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December 29, 1999

Reflections On Prosperity
by Anthony Deden

When, lo, as they reached the mountain's side, A wondrous portal opened wide, As if a cavern was suddenly hollowed; And the Piper advanced and the children followed, And when all were in to the very last, The door in the mountain side shut fast.  - Robert Browning "The Pied Piper of Hamelin"

In lieu of superlatives, when historians at some future point seek to put our recent financial history in perspective, as a way of title, it will be fitting to borrow the words of James Grant: "1999: The Suspension of Disbelief". America and its NASDAQ stock exchange, at the dawn of a new year, are bound in matrimony, forever pledging love and affection to each other, eyes shining in the expectation of everlasting bliss and prosperity. It is the subject of most magazine covers, most of the air time on television and vast Internet bandwith. America loves her stock market!

To say anything contrary to this, to think for one's self, to write or speak with an understanding of history or knowledge of economic laws and their consequences, has become more unpopular than shares in fertilizer producers. Yet, this is what we must often do.

The deafening noise surrounding us suggests that we, in the United States, are in the midst of the greatest prosperity of all time. We are told that the federal budget has a surplus, that inflation is dead, that the fear of anything has been abolished, doubt has been banished, economic laws have been suspended and the only risk existing is that of us being left out of this incredible party. We want to believe. All we need is a fast Internet connection, an online broker, and just a little courage to recognize the little dips that come from time to time.

For the majority of those over age 10, the role of the stock exchange (which is typically one of reflecting the wealth created in the real economy), has now become that of creating wealth out of thin air and the source of all prosperity. My purpose here is not to describe this mania, as it has been well documented by many able (and brave) observers elsewhere. Instead, I wish to address those few thinking souls, who, after a lifetime of old-fashioned work, savings (and perhaps a little luck), have managed to squirrel away something for a rainy day. At the threshold of a New Year and the hoopla of this Millennium idea, they are confronted again and again with this nagging notion:

Is this prosperity or is it an illusion?

Is the incredible rise in securities prices since 1995 a reflection of real value created or is it merely a bubble? Is this really a second Industrial Revolution that changes our very basic economic assumptions or is it not? Is it a 'new paradigm'? A world of fast growth, record unemployment and no apparent inflation? Have economic laws been suspended? And if not, how could so many people be so wrong?

Let there be no doubt, that what we are witnessing is, indeed, history's greatest financial bubble. The indescribable financial excesses, the massive increase in debt, the monstrous use of leverage upon leverage, the collapse in private savings, the incredulous current account deficits, and the ballooning central bank assets all describe the very severe financial imbalances which no amount of statistical revision nor hype from CNBC can erase.

As it happened in 1929 - a boom and bust with which this bubble is often compared to but which pales into insignificance when compared with it - as it happened in 1972, in 1989 in Japan, or in 1998 in East Asia, booms are followed by busts - they are called recessions, depressions, etc. - because booms sow the seeds of every succeeding bust.

Their cause is not the fault of capitalism as it has been suggested, but an excessive amount of money and credit created by central banks. Yet, this seems to escape the understanding of those who will, in one day, convene congressional hearings to determine what caused this destruction. The culprit is, as it always has been, the same organization, which professes interest in bringing about price stability and low inflation: The Federal Reserve Bank and its policies of money market intervention, credit creation and loose money.

Just ask, 'how does the Fed know what the right interest rate should be?' After all there are no other commodities for which prices are set by anyone. So, why is it that the free market can discover the right price for all commodities through free exchange, yet the Fed somehow "sets" the price of money? Does the Fed, for example, know what the price of hogs should be? A central bank manipulating the price of money is no different than the Politburo 'managing' the Soviet economy. They had no clue as to whether the people needed cars or shoes. Some things were in oversupply and others were scarce and so on. Intellectually, there is no difference between a centrally planned economy and a centrally planned currency. The results are equally as disastrous. Twenty four times in a row, the Fed lowered the benchmark rates down to 3% and in the process, it kindled a consumption boom, a general dissaving and an orgy of speculation. At best, such intervention distorts reality. It sends the wrong signals to entrepreneurs who misallocate resources or make investment decisions without understanding the real needs of the market.

