-->The Plug Factor

The Daily Reckoning

Paris, France

Wednesday, August 18, 2004

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*** Foreigners are such nice people...lucky for us!

*** Stocks up...gold up...mega-tsunami threatens...

*** China, Russia, Taiwan, Germany, Brazil and two-and-a-
half Saudi Arabias!

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More and more, we Americans depend on the kindness of
strangers.

The record U.S. trade deficit of June - $54.8 billion - had
to be financed by strangers in strange places. Like Japan.
And China.

The U.S. federal deficit for June - nearly $70 billion -
also had to be financed by someone. Thanks again to
strangers in strange places.

Any other country that ran such huge and chronic deficits
would be an immediate"sell!" You'd want to get rid of its
currency and its bonds as fast as you could. But Americans
think their country is special; the rules, principles and
constraints that apply to the strangers don't apply to us,
they say - we're exceptional!

Besides, the strangers seem to think so too. They save; we
spend - currently, it takes nearly 80% of the entire
world's available savings just to keep us spending in the
style to which we've become accustomed. They produce; we
consume - nobody does it better. They build factories and
production facilities; we build too - houses and shopping
malls.

This relationship - between America and strangers, notably
the Chinese - is thought to be"symbiotic." It allows both
parties to get what they want. Win-win, in other words.

Let's see...the Chinese get new factories, jobs, wages,
profits, technology, assets, savings, capital, know-how. We
Americans LOSE jobs, assets, savings, capital, factories,
profits and so forth. But we get...hmmm...big-screen TVs,
Game Boys, electronic gizmos, toys and everything else you
find on the shelves of Wal-Mart. And debt. Lots of debt.
$32 trillion last time we looked.

Well, that seems like a pretty good deal to us. What do you
think, dear reader?

The foreigners own more and more of what used to be
American wealth-producing assets. When Ronald Reagan
arrived at the White House, foreign-owned U.S. assets were
less than 15% of GDP. Now, they're over 78%. And they're
growing rapidly. Net purchases of U.S. assets by foreigners
rose to $71.8 billion in June, up from $65.2 billion in
May. Most of that was in U.S. Treasury bonds. And most of
those were purchased by Japan and China.

This puts the U.S. economy - and even its elections -
largely in foreign hands. If the Chinese or Japanese should
decide to sell Treasurys, for example, it would certainly
boost interest rates, pop the housing bubble and likely
cost George W. Bush the White House.

Fortunately for us, the foreigners are such nice people.

More news from the newshounds in Baltimore:

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Tom Dyson, tucked away behind Lovegrove Alley, in Mount
Vernon...

- In 1953, two geologists traveled to Lituya Bay, in
Alaska, to survey for oil. They didn't find any oil,
though. Instead, they found evidence of a cataclysmic
natural disaster, the likes of which had never before been
documented.

- The scientists noticed massive scarring in the trees,
some of which grew hundreds of feet from the water. It
appeared as if a massive wave, at least 450 feet high, had
pummeled the bay's shoreline.

- It was all pure conjecture until, in 1958, the scientists
got the proof they were looking for...an entire cliff
collapsed into Lituya Bay, producing a wave a third of a
mile in height, higher than any skyscraper on earth.

-"I had 40 fathoms of anchor chain," said Howard Ulrich,
who was in a boat when the cliff disintegrated,"and it
started running out off the boat - came to the end of the
40 fathoms, just snapped it like a string and then we were
free and - but we were still on the front of the wave. We
were swept up over the land and up above the trees. That's
where I assumed that we were going to end up."

- Now a British scientist is attacking the government
inaction over an infinitely greater threat of the same
nature in the Atlantic."A block of rock approximately
twice the volume of the Isle of Man would break off,
traveling into the sea at a speed of up to 350 km [220
miles] per hour," claims the Benfield Hazard Research
Centre."The disintegration of the rock…would produce a
debris avalanche deposit extending 60 km [40 miles] from
the island. The energy released by the collapse would be
equal to the electricity consumption of the entire United
States in half a year."

