Waiting for Godot
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." - Ludwig von Mises, Human Action, A Treatise of Economics, Yale University Press, 1949
Once again, we are treated to the vaunted "second-half recovery" mantra from the mainstream financial press. Could it be that this year we will finally have our cake and eat it, too? For the benefit of long-time Daily Reckoning readers, we will cut to the chase and dispense with all illusions of suspense: in reality, the U.S. economy is in recession, as reflected in the dismal employment performance.
Pointing to the various statistical adjustments in the price indices that substantially boost Americas real GDP growth, we have argued ad nauseum that the reported U.S. growth rates grossly overstate the reality in comparison to other countries.
Of course, it is nevertheless always possible that the economy is embarking on a strong, solid recovery, as predicted and widely expected. The bullish consensus draws its optimistic assessment largely from the belief that a sufficiently strong policy stimulus is now in place and partly from some better-looking indicators.
As to the first assumption about policy stimulus, we can only express our utter amazement. It flatly ignores the extremely poor economic effects of the even more prodigious monetary and fiscal stimulus of the past two-and-a-half years. To us, this recent experience really forbids any optimism in this respect about the future.
Assessing the U.S. economy's prospects essentially begins with two crucial questions: first, will businesses start hiring and investing again pretty soon? And second, will the consumer be willing and able to keep up his borrowing and spending binge? Please consider that one month of the second half of the year is already behind us.
Looking for the recovery, it strikes us in the first place that the second quarter was no better than the first quarter, if not weaker. Production posted gains of 0.1% in May and June. But it decreased at an annual rate of 3.2% in comparison to the first quarter.
The central assumption behind the consensus' U.S. recovery forecasts is an incipient, strong revival in business capital spending. In actual fact, it is absolutely indispensable that it materialize very quickly.
Since any sign of higher investment spending or even of higher production is so far completely missing, we have to look for early indicators. There are modest improvements in survey indexes, generally considered as leading indicators, but there is no trace of it in the hard data, reflecting current facts.
Capital goods orders and shipments, in our view the best proxy for investment spending, remain stuck in virtual stagnation. In fact, 'core' orders for capital goods excluding defense and aircraft dropped 0.4% in May, following a 2.8% decline in the month before. New orders for machinery were 4.3% below their level a year ago, and among those, orders for computers and electronic products were down by 9.6%.
However, the bullish consensus argues that the necessary conditions for the investment revival - above all, higher profits, higher cash flow and stronger balance sheets - are developing.
It is generally agreed that a strong rebound in profits is the key condition for a solid and sustained investment recovery. Aggregate after-tax profits of nonfinancial corporate business, as measured by NIPA, were $197 billion in 2002, even lower than the $205.3 billion in the recession year before. Yet they improved in the course of the year. But as it is so often, the devil is in the detail.
The fact is that profits have been and continue to be heavily inflated by special factors. We note: first, big 'inventory profits' deriving from rising oil and commodity prices; second, big gains from financial activity and speculation; third, big currency gains by foreign subsidiaries of U.S. firms; fourth, an unusually large rise in the profits of foreign firms in the United States; and fifth, continuous, heavy underfunding of pension fund obligations.
If the poor profit performance needs any further proof, it is in the unfaltering 'earnings-management game.' Despite the condemnation of past accounting tricks, the familiar tricks to make profit numbers look better than they are have remained in rampant use. A common ploy is to report fictive 'pro forma' profits; another is to measure them against deliberately reduced 'expected' profit. For example: the reported profits of Apple Computer topped expected profits by a whopping 67%. In actual fact, they had fallen 41%.
Whenever we read of better-than-expected profits, we presume cheating. Such reports often lead to the systematic delusion of investors. Yet no one protests; instead, they follow after the delusion in the hope that it will mean higher stock prices. Economic reality is too unpleasant to be faced with open eyes. But for people with a bit of common sense, this method of comparison is completely arbitrary and meaningless.
It seems, of course, a fair assumption that a solid second-half economic recovery will not fail to buoy profits. But first of all, we do not believe in this recovery, and second, we fail to see the micro and macro adjustments that are necessary to improve profits.
As we have stressed many times, our own assessment of profit prospects is strictly determined by focusing on the particular flows of business revenues and expenses that generate business profits. Based on this analysis, we see nothing that speaks for substantially higher profits. There is a great risk to profits in a probable, prolonged rise in personal saving from current income. A possible boost may come from the rising budget deficit.
P.S. Poor profit prospects are not the only reason we are unable to see a solid, sustained investment recovery in the United States. General financial viability, measured by various financial indicators, is another indispensable condition.
How robust are American company finances? The short answer is that balance sheets are not a picture of health. What's more, whether they are improving or deteriorating remains an open question. We believe in the latter eventuality; at best, there has been very little recent improvement.
In the frantic pursuit of higher stock prices, American managers in the past few years have systematically devastated the balance sheets of their companies. Financial damage that took several years to build up cannot be corrected in several quarters.
Editor's note: Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebacher wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebacher'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."
Dr. Richebacher continues to warn readers about the follies of the Fed's current easy-money policies. For more, click here: Greenspan Is Robbing You Blind