DR.

KURT RICHEBACHER

CURRENCIES AND CREDIT MARKETS

No. 245 I September 1993

ttIn the end, it will again be the real capital structure, and not the money structure, which
deteroúnes the relative competitive capacities of different nations."
183
Marx and Keynes, Paul Mattick, P4

Merlin Press, 1980.

HIGHLIGHTS
EMS',
Watching the soaring financial markets around the world following the break-up of the
it
convinces us all the more that we are witnessing a once-in-a-lifetime financial mania. While may .

last for a while, it's an absolute certainty that it will end in a bang, not a whimper.

What bas really happened in recent years is the Americanizing of world financial .markets.
Economic and business fundamentals have gone out the window; short-term interest :rates and
monetary policy alone determine stock and bond market values.

Frenzied speculative periods are always propelled by popular myths. Their deception~ usually
only come to light when its already much too late. We identify three myths.

Surveying the world's major economies, we see no prospect for a sustained up-turn any\vhere.
However, it is worth reviewing the respective differences in economic and financial fundamentals.

It now generally accepted that the economic recovery in the United States and other major
is

countries is being inhibited by the unprecedented debt problems and structural maladjustments.
Everywhere it has the same cause: a collapse io investment expenditures.

In the United States, unprecedentedly large monetary and fiscal stimulus has failed to stage a self-
feeding economic recovery. The current economic weakness is not a pause. It's an .end.

Besides the weak monetary and economic data, we identify three big drags on the U.S. economy
that act to pull it down: fiscal policy, the trade deficit and investment.

Interest rates in the U.S. ought to be much higher presently. The paltry supply of ne\v domestic
savings relative to the huge U.S. federal budget deficit is one of the reasons.

The dollar is in jeopardy. A relapse of the U.S. economy and a soaring trade deficit makes its
position extremely precarious.

priorities. We continue to
Long-term capital conservation and liquidity continue to be the top
./
recommend safe h~rbour in the short-term money securities and bonds of the strong-policy
currency countries Germany, the Netherlands, Switzerland as well as Austria..
-
 A GLOBAL CHASM: BOOlWNG MARKETS. LAGGING ECONOMIES

Stock marlcet fever is boiling up and has been levitating markets everywhere. It's become a world-wide
mania. In fact, there isn't a stock market anywhere that could be considered reasonable value by historical
standards. Oddly, it was the recent break-up of tile European Monetary System (EMS) that ignited a new
explosive euphoria under the fmancial markets. While European politicians
may be mourning the EMS's
demise, markets particularly European stock and bond markets are simply ecstatic, celebrating it
-
-

as the impems for easy money and buoyant financial markets the world over.

Liberated from the shackles of quasi-fixed exchange rates, the happy reasoning is that European countries
are now able to push harder for economic growth. If Europe can be expected to slash its interest rates,
acting to jump-start its economies, the tlùnk.ing is that it will in time also help the U.S. economy. Even
more joyously received is the notion that interest rates the around world will now be freed from the
stubborn grip of the Gennan Bundesbank. And lower interest -rates at least the way the Anglo-Saxon
-

stock markets interpret them to the exclusion of almost everything else means soaring stock prices.
-

On the matter of the rigid European

Exchange Rate Mechanism
job blowing
(E~), we share the view that the
currency speculators did good of
a it up. What the world needs presently is policy flexibility
to allow suitable responses to differing domestic requirements, not policy paralysis. However, the
allegation of the French and the British that Germany's Bundesbank is to blame for destroying the ERM
is not valid. It should be remembered that the Bundesbank's
constitutional task is to defend the German
currency, not grander dreams of France's political elite.

. . .
A CELEBRANT EUROPE

Recalling the recent doom and gloom about Europe's supposedly frightful economic prospects, this abrupt /

switch to a rampant financial euphoria has taken us somewhat by surprise. Barron's described it nicely: \
ttForeign and domestic investors alike scrambled
aboard a sinking ship to capture the best deck chairs
from which to watch, and maybe profitfrom, a pending disaster." What's really happened in recent years
is thorough Americanizing of world financial markets. Economic and business fundamentals have gone
a

out the window; interest rates and monetary conditions alone determine security values.

