The Greater Depression
January 30, 2004
Semantics
The language used by the Federal Reserve Open Market Committee in
its press release of January 28th contained a semantic change from
previous minutes. Instead of saying that they will keep interest
rates low for “a considerable period” the FOMC instead
decided it would just “be patient” about raising interest
rates. The market, on the other hand, has no patience. The dollar
immediately strengthened against the euro and, as a result, the
US dollar gold price declined.
In spite of yesterday’s action the dollar is
still very weak, and will continue to decline for many more years.
The more it declines, the more volatile it is likely to become.
In turn that will cause an equal amount of volatility in the dollar-gold
price.
The Greater Depression
Last week we discussed foreign currency crises and the increase
in the US dollar exchange rate during the Nineties. Starting with
Brazil in 1992 one currency crisis after another spread across the
globe causing capital flight. Net foreign investment in the United
States totaled thirty eight billion dollars in 1992 and increased
to over five hundred billion dollars during the past four quarters.
Cumulative net foreign investment since 1992 has been almost three
trillion dollars.
Most of this foreign capital found a home in US bonds,
increasing US bond prices throughout the 1990s. Rising bond prices
mean lower interest rates. The interest on 30-year Treasury Notes
fell from an average of 8.61% in 1990 to 5.02% as of yesterday and
the yield on 90-day Treasury Bills decreased from 7.75% to only
0.87% in the same period.
Lower interest rates meant that corporate borrowing
costs declined and that lead to an almost instantaneous increase
in corporate profits. Higher profits justified higher stock prices
and the thus the stock market bubble was born.
The reduction in interest rates that stemmed directly
from the influx of capital also caused an increase in corporate
cash flows. More cash flow allowed companies to increase research
and development, invest in capital expansion projects and spend
more money on marketing. More people were needed for all this; unemployment
fell from seven and a half percent in 1992 to less than four percent
in 2000.
More jobs meant more consumers, and Americans know
how to consume. The increase in consumption increased corporate
sales, which boosted corporate profits over and above the benefit
of lower interest rates. The increase in profits meant higher stock
prices and since currency crises were continuously occurring throughout
the Nineties, the booming stock market started to attract its share
of foreign capital investment.
Foreign capital investment also created demand for
dollars, increasing the dollar exchange rate. Foreign investors
were able to compound their returns on the US stock and bond markets
with gains in the dollar exchange rate, making US investments even
more attractive. Capital kept pouring into the United States.
As you can see the cycle was self propagating: it
started with foreign capital investment boosting bond prices and
lowering interest rates, the affect of which was to stimulate the
economy and that resulted in higher investment returns that attracted
even more foreign capital investment.
Rising stock and bond prices also made Americans feel
wealthier, giving them that extra incentive to spend just a little
bit more at the mall, at the car dealership and on their homes.
But falling interest rates also meant lower mortgage rates and that,
thanks to all the foreign capital being poured into the country,
enabled many more Americans to buy homes.
The demand for houses caused a real estate boom. Rising
real estate prices have a greater wealth effect than rising stock
prices. Wealthy-feeling consumers spent all they had: the personal
savings rate dropped from 7.26% in 1991 to 1.69% in 2001. Not having
any money did not stop them from spending. Household credit market
debt increased by 140% from 1991 to 2003. Not only are debt levels
historically high, the amount of disposable income going towards
servicing that debt is the highest it’s been in at least twenty
three years, as far back as my data goes. This is despite record
low interest rates. Not surprisingly, non-business bankruptcy filings
increased by 120% from 1990 to 2002.
But these were the good times: the “New Era”
of sustainable economic expansion with no inflation because of increased
productivity. Isn’t that what Greenspan said? I find it disconcerting
that during the most exceptional economic expansion the United States
has seen since the Roaring Twenties we are also seeing record bankruptcies,
record debt levels, a record low savings rate and record low interest
rates. The latter, of course, means that the Fed is between a rock
and a hard place. “But that is not all,” as the Cat
in the Hat said.
