Final Part

The FED Cannot Save Us from Deflation

Because the primary result once a bursting credit bubble bursts is deflation, most pundits believe the Federal Reserve will "flick a switch" and provide a quick cure by lowering interest rates and expanding the money supply. Economist after economist now tell CNBC viewers and Wall Street Journal readers that there can be no deflation as long as the Fed continues to cut rates. Multiple stock market strategists follow suit saying that the stock market should not decline further as long as interest rates are being cut. Yes, central bankers can add liquidity to the system but importantly, cannot control where this liquidity goes, nor can they force bankers to lend or borrowers to borrow. This is why yield quality spreads rise, as the markets gravitate away from borrowers more likely to default. Monetary velocity will slow, and banks will restrict credit once defaults start to rise. The problem in both the global and American economy is too much credit, and attempting to loosen credit further will not solve any problems. Unfortunately, like my friend Bill Fleckenstein has said, "it's like trying to cure an alcoholic by giving him a few more shots of tequila."

In our opinion, reducing interest rates will not save us from the deflationary problems that our global economy is now having. Lower short-term interest rates and an attempt to print money will not revive it. Economic jargon calls the inability of monetary policy to reinvigorate the economy "pushing on a string". With the current crisis in the current global economy, this theoretical example is now all too real. The easy money that fueled stock markets and economies around the world has dried up, and the deflationary forces that accompany the bust side of the boom will swamp government monetary and fiscal policy until the excesses are wrung out of the economy. History has shown us twice that even dramatic reductions in interest rates won't soften the bust side of a credit boom gone bad.

Japan represents the most recent living proof, where interest rates fell from 7% to almost 0% over eight years, and where the Japanese central bank has tried desperately to increase the money supply. Hundreds of billions of dollars of liquidity were injected into the system by the Bank of Japan but borrowers of this "hot money" avoided the deflationary conditions within the Japanese economy, choosing instead to fuel the financial asset bubble in the U.S. and Europe. Instead of helping the system, the BOJ actions only added to the instability of the global financial system that must now be dealt with. Even after all this massive easing, Japanese stocks just hit a 12-year low, and the IMF expects the Japanese economy to shrink by 2.5% this year. Japan's leaders say their economy stands on the verge of a "deflationary spiral" and their devastated banking system requires a massive taxpayer bailout.

Printing Money Was Unsuccessful in the 1930's

In the 1930s, the U.S. also discovered that central bankers were no match for a ruptured credit bubble. The roaring 1920's were more similar to the current economic boom than any time period of the last one hundred years. There are certainly differences as well, but analyzing the aftermath of the 1929 Crash, which started a terrible deflationary bust in the 1930's, is instructive in showing us that "printing money" did not resolve the deflationary cycle. The 1930's was the last time our country has experienced serious deflation. Most economists and Wall Street pundits believe that the Federal Reserve actually contributed to the economic collapse with tight monetary policy. Therefore, they claim that we will never have another deflationary bout, since the FED has learned its lesson and will be extremely accommodative. However, Murray Rothbard, a great economist who studied this period closely, found that the FED tried mightily to inject reserves, yet still there was a contraction in the money supply. After the stock market crash of 1929, the Fed cut the discount rate from 6% to 2% by the end of 1930. The discount rate dropped to as low as 1.5% in 1931 as the Fed frantically bought government securities in an attempt to expand the money supply until 1933. But the problem was the "pushing on a string" phenomenon. No matter how hard the Fed tried to provide "controlled reserves" to the banks by buying securities, it didn't succeed in increasing the money supply. The money supply actually shrank because banks were either unable or unwilling to increase their bank lending. Potential bank customers who were judged reasonable credit risks were unwilling to borrow because their earnings prospects were deteriorating, and they knew it was foolish to borrow and buy something today when the price would be lower next month. Therefore, there was a "demand" problem from potential creditworthy borrowers. Other entities wanting loans were often deemed to be poor credit risks in an environment of spiraling credit defaults. The problem was exacerbated as individuals hoarded cash, causing monetary velocity to plummet. The same circumstances ensue in every time period experiencing a full-fledged deflation, making "printing money" a great concept, but so difficult to accomplish.

