What could tilt the Applecart and put us in a Depression?
Looking towards the future with a cloudy crystal ball.
Bush has been President for almost six months. Yet the Democrats have stopped the confirmation of the largest number of the President's nominees of any administration in history. So in effect, the government is being run by the Clinton left-overs and the Bush team is still waiting on the sidelines. The defection of Senator Jeffords has played a significant role in slowing down the confirmation process as well as handing control of the Senate to the Democrats.
During the past six months, Bush has been very reluctant to overturn any of the policies and executive orders promulgated during the last 30 days of the Clinton Administration. To this observer, the role of government has hardly changed at all . . . it is still way too large, too intrusive, and the bureaucracy continues along its merry way.
Drifting aimlessly on the road to disaster.
From my perspective, the country is drifting towards disaster. The Federal Reserve has cut rates six times since December and the economy is still going downhill. The reported statistics are all suspect and for the last several quarters, all revisions have been negative. One must wonder whether the initial reports are being made for public relations value rather than accuracy. GDP growth for the 2nd Qtr was supposedly 0.7%, the lowest level in eight years. But the first quarters GDP numbers were revised downward from 2.2% to 1.3% over a 30 day period. The use of hedonic assumptions makes all the government numbers truly unfathomable.
The productivity, unemployment and inflation numbers are particularly suspect. About the only number that seems to accurately reflect the real employment market is the large decline in the number of lines of classified employment advertising. So where are all the new jobs coming from?
In 1964, I was involved in a debate in which several of my HBS classmates who were in Washington, D.C. thought that the government could control the economy. We had serious disagreements as to whether centralized planning was the way to go. I pointed out then and do so again today that the record for prosperity in nations is directly correlated to the amount of freedom the population has. More government control generally means lower prosperity. Unfortunately, since 1964, I have not gained many converts except among those HBS classmates who now have become a little older and wiser.
Possible bumps in the road to recovery.
Perhaps, it might be useful to identify some of the areas that might tilt the public's confidence against a recovery. Certainly, the economy during the past six months has been held up by only one thing . . . consumer spending and it has been largely financed by the increased growth in M3 to record levels. The consumer is spending more than they are making as savings are negative, the percentage of equity ownership in housing is down as refinancing have ballooned so that consumers can continue to spend. If residential real estate levels start to fall and more layoffs continue, increases in mortgage and consumer debt delinquencies including foreclosures are sure to confront the financial markets.
Some areas of concern are:
Employment - Unemployment could easily send consumer spending into a tailspin. The number of companies announcing layoffs continues to increase and the people being laid-off are in the middle management and professional ranks. The current round of layoffs does not bode well for continued consumer spending levels. Moreover, there seems to be a disproportionate share of employees over 40 being laid off. The number of age discrimination suits that are being filed grows every day.
Consumer Spending - The only segment of consumer spending that was positive in June was automobiles which were helped by the large incentives provided by the manufacturers. Yet, auto inventories are growing. Auto leasing charge backs on car and truck leases, particularly SUV's, will cost J. P. Morgan and Bank of America at least $1 billion in losses each. Many major banks are leaving the auto leasing business. Losses to other lenders will be equally as bad. If leasing becomes more expensive and difficult, one has to wonder about the profits of the automobile companies and their suppliers in the near future. Same store sales of most department stores showed no growth during June and many were down. Many national chains are closing under-performing stores and cutting back hours in a desperate attempt to regain control of their bottom line. One of the major benefits of the recent oil company mergers was the closing of the number of retail gasoline locations. The Consumer Confidence Index for July fell to 116.5 from 118.9, a major drop as spending rose 0.4%.
Consumer credit problems - Since 1991, average household credit card debt has nearly tripled to $700 billion. Credit card, mortgage and car loan debt stood at $7.2 trillion as of the end of the first quarter. The average household owed $8,132 on credit cards last year, up from $3,233 in 1991. Bad loans, delinquent by 180 days and late loans of 30 days, jumped 21% and 16% respectively in June over a year ago. Customer debt is up 13% in just the past three months. The picture is ominous if employment continues headed south.
Tax Rebates - The boost to the economy from the tax rebate scheme could easily backfire if consumers decide to pay down their all-time high debt levels rather than increase their personal spending levels.
Statement Shock - Many 401(k) and mutual fund holders are getting their quarterly statements and discovering to their dismay that they have lost 20 - 25% of their asset values since the first of the year. Inflows to mutual funds are slowing and many funds have instituted policies preventing immediate redemption of their funds. Also, many funds are instituting fees on the smaller investor and/or mutual fund holder if their portfolio falls below a certain value. Another good case of the greedy Wall Street crowd socking it to the small investor again.
