Delusion and Illusion

Delusion and Illusion

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

Ludwig von Mises, Human Action, A Treatise of Economics, Yale University Press, 1949

Contrary to the optimistic recovery forecasts, the U.S. economy remains as stubbornly soft as Wall Street analysts and the public remain stubbornly bullish. Their one great hope is that the consumer, animated by an endless rise in house prices, unlimited availability of credit and new tax cuts, will continue to spend beyond his current income until strong business investment kicks in. Though too much debt is obviously one of the U.S. economy's main problems, policymakers and economists plead for more and more debt to prevent the economy from slipping into the inevitable abyss.

While policymakers and economists in Europe and Asia communicate honestly to their public and the markets that their economies are in trouble, American policymakers and economists remain in flat denial of the great troubles in their own economy. We guess that this has two main reasons. The one is a general poor understanding of the structural micro and macro impediments to economic and financial revival; and the other one is general great faith in the efficacy of monetary and fiscal stimulus to produce desired economic growth. It happens that the rest of the world does not share such faith.

Indeed, never before have policymakers endeavored so frantically to instill confidence into hearts and money into pockets. Continuous record growth in money and credit, the 13th rate cut by the Fed, the third big Bush tax cut, continuous records in mortgage refinancing and a falling dollar are definitely adding up to the greatest economic and financial stimulus that the world has ever seen.

By the way, persistent disappointment with the economic effects of Keynesian deficit spending led governments and economists to write it off many years ago as an instrument to resurrect economic growth. Yet hopes are riding high again that the new fiscal stimulus will not fail to spark a strong economic recovery in the United States.

Assessing the U.S. economy's prospects, the first thing to realize is that its recent growth has been considerably weaker than expected and generally trumpeted. Though the second half of the year has commenced, the hard economic data so far are not showing any meaningful acceleration in economic activity, neither in consumer spending nor in business capital investment.

In other words, the stock market's run-up during the last few months has its one and only source inoptimistic forecasts and expectations of what the U.S. economy will do in the second half of this year inresponse to the new monetary and fiscal stimulus.

Is the new package of demand stimulus really of such overwhelming size to justify the rampant optimism in the markets? In our view, it pales in comparison to what has already happened in monetary and fiscal policy. Instead of 12 earlier interest rate cuts totaling 5.5 percentage points, there has been just one of .25%. Why should this 13th cut in a row be the magic that finally lights the fire under the economy?

Or take the new fiscal stimulus. According to the latest official estimates, the federal deficit will rise to $455 billion this year, up from $257 billion last year. Most probably, it will be much higher. But the thing to see is that in the last few years the Bush administration has presided over the most abrupt and rapid turnaround in federal finances for decades. The reversal from a $295.9 billion surplus in 2000 into a $257.5 billion deficit in 2002, equal to more than 5% of GDP, represents the biggest fiscal stimulus in the whole postwar period. Even if the 2003 deficit runs up to $500 billion and higher, as we assume, the additional fiscal stimulus will be hardly higher than in the past few years.

What many people flatly ignore in the U.S. case is that it has needed outrageously large injections of new money and credit just for lackluster economic growth that plainly fails to develop self-sustaining thrust. In 2002, total credit growth of $2.3 trillion compared with nominal GDP growth of $375.3 billion. In the end, somebody will have to service these debts.

THE GREATEST POLICY FAILURE

Apparently Fed Chairman Alan Greenspan is still enjoying great admiration for having successfully avoided a longer and deeper recession. We see, instead, a preposterous and frightening discrepancy between most prodigious monetary and fiscal measures to stimulate the economy and their extremely poor effects on the economy. Consider that consumer borrowing surged last year by $768 billion on top of an increase in disposable income -- bolstered by tax cuts -- of $422.3 billion. And what happened to consumer spending? It increased by $316.7 billion in nominal terms and by $198.8 billion in real terms.

In the first quarter of 2003, additional consumer borrowing by $849 billion compared with additional consumer spending of $315 billion, both numbers at annual rate. Business borrowing increased by $263.4 billion, while business fixed investment fell by $60 billion, both numbers also at annual rate.

Plainly, monetary and fiscal policies in the United States have been of an earned generosity that is unprecedented in history. All inhibitions that formerly used to set some limits to their implementation have been swept away. But looking for its effects, we note an extremely unbalanced result.

Record-sized monetary and fiscal stimulus in conjunction with permanent bullish oratory were highly successful in two ways: first, in creating false optimism among consumers and stock investors; and second, in stoking ever-more aggressive and extensive financial speculation. Actually, it created new, unsustainable excesses. But it has completely failed in its most important task and objective -- that is, in sparking a rebound in business fixed investment. Insider selling of stock, actually, remains at record-high levels.

