, DR.

KURT RICHEBÄCHER
t

I)
r

I
CURRENCIES AND CREDIT MARKETS

No. 250 I February 1994

"Working and saving are a totally outmoded ethic during the latter stages of the boom. What was

previously consid~red specuIative is treated as sound investment. People have very little interest
in long-term savings or anything else that fails to provide instant gratification."

Robert Beckman, Crashes, p.8

Grafton Boob, London
HIGHLIGHTS

The world's financial mania has entered tbe "feeding frenzy" stage. It has become a monster.
How long will it last? Can tbe autborities tame it and prevent a bust? While the timing may be
a bust that will play havoc with world
unknown, the final outcome couldn't be more certain -

financial markets and economies.

Never before has the world witnessed a global mania of the proportions we are seeing now. Never
has a financial mania existed in .such contrast to underlying economic conditions.

The sophists of t~ay -

the economists, traders and the media -

bave been as ingenious as never

before in providÎng a false psychological catalyst to the boom. . . luring the masses by illuminating
')
a
new golden, glorious pathway to prosperity.

It's clear that U.S. money flows m:e the big; force behind th~ mania. Interest rate trends -

specifically ellts by the Bank of Japan and the Bundesbank -

helped turn up the heat as well.

There are tbree different scenarios for the future of financial markets. Which one to believe?
We're in the minority camp -

those that worry about a great deflationary spiral.

is tbat
The illusion an ocean of excess liquidity is flooding the markets. To stress again, it's not
abundant liquidity but abandoned liquidity that's driving the financial boom. When the music
finally stops, there won't be enough chairs.

We see two great paradoxes in tbe currency markets that are ripe for reversal. Unsustainable
developments affect both the dollar and the yen. These are liable to abrupt change. We explain
the implications for both currencies.

On the economic front, the world today is experiencing neither textbook recessions nor textbook
recoveries. Weak cyclical forces are still being dwarfed by the heavy structural maladjustments
and imbalances that are the lagging legacies of the excesses of tbe 1980s.

There is no strong investment spending recovery in the U.S. or anywhere else for that matter.
Neither is one expected. That portends a renewed slowdown in the U.S. and continuing economic
weakness around the globe.

) Given the inordinate risks, we see little worthwhile investment opportunities. Investors should
only focus on cash securities and tbe shorter-term bonds of the hard currency countries.
 THE FlNAL CRESCENDO?

Just as we go to press, the U..S.. Fed announced that it is raising its Fed funds rate one-quarter percentage
point to 3.25%.. What to make of it? Is it a signal of a tightening monetary policy? No.. We tlùnk it
is a calculated move by the Fed that's in
concert with the desires of the major players and beneficiaries
of the financial bubble. Although the Fed may couch its move under Ùle guise of protecting its inflation
integrity, it's really a move designed to preseIVe the
speculative mania. It's monetary voodoo and displays
an ignorance of the dangers of a financial mania and a weak economy. It signals that financial markets
have entered an environment of extreme risk..

In recent months, "animal spiritstf have given a further impetus to the unfolding global market mania. The
reasons are secondary to the momentum of the mania itself. On Wall street, markets cheer emerging
economic strength. In Europe, the expectation of falling interest rates, specifically because of weak
economies, is the bullish catalyst. Whatever happens it's rationalized as being
strength, weakness
-
-

bullish for fmancial markets.. In the U.S. and elsewhere, the equity mutual fund "feeding frenzy" continues
at manic levels further heating the mania.. In December alone, these funds pulled in $14.5 billion in the
U..S. bringing the 1993 total to a record $128 billion.. The mania is becoming a monster.. Will the Fed
be able to tame it?

A
WILD WEST IN CAPITAL FLOWS
Clearly, the epicentre of the world financial mania is During 1993, and especially
in the United States.
during the fourth quarter, American money flooded into world financial markets in record volumes.. While
Japanese stocks slumped in the fourth quarter and
U..S.. equities only inched up a mere 2%, European
stocks leapt ahead with an average gain of 9%.. The dazzling stars were the Far Eastern UTiger"countries.
Stock markets in these countries rocketed up by an average of 50% during the last three months of 1993.

~
One wonders what might have prompted this frenzy so suddenly. We see three chief reasons, all of them j

directly related to interest rates trends. lbe biggest cause was ballooning U.S. portfolio outflows.. The
flight of U..S. investors and savers out of low-yielding U.S. bank deposits and into bond and equity funds
spilled over into foreign
markets. More than half of equity mutual fund purchases in recent months in
the U.S. have headed for far shores..

