Pompous Claims V. Poor Reality / The Daily Reckoning

verfasst von - ELLI -, 04.12.2002, 23:15

-->Pompous Claims V. Poor Reality

The Daily Reckoning

Paris, France

Wednesday, 4 December 2002

--------------------

*** Deflation menaces the world...but not us!

*** Stocks down 2 days in a row...do we see a trend?

*** Are JPM's gold derivatives a big problem? A problem? Or
not a problem at all? The decline of America...a bear
market until 2018...and more!

--------------------

"Deflation menaces the planet" says a headline in the
French financial magazine, L'Expansion.

Your editor had picked up the magazine to read the cover
story,"How America Aims to Control the World," and got
distracted.

"More than half the world is in deflation," the article
explains."Five of the world's seven biggest economies,
those that produce more than $1 trillion per year in
output, are experiencing a decline in producer prices: the
U.S., Japan, Britain, Germany, France and China. In the two
Asian giants - China and Japan - consumer prices are
falling too. Global stock markets are falling too. They're
down 20% over the last year, 45% since the spring of 2000.
Only property prices have managed to resist the trend."

This is pretty exciting, don't you think? Something big is
happening...and people don't know what it is, do they? We
don't know either, but we have a few ideas.

The world as we have known it ends not with a bang, but
with a whimper, we believe...about which, more below.

"Production is increasing worldwide at hardly 1% annually,"
continues L'Expansion.

Curiously, while producer prices collapse, the raw
materials the producers use have risen 20% in the last 6
months. How come? Well, partly because China is buying so
much of them. It takes raw materials in order to make
finished goods. China buys resources - thus driving up
prices - and produces immense quantities of finished goods
- which drives down producer prices. Year over year,
Chinese industrial output has risen at an astonishing 13.8%
rate.

A barrel of oil is up about 50% in the last year, while
Chinese-made garden tractors, toaster ovens and office
supplies have fallen in price. Thanks to globalization,
about which, more below too, these cheap Chinese goods
force down prices on domestic manufacturers also - down
1.9% in the U.S., 0.2% in France and 0.9% in Japan over the
last year.

For many people, deflation really is a menace. People
borrowed heavily during the boom years. In the middle of
this year, business debt passed a milestone - more than $7
trillion, almost twice what it was 10 years ago. Are U.S.
businesses so much more profitable today that twice the
debt of a decade ago will be no problem? Alas, no. Profits
for U.S. corporations peaked out in 1997; they are scarcely
higher today than they were in 1993.

And individuals? They, too, have much more debt than they
did 10 years ago. And they, too, have no more income with
which to pay it; at least on the crowded lower steps of the
economic staircase, incomes haven't budged.

Businesses and consumers will have a hard time staying
afloat in deflation; many will sink as they struggle
against it.

But here at the Daily Reckoning, we always look on the
bright side of things. No one would lend us money during
the boom years, so we're free from debt during the bust.
Unburdened by responsibility, we welcome deflation as a 10-
year-old welcomes a blizzard; instead of going to school,
we'll go outside and throw snow balls at tottering old
people.

As we have been saying, we're a little suspicious of all
this 'getting and spending' anyway, and wonder if the world
wouldn't be a better place if people took a break from it
once in a while. If we're right, we'll soon find
out...people may get a holiday, whether they're ready for
it or not.

Over to you, Eric...with your report from the world capital
of Getting and Spending...

-----------

Eric Fry in New York...

- Day two of the"pause that refreshes" on Wall Street
featured the Dow Jones Industrial Average falling 120
points to 8,742 and the Nasdaq dropping 2 1/2% to 1,449.
Gold, the ultimate anti-stock, responded to the stock
market weakness by climbing $2.70 to $321.20.

- Isn't it funny how quickly gloom has turned into boom?
The two-month stock market rally seems to have restored an
air of"normalcy" to life in the U.S. Maybe we shouldn't
judge an economy by its cover, but from all outward
appearances, the U.S. economy seems healthy - almost boom-
like. Consumers are spending a bit of money (at Wal-Mart
anyway), businesses are making a dollar here and there and
the commuter train I ride to Manhattan is as packed as
ever.

