DR.

KURT RICHEBÄCHER
Muehlegasse 33
CH -8oot Zuerich
CURRENCIES AND CREDIT MARKETS Switzerland

No.200j December, 1989

Certainly a credit inflation as such is a thousand times better than a credit deflation; but the
decisive point not emphasized enough by Keynes is that a credit deflation follows a credit.
-
-

inflation just as surely as a hangover a drinking orgy. This is crucial, and takes away the
foundation from that subtle form of inflationism represented by Keynes.

Wilhelm Roepke, Keynesianimus III

HIGHLIGHTS
The recent circumstances in Europe are truly enormous in portent and could emerge as the
single most important factor shaping the international economies and capital markets of the
1990s.

Assuming everything else proceeds smoothly, the only thing that stands in the way of a
:fl.". potential torrent of capital investment in Eastern Europe is a major redirection of European
"...j capital exports (being primarily of West German origin). And that can only happen at the
expense of demand for American, Canadian and Australian bonds.

It isnot accidental that all of the countries with large external deficits have also had
rampant asset price inflation. News that real estate prices have begun to weaken in the
deficit countries adds a complicating dilemma to domestic monetary policies.

The stark reality is that U.S. fiscal and monetary policies have little manoeuvrability in
combatting an economic downturn. Fiscal policy is paralysed by the existence of a huge
budget deficit, and monetary policy is virtually immobilised now that interest rate
differentials vis-a-vis the D-Mark have completely collapsed.

In the case of Japan, there has been too much talk and too little action against inflation.
The Bank of Japan has lost its credibility. That's a classical way to weaken a currency.
In our opinion, the yen's softness has been deliberately engineered.

The inflationary implications of a

stronger German economy are muchless than feared.
Longer-running inflation determinantsare embedded in a high national savings rate, capital
fornlation and producti vi ty growth.All these "inflation fundamentalslt have improved
dramatically in Germany during the 19805 and continue to do so.

The simple reality is that exchange rates have again started moving in line with their true
underlying economic fundamentals. No longer are currency markets singularly driven by
interest rate differentials.

The growing disarray in the U.S. real estate market will, over time, hit the U.S. economy with
tremendous force. Both the Fed and the government won't be able to stave off the inevitable
) disaster. Past excesses have simply been too great.

Our view is that the risks in the U.S. dollar are rising rapidly and that the worst part of a

decline is still ahead.

 2

lOO/h. As our world-wide

.
(Editors Note,: This letter is a landmark issue in a sense...it's our We
has long been written from the European continent.
readers know, this international letter West
recently (and in particular
assure our readers that the heavy focus on Continental Europe Quite
the largest European economy) has little to do with our geographical proximity.
Germany,
simpLy, the recent circumstances in Europe are truly enormous in portent and clearly
emerge as
the single most important international factor shaping the 19905.)

THE 19905: EUROPE AT RINGSIDE

the reality that the opening of
It took little while, but markets have finally awakened to
a
be the potential
East Germany is no reason to pity West Germany. Even though there may is still worth eating.
the goose
bony problem of financial burdens and inflationary pressures
others for its
On the contrary, the world may even have come to envy West Germany among
that the economic integration of Eastern Europe
ringside seat to the gargantuan possibilities
implies.
the twelve members of the
As it was, the campaign to forge a true common market between
Eu ropean Com m un i ty by the end of L992 was alread y boosti ng capi
tal spend i ng and econom ic
even more
growth rates into overdrive. Now, the opening .of Eastern Europe could prove
Western Europe has the most to gain
important than the drive for a single market. Clearly, The assurance
situated to play the key role.
from this development and West Germany seems West Germany's for
of that role is not one of simple geographical proximity. What qualifies
that task is its vast arsenal of excess domestic savings.
a splendid division
Picking Penurious Partners. The way we see it, recent events make for
its excess savings to finance the U.S. trade deficit (thus
of international labour: Japan uses
employs its surplus to
financing a major contributor to its exports surplus) and Germany
finance the rebu ilding of Eastern Eu rope.