Fiscal policy was also highly expansive in the 1930's, with government spending jumping 42% in 1931. But despite the attempts of the Fed and the Treasury to inflate, America's depression and deflation only deepened. Rothbard said that President Hoover "acted quickly and decisively", and put into effect "the greatest program of offense and defense" against deflation and depression ever attempted in America. He concluded that the "depression was instead prolonged by inflationist and other interventionary measures."

Higher Credit Spreads Illustrate this Dilemma

One problem at the close of a credit bubble, and once deflation begins, is that it becomes difficult to "match up" willing borrowers and willing lenders. When fear sets in, the lender fears that the willing borrower will not pay him back, and therefore becomes hesitant to lend. The most credit-worthy borrower, who doesn't really need the money, does not want to borrow, as he knows that assuming liabilities in dollars that are rising in value is not a smart economic proposition in a deflationary environment.

In a credit crunch, the money to lend for risky ventures is not available at any price. This was the circumstance in August-September, as financial institutions deleveraged, and were forced to sell securities. They were not buying securities, they were selling, and unfortunately there were few if any buyers because the entire credit system was seeking deleveraging. This credit unwinding phenomenon took place in the capital markets, away from the banks, which left the FED virtually "out of the loop". Today, the FED and banks control a much smaller percentage of the credit extension process in our high-tech world, which gives the FED much less control over the credit cycle than ever before. And free markets tend to be much less forgiving about lending to risky borrowers than bankers, once they've been burned or lose confidence. Additionally, the banks and other financial institutions are also experiencing losses, their capital is contracting, and they feel more reluctant to make risky loans. Nomura Securities, DLJ, Banker's Trust and Bear Stearns have all announced that they will no longer be holding emerging market securities for their own accounts. Market psychology takes on a major role in the credit creation/destruction mechanism.

This is the reason why spreads throughout the credit system skyrocketed during late Summer, making it impossible for some companies to borrow despite two easings by the FED. Then the FED cut a third time, and the October rescue involving massive purchases of securities by banks and Fannie/Freddie was able to restore some liquidity to the system. However, we expect a comparable liquidity problem to surface again. this recent "fix" only exacerbates the credit and economic excesses and heightens systemic risk down the road. This is a massive problem when investors shun the problematic illiquidity of much of the credit markets (longer-term non-government debt instruments), choosing instead to stay in the safety of short-term money market instruments. This is critical to understand, because the illiquidity impacting today's credit markets will choke the growth of the vulnerable US economy.

The Dollar May Prevent the Fed from Easing Further

The dollar's collapse two months ago, which included the largest weekly drop since the abandonment of the gold standard back in 1971, is an ominous harbinger for US financial markets and the economy. The huge speculative long positions, possibly largely financed from Japanese banks, have been responsible for the long bull market in the dollar despite massive trade deficits that have flooded the world with dollars. Now these positions may be in the process of being unwound as leveraged speculators have suffered huge losses. In combination with a US credit market that is now in the midst of a severe liquidity crisis, confidence in the stability of the US financial system could soon be shaken. Increasingly, we expect foreign investors to repatriate funds back home. And as the trade deficit widens dramatically, the outlook for the dollar is poor. Increasingly, it looks like a collapse in the dollar is a distinct possibility.

Unfortunately, the Fed could quickly lose flexibility to cut rates due to a sinking dollar. Furthermore, Fed rate cuts also act to destabilize the huge market for mortgage-backed securities that suffer from interest rate volatility. This is a major issue, as this huge market is today illiquid and suffering from the likelihood of significant liquidations by leveraged players.

Corporate Earnings Are Falling And This Decline Will Accelerate

Even if you do not agree with our arguments about the credit bubble and believe that the FED can reduce rates far enough to prevent the onset of deflation, we still believe there is a significant problem ahead for corporate earnings. We believe that corporate earnings will decline significantly in 1999. Second quarter earnings, as measured by economists in the national income accounts, were lower vs. the prior year for the first time in years. This weakness in 2nd quarter results doesn't appear to be an aberration, as third quarter results were worse, and actually market the first quarter of decline for public company earnings as reported by several sources.

Operating earnings for the stock market's Top-10 high tech companies actually declined by an aggregate 11% for 1998's 2nd quarter. And these aggregate figures were without special charges that would have made the comparison a –18% (even excluding CPQ's massive charge). Earnings declines from Compaq, Motorola, Intel, TI and Hewlett Packard were too significant to be offset by decent earnings gains from Cisco, Microsoft and Dell. Yet, even with this high tech earnings weakness, the Morgan Stanley High Tech Index has advanced by about 80% in 1998, and its P/E ratio is more than 70. Even Merrill Lynch now fears the spread of earnings anemia at least enough to have mentioned the probability of an upcoming "earnings recession".

