-->Phantom Wealth
The Daily Reckoning
Paris, France
Tuesday, 1 April 2003
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*** The economy rests on 2x4s and mortgage brokers...refis
up 9,380%..
*** Horses pawing...Fannie and Ginnie reeling...
The best short money can buy...
*** War to cost $544 billion. Is it worth it? Apologize!?
The brains behind the war...or not...and more!
Stock prices, and the economy itself, are held up by 2 x
4s."It is a housing economy," say commentators...as if
such a thing could exist.
But it is not exactly the carpenters who keep stocks
trading at 40 times core earnings...nor do plumbers keep
consumers spending - even in the face of war, pestilence,
joblessness, bankruptcies and foreclosures. Instead, the
real work of trying to avoid a correction is done not by
those who build houses, but by those who finance them.
For every person who refinanced his home in 1990, there are
93.8 people who did so last year, reports James A. Bianco.
That is an increase in refi activity of 9,380%.
Consumers"took out" about $80 billion in"equity" from
their homes last year, which allowed them to continue
living in the manner to which they had become accustomed -
despite the fact they were losing their jobs and incomes,
while taxes and fuel costs were rising.
The Fed may cut rates again...and may bring about yet even
more refi activity...which may hold up the stock market and
the economy for a few more months. But sooner or later, the
bull market in refinancings must go the way of the Nasdaq.
Despite all the stimulating, the world's economies - with
the exception of China - seem to be slouching towards
recession.
Bank lending declined 25% from a year ago, reports the
Financial Times. European consumer confidence dropped to a
9-year low, says another report.
In America, the index of Chicago Purchasing Managers has
turned negative for the first time in 5 months. And a new
report from the Levy Institute tells us to beware of a long
"growth recession".
"During the 2001 recession," explains Mark Zandi in
Barron's,"we lost 2 million jobs...And last time we had
unprecedented economic stimulus that we can't...have
again."
We can't have it again because the Fed has already cut
rates 12 times. Maybe they could cut rates once or twice
more before hitting zero...but that is all. And without the
stimulus of householders continuing to borrow to live
beyond their means, what's left for the economy?
Doug McIntosh offers a guess:"We now see Fannie Mae and
Ginnie Mae, with hundreds of billions in sub-par mortgages,
are reeling like drunks. All that is left is a bankrupt
consumer using home equity loans. The actual value of the
homes is a fantasy as recent declines in home prices are
beginning to show. The last two legs sustaining the
economic illusion are now being hammered by high energy
prices, endless war, a savage job market and political
anarchy on our streets. So, all you optimists out there in
TV land...Once the American consumer stops spending, which
is now happening, and stops being able to use home equity
loans, what's left? I say the abyss, but then I'm a doomer.
I prefer to say I'm a student of history, a realist and a
shrewd judge of human character. The time of death is now
upon the planet Earth I call home. If the four horsemen
haven't been released, at least they are pawing the ground
at the starting gate. The days ahead will not be pleasant
to be sure. We may survive them or we may not. At least
it's going to be interesting."
Eric, you're not a doomer...what do you see?
-----------
Eric Fry in New York City...
- So far, war is proving to be somewhat less bullish that
advertised...for the stock market, that is. War is plenty
bullish for oil and gold and all the other sorts of assets
that investors seek when they're terrified of buying
stocks.
- The first 13 days of war have brought very little luck to
most investors. Yesterday, the Dow tumbled another 154
points to 7,992 and the Nasdaq dropped 2% to 1,341.
Meanwhile, gold, oil and bonds continued to power ahead.
The safe-haven metal gained $4.50 to $336.90 an ounce; oil
gushed 88 cents to $31.04 a barrel; and the 10-year
Treasury jumped three quarters of a point, pushing its
yield down to 3.82% from 3.90% last Friday.