TRADING FOR THE SPOILS: HAMBURGERS OR CAPITAL?

it's
As the spectre of Eastern European lucre salivates the tongues of Western industry,
North Americans are quick to seize
interesting to note the differences of approach and style.
enhanced
the notion of vast pent-up demand for consumer goods and services. Prospects for
fi r5tft. To qu ote
trade with Eastern Eu rope are framed in the idea that "the consu mer comes why
McDonald's and Coca-Cola,
Bear Stearns' view of the foreseen opportunities: "And after
this Wall Street theme, they draw the conclusion: "There
not Phillip Morris?" Then, typical of
with strong franchises in Europe."
are a large number of other American consumer companies
a
Engine Before the Caboose. To be sure, Continental Europeans are thinking along
they model a completely opposite set of
completely different wavelength. To begin with, hen shou Id
priori ties. New investment mu 5t come fi rst... in other words, the egg -layi ng
precede the McDonald's Egg McMuffin.. More importantly, heavy investment
into productive
that can then afford to buy consumer
facilities are required to create the wages and incomes
goods. Consumption is limited by production and not vice versa.

HOW MUCH WILL IT COST AND WHO CAN AFFORD THE PRICE?
is to catch up
What Eastern Europe needs most is capital and lots of it. If the eastern bloc
with the West in the next ten years, the cost of new productive investments will run into the
hundreds of billions of dollars.

To gauge of the capital requirement let's isolate the example of the two
the enormity
3 million workers. In West Germany, capital stock per
Germanies. East Germany employs Æ
OM 200,000. To raise productivity in East Germany to
-.:"~-

industrial worker amounts to about

That '\../'
West German levels would require new investment of at least OM 100,000 (per-capita).
makes for a capital project of a potential DM 300 billion -- a breathtaking amount.

Spread over ten years, however, a capital requirement of OM 30 billion annually becomes
 3

. quite manageable for West Germany. That figure compares feasibly with a savings surplus
of more than DM 100 billion per annum presently. The vital point is that West Germany has
both the financial capability and the capital goods to rebuild Eastern Europe. Given the
immensity of these capital needs it also becomes obvious that government hand-outs so far
are nothing more than a few drops in the bucket.

A Truly Monumental Opportunity. Provided that the necessary political and economic
reforms take place soon, German capital could flood into East Germany the quickest. The
country is practically a virgin market, both in terms of the supply and the demand sides of
its economy. That combination offers the salivating prospect of investing into a rapidly
expanding home market. A businessman couldn't wish for a better break. Such an
opportunity hardly exists anywhere else in the world. To us, it assures a strong European
(and German) economy "as far as the eye can see".

Assuming everything else proceeds smoothly, the only thing that stands in the way of a
potential torrent of capital investment in Eastern Europe is a major redirection of European
capital exports (which is primarily of West German origin). An investment boom in the East
will likely only happen at the expense of American, Canadian and Australian bonds.

We agree with the statement of the late Alfred Herrhausen (the recently assassinated
Chai rman of the Deu tsche Bank): "G i ven the necessary reforms, East German livi ng standards
could match those in the West in only five to ten years."

THE WEST GERMAN ECONOMY CONTINUES STRONG

West German y's econom y con ti nu ed to gai n strength in the th ird qu arter. Year-over-year,
real GNP su rged by 4.2% (taken through the first nine months of 1989) and was fuelled by
) a combined export and investment boom. Both components expanded at a 10% clip -- the
fasted rate si nee the late 1970s. In stri ki ng con tfast, pri va te consu m ption rose a modest 1.5%
while public spending even decreased 0.5% (all in real terms). Actually, the consumption
sector, both private and public, accounted for no more than 21% of overall real GNP growth
in 1989.

That's the kind of growth mix policy-makers all around the world would covet. It goes
without saying that the weakness of consumer and government spending due to stringent
-

fiscal policy and stubborn German saving habits played a key role in containing inflation
-

against a backdrop of booming exports and investment.

