Ass-Backward Economics - III Jim Willie CB

I attempt to document the most flagrant and destructive among the constructs held as true. The list continues from the second installment to this article. In the final segment, several concluding points will be made on current developments. With each passing month, many important events occur. The pace picks up, even as the danger level rises.

h) Global trade has been beneficial to the US Economy, opening new markets. Nothing could be further from the truth, as global trade has become a one-way street, replacing our mfg base and its jobs with extreme debt obligations, an unmitigated disaster that has yet to end. In a desire to lower our cost of consumption, our nation has sponsored global trade. Sure, we have assisted developing nations in their growth. We have lowered the cost of imported finished products through (typically Asian) imports. We have lowered the service costs of many tasks through outsourcing. A strong dollar has worked in dovetail to further this process. Everything from consumer electronics to household items, to technological components, to industrial supplies and cars, all have been supplied for years by emerging nations. They are grateful to have our markets so open. However, their markets have not been opened sufficiently to our corporations who reciprocally seek foreign markets in which to sell. What has evolved instead is a one-way street. In our haste to lower the cost of our addictive consumption, we have sold the store on the cheap. The good news is that a Sony stereo has declined in price. The bad news is that our country does not manufacture stereos anymore, and those mfg jobs are unavailable to American workers.

A second and perverse effect from global trade has been the coerced sale of US Treasury debt, mortgage finance agency debt, and corporate debt. As Richard Duncan has described in his recent book, our credit markets are perhaps the largest and most available destination for such enormous outsized trade surpluses largely held by Asians. Our nation willingly invites a weakened set of Asian currencies, watches in glee as our import costs are kept low, and at the point of an "open market gun" coerces the Asians to recycle their surplus back in our debt. In doing so, we have allowed the Asians to gradually accumulate claims on the base capital of a significant portion of our nation. Foreigners in total own almost half of our federal debt, and one quarter of our corporate debt. We are slowly becoming a slave to our Asian credit masters. How on earth will we be in a position to stand our ground on political issues such as Taiwan absorption, North Korean nuclear threats, or the continued copyright theft of software, books, and music by China? Sadly, we will do exactly what our Chinese and Japanese masters dictate. On the other hand, they will in turn use as bargaining chips in leverage a threat to unload large quantities of our govt, agency, and corporate debt securities. A follow through on such threats would wreak havoc on our federal financing operations, our mortgage industry, our real estate sector, our corporate solvency. In short, it would decimate our economy as a whole. Of course, the US leaders would cave in.

The original hope and plan was for the US to realize lower imported product costs, in return for the sale to foreigners of our advanced technology equipment, if not more sophisticated management expertise. The reality has been that Asians purchase some infotech equipment from American firms, but the production for that equipment has typically come from Asian offshore mfg plants. Our sophisticated mgmt expertise has turned out to be accompanied by extreme debt abuse and financial engineering, which Asians do not sanction. Worse still, Asian shipping docks are far more effectively protected from infiltration by American firms. The Japanese and Chinese economies remain stubborn for our firms to export into. In many instances, large contract deals in wireless technology have been sealed with China. Given the incredibly large size of the Chinese market, and the single point of sales, their govt has succeeded in negotiating enormous discounts from American and European technology providers. The sales are magnificent in size; the profits are minimal in size. The motivation for American firms has been consistently to prevent their domestic and foreign rivals from entry into the Chinese market. See Qualcomm and Nokia for easy examples.