- Given the considerable national angst that is resulting
from the Iraqi campaign, investor demand for safe-haven
investments is hardly surprising. But what is at least a
little surprising is that any investor could consider a 10-
year debt obligation from the U.S. government to be a"safe
haven". Is this not the same government that will borrow
about $300 billion this year, just to keep the lights on?
And isn't this the same government that will spend about
$100 billion waging war against Iraq, and maybe tens of
billions more to clean up the place afterwards?
- Last week, while on the air as guest host of CNNfn's
"Market Call," your co-editor dubbed the 10-year U.S.
Treasury note,"the single best short sale in any financial
market". Whatever the eventual military outcome of the
Iraqi conflict, the fiscal campaign back home is already a
resounding defeat. And yet, bond buyers somehow believe
that victory is theirs.
- Whether the military onslaught against Iraq leads to a
fast victory, slow victory or medium-paced victory, the
bond market is sure to become a prominent"collateral
victim" of the costly campaign. Strictly speaking, the $100
billion or so that it will cost to"liberate Iraq" is not
an unbearable burden. But that's just the tip of the
iceberg.
-"The burdens that follow - from occupation,
reconstruction, humanitarian aid and checkbook diplomacy -
could extend well into the coming decade," the New York
Times predicts."Taxpayers for Common Sense put the total
cost of the world's engagement with Iraq at $544 billion,
spread over 10 years."
- And then there are the substantial"hidden costs" - like
high-priced oil. William Nordhaus, a professor of economics
at Yale University, calculates that in a worst-case
scenario, rising oil prices cost as much as $391 billion
over 10 years. The Iraqi war will also speed a regime-
change in the bond markets from one of low and falling
interest rates to one of high and rising interest rates.
- How much the war in Iraq will ultimately coast - or, for
that matter, any of the future wars in the Middle East that
the Bush administration may have up its sleeve - is
anybody's guess."The start of war is like the break in a
pool game," says Jim Grant."Predictions are out the
window. Possibly, President Bush will not allow this
country to become overextended in places where the Founding
Fathers would not have expected to find U.S. troops on any
pretext. However, the presidential rhetoric is messianic -
a 'liberated' Iraq could 'show the power of freedom...by
bringing hope and progress into the lives of millions,' he
declared in a February 28 speech at the AEI - and the logic
of a preemptive foreign policy points to years of full
employment for U.S. forces abroad.
-"The Fed and the Defense Department have, in effect,
traded places," Grant continues."In the 1990s, the Fed
policy was preemptive and national security policy was
reactive. Now, it's the Fed that watches and waits, the
armed forces that move on a forecast (specifically, on the
forecast that Saddam Hussein had the United States in his
chemical, biological and nuclear sites and would squeeze
the trigger). We, too, have a forecast. It's that strategic
preemption combined with monetary-policy inertia will make
the 10-year note priced to yield 4% a dissatisfying
investment experience."
-----------
Bill Bonner...back in the Old World...with the old fuddy-
duddies in the Paris office...
***"So how's your little war going?...I was going to ask
them at the American embassy," said Sylvie with a
mischievous smile."You know, they were all so eager to
start the war...and now they all look kind of depressed. I
don't dare bring up the subject...But everywhere else, it's
all anyone talks about...It's true that you Americans are
not very quick to catch on to the subtle nuances of
language...and especially those at the embassy, where they
tend to be a little, well...dull. But even they would have
detected the ironic tone..."
Sylvie is our French teacher. Her only knowledge of war
comes from reading a thick Russian novel with war in the
title. Thus, she is less well qualified to comment on
military strategy than anyone, except perhaps for the
commander in chief, who didn't read the novel, but only the
Cliff Notes. [Here at the Daily Reckoning, we know no more
about war than Sylvie or George, except that for many
years, we waged a battle against the bottle; even there,
the best we could do was a draw.]
"All I know about the war is what I see on the evening
news, which is probably different from what you Americans
are watching. But I don't understand the strategy at all.
