DR.

KURT RICHEBÄCHER

') CURRENCIES AND CREDIT MARKETS

No. 249 I January 1994

It It is not so much the folly of the ordinary man who played the market during the stock exchange
boom as the folly of those to whom he looked for advice and guidance which is most str.iking.
Many were of course personally interested in the continuatio~ of the Bull Market."

The' Great Slump, Goronwy Rees, p.22

Weidenfeld and Nicholson, 1970.

HIGHLIGHTS

As the new year begins, global financial markets continue to boom manically. The most crucial
question is this: Is the boom a treacherous financial mania or a sustainable, healthy development?

Peering. into the uncharted waters of 1994, the most critical -issue for investors is whether
or not
the U.S. economy is breaking out of its slow-growth, roller-coaster growth pattern of the past 3~4
years and launching into a self-feeding dynamic phase, leading a global recovery.

What's different with this latest economic surge? We have scrutinized the current U.S. economic
recovery again in great detail. The conclusion of our study? We expect that U.S." economic
.

'\
ì
growth will decelerate sharply to a virtual crawl in the .comin"g months.
/

Neither in the United States nor anywhere else do we see convincing evidence of a sustainable
economic recovery. While downturns will level ofT, the world economy is likely to get weaker.

To Wall Street, the Current financial boom has a healthful origin in the prolonged coi~cidence of
low inflation, slow economic growth and very easy money. To -their way- of. thinking, what's
occurring is a perfectly sound "liquidity-driven" boom. We show why the exact opposite is true.

Every speculative era is marked by some new novel theory. We examine some of the ones of past
bubble eras. All of them proved to be false. Upon detailed analysis of present new-fangled yarns,
we conclude that the same fate awaits these also.

Actually, what's unfolding in the financial markets is an unprecedented stampede away from
liquidity. That's the key to unravelling the monetary mystery of how a financial mania can take
place within an environment of broad money stagnation.

There is severe downside to this portfolio shift: holdings of.individual's liquid assets today have
a

fallen steeply as a share of total financial assets. Ominously, overall liquidity (M4) is now the
lowest in history as a share of to~1 debt. There is only so much money that can shift.

Sadly, we see a deceptive process under way that's luring investors into certain financial disaster.

Investors will be fortunate their money in 1994. Investment prospects are beginning
to preserve
to look skimpy everywhere. Investors should avoid overspeculated markets at all costs. It's best
to focus on short-term cash securities and shorter-term bonds of the hard currency countries.
HARD FACTS VERSUS DREAMS
surprises and disappointments. What developed was
No matter what one's views, last year was full of
a picture of unprecedented contrasts:
continuing economic attrition and hardship alongside booming
begins, stock markets and most bond markets are
financial markets around the world. As the new year
speculation. And again, the jungle drums are beating out the
in a fever-pitched frenzy of euphoria and
accelerating recovery, the fourth time in as many years..
message that the U.S. economy has entered an

employment, 1993 was an unmitigated disaster. Gauging by these

Yet, reviewing economic growth and according to the
measures, it was the most
depressed year ever recorded for the industrial countries
Organization for Economic Cooperation and Development (OECD). For all of its member countries
is only around 10/0, in sharp contrast to earlier
combined, real GDP growth estimated to have been
Japan. Will the clouds
forecasts of 2.5%. The sources of the unexpected weakness were Europe and
economically?
finally lift in 1994, either financially or

to be spoil-sports just to be contrarians. But, unfortunately, we still see continuing

We don't want
ballooning risks related to a fast-expanding financial bubble. We are
problems and, above all, huge and
with our wanùngs. It's at times like this when we find ourselves in
very aware that we are lone voice
a

a smaller minority than usual that we are

prompted to redouble our research activities and check the
this letter since we will
readers to bear with us in
numbers twice. Because of that, we especially ask our
to cut through the dreams and focus on the hard facts.
be digging into statistics more than usual. We want

THE KEY ISSUES

1994, the most crucial and important issue for investors is whether
Peering into the unknown waters of ~and
is breaking out of its slow-growth, roller-coaster pattern launching into a
or not the U.S. economy
the beginning of just ;.

self-feeding dynamic phase. Lately, there's been horde of economists announcing

a '\..

help lead a world recovery a desirable development.

such a phase. If it happens, it certainly would
-

1993
the rest of the industrial world, U.S. economic growth in
True, compared to the low growth rates of is
_ probably ringing in at 2.8% or so indeed appears imposing. Unfortunately, this strength
-
only
of Û1e recovery. Despite
relative. Such a superficial comparison overlooks the absolute weakness U.S.
pumping and interest rate cuts efforts begun years earlier than most other
the. Fed's vigorous money
-

countries -
it has yet to succeed in igniting a self-sustaining recovery.