- While happy to see signs of economic vitality, we
disbelieve them. That said, we have greater confidence in
the recuperative powers of the U.S. economy than we do in
the"strength" of the overvalued U.S. stock market. Stocks
are, quite simply, too expensive, and seem to be
discounting not only the upcoming, hoped-for recovery, but
also many future recoveries.

- Curiously, and somewhat ominously, the U.S. dollar has
failed to"catch a thermal" from the steeply ascending
stock market. The dollar's feeble action is no great
surprise to Jim Grant, editor of Grant's Interest Rate
Observer. He considers the dollar a doomed currency, at
least relative to the world's oldest money: gold.

-"Your editor trusts in the capacity of sovereign
governments to bring about the depreciation of the money
they sponsor," Grant writes."Governments have few enough
fields of competence...Governments can still do to money
what they have usually been able to do to it, starting with
the first clipped coins."

- Therefore, says Grant,"We prefer the euro for vacations
in France, the yen for trips to Tokyo and the Swissie for
idylls by Lake Geneva without the children. However, as a
store of value, we favor none of the above. Our best idea
is to hedge one's dollars with gold or the shares of the
companies that own and produce it..."

- Speaking of gold, Bob Moriarty from 321gold.com, an
erstwhile Daily Reckoning reader, took issue with my recent
comments about JP Morgan's gold-derivatives exposure.
"JPM has problems and they are real," Mr. Moriarty writes.
"[Morgan's] $26-trillion-dollar derivatives book is simply
beyond understanding the level of risk they have assumed.
But you didn't write about that. Instead you wrote about a
gold derivatives 'RUMOR' which is pure nonsense. Writing
about a 'RUMOR'...is totally irresponsible, you are
shouting fire in a crowded theatre when a simple question
or two in advance might show you the rumor couldn't be
true.

-"OK, let's look at the rumor: Total derivatives in the
world, $128 trillion dollars: big problem. Total
derivatives at JPM, $26 trillion dollars: big problem.
Total gold derivatives in the world, $289 billion dollars:
small problem. Total gold derivatives at JPM, $45 billion
dollars: small problem. Net gold derivatives in the world,
$28 billion dollars: no problem."

- In general, I agreed with his remarks. That's why, when I
"irresponsibly" mentioned the rumor in the Daily Reckoning,
I wrote:"Perhaps Morgan's outsized gold derivatives
exposure is not a MAJOR accident waiting to happen, but we
wouldn't be surprised to see the high-risk bank stub its
toe...at least."

- However, since I didn't completely agree with Mr.
Moriarty, I gave him a call. During our cordial, 10-minute
conversation, we agreed about most things. But the one
stubborn item of contention was mostly a semantic one. He
insisted that JPM's gold derivatives book was"no problem."
I said,"Well, I wouldn't go that far. Don't you think it
COULD be a problem? I don't think that either one of us can
say anything definitive about Morgan's gold derivatives. We
simply don't have the requisite information."

- Warming to the topic, I continued:"Don't you think it's
possible that a rapid $100 dollar gold rally could catch
Morgan's trading desk wrong-footed, and end up costing the
bank $1 billion or so?...A $1 billion wouldn't be fatal,
but neither would it be no problem."

- He grudgingly conceded that - theoretically anyway -
Morgan could lose some money on its gold derivatives. But
here in the real world, he insisted to the end,"They are
no problem whatsoever."

-"I think you owe your readers an apology," our friend
wrote in his original email."I'm convinced JPM's
derivatives book will bury them. But I'm damned sure isn't
going to be because of any gold derivatives problem."

- Sorry readers, no apology is forthcoming. I am neither
convinced that JPM will perish under a mountain of
derivatives, as the reader asserts, nor am I convinced that
the bank's gold derivatives book is"no problem."

- Rather, I am convinced that the world's growing stockpile
of derivatives - concentrated as they are in the hands of a
few large banks - is a potentially destabilizing influence
in the world's financial markets. Investors should be
vigilant for adverse outcomes, nothing more and nothing
less.

