor position of 13% of GDP to a net debtor
position of 25%. Altogether, this adds up to almost
40% of GDP.
The inevitable domestic result has been a badly split
economy. The part exclusively serving the consumer and
also being sheltered from foreign competition boomed
with strong profit growth, while the sectors that serve
capital investments and are also exposed to foreign
competition have been badly withering with collapsing
profits.
The most striking feature and testimony of this split in
the economy is an extreme divergence in the profit
performance of two sectors - manufacturing and retail
trade. In 1997, manufacturing earned $195.5 billion,
comparing with retail trade earnings of $63.9 billion.
After five years, this relationship has been turned
completely on its head. In the first quarter of 2002,
manufacturing profits had slumped to $68.9 billion,
while retail trade profits were up to $81.4 billion,
both figures at annual rate.
It should be self-evident that this dramatic diversion
in profitability between the two sectors had far-
reaching implications for their investment policies.
While the profitable retail trade sector has grossly
overinvested in relation to sustainable consumer demand,
the unprofitable manufacturing sector has just as
grossly underinvested in plant and equipment. These are
the kind of structural distortions that Austrian theory
emphasizes as the recession-breeding consequence of
major credit excesses.
Assessing the prospects of the American economy, this
big split between consumer-related and investment-
related activity is, certainly, of greatest relevance.
Considering furthermore that it has developed over
years, it cannot be discarded as cyclical. Clearly, the
overall poor profit and capital spending performance is
structural. And with the economy's slowdown it has
dramatically worsened.
For the same reasons, there is clearly no chance under
these circumstances for business investment to lead an
economic recovery. This would have to come almost
single-handedly from the consumer. But for that to
happen, he must do more than keep spending at a high
level. To lead a recovery, consumer spending has to rise
by 3-4%. But in reality, in the second quarter it was
down to an annual rate of 1.9%. Before long, he will
capitulate altogether.
In the end, all questions about the U.S. economy boil
down to one: whether or not business investment will
return with sufficient vigor. But for that to happen, it
needs both a luring profit outlook and accommodating
financial markets.
Neither is in sight.
Though monetary policy could hardly be looser, the
financial markets are nevertheless tightening up against
business financing...and consumer financing is sure to
be next.
Regards,
Kurt Richebacher,
for The Daily Reckoning |