the U.S. stock and bond markets have starkly underperfonned

other world markets.
Nevertheless,
the Far East. Rather oddly, U.S. stocks have
Financial speculation has shifted heavily towards Europe and
stocks soared an average of
been the laggard of global markets, rising only 7%_ By contrast, European
Star perfonners were the Far East stock exchanges with an average gain of 81 % (ex. Japan).
240/0.

mania or a
is this: Is this long financial boom a treacherous financial
The most crucial question
sustainable, healthy development?

THE AMERICANIZA nON OF GLOBAL FINANCIAL MARKETS

Two predictions appear to have supplied the rocket fuel

-

Why have European stocks taken off?

further sharp falls in interest rates
although somewhat contradictory and overblown to us: expectations of
is unlikely. But never mind.
and an impending cyclical recovery. either one should happen, the other
If
it is widely taken for granted that the Bundesbank will rapidly slash rates
Conforming to the U.S. pattern, ,

~,

\ 1994
Curren(:ies and Credit Markets January
 ..
DR. KURT RICHEBACHER
Telephone: (90S) 957-0602 Dr. Kurt Ricliebicher
Subscrlpdon Administration:
FAX: (905) 957-0602 Mendeissohn Sb"UIe 51
Mulberry Press Ine. 1
D -
60325 FRANKFURT
7889 Sixteen Road
CAISTOR CENTRE, Ontario GERMANY
CAN A.Ð A, LOR IF..O

CURRENCIES AND CREDIT MARKETS

1..[:Iì,~'..II~:II:ji..'..::::~~':'I~~I:\.~~ll"":[l~:::!l~""~!:l':.~~ll:'l;'~~!.~:~:':"::j:.~.l[~~':':!:';

ERRATUM NOTICE

Dear Reader,

A last -minute production glitch caused a serious error on page 3 of the January 1994 letter. The
two paragraphs under the first headline should have read as follows:

IS THE WORST BEHIND?

is over and that, generally,
Overall, the consensus thinks that the worst of the world recession
things can only get better. A great sense of confidence has emerged on the evidence of recent
growth stirrings in the United States~ Canada~ Britain and Australia. Given this flow of warm
pick-ups in Continental Europe
feelings in recent months, the mood is to wager modest growth
and Japan, as welL

unprecedented chasm has

Brazened by this new faith in the powers of Low interest rates, an
opened up between miserable economic and fmancial fundamentals poor profits, low
-

savings and record-sized budget deficits and celebrant

-
financial markets. Most brokerage
and bank reports spin a delightful tale of marvellously improving fundamentals and the
promise of a new economic and financial age.

this may have caused.

We sincerely apologize for any confusion
 3

-........

'} from the present 6% level down to 3%, paving the way for corresponding cuts everywhere else in Europe.
These interest rate forecasts, in turn, give rise to predictions of impending economic recovery for Europe.
Happìly, the high-flying stock markets seem to be discounting both.

We have great difficulty in reconciling these assumptions. Firstly, we don't think the Bundesbank will
comply. As opposed to the Fed, it is hardly likely to slash short-term interest rates to levels below the
inflation ratc. Besides, the Bundesbank is much more sceptical about the effectiveness of interest rate cuts
in stimulating economic output than U.S. policymakers and economists are. As a matter of fact, this
scepticism is widely shared throughout all of Europe though the Bundesbank selVes as the scapegoat.

IS THE WORST BEHIND?

Overall, the consensus thinks that the worst of the world recession is over and that, generally, things can
only get better. A great sense of confidence has emerged on the evidence of recent growth stirrings in
the United States, Canada, Britain and Australia. Given this flow of warm feelings in recent months, the

Brazened by this new faith in the powers of low interest rates, an unprecedented chasm has opened up
between miserable economic and financial fundamentals poor profits, low savings and record-sized
-

budget deficits and celebrant

-

financial markets. Most brokerage and bank reports spin a delightful tale
of marveUously improving fundamentals and the promise of new economic and financial age.
a

mood is to wager modest growth pick-ups in Continental Europe and Japan, as welL

Our main dissent from the consensus view, however, concerns the near- and medium-term prospects of
the world economy in general and the U.S. economy in particular. To us it appears that false optimism
) about the U.S. economy has been translated into an optimistic dream about the world economy.. That must
sound like heresy given the apparently unarguable surge of bullish economic statistics out of the U.S.
during recent months. However, we are guided by hard facts 4 Thorough investigation reveals important
information that supports our view.