------------

Back in Paris...

*** We've been betting that the developed economies would
slow down. First, because that's what economies do after a
period of feverish activity. And second, because that's
what people do when they get older. Populations of all the
developed countries are getting older. Would it be any
surprise if they began to act like old people?

And now comes a report from my old friend, Mark Hulbert,
writing in the New York Times:

"A new study of American demographic patterns and the stock
market predicts that while the market may rally
periodically, its overall direction will be downward until
around 2018."

The three professors who did the study"report that their
model has done a good job of explaining the bull and bear
markets of the last century. But its accuracy as a
forecasting tool is untested," Hulbert continues.

The professors' insight was no different from ours, but
they applied it to the stock market rather than to broader
economic trends. When the proportion of old people to young
people increases, stocks go down, they say.

"Younger adults, from 20 to 39, are generally consumers,"
Hulbert explains."Middle-aged people, 40 to 59, tend to
invest in stocks. Retirees are more likely to sell stocks
than buy them. Market performance is strongly affected by
the relative numbers of people in each of these three life
stages..."

During the '90s, America had a very high proportion of
people in middle age - just as Japan did during the '80s.
But now, the oldest baby boomers are getting close to
retirement age.

"That trend is reversing, according to the model," Hulbert
continues,"which predicts a long decline caused by sales
by baby boomers, as they approach retirement, outweighing
purchases by the smaller group entering middle age."

*** There's no smarter man than the one who throws our own
discarded ideas back at us. By that measure, French
historian Emmanuel Todd is a genius.

We wondered why American conservatives during the Reagan
years were so eager to eliminate communism from the face of
the earth. After all, the doctrine was not only
entertaining...it had taken half the world out of
competition with American industries, and enfeebled nations
which otherwise might have been vigorous opponents. Russia
was growing as quickly as the U.S. at the beginning of the
20th century. Had it not been for Bolshevism, it might be
equal in power and wealth to the U.S. today. And suppose
China had developed at today's rates for the last 50 years?
It would far surpass the U.S. by almost every measure.

The fall of the Berlin Wall - and the end of communism -
was hailed as a triumph for America. But it also marked the
beginning of America's decline. For the first time in
nearly a century, the U.S. would have to compete with
Russia and China.

"That is the great paradox," says Todd, interviewed by
L'Expansion,"the victory of American ideas of free trade
and globalization [following the collapse of communism] are
weakening the U.S. economy. America now confronts the
inexorable reduction of her own strength relative to the
rest of the world. The major effect of globalization has
been to solidify Europe and organize Asia..."

Natural resources now come from Russia...finished products
from China. America cannot produce raw materials as cheaply
as Russia, nor can it produce finished products as cheaply
as China. For the moment, it relies on the kindness of
strangers to cover the difference between what it spends
and what it earns. Sooner or later, says Todd, the
strangers won't be so accomodating.

*** More on the pomposity of Reaganites below...

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---------------------

The Daily Reckoning PRESENTS: Pompous claims of the
superiority of the U.S. economy throughout the 90s,
contends Kurt Richebächer, contrast grotesquely with the
miserable economic reality. Haven't we seen this picture
before? Why, of course, we have: the Reagan years.


POMPOUS CLAIMS V. POOR REALITY
By Kurt Richebächer

Considering the horrible backdrop of accounting scandals,
crashing stock prices, plunging profits, a yawning budget
deficit and even an unprecedented negative interest-rate
differential against the euro, the dollar has certainly
been performing astoundingly well. Yet let's not overlook
that against the euro, it is down almost 20%.

Inertia of exchange rate expectations is a familiar
experience. Basic to the dollar's relative strength is
obviously a general perception that the U.S. economy will
continue to outperform the economies in Europe and Asia.

Somehow in the past few years a perception has taken hold
in the currency markets that exchange rates are mainly
determined by differences in economic growth. There have,
indeed, been striking examples of this kind, but more often
it has not been vindicated. All the lessons of history say
that in the long run, it is the state of the balance of
payments that determines the strength of a currency.