Whaf's happening in Europe, in essence, is a literal replay of what occurred in the U.S. in Oétober 1990
when it was realized that the American economy was sliding into recession. Immediately recognized was
that a hard economic landing in contrast to the earlier expected soft landing
-

implied falling interest -

rates and, voila, the U.S. stock market immediately shot up in celebration even though business profits
and economic conditions were to remain sick for years to come.

WARPING STOCK MARKET DYNAlWCS

Actually, it's the norm for stock markets to begin rising at this juncture in the business cycle the stage -

when business conditions are deteriorating and interest rates begin to drop sharply. As a rule, changes
in monetary policy and money growth lead stock and bond prices which in turn lead the business cycle.
All through the postwar perio<t this pattern unfolded perfectly every time. That's why stock prices are
a sizable
component of the official U.S. leading economic indicators. But it's only valid as long as
business activity follows the lead of money growth and securities.

A big exception to this rule in 1929. Business activity peaked in June of that
occurred once before -

year, whereas stock prices peaked later in September and then crashed in late October. In fact, it was the

Currencies and Credit Markets \ September 1993

 3

spectre of a booming- stock market which deceived so many people about the economy's true vulnerability
at the time. It's a fact of life that when people feel good about fmancial markets, they tend
to feel assured
about the economy.

lbis time, anomalies are truly rampant In the past, a monetary easing, generally typified by sharp cuts
in short -tenn interest rates, normally caused a
regular sequence of identifiable effects. TIle first to respond
were always the stock and bond markets in association with rising money and credit growth. In due time,
usually no more than one year, the excess money which poured into financial markets
began spilling over
into the real economy that is into the growth of employment and production which initiates the
4.
4

new,
cyclical recovery4

THE SEEDBED OF FINANCIAL SPECULATION

What's gone wrong this time? For the economies that went into recession first some years ago in 1989
-

and 1990 the typical boom in the financial markets anived without any delay. But in stark divergence
-

from the nonn, all the other regular effects of a monetary easing largely remain missinga

Protracted, unprecedented sluggishness i~ credit and broad money growth clearly signals that the monetary
stimulus has failed to reach the real economies It is as if financial markets and real economies have
a

become completely disconnected. Contrary to any experience in the postwar period, a growing gap has
opened between increasingly bullish and highly-valued financial markets and the dismal underlying
performance of the real economies.

Adding greatly to the confusion in the major

countries Japan, the U.Sa, Britain, and others
-

is the -

unprecedented experience that narrow money supply (MI) has exploded on the upside alongside stagnating
broad money supply (M2, M3, M4). In the United States, in particular, where
bank and the
reserves
monetary base have skyrocketed as well, it gave rise to serious inflation fears even in the midst of
near-
recession in the real economy.

In contrast to the prevailing we have taken a somewhat opposite position.

fears, We have always
emphasized that, yes, there is inflation in
an the United States one
-

that could even be called a rampant

inflation. But the inflation we see is confined to the financial markets4 Prodigious
monetary stimulation,
as reflected in soaring bank reserves and
rock-bottom short-term interest rates, vents itself into frenzied
speculation in stocks7 bonds and derivative instrumentsa On the other hand, the protracted' weakness in
broad money and credit flows is directly inter-related with economic activity
and clearly implies that the
monetary channels into the real economies are clogged. More or less, the same picture is evident in most
countries"

The country that is the furthest advanced with this syndrome is the United States. Since 1989,~ the U.S.
spigots of monetary and fiscal stimulation have
turned on as never before. While the Fed slashed its Fed
funds rate from almost 10% to 3% and simultaneously
swamped the banks with excess reserves, the
administration doubled the budget deficit to abour$300 billion
annually. Together it has added up to a
stimulus of unprecedented magnitude.

True, the U.S" economy did recover. barely. The most ominous and disturbing aspect is the colossal
. .

disparity between the record-sized

doses of monetary and fiscal stimulation and their puny effects
on the
real economy.

