PULLING OUT THE RUG
by Kurt Richeb�cher
Apparently, the consensus economists are still convinced
that the growth acceleration in the second half of 2003,
and above all a sharp rise in profits, have laid the
foundation for sustainable growth. In particular,
sustainable growth with sufficient creation of employment.
We disagree.
But we must admit that our own assessment is prejudiced by
the postulate of the Austrian school, that "the thing which
is needed to secure healthy economic growth is the most
speedy and complete return both of demand and production to
its sustainable long-term pattern, as determined by
voluntary consumer saving and spending."
Friedrich Hayek said in 1931: "If the proportion as
determined by the voluntary decisions of individuals is
distorted by the creation of artificial demand, it must
mean that part of the available resources is again led into
the wrong direction and a definite and lasting adjustment
is again postponed. And even if the absorption of the
unemployed resources were to be quickened in this way, it
would only mean that the seed would already be sown for new
disturbances and new crises."
We think this precisely describes what has been happening
and continues to happen in the United States. The Greenspan
Fed has discovered a new, amazingly easy and quick way to
create higher consumer spending virtually from thin air -
by way of so-called wealth creation through asset bubbles.
It began with the stock market bubble, to be followed by
bubbles in bonds, house prices and mortgage refinancing.
Measured by real GDP growth, it seems a successful policy.
But measured by employment and income growth, it is an
outright disaster. The so-called "wealth effects" are not
for real, neither for the economy as a whole nor for the
individual asset owners. The reality in the long run is
only the horrendous mountain of debts that consumers,
corporations and financial institutions have piled up.
Given the general euphoria about the U.S. economy and its
recovery, there appears to be a general apprehension in the
markets that the Federal Reserve will be forced to raise
interest rates in the foreseeable future. The Fed is
clearly anxious to dispel any such fears - and this, in our
view, is for a compelling reason. U.S. economic and
financial stability have become inexorably dependent on the
existence of a steep yield curve allowing and fostering
unlimited carry trade in long-term bonds. Any major rise at
its short or long end would shatter this artificial
stability and send the economy and financial system
crashing.
Considering all the imbalances impairing U.S. economic
growth, we are unable to see the sustained, strong
recovery. A closer look at the recent economic data [and
last Friday's jobs report] confirms this skepticism.
Possibly, if not probably, economic growth has already
peaked. For us, the question rather is when general
disappointment will gain the upper hand.
That, of course, is sure to soothe the bond market,
allowing moreover the Fed to maintain low interest rates.
But it will conjure up another, even greater risk at the
currency front. It will pull the rug out from under the
dollar.
In our view, the U.S. trade deficit is big enough to cause
a true tailspin of the dollar against all currencies. So
far, two things have prevented this threatening dollar
collapse: the gargantuan dollar purchases by Asian central
banks and the still rather positive perception around the
world of the U.S. economy. In our view, few people realize
its true weakness and vulnerability.
There is widespread hope that the falling dollar will go a
long way to lower the U.S. trade deficit. It takes a lot of
wishful thinking to believe that. Its persistent growth has
various reasons. One of them is that the gap between
exports and imports has simply become too big to be
reversible. Last year, exports amounted to $1,018.6 billion
and imports to $1,507.9 billion. Just to prevent a further
rise of the deficit, exports would have to rise 50% faster
than imports.
Principally, the trade flows of a country are exposed to
three major influences: first, relative prices and the
exchange rate; second, relative demand conditions; and
third, relative supply conditions.
Empirical experience suggests that exchange rate changes by
themselves have very little effect on trade flows. One
obvious reason is that Asian as well as European exporters
readily adjust their prices to maintain their market
shares.
For years, the United States has been top in the world with
its domestic demand growth propelled by the loosest
monetary policy in the world. For sure, lacking demand
growth in the rest of the world has played a role in
boosting the U.S. trade deficit. Yet what matters most for
the trade balance is not U.S. growth in relation to other
countries, but U.S. demand growth in relation to U.S.
capacity and capital-stock growth. In essence, such a
deficit indicates an equivalent excess of domestic spending
over domestic output.
More precisely, the U.S. trade deficit reflects gross
overspending on consumption on the demand side and a
grossly unbalanced investment structure on the supply side.
There was gross underinvestment in manufacturing versus
gross overinvestment in retail, finance and high-tech.
Our assumption is that there is no intention or will on the
American side to correct any of these maladjustments. Given
their enormous size, it is a Herculean task, too Herculean,
in fact, to be seriously addressed.
Principally, American policymakers and economists take only
two economic problems seriously: high rates of inflation;
and, in particular, slow growth and rising unemployment.
They could not care less about the dollar. The low
inflation rate is the excuse for more of the same extreme
monetary looseness.
There is quite a variety of accidents waiting to happen in
the markets, but the most predictable and biggest risk is a
dollar crisis. In addition to the gargantuan trade deficit,
looming in the background are existing foreign holdings of
dollar assets in the amount of $9 trillion.
As explained, the tremendous vulnerability of the U.S. bond
market due to its underlying heavy leveraging prohibits any
defense of the dollar through tightening.
Instead, the plunging dollar will pull the rug out from
under the bond and the stock markets.
Regards,
Kurt Richeb�cher
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 Richeb�cher wrong." A regular contributor to The
Wall Street Journal, Strategic Investment and several other
respected financial publications, Dr. Richeb�cher'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."
This essay was adapted from an article in the March edition
of:
The Richeb�cher Letter
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