- The island in question is an active volcano called Cumbre
Vieja on La Palma, part of the Canary Islands. A large
fault runs for 1.3 miles along the western flank of the
volcano and would become unstable during an eruption. The
10-foot-wide fissure opened in 1949, when the volcano last
erupted."We found that the relatively small rising
temperature in the core of the volcano due to the injection
of magma could result in very large changes in water
pressures. These water pressures are large enough to
produce strength in the flank and result in collapse of the
volcano. What this of course means is that the next
collapse will ultimately be tied to a future eruption."

- This natural phenomenon is called a mega-tsunami. They
are caused when massive volumes of rock slide into a body
of water. Scientists are concerned that the greatest mega-
tsunami ever imagined could be heading for the East Coast
of the United States in the near future.

-"Their [experts at University College London] research
suggests the Caribbean and the East Coast of the United
States would take the brunt of the devastation," reports
the BBC,"but high water could also submerge large parts of
the west coast of Britain."

- Wonks in Switzerland created complex models to analyze
this phenomenon. Erring on the side of caution, they
envisaged an initial wave height of 2,000 feet and a
wavelength of 20-28 miles traveling towards America at 450
miles per hour.

- Cumbre Vieja has erupted three times since 1646. No one
knows when the next eruption might occur..."Tourists in
America and the Canaries shouldn't cancel their holidays,"
advises the BBC."The next summit eruption is unlikely to
happen for decades and it may take many more eruptions
before the flank of the volcano is pushed into the
Atlantic. The problem is scientists cannot tell."

- Here at The Daily Reckoning, we don't plan to take any
immediate action...and we won't be canceling our holidays
to the Canaries. As regular readers already know, we're
more focused on the mega-tsunami heading for Wall Street.

- No sign of any financial tsunami yesterday - stocks
continued to bounce. The Dow added 18 points, closing in on
the 10,000 mark again. By the bell, it had reached 9,973.
The Nasdaq gained too; it added 0.7% or 12 points, closing
at 1,795. Gold liked the news that the CPI fell by 0.1% in
July and took the opportunity to put some daylight between
itself and the $400 mark. It gained $1.50 to $404.50.

- If we do get wind of an eruption on La Palma, we may have
to reassess our situation here in Baltimore. But rest
assured - readers will continue to receive The Daily
Reckoning regardless. And one more thing - we would
politely ask readers to refrain from telling bin Laden
about the fissure...

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Bill Bonner, back in Paris...

We're back in France...but still ruminating on our long
trip through North America. We began on the east coast of
Canada and finished on Canada's west coast, after looping
through southern USA.

What did we learn from our trip?

The raw country is stunning. Magnificent. Beautiful. And
mostly empty.

There, Americans have built a style of life that is
alternately trashy and refined...exuberant and
dull...appealing and incomprehensible.

We never understood why anyone would want to stop at Hog's
Restaurant (with a picture of a pig on the advertisement)
in Aztec, New Mexico, for example. Nor why anyone would
want to live in the typical American suburb. Nor how
Americans could work so hard and have too little to show
for it; they get poorer each year. They have a standard of
living that few people in the world can afford - not even
Americans themselves.

Americans are"a decent people caught up in an indecent
conceit," we quote ourselves, finding no better reference.

They believe they are not subject to the ordinary laws of
economics...or fair play. If any other country tried to
spend so much, or live so far above its means, we would say
it was headed for trouble. Americans forgive themselves;
for they believe that they are blessed by such good fortune
that they will never have to pay their debts.

Or imagine that Germany decided that"regime change" was
what South Africa needed? Or that Morocco decided to attack
Tunisia on the pretext that the Tunisians were up to
something? We would find it unforgivably arrogant and
unpardonably aggressive.

Yet we Americans pardon our own aggression, as well as our
own extravagance. We are the guardians of the world's
peace, we believe, and are endowed by our Creator with some
special duty to spend the world's money as well as tell
others what to do.

"For the first time in human history," wrote Michael A.
Ledeen,"a singularly diverse people has been given the
chance to experiment with a new kind of society, inhabited
by a new kind of man, driven by a new kind of ethos...

