Storm Watch: Debt Valley
(July 12, 2002)
by James J. Puplava / Financial Sense Online
Another Day Older And Deeper In Debt
The headlines are repetitive and the stories seem to be the same. The best that
can be said is that they are consistent. Accounting scandals, profit warnings,
bankruptcies, currency devaluation and threats of terrorism, fill the evening
news broadcasts. Against this background is news of an improving economy. The
unemployment rate is still climbing and profits are still declining albeit at a
slower rate of descent. So if there is going to be a recovery it will be devoid
of jobs and profits.
The economists and analysts seem perplexed as to why the stock market hasn't
recovered given the news of improving economic conditions. So they cite
everything from terrorist attacks, geopolitical tensions and accounting scandals
as reasons why their forecasts for a market recovery haven't occurred. The
consensus view is the Fed has created all of the monetary conditions for a
recovery by lowering interest rates. If the economic numbers are improving, then
it only follows that the financial markets should be tagging along. That hasn't
happened and the only advice that can be given is that the markets will improve
during the second half of the year. It has become a familiar refrain.
As the daily headlines capture investors' attention, there is a growing sense of
unease that there is something wrong and more serious with the financial system.
Investors and voters cry out for Washington intervention to fix things and make
them better. However, that is like putting the fox in charge of the henhouse. It
was Washington intervention, and especially the actions of the Federal Reserve
that created this mess.
The Making of a Bubble
The expansionary monetary policy of the Greenspan Fed during the 1990's created
a bubble in the financial markets. Every time there was a crisis, the Fed
flooded the financial markets with money to fix the problem -- whatever its
source -- the peso or the insolvency of a hedge fund. The standard solution was
always to create more money. Throughout the 1990's the supply of money and
credit in the system expanded nonstop.
As the graph above shows, each new financial crisis was met with money and
credit. Beginning in 1994 with the peso crisis the Fed has pumped money and
credit into the financial system. Then in 1995, the rate money and credit began
to expand grew faster than the economy. During the second half of the decade
that money went into the financial markets, mainly in the large cap stocks in
the Dow, the S&P 500, and the Nasdaq.
The majority of that money found its way into the financial system. The rest of
it went into debt creation at the corporate and consumer level as shown in these
graphs. The money that the Fed created flowed into the financial markets and
debt induced consumption. It created the illusion of prosperity. This prosperity
turned into a full-fledged boom, then turned into a bubble, producing
malinvestments in the economy and speculation in the financial markets. The
secondary effects of that bubble were a grossly inflated stock market, rising
debt levels at all levels within the economy, an expanding trade deficit, and a
negative savings rate.
These were not the symptoms of a "New Paradigm." They were more manifestations
of growing imbalances in the economy. The rising stock market, the boom in real
estate, the rising level of debt, the trade deficits, the growth in consumption
were not signs of economic health as originally construed. Instead, the excess
consumption and the degree of financial speculation in the markets were signs of
a patient that was terminally sick.
A New Bubble is Born
In response to this illness, the standard prescription of more money and credit
failed to produce an improvement in health. The patient didn't responded as
planned. The stock market went down instead of up. Instead of resurrecting the
stock market bubble, a new bubble was created in the real estate market. This
helped to extend the consumers ability to borrow and spend through the
refinancing of mortgages and home equity loans. Today money and credit are still
flowing into consumption and the new bubble in housing is kept inflated by
artificially low interest rates. Therefore, instead of reinflating the bubble in
the stock market as hoped, a new bubble in the housing market took its place.
Each month passing, there is more evidence that the consumer continues to go
deeper into debt. The consumer has added new mortgage debt through new and more
expensive home purchases or home equity loans. In addition to mortgage debt,
installment and credit card debt is also expanding rapidly.
Economists and analysts hail the increase in debt as a sign of consumer
confidence in the economy rather than a sign that the consumer is financially
over stressed. At the same time, the number of delinquencies and bankruptcies
are ignored even though they are at record levels. Credit has replaced savings
and this is now viewed as a positive. Today we have multiple bubbles in the
housing market, consumer spending, the bond market, the dollar, and a monstrous
trade and current account deficit. These resemble signs of high blood pressure
more than they do a healthy heart and circulatory system.