The USGovt and financial markets remain a tremendous obstacle to stem the capital bleeding from the global trade one-way street. This global movement came with a mantra that sounded good while its effects were lethal. Political leaders continue to parrot the urgent support of a "Strong Dollar Policy," despite its awesome and far-reaching destruction to our economy. When Dept of Trez secretary Snow backed off on currency support, minimizing the extent of the dollar decline this spring, FOREX markets went crazy. They took the USDollar down over 5% suddenly, thus establishing yearly lows. This has to be the greatest Catch22 in which our national currency has ever found itself trapped. A sustained and unforgiving dollar decline would cause incredible damage to the USTBond market and federal debt finance operations. The domino effect extends immediately to the mortgage finance industry. Given the strong connection between the housing sector and the general economy (e.g. retail consumption), a falling dollar would send the US Economy firmly into recession, a recession sure to gather momentum. A reeling bond market would also hurt the stock market, unless a recovery is sufficiently robust. It is not. This recovery is pure phony (possibly a recession) and founded upon creative statistical chicanery. On the other hand, our nation's businesses, and therefore jobs, absolutely require a USDollar valued much lower if they are to survive. Many will not. If American companies are to be in a position to compete, they must be the beneficiary of a properly valued equitable currency versus trade competitors. They are not.

Our competitive position is disadvantageous due not only to currency concerns, but also to many other factors. This is precisely the trap that Rubin orchestrated. His Goldman Sachs cronies surely profited in the hundreds of millions of dollars in the late 1990 decade, by means of carry trades. The initial motivation for the "Strong Dollar Policy" was to reduce the cost of imports. The secondary motivation was to encourage a stock and bond market boom. It was fueled by gold sales, and accelerated by carry trade gearing via futures contract leverage. Now we are trapped with low bond yields, a high currency valuation, and a thoroughly lost competitive position. The US Economy is listing badly. China is killing us on the production side, while India and Hong Kong are killing us on the service side. The global trade gambit has not seen reciprocity. The global trade fostered a movement that propelled the USDollar to unforeseen heights, at a time when the euro currency was ill-prepared to provide a healthy countervailing force.

The goal of global trade stood on high ideals. The practical outcomes have been far from it. The role of our more mature and paternal economy was to provide markets for developing nations. We did our duty without durable benefits. An obstacle to attain the ideal in the early days of the experiment had been our nation's price/cost structure, to date prohibitively uncompetitive. Costs are high as a result of chronically high tax burden, worker pay scales, health provision, and debt loads, all compounded by a still overvalued USDollar. Global trade has been an utter failure, and has contributed greatly to the ongoing bankruptcy of America. In fact, the debt claims against our nation's asset base now equal the entire value of that base. Be sure to expect trade sanctions, trade barriers, and other restrictions in a futile effort to save American jobs. Some will stick, but their net effect will be to allow for higher domestic prices, as seen in the protected steel industry. Everything nowadays is backwards.

i) The US Economy will break free of any Zero Bound trap, as broad demand grows, interest rates rise, and critical sectors weather the return to more "normal" interest rates. How little is understood about the powerful Liquidity Trap signaled by zeros. The customary path is for capital to find safety in the bond market as economic activity slows markedly. Next in the customary cycle is for capital to flow into stocks, preceding the revival of final demand from pent-up sources. Then comes the arrival of the economic rebound, complete with inventory replenishment, final sales, investment in capital equipment, and jobs. Last to kick in is the filtering down of profits, which confirms the rise in stock equity values in anticipation. A key element in the cycle's completion allows for increased cash flow and profitability to offset somewhat higher interest expense. This patterned cycle of capital flow has been the case for four decades. Is it that simple this time once again, a typical stroll through the economic cycle? I sincerely do not believe it is, no way, not this time. Profits, demand, and investment will not arrive as expected, not this time. If they do, their volumes will be scant, a disappointment.

This cycle bears little resemblance to any previous cycle since World War II. All preceding post-war cycles had a first phase characterized by rising prices, product shortages, excessive credit demand, and high interest rates. During the sudden next phase, debt loads were reduced, balance sheets were repaired, as pent-up demand for cars, housing, and capital equipment gathered. Expansion was briefly interrupted for only a few quarters, then resumed. Any diligent student would have to dig back to 1930 in order to produce a similar cycle for today's events. We are in a supercycle correction, with prevailing conditions in stark opposition to preceding cycles. Amazingly, reports from within the hallowed halls of the economist priesthood detail similarities in the data to 1930, without making the clear connection in structural similarity !!!