Secondly, the sharp interest rate cuts by the Bank of Japan on September 21st of last year provided an
additional push.. In response to continuing economic weakness, the central bank cut its discount rate to
1.75% from 2.5%. Short-term rates below 2..0% and long-tenn rates declining to near 3% levels triggered
soaring portfolio outflows. This money largely went into the 1fTiger" markets such as Malaysia, Thailand
and Singapore, not to mention Hong Kong. And voila, these relatively small, illiquid markets catapulted
upwards by as much as 50% in the fourth quarter alone.

A third influence was the

Bundesbank. In quick succession, it cut interest rates in late September and
again in early October surprising the markets and arousing expectations of bolder action on German and
European interest rates in the future. It harmed the D-mark and ignited the European securities markets.

u.s. MONEY FLOODS THE WORLD FINANCIAL MARKETS

u.s. money has had a big impact on markets everywhere.. During the first nine months of 1993, U..S.. net
ponfolio outflows amounted to a staggering $99..3 billion.. In the third quarter alone, these outflows shot
up to an annualized rate of more than $185 billion.. By comparison, in the mid-1980s -

the previous

-~,
Currencies and Credit Markets \ February 1994 }
 3

period of cheap U..S.. money net portfolio outflows amounted to only $6-8 billion per annwu.
þ )
-

Presently, it only takes two weeks for this much to flow oul

figures we cited for last year are only net amounts.. It doesn't reveal the heavy churning that goes
lbe
on underneath. During the first nine months of 1993, total buying and selling of foreign stocks by U.S.
residents totalled $370 billion. TIle same figure for foreign bonds was a staggering $1.2 trillion..

What boggles the.mind is the

fact that everybody keeps u.s.. PORTFOLIO OUfFLOWS AND CURRENT ACCOUNT DEFICITS
forecasting a rising dollar BlDlons or Dollars

even though U.S.. portfolio

1991 1992 1993. 12 ~ !.2
capital outflows are soaring Net Stock Pmcbases 320 323 47~7 8~9 14.1 2S~O
on top of a rising U..S. Net Bond Purchases 14.8 19.6 51.6 15.2 120 21.4
Total Purchases 46.8 51.9 99.3 24.1
current-account deficit in 26.1 46.4
Current Account Deficit 8.3 66.4 77.5 22.3 21.2 28.0
excess of $100 billion at an Annualized Payment Deficit 55.1 118.3 235.7 185~6 213.2 2cn~6
annual rate, up from $66.4
·
January to September

billion for all of 1992.

Observing the enormous U..S. dollar flows flooding into the rest of the wo~d in spite of the huge U"S..
current account deficit (as shown in tht? above taQl~), we ask ourselves this critical question: Just who is
fmancing this international deluge of dollars in such abundance that it actually buoyed the dollar? Outside
of U .5. export earniI;1gs, we see five potential major sources of dollar demand in the foreign exchange
markets: 1) foreign central banks; 2) foreign purchasers of U.S" stocks and bonds; 3) short-term "hot
money" that's speculating on a ñsing dollar; 4) the hedging ofinvesbnent portfolio capital; and 5) changes

) ) in the timing of payment for U.S.. exports and imports (so-called leads and lags)..

In 1993, foreign central banks bought about $60 billion in U..S" dollars, a large amount by their standard"
lbe Bank of Japan accounted for almost half of this figure.. Non-resident purchases of U..S.. stocks and
bonds duñng the first nine months of 1993 amounted to about another $60 billion.. However that inflow
was far below U.S. portfolio outflows of $99.3 billion as the above table shows"

Given a huge current account deficit of approximately $100 billion, there is a .huge gap in the U .S.. balance
of payments of more than $70 billion. Yet, the dollar rose though, much less than the dollar bulls
" . .

had been predicting.- Where did this money come from?

In short, the dollar gap must have been filled by short-term speculative money, investment hedging and
changes in tenns of payment When currency speculation becomes one-sided, these
three sources of
currency transactions surge in favour of the currency that is believed to be appreciation-prone.. Given the
deafening, virtually-unanimous forecasts for a rising
dollar, this is exactly what happened. In recent years,
portfolio transactions have become particularly influential in determining the trends of currency markets..
What we see is notlùng more than the self-fulfilment of the dollar forecasts. The point to see is that this
can only boost a currency for so long.

It's really bizarre when you think of it: U~S~ investors are dumping dollar balances in a desperate search
for higher yields and returns. On the other side, currency speculators are pouring into the low yielding
dollar balances betting that a rise in u.s. short-term rates will reward them with currency gains on the
dollar. Somebody must be awfully wrong.