You say you are liberating the Iraqis and expected them to
throw rose petals in your path. Instead, they don't seem to
want to be liberated; they act as though they were
defending their country. And Saddam is now much more
popular throughout the whole Arab world than he ever was
before. He's putting up a fight. They must admire him for
that. And even if you kill him, he'll then be a martyr. And
his followers will attack you the way they now attack the
Israelis. What a mess! Wouldn't the smart thing to do be to
admit you were wrong? Bush could go on TV...announce that
he was withdrawing the troops...apologize...and the world
go back to its business.
"But, of course, that will never happen. It would have been
as if Napoleon had arrived on the steppes of Russia and
reconsidered. He might have simply said -"this is just not
worth the effort" - and returned to Paris. He probably
would have lived happily as Emperor for the rest of his
life. But there's a certain kind of madness that seems to
need to go all the way...
"I think you've gotten yourselves in a trap. You either
have to try to get into Baghdad and seize control...and who
knows what kind of fighting that might require? Or you are
going to surround the city and starve it out. But do you
think Saddam is going to quit when he sees his countrymen
starving? And what are you going to do if women and
children are dying...the people you said you were
liberating? Who's going to blink first?
"It's a trap, because you can't go forward or back down
without a big mess..."
*** From Patrick Buchanan:"'Bush Ideologues Reshape the
World Over Breakfast'
"So ran the front-page headline in the Financial Times. The
story described a 'victory celebration' at the American
Enterprise Institute the morning the Marines rolled into
Iraq.
"The AEI panelist-celebrants were Bill Kristol of the
Weekly Standard, Richard Perle of the Pentagon's Defense
Review Board and Michael Ledeen, author of"The Terror
Masters". Apparently, the boys were yukking it up over what
we were going to do to the French, Germans, Iranians,
Syrians and Untied Nations, after we polished off the
Iraqis.
"Kristol bewailed the failure of Bush's father to take
Baghdad. This resulted in a regrettable 'lack of awe' among
Arabs, said he. Perle joked that there were more anti-war
demonstrators in San Francisco than Iraqis willing to fight
for their country. Ledeen said France and Germany had
reached 'new lows of disgustingness' by 'shoring up
tyrannical regimes'. Then he went into his mantra about the
need for 'a longer war'.
"Kristol urged that we split Germany off from France but
noted that such 'intelligent diplomacy may be too much to
hope for from the State Department.' When Perle declared
that 'Americans are not vindictive,' Ledeen interrupted to
say that, in the case of France, he certainly hoped we
would be.
"What was it Burke said? Great empires and small minds go
ill together..."
---------------------
The Daily Reckoning PRESENTS: Since when, asks Kurt
Richebächer, do rising share prices constitute wealth
creation? The answer may surprise you...or not.
PHANTOM WEALTH
By Kurt Richebächer
Strikingly, the late great bubble of 1996-2000 in the U.S.
stock markets represents the first time since economic
thinking started that this kind of wealth creation -
through rising asset prices rather than through capital
formation - found overwhelming attraction and admiration.
The old economists never gave it any serious consideration.
They flatly discarded it as pseudo or phantom wealth.
What the rising asset values effectively create is a
corresponding rise in claims on the economy at the expense
of those who do not own such assets. But this is wealth
redistribution, not wealth creation. More importantly, this
kind of wealth creation involves no gain in current incomes
and productive capacity. To the extent that it actually
boosts consumption at the expense of investment and the
foreign trade balance, the net result from a macro
perspective is overall impoverishment.
For the first time ever in the history of economic
thinking, economists - that is, American economists - are
claiming that growing asset prices represent fully valid
wealth creation. In 1996, an article in Foreign Policy
entitled"Securities: The New Wealth Machine" effectively
explained that the financial markets have become the most
powerful generator of wealth.