Herein lies the dissimilarity from past cycles. Intense competition, overproduction, and crazed credit expansion prompted the onset of economic winter, manifested by liquidation on multiple fronts. Momentum of declining prices feeds upon itself in a vast feedback loop, from the liquidations and bankruptcies. The presence of Chinese competition only aggravates the lost pricing power. Their continued presence makes for unrelenting price pressure. Bankruptcies accompanied corporate scandals to lay bare both the excesses and fraud, much like the 1930 decade. Money velocity has slowed substantially, further hampering debt service, again like the last supercycle winter.

Let's touch each difference. We now have falling prices, not rising. We have product gluts, not shortages. We have low interest rates, not high. We have no accumulative demand for big-ticket items, exhausted rather than pent-up. Debts have increased since the 2000 stock market bust, especially consumer and household debt, not decreased. Corporate balance sheets have not improved, but rather face the threat of reduced potential cash flow from a diminished work force and neglected investment in capital equipment. Balance sheets of firms within the financial sectors have improved, but only by means of Fed pump prime inflation, and not from real production of anything. Mainstream production firms which have sizeable financial subsidiaries have fared well in recent quarters. General Motors boasts 75% of its profitability coming from car loans and mortgage origination. GM is apparently a large mutual fund, operating a small car operation and a large credit operation. Is Home Depot next to offer mortgages? How about IBM? This is precisely the manifestation of financial sector cancer metastasizing to other production sectors. When mortgage finance turns sour, productive sectors will be more hurt than otherwise, since they have deferred balance sheet repair and other hard decisions. Their nascent financial arms offered a welcome reprieve.

The largest firms have been exposed for their pension obligations, executive stock option dilution, and off-balance sheet debts. Finally, we have the failed arrival of three 2nd Half Recoveries, whose label evokes laughter in the some expert circles. I regard this rallying cry as the ultimate dupe game on Wall Street, with no shortage of takers. In my view, every requisite characteristic of a completed recessionary remedy is unmistakably absent. The foul wind of rising domestic production cost pressures coupled with a tight lid on pricing power are the new ingredients which magnify the current risk over and above past recessions such as 1992-93. Rising production costs will next shrink profit margins. Rising energy costs will next inhibit household budgets. All inflation is not beneficial, now that we perceive price deflation as a risk. Drowning investors seem to lurch to grab at this stick in the cresting waves, but the stick has sharp teeth.

Low interest rates grip the entire economy on many dimensions, a condition not easy to emerge from. Unless Detroit significantly cuts back on production, consumers can continue to expect low rates, as car manufacturers work free from union strangleholds. On a per car unit basis, as long as the furlough costs exceed production costs, car inventory will be under liquidation pressure. In other businesses beyond cars and housing (including furniture), customers are being conditioned to expect low rates. As long as consumption slumps are not tolerated nor allowed, price pressure will be perpetual.

Swaps and derivatives in recent years have squeezed precious profits from the stressful business-credit environment. Corporate swap contracts exchange sterling longterm bond ratings and low yields for shorterm rate exposure. If shorterm rates rise, a multitude of corporations will see their earnings eaten like seedcorn in summertime, reversing the recent swapped advantages now committed toward. Interest rate derivatives clutch the credit markets like an extremely tight waistband. As the trend became clear a couple years ago, speculators and hedged businesses alike leveraged their big bets to exploit the disinflation trend. If rates rise, derivative damage could be an unwelcome new toxic agent to the market mix, both shorterm and longterm. The brokerage industry also applies pressure for lower rates, as the misleading and illusory "Fed Model" for stock valuation is trotted out. This model has no relevance in a contracting environment. The Fed Model has fooled the stock market to bid up valuations when profit arrivals are far from certain, setting up a possible crash. Lastly, a slight rise in rates would have little material impact on housing prices, but it would certainly stall mortgage refinances and thus consumption within the economy. The recent rate rise has indeed brought refi's to a standstill. More than a small rate rise would probably cause residential real estate to officially go into decline. The impact to the overall economy would be potentially crippling. Derivative events would be certain.