þ ) Currencies and Credit Markets \ February 1994

-.- .~.~~- ~.-- "'""":";'

__:..-::-:r.\_-:..~. :~;-~"""""':'.:'::."":_~..'~.~~.~~~.-~':.~~1
 4

JAPANESE CAPITAL OUTFLOWS: THE OTHER WILD CARD '\

l

Japan and its yen are the opposite paradox to the U..S~ and the dollar. Last year. Japan ran a record-high
current account sutplus of $140 billion. At the same time, its private portfolio outflows virtually halted.
As the yen pushed upward. the- Bank of Japan intervened heavily in the foreign exchange markets,
boosting its dollar reselVes from $27 billion to $95 billion between January and September last year..
These balancesy habitually, are invested in U~S~ Treasury paper.

Ye~ irrespective of this huge structural current account surplus, the consensus view is that the yen is
destined fall against the dollar. Behind this view a~.Jw-G-favo~_rite arguments: firstly, that -Japan's
to

economy is in a ghastly mess in comparison to the U..S~economy; arid--,s~condly, that the yen is grossly
overvalued in purchasing power terms. Incidentally, these, are the sàìn~ reasons cited for D-mark
weakness~

Taking this perspective, there seemingly must exist a mysterious, direct connection between relative GDP
growth and currency movements. Such elements as an immense sutplus in Japan's current account
apparently don't matter in tlùs analysis~

Over recent years, Japan's international recycling of its current surplus has worked out quite smoothly,
at least so far. But it's important to realize that this was due to a special, temporary factor which is
coming to an end~ During the "bubble years of the later 19808, Japanese banks and corporations invested
11

money abroad, far in excess of the country~s current surplus. In doing SOy they borrowed hundreds of
billions of dollars, piling up a fast foreign indebtedness mainly in the Eum-markets.

This mountain of foreign debt is actually the main reason why Japan was able to so easily dispose of its '\
-)
cumulative $340 billion surplus over the past Úlfee years~ This surplus was used to pay back the debts.
But given the rapid repayment, this convenient outlet for the surplus has since largely been exhausted.

Now Japan's problem begins in earnest It has to find another way of disposing it's surplus. Will Japan's
banks, corporations and investors embark on new international
a invesbnent binge?
Or will Japan's
gigantic surplus collapse for some unforeseeable reason? Whatever the
case, we think Japan will be a wild
card for the currency and fmancial niarkets.

LIQUIDITY ILLUSIONS

Looking at the huge frenetic flow of cross-oorder capital which is buoying the financial markets, we are
sureof at least one thing: Rows of this size are unsustainable, not to mention unpredictable. OUf dissent
with the euphoric consensus view starts with a contrary interpretation of the inherent liquidity conditions.

The bullish happily received by virtually everyone, is that an ocean of excess liquidity is flooding
story~

the markets. Given the general economic sluggishness in the major industrial nations, so the popular
rationale, the money has nowhere else to go but into fmancial assets~ The truth is otherwise as we Yve
explained before in past letters. Measured by broad money, actual liquidity trends
are the worst they've
been during the entire postwar period. At work, instead, is a massive asset shift, a flight from low-
yielding bank money into securities~

TIle flows resulting from tlùs enormous asset-mix shift are obviously creating an illusion of unlimited
--.\

Currencies and Credit Markets \ February 1994

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 5

þ: ~ liquidity and capital. The flaw is this: Transactional volume is being confused for liquidity..
Because of
i. ~ that, many so-called experts ignore low broad-money growth as irrelevant Who cares if money growth
is low if the stock and oond market
volumes can easily facilitate large sales? 1bis belief, as historians
know, is a classic delusion. Securities are liquid amy so long as markets continue to boom. What's truly
driving the financial boom is not abundant liquidity but abandoned liquidity.
When the music of the
fmancial mania finally stops, there won't be enough chairs to go around. The jaws of the infamous
--liquidity trap" will
snap shut virtually oveoùght.

THREE POTENTIAL SCENARIOS

Ultimately~ all of our

concerns give rise to two big questions: Firstly, how long can this fmancial boom
last? Secondly, how will it end? Basically, there are three main views.