"No longer impeded by our youthful weakness, we can
continue our national mission beyond the boundaries of our
national frontier...There is no one to stop us except
ourselves."

We are surely up to the job.

***"I came here after the war," said an old man we met in
Los Angeles."It was great. But it was different then. You
could drive down the freeways at 50 mph. Now they're all
clogged up with cars.

"America was the land of opportunity. Well, maybe it still
is the land of opportunity. I'm not sure. But if I were a
young man again, I think I'd go to Russia or Brazil.
They're wide open."

***"Even in difficult conditions, there are opportunities
to make money [in Asia]," writes old friend Martin Spring:

Real estate"is a no-brainer." Tens of millions of people
are moving from the rural areas to the cities every year,
creating enormous demand for housing. What's more, unlike
in the manufacturing sectors, there is in other Asian
countries no competition from China. In India, in
particular, the property market is very underdeveloped, so
there are"huge opportunities."

Tourism is Asia's most promising growth industry. As the
middle classes burgeon and become richer, they have the
time and resources for leisure activities. Over the past
five years, the number of Chinese holidaying abroad has
doubled to 16 million. Marc Faber foresees up to 100
million Chinese visiting other Asian countries.

Commodities. When you have a nation that is industrializing
rapidly, the need for natural resources explodes. China's
steel industry is already larger than those of Japan and
America combined, while its share of the world's copper
demand has soared from 6-27% over a decade.

Asia's oil consumption is likely to double, from 20 to 40
million barrels a day, over the next 10 years. That extra
demand is equivalent to two-and-a-half Saudi Arabias.

Rising living standards will also generate exploding demand
for food imports, especially from China, where agricultural
production is declining. As an example of the potential,
Faber says, Taiwan consumes 81 kg (180 lbs) of meat per
person each year, compared to China's 15 kg (35 lbs).

Services. The middle-class explosion will also generate
fast-growing demand throughout developing Asia for
financial services, advertising, distribution, health and
personal care services, entertainment and media.

Local business giants will emerge to challenge the existing
multinationals, just as happened in Japan during its
"miracle" years and has been happening more recently in
Korea.

This is not necessarily the right time to rush in, as the
U.S. central bank has created a colossal worldwide bubble
in Asia as much as elsewhere, and it's conceivable that
this bubble will burst this year or the next.

However, that should not undermine the long-term case for
investing in Asian themes.

American growth has been driven by consumption, which has
been artificially high because of the transitory phenomenon
of cheap, abundant credit instead of growth in employment
and earnings.

By contrast, Asian growth is being driven by
industrialization and related development in China and
India as dramatic as the transformation of the United
States in the 19th century from a small colonial economy of
4 million people to the world's largest economic power."

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The Daily Reckoning PRESENTS: The Good Doctor takes issue
with the"plug factor," a statistical adjustment used to
capture small-business job creation overlooked by the BLS's
standard surveys. Until 2000, it was set at 35,000 per
month. Now the plug factor regularly reaches 300,000...

THE PLUG FACTOR
by Dr. Kurt Richebächer

At first look, the May consumer income and outlays numbers
- which we were eagerly awaiting last month - appear
excellent: Incomes are up 0.6%, and spending is up even a
full percentage point. At second look, after adjustment for
inflation, the reality is pretty ugly.

The increase in disposable income melts to less than 0.1%
in real terms, and that of spending to 0.4%, of which well
over half came from the burst in motor vehicle promotion.
Spending on nondurable goods has been flat for two months.
The whole of the extra increase accrued from a blip in
spending on services.

Amazingly, this sharp slowdown in consumer spending, though
lasting for half a year, has been met with flat denial all
around. During the five months to May, it was up in real
terms by $78 billion, or $186 billion annualized. This is
less than half of the consumer spending growth in the
second half of last year - $376 billion annualized.
Meanwhile, we know that June was another horrible month for
consumer spending.

One important reason for the general indifference to this
drastic reversal in consumer spending was apparently the
fabulous job figures for the three months March-May that
the Bureau of Labor Statistics (BLS) miraculously pulled
out of the hat, reporting almost 1 million new jobs during
these three months.

