Old Dogs, Old Tricks

In my previous report on Fred Sheehan’s essay, “An Investor’s Manifesto,” I presented his basic thesis: all of the investment fund managers’ fancy mathematical analyses are no guarantee that the geniuses and their computer programs will keep a major disaster from happening.

The various investment bubbles created by Federal Reserve monetary policy have not yet been liquidated, he argues. The size of the debt load of American consumers is still very high.

I would make this modification: the size of the debt load is high, but the monthly debt repayment burden has not changed much. It never does. Year after year, decade after decade, the ratio of debt payments to disposable personal income fluctuates within a narrow range of two percentage points: 12.5% to 14.5%.

This means that as interest rates have fallen in response to (1) the recession and the weak post-recession recovery, and (2) Federal Reserve monetary inflation, the American consumer has loaded up on new debt. Because he can now afford to finance more debt because of lower interest rates, he has leveraged his income. He has bought more consumer goods, especially housing, with the same income because he has been able to borrow more money at lower rates.

The problem will come if (1) his income falls, or (2) interest rates rise. Families that have re-financed with ARM’s — Adjustable Rate Mortgages — will find themselves facing unexpectedly large mortgage payments when long-term interest rates go back up in response to price inflation, i.e., a depreciating dollar. The ARM’s allow lenders to raise rates in response to rising rates in the credit markets. Anyone who has an ARM is playing with financial fire.

OVERHANGING CAPACITY

Sheehan points to the overcapacity of production facilities that were built because of the stimulation created by FED monetary inflation. This is consistent with Ludwig von Mises’ theory of the business cycle. Mises taught that central bank monetary inflation lowers interest rates temporarily, thereby luring entrepreneurs into projects that they would not have begun, had the interest rates not been artificially reduced by an expansion of central bank credit. This is the boom phase of the business cycle. When the expansionist monetary policy ceases, rates go back up, and many entrepreneurs suffer losses. This is the bust phase of the business cycle. I have written a chapter on this process in my eBook, Mises on Money.

What we now see is worldwide manufacturing overcapacity because of prior central bank monetary expansion. This is what the bubble has been all about. This overcapacity has not yet been liquidated by collapsing capital prices, although the performance of stock markets from January, 2000 to March, 2003 surely was the beginning of the liquidation process. But central banks, especially the FED, have poured new money into the economy to lower rates and keep the capital liquidation process from fully revealing the true free market value of capital assets. This monetary inflation extends the illusion that these goods are still more valuable than the market would reveal. But when this phase of the inflation ends, either by monetary stability, deflation, or the inflationary destruction of the monetary unit, the true value of capital will be revealed.

This overhang of productive capacity is keeping consumer prices from escalating to match the expansion of central bank credit. But it is also keeping businesses from investing this new credit. There is no confidence among entrepreneurs that new investments today will produce profits later. So, consumers are borrowing and spending, oblivious to the continuing bubble status of the capital markets.

OLD DOGS

Sheehan thinks that fund portfolio managers will not shift from equities to money-market investments, especially foreign currencies, that are safer than American equities for preserving not only capital but purchasing power. The managers follow the same drummer. They are a pack of old dogs.

He cites Peter Bernstein, the author of a great book on the history of the discovery of statistics and their applications to the external world, especially the world of markets. The book’s title is Against the Gods. Bernstein has warned about investment advisors who refuse to learn that their formulas will not perform well in protecting portfolio value. We really are in a new economy, i.e., the end of the boom phase. Writes Sheehan:

Let’s assume we’ve collected a few willing listeners; what do we tell them? A good place to start is Peter Bernstein’s interview in the February 28, 2003, issue of welling@weeden. A large number of his clients are institutional managers and pension funds. He is telling them that, “the traditional institutional approach, ‘I will structure my portfolio in this way and make variations on the theme,’ won’t work. So what I’m suggesting is, throw it away. You have to be much more unstructured, opportunistic and ad hoc than you have been in the past.” Later in the interview, “. . . in this looser, more opportunistic environment I foresee the abandonment of the dreadful, depressing, defaulting process of putting managers into cubbyholes — large-cap growth, small-cap value and such foolishness — along with the stifling, stupid, obsession with tracking error instead of absolute returns and risks incurred.”