The majority, as represented by the punch-drunk consensus, is convinced that the fmancial nirvana is here
to stay. Most financial seers now predict conditions highly favourable to such a
scenario well into the
far future. It is not seen as a speculative bubble at all, but rather as a healthful,
secular portfolio shift
away from deposits and towards securities which is a natural reflection of a secular decline in inflation
and interest rates. Meanwhile, outstanding profit prospects are believed to legitimize tlùs rosy view~
That
summarizes the three touchstones of the prophets of boom: low inflation, low interest rntes, and improving
corporate profits. Delightfully, they all herald continuing increase and assure lofty valuations of financial
assets as far as the eye can
see.

There is a second
camp that has a contrarian view to the first and has a following largely in the U.S.. TIùs
group is on the watch for an inflation eruptiofi4 They point to the extreme money pumping of the Fed
t t) over the past few years and assume that, at some point, investors will switch over from overvalued
fmancial assets to undervalued real assets. When that happens, they believe, it will launch an unbridled
inflation in commodities and goods and services much as happened in the 1970s~

A third, motley contingent

seems to have the fewest adherents though it does get serious attention in Japan
presently.. Its central and defining view is that the present world economic slump degenerate into
could
a vicious deflationary circle~
According to their theories, the greatest threat to the world economy is the
inevitable bursting of the fmancial bubble~ We identify ourselves with this
group.

That's three very different scenarios with radically different implications for the markets. Which one to
believe? Markets, of course, are playing the first scenario for all its at least for the time being.
worth. . .

With the world economy entering its fifth year of sub-par growth, fmancial markets continue to be
entranced with this scenario. Yet, it's a case never experienced before.. During the stock market lx>om
of the 1920s, the U.S. economy did very well until quite shortly before the craslL The
same applìed to
Japan in the 1980s~ Economic weakness was not seen as a cause for a financial boom.

CLUES TO THE LIKELY OUTCOME

In trying to deduce the endpoint of the present situation, we need to first identify its causes~
The one key
source of the present world fmancial boom is, of course, the Fed. By slashing short-term interest
rates
to the bone and flooding the banks with reserves, it turned up the heat by setting up the
steepest, longest
yield curve in modem history and literally chased
money out of low-yielding deposits and into the
securities.. By now, that part of the saga is well known..

þ O.._<--.~
,-
Currencies and Credit Markets \ February 1994

~
It
 6

Yet, a
central bank. can't do this single-handedly. to the supply
a boom psychology.
In addition moneYt what's needed is
of
mass belief. What's required are appealing stories and slogans"that rationalize
. .
a
)
the current price rises and promise their continuation. The slogans
vary from one boom to another but
one mantra always recurs that "things are really different this time." The view is popularized that the
-

new era has no prior comparison; that therefore valuation standards of the past no longer apply.

Having studied ruStOry7 we must give credit where it

is due. This time, the economists, traders and media,
the flllancial soplùsts of the day who essentially
contribute this psychological catalyst to the boom are
ingenious as never before. In the past, economic sluggishness has always been seen for what it was -

undesirable and bad. 111is time, these ttspin doctorslt have actually succeeded in making a virtue out of
poor economic performance. a glorious pathway to
. .
prosperity. More than once recently, we have read
that this is tIthe best of possible worldsu for the
U.S. economy and its financial markets, indeed the world
fmancial markets.

Here is an excerpt from the London Economist which is more or less characteristic of the present
optimism about the U.S. and the
U.K. economies (and incidentally, also reflective of the tlùnkìng in
Australia and Canada): Despite the subdued nature of this economic recovery profits have been booming
n

in America and Britain...This year, if forecasts prove correct, profits as a percentage of GDP will reach
their highest levels since the 196Qs, and almost double their lows .in the early 1980s...From the point of
view of the economy as a whole, fatter profits are exceLlent news. Other things being equal, they will
encourage firms to invest more, and to boost output and jobs. Likewise, a shift from consumption to
investment wilL make recovery more sustainable by helping to keep inflation low as economic growth
"

accelerates.

Taking tlùs comment at face value, one would tlùnk that the U.S. and British economies were suddenly
ebullient in economic health. In this view, the widespread corporate job shedding and restructuring is the
)
great recipe working wonders on productivity, profits and future economic growth.-

UNDERPERFORMING ECONOMIES EVERYWHERE

When reading such reports, we wonder what's missing? Is it analytical smarts or just plain old-fashioned
honesty? As the last letter showed in detail, the current U.S. economic
recovery has underperfomled past
business cycles in every way. The only aspect that looks better is inflation. But even this achievement
loses much of its lustre when the economy's sluggishness and the exploding trade deficit are taken into
account. In comparison to a dynamic, capacity-expanding
economy that has low inflation mainly due to
its high-productivity growth, low inflation in an economy that's under duress is nothing to cheer about

It also boggles our mind how inflation rates of 2-3% can be treated as miraculous harbingers of economic
growth and prosperity and be the justification for zero real interest rates and unprecedented high valuations
of stocks and bonds. Equally ludicrous in our eyes is the general tendency to glorify the corporate Itslash-
and-bum" strategies of job shedding and downsizing as the key to sustainable," healthier and more
profitable economic growth.