The high-tech expansion of the 1990s is strikingly similar to the Savings and Loan-fueled real estate boom of the 1980s. Both booms were fed by cheap credit and by equity valuations that were a consequence of cheap credit. Both created more productive capacity than would otherwise have been forthcoming. The end result of each process was not an inflation of consumer prices. Rather, it was inflation in stock, bond and real estate prices. Vast supply of buildings in the 80s, a vast supply of cheap merchandise in the 90s. And why is it, I ask you, that we do not learn from an equally as explosive credit created bubble and the subsequent phenomenal wealth destruction that it brought - in Japan?

Mainstream economists claim that 'savings' is not as necessary an ingredient to the creation of wealth any longer. They claim that technology can improve productivity without the need for additional capital. This is politically correct as rules are made to fit the circumstances. There is no need for standards. No need for analysis. There is no right and wrong. This is the new Economics being written and what is loudly being trumpeted by an ever grateful but intellectually ignorant media.

They tell us that we are witnessing truly remarkable economic growth. First, let us acknowledge the fact that it takes an increasingly larger growth in personal and corporate debt - recently approaching $5.3 - to result in $1 in incremental GDP growth. As an analogy, a man with no assets or savings but armed with a credit card with unlimited credit can also appear to have an increasing personal GDP. Further, excluding consumption (which grew by 20% in the last year alone) making up 65% of the ubiquitous GDP, and excluding the disproportionate weight to growth rates given to GDP calculations by computer sales, the bulk of the 'real economy' - that is, the part of the economy that is sustaining, is not growing much at all.

They remind us of this technological revolution. Indeed, the advancements in telecommunications and the Internet are extraordinary. No one knows how different our world will be as a result of these capabilities. Yet, we should not confuse technology improvements with their actual economic value, or their ability to make a profit and add to the food plate of the nation. Technology may be of significant benefit but its economic value is another matter altogether. For all the wonders of the Internet, a book bought online is one book the neighborhood bookstore does not sell. For the store owner, his employees, his landlord and their tax assessor, it is a marginal loss. The net economic benefit of buying a book online is just a big fat zero. Add to this the deflationary effect price competition brings and how marginal online commerce is overall, and measure it against the massive amounts of new money being plowed into the field and the mammoth valuations of Internet companies.

They tell us of this productivity explosion. Even without further observation, increases in productivity with negative savings is an event unique in economic history. Prosperity created by consuming more than one produces is worth noting--until one realizes that in the annals of economic history it has not been done before. The computer sector, at 3% of the economy has indeed seen a productivity rise of as much as 42%. Yet the bulk of the economy is abysmal at less than 2% and lower than the historic averages since 1952. Fancy GDP accounting just averages these diverging rates resulting in false appearances. How then is this an economic miracle? " Professor Hans Sennholtz in a recent article on credit and money growth wrote: "It is true, a few corporations have used the Internet to increase their profits by cutting costs, eliminating middlemen and attracting new customers. They have implemented aggressive, wide-ranging Internet strategies designed to squeeze costs out of their operations, perhaps as much as two or three percent per year. It is estimated that, in five years, Internet-related efficiencies may add some 10 percent to the average Dow stock earnings. But the companies will have to spend most of their profits to put the Internet systems in place." It should remind us also of Ludwig von Mises' unambiguous advice: "A man can surely heat his stove by burning his furniture, yet he should not be deluded into believing that he has discovered a wonderful new method for heating his premises."

They tell us that profits have soared. Indeed, between 1992 and 1996, non-farm corporate profits doubled. The bulls assure us this is a productivity miracle. In reality, it is a result of lower net interest expense, a strong dollar and other non-recurring factors. In the cyclical upswing, the growth rate in profits is lower than normal despite huge increases in credit and massive amounts of new debt. One should also note the effect of accounting gimmicks on profit results. Notwithstanding, stock options, stock buybacks, write-offs, reorganizations and a list of assorted financial trickery has clouded the 'E' part of the P/E equation. Average EPS for the S&P 500 are lower today than a year ago despite forecasts for double digit growth. Today they make similar forecasts only to be met by similar disappointments in the not too distant future.

