Two and a half years into one of the most severe Bear Markets in History, the most striking feature of the typical economic discussion is the persistent state of denial about how parlous our situation truly is. Also notable is the unthinking promulgation of a species of economic fallacies which, though long since discredited, keep springing up like weeds to choke our reasoning about where we might go from here and, therefore, of how we should be preparing to act.
Let us take a look at a few of the more important reasons.
Myth #1: The consumer is two-thirds of the economy: as long as she is spending, we can avoid recession.
Yes, the private consumer makes up 70% or so of GDP, but GDP is not the economy in the sense that the map is not the territory. The concept of GDP was cooked up in the 1930s by Simon Kuznets to help Roosevelt's Mussolini-inspired New Dealers apply Keynes' flawed General Theory to the command economy they wished to create, and the National Bureau of Economic Research which was set up to do this received the second tremendous boost to its influence and funding in World War II.
So, just think, when you look to GDP for a guide, you are relying upon a methodology responsible in great part for protracting the business collapse of 1929–30 into that decade of woe, the Great Depression, and then of assisting the assumption of a totalitarian control of resources in wartime.
If we are going to intone a truism, a better one would be "the producer is 100% of the economy," for without production, not only are there no goods and services to buy, but no means with which to buy them. As for paper money and electronic credit, they are convenient but dangerous fictions that mask this essential truth. The sooner we start to focus on this, the better our decisions—whether as policymakers or investors—will become.
Myth #2: Lower interest rates and easy credit will promote recovery.
Just as policy in the second half of the 90s led a whole host of entrepreneurs—many of the honest and gifted ones, as well as the crooks and the charlatans—into the blind alley of the boom, the present focus on consumption and easy money is not only not helping the survivors, but it is actively hindering them.
Easy money is preventing the rapid liquidation of bad businesses which thus remain to cling on to scarce resources—whether human, physical, or monetary—rather than scrapping them or selling them to others who are able to make better use of them.
From the perspective of business—particularly up at the specialized, higher-order, capital goods end on which our future prosperity rests—easy money is doing little more than to prevent resource costs from falling sufficiently into line with output prices so that they can, once more, hope to make a profit.
Without getting too theoretical, if we have a problem today, it is not the phantom of overproduction, but the very real bane of overconsumption.
Promoting consumption in order to provide an artificial support to expenditures—without caring what form it takes—may provide a temporary stay of execution for some over-extended companies (and a source of revenue on which to rebuild banking finances). But it nonetheless consumes capital; that is, it takes resources out of reproductive use and puts them into exhaustive use instead.
To take just the worst two cases, in the UK personal indebtedness is rising at the rate of nearly 1% of disposable income a month—meaning households are borrowing £3.70 for every extra £1 of income. In the US, personal debt, measured as a fraction of the sum of wages and proprietors' income, having been relatively stable at 140% for nearly a decade prior, has soared to 166% in just the past two years—implying that every extra $1 earned has been accompanied by a mind-boggling $10.50 borrowed!
And to what purpose is this perilous gearing, this destruction of middle and working class financial security, being promoted by central banks and finance ministers? So people can consume more than they can produce and 'heal' the economy, by somehow helping absorb the supposed 'oversupply' of goods and equipment which was the boom's legacy.
It would take too long to explain here why there can never be a generalized oversupply on the free market—merely a specific, or a mispriced, one—or why what we suffer from is not a surplus of capital goods in general. We are in fact faced with an imbalance in their composition of supply, compounded by what is actually a shortage of sufficient genuine capital resources with which to complement and so profitably to employ the capital we do have.
But, consider two sets of questions to provoke some thought about this:
Will easy money help Lucent sell enough network gear to survive? Has it helped find a market for the 500 million miles of mostly unlit fibre optic cable laid around the world? Would it have made WorldCom solvent? Has it helped Fiat, or Ericsson, or Sabena, or British Energy—any more than it has helped Daiei, or Sogo, or Nitto Kogyo in Japan?
Secondly, are we really faced with oversupply? Really? Do you have the exact model of car you want? Is your house fitted out as luxuriously as you would wish? Do you get enough beer to drink? Do your kids tire of sweets, or your wife of new shoes? Do you have access to all the medical care you want, when you want it? If you can answer 'Yes' to any of those you are either a hermit, a liar, or Larry Ellison.
Otherwise there can be never be a case of 'oversupply', whatever the collectivists tell you.