That's exactly what happened during the Great Depression of the 1930s. The difference then was that
there wasn't a single economist in the whole world who would have extolled tlùs as a prescription for
better economic growth. Unanimously, the job shedding and downsizing was deplored as part of a vicious
circle of self-reinforcing deflation.

Currencies and Credit Markets \ February 1994

~
 7

is that these slash-and-bum strategies ultimately hollow out and weaken economies if they are
I A. The point
is the view that these measures ensure

\I not associated with sigrùficant new investment Just as fallacious

abnormally high profits at the
expense of wages. As long as such actions remain limited in scale, it will
undoubtedly help the participating businesses to improve profitability. But when it becomes epidemic,
it squeezes purchasing power and ultimate profits.

considerably underperformed in this recovery. Several

The truth is that profits, like everytlùng else, have
factors have contributed to the illusion that profits have been strong. To begin with, profits had fallen to
r~ all-time secular lows before the recovery began. in fact, even before the recession. Improvements from
. .

likely is the fact that bank and

\,. a low base are more to look large in percentage tenus. More critical
J"
disproportionate contribution to aggregate profit levels. Without
broker profits have made an enonnous,
this influence, what is revealed is that domestic non-financial profits are still near historical lows as share
a

of Gross Domestic Product (GDP). Although strong gains probably occurred in the fourth quarter of last
year, there was no profit growth in the non-financial sector in the preceding nine months.

What we are wimessing are neither textbook recessions nor tex.tbook recoveries. Weak cyclical forces are
legacies of the excesses
dwarfed by heavy structural maladjuSbnents and imbalances that are the lagging
dissipated yet. The root structural
of the 1980s. No, we don't think that the excesses of the past have
problems of all Anglo-Saxon countries remain prolonged overconsumption at the expense of investment
and the trade balance. Because of tills, as we've pointed out many times before, the Anglo-Saxon
Japan and Germany's structural root
countries have ravaged their long-term growth potentiaL In contrast,
problem is overinvestment, which in the case of GelTIlany has been complicated by the horrendous costs
of unification.

1-:;.
if' ,-') THE LAGGING LEGACY OF PAST EXCESSES

Trying to untangle the forces at play currently, it's necessary to separate the short-term cyclical from the
depends entirely
long-term structural trends. In all countries, sustained growth of output and employment
on the successful correction of structural maladjusnnents. In a stunning downward revision of earlier
Fed capacity in one fell swoop slashing
estimates, the erased some 3.7% of U.S. industrial last year -

annual capacity growth between 1987 and 1992 from 2.4% to 1.7%. Lately, average
capacity growth for
this period has been revised down even further to 1.6%. Essentially, it's crucial to remedy tills disastrous
trend by higher capital formation and productive investment. But that requires rather more than just a
cyclical recovery -

namely, a massive reallocation of resources from consumption to investment in

productive plant.

Present! y, the Anglo-Saxon countries are perceived to be in the vanguard of the world economic recovery.
In 1993, U.S. real GDP grew 2.9% and U.K. GDP grew 2%. Though growth was positive, it's important
to know its composition. Just what role did the badly needed capital fannation play?
l
!l

\, is excelling in regard to
o Well, according to virtually all of the reports we read, the present U.S. recovery
invesunent trends. We read this from an influential voice of consensus, Morgan Stanley: "Capital
spending in the U.S. has risen at an 11%
annual rate since the middle of 1991 and has accounted/or
roughly half of the totaL gains in GDP during the current recovery." In like vein, inany observers croon
States.
that an unprecedented boom in capital spending is taking place in the United

OUf conclusions are diametrically opposite: The current U.S. economic recovery, despite its strong surge

t ) Currencies and Credit Markets \ February 1994

I
 8

during the fourthquarter~ has remained unusually sluggish, mainly owing to profound, long-tenn weakness \
J
in fixed investment. During the first 30 months of this U.54
recovery~ fixed investment overall rose in
real terms by only 17.8%. That compares poorly with an average rise of 28% in the previous five
cycles.