Market multiples have moved from 6 to 30 on the S&P 400 since the inception of the Great Bull Market because strong earnings growth was a certainty. Now, this is no longer the case. When will the P/E revision process begin? How in the world can earnings growth accelerate with the economy slowing further and a "credit crunch" at risk to return at any time? At such levels, it won't take an earnings disaster to take stocks down, just a return to normalcy. Challenges to profitability, including cost pressures, weak foreign markets, and limited pricing power, are not extinct.

One reason that corporate profits have increased so much during this boom has been employee compensation vs. productivity growth. For the last seven years, Corporate America has made a terrific accomplishment. It has increased productivity without a commensurate rise in employee compensation. This is highly unusual, as it has been traditional that increases in productivity have been accompanied by a roughly equal rise in real wages. Productivity is where wage growth comes from—the ability of workers to do more with less. But since 1991, real wages have not kept up with productivity growth. Credit massive white-collar layoffs, offshore manufacturing, or shifting more employees to stock options, but the fact is, history suggests the gap between wages and productivity will soon close. This is happening already. The Employment Cost Index (ECI) advanced by 3.3% in 1997, while inflation was a mere 1.7%. For 1998's second quarter, the ECI increased by 3.5%. Unions are gaining some strength after years of losing ground, and in some industries, a shortage of workers has kindled a bidding war for employees.

None of this matters, of course, if companies can raise prices at will. The problem is they can't. Heavy investment in equipment has left corporate America with too much capacity just as major trading partners are buying less and competing more. The combination of overcapacity and repercussions from the Asian problem led Business Week to rank the pricing power of U.S. corporations as the weakest in 35 years. Companies that we have recently written about that currently lack pricing power include: Rubbermaid, Anheuser Busch, Coca Cola, Compaq and Gateway, to name just a few.

The other problem is that the American consumer, who has been the last stronghold in a declining world economy, seems to be becoming "tapped out". The US savings rate has now gone negative for the first time in history. And while current strong consumption is powered by a rising stock market and huge borrowings, this problematic situation is clearly unsustainable. As we addressed above, household debt is at record levels, but soon, credit will get tougher to obtain. Auto companies are having to offer record rebates and cheap financing plans with little or no downpayments. Despite this, sales growth at hundreds of companies is nonexistent. How can there possibly be significant earnings growth with sales slowing down dramatically and excess capacity existing throughout the world? Companies reporting dramatically lower sales include Gillette, Procter & Gamble, Revlon, Coca Cola, Best Foods, Disney, Intel, and the list goes on and on.

Conclusion

Our phenomenal economic performance is not the trumpeted product of technological advancements nor the result of a new era of perpetual strong growth and low inflation but, instead, largely the makings of an unprecedented credit bubble. Unfortunately, years of credit excesses have created an an unprecedented asset bubble and a perilously distorted economy. And seemingly, only advocates of the Austrian School of Economics understand the critical role excesses from the preceding boom play in determining the depth and protraction of the following bust.

In effect, we see Greenspan's rate reductions as an extraordinary crisis management effort, desperately lowering borrowing costs for leveraged players as well as conveying to market participants both the Fed's willingness and ability to support markets. Apparently adopting as the overriding objective the reliquification of the credit markets, the Fed now foments truly unprecedented credit excess and financial system leverage, not to mention egregious stock market speculation.

Supplanting the reckless hedge fund and brokerage community as the leading purveyor of the American credit bubble, today this baton has been passed, on one hand, to the domestic banking sector backed by deposit insurance and, on the other, to Fannie and Freddie with their implied debt guarantees from the American taxpayer. Appallingly, after turning a blind eye to years of massive hedge fund and Wall Street leveraged speculation, allowing such to grow to both dominate and debase the entire financial system, the Fed now acts forcefully to perpetuate this hopelessly parlous financial bubble. And, admittedly, so far with much success, although this only raises the stakes for the inevitable day of reckoning.

David W. Tice
11 January 1999

DAVID W. TICE manages the Prudent Bear mutual fund.
His Dallas-based research firm advises more than 150 institutional investors.
Prudent Bear Fund: http://www.prudentbear.com