NEW AGE VERSUS OLD THEORY

Is it time to revise our higWy critical view of the world financial boom and the U4S economy? Are we
simply outdated or are we missing something? To answer this question, we undertook a most
. . .

comprehensive and thorough investigation of U4S, economic, financial and monetary conditions In 4

contrast to the outbreak of optimism everywhere else, this analysis has deepened our scepticism.

Searching the history books and reviewing theory for guidance, we discovered that all financial manias
have occurred at times of low inflation. or at least, apparent low inflation. Economic growth during
. 4

these periods more usually was sluggish. While that may be perplexing, the real Linkages to a financial
mania are of course the associated loose monetary policy and extremely low interest rates.

Thus, the stock market boom in the 1920s was stoked by the slogan of a 11new eralt of permanent price
stability. Consumer prices were in 1929 no higher than in 1922. During the 1980s, the battle cry of the
financial speculators was fldisìnflation.ll Correspondingly, the current run-up in stock and bond prices
is widely seen as a natural corollary of low and falling inflation and interest rates.

"New \Vavefl and "New Economy1f are some of today's euphemisms for a new golden age. The essence

~)
Currencies and Credit i\;farkets \ January L994
 4

l
of all these that some new principle applies today that wasn't operative ever before.
theories is
\.
Perpetually low inflation and low interest rates we are told rather than rising incomes and dividends
-

-
should be reasonably expected to drive up financial asset valuations to unprecedented level~. Or, an
explosion of "knowledge based industries" will be the new growth engine of economic growth and
productivity of the future. We want to invesùgate the basis of these theories.

The connection between inflaùon and interest rates is certainly much looser than markets think presently.

There is a host of other factors that determine interest rate levels. Yet it's a fact that low inflation tends
to be regarded in America and some other countries as a key barometer of economic excellence and
health. Oddly, in some countries it tends to mislead policymakers into excessive monetary ease.

MARKETS AND THE ENIGMA OF LIQUIDITY

For Wall Street and the City of London~ the current fmancial boom has its healthy origin in the prolonged
coincidence of low inflation, slow economic growth and very easy money. As a result so the cheerful -

conclusion sUIplus money

- has nowhere else to go but into the securities markets. To this way of
"liquidity-drivenn
thinking, what is happening is a perfectly sound boom.

In reality, it's neither sound nor '1iquidity-driven.u

This parlance came into use during the mid-1980s
when the economy slowed while broad money continued to forge ahead. The argument then was that
It
excess liquidity" essentially had to flow into financial markets therefore buoying financial values.
Between 1983 and 1986, total nominal GDP growth of 24.2% coincided with greater broad money (M2)
growth of 28.6%. Actually, this experience had a famous parallel in the 1920s stock market boom.
Between 1923 and 1928, U.S. GDP rose 21 % and bank deposits (the closest equivalent to M2 of that day)
by 32%. Howevery later in ]928, money growth stopped.

Today, again as dichotomy between economic sluggishness and financial

in the mid-1980s, there's a

bullishness only this time it's greater than ever. So, the ready convenient explanation is that a vast
. . . ~

"excess" of "liquidity" is pouring into the markets. But apparently, nobody must be bothering to check
this explanationy because the truth is precisely fue opposite.

BROAD MONEY IS THE KEY

In general, broad money (except in Germany and most of the Asian countries) has been growing at its
slowest pace on record. It is sharply and progressively falling short of economic growth. For example,
since 1990, U.S. nominal GDP has expanded a cumulative 15.3% while M2 and M3 have grown only
5.2% and 1.4%, respectively. That's no Uliquidity surplus." What we see is the biggest "liquidity gap"
of all time. Clearly, something else must explain this financial boom.

True, various monetary aggregates bank reserves, the monetary base (made up of bank reserves and
-

currency) have
-

been expanding at a record pace. By the light of these measures of money which -

be favoured by the American monetarists there is a supply of liquidity.

happen to rampant -

THE EUROPEAN MONEY VIEW VERSUS THE MONETARIST

Now we come to some key conceptual differences between American monetarism and traditional European
money and credit theory. According to the latter camp, the kind of liquidity that's most important for

Currencies and Credit Markets \ January 1994

 5

) economic activity are not the bank reserves or the monetary base but the liquid assets in the hands of
businesses and consumers. What good is liquidity in the coffers of banks if it's not being redeployed in
the real economy? What best measures the liquidity of businesses and consumers is bank deposits and
the broad money aggregates (M2, M3, M4).