To review an important point we made in the last letter, what's worse is that capital spending is as lop-
sided as never before toward one single category: infonnation-related equipment (mostly computers)..
All
other investment home building, non-residential construction, and industrial equipment
-

are weak
compared with past recoveries and, net of depreciation, are very near or below previous postwar lows..

Since early 1991 (the official end of the recessìon) computers accounted for literally 50% of the increase
in fixed investment The last letter gave a detailed explanation why these big
computer expenditures
grossly distort the GDP data on the upside.

As a
cyclical demand component, sharply rising investment spending is crucial for its so-called multiplier
effects on.employment and wage income.. These effects arise primarily in the industries mat produce the
capitalpÓOdS.We said that spending on building has the biggest impact on jobs and incomes by
far
becau~ it is most capital- and labour-intensive. All the money earned, less that portion saved, is in turn
spe9-ragain, and so the spending cycle continues.
/
)'Ie fully share the admiration for the v.S4 computer industry.. However, the fact is that from a cyclical
/// perspective, its impact on employment and incomes is virtually nil since it is meeting the soaring demand
for its products with minimal additions in jobs and with plunging prices. Since the first
quarter of 1991
-/// through to the end of the third quarter of 1993, computers accounted for 18% of overall GDP
growth"
However, one should know that fully 74% of this stated GDP growth was due to a statistical adjustment
for price cuts and increased computer power. ~)
lbe more we study this, the more we realize that the U.S.. computer industry grossly distorts the whole
U.S. economic picture. Though accounting for only 2.6% of total manufacturing output, it has contributed
one-third of total manufacturing productivity growth. While heavy computer investment has great merits,
it's im{X>~t to recognize its limited effects. It~s no substitute for the
type of investment that produces
goods. And it's these of investment that remain in a
types slump"

A FALSE DAWN IN BRITAIN

What about the widely-publicized economic recovery in Britain? Is it sustainable and what aoout its
composition? Presently, Britain stands out from the rest of Europe
as the one major country where the
economy managed to grow last year. In the third quarter, real GDP had risen 2% year-over-year.

What's driving this U.K. recovery? It isn't invesunent spending. Total fixed investment has OlÙY risen
1.1 %
year-over-year, following a decline of 18%. This rise accounted for only 8.4% of GDP growth
It was consumption and government spending, accounting for more than 90% of overall
growth, that drove
Britain's recovery..

Meanwhile B titain s trade deficit has ballooned to í 13 billion and the budget deficit has risen to {50
'

billion at annual rate (approximately 10% of GDP).. Private sector credit growth, at 3% over the year,
remains very low" These figures already reveal enough to conclude that the U4K. recovery is extremely
ill-structured and destined to be aborted. For Britain it's definitely a false dawn.

Currencies and Credit Markets \ February 1994

~)

j
 9

e ") WHAT TO MAKE OF SEEMING ECONOMIC RECOVERIES

The strong performance of the U.S. economy in the fourth quarter of last year apparently has put all of
the doubters on the defensive. Early estimates put fourth quarter GDP growth at an annual pace of
5.9%..
To gainsay such strong growth now would be to court laughrec Everyone is convinced that a self-
sustaining recovery has fmally taken hold in the United
States. Yet, we still don't read or hear any
convincing explanation as to why tlùs upturn is the real tlùng and not just another false
start. The fact
that there have been at least three such false starts over the past
three years alone argues for such a critical
analysis.

We see number of erratic and unsustainable items in the U.S. economic data
a
the effects of flood
-

damage repair, a credit card borrowing spree, a wave of year-end purchases by business to take advantage
of an expiring opportunity to deduct up to $17,000 against taxable income and a car sales room, to name
the major ones. As
well, exports have added 1.6 percentage points to the fourth quarter increase.. In a
global recession, that trend is not likely to continue much longer.. But all of these factors don't lead us
to the main point

Ultimately crucial in our assessment are the broader considerations

the identity of the underlying and
-

prospective cyclical forces. Business cycles. reflect interacting investment, credit and income cycles.
Every single self-sustained, self-reinforcing cyclical recovery has been characterized by double-digit
growth in fixed investment, credit and profits entailing strong growth in employment, productivity and
consumer incomes.

None of that is evident in any of the Anglo-Saxon recoveries currently. We see nothing that sUP(Klrts the
-')
e conclusion that these "cyclical dynamics" have kicked in. The inevitable conclusion is that economic
./ momentum must soon wane. In fact, the real question is whether or not a renewed slowdown will develop
into a serious relapse.. If our view seems too incredulous to believe given the present burst of market
euphoria, well, we can only say that facts and theory support our opinions.. Time will tell.. We certainly
plan to be around to answer for our conclusions.