THE WEST GERMAN INFLATION QUESTION

German Inflation Versus U.S. Disinflation? A lot of gloom and doom has been spread
recently about Germany's ascending inflation rate, already ru nning at 3.2% and is still widely
seen to be rising. In many reports, accelerating German inflation is contrasted unfavourably
with the decelerating inflation (if not disinflation and even deflation) in the United States.

For many Wall Street economists, the word "disinflation" conjures up images of a healthy
economy that holds the promise of all kinds of delights: a strong dollar and a bull market in
U.S. bonds and stocks that will lure legions of foreign investors.

Bu t, let's
get back to reali ty. Tru e, the U .5./ German i of la tion differential has narrowed
to low not seen since the 19605. However, such a superficial comparison makes for a grossly
a

flawed conclusion. The two inflation rates, after all, have come about under radically
different economic conditions, both internally and externally. The fact toat everything is
booming in West Germany while the economy is slowing in the United States is bound to
narrow the differential...and for very positive reasons.
;,)
Germany's inflation rate, moreover, has been heavily swollen by two extra-ordinary factors:
significant increases in indirect taxes and the adverse impact of a strong dollar on German
import prices. Taking both of these one-time factors into account, Germany's "coren inflation
~

.
rate appears to have remained at its long-term trend of about 2%. That compares very
favourably to an American "core" inflation rate of 4-5%. And, let's not forget that Germany's
the
lower inflation rate still facilitates a profit boom while serious profit squeeze afflicts
a

U.S..

Germany: Demand and Cost Push Pressures. However, without a dou bt, there are some
a cost push in
inflation pressures to contend with. The stage is set for both a demand and
Germany next year. The demand push will come from three sides: a drastic income tax cut
amounting to about DM 24 billion, from sizable wage hikes, and from the large inflow of
i m m igran ts from the East. Together, these th ree influ ences will certai nly lead to a spu rt in

consumer spending and residential construction. The threat is that this probable demand
push will become linked with a cost push. For example, a giant metal workers union has
35 hours in
lodged a claim for a 9% wage rise and a two hour cut in the work week to
forthcoming pay negotiations.

Mea n w hi Ie, a mass m igrati on i oto West German y is reach ng staggeri ng dimensions. Con nti ng
i

newcomers from East Germany, the Soviet Union and other parts of Eastern Europe,
1% of the West German population.
immigration this year will exceed 700,000, well over
Sharply higher demand for housing is therefore very likely and will probably add to
inflation pressures.

Taking all these points into consideration, it's become a foregone conclusion for many market
already at 3.2% is a sure precursor to
analysts that accelerating inflation in Germany
-
-

long-term weakness of the D-Mark against the dollar. The dollar, on the other .hand,
supposedly will be supported by decelerating inflation. From this viewpoint, the drastic
shrinkage of the U.S.jGerman interest rate differential is largely seen as irrelevant for the
currency markets. Apparently, it is expected that the currency m-arkets will primarily reflect
narrowing inflation differentials. þ
Inflation More Than a Monetary Phenomenon. Apart from the factors we cited above, we
nonetheless think that the inflationary implications of a stronger German economy are much
less than feared. There doesn't appear to be anything in sight that would point to
deteri.ora tion in long-ru nn i ng inflation fu ndamen tals. Germ an y's low inflation bias in -

contrast to Americas high bias -

originates from considerably deeper causes than just

di fferences in monetary policy. The primary inflation determ inan ts are embedded in a high
national savings rate, capital formation and productivity growth. All these "inflation
fundamentals" have improved dramatically in Germany during the 1980s and continue to do
so.