Finally, from the Chairman of the Fed to the airheads on television, much is being made over the absence of inflation. And this is where the crux of the matter lies. As long as consumer prices (as measured by the CPI) are not rising, or are rising only modestly, it is assumed that there is no inflation, or only very little inflation. Dr. George Reisman suggests that this is "..akin to saying that so long as someone shows no visible signs of illness, he has no illness - that his illness begins only when its symptoms become unmistakable." He goes on to say that "inflation does not come into existence when prices start rising noticeably, any more than heart disease or cancer come into existence when a person finally has a heart attack or experiences the acute symptoms of cancer. On the contrary, these diseases are already well advanced before their obvious symptoms appear." Inflation, to classical economists is the undue increase in the supply of money above the rates that can be supported by savings. Such inflation ultimately gives rise to the prices of goods, or prices of assets or commodities, et cetera. Lack of CPI inflation, in itself a result of several non-recurring reasons. But inflation-proper is alive and well in the form of the Nasdaq Index and assorted financial assets.

It seems to me that words of caution about the odds of winning at the roulette table are not popular in Las Vegas. Not suprisingly, the owner of every gambling establishment would find it offensive. Yet, this is also the case with this Wall Street prosperity. You want to go up to someone whose lifetime savings are turned over hourly at the altar of Nasdaq and scream: "Hey buddy, you know, this entire fast growth-no unemployment-no inflation-high productivity-miracle is just an illusion. Economic laws have not been suspended. Profits mean something. Risk does really exist. Sins have consequences. Perhaps you should take the chips of the table.." Never mind, he does not want to hear you. He will not renew his subscription. If you are his advisor, he will fire you. Plenty others want to tell him what he wants to hear. He wants to be rich. Get out of the way.

What sustains the illusion

The US aggregate current account deficit is now over $1 trillion and rising by $300 billion a year. The illusion of prosperity is clearly sustained by a confidence in the almighty greenback. It is perhaps the biggest game of confidence ever. But a con game nonetheless. Were it not for confidence in the dollar none of this explosive growth in money and credit could have taken place. By substituting the mighty deutschemark and the sound money policies of the Bundesbank with the politically weak and intellectually poorly conceived euro, the demise of Japan as an economic power and the end of the cold war, the dollar has come to be viewed as a source of stability and a store of value for billions of people around the world. Alas, such confidence is not permanent. Unfortunately for most investors, the memories of the most recent (1979-1980) dollar crisis have faded. No currency can really serve as a reserve currency for too long when the issuer has the power to increase its supply at will.

In the end, the force behind the boom is not hard work, savings or ingenuity (excepting Mr Greenspan's, of course). The cause of the boom is the same that has powered all boom cycles. It is the creation of money and credit without corresponding savings. It is the distorting of the money markets and the ensuing malinvestments that such intervention causes.

Consequences

Booms are not only about financial distortions and malinvestments. Their effects carry social consequences and equally substantial magnitude.

Booms tend to reinforce the general dissaving of the population. The savings rate in the U.S. has been declining even further in recent years--from and average of 7.9% in the 70s, to 2.0% in the 80s to a negative 1.5% recently. Someone recently calculated that just to maintain the rate of consumer spending growth the dissaving would be 3% in 2000 and -4.5% in 2001. By 2002, Americans would be drawing down their wealth by $500 billion a year. Keep this in mind as you also consider that almost 35% of households have less than $1,000 in liquid assets.

Booms distort economic reality. For example, despite popularity in its notion, wealth creation via the stock market does not create resources in the economy. Booming markets without sabings is not an accumulation of resources but an accumulation of claims on existing resources. Finally, when a community consumes more than it produces, capital decreases. And thus, on top of being a chronic low-saving, low-investment country (at least since the 1960s), America now also consumes capital. Frankly, this is no 'new paradigm.'

