The Daily Reckoning - Down Is Still Down

verfasst von Firmian, 27.08.2003, 11:15

-->Down Is Still Down

The Daily Reckoning

Paris, France

Tuesday, 26 August 2003

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

*** Federal deficit reaches $500 billion...

*** China grows 3 times as fast as U.S....new house sales
hit record... Financial Reckoning Day draws near...

*** Enrolling in the American School... and more...

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

The U.S. federal deficit is now expected to hit half a
trillion dollars next year, according to a congressional
committee. John Spratt, a S.C. Democrat, says the deficit
pile-up over the next 10 years would total about $3.7
trillion.

A half a trillion is also the amount of capital that the
U.S. needs to import from overseas to make up for the trade
deficit.

How can these deficits be financed? Consumer savings rates
are near zero. Corporate savings, or retained earnings, are
actually negative. The money must come from abroad.

Still, many economists say these deficits are signs of
health. The federal deficit helps stimulate the economy,
they say. The current account deficit just shows how much
foreigners admire us; overseas investors buy up our stocks
and bonds because they know we have the most dynamic
economy in the world. Besides, what else can they do with
the money?

Thus, we have one of the goofiest ideas of modern
economics: that the world's creditors are at the mercy of
its biggest debtor.

The idea is absurd; our intuition tells us so. Does it not
say in the Bible that"the borrower is slave to the
lender"? In a meeting of banker and borrower, is it not the
former who swaggers and the latter who grovels?

And yet, from Federal Reserve governors to university
economists to TV presenters runs the notion that China and
our other major trading partners must reinvest their trade
surpluses back in the U.S., no matter what.

These foreign investors have already lost trillions - first
when the dollar fell against major foreign currencies over
the last 12 months... and then when U.S. bond prices
collapsed this past summer. We do not doubt that overseas
investors are no geniuses. But even a Social Democrat
eventually figures out how to stop losing money.

'Yes, but we've got them over a barrel,' say the
economists. 'If they don't re-invest in the U.S., the
dollar will fall even more. Then, they won't be able to
sell so much of their production on the U.S. market. In
fact, without the U.S. deficits, the whole world economy
will go down the drain.'

The U.S. might be likened to a company that sets up in a
small town... and becomes its biggest business. Soon, the
whole town depends on it. It is the major buyer at the
hardware store. Its employees are the biggest spenders at
the grocery store. Its executives are big spenders at the
local bar... and the biggest borrowers at the local bank.
Its owners give the nicest parties and are accorded a
special unspoken rank at the local Presbyterian church,
where they are the biggest givers.

But The Company loses money each year. So, it goes to the
bank and to the merchants and says: give us more credit, or
we stop spending. More and more credit is extended, because
each merchant wants the business. The tavern owner allows
the bar tab to grow. The banker increases the company's
line of credit. Even at church, the minister might want to
give an especially warm handshake to the owner.

The townspeople may even get together and decide to back
The Company 'for the good of the whole town'... even going
so far as to contact their legislators in the state capitol
or Washington in an effort to get the company special
favors or extra loot.

But as The Company goes deeper and deeper into the hole,
eventually, one by one, the townspeople begin to feel like
fools and patsies. 'When are we ever going to get paid,'
they ask. 'How,' they want to know. 'It may be in the
interest of the whole town to have The Company spending
money,' says the barkeep to himself, 'but I'm tired of
giving away good liquor.'

Finally, they all turn on The Company... dump its I.O.U.s at
whatever prices they can get for them... and forget to
invite the owner's wife to tea.

Someday, we remind readers, foreigners will turn on the
dollar. What day? We don't know...

In the meantime, here's Addison with the latest news:

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

Addison Wiggin writing from Paris, France...

-"It is too early to suggest it is a total turnaround,"
Intel's CEO Craig Barnett said yesterday. You think so,
Craig? The Dow apparently agreed; it continued the sell-off
it began on Friday. The Dow dropped 31 points to 9317. The
Nasdaq fell but a point to 1764.

- Gold lost 70 cents... and rests at $360.