Even though this is addressed to an institutional audience, the way of thinking is not dissimilar to the retail investor. Replace “portfolio managers” and “investment boards” with Uncle Bob and Aunt Millie. “. . . People forgot during the 20-year bull market . . . that investing is all about taking risks to get rewards. You’ve got a whole generation of portfolio managers and investment boards who’ve convinced themselves that if they diversify, stick to a style, and hold on for the long-term, they’re home free.” (p. 11)

Sheehan then applies to today’s markets Bernstein’s warning against assuming that tomorrow will be pretty much like today.

We are living at the long end — if “end” it is — of gross financial imbalances. Most people don’t understand this, or won’t acknowledge it. This fog of extremity and perplexity is a financial maelstrom that has been building for a generation.

Toward the end of his essay, he summarizes our present dilemma: the aging of the West’s institutional innovation.

If you look back at Peter Bernstein’s interview, his description is of a tired, exhausted mind. In the past century, we have grown and grown, but lacking originality, only compounding behemoth structures in most every walk of life. Bernstein calls for a renewal, a re-birth. He repeatedly emphasizes the convulsion we face: “[W]e are going to have to learn to live without the crutch of things like policy portfolios — because the conditions that justified their existence for so long have been shattered.” (p. 15)

The problem is the welfare State. Everywhere, there are State-mandated safety nets. Compulsory safety nets reward the losers at the expense of the winners. The old dogs, being old, refuse to learn new tricks. The system is too large, too geriatric, and too wealthy to change, except through the pain of competitive pressures imposed by agile, innovative, and youthful entrepreneurs outside the West.

Institutions as a whole have grown to a size at which they can no longer act because of girth. They must follow a set of implicit assumptions that stifle imagination. What, for instance, can really be done to restructure Fannie Mae if its financial models go awry? One can go on and on: public school systems, the airlines, the auto companies, the multinational consumer goods companies (Coke, McDonald’s), pension consultants and their benchmarks, the central-bank created money flows, trillions of dollars a day flowing between markets with little attention paid to economic valuation, financial derivative contrivances, the IMF, professional sports, the Olympics and stockholders of fractional interests in the companies they own with little knowledge or ability to act as an owner.

This is not only a problem of advanced age; it is also of wealth. We live comfortably; our houses are filled with material possessions. To reform radically could endanger our cozy living rooms, fervently encased with rolls of duct tape.

It is not by coincidence that countries with the oldest demographics find it harder to change their ways. Japan is Exhibit A; Europe and the US are right behind. Older countries worry more about things like car seats, tamper-proof bottles, smoking and bicycle helmets; are up-to-speed on the latest FDA warnings; and cling to the television set if a large storm threatens. With younger demographics comes greater flexibility and dexterity. (p. 16)

RECOVERY? WHERE?

It took the National Bureau of Economic Research until this month to conclude that the recession that began in March, 2001, ended in November, 2001.

So, the U.S. has been in recovery mode since November, 2001. Question: Why is unemployment still rising? What kind of economic recovery loses millions of jobs? For two charts comparing today’s rising unemployment figures with falling unemployment figures in previous recessions, click here.

What is also abnormal about this recovery is that unemployment is rising in Europe, too. This is a Western problem, not just an American problem.

A look at unemployment figures is worth considering, of Us and Them. According to government numbers (which surely understate any bad news), the US unemployment rate rose from 5.6% a year ago to 5.8% today. The change over the same period in Belgium was 10.8% to 11.7%, France 8.8% to 9.2%, Germany 9.6% to 10.6%, Switzerland 2.6% to 3.9%, and Spain 11.1% to 11.9%. (p. 12).

THE FALLING DOLLAR

Along with rising unemployment, we have seen the falling dollar. Sheehan believes that the dollar has only begun to fall.

The dollar’s fall from grace might be enlightened by a look at our debt obligations. What we owe is growing at a clip many multiples in excess to the growth of the economy. During the fourth quarter of 2002, total credit debt grew by US$2.3 trillion, but the economy grew (measured by GDP numbers) US$363 billion. The paper debt grew 6.3 times faster than the economy. To look at a longer view, US total credit market debt was about US$7 trillion in 1985; it is over US$30 trillion today.