Historically, periods of recession and slow economic growth have been times in which consumers and businesses retrench, forced by tight money and credit imposed by central banks. The fact that the present global economic downturn started and developed in the face of generally very loose money invariably suggests that it must have other causes than usual.

This economic downturn differs from all its precedents in the postwar period in that it is globally synchronized. Insofar, all countries are in the same boat. But American policymakers stand out as the ones who responded to the economic downturn with unparalleled and unprecedented activism, in particular in monetary policy.

Obviously keen to prevent any painful retrenchment, Mr. Greenspan opened the money spigots wider than ever before in history. His success in preventing a sharper slowdown in consumer spending is obvious. By slashing the Fed's short-term rate with unusual speed far below prevailing long-term rates and announcing his intention to keep it there, he established a very steep yield curve that cried for a massive, heavily leveraged carry trade in bonds. Given America's grossly oversized financial system, it quickly turned into a bond bubble of astronomic size.

With the prolonged persistence of the steep yield curve and his promise to be slow in raising the federal funds rate, he became, intentionally or not, the great creator of three interrelated new bubbles -- in Treasuries and corporate bonds, in house prices and in mortgage refinancing, in combination enabling the consumer to maintain his borrowing and spending excesses. Steven Roach of Morgan Stanley called him a "serial bubble blower."

We keep reading that economic news has lately improved. Nonsense. Looking at economic data, we distinguish between two different kinds: hard data, directly related to economic activity, such as figures for production and new orders, and artificial data that are derived from indexes and surveys, widely regarded as early indicators. Any apparent improvements have been exclusively in these heavily opinion-laden indexes that we regard as rubbish.

Ultimately, all questions about a sufficiently robust U.S. economic rebound boil down to one single question: whether this will jump-start business fixed investment. Consumer spending, bolstered by the house-price and bond bubble, has so far prevented the economy's relapse into recession, but it completely lacks the necessary thrust for a sustained and self-reinforcing recovery.

Putting it briefly and bluntly, the U.S. economy's recovery will be investment-led or it will be a non-starter.This letter scrutinizes this problem and gives an answer that we regard as compelling.

BADLY FLAWED COMPARISONS

The whole world economy is in trouble. Yet there are major and minor differences between countries. American policymakers and economists like to boast that the U.S. economy's growth, though also pretty weak, compares very favorably with that of most other countries, the euro zone and Japan in particular.

The most popular measure of the U.S. economy's superior growth performance is its persistently higher real GDP growth rates, measured in chained dollars. Ironically or oddly, all statistical tables containing chained dollars published by the Bureau of Economic Analysis carry a plainly visible note: Caution on theuse of chained-dollar NIPA estimates. We have always taken this advice to heart.

For many years we have emphasized that America's real GDP numbers, compared to those of other countries, are heavily tilted to the upside through repeated downward revisions in the price indexes. Obsessed with the idea that inflation rates are overstated, American policymakers, Mr. Greenspan in particular, have exerted heavy pressure on the government's statisticians to produce lower ones. They did.

As he attested in a congressional testimony on June 10, 1998, Mr. Greenspan had still another specific reason for wanting lower inflation rates: "The essential precondition for the emergence and persistence of thisvirtuous circle is arguably the decline in the rate of inflation to near price stability" -- which, by way of allowing lower interest rates, provides the precondition for a stock market boom.

The last and most ambitious revision of the consumer price index (CPI) occurred in 1998. According to official estimates, it reduced the index by two-thirds of a percentage point. But including earlier changes, the adjustments have been well over one percentage point.

The official explanation and motivation of the adjustments was the declared intention to capture an existing quality bias and a substitution bias. The quality bias refers to quality improvements in the items that the consumer purchases, being translated into price reductions. The substitution bias tries to capture the reaction of the consumer to price increases by switching his purchases from a more expensive product to a cheaper product. For example, if the cost of beef goes up, the consumer buys less expensive chicken.

In the view of American statisticians, they have developed a greatly improved dynamic price index, in contrast to the former stupid, static price index. For sure, the new dynamic measuring offers enormous flexibility.

Not included in this most recent revision of the CPI are the substantial GDP growth effects that have in the past few years arisen from the application of hedonic pricing for business spending on computers, capturing increases in computational power (MIPS) or memory storage (BITS), and dating already from 1986.

In the nominal GDP account, measuring all expenditures in current dollars, this item of business spending edged up from $64.6 billion to $76.3 billion between 1995 and 2003. However, in the real dollar accounts -- which is the GDP data that everybody focuses on -- the application of the hedonic deflator transformed this minimal increase of just $11.7 billion into one of more than 20 times that amount: $269.9 billion, rising from $49.2 billion to $319.1 billion. Actually, this was the main part of the phony investment boom.