by Gary North
Now faith is the substance of things hoped for, the evidence of things not seen (Hebrews 11:1).
To get a sense of what the market has done since 1999, click the link and take a look at the chart of the S&P 500.
The peak came in the spring of 2000. It reached 1,540. Today, it is 1,100. It has been moving down from the 1,150 level since spring. From mid-2002 until the spring of 2003, the index bumped around from 800 to 950.
Four years ago, it was an election year. The market bounced around until late summer. Then it declined through the end of the year.
Traditionally, election years are economic boom years. The Federal Reserve System is ready to supply liquidity — fiat money — in order to keep consumers happy and buying, thereby keeping business income high and the stock market high. Legally, the FED has no obligation to subsidize stock market investors, but it almost always does in the first half of a Presidential election year. The main exception was 1980, when the FED kept money tight and let interest rates skyrocket. That cost Carter the election. But 1980 was an exception in other ways. The monetary inflation of the Carter years had created the worst price inflation of the postwar era. It could be stopped only by tight money.
This year, the FED is being highly accommodating. The adjusted monetary base, which the FED controls directly, is up sharply. Look at the move that began in January.
With the FED pumping in new money, the banking system receives the legal reserves that it uses to expand loans. The low interest rates that prevail today, despite the half percentage point increase that took place this year, are being funded by FED policy. The pair of increases in the federal funds rate were token increases. The FED is making sure that the President's bid for re-election is not going to be thwarted by sharply rising interest rates and an economic slowdown.
INVESTORS LOOK AHEAD, BUT NOT TOO FAR
In 2000, investors looked ahead, months beyond the election. It was a tight race. Even after the voting was over, it was a tight race. Investors in mid-2000 could not have foreseen the outcome. So, the stock market decline that took place, beginning in late summer, anticipated the recession of 2001, which began in March.
The year following a Presidential election tends to be bad for the stock market. The FED usually slows the rate of money creation in order to forestall rising prices. This slowing places constraints on bank lending and economic growth. Consumers cut back, the economy sags, and market forecasts that began in the second half of the election year are confirmed.
This year, we have another tight race. We had a booming stock market for one year: 2003. The market in 2004 is showing signs of investor fatigue. This may be the traditional summer doldrums, or it may be a forecast of a post-election contraction in the money supply and the economy.
What is missing this year is evidence of a shift in investor commitment to the stock market. The market is flat. It is flat 500 points below the peak in 2000.
The chart reveals an unwillingness on the part of investors to get out of this market in a final bear bottom sell-off. The presence of stock market mutual funds, especially retirement funds, has kept the market from entering the final collapse of hope that marks the end of bear markets. There is a floor under this market because of the automatic monthly purchases of shares by fund investors. The "buy and hold" philosophy promoted by economists, which paid off after August of 1982, has produced capital losses on a massive scale since 2000.
The typical investor has not lost hope in the economists' dreamy scenario of automatic wealth through compound growth and tax-deferred gains in a 401(k) retirement fund. But he no longer holds this creed with the fervor that he did in 2000. He has seen the reduction of his index fund's portfolio. It declined for two years after 2000. The recession of 2001 supposedly ended in November, 2001, yet 2002 was as bad a year for stocks as 2001 had been.
Where was the stock market recovery that supposedly begins six months before a recession ends? It was nowhere to be seen.
WHEN WILL THE RECOVERY RECOVER?
The economic recovery has been weak across the board: low growth in jobs, a low rate of capital formation, and caution on the part of employers. Who can blame them? Consumer spending never lagged in the 2001 recession, but consumer spending on American-made products surely did. With annual deficits in the balance of payments in the $500 billion range, American manufacturers have good reason to be cautious. This deficit is now at its highest level in history. Despite the recovery, this deficit is getting worse.
There were tax cuts, but they are spent. Bush is not campaigning on a platform of additional tax cuts. Kerry promises tax cuts for the middle class and a rollback of Bush's cuts for the rich. He has yet to show the figures as to how much, when, and with what effects.
We are now facing a new reality. The trade/payments deficit now appears to be permanent. Consumers are going to buy cheap, and this means buying Asian. Consumers are in charge in capitalism, and they want bargains. American suppliers are either going to supply these bargains or else foreign sellers will.
Blaming "corporate America" for going abroad to hire low-paid workers is like blaming New England merchants in 1800 for importing slaves for Virginians to buy. The merchants, then as now, are just following orders. Buyers want deals. They don't care who provides these deals.
There was a two-evening segment last week on PBS's "Lehrer News Hour." It dealt with Wal-Mart. It showed how Wal-Mart cuts costs by better inventory control. But then we were told that Wal-Mart exploits its workers. Odd; the company seems to be able to hire all the workers it wants. It appears that workers would rather be exploited than out of work. But the old Marxist language remains. They interviewed several sociologists, a profession completely dependent on taxpayer funding of sociology students and taxpayer funding of sociology professors. No one asked them about the exploitation of taxpayers who don't want to fund sociologists.
Then came the section on exploited foreign workers. The reporters could not find any to interview, but a Berkeley professor hinted that they are probably out there somewhere.
The interviewer spoke with a yuppie couple that had just purchased a pair of bicycles and helmets for $216, total, including tax. He asked them if they had thought about the fact that Wal-Mart bought these bicycles from companies that paid their workers 31 cents an hour — and sometimes less. They admitted that they had considered this, but then the decided to buy anyway. It appears that yuppies are like the rest of us. They want low prices, always.
