first majestic silver

Euro Travails

October 6, 2000

"Soaring share prices and the massive U.S. trade deficit are the most worrying threats to the stability of the British financial system," according to the Bank of England its semi annual Financial Stability Review published recently. If there were to be any crack in the U.S. main equity market, the feed-through to confidence might be quite significant, commented the deputy governor of the bank, David Clementi, in an interview with the Financial Times. In the last letter, we quoted the Bank for International Settlement, Basel, with the following remark from its recently published Annual Report: "Looking further ahead, the biggest policy challenge could be coping with a sudden reversal in the fortunes of dollar."

It is our long-held view that the fate of the euro against the dollar is primarily determined by what happens in the U.S. economy and its financial markets. This was true in the 1980s and again in the 1990s, and it will definitely be true in the coming years, once the U.S. bubble bursts. Dramatic changes in the sentiment and the markets only take place in the United States. Few people seem to realize a world of difference does exist between Americans and Europeans. That applies to the whole spectrum of people: politicians, bankers, corporate managers and the broad public. It is the new fashion in America to call the Europeans inflexible. We would rather characterize Europeans as being highly conservative in economic and financial matters. Nobody in Europe is raving about technology-driven economic growth and productivity gains. If there is one, he doesn't find any publicity. Nor are stock market wealth effects a general topic of discussion.

There is a lot of talk about unemployment in Europe. Its flip side, though, is rarely mentioned. In contrast to the American worker, his European counterpart has enjoyed an uninterrupted rise in his living standard for decades, owing to wage hikes that have consistently exceeded the annual increase in the inflation rate in consumer prices. Inflation-adjusted average weekly earnings in the United States today are 13% below their high in 1973. A gradual rise in real terms, after a long decline, dates as recently as 1996. In Europe, real wages have virtually doubled during this period. What has shielded the American worker from a failing living standard for more than 20 years was heavy borrowing. Just as an aside, the average European has six weeks paid holidays every year, as against two weeks in America. The ugly flip side of the horrendous wage increases is, of course, Europe's high level of unemployment.

More importantly, in recent years Europe has been mending its former wage excesses with consistent wage moderation, showing strikingly both in a gradual decline of unemployment and also in low inflation rates. Employment in Euroland grew by 1.4% during 1998 and by 1.5% in 1999. If unemployment seems high at 9% of the workforce, it is nevertheless down by 2.7% from its peak in 1997. Industrial production is up 7% year-over-year. Annualized is currently rising at around 8%. Broad money growth over the least year has accelerated from 4.7% to 5.6%. While the U.S. Fed refuses to worry about more than 10% broad money growth, the European Central Bank does worry about its much lower rate. Even though the weak euro and the surge in oil prices have boosted the level of import prices by 20%, the inflation rates 2.4% headline inflation and 1.4% core inflation look rather tame in comparison to a U.S. headline inflation rate of 3.5%. However, while policymakers and the public in the United States seem to regard inflation at this rate as virtually nonexistent, the ECB considers 2% as the tolerable limit. As to real GDP growth in 2000, the consensus forecast for the euro-zone is around 3.5% this year.


What's wrong with this economic picture? Nothing really, except that there is nothing exciting. Yet, not so long ago, this pattern would have been hailed as a Goldilocks scenario, not too hot, not too cold. Overall, it is definitely "well-balanced" growth. The external current account of the region is slightly in surplus. The main engine of growth is non-residential investment spending. Wages per worker are up a little more than 2% on average. Compared to overall productivity of 1.5%, this implies a slight increase in unit labor costs. Essentially, both wage and productivity numbers differ considerably between countries as well as between branches of the economies.

In the current markets, a lot of hope was attached to the possibility that growth in the euro-zone would outpace that in the United States. Stronger growth and much lower inflation than in the United States were expected to make European assets attractive and pull in foreign capital. As a result, investors would do well both on the appreciating currency and on their euro assets. We readily admit that we are among those who are convinced this will happen, and have been for some time. Our fault is to have underestimated how much and for how long manipulated numbers can manipulate market opinion.

If there seems to be an impending prospect of a change in market opinion, it was battered by a few good news items about the American economy and one bad news item from Germany took the markets completely by surprise. On the part of the U.S. economy, these were the astounding high GDP and productivity figures for the second quarter, both of them exceeding 5%. Together, they helped to strengthen anew, just as critical juncture, the notion that the U.S. economy has, indeed, undergone far-reaching structural changes that warrant high growth with high productivity in the long run.

At the same time, one single piece of bad news, among numerous good news, is said to have cast a shadow over economic prospects in the euro-zone. That was the recently published Ifo indicator for German business confidence, showing a decline for the second month. It instantly made headlines throughout the global media. Just the day before, the Bundesbank August monthly report said that, according to estimates, second-quarter domestic product had grown by 1% quarter on the quarter. In America, the same number would be presented at its annualized rate of 4%. Neither the media nor the currency markets took notice.

