A President Bush Economic Boom????
It is with utmost interest that I watch the usually very upbeat news on CNBC. In fact, Mr. Kudlow and Mr. Cramer are extremely fitting commentators for the current economic and political environment. We have a righteous, intolerant and belligerent third rate intellectual who lives in a big white house, runs the world's largest economic and military power, and who has surrounded himself by some very shady characters who are also because of their complete military incompetence, and lack of any knowledge of history and understanding of geopolitical conditions very dangerous. At the same time, we also have the pleasure to regularly watch two fast-talking and squeaky clowns in the CNBC circus who, for the last few years, have given their upbeat views on any economic, financial and political issues. The "know it all" duo's advice has not been particularly rewarding for investors, and had you invested your money according to their "never in doubt" bullish mantra, your assets would be worth today at least 60% less than in 2000 (in terms of Euro or in a hard currency such as gold, they would be down in value by another 25%). But since poor advice is not only endemic to the two relentlessly irritating CNBC financial commentators but is almost a prerequisite for success in the financial service industry, we shall not hold it against them. Still we have a question relating to a recent statement by Mr. Kudlow, which somewhat surprised us, since Mr. Kudlow is not exactly born yesterday although some of his views could lead one to believe so. In a recent article he explained why "this Bush Boom is a lot like the Reagan Boom 20 Years Ago".
Now, I have some reservations about this comparison for the following reasons. If you look at interest rates over the last 40 years or so, you will see that when, in 1980, Mr. Reagan became President of the US, rates were near their highs and since Mr. Volcker (then the Fed chairman) pursued at the time very tight monetary policies he managed to bring down the rate of inflation, and subsequently also interest rates, which then fell for the next 22 years (see figure below). Needless to say that whereas interest rates were sky high in 1980 and significantly above the rate of growth of nominal GDP, today the Fed Fund rate is significantly below the rate of nominal GDP, which suggests that short term interest rates can only rise if nominal GDP continues to expand, as Mr. Kudlow suggests with his "Bush Boom" fantasy.
Table 1: US Short Term Interest rates and Nominal GDP Growth
Source: Bridgewater Associates
The tight monetary policies of Mr. Volcker in the late 1970s and early 1980s were evident from the fact that short-term interest rates were pushed above nominal GDP growth and above long term interest rates (see figure below) . This very tight monetary policy implemented by Paul Volcker is usually credited for having brought down the rate of inflation after 1980. However, it is my view that the rate of inflation would have come down regardless of monetary policies because strong price increases for all commodities between 1965 and 1980 had led to additional supplies, which after 1980 began to flood the market and depress prices. This was particularly true for oil, which had risen in price from $ 1.70 per barrel in 1970 to close to $ 50 per barrel in 1980. In addition, conservation efforts all over the world had curtailed demand. Finally, the fourth Kondratieff price wave, which had turned up in the 1940s was due to reach its plateau between 1975 and 1985, and then to turn down, since each phase of the long wave lasts between 22 and 30 years (according to Nikolai Kondratieff the ideal length of the long wave cycle, which consists of a rising and falling wave is between 45 and 60 years). Therefore, the combination of rising supplies, energy conservation, and diminishing purchasing power on the side of households (because of inflation exceeding nominal income gains) would have in the early 1980s - regardless of monetary policies - brought down the rate of inflation sooner or later. Nevertheless, it is clear that whereas monetary policies were very tight in the early 1980s (short term rates significantly above long term rates - see figure 2) today monetary policies are ultra expansionary and inflationary since short-term rates are not only below the rate of nominal GDP growth (see figure 1) but also significantly below long term interest rates (see figure 2).
Figure 2: Yield Spread between Short and Long Term Interest Rates
In addition, while we may argue about the severity and ultimate duration of the ongoing slowdown in the Chinese economy, it is clear that the incremental demand for commodities from China will at least support commodity prices above their level reached in 2001, when the price of most industrial commodities were 50% lower than they are today. I may add that by 2001, commodity prices had been in a bear market for the last 25 years, and had reached in real terms (adjusted for inflation) the lowest level in the history of capitalism (see figure below). In other words, even taking a negative view of the world's economic outlook, it would seem that the secular bear market in commodities, which began in 1980, has come to an end and that from here on we shall rather see higher than lower commodity prices. So, even a third rate economist should see the difference between today's situation and that of the early 1980s - this especially if he were optimistic about the global economy, which would sustain demand for raw materials. So, whereas in the early 1980s commodity prices and interest rates began to decline from a secular point of view, in the period 2001 to 2003, it would appear that commodities and interest rates have begun to rise.