If are asked what the precise mechanism is that translates changes in bank reserves or the
monetarists
monetary base into a real economic impact, they have no answer. TIle widely accepted Friedmanite view
(originated by Milton Friedman) is that the transmission process is so difficult to trace that one should
instead pursue the statistical route of searching for monetary aggregates that show the most stable
correlation with income. And that's what American monetarism mainly is -

statistics.

European money and credit theory is mainly preoccupied with the search for causal links between money,
credit and the economy. Associated with that is a distinct contempt for the value of statistics in
understanding these processes. To quote Joseph L. Schumpeter on this point: ttNo proof is ever possible
by statistics alone. Ludwig von Mises, too, had a deep distrust of statistics being convinced that there
11

were no such thing as a durable statistical relationship.

Taking the European view, liquidity, creation is a two-step process. The first step involves the central
banks. Their purchases of bonds creates liquidity. However, to this point, it's only bank liquidity..
Whether or not this increased translates into higher business and consumer spending depends
liquidity
entirely on the joint response of the banks and their customers. The growth of money (mostly bank
de(Xlsits) in the hands of businesses and consumers essentially involves the expansion of bank credit

At its roots, European theory is basically credit theory. Its guiding principle is that any economic
expansion is reliant upon money and liquidity created by the commercial banks to ~e credit of businesses
and consumers. That's what is reflected in broad money growth. How has broad money fared over the
past few years? As we've already pointed out, broad money has been weak almost everywhere. Over
the past three years in the U.S., M2 has grown at an average annual rate of 1.8% and M3 at 0.7%. This
compares with average annual broad money growth of approximately 10% during past cyclical recoveries.
Seen in tills light, the Fed's easing, though most aggressive, is a complete fiasco in terms of generating
liquidity and activity in the real economy.

THE SOURCES OF THE BUBBLE

Still, the fact is that there are the booming fmancial markets. For most observers, that's taken as llpoint-
blank" evidence that there is vast supply of excess liquidity. But, that's dead wrong. When assessing the
sustainability of money flows into the securities markets, we need to distinguish between three different
sources: current savings, 2. new money creation
1. current flows, in other words
- -

and 3. portfolio
shifts, which are movements of money balances that already exist.

These three sources are at play in aU markets, although in different degrees and proportions. As described
in previous letters, the main force behind the U.S. bond market boom is massive money creation fuelled
primarily by big bond purchases on the part of the Fed, and secondly, by banks and institutions playing
the steep yield curve. The resulting bond purchases by these players (approximately $400 billion over the
past two years) were crucial in forcing down U.S. long-tenn interest rates, and in turn, added considerable
fire to the stock market boom.

Currencies and Credit Markets \ January 1994

 6

u.s FINANCIAL FLOWS: INDIVIDUALS {,

Expressed as a % of Nominal GDP, Quarterly, Since 1960
7.30k
Annual Flows into Deposits
6.3% and f\Aoney Market MubJaI Funds
5.3% ~
4.3% }
3.3%
j
2.3%

1.3%
0.30/0

-0.7%
-1.7%
-2_7%
Source: Board of Governors of the Federal Reserve

However, the fact remains that liquidity as measured by the broad money aggregates and savings have
grown only very slowly.. So, apart from the liquidity growth in the fmancial system there is none in -

fact there is a decline elsewhere. Where then

- is the big impetus for the fmancial boom coming from?
It's the third source mentioned above an immense portfolio shift or asset reallocation away from cash
-

(bank deposits) into securities.. The salient point is that such a shift relates not only to the current
increment of wealth or savings, but also to the whole stock of existing money holdings. Actually, this
kind of shift occurs regularly at the bottom of the business cycle. But, never before has it occurred on
such a stupendous scale as today.

THE TRASIDNG OF CASH

Today, an unprecedented panic stampede away from liquidity is unfolding. It is precisely this effect that
explains the
monetary mystery of a financial mania taking place in an environment of broad money
.
stagnation. lbe graph above shows the enormity of the current portfolio shift on the balance sheet of U.S.
individuals. For the first time on record there is a net outflow from deposits and money market funds.
lbe rush into stocks, lx>th direct and through mutual funds, is also the largest on record by far.