Profits - While the 2nd quarter corporate earnings reports are behind us, the US averages have not reflected the serious nature of the downturn. P/E ratios for the DJIA, NASDAQ and S&P 500 have all risen during the last 90 days and continue to hold near the all-time highs. In fact, the combined earnings for the 100 largest NASDAQ companies during the past 12 months is negative. Many Wall Street guru's as well as government spokesman continue to pontificate that the bottom has been reached but based upon the fundamentals in inventories, purchasing outlooks, and factory utilization, one has to be quite an optimist with rose-colored glasses to swallow that line.
Construction and Housing - Commercial construction has been reduced and many projects placed on hold. The vacancy rate for commercial and industrial buildings is growing throughout the nation and lease rates are falling. Sales of pre-owned homes are slowing and prices are under pressure. The only bright spot is the sale of new homes which are often financed to the maximum. During the 2nd quarter of 2001, 72.3 million, or 68%, of American families owned their own homes. The big gains occurred among minorities as they hit 48.8%, the result of the no down-payment program. However, the rate of delinquencies is soaring in these no down-payment programs and the number of foreclosures is rising to record heights.
Interest Rates & Mortgages- Greenspan may well cut interest rates once again in August. However, the economy is still headed downhill despite the massive monetary infusion into the banking system. The FED is still shoveling money and credit into the monetary system. In the six months ended June, M3 increased 23.7%. The recipients were the stock and bond markets and housing, that is Fannie Mae and Freddie Mac. Refinancing loans totaled $494 billion during the first six months of 2001. All those no-down loans have pushed household debt to 272% of GDP up from 150% in 1974. At the end of 2002 2.73% of sub prime loans were delinquent by 90 days or more or 10 times the rate of conventional loans. 13% of mortgages written last year were sub prime. Any further slowing of the economy could be disastrous in this area. Whether the domestic and foreign holders of American currency continue to believe in the Fed's monetary policies could have a major impact on the value of the"fiat dollar" in the near future.
NAFTA & Free Trade - NAFTA and Free Trade policies have decimated our manufacturing base. Our ability to secure our borders and make many of our military items is suspect. Bush's call for amnesty for illegal immigrants could seriously upset the body politic. One analyst has suggested that over 10 - 15 million Mexicans might apply for amnesty or rush to the border to take advantage of it.
Dollar Strength - The dollar's strength cuts two ways. A strong dollar continues the net capital inflows to the U.S. which have largely enabled the country to continue to finance its recent growth. The trade deficit continues at the $30 billion per month level. The U.S. is the world's largest debtor nation and if confidence in the dollar erodes, the piper will have to be paid. A lower dollar might increase exports particularly of agricultural products. However, for many American made products except military items and Boeing airplanes, they are simply not competitive in the world market place at any price.
Gold Manipulation - The price of gold has been manipulated by central governments and the gold bullion banks for many years. The U.S. Treasury recently reclassified its gold holdings but refuses to provide a definition for the reclassifications. If "Deep Storage Gold" means gold that has not been mined but is owned under a forward contract, the U.S. government has sold its gold stock, yet wants us to believe otherwise. If you or I reported our assets like this, we'd be looking at a long stretch in the pen. As a result, Reg Howe's lawsuit in the US Federal Court in Boston against the gold cartel, if permitted to go forward, could lay bare the manipulation and fraud perpetrated by the U.S. Treasury, the Federal Reserve, the Exchange Stabilization Fund and the gold bullion banks. It is estimated that between 10,000 and 15,000 tons of gold have been diverted in the market from various government reserves to drive the price down. If gold were to rise to the $325 per oz. level from the current $265 level, the derivative losses to the financial system could reach the trillions world-wide.
GSE Exposures - Freddie Mac, Sallie Mae or Fannie Mae could finally get into trouble as loan delinquencies continue to increase. Personal bankruptcies will continue to increase as layoffs continue. The bailout of these GSE's could make the savings and loan crisis seem like a pebble in the ocean. These GSE's are making the terrible choice of borrowing funds short to lend long . . . history has proven that it is always a quick way to disaster. It is interesting to note that the Chinese government has purchased $30 billion of Freddie Mac and Fannie Mae bonds in the 12 months ending in April. Guess that is where the trade deficit funds have gone. That was more than was purchased by US banks and nearly three times as much as was bought by US insurance companies.
Fiat Money - If confidence in the dollar wanes, a massive outflow of funds from the U.S. could occur. The Saudi's are already talking about pricing oil after 2002 in the Euro. Former advocates of the strong dollar policy, e.g., Robert Hormats and William Dudley of Goldman, Sachs have hinted that the value of the dollar is too high but admit they don't know of a way to bring it down without massive problems for the financial system. The Euro will be backed by at least 15% in gold and perhaps as much as 25%. Compare that to our greenback's "full faith and credit" - - - which would you rather have? The Federal Reserve has indicated that over 50% of its greenbacks are now held by foreign interests, either government, corporate, or private citizens. Since 1947, the American greenback has been the currency of choice for the world's transactions. Ron Linam once said, "The rest of the world is stupid. They send us their hard goods and only get paper back for it. And maybe the only thing that the paper will be worth at some future point is as toilet paper. What a world we live in!" Don't you find it interesting that Russia is now issuing a gold coin in order to remove some $100 billion from its economy. Apparently, the Russian's expect a dollar devaluation soon. That is borne out by the massive accumulation of gold by a syndicate composed of Russians, Indians, Chinese, Arabs and the Rothschild interests led by George Soros.