The above arguments outline the reasons why Zero Bound interest rates force the US Economy to engage in a "Battan Death March" where pressures abound to stay the course, even against the will of certain financial experts and leaders eager to see the cycle resume. The march for the US Economy follows a very narrow path, threatened by more dangerous and explosive pitfalls than anything seen in Japan. Formidable pressures are encountered from political sources, financial sources, commercial sources, investment sources, and housing sources to proceed on course. The Zero Bound phenomenon is a vivid symptom of our Politburo central planners having lost control, whose policies are no longer effective. In plain language, the committee policies have failed. The procession into the Liquidity Trap is orders of magnitude more complicated, problematic, and challenging than even the experts realize. Ask Japan, which tried to liquefy and monetize its way out of the trap, without success.

The low rates within the Japanese Govt Bond market, combined with reluctance to liquidate the submerged banking system will keep Japan from exiting the trap. For many reasons the US Economy will experience shock waves and a rocky revulsion of lower interest rates (see [12]), unlike Japan. Reasons include reliance upon foreign imports, dependence upon consumption, foreign-held debt, ease of bankruptcy, Federal Reserve monetary expansion on steroids, a shaky monolith monster of Structured Finance, and most importantly our overvalued currency, the USDollar. The recent bond market revolt is but the first step in departure from the path on the death march to Zero Bound. It has not been smooth, will not be smooth in the future, nor will it be quiet. We are approaching a treacherous fork in the road. The unwinding of bond hedges and speculative wagers could easily push our economy off the narrow path, and force our financial markets to face extreme peril.

Right now, we are seeing prevailing longterm interest rates rise. The US Economy is attempting to absorb the effects of rising rates. Stock valuations are stretched. Mortgage finance has taken losses, led by Treasuries. Swaps will not do harm until shorterm rates rise. The effects of rising rates are being minimized by the press & media, as well as by financial leaders and private sector executives. In 1994, rising rates were adequately handled by an economy which resumed its expansion. Private savings were adequate to meet the demand. Today, private savings are actually negative, just like GDP growth. The current economy expanded minimally in the last few quarters, up against formidable headwinds. Is the economy truly recovering, or is the bond market experiencing the first of several shock waves? Is further fallout coming soon? Are unexpected surprises lurking around the corner? Could an unfortunate derivative event finally be near, rumbling under the surface? Will foreigners soon question whether US Treasury debt could grow so large that default could occur? I suspect the answers to these questions are an unequivocal YES. All in time, probably sooner than we think.

j) The US Economy is growing again, with profits returning, led by strong productivity and improved balance sheets. What a fantasy sold by Wall Street, and sold well. This claim is a downright incorrect perception. We may see some temporary resuscitation in the economy from countless billion$ in sloshing funny money to spur activity. But for how long? But in what sectors outside the financial and housing sectors? The national gross domestic product is not what it is reported to be. Several absurd adjustments enhance the GDP in misleading fashion, only to paint a deceptive picture on income and savings. Corporate earnings are evident only on a pro-forma basis after unwanted costs are bypassed in publicly released reports. Revenues are still in decline, while earnings are compared to expected analyst figures which are racheted down in orderly but secretive fashion. The central foundation for managing any semblance of earnings comes from job eliminations and curtailed spending on capital equipment. Rather than boasting of economic growth, one might easily conclude that a slow motion liquidation process is underway in relentless fashion. Job cuts and investment cuts now threaten corporate financial health, as cash flow will be unlikely to revive.