The self-evident problem with such a big portfolio shift is, of course, that it can't last
Besides causing
significant excesses in securities markets -

unsustainably high valuations and overspeculation-

there
is omy so much money that can shift )
The big dash from cash has two causes. One is the result of the machinations of the Fed, more precisely,
)
the pitifully-low yields that it has imposed on liquid assets. The second contributing cause is the
detennination of investors starved of income desperate to achieve returns above the inflation ratc. Like
sheep to the slaughter, they are unwittingly being driven into overspeculated securities
markets. UnneIVed
by the prospect of prolonged economic sluggishness and rock-bottom short-term interest rates, they are
loathe to remain in low-yielding assets.

Currcodes and Cr~d1t Markets \ January 1994

 7

All these facts are well-known and widely reported. What is conveniently ignored are the extremely
negative liquidity consequences for private households and the economic and financial system
overall.
Consumer holdings of liquid assets are today no higher than four years ago and have fallen steeply as a
share of total financial assets. As we showed in previous letters, overall liquidity (M4) is now the lowest
in history as a share of total debt.

Concluding this part of our analysis, it's not an abundance of liquidity that is driving the worldwide
) financial mania but a panic-like escape from liquidity~ Compounding it are the psychological effects of
momentum. For a time~ the spectre of rising securities prices simply begets higher prices. Rather than
) heralding the start of a new age of golden financial prosperity~ we see a deceptive process under way
that's luring many investors into certain financial disaster. What irritates us is not so much the behaviour
of the ordinary investor but the complicity of the experts and economists who show no lack of ingenuity
in spinning endless bullish yams from a threadbare economic performance, the poorest in five decades.

TESTING THE ECONOMIC FORECASTS

Just how believable are all of the economic forecasts that underlie recent bullislmess? According to the
co~ensus, the U.S4 economy is presently enjoying a well-balanced, relatively strong recovery. It's the
third -
if not fourth surge in as many years Each time it has triggered the same sanguine forecasts
-

and each time it proved to be mistaken. What's different this time?

u.s. real GDP during the first three quarters of 1993 grew at an annual rate of 1.8%4 Yet, consumer and
business capital spending rose much more strongly at a rate of 3.8%. The big difference between the two
were soaring imports which swallowed up about 40% of the increase in domestic demand4 As such~
imports have acted as a tremendous drag on the U.S4 economy.

As a result, the current argument is that tlús latest rebound is very broad and is based upon strong gains
in business capital spending, housing, consumption and consumer sentiment. Its most promising feature
is seen in the two-year old business capital spending
boom. Additionally, the wide publicity given to
large-scale labour shedding and IIrestructuringn has given rise to the general
assumption of superior
productivity and profit gains~ both currently and in the future. Understandably~ this is sweet music for
the stock markets4

Since we see the U4S. economy and most other economies, for that matter
-

more in the grips of a

-

structural crisis than in a cyclical recession, we're not so easily inclined to believe in such sudden
beneficial developments. In assessing such trends~ it's therefore very important to carefully distinguish
between short-term cyclical and long-teon structural changes. There is a general failure to make this basic
distinction, consequently leading to gross misjudgments.
)
A PRODUCTIVITY MIRAGE AND PROFIT MYTH
)
It is true, as the consensus economists like to stress~ that output growth during this past U4S recovery
was
largely due to sharply túgher gains in productivity rather than employment But that apparent productivity
"miracle" is entirely attòbutable to substandard economic grbwth~ not an above-average productivity
perfonnance. Over the first 10 quarters of recovery, GDP has grown 6.2%, (See Table I on the next page)
or just one-half of the average output growth following previous postwar recessions since 1960.
Productivity growth was no better in fact it was slightly worse
-

than in previous cycles.

-

\
)
Currencies and Credit Markets \ Januacy 1994
 8

Quoting the OECD on tlùs point (Economic Outlook, June 1993, p~ 13): "The evidencefrom the current
recovery does not suggest productivity behaviour substantially different from that observed during previous
recoveries. The predominance of productivity growth is due to the relative weakness of the recovery
compared with output growth in previous upswings~"