- It's the end of summer, and the living is still easy. And
you are fortunate, dear reader; this is an historic time to
be alive and a spectator of the financial markets. Why?
Well, for starters, new house sales hit another record in
July, with the median house selling for 12.1% more than a
year ago - the biggest gain in more than 20 years. In the
meantime, as we reported yesterday, Freddie Mac's chief
executive, Greg Parseghian, was chased out of his post by a
meddling Fed regulator. How are these two news items
related? If you have been following along you probably
already know the answer. Your meddling editors, at least,
suspect they signal the opening salvo to one of the
greatest spectacles ever to unfold in financial history.

- The Daily Reckoning began life as an awe-struck witness
to a dazzling run-up in the stock markets, most gloriously
exemplified by the Nasdaq topping out at 5048. Your editors
were cranks who just didn't 'get it.' It was a hoot. (If
you're a long-time reader, you'll recall we enjoyed a
remarkable stretch of schadenfreude while the Nasdaq was
getting splattered all over God's green earth.)

- While doing research for"Daily Reckoning: The Book"
("Financial Reckoning Day," John Wiley & Sons - due to
bookstores soon), we noticed that even far back in the
recesses of history - all they way back to John Law and the
Mississippi scheme - exploding financial bubbles usually
get some of their goo on the real estate markets... which
voraciously gobble it up... until they, too, go boom.

-"If you want to be successful," Jimmy Rogers writes in
the foreword to our book,"you've got to understand
history. You'll see how the world is always changing.
You'll see how a lot of the things we see today have
happened before. Believe it or not, the stock market didn't
begin the day you graduated from school. The stock market's
been around for centuries. All markets have. These things
have happened before. And will happen again.

-"As [Financial Reckoning Day] demonstrates, artificially
low interest rates and rapid credit creation policies set
by Alan Greenspan and the Federal Reserve caused the bubble
in U.S. stocks of the late '90s. Now, policies being
pursued at the Fed are making the bubble worse. They are
changing it from a stock market bubble to a consumption and
housing bubble.

-"And when those bubbles burst, it's going to be worse
than the stock market bubble, because there are a lot more
people that are involved in consumption and housing. When
all these people find out that house prices don't go up
forever, with very high credit card debt, there are going
to be a lot of angry people."

- By the way, Jim Rogers will be speaking at the upcoming
New Orleans Investment Conference, alongside Bill and your
New York editor, Eric Fry. If you'd like to catch them, you
can sign up to attend below...

.. and if you're among the first 200 to sign up, I will
personally hand you a free copy of"Financial Reckoning
Day" when you arrive...

The 2003 New Orleans Investment Conference
http://www.oxfordclub.com/conferences/neworleans2003/home.cfm?id=2

- The fact that new house sales reached an all-time high
just about the time the Federal spooks started hunting for
heads at Freddie Mac, we'll take as an ignominious sign
that the housing bubble is about to blow. Not to mention
the fact that long-term rates began rising in June, despite
the best efforts of Mr. Greenspan and his band of cronies
at the Fed.

- Our friend and colleague Gary North, following the
housing bubble saga closely, has noted that even the
mainstream press has been getting edgy over Fannie and
Freddie's frolicking in the credit markets. An article in
the New York Times on August 8th noted that Fannie Mae
"faces much bigger losses from interest rate swings than it
has publicly disclosed."

-"At the end of last year," the Times piece goes on,
"[computer models] showed that Fannie Mae's portfolio would
have lost $7.5 billion in value if interest rates rose
immediately by 1.5 percentage points..." That's a sum equal
to half its market value."With $923 billion in assets
under management, the Times also reports,"Fannie Mae is
the second-largest financial company in the United States,
trailing only Citigroup." The implications of a collapsing
mortgage market extend far beyond these erstwhile GSE's...

- Gretchen Morgenson, also writing in The NYTimes, and
citing the work of Jim Bianco's research firm in Chicago,
notes that"the last time interest rates moved up - in the
mid 1990s - the mortgage-backed securities market was much
smaller and more manageable. 'Back in 1996, the mortgage
market was roughly half the size of the Treasury market',
Bianco says. 'Now it is 125 percent of the Treasury
market.'"