The "Fix" Isn't Forthcoming
Meanwhile on Wall Street money managers of equity funds want the Fed to lower
interest rates or at least keep them low. Bond fund managers want the Fed to
induce banks to keep the credit flowing to businesses that are on the verge of
bankruptcy. Voters want the government to fix things.
With the recession producing declining tax revenues, governments at all levels
are increasing spending and taxes. Deficit spending is back in vogue. So are tax
increases. On the day of this writing, Democrats in Congress floated a new tax
bill. We now have massive fiscal stimulus added to massive monetary stimulus in
an effort to resuscitate a sick economy and financial system. All that has been
accomplished by these hefty injections of monetary and fiscal stimulus is that
the economy hasn't fallen deeper into recession. The fact that the housing
sector is booming is taken as a sign of the economy's resilience rather than an
ominous sign that monetary and fiscal policy are having little impact outside of
housing. Rising real estate prices is viewed as a sign of prosperity rather than
another inflated bubble that is due to burst just like the Nasdaq bubble that
preceded it.
In Washington, there is a call for major legislation, new regulations, and
higher taxes. I have written about this in the past, but in times of economic
crisis, government can always be counted on to do something stupid. Politicians
are a strange breed of human beings. They love to take credit when things are
going well in the financial markets or the economy even though they had nothing
to do with it. They are also good at distancing themselves and finding a
scapegoat when things go wrong or go in the opposite direction. The degree of
demagoguery, grandstanding, and hypocrisy displayed over these last few weeks
has sunk to levels I never thought possible. At least the left is consistent in
its response to a crisis created by government. The standard solution to any
problem is always bigger government, more spending and higher taxes. I suppose
if we had an outbreak of malaria they would propose a blue ribbon panel to study
it, a new government agency to oversee it, and more new taxes to pay for it.
Where were these same politicians during the boom years and the stock market
mania of the late 90's? What were the regulators and politicians doing during
this time? Does anyone in Washington understand the dangers of debt? Is the
degree of economic literacy so low that politicians think they that you can
inflate and borrow their way to prosperity? I never heard a word about stocks
being overvalued outside of Mr. Greenspan's utterance of irrational exuberance.
The Fed Chairman knew better because it was Fed policy that was flooding the
markets with money.
The Root of The Matter
Today's headlines of accounting fraud, deceit, and financial manipulation were a
product of the boom years of the last decade. At its root was greed. Plain and
simple. As long as the markets went up, nobody was willing to question it. It
was only when stocks fell that it became a problem. The fact remains that
investing has always been an uncertain endeavor. There are no guarantees only
degrees of risk.
An American President and Congress can't guarantee investment outcomes. Nor will
they be able to replace the trillions of dollars lost in this bear market. The
more they try to interfere, the more they try to legislate, the more they try to
tax, the worse things will become. There are plenty of laws on the books. We
don't need more laws. We need stricter enforcement of the laws we already have
on the books.
Regarding the current bear market, there is nothing that Congress or the
President can do to prevent it. In my opinion, the greatest risk now lies with
government intervention. The risk of moral hazard has never been greater.
The point that needs to made here is that all sectors of the economy -- the
government, business, and the consumer -- are addicted to credit to keep them
functioning. However, there will come a time when the financial system is unable
to provide the ever-increasing amounts of credit to keep the economy and the
financial system afloat.
Foreigners who now provide the US with $1.5 to $2 billion a day in credit to
finance our widening trade deficit may run out of patience with our proliferate
spending. In the end, the markets are going to enforce discipline in one form or
another through a collapsing dollar, a collapsing economy, a plunging stock
market, or more likely a combination of all three. The simultaneous occurrence
of all three events will give us "The Perfect Financial Storm."
$ 6,126,486,630,756.66
U.S. National Debt Clock as of July 12, 2002,
8:45AM, Pacific
The estimated population of the United States is
287,768,105
so each citizen's share of this debt is
$21,289.67.