The ugly truth seems to be that, whatever positive happens in the euro-zone, the U.S. economy is going to slow down, it is now widely believed that it will be capable of growing just as fast as the economy of the zone at the top of the business cycle.

Likewise, few people noted that the Bundesbank had explicitly pointed out for the first time that comparisons of economic growth between the United States and Germany were grossly distorted by the so-called hedonic price adjustments, used in the U.S. statistics to measure increases in computer power. Had the German statisticians applied the U.S. methods for deflating IT equipment, according to the Bundesbank, real IT investment in Germany in 1998 would have been DM 64 billion, that is, twice as high as reported. In 1999, the difference would have risen to 170%.

According to the measurement practices in the German GDP statistics, computer prices have fallen by 20% altogether since 1991. By the measurement practices in the United Sates, they have fallen 26% a year for the past five years. Official statistics for the United States show an average annual increase in business expenditures on computer equipment per year by 40% since 1991, as against only 6% in Germany. Using, the American deflator, however, the average annual increase would have been 27.5% for the whole period. As the divergence in the deflators is rapidly compounding over time, the divergence in measured output follows suit. Numbers get more and more absurd. Just think of what we mentioned earlier: fixed nonresidential investment, of which 75% is "hedonised" new high tech, have accounted for 55% of U.S. real GDP growth in the first half of 2000.

In other words, the hedonic deflator has come to represent the most powerful factor behind the seemingly miraculous growth of U.S. GDP and productivity.

In reality, hedonic price indexing corrupts the U.S. economic statistics in two ways. Gross overstatement of apparent faxed investment, GDP and productivity growth is the most obvious part. The other part is understatement of apparent inflation rates. In a recent report, the Commerce Department said that the falling prices for electronic and computer equipment have pulled down inflation rates by half a percentage point a year.

The essential conclusion is that U.S. economic growth, deprived of the hedonic deflator, is anything but illustrious. Not only that. It's obvious true decisive propellant was the consumer borrowing and spending binge, which Mr. Greenspan chooses to ignore in public. Credit excesses have many parallels in history, but those in the United States of the last few years are of such extreme magnitude that they suggest a form of collective, manic euphoria. Importantly, this influence is being rapidly eroded by the steep rise of imports. Totaling $120 billion in June, they were up 19%, year-over-year, telling us that an ever-greater part of domestic spending is leaking abroad. Outside the IT sector, imports are rising many times faster than domestic output. Consider that in the second quarter, the net increase in the trade deficit absorbed 1.51 percentage point of GDP growth. For sure, the borrowing and spending binge is an absolutely unsustainable element.


Comparing economic growth in Europe with that in the United States, we must say that we have a distinct preference for the European pattern, for one overriding reason. That's the virtual absence of major excesses and imbalances. Europe, too, has fully participated in the global stock market mania, but with two very important differences to America: first, participation of the public is incomparably smaller, and second, there was no visible effect on consumer spending.

And look at the economic fundamental: the region's current account is in equilibrium with a slight surplus, a gross investment ratio of about 21% is fully matched by domestic savings; broad money growth of 5.3% is a little in excess of the central bank's target of 4.5%, but little more than half the rate in the United States. Debt and credit expansion are incomparably lower than in the United States. In short, absence of any excesses.

So what is ailing the euro? Three things: statistics, perceptions and propaganda. The main argument for dollar strength and euro weakness is the perception that the U.S. economy is going from strength to strength because it is enjoying peerless productivity gains from vastly superior investments in the new information-technology. We have seen that the apparent, big technical gap, suggested by the official statistics, results overwhelmingly from the use of extremely different yardsticks for computer output and investment. Hedonic price indexing is grossly exaggerating the rate of U.S. economic growth.

That' s the underlying fact. But in addition there is something that plays perhaps the most important role in having created the glowing perception of unprecedented American economic superiority, and that is the enormous fuss that American propaganda has made of it. We hasten to add that the person who has done far more than anybody on Wall Street in this respect is Mr. Greenspan. While hardly ever mentioning words like credit, money or debt, his speeches about the U.S. economy abound with three words: technology, innovation and productivity. Somebody noted that in his last 10 speeches, he used these words 281 times. In his most recent speech, at the Kansas City Fed's annual symposium, he explicitly repeated again that Continental Europe has benefited much less than from the new technology owing to a lower level of high-tech capital investment and inflexible labor markets.


The bogus numbers about U.S. GDP and productivity growth for the second quarter have once postponed the day of reckoning for the U.S. financial markets and the dollars.

The great digital divide between America and Europe is not in the economies. It is in vast differences in statistical measurement and in the propaganda.

Fed members in general and Mr. Greenspan specifically play a key role in misinforming the public. Nevertheless, the rapidly deteriorating fundamentals of the economy and the financial system trade deficit, savings, indebtedness are inexorably leading to the bursting of the bubble. We regard it as quite near, yet precise timing is not possible.

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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