It shocked us to see how readily and uncritically research
institutions, economists and media around the world
accepted these numbers at face value, even though they came
like a bolt from the blue in the face of otherwise rather
mixed economic data. For the few who wanted to see, these
numbers were bluntly suspect.

It turned out that virtually two-thirds of the new jobs had
come not from the survey, but from a new computer model.
For decades, the BLS has aimed at small businesses when
measuring job creation in times of recovery, especially
those not captured by its established monthly survey. Until
2000, this statistical adjustment was fixed at 35,000 each
month, called the"plug factor."

The recent sudden jump in these figures towards 300,000
each month results from a computer model based on a
calculated"net birth/death adjustment," which is supposed
to measure how many jobs small firms have created and
shuttered. In this way, the former monthly 35,000 figure
exploded into numbers that are almost 10 times greater.

For us, the sudden statistical spike in job creation during
March-May was massively out of whack with prior numbers and
other concurrent economic data to be credible. Then came
June: 112,000 new jobs created, less than half the expected
number. We never saw it mentioned that the net birth/death
adjustment contributed 182,000 to this disappointing
increase. Without it, employment would have fallen 70,000.

What all this means for the U.S. economy's prospects should
be clear: The suddenly strong support from job and income
growth looks very much like a mirage. To the contrary,
sharply slower consumer spending is essentially exerting
the opposite effect of depressing income growth.

What, then, induced the American consumer to his sudden
retrenchment in spending in the first quarter? Partly due
to lower taxes, his nominal disposable income grew during
the quarter by $171.7 billion. Yet he raised his spending
by only $119 billion, putting fully $52.7 billion of his
higher earnings into savings. That was definitely a drastic
break with his past spending mania.

The salient point here is that the retrenchment was plainly
not forced by tight money or credit. Oddly, consumer
borrowing set a new record at the same time with an
increase by $1,008.2 billion at annual rate, after"only"
$659.9 billion in the prior fourth quarter of 2003. We have
a hard time making sense of this mixture of income growth,
savings growth and record borrowing.

The answer probably lies largely in the fact that the
"average" private household is a statistical fiction. The
other day we read that nearly a quarter of households have
to spend 40% of their current income on debt service, as
against 14% on average. On the other hand, there are, of
course, many households with net income from assets after
debt service. Higher bond yields and loan rates speak,
in any case, for sharply lower borrowing in the future.

In April, an increase in nominal disposable household
income by $52.3 billion compared with an increase in their
spending by a mere $16.3 billion. In real terms, spending
even declined slightly. No less than $36 billion went into
savings. Due to the huge promotions and rebates by the
automakers, spending in May was drastically distorted.
Purchases of durable goods were up $17.8 billion,
accounting for 54% of the total increase. News about auto
sales since then has been disastrous.

Glancing over the figures for real personal consumption
expenditures, it strikes the eye that the sudden spending
weakness has gripped all sectors of consumption, services
and non-durable goods, as well as durable goods.

As mentioned earlier, lesser consumer spending essentially
means lesser income growth. If allowed to develop, it
implicitly turns into a vicious circle where lower and
lower spending leads to lower and lower incomes. One has to
wonder what Mr. Greenspan can come up with next. In 2001,
he had more than 500 basis points of interest rate cuts at
his disposal to fight the economy's downturn, led by
plunging business investment.

Our view has always been clear and unambiguous. Ultra-cheap
and loose money together with fiscal priming of
unprecedented scale have provided a tremendous stimulus to
consumer spending in the United States. For the bullish
consensus, this policy stance has been most successful, as
measured by recent real GDP growth of 4% and higher at
annual rates.

For us, this is a much too simplistic and superficial a
view. Lost in the celebrations are the long-term costs of
this recovery as manifested in the form of ever-mounting
structural imbalances - namely record trade gaps, record
levels of financial leveraging, record levels of personal
indebtedness, a record-high budget deficit and rock-bottom
national savings.

For any reasonable person, it ought to be clear that this
cannot be the road to healthy economic growth.


Regards,

Dr. Kurt Richebächer
for The Daily Reckoning