1990,
Worries Overdone. Next, let's take a look at short-term inflation trends. In January of
Germany's inflation rate will suddenly look much better and can be expected to dip well
below 3% as the effects of last year's early-year spurt will drop out of year-over-year
comparisons. Even more surprising is the fact that nobody ever mentions the strong anti-
inflation effects of the recent sharp dollar drop. These effects are formidable since
international commodities are priced in U.S. dollars. That works to Germany's favou since
r

at least 30% of its total imports are priced in dollars (while only 6.6% of imports are from
the United States). Therefore, changes in the dollar's exchange rate can have
disproportionate effects on the price levels of other countries
-

exaggerating the negative

when the dollar rises and overstating the positive when it falls. Last April, German import
prices were up 7.3% against a year ago. Now, the same rate is already down to 3%.
i
A strong D-Mark wi 11 sign ifican tl y add to the German trade su rplu s by mprovi ng the terms
of trade the famous J-curve effect
-
as imports cheapen relative
-
to exports. Ultimately,
lower-than-expected inflation will favourably impact long-term interest rates. Once
sentiment swings sharply against the dollar, German...-and European hard-currency bond 0...-...
~ .

markets can be expected to fu 11 y "decou pie" from U.S. rates.

This brings us to another important point that is generally ignored. All these beneficial ~.'~..1:

effects of a declining dollar on costs, prices and trade balances

-

will not be confined to

-

:+
 5
.
just Germany. These gains will accrue in the same way to all countries in the DM-bloc in -

other words, all of Europe. Lower inflation and long-term interest rates, in turn, should be
su pporti ve of relati vel y strong econom i c grow th in Eu rope.

WHITHER THE DOLLAR? THE FIVE PILLARS OF "DOLLAR OPTIMISM"

So far the dollar has fallen 14% from its peak of OM 2.0475 on June 15th. We don't need to
mention that most forecasts were bullish at that time and foresaw further advances to OM
2.20, if not DM 2.40. Yet, despite the recent dollar drop, most commentators still keep talking
abou t a dollar bu 11 market.

Each new fall is followed by the soothing comment that the final dollar-bottom has arrived
and that the dollar could now be expected to stay in a narrow trading range. Typically, the
focus is more on the question of when the dollar will rebound rather than how deep the
dollar may yet falL Another symptom of an underlying positive sentiment is the absence of
a big rush into the normal vehicle for
German bonds by foreign investors. DM-bonds -

ell rrency specu lation-

have seen 1i m i ted in terest even thou gh the yield advantage of U.S.
bonds has virtually disappeared.

Why is "dollar bullishnesstt so stubborn and persistent? There seems to be quite an array of
perceptions and theories, both old and new, that continues to foster such psychological
resilience. Let's quickly review a supporting cast of five of these.

The Yen Makes Good Company. It is probably most notable that the dollar has held up well
against the Japanese yen. Popular opinion is that the yen is the strongest and most important
cu rrency next to the dollar and certainly far more important than the D-Mark. Therefore
".J"', the logic that follows is simple and plausible: If the dollar stays even or appreciates against
~ ,

'\.- .-'
the yen, it can't really be categorized as weak. From that perspective, the dollar's decline
against the D-Mark must be just an isolated liD-Mark phenomenontt that is bound to be
temporary.

Greenspan: A Legend in His Own Time. In our opinion, a second major pillar still supporting
the dollar is the fi rm fai th placed i n Mr. Greenspan and the Fed... or pu t more preci sel y,
over-confidence in the Fed's ability to engineer the famous "soft landing". Even though
economic data has become considerably weaker than expected, this evidence is brushed aside
with the argument that the Fed will do whatever is needed to avoid a recession. Most
analysts and investors remain convinced that interest rates will, if necessary, fall fast enough
to stimulate the economy before it falls into the grips of a recession.

Soft-Landing Benefits. A third source of dollar optimism is the hope that an economic
slowdow n will bring abou t lower U ..S. trade defici ts, w hi Ie a t the same ti me decreasi ng
inflation and interest rates. The prospect of a new bull market in bonds and stocks is seen
to be supportive of the dollar.

A Revival of the PPP. A

fourth support for dollar optimism seems to stem from the timely
rediscovery and newfound popularity of the purchasing power parity theory (PPP). This
doctrine has had its ups and downs since Word War I. Nonetheless, it claims that exchange
rates over the long-term are determined by relative national price levels. On that basis,
OECD economists have declared that the U.S. dollar is the most undervalued major currency,
trading some 20-30% below pu rchasing power parity against the yen and D-Mark.