)
Currencies and Credit Markets \ September 1993
 4
/
~.~
Officially~ the U..S.. recovery started in March 1991. U.S. real GDP (Gross Domestic Product) has since
grown a cumulative 4.2% or 2.2% annually which, by the way,
is below the economy's annual growth

potential of 2.5%. 1ñat compares extremely poorly with the average cumulative GDP growth of 10.2%
during the first two years of previous postwar cyclical upswings.

On the other hand, while the Fed's liberality has grossly failed in the realm
of the real economy, it has
hyper-stimulated the financial lbe Wilshire
world. Index of 5,000 stocks appreciated from a value of
$2,772 billion on Oct 10, 1990, to over $4,500 billion by the end of August 1993. That's a gain of well
over 60% and compares with an average gain in business profits of aoout 20%.

RATIONALIZING THE SPECULATIVE BUBBLE

Frenzied speculation is always seasoned with myths. We see a number of them presently. The first is
the belief that the sharp decline in U.S. interest rates is the healthy reflection of declining inflation and
inflationary expectations whi~h gives rise to the suggestion that investors are rushing into bonds.

None of this nue. The Fed's quarterly flow of Funds Accounts clearly bears evidence. But who bothers
to check? Apparently, nobody wants to investigate for fear of spoiling the party. The truth is that it has

been the Fed, the commercial banks and the brokers, egged on by the lavish policics of the Fed itself, that
have been the dominant buyers of bonds and are pushing U.S. long-tenn interest rates downward.

For example, here is what really happened in the U.S. credit markets during the first quarter of 1993. On
an annualized basis, total borrowing amounted to $529 billion, the government and
its agencies accounting

for $447 billion or 84% of the totaL lbe Fed kept its funds rate at 3% and glutted the banks with reserves ,(
~\,-
by purchasing $49.6 billion worth of government bo~ds. Given the lack of credit demand, the resulting
excess reserves in turn put the commercial banks under pressure to buy bonds. Their purchases amounted
to an annualized $100.2 billion during that quarter. Brokers and dealers snatched another $40.5 billion
for their on-going game of playing the shatply positive yield curve with cheap short-tenn money.
Broadly, the combined bond purchases of these three .buyers the Fed, banks and brokers
-

fmanced-

two-thirds of the Federal budget deficit. Money pumping by the Fed and nothing else is the true reason
for the incessant fall in U.S. long-term interest rates.

Nonnally, over the long run, interest rate levels are determined by the balance between credit demands
and the available supply of savings. Considering that the mammoth U.S. federal budget deficit exceeds
the paltrysupply of new savings, U.S. interest rates ought to be much lùgher. It goes .without saying that
the extremely low interest rates presently are even more poison for savings. When interest rates are so
low there is little encouragement to save.

MONEY DECEPTION

Another myth is the widespread assertion that the booming stock markets in the United States, Japan and
Europe are "liquidity-driventt. By traditional definition, markets are liquidity-driven when the money
supply grows faster than nominal GDP. That was the case worldwide after 1984 when the U.S. recovery
faltered. The Fed started to ease aggressively and the foreign central banks monetized massive dollar
purchases in order to slow its steep fall.

But that episode of exploding international money growth ended abruptly in 1990. Since then, the exact

Currendes and Credit Markets \ September 1993

 5

opposite has happened. Instead of exceeding GDP growth, money growth has been increasingly falling
short. Gennany is the sole major exception. To speak of I1liquidity-drivenu markets is therefore a
misnomer. Financial markets are booming in a world of shrinking overall liquidity as reflected in the
protracted weakness and deflationary trends in the real economies. The graph below shows the money
growth trend of the 06 countries..

Looking closer, we must G6 MONEY GROWTH TREND

distinguish between two
U.S.. JAPAN. GERMANY. FRANCE. U.K. AND CANADA
different liquidity trends in M2, Year-oyer-year Per Cent Change
most countries~ Aggregate
liquidity is generally shrinking
relative to nominal GDP~
14
However, within the broad
aggregates there continues to
be a big shift towards narrow
12
money (Ml). What this shift
reflects is frenetic financial
10
speculation. Keynes would
say that the financial sphere is
stealing money away from the
8
real economy.