Productivity has never surpassed 2.0% for at least two decades, unless one allows for fictitious output. The productivity miracle was successfully sold to the public in the last decade. In the last several months that miracle has been quietly dismissed by true experts, even as official govt statistics are slow to ease out their deceptive adjustments used far too liberally. Confusion abounds, as productivity is exaggerated to explain meeting new product demand. Hedonics and shell games are the culprits. Pundits proclaim the benefits of a mfg capacity which is 25% idle. Instead, statistical deception is responsible. Each new computer generation brings with it even more magnified productivity accounting miracles.

Corporate balance sheets are not only overloaded with more debt than in the year 2000, but pension obligations of extraordinary proportions are coming to light. Many corporations have indeed replaced much of their debt with lower yields, which will allow for their bond investors to take the losses. General Motors just added $19 billion in debt to its obligations, crowing to the public in news releases that it has improved those same balance sheets. Only a financial idiot would agree, or a desperate investor eager to embrace certain "greater fool" nonsense. Focus here may be unfairly directed at General Motors. Hundreds of large companies are in a similar bind. Sadly, GM bond investors will be taken to the cleaners, just like dotcom stock investors were several years ago.

The "jobless recovery" continues, showing multiple distress signals. Investors continue to be fooled. Maybe they do not mind being fooled, as long as their stock portfolios are rising in value. The US Economy proceeds with its ultra-slow-motion liquidation of debt, labor force, and inventory. Investors seem not to make the clear connection between jobless recovery and actual economic recession. Their illiteracy leaves their financial wellbeing greatly exposed in a manner that has not materially changed since the year 2000. The chief exports from our nation remain to be debts, jobs, and military hardware. The umbilical cord to the Federal Reserve credit line must remain for years, evident in an intravenous lifeline to the non-productive financial sectors.

This nation does not admit its errors, does not correct its errors, and refuses to allow the natural corrections to occur, because the pain would be far too great, even to the point of causing social upheaval. We revel in self-deception and delusion, trusting our leaders far more than we deserve. Motivation to learn the primary principles of economics is nearly nonexistent, despite its critical importance. A feeling of helplessness may prevail. Meanwhile, our leaders compound errors with greater errors with economic policy that is clearly ass-backwards.

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PERSONAL ASIDE: It is my sincere curiosity how many readers are willing to make the commitment to pay a nominal $8-10 per month charge for regularly timed clarification on economic matters, to debunk conventional claims, and to provide guidance through the minefields in today's confusing financial world. Something very ugly this way comes, on the tail end of the dissipating bond market bubble and real estate decline that has begun. The long treacherous ride ahead requires a guide.

Professional crossroads lie ahead in my life. For months now, my efforts in the economy, gold, and currency front have been given away. I am excited by the prospect of performing a labor of love in a new opportunity. An informal survey would be helpful for my personal planning. If interested in a monthly paid subscription to a website newsletter with primary focus on economical policy and principles, with direct implications on currencies and gold, please let me know. If you wish, shoot a quick email to me at : JW@goldenjackass.com

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REFERENCES (including those from part II) :
[1] "A Statistician's Indictment of Economists" by Jim Willie CB (Dec 2002)
[2] essay archives by Stephen Roach (July 2003)
[3] "Govt Statistics: Lessons in Cooking and Spinning" by Richard Benson (June 2003)
[4] "Statistical Revisionism and Wizardry" by Michael Hodges (June 2002)
[5] partial editorial list by Kurt Richebacher (2000 to 2003)
[6] "Wall Street Great Says the Market is Broken" by Bill Fleckenstein (July 2003)
[7] "Vicious Circles and US Credit" by Jim Willie CB (May 2003)
[8] "Looming Mortgage Crisis" by David Chapman (June 2003)
[9] "Housing Cover Clause" by Rodney Cook (June 2003)
[10] "The Crumbling Strong Dollar Policy" by Ashraf Laidi (May 2003)
[11] weekly Japanese yen chart by Stockcharts.com
[12] "Japan, Argentina, Weimar, or Muddle?" by Jim Willie CB (April 2003)

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Jim Willie CB
August 14, 2003