TABLE I: U.S. BUSINESS CYCLE COMPARISON

NON~FINANICAL REALGDP REAL DISPOSABLE OUTPUT PER NON~ EMPLOYMENT
CORPORATE PROFIT (1987) INCOME (1987) FARM MANHOUR
EXPANSION PHASE % ChanRe % Chan~e % Chan2e After % Chanfle After % Change After
After After
(All calcu1atiOOl on. Recovcrv Stan RecoVCIV Sun Recovery Start Rccoverv Start Recoverv Stan
1
nearest uuterl buiJ.) Year 2 Ycaø 1
Year 2 Yeall lOQ's ]
Year
2 Years lOQ", 1
Year 2 Years 10Q's 1
Year 2 YealS 10Q's
Feb. 61 to Dec. 69 36.6% 423% 6.4% 9.8% 13.2 5.3% 8.3% 10.3 4.7% 7.4% 3.1% 5.09'0 6.6%
Nov. 70 to Nov. 73 15.0% 32.3% 49.7 23% 8.0% 124 3.0% 7.3% 125% 22% 5.2% 1.0% 4.6% 7.6%
Mar. 75 to Jan. 80 67.8% 62.2% 107. 6.4% 9.9% 13.3'1 6.2% 7.9% 11.3% 4_8% 6.3% 3.1% 6.3% 9.2%
Jul. 80 to Jut 81 26.5% N/A N/A 3.0% N/A N/A 3.1 % N/A N/A 2.0% N/A 1.5% N/A N/A
82 to JuL 90 52.1 % 83.5% 826 5.1% 11.0% 12.4 2.6% 10.4% 4-4%
Nov. 9.7% 2.5% 2.3% 6.9% 8.7%

429% 55.1% 73.9 5.1% 9.7% 12.8 4.3% 8.3% ILl 3.5% 5.8% 7.6% 2.4% 5.7% &.0%

Mar. 91 to Sept. 93 8.4% 25.5% 36.1~ 1.7% 5.0% 6.2~ 2.2% 4.4% 6.2%1 2.7% 4.9% 5.9%1-0.2% 1.1% 2.0%
Source: U.s. Deparbnent of Commerce

As well, we often read of a superb profit performance taking place in the U~s. Just as does productivity,
business profits nonnally rise with a recovery. So. too, did profits this time but much less than in past
recoveries. Non-financial corporate profits have only risen 36.1 % over the first 10 quarters of this
recovery as compared to an average of 73.9% in past recoveries. Measured another way, in tenns of GDP
share, business profits have only recovered a third of the usual advance during this phase~ In light of the
huge profit gains attributable to the big non-recurrent benefit of exceptionally steep fall in interest rates
an
during recent
years, the actual profit perfonnance appears particularly poor.

In the same way. we have scrutinized the current U.S. economic recovery. Table I shows the results of
some of the key comparisons GDP growth, employment, and real disposable income. Over the 10
-

quarters of this recovery employment has risen 2.0% versus an average of 8~O% and income has only
expanded 6.2% versus
an average of 11.1 %. We draw two conclusions: firstly, all improvements are
purely of a cyclical variety and in no way are indicative of a secular turn of events;
secondly, all the gains
are grossl y inferior to past cycles.

ADDRESSING THE LONG-TERM SECULAR PROBLEMS

The U.S. economy suffers from two interrelated macroeconomic maladies: first, that demand falls short
of the economy's capacity to produce; and secondly, that productive capacity growth itself has sharply
slowed due to inflated consumption. The counterpart to this latter problem is chronic9 progressive
underinvestment and a persistently large trade deficit. The chart on the opposite page captures the trends
in investment and also explains why corporate profits remain anaemic. TI1ere's absolutely no indication
of any long-tenn trend change.

Additionally, the graph highlights a telling discrepancy between gross and net investment. Net investment

~-
'....

Currencies and Credit Markets \ January 1994

 9

u.s. INVESTMENT AND PROFIT PERFORMANCE

% of Nominal GDP, Quarterly, 1960..1993 3Q

19.0%

17.0%

15.0%

13.0%

11.0% Non-Financial
Corporate Profits
Q.~
7.Cffo
~.
5.0%

3.0% Net Rxed Investment

1.0%
I 62 I 67 72 77 82 87 92
Source: u.s. Department or Commerce

has fallen much more steeply than gross investment. 1ñat's due to a major shift in investment from 100g-
lived assets toward assets with short lives (for example computers). What it implies is that ever more
gross capital formation is required to yield a net addition to the capital stock. Statistics recording
investment and output growth are therefore artificially high relative to capacity growth.

The most striking and frightening part of tills process is the inexorable shrinkage of the industrial base.
During the 1960-70 period, U.S. industrial production rose 86% or 4.3% annually. At present, annual
capacity growth of the manufacturing sector, as calculated by the Fed, is a lacklustre 1~6%. It's more a
case of industrial anorexia than a hale expansion.

TI1ere is a two-edged consequence to tlùs long-running underinvestment trend. Despite four years of very
sluggish demand growth, the rate of industrial capacity utilization, now at 83%~ is only two points short
of its decade high of late 1988~ The positive implication is a surprisingly small output gap. The negative
reality, though, is that any strong recovery will quickly
run into supply constraints, triggering inflation and
soaring imports. Economic growth spurts are destined to sholt-circuit very early.