Specifically, with respect to 6

the U~S. financial markets, we

identify two different channels
of liquidity into the financial .4

72 74 76 78 80 82 84 86 88 90 92
markets. In either case, the
Fed plays the dominating role. Source: international Strategy and Investments

lbe first is the booming U.S. bond mark.et~ As described, it is largely the product of the Fed's plentif~l
reserve injections. By forcing the banks into heavy oond purchases, this reselVe policy has lead to
extensive money creation and sharply lower long-teon interest rates~

On the other hand, the booming stock market is largely the product of the Fed's interest rate policy..
Private investors, stunned by the sharp decline in short-tenn interest rates on banks' time and savings
deposits, have been pouring their money into equity mutual funds, driving stock prices higher and higher.
In contrast to the purchases of bonds by banks, however, the shifts out of bank deposits into mutual funds
and securities by private and non-bank. investors leaves the total broad money supply unchanged. Yet,
the spurt in financial transactions essentially inflates the need for demand deposits and therefore buoys
narrow money (Ml).

This explosive rise in demand deposits, mainly reflecting rampant financial speculation, has an intriguìng
side-effect. Banks' demand deposits are subject to reserve requirements which must be held on account
at the Fed, the central bank. Therefore, as these deposits soar, bank reserve requirements rise in step.
Normally, this would put upward pressure on short-tenn interest rates. However, the Fed is preventing
that from happening by supplying whatever reseIVes are necessary to meet the system's requirements.
I

That explains the Fed s persistent, large oond purchases.

\

,.) Currencies and Credit Markets \ September 1993

 6

point is that the Fed, through its reserve and interest rate policies, has succeeded magnificently in
lbe
turning the whole U fmancial system into a perfectly working perpetual motion machine for financial
.5.
speculation. As long as that's the case, why worry unduly about the real economy?

QUESTIONING THE FED

Contradicting the rosy consensus view, we have always stressed the artificiality
and vulnerability of both
the current U.S. recovery and the associated boom in the fmancial markets. Investigating the causes of
the prolonged, extraordinary weakness in broad money, we have insisted that it means precisely what it
implies -

that economic activity is sluggish at best. Unprecedented weakness in money growth happens
to coincide with an economic recovery of like weakness. "

,
Being unable to influence money and credit trends, Mr. Greenspan and the Fed have decided to overcome

this failure by ignoring it. M2 has been effectively discarded as an official monetary target. Above all,
the Fed alleges that it is the unprecedented steepness of the yield CUNe that is distorting M2 growth on
the downside. To quote Mr. Greenspan: "Low deposit rates have induced savers to cut back on holdings
of deposit liabilities included in
M2...The unprecedented steepness of the yield curve is pulling deposit
funds into capital markets." In addition, it's believed that the yield curve has shifted borrowing and
lending away from the banking system to the cheaper money and capital markets.

Logical as this explanation sounds, It's not the first time that we've questioned the
it's dead wrong.
knowledge of Fed experts about the monetary mechanism how money is created and destroyed. What's
-

wrong in the first place is Mr. Greenspan's belief that the large money flows into mutual funds
automatically reduce the money supply. They don't As we've explained in previous letters, money
supply contracts only when businesses or consumers repay loans.

Mr. Greenspan's second big mistake arises from the fact that he completely ignores the flip side of the
steep yield curve: namely, the massive bond purchases of the banking system. TI1ese purchases are just
a different form of lending, mainly to the public sector. Rising bond holdings increase the money supply

just as much as rising bank loans. Remember that bank holdings of bonds have increased by a staggering
$213 billion over the last two years.