Figure 3: Commodities in Real Terms
There are several more fundamental differences between the early 1980s, which led to the Reagan boom and today's economic conditions. When in 1980, Mr. Reagan became President of the US, the debt to GDP ratio stood at around 130% and was not meaningfully higher than in the 1950s. In fact, from the figure below, courtesy of Barry Bannister of Legg Mason in Baltimore, we can see that until the 1980s, one dollar of additional debt boosted GDP by about $ 0.70. But now, with debt at close to 330% of GDP, one dollar in additional debt only leads to an increase in GDP of about $ 0.25!
Figure 4: Total Credit Market Debt and GDP
Source: Barry Bannister
We can, therefore, say that today, because of excessive debts in the system, debt growth and fiscal deficits are far less effective at stimulating the economy than they were at the time of President Reagan. In fact, I would argue that for monetary policies the "Mother of all Monetary Tests" is unfolding right now, as it may be that monetary stimulus is no longer going to boost the economy, but inflation alone, which would lead in a benign scenario to stagflation and in a worst case scenario to a inflationary depression a la 1980s in Latin America. (I admit that a deflationary recession/depression remains a possibility, although not a very likely one given the Fed's monetary policies, Mr. Greenspan's track record at tackling every economic discomfort with an additional injection of liquidity, and Mr. Bernanke's recent statements about the Fed's ability to print money.)
Another difference between the early 1980s and today's conditions relates to the US dollar. In the early 1980s the US dollar had become significantly undervalued following its steep decline against hard currencies after President Nixon had closed the gold window in August 1971 (see figure below). Today, however, the situation is fundamentally different. Whereas one could argue that the US dollar is about where it should be against the Euro, the dollar is certainly grossly over-valued against the Asian currencies. A sustained dollar rally such as occurred in the period 1980 to 1985 is, therefore, given also the large external deficits of the US, almost out of the question (see figure below). More to the point, whereas in the early 1980s a dollar rally unfolded at the same time the US had growing trade and fiscal deficits, today even larger trade and fiscal deficits are more likely to lead to additional dollar weakness - not strength. I may add that I feel that the dollar has about the same downside risk against the Asian currencies as it had in 1971 against the European currencies, against which it then declined by 70% in the course of the 1970s and led to its early 1980 under-valuation.
Figure 5: Trade Weighted Dollar 1980-2004
Source: Ed Yardeni
Needless to say that additional dollar weakness would add to inflationary pressures and intensify the trend toward higher interest rates.
The last fundamental difference between the early 1980s and today concerns not only the stock market and housing market in the US, but also most stock and property markets around the world. In 1982, the Dow Jones Industrial Average was no higher than it had been in 1954, and adjusted for inflation it was down by 70%. How inexpensive equities were relative to the overall price level and especially against commodities is evident from the gold to Dow Jones Ratio. In 1980, with one ounce of gold you could have bought one Dow Jones Industrial Average. Today, however, it takes about 25 ounces of gold to buy one Dow Jones Industrial Average, suggesting that US equities are not particularly cheap (or very expensive, as I believe, compared to gold). Moreover, in 1982, stocks sold below their book value and had a dividend yield of 7%! Compare that with today! Equally property markets around the world were depressed in the early 1980s, due to sky-high interest rates. Today, property markets, especially in the Anglo-Saxon countries all exhibit symptoms of bubbles.
Finally, in the early 1980s, consumers had a pent-up demand for goods and services following the 1980/81 and 1982 recession. Their saving rate was above 9%, whereas today, we have no pent-up demand whatsoever, and there are on the household level practically no savings. So, whereas in 1982, the then existing pent up demand led to a strong consumption led recovery, today, the over-leveraged consumer may actually, as some recent economic indicators seem to indicate lead - if not to a consumption slump - then at least to a slowdown in the growth of consumer expenditures.
In sum, we can see that today's economic conditions are widely different than what we had in the early 1980s. In particular, today's debt load, the vulnerable position of the US dollar against the Asian currencies, the long-term price cycle in terms of commodities and interest rates likely to have bottomed out and having embarked on a rising trend, the consumer's debt load, and stock valuations are such that a sustainable healthy recovery is unlikely to shape our future. In fact, I would argue that conditions are now so blatantly different that a "Bush Economic Boom" is almost certainly to end up in a "Bush Economic Slump " perfectly matching the "Bush Military Calamity".