Verbatim:"Historically, manufacturing, exporting, and
direct investment produced prosperity through income
creation. Wealth was created when a portion of income was
diverted from consumption into investment in buildings,
machinery and technological change. Societies accumulated
wealth slowly over generations. Now, many societies, and
indeed the entire world, have learned how to create wealth
directly. The new approach requires that a state find ways
to increase the market value of its stock of productive
assets. Several countries have successfully directed their
economic policies toward that goal, achieving and
sustaining faster growth rates than were once thought
possible..."
Nowadays, wealth is created when the managers of a business
enterprise give high priority to rewarding the shareholders
and bondholders...In such a strategy,"an economic policy
that aims to achieve growth by wealth creation therefore
does not attempt to increase the production of goods and
services, except as a secondary objective."
We wondered whether we should reprint such ridiculous
economics. We choose to do it because this economic
nonsense concisely reflects the confused thinking behind
the new equity culture that has spread from America to the
rest of the world. Economies exist for the securities
markets, say the new equity thinkers; the markets, not the
producers in the real economies, create the nation's
wealth. Besides, they say, the markets do this much more
efficiently by pleasing shareholders and nobody else.
There is one consideration, however, which makes the
transient and ephemeral character of wealth"creation"
through the markets poignantly clear - namely, the way it
is calculated. Trillions of dollars of new wealth simply
arise from the common practice of treating the value of the
whole outstanding stock of assets as if it could be
calculated based on the last stock trading price...which,
as a rule, is of marginal size. It is like printing wealth.
Indisputably, the new imperative to maximize shareholder
value induced profound changes in corporate strategies. For
better or worse, that is the question. Wall Street's
propaganda machine, greatly assisted by confirmation
through Mr. Greenspan, hammered into people's heads that in
America,"unprecedented technological advances in high-tech
technology and corporate governance had ushered in a New
Era in which businesses were making unprecedented gains in
productivity and profitability". Rapidly spreading belief
in this nonsense kindled fantastic profit expectations
that, in turn, helped kindle the steep rise in stock
prices.
Realizing that the traditional process of profit creation
through capital formation was much too tedious to satisfy
the new, grossly inflated profit expectations in the
market, corporations switched massively to new strategies
that seemed to promise much quicker and higher returns.
Thus, mergers, acquisitions, restructuring, downsizing,
outsourcing, cost-cutting, stock buybacks and creative
accounting became the main characteristics of the corporate
strategies to expand.
While the consensus has been trumpeting a profit miracle,
we have been protesting for years that this is impossible.
What led us to this opposite conclusion were simple,
compelling macroeconomic considerations. They say that
there is ultimately but one single way for businesses to
increase their profits in the aggregate, and that is by
mutually increasing their revenues through higher
investment spending. With this rule in mind, we realized
that all those new corporate strategies meant to boost
profit creation when taken together could only have the
opposite effect of depressing profits.
In fact, at the height of the boom, executives and firms
faced sharply falling profits, while the prices of their
shares, reflecting the inflated profit expectations, were
soaring. Most importantly, Mr. Greenspan eagerly supported
the stock market boom not only with absurdly euphoric
statements, but also with record-high money and credit
creation.
Confronted with tremendous pressure from the markets to
meet the grossly inflated profit expectations, the great
corporate account rigging developed for a straightforward
reason. It was the need and desire to cover up the
increasingly desperate corporate profits picture,
contrasting dramatically with the former high-riding
promises. Manifestly, the unfolding epidemic of accounting
frauds is not just bearing witness to an unprecedented high
level of greed. The far more important aspect is its deeper
cause: the horrible reality of Corporate America's worst
profit performance in the whole post-war period.
Measured as a share of GDP, profits today are at their
lowest level in the whole post-war period. During the last
year of the boom, in 2000, before-tax profits of
nonfinancial firms were equivalent to 4.3% of GDP. That was
down from 6% of GDP in 1997. This plunge of profits has to
be seen against the backdrop of 18% GDP growth during this
period.
More recently, profits are down further to 3% of GDP. What
has hammered the stock market is plainly not a lack of
confidence but collapsing profits.
Regards,
Kurt Richebächer
for the Daily Reckoning
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