- Mr. Bianco, apparently, fears that"the size of the
market" and"the fact that so many players are heavily
leveraged make a disaster almost inevitable."

-"Because of the threat to the American bond market that
mortgage lending institutions pose," North elaborates,"I
don't expect the Fed to allow long-term rates to rise to
double-digit levels. But, before the Fed panics and starts
buying T-bonds to force down long rates, I do expect
mortgage rates to rise at least back to the 7% to 8% range.
This will have negative consequences for the following:

1. The supply of people who can qualify for loans;

2. The retail prices of homes that prospective buyers can
finance with their existing incomes;

3. The home equity that existing buyers now possess;

4. The liquidity of the housing market;

5. The monthly disposable income of people who bought
homes using Adjustable Rate Mortgages.

-"In short, pop goes the bubble." It hasn't happened yet,
but when it does, there are going to be a lot of angry
people.

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

Bill Bonner, back in Paris...

*** China's economy is growing 3 times as fast as the
U.S.'s.

"With an expected annual GDP growth rate of 7% this year,"
writes James Boric, editor of Penny Stock Fortunes,"China
is growing faster than any other large country in the
world."

In particular, Chinese manufacturing is enjoying a season
in the sun. If the '80s were the hey-day of China's
farmers, subsequent years have glorified its producers.
Thousands of empty containers have piled up in New Jersey
(they came full, but there is nothing to ship back in them)
and trillions of dollars have accumulated in overseas bank
accounts. These are the silent witnesses of China's
manufacturing revolution.

But it's not only exportable gadgets and gee-gaws that
China makes; the country must provide for its growing
internal industry, too.

"Today, there are about 160,000 kilometers of paved
roadways in China," continues James Boric."That's
significantly more than in 1985, but still very low for
such a large country.

"There is a ton of room for growth in China. Billions of
dollars still need to be spent on new roads, cars and
engines. And now that China is opening its borders more to
the rest of the world, you can bet it will go the extra
mile to improve its infrastructure, make new cars and
bolster its public transportation system."


*** Americans expecting an economic recovery are destined
to be disappointed. Samuel M. Robbins explains why:

"There is no longer the pent-up demand that followed WWII.
There is no shortage of cars or houses or computers. Thus,
consumer demand, once thought to be the mainstay of the
domestic economy, is unlikely to hold up the economy....
After all, the consumer has already borrowed and spent all
he can. Consumer debt has risen twice as fast as consumer
income. At some point, debt service will take priority over
consumption. One can hardly expect manufacturers to expand
their domestic production when they are already operating
at 75% capacity. Thus the ingredients of a boom or a
recovery do not exist..."

*** We spent yesterday enrolling Jules, 15, in the American
School of Paris. Jules has been in French schools for the
last 6 years; the American school is a new experience.

"We know some of you are nervous," said the principal to
the new recruits."There may be some of you who are not too
happy about being here. We know that many of you are here
because your parents were transferred to Paris for business
reasons, for example. And you may not even like being here.

"But our job is to make you comfortable and make sure that
the year you spend with us is one of the best learning
experiences you ever have."

So pleasant with their mid-western accents. Everybody
smiled. Everyone was so up-beat and positive. So relaxed.

This was very different from our encounters with the
headmasters of St. Jean de Passy or the Institute de la
Tour. They would not waste a minute trying to make students
or parents feel at ease.

At St. Jean, for example, the principal is a man with a
white-bearded face like Victor Hugo and the demeanor of a
whaling captain. Each year, instead of warmly welcoming the
children and parents, he calls them together and delivers a
chilling 45-minute lecture... warning that if any student
comes to school late, or unprepared, he will hold the
parents personally responsible. He gives this warning while
pacing back and forth on the stage with what looks like a
harpoon in his hand, practically daring the parents to ask
a question or raise a doubt. The parents, two per child,
and many of them former students, sit as still and mute as
dead fish. Back home, they immediately set upon their
children with rigid homework schedules... and tutors in
French, history, math, and Latin. More math... more
literature... more languages... more history. Day and night,
the parents push and prod... tempt and torment... trying to
get their children to do better. The last thing they want
is to face the headmaster in a private conference... or
worse, have their children sent away from St. Jean.