A HOLLOW INVESTMENT BOOM

Recent U.S. recovery forecasts now trumpet the perception that an investment boom will take the lead
from liquidity in driving the stock market upward. Stock markets will now become earnings-driven as
opposed to liquidity-driven. According to many reports, the U.S. economy is fast breaking out of its
chronic investment stupor.

Others, including the OECD, have qualified the current U.S. rebound as being ìnvesunent-led, pointing
to a double-digit surge in business capital spending on plant and equipment, the strongest in decades~
Before we can join the jubilation, we need to look underneath these surface statistics. An entirely different
and shocking story emerges.

.J Currencies and Credit Markets \ January 1994

 10

Old European business cycle theory the guiding principles to our analytical work
-

ascribes the -

leading cyclical role to invesunent spending. Its regular steep cyclical rebound produces a strong credit
expansion and, through the so-called multiplier process, strong employment and income growth. For us,
the present prolonged economic sluggishness in the OECD countries is the direct resu~t of a collapse in
investment spending and the multiplier process working in reverse.

TABLE TI: U.S. CYCLICAL INVESTMENT TRENDS

TOTAL FIXED RESIDENTIAL FlXED PRODUCER DURABLE NON-RESIDENTIAL

INVESTMENT INVESTMENT EQUIPMENT STRUCTURES
EXPANSION PHASE % Change After % Change After % Change After % Change After

(All calculations on a
Recovery Start Recovery Start Recovery Start Recovery Start
1 10 1 10 Quarters 1
nearest quarterly basis.) Year 2 Yean; Quarters Year 2 Years I
Year 2
Years 10 Quarters Year 2 Years 10 Quarters

Feb. 6110 Dec. 69 8.4% 12.6% 21-0% 11.4% 18.8% 29.8% 13.4% 17.4% 25.5% -0.5% -0.2% 5.2%

Nov. 70 to Nov. 73 8.3% 19.8% 30.7% 34.5% 52.6% 63.1% -0.4% 1.8% 23.5% -1.8% 1.0% 6.0%

Mar. 7S to Jan. 80 7.8% 20.3% 28.3% 25.2% 47.3% 63.5% 1.8% ] 5.1 % ]9.8% -0.6% 0.7'10 5.3%

Jut 80 to Jut. 81 5.2% N/A N/A 6.5% N/A N/A 3.1% N/A N/A 6.2% N/A N/A

Noy. 82 to JuL 90 11.8% 28.6% 31.9% 55.4% 67.1% 66.5% 5.9% 25.7% 28.9% -9.3% 6.6% 12.6%

9.1% 20.3% 28.0% 31.6% 46.5% 55.7% 5.2% 16.5% 24.4% -3.1 % 2.0% 7.3%

Mar. 91 to SepL
93 1 1.7% 12.9% 17.7%113.7%29.1'10 29.2%1 1.5% 17.5% 25-9%1-9.5% -12.3% -10.5%

Source: US. Department of Commerce

Is the U..S. economy really breaking out of its investment stupor? is not.
During the first three No, it
quarters of 1993, U.S. real fixed investment rose $52 billion or at annual rate of 8.8%. Over the first 10
quarters of the recovery since early 1991, investment only rose a cumulative 17.70/0 and compares poorly
with an average 28% rise during previous cyclical recoveries (See Table II above). Far from being
exceptionally strong, seen in this light, the investment recovery is exceptionally weak. Of key importance
to us are the cyclical demand and employment effects of current capital spending.

Consider this: the 1993 increase in investment, 62% was accounted for by infonnation equipment,
Of
mostly computers. On the other extreme was building and production machinery which only rose
minimally. Traditionally, building plays a huge role in the investment upswing. But forging further into
tlùs investigation quickly brought Mark Twain's famous quip to mind about It....lies, bloody lies, and
statistics.." The statistic that utterly begged our credulity in this regard was the discovery tha140% of U..S.
real GDP growth during 1993 was attributable to computer invesunent. How is that possible?

In the first nine months of 1993, total spending on computers increased $9 billion. That's rather small
in terms of the overall economy and doesntt look like much of a boom. The statisticians, however~
calculated that the actual computational power buyers received for this moneYt due to the large declines
in pricest was actually wonh $27..7 billion. It was this greater amount that was added, literally padding
GDP.