Bond Market - Issuance of corporate bonds slowed from $89 to $80 billion a month over the past six months. The largest purchasers are foreign investors. The Treasury Department estimates that net purchases of US government and private securities have been running at record levels in recent months and totaled $469 billion for the 12 months ended April. European investors purchased $150 billion in US corporate bonds in the 12 months through April, a record. Asian investors bought $74 billion in debt issued by Fannie and Freddie and other GSE's, government sponsored enterprises, during the same period or four times what they purchased in 1999. A major portion of the net capital inflows is from Asia. Imports from the Pacific Rim will be the most affected by the US slowdown. To assist their own economies, the Pacific Rim countries will need to bring a portion of this money back home. The reparation of these funds will have a negative effect upon the U.S. financial system.
Japanese Economy - The Japanese economy is still in the doldrums. However, the Japanese have over $1 trillion or 20% of the outstanding debt of the U.S. in assets. If they decide to cash these bonds in, or fail to roll them over, the U.S. financial system will be in trouble. Eight of the twelve largest banks in the world are also located in Japan. One recent study indicated that uncollectible loans of these eight banks amounted to over 20% of their total assets, or were almost five times their total net worth including reserves. When I took accounting, we would classify those numbers as being "insolvent or bankrupt." But then, I guess when you are looking at the collapse of the world's financial system, you stretch the truth.
Production Capacity - Capacity ulitization is running at about 77%, the lowest since 1983. US industrial production has fallen for nine straight months. Does anyone seriously expect that capital spending will lead us into a economic boom in the near future short of a major buildup in defense and infrastructure spending? The Chicago Purchasing Managers Index for July fell to 38.0 from 44.4 in June, a major drop. The collapse of the fiber network business and the telecom sector has left many companies either seriously weakened or in bankruptcy. Production of computer chips is way down and inventories still have not gone down. Several chipmakers have sent their workers on unpaid holiday leave. What will happen to the investor psyche if Lucent, Xerox, and one or two other major companies declare bankruptcy with a few weeks time. I don't think it will be positive. The NAPM Manufacturing Index fell 43.6 in July from 44.7 in June. New Orders Index dropped to 46.3 from 48.6. I doubt if we have seen the bottom.
Derivatives - Then we have the bubbles in the derivative market. J.P. Morgan Chase is rumored to have a $700 billion exposure in the derivatives market . . . significantly more than their net worth. Other money center banks are also at risk. Banks are also selling off portions of their loan portfolios to mutual funds which places the risk on the unsuspecting mutual fund shareholder.
Foreign Currency Problems - Argentina has become the last nation confronted by a debt crisis. The country is in a three-year recession and is on the verge of a major social upheaval and possible revolution. If default arrives bondholders could lose as much as 35% of bond values. $7.7 billion in debt comes due in the next six months. Overnight government paper brings 37%. Argentineans are paying 50% monthly rates on their credit cards, consequently few are using them. That is 600% compounded on a yearly basis. The IMF is again being beseeched to send money. Unfortunately, almost every country that the IMF has supposedly helped is today worse off than before it got involved. So far this year we have seen problems in Turkey, Pakistan, Brazil, Columbia and now Argentina. I wonder how many holes in the dike there remain before the whole financial structure washes away.
The Surplus is shrinking - Plunging tax receipts and the tax rebate will produce the biggest reversal ever in the Treasury's quarterly budget-funding projections. The Treasury expects to borrow $51 billion for the quarter ending September 30th. They have to pay down $57 billion in debt incurred in the previous quarter. That is a $108 billion swing. The government predicted surplus would not be $250 billion. It will be more like $150-$160 billion. Also, many state governments are faced with a significant downturn in tax revenue. In Tennessee and North Carolina, attempts at increasing state taxes are met by citizens almost ready to revolt. The Magna Carat was forced upon the King when he dared increase the governments tax to about 20%. One can only wonder how those knights and lords of old would react to today's 50-55% rates.
Possible explosions - The Middle East, Balkans, Columbia, Peru, the Phillipines and the Indian sub-continent all continue to boil. NATO is becoming a paper tiger as the Europeans are pushing for a unified European army. The U.N. is using the US armed forces are "policeman" thus, seriously eroding their skills as fighting troops. One wonders when and where the next shooting war will involve US troops.
Should I go on. It has been a long time since I have seen so many potential negative factors on the economic windshield. There are way too many possible triggers that might send the economy into a major recession or possibly a depression. Hopefully, I will be proved wrong but the many tea leaves suggest that trouble is brewing.
But then - 'Tis Only My Opinion!
Fred Richards
August 2001
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