A COMING INFLA nON OR DEFLA nON?

Returning to the
debate we opened earlier, we pointed out that one school of thought sees the present
fmancial inflation eventually converting itself into a general price inflation in commodities, goods and
services. If liquidity is overflowing on Wall Street, why shouldn't it spill over onto Main Street?
Essentially, to put it into our
terms, this group wonies that the prevailing asset inflation actually a -

narrow securities inflation will give way to a price inflation. We strongly dissent with this view..
-

The favourite arguments supporting this argument are two: firstly, that excess liquidity will switch its
attentions from overvalued financial to real assets; and secondly, that slow-growing production capacity
will be unable to meet sharply rising demand given alrc'ady high capacity utilization levels.

We fully agree with ilie concern that there is

a dangerous lack of
U.S. industrial capacity to meet a strong
rise in demand. Capacity bottlenecks, resulting from many years of under-investment as
we see in the
United States today, have been the regular harbingers of inflation.

This time, though, there is a significant difference that changes the analysis. Given the very slow

I Currencies and Credit Markets \ February 1994

1-
 10

economic growth relative to the strong capacity expansion in the rest of the world.. there '8 a lot of under-
utilized capacity out there that's ready to pounce on any rise in U..S.. domestic demand. Instead of
inflating domestic prices, rising U..5.. demand would mainly inflate the U.S. trade deficit and could
possibly trigger a dollar crisis. As a
matter of fact, wiÛlout the safety valve of surging imports, U..S..
inflation would already be much higher than it is presently..

Yet, the main reason why we disagree with the inflation crowd is liquidity.. The whole idea of a possible
or even probable switch from financial assets into real assets is sheer illusion.. It would necessarily
involve a massive shift between two groups of "marketable" assets -

from securities into real assets..

That's very different from the present wlúch is taking place from cash into securities.. Few
asset shift
people seem to realize that these two flows have diametrically different effects on the financial system.

A flight from cash causes a boom; a flight from assets causes a crash.. That's the key and crucial
difference.. The reason that's so is because money invested in non-liquid~ marketable assets is
pennanently
locked in.. To get out again, the owner has to find a buyer who is willing to
give up cash.. And so, for
the overall fmancial system, no flow of funds takes place, only a
change of ownership. If too many
investors want to sell, the market crashes~ destroying all of the imaginary wealth and liquidity in its
wake"

The dangerous fallacy in the general thinking is that booming markets reflect overabundant liquidity.. As
explained, the mania is really the product of rapidly declining liquidity.. While new savings rates
are still
near secular lows in the United States, investors are unloading their liquid assets in favour of securities.
To call this a liquidity-driven process is an absurdity, especially in the face of record-low broad
money
growth (M2, M3, and M4)..

That leads us to the third and bleakest of the possible scenarios.. Frankly ---',
speaking, tlùs is the outcome
that we expect will take place in some form.. Its key premise is a continuing
general sawtooth economic
performance as the stI1Jctural impediments drag on but only as long as the financial room continues.. The
easy profits of the mania and its wealth effect have. buoyed psychology and above all consumer demand..
What will eventually sabotage this trend is bust of the financial boom.. That is the greatest threat to world
economic stability..
/

MONETARY MAKE-BELIEVE

For the U~S., there are two central facts: first, its economy is much weaker and
more vulnerable than
policymakers and the market consensus seem to realize: second, the present financial boom, having
begun
in late 1990, is not based on a healthy, sustainable foundation of higher savings and low inflation but
the
greatest and most frenzied financial speculation in history.. Abnormally low short-tenn interest
rates and
excessive reserve injections by the Fed, rather than starting a genuine
recovery in the nonnal way, have
hyper-stimulated the fmancial markets..

Most observers exult about the resulting surge in stock and bond pñces and condone it as
the emblem of
excellent policies. By contrast, in the 1920s, senior people in the Fed
worried about the rampant
speculation in the stock market and its likely aftermath~ The main barometer of their
concern was the
rising valuation level..
Apparently, today,
Mr. Greenspan and the Fed are unreservedly pleased with the
boom.. Its wealth effects and the sharp decline in long-term interest rates are welcomed as stimulants to
spending.