"Well, Jules, what do you think," asked his father after a
day at the American school.

"I don't know... it will be a change... I'm taking a course
in pottery..."

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

The Daily Reckoning PRESENTS: So what if we become a nation
of hamburger flippers? John Mauldin responds to a question
put to him by Bill Bonner, while they were hanging out
together on the back porch at Ouzilly.


DOWN IS STILL DOWN
By John Mauldin

"How can we," asked my friend and your editor, Bill Bonner,
as we sat basking in the evening sun at his château in
pastoral France only a month ago,"continue to buy goods if
all we sell is services? Can we be a nation that just
produces services and still maintain our way of life? How
can we survive if our largest exports are jobs and the U.S.
dollar?"

(Note: it is easy to ask such pessimistic questions while
you bask in pastoral splendor at your château on the second
bottle of wine.)

The numbers appear to confirm Bonner's suspicions:
"According to the Bureau of Labor Statistics," writes Bruce
Bartlett of the National Center for Policy Analysis,"there
were 14.6 million Americans employed in manufacturing in
July, down from 15.3 million a year earlier, 16.4 million
the year before that (2001) and 17.3 million the year
before that (2000) - a decline of 16 percent in 3 years.
The recent peak for manufacturing employment occurred in
March 1998 at 17.6 million - about the same as it had been
for the previous 15 years."

The stories are all over the press about how manufacturing
jobs are being shifted to China, Mexico (think NAFTA) and
(pick your favorite third-world country). They are the same
stories, with different countries substituted, that I read
in the 70's. We read in those tough economic times that the
U.S. was then at its zenith and moving into an era of low
employment. Eventually, we would see Japan eclipse us as
the pre-eminent economic power.

But"it is also important," Bartlett tells us,"to note
that virtually every other major country has seen declines
in manufacturing employment. Between 1992 and 2002, U.S.
manufacturing employment fell by 3.7%. In Britain, it fell
4.7%, in Japan it fell 5.2%, and in Germany it fell 6.1%.

"... Industrial production [in the U.S.] has remained
relatively strong. The Federal Reserve Board's industrial
production index is up 5 percent since manufacturing
employment peaked in 1998, and down just 5 percent from the
index's peak in July 2000, despite a rather severe
recession in the meantime.

"Looking at gross domestic product, real goods production
as a share of real (inflation-adjusted) GDP is close to its
all-time high. In the first quarter of 2003 - the latest
data available - real goods production was 39.2 percent of
real GDP. The highest annual figure ever recorded was 40
percent in 2000. By contrast, in the 'good old days' of the
1940s, 1950s and 1960s, the U.S. actually produced far
fewer goods as a share of total output. The highest figure
recorded in the 1940s was 35.5 percent in 1943; the highest
in the 1950s was 34.9 percent in 1953; and the highest in
the 1960s was 33.6 percent in 1966.

"In short, manufacturing output is very healthy. There is
absolutely no evidence whatsoever that we are becoming a
nation of 'hamburger flippers.' We are producing more
'things' than we have in almost every year of our history
for which we have data."

The decline in employment is, in effect, a good thing,
because it means that manufacturing productivity is very
high. That is also a good thing, because it means that
employers can afford to pay high wages to manufacturing
workers while still competing with low-wage workers in
places like Mexico and China."Remember," says Bartlett,
"what really matters for employers is not absolute wages,
but unit labor costs - how much the labor costs to
manufacture a given product. If a U.S. worker is five times
as productive as a Mexican worker making one-fifth as much,
they are exactly equal from the point of view of a
producer."

