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The Perfect Storm

Gloucester, Mass has received a lot of publicity recently as The Perfect Storm scores box office bonanzas but on a trip to that seaside town some years ago the sign over the registration desk reflected a belief in Yankee conservatism. "In God we Trust, All Others Pay Cash," was lettered in plain but unmistakable type and the polite but efficient lady behind the counter indicated that green bills embossed with the portrait of a president were the preferred means of payment. This unexpected relic of fiscal conservatism came like a fresh breeze off the bay.

And the memory of it lingers reading the headline "Debtor Nation" (WSJ, C1 July 5, 2000.) The numbers were all too familiar: "A record $44.5 trillion in debt has been accumulated by US non financial corporations up 67% in the past five years, household borrowing up almost 60% to $6.5 trillion. The average US household now sports 13 credit or charge cards and carries $7,500 in credit card balances up from $3000 in 1990." The article then continues with the obligatory salve that debt isn't really bad as it has boosted consumer demand.

But households are not alone in taking on debt. One might expect that during boom times corporations would pay down debt and strengthen their balance sheets but investment grade corporate debt issued in the first six months of this year totaled $223.7 billion, up from $213.7 in the same period of 1999. (Thomson Financial Securities Data.) And government sponsored enterprises Fannie Mae and Freddie Mac last year alone issued $260 billion in long term debt.

On July 21st Alan Greenspan told the Senate Banking Committee that inflation was expected to remain subdued at about 2.5 to 2.75% this year declining to 2 to2.5% in 2001.

The government inflation numbers are an exercise in wishful thinking presided over by Bureau of Labor Statistics. In June the US reported that consumer prices increased 0.6% vs. 0.1 percent in May. The BLS uses hedonic regression to quantify gains in quality as it relates to price. For example, according to the BLS, computer prices have fallen by 26% a year for the past five years.

Over the last year the BLS states that housing has increased by 3.2%. This is hardly corroborated by the individual observations of anyone I have met most of whom are thrilled by the increases in their real estate. "We have seen the biggest-ever across-the-board quarterly jump in home prices in the Hamptons," gushed Diane Saatchi, president of Dayton-Halstead Real Estate. The average price of a home in East Hampton has jumped to $2.1 million from $1.2 million in the last three years with two thirds of that increase in the first quarter of this year. (New York Times, July 18, 2000.) What about mere mortals who don't have a spare couple of million to blow on a summer home? The "State of the Cities 2000" from the Department of Housing and Urban Development states that "from 1997 to 1999, the CPI rose 6.1%, an average of 2% per year. During the same period, rents rose by 9.9% and house prices by 16%."(as reported in Grant's Interest Rate Observer July 7, 2000.)

It's easy to see why the BLS is intent on understating inflation. Social Security, veterans and government pensioners are all indexed for inflation. No inflation, no increase in payments which could effect the "budget surplus." Second, the US is running a trade deficit of $1 billion a day. If inflation trends are up foreigners may not be so willing to finance our consumption.

And finance our consumption is necessary as the US trade deficit widened in May to a record $3l.04 bln, the worst performance ever. It was more than a year ago that Chairman Greenspan addressed this issue, "A more distant concern, but one that cannot be readily dismissed, is the very condition that has enabled the surge in American household and business demands to help sustain global stability: our rising trade and current account deficits. There is a limit to how long and far deficits can be sustained, since current account deficits add to foreign claims on the United States…but the arithmetic of foreign debt accumulation and compounding interest costs does indicate somewhere in the future that, unless reversed, our growing international imbalances are apt to create significant problems for our economy."

It is axiomatic in our society that addressing a problem has solved it. How often have you heard that a "problem has been addressed and it's time to move on." Since these words of concern the deficits have increased with no end in sight.

