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January 23, 2003

Panacea Du Jour
by Kurt Richebächer

It used to be elementary knowledge among economists that rising investment in tangible assets - factories, offices, machinery and other forms of equipment - is paramount for economic growth and general prosperity.

First, it generates demand, employment, incomes and tangible wealth while the factories and the equipment are built and produced. Once the capital goods are installed, they increase supply, employment, incomes and productivity. The key point to see is that investment is the one and only GDP component that adds both to demand and supply.

But mainstream American economic thought seems to overlook this reality. It places, first of all, an unusual emphasis on consumption as the prime mover of economic growth, and there is furthermore a general disregard of what is happening to saving and capital accumulation. Alternatively, the emphasis is on autonomous changes in productivity growth through new technologies as the root cause of economic growth and profitability.

This is a radical departure from the thinking of the old economists. Measured by the rate of productivity growth, the U.S. economy appears to be in excellent shape, definitely better than the whole rest of the world. But measured by its record-low rates of saving and capital accumulation, it is in most miserable shape. What is the right interpretation?

For America's policymakers and economists, productivity growth seems to be that great magic that solves all problems and that will sustain an economic recovery. It appears to be a widespread view that the measured stellar productivity growth is the main warrant of a mild recession and of an impending recovery.

The crucial point to see about productivity growth is that, by itself, it only means that hours worked have risen less than real GDP. But there is nil economic merit in this effect unless it is accompanied by an improvement in some other kind of the economy's performance such as growth of output, profits or investment. In the case of the United States, in actual fact, everything else is deteriorating. That is probably the main reason for the general, singular focus on productivity growth.

Looking at the whole postwar period, the United States actually experienced its most vigorous and definitely its most healthy economic performance in the 1960s. Its rates of national saving and of capital investment were then at their highest in the whole postwar period, and so were its rates of business profits. The main purpose of moderate borrowing on the part of the consumer at the time was the financing of new homes, and the main purpose on the part of businesses was the financing of new investment in plant and equipment, that is, in tangible assets. In essence, it was overwhelmingly borrowing for capital formation.

This pattern of borrowing began to change gradually in the 1970s and rather dramatically in the 1980s. From then on, debt growth went exponential. Consumer debts have since skyrocketed by 473% and business debts by 382%. These numbers compare with simultaneous GDP growth by 283%.

A drastic change in the use of the new debts was the other striking new feature of the developing borrowing binge. Exploding credit quantity implied plunging credit quality.

Consumers started to borrow like crazy to finance increased current spending, and businesses borrowed like crazy no longer to invest in plant and equipment, but to finance financial transactions - mainly leveraged stock buyouts, mergers, acquisitions and stock repurchases - that were thought to be more appropriate for quickly raising shareholder value.

Ever since firms and retailers invented consumer installment credit in the 1920s, U.S. economic growth has become heavily geared to consumer spending and borrowing. But this traditional consumption bias took a big leap in the 1980s and in particular in the late 1990s. The most striking characteristic of both periods were exploding consumer debts and collapsing national saving.

In the 1980s, in actual fact, the hemorrhage of national saving had caused great and widespread concern. Many American economists expressed their strong misgivings about the implicit negative effects on capital investment. This time, in diametric contrast, nobody seems to care or even take notice.

There seems to prevail a widely accepted view that credit creation makes old-fashioned saving from current income superfluous. As to the equal utter lack of interest in capital formation, the apparent explanation is a singular focus on productivity growth. Why are saving and investing even necessary, if the U.S. economy is enjoying stellar productivity growth without them?

What's wrong with this view? In short, everything. It's macroeconomic nonsense.

Productivity growth is not the panacea for which American policymakers and most economists seem to take it. If there is insufficient demand, as today, increasing productivity can only result in increasing numbers of unemployed workers, declining capacity utilization and, ultimately, slower growth.

What really induced generations of economists of all schools of thought to elevate saving to an indispensable, key condition for economic growth? The basic reason is that it is the limiting factor for capital investment. Short of nirvana, all resources are scarce. Due to this elementary wisdom, new capital investment can only come about to the extent that somebody makes the resources for the production of the capital goods available. That somebody happens to be mainly the consumer. By saving, that is, by spending less than he earns, he effectively releases the necessary productive resources for investment.

But this necessary release of productive resources is true only for saving from current income, coming implicitly from current production. The attendant release of resources is what makes this kind of saving indispensable for investment and economic growth.

In essence, capital formation represents the surplus of production over consumption, and that has to be made possible by saving. To quote Friedrich Hayek on the subject: "Saving is not synonymous with the formation of capital, but merely the most important cause which normally leads to this result."

A lot of energy has been devoted to whether there will be a double-dip into recession. This is the wrong question. What really matters, instead, is whether capital spending will rebound after its steepest decline in the whole postwar period. This is also a question that can be answered with reasonable foundation from the available data.

If yes, the U.S. economy has a chance for a sustained recovery. If not, it will be Japanese-style near-stagnation and sub-par growth for years to come. We think the prevailing conditions speak overwhelmingly for the latter.

Regards,

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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