Act III

December 7, 2002

"Economists say America is unlikely to follow into Japanese-style deflation," said a recent Wall Street Journal article, "because U.S. leaders reacted to their slowing economy much more quickly than Japanese leaders did..."

Oh?

The question bores most people. But here at the Daily Reckoning, it haunts us like an unsolved crime. Spectators, we sit on the edge of our chairs to see what will happen next.

The U.S. economy seems to us to be following a script written in Japanese. With only an occasional improvisation, and a broad allowance for cultural differences, the essential dialog in America 1995-2001 has been very much that of Japan 1985-1991.

The plot was much the same - hotshot new era meets cold realities of marketplace.

The love interest was identical - investors fell head over heels for financial assets, and abandoned all sense of reason or dignity, and made fools of themselves... The first couple of acts were similar...with rising action in the investment markets and a climactic sell-off.

But now, the curtain has gone up on Act III...and our American audience expects a twist. Unlike the dumb Japanese, U.S. investors and consumers will be saved by the prompt action of the hero, Alan Greenspan, they believe.

Greenspan, wielding his rate-cutting sword, has chopped off 450 basis points in 10 months, while it took the Japanese central bank more than 4 years to do so.

Bullish economists think his speed will be decisive. We are less sure. But then, we see an economy that suffers from too much credit, not a shortage of it. So we doubt that giving it more credit, more quickly than the Japanese did, will make any difference.

Anything could happen, of course. But the Japanese analogy has worked well enough so far. We'll stick with it.

Most economists, says Dr. Kurt Richebächer in his latest letter, reject the idea that America might follow Japan with a prolonged period of economic stagnation. But these are the same economists who saw no downturn coming the first place...and who expected lower rates to have already perked up the U.S. economy by the 2nd quarter.

Each month, they push back their estimate of when the upturn will happen.

Now that short-term rates have hit 2%, stocks have rallied for a couple weeks, new unemployment claims are down for 3 weeks in a row, and bonds are turning down...these economists, analysts and investors think the worst is behind us.

But, "in April 1992, as the Nikkei appeared to be hitting bottom at 17,000 [from a high of 39,000 a year and a half earlier]" the Wall Street Journal reminds us, "a consensus of a dozen top forecasters still foresaw Japanese economic growth for the following year at between 2% and 3%. It ended up growing at 0.4%. Today, the Nikkei hovers around 10,000 and the Japanese economy is back in its fourth recession of the past decade."

Most economists have no idea when the market will turn up, because they have no idea why it turned down. They believe lower rates can restore economic activity to former levels. But as pointed out yesterday, rates are already below zero in real, inflation-adjusted terms.

And, as mentioned here many times, while it took the Japanese longer to get there, short term rates in Japan have been "effectively zero" for more than 5 years.

Does ineffective medicine work better because it is administered faster?

There are 3 possible effects from lower rates:

  • They could do the economy some good.
  • They could do it some harm.
  • Or, they could do nothing at all.

In Japan, lower rates seem to have done as much harm as good. "Plentiful credit is financing stagnation," reports the Wall Street Journal, "banks use cheap credit to keep ailing companies on life support."

That's why, even 12 years after a stock crash, bankruptcies are hitting record highs in Japan. These companies should have given up the ghost long ago. Easy credit has not cured what ailed them...it merely stretched out the period of suffering.

Ignoring the actual experience, economists turn to theory. Since the Hoover administration, they have counted on lowering interest rates and cutting taxes to boost economic activity, thus putting more dollars in the hands of people who would spend them.

But consumer spending does not really make people richer. Consumption is the end result of getting richer...not the means to it. Real prosperity results not from consumption, but from its opposite - forbearance. It is the capital that is not consumed - the savings - that determine how quickly a society gets rich.

Savings can be invested in capital improvements that produce more and better products...and give investors a profit. These profits are the key to everything. They tell us that the effort was worthwhile - that the investment is paying off, making people wealthier. They encourage the business to hire more workers...and spend more on new plant and equipment.

The "old economists", says Dr. Richebächer, knew this. But the new ones seem to have forgotten.

"Ever since Adam Smith published his 'Inquiry into the Nature and Causes of the Wealth of Nations' more than 200 years ago," he writes, "it was undisputed doctrine that there is but one single route towards economic growth and the creation of wealth - through saving and capital accumulation in tangible, income-yielding assets.

"Rising capital investment is the one and only component in the economy that pulls up with it everything else that matters in the process of creating growth and prosperity: capacity, production, productivity, output and consumer income..."

Of attempts to induce prosperity by making more consumer credit available, he adds, "only in the alphabet does consumption precede production. But that is what every president and every Fed governor has done in America since the Great Depression." The result? "This country's economy is geared to rising consumption," Richebächer quotes Simon Kuznets from a 1961 book, "and our institutions and patterns of social behavior encourage higher consumption per capita...Unless in the next few years the private sector can generate savings and capital formation in a greater proportion to a rising product, the pressure in the demand for goods upon the supply of savings will persist."

But instead of increasing savings to meet the new capital needs, gross savings plummeted from a 1950s high of nearly 20% of GNP to personal savings rates near zero today. Instead of saving resources, the U.S. economy consumed it.

"Capital has been consumed and misused," writes Sean Corrigan of Capital Insight. "Everyone would surely be forced to concur that the sooner we cease the first and the quicker we attempt to correct the second, the better it will be for all of us.

"Instead, what do we find? Interest rates are slashed, reserves are injected by the central bank, and the mindless chant. 'The economy depends on the consumer, the economy depends on the consumer' is repeated over and over again, as if a farm thrives on the crows pecking at the corn...

"Every extra dollar borrowed by a consumer now puts us all a dollar further from recovery, the debtor a dollar closer to default, and his bank a dollar closer to a bigger loan loss provision than it would have had to face by foreclosing while there was still something to be salvaged."

Will feeding more corn to the crows - that is, making more dollars available to borrowers, cheaper and faster - rescue the situation?

We will see, dear reader, as Act III continues...

The purity of gold is measured in carat weight.

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