Above the Laws of Economics. Last, but not least, there seems to be a widespread notion that
the U.S. dollar is not subject to the same rules as other currencies because of the outstanding
size of its economy and the dollars role as the world's reserve currency.

,) We don't subscribe to this uspecial case" theory in the slightest. History has already clearly
disproved it during the 1960s and 19705 when one dollar crisis followed another. It may
seem that the dollar has since become immune to a persistent trade deficit, but in this respect
it is also true that doJlar-strength has not been exceptional. During the last two years,
 6
.
currency exchange markets have generally been governed by nominal interest rate
differentials, whereas most other fu ndamental considerations in valu ing cu rrencies were
completely ignored.

TRENDS WEA THERING THE DOLLAR

Our view is that the risks in the U.S. dollar are rising rapidly and that the worst part of its
decline is yet ahead.

Interest Rates Are No Longer a Buffer. We think that the heightening risks for the U.S.
economy and the dollar stem from two main sources. Firstly, economic data portrays a
progressively weakening economy which in normal circumstances would justify an easier
monetary policy. Unfortunately, the stark reality is that fiscal and monetary policies have
little manoeuvrability in combatting an economic downturn. Fiscal policy is paralysed by
the existence of a huge budget deficit, and
monetary policy is virtually immobilised now that
interest rate differentials vis-a-vis the D-Mark, have completely collapsed. Any further
reduction in the Fed funds rate risks a sharp dollar fall.

The differential on three-month Euro-deposits has shrunk to a narrow 20-30 basis points in
favour of the dollar compared to 375 basis points as recently as last April. Fear of letting
~.S. short-term interest rates fall below those of Germany is the most obvious explanation
for the Fed's hesitancy to allow the next downward move in its funds rate.
A Growing Alternative. Is the
O-Mark really that important for U.S. monetary p.olicy? Yes,
and in fact more than that, we think the D-Mark may even be the most important element.
Despite the increasing importance of the yen, the $\DM rate represents the key axis around
which world currency markets revolve. Japan clearly has greater financial power than 0':'"
Germany, yet the polar power to the U.S. dollar in the international monetary system is
D-Mark and not the yen. the."
This development is attributable to the fact that the O-Mark has steadily increased its
international functions, both between central banks and investors. It is the undisputed
(thou gh undeclared) key cu rrency of Can ti nen tal Eu rope. Man y cen tral banks, even au tside
Eu rope, hold part of thei r international reserves in D
-Mark. Si m i larl y, the D -Mark (a nd the
currencies of the D-Mark bloc in general) are seen as the main alternative to the U.S. dollar.

1m partan tl is a second d i
y, there ff erence between the D -Mark and the yen: the re la ti ve sh are
of world trade. Only 7% of total
European exports go to the United States. In contrast, the
share of Japanese exports funnelled to the United States has risen dramatically from 200/0 in
1975 to 34% in 1989.

Having presented all this background material may we re-emphasize three main conclusions:
Fi rst, it w au ld be a grea t
mistake to d ism iss th e weak ness of th e dollar aga i nst the D-Mark
as something of only passing
importance; second~ since the direct trade influences on the
$jDM exchange rate are very weak, this relationship can swing widely under the force of
changing investment demand. And, for that same
reason, it is also true that PPP only has a
weak influence on the $/DM relationship.