Booms warp the character of a society. For most investors, the fear of not making money outweighs the risk of loss. They seek rewards without a corresponding understanding of the assumed risks. They dismiss caution. Banish the prophets. Today, perhaps tens of millions, of Americans see their financial prosperity as a reflection of the stock market. They want the boom to continue. They also worship the Fed as they know that it has the power to give them eternal bliss by way of maintaining an easy money policy. Politicians are lost in their vain pursuit of power and intellectual poverty. And so, the entire political and economic establishment has become, along with the masses, a giant mob which will do anything to keep the game going. Eventually, just as our fathers or grandfathers learned, we too, will discover savings accounts and learn the value of thrift.

Booms distort entrepreneurship. In corporate headquarters all over the country, the desire for short-term gain is leading more and more companies into financial engineering, the managing of income statements, the managing of expectations and the view of the price of their shares (not to speak of the options managers give to themselves) as a barometer of a company's worth. American corporate managers claim such is the pursuit of "enhancing shareholder value." Rubbish. A company creates value by investing in productive capacity, investing in equipment and methods that improve productivity and by having a long-term view toward employees, customers and products. Financial engineering schemes such as cost-cutting, rationalizations, restructurings and acquisitions, are just hollow and, more often than not, admissions to failure. No one ever prospered by cutting costs. Unless, of course, his eyes were on today's stock price and his hands on a pocket-full of stock options.

Finally, booms distort the economic calculation. An investment during a mania depends on the continuation of the boom conditions. The economic assumptions being made on financing projects require that such current ideal conditions remain. But this is not to be. The unwinding of liquidity and credit crunch, when the boom subsides, eventually destroy not only the malinvestments made during the boom but the productive economy as well. Let Japan and South East Asia be the most recent examples in a long and painful history of how, "The more we try to provide full security by interfering with the market system" in the words of Friedrich Hayek, "the greater the insecurity becomes."

When will it all end?

No one knows how much further it will go or how long it will last. No one can predict with any accuracy the length of these manias. One thing certain is that busts follow booms. It will be sudden, nasty and impossible to escape from it. Many thought that the Japanese market was ridiculous when it passed 50x earnings in 1988. But when the bubble topped at 70x earnings a year later, it went straight down with enormous wealth destruction consequences.

Many economists and commentators have speculated as to what the catalyst is likely to be. The answer is that no one knows as there is a great deal of emotion involved. Irrational markets cannot be expected to function within rational expectations. Perhaps a sudden rise in the price of a commodity, a surprising loss in a large company, the insolvency of a financial institution, or a further rise in interest rates might turn greed into fear and then panic. In addition to loss of confidence or rise of suspicion, several exogenous events could also spark an exodus from the US dollar and the resulting bust of the stock markets. What is certain is that the longer this boom lasts and the further it expands, the greater the ensuing turmoil it is likely to produce. No reassuring words from a benevolent Fed will succeed in corralling the fear of a mob running for cover.

For the benefit of investors who expect that, somehow, they will recognize the end and pull their chips off in time, and for one Mr. Alan Greenspan who perhaps fancies himself becoming the first Fed Chairman in history to guide a bubble economy into a 'soft landing', history teaches us that bubbles end in just the same way every time - with no bids.

No nation in history has ever survived the prosperity test. Few families ever do. "We know the price of everything" Oscar Wilde wrote, "and the value of nothing." And when it comes to substantive issues, nothing has changed since his time. We confuse information for knowledge. We confuse knowledge for wisdom. We also confuse real prosperity with the illusory kind. I assure you it is not popular to stand against the crowd, take an opposing view or think for yourself. Yet, this is the trouble with prosperity.

Anthony Deden
Sage Capital Zürich AG

Mr. Deden advises families and co-manages the Bermuda-based Edelweiss Fund.

© 1999 - 2003 Sage Capital Zürich AG

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