Critics to this optimistic view note that Bartlett includes
agricultural and mining output. My answer is, so what? Are
not food and minerals part of the"stuff that so many say
we're not producing"? Agriculture and mining certainly
produce exports and employment, which is the concern
expressed by those worried about the collapse of U.S.
manufacturing. Others suggest that the numbers reflect the
fact that U.S. manufacturers are selling Chinese goods,
which masks the problem.

Bartlett in a later column notes that this is not the case.
"This is just a misunderstanding of how the gross domestic
product is constructed. All imports are subtracted from
final sales to calculate GDP. Therefore, imports from China
or anywhere else can never raise GDP; they always cause it
to be lower than if they were produced domestically. GDP
measures only actual production on U.S. soil. In short,
imports reduce GDP and exports increase it."

One final thought from Bartlett: much of the 'decline' in
manufacturing employment is not real. Many manufacturing
companies used to do everything in-house. Now many
outsource as much as possible: janitors, accounting, data
processing, sales, human resources, etc. Before, these jobs
were counted as manufacturing because they were employees
of manufacturing companies. Now, since the same jobs are
part of an out-sourcing firm, they are considered service
jobs.

As Bartlett notes, even if we are producing more stuff than
ever, we are doing it with far less employees, and are
doing so every year. Manufacturing jobs are indeed leaving
the U.S. or being replaced by more efficient machines, but
their demise is not voluntary: they are forced out by both
productivity increases and price margin squeezes.

Citing the Philly Fed survey for August, Greg Weldon,
editor of The Money Monitor, points out that twice as many
firms were planning to cut employees in August over the
previous month... even as 75% of these firms projected
rising sales and improving business conditions.

Weldon slices and dices numbers as well as anyone I know,
and he found a few devils in the details of the seemingly
bullish report. The Philly Fed survey noted that prices
paid for input material are up 16%, but prices received are
up only 1.1%... meaning that sales margins are being
squeezed. No wonder jobs are being cut, as costs are rising
(in no small part due to energy costs), but the prices
firms can charge are not.

Something has to give, and it is jobs.

This is a classic symptom of deflation. Indeed, all but one
Fed governor was out in force this week talking about the
'risks' of lower inflation.

Second, Greg notes that expectations for improved business
conditions are at a ten-year high. The last time they were
this high, we headed into the 1991-2 recession. Not one
firm reported a decline in expectations. It doesn't get any
better than that. It also means that perfection is 'priced
in' to the expectations. Anything less will be
disappointing.

A friend of mine in a high place has been keeping track of
an interesting statistic: actual initial claims for
unemployment. The number you see in the news is"seasonally
adjusted." (That means seasoned and cooked by the
government agencies that release them.) Even though the
reported number was 386,000, the actual number was 307,000,
which seems better in comparison. The key is the trend.
Continuing claims are over 100k more in 2003 than 2002,
using August 9 data (3,419,378 in 2003 versus 3,272,880 in
2002).

But for the first time in a long time in this cycle, week
on week comparisons for last week showed a real drop of
about 5% from one year ago. We are assured by all concerned
that it had nothing to do with the blackout and people not
being able to file.

Hopefully, this trend will continue. But maybe it won't.
Lay-off announcements usually increase after Labor Day (can
you spell irony?), and they are running well ahead of last
year. Challenger Gray reports an unusually high number of
announced lay-offs for the month of July. 76,000 jobs went
poof last week before last.

The fact is, the 'recovery' is not doing the one thing
recoveries are supposed to do: create jobs. Unemployment
didn't actually fall last month, as BLS reported to us. The
authorities who count such things only count those who are
actually seeking jobs as unemployed, which makes some kind
of sense. But last month, they dropped around one half
million of our fellow citizens from the unemployed ranks,
not necessarily because they had found jobs, but because
they had become so discouraged, they stopped looking.

The old line is that a recession is when your neighbor
loses his job. A depression is when you lose yours.

Labor unions on the left and Pat Buchanan on the right are
calling for trade barriers to 'protect' American jobs. The
self-righteous vigor with which they decry the free markets
borders on the religious frenzy of the tent revival
meetings of my West Texas youth.