Third~ (precisely for the above reasons) the Fed must be frightened to let dollar-based
interest-rates fall below DM interest rates. Any such move would risk a sudden slide of the
dollar with devastati ng canseq u ences for Wall Street. U nf ortu na tely thou g h, as th e U .5.
economy continues to sink (as we assume), the Fed will be forced to ease further and at
great risk to the dollar.
A RESHUFFLING OF SURPLUSES eJ
o ve r the pas t .-'j
two yea r s, bot h the me d i a and the fin a n cia I mar k e ts h a v e bee n sop reo C cup i e d
with what happens in the United States that important changes on the part of Germany and ..~
Japan have gone largely unnoticed. One of the most important aspects has been the trend
~~~
 7
~ . in the current balance of payments.

The figures in Table 1 draw a picture which differs from prevailing perceptions. First of
all, it may seem that an improving trend in the U .5. Cll rrent-aCCQU nt deficit has picked up
momentum in the third quarter. We must point out that that is entirely the product of an
statistical illusion. In the first place, the trade deficit deteriorated slightly, falling from
$27.55 to $27.75 billion. The stark reality is that the whole improvement came from the
decline in the value of the dollar against the D-mark.. That occurrence pushed up the value
1 of assets and income in Europe. Capital gains and higher
dollar income are treated as
reductions in the current account..
~l
The second outstanding feature is the rapid deterioration in the Japanese trade balance. The
trouble is that very little of that decline has been to the benefit of the United States. A third
astonishing feature is that West Germany is on the verge of outperforming Japan in its
external su rplu s.

Two years ago, in 1987, the current-account surpluses of Japan and West Germany were $87
billion and $45 billion, respectively. This year, the surpluses should draw even at about $60
billion. Next year, we would not be surprised to see a German surplus of well over $70
billion largely due to the falling dollar
-

and a Japanese surplus of only $40-50 billion. -

G"ERWNY:1. UNITED:.STÁTES2 JAPAN.3

-...
..
-
.
-

..
. -

..

..
-.-
.

.
"

-.
.

.
.
" .

~""~~~~--~';"--":","---~",!,,,,~';'~-~IIIIIIþ--"'~""~.~~""~"~.~:~~~~"'~"""~'~~~~"'"--~~-~~"'.~~_"!I-_;"".~~~""aI!!~-~.~~~~----'IIIII!II~~~~~~""___~~_.~~"'_~~
-

., .

..
.
- -
- -

..
. . - -

"-1988
.

) :Jan-March,
April-J'une "
'16~6'
25.3.:"
.~32~O
,

...33~5:"'
23.1
16~8
July-Sept. .

"
,23.0 -32.3:. 1~.1.
:O'ct.-Dec. 20.1 -28~7 20..8
":1989
"
Jan-March' 30.2 ~30.4' "

21.5
."A'ptil-June' 26.4 M~2.1 12.8
July-Sept.
.

27.8 -22." 13.1

.t\u in :Dt.(, l:ÞilIi9~
.

fig~~seasonal"y ~justed:. 1..

2'- 3.. ÍI1 $, .billions.

MADE IN JAPAN: YEN WEAKNESS

In Japan, industry is working at exceptionally high levels of capacity Labour

utilization..
shortages are spreading. The wider money supply is expanding at almost 10%. Asset price
i n f] a t ion
par t i eu I a r I y a f f lie tin g I and and s to c k p rice s i s ram pan t. Ma chi n e r y 0 r de r s are
-
-

up some 20% against year-ago levels. All in all, the economy is clearly more overheated than
that of Germany. Given these boom conditions, it is plainly obvious that Japanese interest
1. rates are ridiculously low at a discount rate of 3.75%. There are plenty of
overwhelming
reasons why the Japanese central bank should tighten further.
l There has been too much talk and too little action against inflation. Quite simply, the Bank
of Japan has lost its credibility. That's a classical way to weaken a currency. Despite its
unfailing rhetoric against inflation and the weak yen, the Bank of Japan clings to an
extremely expansive monetary policy one that is the most expansive among the major -

COli ntries by far.

One thing we are absolutely certain of: If the Japanese authorities really wanted a stronger
) yen, they could have it tomorrow by simply stepping on the monetary brakes. Their booming
economy, laced with growing inflationary pressures and the weakness of their currency, urge
it upon them. In fact the case is so
compelling, it is our opinion that the yen's softness is
deliberately engineered by the Japanese central bank..

_H
 1
8
0.0"':""
Reasons For the Weakness? It wall ld be very interesting to know why the Japanese '-.
authorities are keeping their monetary policy looser than justified. Is it for internal or
external reasons? Does the Japanese governm~nt doubt the robustness of their own economy?