Dr. Kurt Richebacher writes in his July letter, "Of particular importance is, of course the dramatic deterioration in the U.S. foreign trade and indebtedness. In 1995, the US deficit in current account had been $113 billion in the red. Presently, it is running in excess of $400 billion annually. During the four years since the dollar's low in 1995, US net foreign indebtedness has roughly doubled by abut $830 billion to more than $1,600 billion. In the same letter he also notes that "there is far more at stake than merely financing of current outflows. An even bigger threat to the dollar looms in the existing, vast foreign holdings of dollar assets that have accumulated in the last few years. According to latest official calculations, these amounted to almost $2,700 billion on Dec. 31, 1999, of which $1,837 billion was on private account and $833 billion on account of central banks."

Since then these inflows have increased creating the vast and happy illusion of ongoing prosperity and a state of disbelief on the part of the public that the current credit boom will never end. This is fostered by an ongoing stream of soothing comments by financial commentators.

An unprecedented increase in credit has fueled an equity inflation, better known as a bull market, and in the words of the Wall St. Journal, "The tech bubble had one thing no past manias had: the push from online brokers, who made speculating on stocks easier than ever and advertised heavily to encourage people to chase riches." (WSJ July 14, 2000.) The above quote comes from an article titled, "The Internet Bubble Broke Records, Rules and Bank Accounts." The carnage is described in retrospect. "Internet stocks as a group, valued at $1.4 trillion at their March peak, have lost 40%of that—erasing almost as much paper wealth as the 1987 crash."

But what kind of wealth does the investment public have other than "paper." A review headlined "Progenitor of the Paper Millionaires "(WSJ July 19, 2000) extolled John Law who's singular achievement up until the spin placed on it by this book "The Rich and How they Got that Way", was to be known for bankrupting France. It is a sign of our times that the review concludes: "John Law's experiment, like many experiments, was a failure, even a tragedy for some. But his ideas were like smoke from a bottle: Once out, they could not be put back. He had proved that the value of money is an agreement among people, not an objective standard measurable in nuggets or ingots, a distinction that fostered future stages of wealth creation."

While it may seem preposterous in the current environment it is easy to imagine future generations reading volumes written about the experiment in floating exchange rates and currencies without gold backing that resulted in an immense experiment in unbridled credit creation as a proxy for economic growth.

At the center of this cult is the Chairman, and we are not referring to Frank Sinatra. Last week Mr. Greenspan corroborated some of our own misgivings when he spoke of "the rising debt burden of households," commenting that "interest and amortization as a percent of disposable income have risen materially during the past six years, as consumer and especially mortgage debt has climbed."

But have consumers really ended their debt binge? As Gene Epstein writes (Barron's July 24th) "Since early 1996, Fed Chairman Alan Greenspan has been singing the same refrain: the unemployment rate will stabilize, and economic growth will moderate. He's always been wrong. Last week, he made the same forecast for 2001? Will he be right this time?"

And as if to negate all of his prior warnings he wrapped up by saying, " There is very little evidence to suggest that rising debt burdens on households are per se a trigger of an economic recession. Most people have a pretty good idea of how much debt they can carry. Consumer debt has been a remarkable beneficent force in moving people into the middle class over the last two or three generations, and it continues to be a potent financial institution."

Classifying consumer debt as a financial institution is certainly a novel idea especially to the 1.3% of US households who declared bankruptcy last year. That's up from .8% in 1995 despite the "unprecedented economic boom." Similarly, in the last twelve months, the corporate sector has seen "junk" bond defaults soar to 5.4% of interest payments from 1% in 1997 and Moody's expects that figure to rise to 8% this year. So what do we have here? Unprecedented credit creation coupled with a record increase in the amount of debt burdens on both corporations and consumers. And finally the rogue wave of gross misrepresentation of inflation as perpetrated by a cynical and manipulative government. This confluence of events has the makings of what a financial analyst would describe as "a major systemic risk to the US financial system."

To the layman that would be the Perfect Storm.

Greg Pickup
July 28, 2000
gpickup@ix.netcom.com