That's three times the nominal spending amount and now represents a large portion of real Gnp growth.
But what are the actual employment and income effects of this? One needs a microscope to find them.
The computer manufacturing industry accounts for 2.60/0 of total manufacturing output and 7/100ths of

Currencies and Credit Markets \ January 1994 (f

 It
one percent of the total non-fann workforce. Owing to fabulous productivity gains, this industry is able
to boost its output while at the same time reducing its employment and slashing prices. Statistically~ it's
an investment boom but economically, nobody feels it

GAUGING THE STRENGTH OF THE U.s. RECOVERY

How'-really strong is the U.S. recovery? Oddly, the answer depends critically on the evaluation of the
computer~m and its leverage effects on employment and incomes. Since the end of 1989, invesunent
in computerS' and__~ripherals accounted for ~Q.5?%of real U.S. GDP growth. Of this, 81 % is explained
by the price
adjustm~.aise-lJ;-S-:-business spending on equipment close to a 23-year high as a
share of real GDP. On a nominal basis~ spending on equipment is near a 23-year low.

[n the end, the alleged investment- and productivity-led recovery rests on nothing more than a vision of
the future, for exampLe, what new trends and fads might take over from the current restructuring and
computer-ìnvestment boom. However, we are not futurologists, but economists. As European theory
propounds, what matters solely in the shon run of a recovery are the leverage effects on employment,
incomes and purchasing power resulting from the production of the capital goods.

The computer industry has only a minute impact in this regard. The most important sector in this regard
is construction which possesses
every attribute that generates a self-reinforcing recovery. It is capital-,
credit-, employment- and income-intensive. And it is precisely this sector that has the weakest
perfonnance. (See Table lIon page (0). In this light, both the investment boom and real growth are
grossly overstated.

We are led to this conclusion: The present U.S. recovery lacks any ingredient that could make it self-
sustaining, let alone self-reinforcing. As long as consumer income growth stays weak, the
temporary
borrowing binge is bound to fade. Personal savings already have fallen to near all-time lows. We expect
that U.S. economic growth will decelerate sharply to a virtual crawl in the coming months.

A COMMODITY SCARE?
A related conclusion is that inflationary in the U.S. are misplaced.
expectations Convinced by the
coincidence of production constraints and perceived invesunent boom, inflation fears have been rising.
a

But this notion misses two crucial points: firstly, that the computer investment boom, being readily met
by soaring productivity gains and imports~ is not at all prone to overheating the economy; and secondly,
any stronger rise in U.S. domestic demand is promptly swallowed by rising imports because the rest of
the world has mountains of unused capacity. If anything, the U.S. economy~s Achilles heel is the balance
of payments and the dollar, not the domestic inflation rate.

[n conclusion, neither in the United States nor anywhere else do we see convincing evidence of a
sustainable economic recovery. While downturns do level off eventually, the world economy is st~lllikely
to get weaker. This forecast is a direct outflow of the observation that there is an unmitigated slump in
world investment.

Sustained, strong recoveries are ushered in by surging investment spending that in turn bring forth the
typical big expansions of bank credit and broad
money. These are the three key interlocking parts of the
business cycle. In the main industrial world, all three of them are as dead as mutton.

Currencies and Credit Markets \ January 1994

 12

CONCLUSIONS I

!
----------,- i .~
1994 has begun on a note of
fatSê~d
wishful thinking. There are/great expectations that a genuine
world economic recovery will begin. The ÌÌìâìñ-reas.Qn why this won'tltappen is
the con9nuing worldwide
slump in investment with its progressive contractivèeffec!Lon
~ptoyment and incomes. Profits will
generally fall.

As our research concludes. both the

U.S. economy and the dollar have most probably peaked.

Stock markets around the world

are overspeculated~ overvalued and therefore extremely vulnerable to
disappointments. By witnessing
far.. we are the greatest financial market mania since the 1920s.

Weakening economies in 1994 stand to shock and shake the stock Is another crash possible?
markets.
Consiâering the disastrous liquidity trend that we described which is obseIVable around
the world, it
already seems predetennined to us. The only question is the timing.

Contrary to the comforting coWlSe1 of conventional economists, events will show that politicians and
central banks" despite their best intentions, will be unable to
prevent the coming financial fallout

Investors will be fortunate topreselVe their money in 1994.

Investment prospects are skimpy. Certainly,
there is little value to be found in stock markets
anywhere.

Investors should avoid overspeculated markets at all costs. For security, it's best to focus on short-term
cash securities and shorter-tenn bonds of the hard currency countries
Germany, the Netherlands,
-

Switzerland. and Austria.

)

Next Ma-i1ing: February 8, 1994

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Currencies and Credit Markets \ January 1994

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