Over the 1991-92 period, banks, with their bond purchases have financed 21.3% of the total credit
expansion~ During 1983-84, their share was 24%. True, the banks have lost some market share, but not

nearly enough to explain the extreme divergence in M2 growth between the two periods. In 1983-84, M2
growth was 21% and in 1991-92 it was 4.5%. .,
THE REAL CAUSE OF LOW MONEY AND CREDIT GROWTH I
Forget about mutual funds and other technicalities. One must look at the broad picture which is
determined by total credit That explains why the U.S. recovery has been still-born right from the
beginning. The decisive differences with past cyclical recoveries are of two kinds: first, a virtual collapse
in total credit growth; second, a radical change in the credit pattern. More than anything else, it is the
purposes for which credit is used that determines the effect on the real economy.

A comparison with the 1983-84 recovery highlights the impact of these differences. Total credit expanded
altogether by 28% in 1983-84. In 1991-92, it only expanded 9.6%. That makes a difference.

Currendes and Credit Markets \ ~ptember 1993

 7

-"
) The second big and crucial divergence is
found in the pattern of borrowing and spending. In 1982-83,
/

the public sector the Federal, state and local governments

-
-

gobbled up 34% of total new credit. In

1991-92, their share was 65%. Private borrowing has thus been crowded out.

But who in the private sector has been crowded, the consumer or businesses? Almost exclusively, it has
been businesses. For comparison, in 1982-83, businesses borrowed a total of $447 billion, while in 1991-
92 they have instead repaid $15 billion. With these two figures you really know everything about the
current U.S. economic recovery. The table below provides some greater detaiL

Being dead wrong in the assessment of M2 and the causes of

, its ominous, peottacted anaemia, Mr. Greenspan and the Fed are
u.s BORROWING TREND
, essentially just as
wrong in their assessment of the U.S" COMPARISON: 1983-84 VERSUS
Billions of Dollars
1991..92

recovery's strength and sustainability. As late as July 20th this

year, Mr. Greenspan in hìs Congressional testimony predicted 1983-84 1991-92
that real GDP growth for the second quarter of 1993 would be
Total Credit $1,318 $1.035
between 2.5 to 3%. One week later, the Commerce Department
Federal Govermnent 382 582
publìshed an estimate of 1.6%. The latest calculations now Sute& LoC&GovL 70 85
only put it at a 0.6% annual rate, following the measly 0.7% Consumers 418 330
Businesses 447 -15
growth in the first quarter. 38
Foreign 26

Though this economic weakness great! y surprised the

consensus, it hardly challenged the prevailing optimism at alL
Future growth forecasts remain as positive as ever. It simply remains
a foregone conclusion that U"S.
real
.~\ growth will snap back to a 2.5 3% armual rate in the second half of 1993. But with two months of the
-

third quarter already behind us, neither the economic nor the monetary data bear this assumption out
.)

RECENT MONEY GROWTH JUST A BLIP

There has bee.n some modest strength in the monetary aggregates recently" Exclusively, it's coming from
a new bubble in narrow money (Ml) which is plainly related to the latest surge in the financial
markets.
During May-July, Ml surged by $42 billion or at a 16.3% annual rate. M2-minus-Ml declined at the
same time by $11 billion and M3-minus-Ml by $24 billion" In other words, more of the same: all new
money goes into financial speculation at the expense of the real economy.

All other economic data are not given the slightest support to the forecasts of an improving U.S. economy
either. What, then, are all the optimistic forecasts based upon? More than anything, it appears to be blind
, and steadfast faith in the stimulative power of low inflation and record-low interest rates despite the many
disappointments
i so far.

OUf own view is very much the opposite: There is not a shred of evidence that the U"S.. economy is
resuming growth.. It's clearly faltering again" Despite unprecedentedly massive monetary and fiscal
stimulation, the resulting lacklustre recovery lacks any dynamics.

THE U.S. ECONOMY UNDER DRAG

However, by no means are the weak monetary and economic data the only elements pointing to a
regressìve
U.S.. economy. Our worrying view is mostly determined by the recognition that the U.S.

Currencies and Credit Markets \ September 1993

 8

economy is being impacted by three major drags. The first one is the Federal budget with its considerable
cutbacks in defence spending and the Clinton tax increases. After all, it was a big fiscal boost that had
given the economy strong support in the period through 1989-92.