What if Americans don’t want to buy all of this paper? Well, we haven’t bought it for quite awhile, so we ship these IOUs overseas. About 80% of the world’s savings was spent last year investing in the US. How much more will the rest of the world buy? (According to Steve Hanke, it is 100%.) Isn’t there some farm equipment company at home with a decent shot at success? (p. 12)

Why should American investors expect the rest of the world’s investors to continue to invest 80% of their savings in dollar-denominated assets when the greatest economic growth is in Asia? Why should the world invest here when American business owners are not investing here?

Then there is the expansion of American military power into Iraq. When Sheehan wrote his report, Americans were not seeing news reports every day about another American soldier killed. Americans are now discovering that occupying a defeated nation where individual citizens are armed is no picnic. The cost of occupying the world looks higher than it did last March. The troops will not be home by Christmas. In fact, there is serious talk about having to increase the size of the occupying force. Taxpayers will pay for this. We hear no more about the oil bonanza that will pay for it all. There is only silence on the Iraqi oil front. Being on top is risky, Sheehan says.

Being on top of the world is a precarious spot and it can end in a flash: the Spanish Armada in 1588 and the Japanese at Midway in 1942 are just two examples. In 1914, the US was a debtor nation. It owed, mostly to the Europeans, US$3 billion. (That really was a lot of money back then. It really was! Please trust me.) By 1919, foreigners owed us US$10 billion and the US booked a US$3 billion surplus. We were on top of the financial world and sit there today. We displaced Britain in a very short period of time. (A half-century later, Britain had spent itself so thoroughly into the poor house that the IMF bailed out the pound sterling.) By 1929, the national income of the US was greater than that of Great Britain, Germany, France, Canada, Japan and several other countries — combined. Jim Rogers tells us that today we owe foreigners US$6.4 trillion and overseas interest payments alone cost US$333 billion last year. (pp. 13—14)

Donald Rumsfeld might talk of an old and new Europe, but the truth is, we’re all old and bloated now. The United Nations is no longer capable (if it ever was) of making a large decision. It is too big and too entrenched in its ways. Politicians fiddle around with microscopic changes to programs that will bankrupt us all (Medicare, the NHS, welfare, etc.). They give no thought to tossing them out the window and starting over again. (p. 15)

Old dogs grow tired. They do not learn new tricks. They are replaced by younger dogs. But they yap as loudly as young dogs until the very end.

GRASSHOPPERS AND ANTS

As a child, I saw the Disney cartoon of the grasshopper and the ant. I can still remember the tune sung by the grasshopper in summer, “Oh, The world owes me a living.” I was maybe seven years old, but I got the message. By the wonder of the Web, I was able to refresh my memory. Disney released that cartoon in 1934, long before I was born, during the Great Depression. The lyrics were more pointed than I had remembered.

The good book says the Lord providesThere’s food on every treeI see no need to worry and workNo sir, not me.

Oh, the world owes me a living.Oh, the world owes me a livingOh, the world owes me a livingYou shouldn’t soil your Sunday pantsLike those other foolish antsC’mon, let’s play and sing and dance.

(Queen Ant) You’ll change that tune when winter comesAnd the ground is covered with snow.

(Grasshopper)

Oh, wintertime’s a long way offYa dance? Let’s go!Oh, the world owes me a livingOh, the world owes me a livingYou shouldn’t soil your Sunday pantsLike those other foolish antsC’mon, let’s play and sing and dance.

Residents of the West don’t want to believe that winter still follows summer, but it does. We have had a long summer. We have done a lot of dancing. We are a lot older. But we have not grown wise with age.

CONCLUSION

Moses warned a younger generation of Israelites who had gone through forty years of wandering in the wilderness with their now-dead parents:

And he humbled thee, and suffered thee to hunger, and fed thee with manna, which thou knewest not, neither did thy fathers know; that he might make thee know that man doth not live by bread only, but by every word that proceedeth out of the mouth of the LORD doth man live (Deuteronomy 8:3).

Central bankers have revised this ancient warning: “Man doth not live by bread only, but by every fiat credit that proceedeth out of the central bank doth man live.” It is time to go back to the original text.

One other thing: when the younger generation crossed into Canaan, the daily supply of manna ceased (Joshua 5:12). For those addicted to manna from heaven, the new challenge must have been fearful. When an entire civilization looks at the central government and sees “Department of Manna,” there will be a time of dieting ahead.

July 22, 2003

Gary North is the author of Mises on Money. Visit http://www.freebooks.com. For a free subscription to Gary North’s newsletter on gold, click here.

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