OMINOUS PARALLELS
by Dr. Kurt Richebacher
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
Editor's note: Dr. Kurt Richebacher is the world's
foremost Austrian economist. His articles appear
regularly in The Wall Street Journal, Barron's, The
Fleet Street Letter and other respected financial
publications. France's Le Figaro magazine did a feature
story on him as 'the man who predicted the Asian
crisis.'
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