Currencies and Credit Markets \ February 1994

,)
 11

Then, what to make of the Fed's recent quarter-point tùke in its Fed funds rate to 3~25%? We see a
þ /':..... pelVerse logic at play behind this minor move~ The view in the markets
a view obviously shared by
.,
-

signal be bullish for me markets. Wlúle being too

the Fed -is that a mild of this kind would actually
by slightest of inflation, the Fed is trying to
small to do any harm to the economy, reacting to the trace
vigilance. it is hoped, will help to again lower
convince the markets of its serious anti-inflation This,
heavy losses on the big yield-cuNe
long-term interest rates which backed up in recent months and inflicted
players~

play which has suffered

Putting it plainly and simply, the Fed wants to rev up the speculative yield-curve
the past few months because the banks stopped their bond
buying binge. This isn't serious monetary
it does is stoke the speculative furnaces
(X>licy at alt As we said at the start, it's monetary voodoo. What
through anti-inflation make-believe~

We wonder whether this monetary trickery will work. It must have greatly surprised and even shocked
the advocates the bond market's immediate reaction was very negative. Apparently,
of this play-act that
little does the Fed know that it is playing with fire~ [t is underestimating the precariousness of the
fmancial bubble and overestimating the strength of the economy. As the historical record of past
speculative bubbles shows, even litt1e~ quirky things can prick them. And if the Fed's actions
inadvertently should serve as the catalyst for such a bust, it would play havoc with the world financial
markets as well as the U.S. economy.

today, in contrast to 1929-

TI1ere is a complacent belief that the economy and its fmancial system are safe
30, because the Fed's low-interest rate policy has served to greatly strengthen the banking industry's
is the misconception that the banking
balance sheet over the past three years~ Supporting this notion
collapse of the 1930s, triggered by the brinkmanship of the Fed, was the major cause of the Great
) \
j Depression.

1l1at is the view perpetrated by Milton Friedman which has since become axiomatic in public opinion and
most textbooks. Actually, the impact of bank failures in the 1930s was puny in comparison to the stock
imposed losses totalling about
market losses. During the four years between 1930 and 1933, failed banks
$2.5 billion on stockholders, depositors and other creditors~ By comparisons, the stock market crash wiped
out an estimated $85 billion in capital values. Yet, Mr. Friedman concluded that the bank failures were
the drastic decline in the stock of money was
crucial because "they were the mechanism through which
"
produced.

We have always subscrired minority point of view: that the stock market crash itself,
to the opposite,

rather than the bank failures, was the precipitating cause of the U..S.
depression. To begin with, the wealth

destruction caused by the stock market was incomparably greater. Last but not least convincing is the fact
that the stock market crash lead the economy's slump whereas the bank failures followed, the first wave
of closures having only begun in late 1930.

CONCLUSIONS

speculative bubble
Looking at the world financial markets, we know one thing for sure: It's a frenzied,
inflated by gigantic, unsustainable flows. The great general error in the accompanying complacency is
to confuse the mass flight from liquidity with a condition of overliquidity. As reflected in the broad
money aggregates around the world, liquidity growth remains dismal.

).'....
~
~.
Currencies and Credit Markets \ February 1994
./

:J?:.~~~~
 12

It's important to get sense of lùstorical perspective. While the media and
a
a
the experts make it all sound
global mania of the proportions
e
so glorious and non-threatening, never before has the world witnessed
such stark contrast to underlying economic
being experienced now. Never has a financial mania existed in
conditions.

speculative financial frenzy

is the Damocles sword over the world economy just as it was
We think. the
in the 1920-308.

gain stem inflation fighter.

the image;of But though its rate hike
a
The Fed is bluffing, wanting to bubble..
it is taking enormous risks given the fragility of the financial
amounts to no more than tokenism.

a successful gamble in maintaining

It's too early to say whether the Fed's recent action will have been
it fails to
bond market will be the litmus test If
buoyant fmandal markets. The response of the U.S.
is backfiring on the markets and the U.S. economy. And if U.S. stock
recover, it will mean that the move
markets fall out of bed, so will world stock markets.

worldwide as well. To be on the

Even though long-tenn bonds are exposed to less risk, they may suffer
liquidity. Though the dollar may get support over
safe side, always go with the currencies with the best
the short it will resume its long-teon downtrend once markets awaken to the U.S. economy's
run,
weakness.

presently. we see little worthwhile investment

Given the inordinate risks in global financial markets
Capital preservation is the overriding objective. Investors should oIÙY focus on cash
opportunities.
Switzerland,
securities and the shorter-term bonds of the hard currency countries, specifically Germany, ():T.'"
f",~!.,',
,,"
Holland and Austria. \1-., ".

Next issue to be mailed on March 8, 1994

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~
\
Currendes and Credit Markets February 1994