Myth #3: George Bush, Gordon Brown, Monsieur Mer and Signori Prodi and Tremonti are right: government spending can promote growth.
This idea of the State as our saviour is one of the oldest fallacies of all—the broken window fallacy which Frederic Bastiat dealt with so firmly nearly 200 years ago. To see this, ask yourself where the government gets the bulk of the resources it wishes to spend in the first place? From you, of course.
(Even if it employs you, by its very nature it is likely to use your labor to do things that are either extra-economic or sub-economic, so still occasioning a partial or complete loss of your effort.)
It borrows from you, it taxes you, it requires licenses and user fees. It fines you if you break its petty rules. It steals from you through the inflation its chartered central bank helps create.
And then what?
It decides where the money goes. It decides which corporate cronies will get your cash. It decides whether you must put aside thoughts of a new suit, so it can buy one for its newly hired traffic warden instead. And all the while it pays one army of bureaucrats to lift the money out of your left pocket, another army to spend it where it buys most votes, and finally a third—much smaller—army to put some of it back in your right pocket, so you don't realize the full extent to which you've been exploited.
None of this creates one single dollar of new wealth: it merely redistributes it. It shrinks the space in which the market can allocate scarce means to their most urgent ends, it corrodes the stock of capital, and it removes incentives to self-improvement along with property rights.
If running big deficits were an answer to our problems, why did Argentina go bust? Why has Japan been stuck in a hole for fourteen long years?
If government spending were the answer, why didn't the Berlin Wall get knocked down by anxious Frankfurters fleeing east?
Myth #4: All tax cuts are good: those on dividends will drive equities higher.
Well, who knows what the short-run response of the market will be, but economically, unless any tax cuts are financed by offsetting reductions in government outlays, we are just back to the transfer problem outlined above.
As for the much-feted dividend cut, why stop at the abolition of double taxation, why not abolish single taxation, too? Why not make dividends tax deductible like interest payments are (or even remove interest deductibility entirely to stop subsidising corporate and real estate indebtedness at the expense of equity issuance)?
In any case, US non-financial corporates have paid out fully 130% of after-tax profits in the past 8 quarters for which we have the numbers, effectively eating into their depreciation allowances. Thus, to the extent their recipients do not themselves invest the dividends, they are consuming, not rebuilding, capital. So how much more can they do—tax break, or no tax break—to raise returns?
If you add dividends paid in the US to the net of stock buybacks and issuance, you find the cumulative total payout for the past 50 years is a cool 95% of all the after-tax profits earned this past half century.
There's not a lot US business can do to increase that sort of ratio!
Myth #5: We are staring deflation in the face.
Or, as my particular Keynesian bete-noire, PIMCO's rent-a-quote Paul McCulley puts it: "We are on the edge of a deflationary cliff."
First, let me offer a strict definition of deflation—useful not just for terminological exactitude, but to avoid an impediment to clear reasoning. Deflation is a fall in the amount of money beneath the freely expressed demand for it—it is not an observed fall in prices, even when that is generalized, though such an event may be the result of a deflation.
So, if we said that the Fed has presided over an M3 increase of over $1.5 trillion dollars since the Great Bear Market started on Labour Day 2000—more money than even existed as recently as 1980!—or that G7 broad money went up by a seventh, or by $3.4 trillion dollars, in the past twelve months, could we say we have deflation?
Now, it may not have done much for stocks, since it has done nothing for profits (as we have argued above we cannot expect it to do!), but the reflation correlates highly with the bubble in the JPM global government bond index.
Moreover, what it has also ignited is a housing bubble which has seen, to take a few instances, UK prices rise 45% and loan volumes soar 140%; Ozzie loans rise 51% and average loan amounts climb 33%; Kiwi turnover rise 77% and prices 15%; Canadian prices gain a more modest 9.5%, sales jump 11%, and building permits rise 30%. Most notably, US prices increased 15–20% nationwide last year—a gain which jumps to 30% on slightly higher recorded sales in California, and national dollar turnover volumes soared 25%.
It may have taken a while, but commodity prices, too, have responded vigorously, from the Journal of Commerce Index's 23% climb to the GSCI's 53%.