Recent 90s history in the U.S. is reminiscent of the 1980s
'Reagan' era. Then, too, the dollar astounded the world by
soaring against the European currencies in flat defiance of
an exploding U.S. trade deficit. It was a completely new
experience for the currency markets.

While the U.S. current account between 1981-85 went from a
small surplus of $5,000 billion to a deficit of $121
billion, the dollar skyrocketed against the D-Mark from DM
1.74 to DM 3.42. From then on, however, the dollar fell
sharply, although the growth of the deficit slowed sharply
as well. The dollar's slump ended in 1995 at DM 1.25.

Let us peruse the figures of the recent past for
comparison: since 1997, the rise in the U.S. current-
account deficit has grown exponentially from $128 billion
to almost $500 billion. But this time, in addition to the
mammoth deficit, there looms a negative interest rate
differential of 2% against the dollar at the short end.
During its bull run in the first half of the 1980s, the
dollar enjoyed a big interest advantage against the other
major currencies.

Currency strength under such extremely negative conditions
is definitely unprecedented in history. There is only one
possible explanation for this extraordinary experience, and
that is phenomenal faith in the U.S. economy's inherent
strength and health.

Apparently, it was mainly two influences that drove the
dollar's bull run of 1981-85. Probably the most important
one was worldwide admiration for America's new"supply-
side" Reaganomics, against pronounced pessimism about the
European economies. (Eurosclerosis became the catchword of
the time.) A big interest-rate advantage for the dollar was
the other influence. The dollar's long decline began in
1985 when, in the face of a weakening economy, the Fed
accelerated its interest rate cuts.

It is still widely believed that Reagan's supply-side
strategies worked, although nothing could be further from
the truth.

Looking only at the increases in aggregate real GDP and
employment, they were indeed a great success. Economic
growth, which had stumbled in the early 1980s, began to
surge in 1983, compiling a more durable recovery than at
any time since the 1960s. For more than five years, real
GDP kept growing at an annual rate of more than 3%.
America's unemployment rate fell from 11% to 6%.

But looking at the pattern of economic growth and the
changes in the allocation of resources, Reaganomics has
been a total flop. The crux of economic policy is always
its impact on capital formation and profits. What happened
to the U.S. economy in the 1980s, in actual fact, was the
precise opposite of what the supply-siders had expected and
predicted. Soaring government and consumer borrowing
ravaged capital formation to unprecedented lows, and
business profits showed no improvement as a share of
national income or GDP.

The net national savings rate - the average rate of
business and consumer saving minus the government deficit -
virtually collapsed from about 6.5% from 1968-82 to 2% of
GDP, due both to sharply higher government and consumer
borrowing. Net capital investment as a ratio of GDP fell to
5% of GDP, nearly two percentage points below the post-war
average. Manufacturing net investment was flat for years.

Ultimately,"supply-side" Reaganomics grossly failed by all
accounts. Three bull years for the dollar were followed by
10 bear years.

We have recalled this experience of the 1980s because of
its stunning resemblance in virtually every detail to what
has happened in the past few years.

It begins with the bogus New Era. In the 1980s, it was
newly fashioned supply-side policies that would work
miracles for the economy. In the 1990s, it was a new
paradigm economy with miraculous efficiency gains through
massive investments in the new information technology and a
revolutionary improvement in corporate governance, guided
by the goal of increasing shareholder value.

What's more, in both periods, there was exactly the same
American derision of Europe's inflexible economies, and on
the part of the Europeans, there was exactly the same
inferiority complex. Even more stunning are the parallels
on the domestic side. In both periods, the pompous claims
of superior, new government and corporate strategies
contrasted grotesquely with the miserable economic reality.

Looking at what effectively happened to resource allocation
between capital formation and consumption, as well as to
profits - the policies in both periods were an outright
disaster. However, the macroeconomic damages of the 1990s
are worse...and have yet to be reckoned with.


Regards,

Kurt Richebächer,
for The Daily Reckoning

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• Pompous Claims V. Poor Reality / The Daily Reckoning - - ELLI -, 04.12.2002, 23:15