So much foreign capital made its way into the United
Sates that the dollar exchange rate, on average, more than doubled
from 1990 to 2002. The stronger dollar made foreign products more
competitive in US markets and made US products more expensive on
foreign markets, causing the US trade deficit to increase from thirty
one billion dollars in 1991 to its current level of about five hundred
billion dollars.
The good news is that large trade deficits can be
eliminated. The bad news is that a large trade deficit is almost
always followed by a recession, the magnitude of which is proportional
to the trade deficit. Given the size of its trade deficit, it would
be a pleasant surprise if the United States can eliminate its current
trade deficit by a mere recession. The magnitude of the deficit
suggests a depression is more likely.
A recession is defined as at least two consecutive
quarters of decline in gross domestic product. If it lasts more
than a few quarters and is associated with rising unemployment,
a general decline in prices and a loss of purchasing power, it becomes
a depression.
Recessions occur when excess inventory accumulated
during the expansion phase of a business cycle has to be absorbed
into the economy during the ensuing contraction phase. Depressions,
on the other hand, occur when the economy has to catch up with excess
production capacity. This takes much longer than merely working
off inventory.
When there is excess production capacity companies
cut their prices to try and stay in business. Think of the rebates
we have been seeing in the auto industry as an example. Companies
also cut costs by reducing their work force, and so unemployment
rises. Higher unemployment means fewer consumers and fewer consumers
mean less sales.
Consumers now have no purchasing power left: they
spent all their money and all the money they could borrow. Corporations
will have no choice but to engage in price wars and in the short
term that will lead either to lower prices (deflationary depression)
or stagnant prices. There is a probability that fiat inflation of
the money supply could ward off deflation. We will most likely see
a prolonged period of economic stagnation if it does.
Lastly, the massive influx of foreign capital and
the debt driven economic expansion lead to a considerable investment
in infrastructure. Manufacturing capacity currently exceeds production
by 33%, a historically low level of capacity utilization and this
is what causes depressions.
It is unlikely that we will see capacity utilization
increase until consumer balance sheets are fixed, and that could
take a long time. As Doug Casey often said, when the history books
are written the coming contraction could well become known as the
“Greater Depression”.
I find it hard to imagine that the US dollar is going
to reverse its downward trend while US consumers pay off their debt,
file more bankruptcies and see more of their friends collect unemployment
insurance. And a declining dollar means higher gold prices in US
dollars.
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
investment publication. For more information please visit his website (www.paulvaneeden.com)
or contact his publisher at (800) 528-0559 or (602) 252-4477.
Disclaimer
This letter/article is not intended to meet your specific individual investment
needs and it is not tailored to your personal financial situation. Nothing contained
herein constitutes, is intended, or deemed to be -- either implied or otherwise
-- investment advice. This letter/article reflects the personal views and opinions
of Paul van Eeden and that is all it purports to be. While the information herein
is believed to be accurate and reliable it is not guaranteed or implied to be
so. The information herein may not be complete or correct; it is provided in
good faith but without any legal responsibility or obligation to provide future
updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility,
or assumes any liability, whatsoever, for any direct, indirect or consequential
loss arising from the use of the information in this letter/article. The information
contained herein is subject to change without notice, may become outdated and
will not be updated. Paul van Eeden, entities that he controls, family, friends,
employees, associates, and others may have positions in securities mentioned,
or discussed, in this letter/article. While every attempt is made to avoid conflicts
of interest, such conflicts do arise from time to time. Whenever a conflict
of interest arises, every attempt is made to resolve such conflict in the best
possible interest of all parties, but you should not assume that your interest
would be placed ahead of anyone else’s interest in the event of a conflict
of interest. No part of this letter/article may be reproduced, copied, emailed,
faxed, or distributed (in any form) without the express written permission of
Paul van Eeden. Everything contained herein is subject to international copyright
protection.
|
Printer Friendly