Now all attention is focused on a falling stock market. Experts are bewildered
as to why an improving economy hasn't been accompanied by a rebounding stock
market. Wall Street and the investment community are far too complacent. The
standing response is that there will be a second half recovery in the financial
markets. The economy will get better and eventually stock prices will improve.
The accounting scandals will be cleaned up, CEOs will go to jail, and investor
wrath will be mollified. Once profits begin to improve and the scandals go away
the financial markets will be back to normal and the good times will return.
Conspicuously absent from this debate is the fact that this is the most
overvalued stock market in the history of this country.
The Problem is Structural
Every measure of valuation is at extreme levels. It doesn't matter what you look
at -- whether it is P/E multiples, dividend yields, price-to-book ratios or
price-to-sales ratios -- all are at excessive levels never seen before. By
today's standards, the stock market bubble of the 20's, the hard asset bubble in
the 70's, and the financial bubble in Japan in the 80's all look mild by
comparison. A comparison of these extremes will be the subject of next week's
Storm Watch Update. My point today is that every measure for evaluating the
market is at an extreme. Too many imbalances within the economy have yet to be
corrected. In fact, the unabated expansion of credit will only exasperate an
untenable position.
This is no ordinary recession or bear market. The problem isn't cyclical. It is
structural. Past recessions were caused by tight monetary policy and a buildup
in business inventories. Once inventory levels were worked down and the Fed
eased interest rates, the economy would recover. Consumer demand picked up,
capital spending by business rose, and profits improved. The financial markets
responded with higher stock prices. This has been the pattern throughout the
second half of the 20th century. Most recessions and bear markets were cyclical
not structural, the exception being the recession and bear market of 1973-74.
This time around, things are different. Loose monetary policy is having no
impact. The financial markets have failed to respond and economic growth has
been anemic despite the fluff in the economic numbers. What we are witnessing is
the evaporation of a mirage. There never was a "New American Paradigm" in the
90's. It was all an illusion created by an enormous spin machine in Washington
and on Wall Street to justify the bubble in the financial markets. Rising stock
prices masked the credit and monetary excesses of the era. Profit growth was
below normal and the product of fraudulent accounting. The miracle economic
numbers were the result of manipulated government statistics.
The Mirage of Prosperity
We will shortly get a glimpse of this manipulation when the government releases
its revised economic numbers for the years 1999-2001 on July 31st. The boom of
the 1990's was created from credit -- nothing more. As these graphs of the
savings rate, the trade deficit, corporate debt, consumer debt, revolving
consumer debt, mortgage debt, government debt, and total American debt show, the
economic and financial boom of the 1990's was the product of the greatest credit
boom in the history of the world. There never was a new era. There was simply
abundant credit.
What is striking about all of these graphs is that very few in the financial and
political establishment see anything wrong with them. In fact, most members of
the ruling class are calling for more of the same. Austrian economist Kurt
Richebächer described this lack of comprehension in his most recent newsletter.
"Symptomatic of today's general incomprehension of macroeconomics is a
narrow-minded concern with undifferentiated aggregates, like GDP, credit, money
supply and income. But economic problems generally arise from a major shift
within these aggregates, for example from shifts between consumption and
investment or profits and wages. Or in the case of credit, the critical factor
is often not changes in quantity but changes in their use."
In summary, the largest credit bubble in history created the boom of the 90's.
The American economy rests on a pyramid of debt: debt at the consumer level,
debt on corporate balance sheets, government debt, and enormous leverage in the
financial markets. The economy and the financial markets are kept alive by a
constant infusion of new credit. Stop the flow of credit and the whole system
implodes. It is an economic and financial system in badly need of a diet and
self-discipline. Until the system is cleansed of all of these credit excesses,
there will be no sustainable economic recovery either in the economy or in the
stock market. In the words of Peter Warburton, we live in a world of debt and
delusion.
© 2002 James J. Puplava
by James J. Puplava
July 12, 2002
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