The growth of the payments deficit is said by some to represent a shift in the buying habits of Americans. This is nonsense. Americans have always been aggressive discount-seekers. What has changed is Asian economic policy. By freeing up the economy — by adopting capitalism — mainland Asian politicians have made it possible for mainland Asian producers to enter western markets as sellers. It is not that American buyers have changed their buying habits. It is that Asians have changed their selling habits. They have generated a surplus of production over mere survival.
Like every auctioneer, we Americans have something to sell. The main thing we have to sell is a dream: the dream of investing in America, of getting in on the deal. So, Asians and others sell us goods, and we sell them a dream. It is the same deal that the Indians used on Manhattan Island in 1624. Well, not quite: the tribe that sold the island for trinkets actually didn't own it. But it's the thought that counts.
The problem is, the dream is looking more and more risky. To buy into American markets means buying claims on future wealth — wealth denominated in dollars. But that means wealth supplied by workers who are no longer competitive in world markets. It also means wealth supplied by the Federal Reserve System.
Yet the dream remains a powerful one. Foreigners are enchanted by it. They can't move here, but they can buy promises to pay dollars (bonds) and the hope of capital gains in dollars (stocks). They, too, trust Alan Greenspan and his colleagues.
But for how long?
PRODUCTION GOODS, NOT CONSUMER GOODS
Dr. Kurt Richebacher, a former central banker, has been sounding the alarm against the reality of this recovery. Last February, he warned that asset inflation is not a productive substitute for thrift.
America's policymakers and economists view asset inflation as wealth creation as if this were a self-evident fact. What this asset inflation truly generates is phony collateral for runaway consumer indebtedness, luring the consumer into unprecedented debt excesses. It is phony wealth creation because unlike the real wealth creation through capital investment, both its creation and its use involve no income creation.
This perception of wealth creation, actually, runs completely counter to traditional thinking in economics. It has always been apodictic in economics that there is but one way to create genuine wealth for an economy as a whole, and that is to consume less than current production or income. Wealth creation from the macroeconomic perspective essentially occurs through saving and investment in tangible, income-creating plant, equipment, and commercial and residential buildings.
Asset inflation is not the same as capital formation. This has been his point for a decade. Capital formation represents a willingness of consumers to forego present consumption. They make money available to producers so that the latter can provide tools for their workers to produce wealth. Asset inflation does not result in future economic growth, because it does not require a reduction of consumption — thrift. It is the result of more fiat money being injected into the economy.
Guided by the Greenspan Fed, America is practicing a radically different pattern of "wealth" creation. An extremely loose monetary policy forces up asset prices, providing both the impetus and collateral for higher borrowing. Being offered almost limitless credit at rock-bottom interest rates, the consumer responds with a frenzied borrowing and spending binge. . . .
The crucial concern is the inherent effects of this so-called wealth creation to the economy. Asset inflation by itself has no effects at all. Its economic effects arise only from the associated increase in consumer borrowing and spending. But that has two highly malign effects. An endless escalation of unproductive debt is one. The other is that consumption takes an ever-greater share of GDP. Overconsumption is, really, America's deep-seated, structural disease, and asset inflation is worsening it.
This "disease" is iatrogenic: created by the "physician" who is supposed to be curing the disease.
U.S. economic growth is no longer based on saving and investment. Its essence is that credit excess provides soaring collateral for still more credit excess, creating still more asset inflation for still more borrowing and spending excess. It seems like a perpetual motion machine that just goes on cranking out wealth and spending. It is important to see that the true name of this game is bubble-driven growth, and all bubbles end by bursting. America is the next Japan.
Consumption today is an enticing opportunity. But it involves a cost: foregoing future consumption. The corn you eat, you cannot plant.
The American consumer has been subsidized by fiat money, which has produced lower interest rates. When the price of something falls, more is demanded. When the price of borrowed money falls, more is demanded. The rate of interest is the price of money.
The consumer is told by economists (Keynesians) and incumbent politicians that he should spend more, even if this means borrowing more, in order to keep the economy booming. He owes it to himself to have a good time. He owes it to the rest of us to turn loose of his money — not to buy producer goods but consumer goods. The consumer likes what he hears. He is being told that present-orientation is more productive than future orientation. We have heard this before:
Come ye, say they, I will fetch wine, and we will fill ourselves with strong drink; and to morrow shall be as this day, and much more abundant (Isaiah 56:12).
This way of life always produces the same outcome: a bad hangover.
Faith in the stock market continues, but it is a weakening faith. The "buy and hold" strategy has produced losses over the last four years. Fund managers are still being paid well. Fund expenses are still as large as dividends. But the dream of asset-inflated wealth is fading, just as it faded in Japan after 1989.
Men will stick with a plan that used to work out of habit's sake, and also out of a desire to be proven right. But if the market does not recover its 10% per annum increases, the old faith will die. It is already fading. Asset inflation will not make the middle classes rich after all. When this message finally penetrates the minds of millions of retired people, they will be driven psychologically to unload ownership of assets that do not produce income (dividends) for retirement living. They will sell. Asset inflation will become asset deflation.
You can't eat dreams.
August 27, 2004
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