Are they afraid of pricking the inflation bubble in the domestic asset prices of stocks and
property? Or, are they more afraid that an aggressive monetary tightening on their part
would knock out Wall Street and the dollar by trimming Japanese capital outflows. They
may anticipate that such a sequence of events would have devastating consequences for
Japanese investors and U.S. exports. All of these are plausible reasons.

More Than a nD-Mark Phenomenon".. These and other considerations wou Id certainly take
Japanese monetary policy hostage. If au r specu lations have any basis, it means that markets
are taking a false comfort from the fact that the dollar has been holding its ground against
the yen. The dollar is being compared to a currency that has its own reasons for weakness.
All the weak currencies dollar, yen, pound, etc. have their own special problems.
- -

The simple reality is that exchange rates have again started moving in line with their true
underlying economic fundamentals. No longer are currency markets singularly driven by
interest rate di fferentials.

Ani m
partant poi nt to recognize is that the weakness of the dollar and the yen ha ve
fundamentalIy different origins. The yen's weakness is traceable to monetary causes and
may therefore only be a temporary phenomenon. By contrast, the dollar's weakness is a
function of deep structural problems that may have long-term implications.
THE JAPANESE CAPITAL SPENDING BOOM VERSUS THE U.S. BORROWING BINGE

Experience and theory say that the most important influences on currency movements over
the short-term are relative monetary conditions- The key to the dollar rally until mid-1989 J
C)
was the Federal Reserve's tightening relative to the monetary stance of both Germany and
Ja I f
pan. Fur the r m 0 r e, the pop u 1a r per ce p t ion 0 f the U.S. e co nom y i n ea r y 989 was 0 n e 0
I

rapid economic growth, an improving trade balance, and rising inflation in the face of a 000-
accommodating central bank.

Over the long term, however, a currency's strength or weakness is determined by more
fu ndamental forces. The most important of these is the rate of capital accu mu lation,
particularly as measured by the relative growth rates of manufacturing capacity. That has
been our long-held view, and is one that we have emphasized repeatedly in direct
contradiction to the purchasing power theory that still remains the cornerstone of dollar
bu llish ness.

What counts in a dynamic world economy is not how cheap a country~s products are, but what
it can produce and deliver at internationally competitive prices. Where there is strong
investment there is also likely to be price competitiveness. If that were not so, business
would not have the motive to invest.

Japan is on a capital spending binge that is sure to boost its trade surplus over the long haul.
Super-efficient producers are rushing to expand capacity, modernize plants and to develop
new products. America's situation, by contrast, emerges from a borrowing binge that has
financed overconsu mption and internal asset price inflation at the expense of productive
investment. Long-term trade improvement can only be built on the strength of accelerated
capital accu mu lation. In this respect, however) the U.S. economy is far from catching up
wit h J a pan and G e r man y. The U.S. is rap i d I y fa 11 i n g be h i n d
.

THREE CRITICAL FACTORS FOR THE DOLLAR

The crucial questions -

the éurrency markets

for Wall Street and is whether the current
-
o
economic slowdown will end in the elusive soft landing, or a recession and if the latter, how
severe will it be?
 9
. To us, the general complacency on these questions are simply incomprehensible. We see three
conditions that are extremely critical in framing any forecast.

First.. long years of pervasive, non-stop over-borrowing and over-spending have unbalanced,
distorted and leveraged the U.S. economy as never before. Given such unprecedented
excesses in credit and debt, a return to normality is simply not possible without very painful
withdrawal symptoms, both in the real economy and in the financial markets.

Second.. over-leveraged borrowers also have their problematic counterparts in the financial
system. Thrifts, many banks and the junk bond market are in deep trouble with souring
loans and investments looming into the hundreds of billions of dollars.

