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February 27, 2004

Vindication for the FED?
by Kurt Richebächer

Manifestly, there is general overwhelming optimism about the U.S. economy. Positive arguments abound:

Thirteen rate cuts and the lowest interest rates in decades; runaway money and credit creation; rampant fiscal stimulus; the long and strong rally in the stock market; persistent, massive wealth creation through rising house and stock prices; an impending, powerful boost to output from a widespread need to replenish run-down inventories; reported strong profit gains promising an additional strong boost to business investment, returning job growth; surging commodity prices; and the strong stimulus to exports from the slide in the dollar.

To be sure, a more impressive list of growth-boosting influences is hard to imagine. More and more economic news-beating expectations seem to have carried away many people. Late in 2003, there was even widespread talk that strong economic growth in the New Year would soon force the Fed to start pre-empting inflation by tightening monetary policy.

It did not carry us away. Much of what we read and hear reminds us of a book by Paul Krugman, published in 1990: "The Age of Diminished Expectations." The main subject of the book was the observation that "relative to what everybody had expected twenty years ago, our economy has done terribly." Krugman expresses his amazement "how readily Americans have scaled down their expectations in line with their performance, to such an extent that from a political point of view our economic management appears to be a huge success."

It seems to us that in particular, there is a general perception that the anti-recession policies pursued by the government and the Federal Reserve during the last few years have been a great success, considering above all the rapid sequence of severe shocks imparted to the economy through the bursting of the stock market bubble, Sept. 11, corporate scandals and the Iraq war.

Yet, according to this mantra, America experienced its mildest ever recession. For many people, even outside the United States, all this is just further proof of the U.S. economy's wonderful flexibility and resilience.

In a recent speech to the American Economic Association in San Diego, Fed Chairman Alan Greenspan applauded himself once more for his successful policy with the following words:

"There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession - even milder than that of a decade earlier."

He offered mainly two explanations - "notably improved structural flexibility" and "highly aggressive monetary ease."

We are tempted to say that we disagree with every single word.

In the first place, we reject the general perception of America's "exceptionally mild recession." Measured by real GDP growth, that certainly appears true. But that is a very arbitrary measure. The officially declared end of the recession in November 2001 was by no means the end of the bubble's painful aftermath.

That painful aftermath has continued for more than two years, and not only in terms of protracted, sluggish GDP growth, but above all in America's worst by far postwar performance in employment and associated growth in wage and salary income.

Consider: While real GDP surged in the third quarter at an annual rate of 8.2%, wage and salary income adjusted for inflation edged up at an annual rate of 0.8%. Citing Paul Krugman: "In the six months that ended in November 2003, income from wages and salaries rose only 0.65% after inflation." For most workers real wages are flat or falling even as the economy expands. For America's employees and workers, numbering almost 150 million people, there has been no recovery.

In light of these facts, all talk of America's mildest recession in the whole postwar period is outright absurd. It plainly serves to delude people. GDP numbers are an abstract statistical aggregate. What truly counts for people is what happens to their employment and their income. By these two measures, the U.S. economy is experiencing its longest and deepest recession since the Great Depression of the 1930s.

For the bullish consensus, this tremendous, unprecedented discrepancy between real GDP and employment growth in the United States finds its ready and also most convenient explanation in the simultaneously reported record-high, unprecedented productivity growth, accruing from corporations that are becoming marvelously efficient through cutting labor costs.

We do not buy this explanation. It does not make any sense to us. Investigating the relevant statistics, the first thing to note is that the U.S. economy's growth pattern since the early 1980s has become increasingly geared toward consumption. Its share of GDP during these years has steadily risen from barely 63% to recently 70%. For most other industrialized countries this share is between 50-60% of their GDP. Since end-2000, the U.S. recession's start, consumer spending has accounted for 101.6% of real GDP growth.

To us, an economy in which consumption has been taking a steeply rising share of GDP for years is in essence an economy ravaging its savings and investments, both being normally the key source of productivity growth.

In consideration of these and other facts, we feel flatly unable to buy America's trumpeted productivity miracle. There is one obvious statistical source: artificially low inflation rates.

We can make a simple test by comparing both real and nominal GDP growth between the United States and the eurozone over the period from end-2000 to the third quarter of 2003. Measured by real GDP, the U.S. economy grew overall by 6.9%, compared with 4.5% for the eurozone. But measuring by nominal GDP growth, the difference contracts sharply - a U.S. growth rate of 13.1% over the whole period compares with 12.2% for the eurozone.

As we have repeatedly pointed out, the U.S. economy's superior growth performance during the past few years, measured after inflation, had its source largely, though not solely, in the application of lower inflation rates. For the United States, the price deflator for GDP in the third quarter of 2003 since end-2000 had risen a mere 5.8%, as against a reported 7.5% for the eurozone.

Considering the U.S. economy's parabolic credit excesses, the relationship between inflation rates should be the opposite. But pressured by politicians and in particular by Mr. Greenspan to produce the lowest possible inflation rates, America's government statisticians have worked hard to comply, in particular by counting quality improvements as price reductions. Understating inflation rates, in turn, overstates real GDP. A more accurate GDP deflator would lower real GDP growth to a rate that would certainly correlate better to the poor employment performance.

In our view, the prevailing perception that the U.S. economy experienced but an "exceptionally mild" recession - and now continues to perform exceedingly better than the eurozone economy - needs drastic revision.

P.S. This particularly applies to the job market. For decades, all through the postwar period, job creation has been the U.S. economy's outstanding superior feature among the industrialized nations. But that has radically changed. Since 2000, America is by far the worst performer in this respect. Following past postwar recessions, payroll employment was on average up 4% after two years. This time, it is down almost 1%. Something very ominous is going on.

Dr. Kurt Richebächer
The Daily Reckoning

A version of this essay was first published in the free daily e-mail: The Daily Reckoning.

Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

Copyright © 2003-2007 Kurt Richebächer

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