A second big drag is the rapid widening of the U.S. trade gap caused by the coincidence of slowing
exports and soaring import penetration. For this recovery, between the first quarter of 1991 and the same
quarter of 1993, the import volume of goods has skyrocketed by 26% compared with a rise of only 4.5%
in the domestic spending of goods. Final sales of goods grew a mere 1.45% during the full two years.

In actual fact. the rapidly widelÚßg trade gap is playing a key role in undennining the U.S. economic
recovery. It's robbed the economy of approximately half of its domestic demand growth during the first
two quarters of this year. Since the end of 1989, when the U.S. economy first began to weaken, im{X>rts
of goods and services have risen from 11.4% to 13.3% of GDP as the graph below highlights. GDP grew
a total of only 3.1 % in this
period. Essentially, this dramatic deterioration of the U.S. trade balance raises
critical questions about the dollar.

u.s. MERCHANDISE IMPORT TREND

% Of GDP, Quarterly

11.5%

t1.0%
.

10.5%

10.0%

9.5%

9.0%

8.5%

8.0%
85 86 87 88 89 90 91 92 93

Source: u.s. Depar1lla!Jd 01 Commerce Format: CCM

The.third major drag on U.S. economic growth is sharply slowing fixed investment. In addition to the
bulging budget deficit, it was a small boomlet in residential building and investment in plant and
equipment that gave the recovery some momentum. Housing is virtually flat though hopes are riding high
that the lower long-teon interest rates will revive it.

INVESTMENT IS THE KEY TO RECOVERY

It is now generally accepted that the economic recovery in the United States and other major countries
is being inhibited by the unprecedented debt problems and
structural maladjustments that accumulated

Cuneod. aad CredIt Markets \ September 1993

 9

during the prior booma Essentially, these ailments vary in kind and degree between different countries.
But one consequential effect is the same everywhere: a collapse in investment expenditures. It is in this
sector that one must look for the explanation to the world~s prolonged recession.

In Britain, during 1990-92, fixed investment fell by more than 30% or about 4% of GDP.
Japan's
recession is led by a similar downturn in industrial and commercial building investment In Canada.,
investment fell by 12% or 2.5% of GNP over me same period.

Just recently, the Federal ReselVe Bank

of New York. published a very detailed
u.s.: HISTORICAL COMPARISON OF RECOVERY PERIODS
study analyzing the slow-growth period First El2ht Quarters of Rerovery, Cunudatlve Per Cent Cban~e
of 1989-92 from a historical perspective.
1991-1 1982--IV 1975..[ 1970-IV
It clearly shows that the relative
1993-1 1984..IV 1977-1 197:z...IV
weakness in investment spending is the
most outstanding difference between the Rea! GDP 4.2 11.6 9.9 10.5

present and past UaS. recoveries. (please

Conswnption 4.4 9.7 10.7 11.6
see the adjacent table.) Real wage
Fixed Investment
growth and consumption growth have
Durable Equipment 18.6 31.2 15.0 24.3
been much lower than usual as welt
Non-residential Structmes -13.7 9.4 0.7 3.8
But it is investment that always provides Residential Investment 23.7 51.5 47.3 42.6
the great spark for these in recovery
Real Wages & Salary 1.9 9.1 6.0 10.0
periods.
Source: Federal Reserve Bank of New York, Quarterly Review, Summer
A good look 1993
) at figures should
these
destroy any existing illusions about the
viability of the
U.S. recovery. It clearly reveals its outstanding vulnerability. Past cyclical recoveries were
all driven by a burst in investtnent spending which consequentially led to sharp
increases in employment,
consumer incomes and consumer spending. Yet, strangely, we hear laudable mention that investment has
held up relatively well in this past recession. That
may be partly true against the backdrop of the unusual
weakness of the recoverya However, compared with past recoveries, this
upturn has been far below par.