What they are really saying is that America should produce
fewer goods with more workers, thus forcing American
consumers to spend more for their goods and services. They
want us to protect people from change. This type of
'protection' is as much a tax as is the income tax, and is
just one reason why the Bush steel tariff policy is so
wrong.

One industry after another, as it matures, becomes more
efficient. Its products become more of a commodity. TV,
electricity, cars, transportation... all are less expensive
today than when they were first introduced. I write today
looking at my new Dell plasma 19" monitor, which cost
around $550. A few years ago, such luxuries were $10,000.
In a short time, they will be only a few hundred dollars at
most.

Should we force Dell to produce these in the U.S.? Should I
be forced to pay $5,000? Of course, if that were the price,
I would not buy, and neither would anyone else.

This is called the Law of Comparative Advantage, which was
developed in the early 1800s by the great English economist
David Ricardo. In short, this is a principle that states
that individuals, firms, regions or nations can gain by
specializing in the production of goods that they produce
cheaply (that is, at a low opportunity cost) and exchanging
those goods for other desired goods for which they are
high-opportunity-cost producers.

This is a very neat and tidy law, and is true for all
places and all times, in capitalist as well as socialist
countries. But it has a caveat.

When that comparative advantage changes, those directly
affected in the negative will not be happy. If it is your
job that is lost to China or to a robot, you are the one
who must find a new avenue of support.

If enough of your peers in your industry also experience
'down-sizing,' it will serve to drive down the wages of
your profession. Think India and other educated third-world
countries and what they are beginning to do to wages for
technology-sector workers, especially software programmers.

You can only be protected from change for so long.
Eventually, the Law of Comparative Advantage will exact its
economic due, and the resulting change will be just, if not
more, serious.

The world is changing at an ever-faster pace. It is quite
unsettling to many workers, yet that is the reality with
which we are faced. Sometimes the changes will force people
into a lower life style. Sometimes it makes them become
creative and start new companies and whole new industries,
creating the demand for far more workers.

Thus, I can with one breath say that the United States will
do just fine during this period of change, and yet
acknowledge that the head winds of change will create
significant problems and require substantial adjustments.

It is entirely consistent to suggest a 30% real GDP growth
for the U.S. economy over the next ten years (which is
still well below trend and potential growth), and also
suggest that we will see at least two recessions as we
resolve the U.S. imbalances in the trade deficit and the
imbalance in the world of U.S.-centric global trade.

Readers of my weekly e-mail know I have come to call this
the Muddle Through Decade. It refers to a long period of
below-trend growth in which we must come to terms with all
of the imbalances created by the last boom. It will be far
more like the 70's than the 90's.

Cataclysmic changes are rare events for free market
economies. They usually come as a war or revolution, and
not because of a shift in comparative advantage. While
economic shifts can be far-reaching, in a free market
world, the changes can be dealt with individual by
individual.


Warm regards,

John Mauldin,
for The Daily Reckoning

P.S. In 1532 Juan Pizarro met a force of 80,000 Incas along
with their God-Emperor Atahuallpa at Cajamarca. He had a
ragtag group of 186 soldiers. It was no contest. Pizarro
captured the Emperor, through deceit and other infamous
acts. This produced a cataclysmic change for the Incas.

Think of many modern economic changes which produced
changes no less significant for the world economy, but
which worked themselves out in a more reasonable manner.

Gary Shilling notes in his book that the construction of
the Erie Canal precipitated a serious drop in the price of
wheat. Think of the changes that wrought upon the farmers.
New markets became available, but at much lower prices. Not
everyone liked the new world order, or praised the canal.
But from the time advantage of our perspective, we see the
canal as a positive move forward.

What will future historians say about our time? That we
were met with challenges and did just fine, thank you. Did
some groups do better than others? Yes.

There can be no insurance for change, no policy that
protects. You just have to deal with it. I see no reason
why we should not deal with change as well in the future as
we have in the past.

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• The Daily Reckoning - Down Is Still Down - Firmian, 27.08.2003, 11:15