We should never say never, for we in the West carry unprecedented amounts of debt on the shallow foundation of our failing global productive competitiveness. But we certainly haven't seen any evidence of deflation yet—only just enough mindless chatter about it to deter those entrepreneurs not already hindered by the combined shackles of the Bubble overhang, bad monetary and fiscal policy, over-regulation, the imposition of tariffs, high energy prices and the threat of who-knows-what unintended consequences arising out of the Fourth Mithridatic War.
In-flation, as ever, is the sleeping dragon the authorities are desperately trying to rouse, as Governor Bernanke of the Fed so infamously pointed out for us recently. De-flation is still a fairy tale bogeyman at this stage–a Troll with which to frighten the children into silence and compliance.
Myth #6: Stocks always go up in the long run. The rally will start next quarter, or the quarter after that, or the quarter after that.
Well, they have done that in the last six decades, in nominal terms, at least–except, that is, when they haven't, like, for instance, the whole stretch from 1966–1982! In real terms it's even more chastening to realize that from the Fed's inception in 1913, it was one big, go-nowhere roller-coaster ride to 1949 and that we were back pretty much at these levels over three decades later, in 1982.
1929's peak was not exceeded until the Fifties, and it was revisited as recently as 1991. It took until the start of this Bubble, in 1995, to recoup the 1966 high.
Moreover, the 1920s Bull market saw a 340% real term gain—all of which was then surrendered. The more sedate post-WWII run to the '66 top was again around 340%: all was given back. The run this time, taken from the 1987 Crash lows was, once again, a very similar 330%—which could be a very bad omen, indeed.
Stocks go up in the long run, alright, but they also go down. Especially when we adjust for inflation, when they are not cheap to start with, and when business everywhere has to cope with the legacy of two generations of debt-fuelled capital consumption, the return of big government from its brief hibernation and the shattering of the international consensus and the superficial neoliberal harmonies it imposed.
* * * * *
So where from here?
The first point to realise is that, whatever the monetary obfuscations of this fact, we have all squandered an enormous—perhaps an unsurpassed—amount of real wealth in the boom and the ramifications of this impoverishment will haunt us for some time to come.
Some say this will cause a deflationary collapse, but presently this seems a decidedly small, if nonetheless finite, probability—an out-of-the-money catastrophe option, if you will. At the first sign of any systemic crisis we will see the Fed swing into action with liquidity provision, and we will see exchanges shut; rules suspended or broken, and all manner of desperate remedies applied.
Absent such a panic, it is clear that those central banks still not actively reflating will be loath to fight any hint of price pressures emerging in the near future, with the worthy exception of the Kiwis, the Norwegians and, perhaps, the Canadians.
This implies steeper curves and—where equities stabilize for long enough to allow—narrower corporate spreads. Precious metals should continue to flourish, too.
The longer the European governing elite can keep the Bundesbank doves quiet—and thus the Euro rising—the less chance the Dollar has of finding a base and the increasing risk it runs of an accelerating decline.
People may have sweated long hours in Far Eastern factories to accumulate dollars to buy into the American technology fantasy, or just so Westerners could borrow back the money they paid for their imports, to enjoy all over again in the form of cheap mortgage credit. But the Asian producers are waking up to what a bad deal this is for them and nobody is going to want to lend George Bush the wherewithal to point a pre-emptively aimed missile at back at them.
The hope here is that Europe concentrates on being a value-added provider abroad, while using the pressure to force through deregulation at home, that Japan avoids meltdown and that intra-Asian trade continues to blossom, so reducing reliance on Western consumers. Britain, America, and possibly Australia will fare increasingly badly if this is the case.
While bad businesses everywhere are being folded or reformed and while the overall structure of production is being driven, by easy money and deficit spending, to more urgent consumption ends, or to government misuse, this implies a less capital-intensive, less productive, more inflation-prone economy, with low (real) revenue growth and thus restricted overall (real) profitability.
All of this will bring further calls for protectionism and that, in turn, will increase international frictions in a world where discord is already rising. It will be a time, then, for householders and companies alike, to end the foolish focus they have come to devote to their income statement alone, and to look once more to the quality of their balance sheets.
Finally, it will be a time for the careful and conservative stewardship of customer monies and for those charged with this to display a willingness to challenge prevailing myths, whether these arise from economic sophistry, or from institutional prejudice and intellectual inertia. If we can all become convinced that these are aims well worth achieving—and we are not precluded from such a goal by the cack-handed intrusions of the State—this recession might actually turn out to have been fully worth the cost.