What this Fed study does as well is dispel the comforting notion that the recent U.S. recession wasn't so
severe as earlier postwar recessions. Actually, with a real decline of 2.2%, it was a little aoove the
average of 2%. But to fully grasp the structural disaster that ~as struck the
U..S. economy, it is
necessary
to look at a more extended period. What really frames the situation is the unusual weakness
of growth
both before and after the recent recessioIL Quoting their comment on the rise in
real GDP over the four-
year period between early 1989 and early 1993, it represented "the weakest performance since the Great
Depression. "

The study illustrates ttùs fact by comparing the four-year periods during which the six postwar recessions
occurreda The figures on the next page illustrate the extreme differences in composition and
strength of
growth between. the present period and those in the past.

In general, the study confinns our long-expressed view that the U.S. economy is in a
deep structural crisis
which is manifested in two protracted and savage drags on economic growth. One is the invesunent
collapse and the other is soaring import penetration. In the Învesbnent sphere, the problem is that the
chronic weakness in industrial investment is now greatly aggravated by weakness in buìlding.

Currencies and Credit Markets \ September 1993

 10

A WHOLE WORLD IN THE SAME SOUP

u.s.: HISTORICAL COMPARISONS
Being downbeat on the U.S. economy doesn't OF PAST RECESSION PERIODS
necessarily imply that we're optimistic about others. In Four- Year Period Per Cent Change

most countries, downturns have slowed or given way to 1989-11 A

verage of
modest upturns. true self-feeding recovery is
Still, a to Preceding
1993-1 Cycles
nowhere to be seen. For that to occur would require an
investment boom either in building or producer's plant Real GDP 3.3 11.5
and equipment. Since txJth remain in the dold~s,
and likely will continue to do so, we see a world-wide, Consmnption 4.8 14.0

self-reinforcing economic weakness. Fixed Investment

Durable Equipment 9.8 14.5.
Non-residential -17.6 7.1
really reflect is excess
Structures
What Ûle soaring stock markets
Residential Investment -5.8 17.3
optimism, not excess liquidity. 1bis optimism has its
root in two maio convictions: first, that lower interest Lndusniæ PToduction 2.8 126

rates will, in time, dislodge the sluggish economies and

Real Wages & Salary 1.1 10.5
lead to accelerating growth; second, that business
profits are bound to rise due to cost -cutting and Source: Feder-a) Reserve Bank of New York, Quarterly

downsizing. Review, Summer 1993

Considering the accomplishment so far of the countries that have already slashed their interest rates long
ago, this lingering faith in the power of easy money is astonishing. As for the prospect of higher business
profits, the widespread belief in the overall salutary effects of cost-cutting is simply wrong. When
companies can only raise their profits at the expense of the incomes and profits of others, it beco~es a
zero sum gain. One entity~s income gain is the loss of another. Over the longe~ lUll, expanding profits
depend on expanding economies7 particularly expanding investments. That is the dynamic that has
been
clearly evident in the high-growth Asian countries such as China, South
Korea, Singapore and others.

THE DOLLAR -
THE FIRST VICTIM

The upshot of our analysis is that world business conditions remain fragile. There is much hand-wringing
over the recession in Europe. Given that other countries the U.S., Britain, Canada, Australia and a host
-

of others -
had already succumbed to recession much earlier, Europe's downturn hardly deserved the
great sensationalization that it received by the media. The far gre~ter calamity is the fact that the countries
who went into recession first proved unable to stage a normal self-feeding recovery. We find it curious
truly foreboding developments are completely neglected. Yet ~t has far-reaching implications
that these
for the currency markets, in particular the dollar.

Gauging the U.S. dollar, we distinguish between cyclical and structural influences that detennine its
performance~ To begin with, it was the perception of a brisk U.S. cyclical recovery relative to the
recession-bound European economies that propelled the U.S. currency upward.

Well, Europe has its recession, but the U.S. recovery is proving to be far weaker than the dollar bulls had
expected.. Therefore, the rise in U.S. short-term interest rates that the dollar bulls had anticipated has not
occurred. In our view, that alone should put an end to the dollar rally.

But another great danger for the dollar now arises from the rapidly weakening trade gap. Sooner or later,

Currendes and Credit Markets \ September 1993

 11

thìs development must lead to a fundamental reappraisal of the health of the U.S. economy and its
currency. Not only does it seriously undermine the recovery, it flies smack in the face of the general
perception of the U.S.. economy's superior international competitiveness and grossly undetValued dollar..

These perceptions usually found their basis in the highly popular ppp theory (Purchasing Power Parity).
We have never taken these calculations seriously and have repeatedly criticized them.. To compete
successfully in world markets requires more than just low wages and an undervalued currency. More than
anything else what's required is growing production capacity, specifically in manufacturing..

What these PPP fans completely overlook is that there is a widening investment gap between the U.S..
economy and the rest of the world. The U..S.. capital stock is progressively declining relative to foreign
capital stock, particularly in the industrial sector.

Wall Street loves corporate downsizing and rationalization, seeing it as a prescription for perpetual rises
in business profits and share prices. It ignores the important fact that shrinking capacities and reC<?rd-low
new investments are a sure-fire way to lose market share in a world where many foreign competitors
invest heavily. Essentially, the resulting capacity constraints limit U.S.. export and import-competing
capabilities regardless of competitiveness in prices and costs~

In the final analysis,

all of the ills of the U..S. economy can be traced to a single structural deficiency:
abysmally low savings and investment ratios. And unfortunately, rather than showing any improvement,
these conditions continue to worsen.

For the time being, markets aren't overly concerned with the widening U.S. trade gap. Comforting
explanations are always at hand. But seen against the backdrop of protracted economic sluggishness,
this
development is calamitous. At the same time, compounding the problem. record-low U~S. interest rates
act to weaken the capital account.. Given these serious negatives, the outlook for the dollar is becoming
highly precarious.

CONCLUSIONS

For the reasons explained, in our view, the U.5.. recovery has defiIÙtely peaked.. The only question is how
much economic weakness is to follow.. The most important issue for the investor is how a renewed
economic downturn will impact the currency and financial mark.ets~ In our opinion, a renewed downturn
would be sometlùng entirely unexpected.

Slowly and grudgingly, the dollar bulls are starting to consider their error. But the decisive shock is still
to come when the markets fmally realize that the paltry
U.S. recovery has been more or less aborted.
Then, the market will suddenly come to focus on all the other ignored negatives the soaring trade
-

deficit, abysmally low savings and investtnent ratios.

With its recent decision to leave interest rates unchanged, the Bundesbank again has demonstrated its
uncompromising stance on fighting inflation. This decision forces the other European central banks to
review the agenda for their monetary policies. Overall, the case for lower interest rates is clear.

What has surprised us, given our view that European economies remain mired in recession, is the extreme
bullishnessin Europe's stock markets. You might say that Wall street has come to Europe. Primarily at

Currencies and Credit Markets \ September 1993

 12

the behest of U.S. money managers -

who are loath to miss any stock market upturn and are diversifying
away from high-priced U.S. markets.
-

we see the Anglo-Saxon financial mania now spreading abroad

in earnest

Bearing in mind the U.S. experience where a drastic monetary stimulation has failed to benefit the real
economy, we urge caution. Low and falling interest rates may provide short-tenn support to the stock
markets, however the associated assumptions about the future course of the economies and business profits
are wildly over-optimistic. Simply put~ share prices are ridiculously overvalued worldwide. Investment
risk has gone from bad to terrifying.

A
sharp fall in the dollar, which we expect, will provide an appropriate opportunity for a monetary easing
in Germany and Europe. As such, selected European bonds should continue to perform welL

We stand by OUf long-running recommendations: For American investors~ there is little else to do other
than to continue seeking safe harbour in risldess short-term money. and to diversify into hard currencies.
Investors outside of North America should stick with bonds in the strong-currency countriesy namely
Gennany, the Netherlands, Switzerland, and Austria.

\
_J

Next Mailio!!: October 6th

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CUrrendes and. Credit Markets \ September 1993