Third.. it becomes increasingly apparent that the Fed is caught in an unprecedented conflict
between two policy requ irements. From the perspective of a faltering economy and the
inherent risks of over-leveraged balance sheets, the Fed clearly should be easing. However,
worries over inflation and the dollar oblige the Fed to hold interest rates too high for the
comfort of a weakening domestic economy. Needless to say, this predicament raises the risk
of an econom i c dow n tu rn.

With all these worrisome factors in mind, the general complacency about the Fed's fine-
tuning capabilities is a mystery. Are there any hard facts that might justify this faith in the
Fed from this point forward? We would say there are virtually none given the spectre of
current trends. Trade and capital spending, the engines of growth over the past two or three
years, are sputtering. Exports have flattened out and net exports are falling. The dismal
prospects for capital spending are evident in nose-diving new orders and diving corporate
earn i ngs. Non-defense capital goods orders, apart from the aircraft i od u stry, p lu nged 18%
in the th i rd quarter.
)
Consumer spending is the only possible expansionary influence on the economy in the near
future. Many economists are relying on continued strength in the service sector to provide
the necessary income growth. In the meantime, employment in the service sector is slowing.
Even if it were to happen, such a mix of weak exports and investment and strong
consumption would be utterly undesirable.

THE SOFT LANDING: HAS IT ENDED?

We cannot over look th e fact that market sen ti men t sti 11 remai ns rather opti m istic on the U .5.
economy and the dollar. While outright bullishness may be somewhat restrained now, it is
true that very few seem to be able to envision any down-side whatsoever.. Consumer
confidence, as measured by the University of Michigan and the Conference Board, is still as
high as it has been in about 20 years. We can only conclude that Wall Street is not alone in
giving Mr. Greenspan a great deal of credit in managing to slow the economy into a Usoft
landing".

No doubt, Mr.. Greenspan deserves some praise. Nevertheless, we must remember that it
wasn't his fine-tuning skills that rescued the U.S. economy from recession over the past 2-3
years. While the Fed aggressively tightened, exports propelled by a prior massive dollar
-

devaluation and vigorous demand growth abroad took up the lead and compensated for
-

depressed domestic demand.

The charts on the next pages illustrate the main aspects of economic developments since
1984. We draw particular attention to the upper chart which shows the composition of GNP
growth divided between domestic demand and exports.

) We strongly suspect that the unique experience of an export-led recovery has m-isled many
observers into over-estimating the effectiveness of fine-tuned monetary policy and to under-
estimate the degree of monetary tightness. As the export boom peters out, the drastic
slowdow n in credit and money growth w ill now more fu lly impact the domestic economy.
That points to the critical difference between 1987 and 1990, and it could well be that we

.
 10
C)
Exports, the biggest engine of growth now sputtering. are now wi tnessi ng, not the
beginning, but the end of the
"soft landing".
~Cð USA: GNP GROWfH COMPONENTS

2S
THE EFFECTS OF CREDIT
INFLATION REVISITED
20
As au r last letter showed,
1~ credit growth in the United
States has been almost cut in
10 level of
half, falling from a

13-14% 1984-86
in to 7-8%
:5

recently.. We said that credit

" provides the best information
as to what is happening in an
-~ economy.. People who borrow,
spend it. They may bu y
-121
1984 196:; 1966 J.9S? 198a 1995 cu rrently produced goods and
_ services or they may bu y
Exports
_ Domestic physical assets that have been
Source: Datastream produced (houses for example).
As consu mefS do so, GNP and
price inflation (as measured in
the ordinary price indexes) go
up.
us: INDUSTRIAL PRODUCTION
::. ..: :.:: ~::~i ~~a~i e x
~:ss~ ~~~~
:::::::::.
::..::: :::: ::::
::::
:::
:::::::::.
.:::::: J
::::::::..:::.:::.:.:.:....
..::...::..... t y
the
s )
abroad through trade
10 accou ot or some may flow over
a
into existing assets markets
(i..e. real estate, factories and
paper assets including stock,
6

<1.
bonds, mortgages...etc.)
Additionally, it is important
2
that the monies
to recognize,
" out of the trade
that leak
deficit tend to return in the
..2
1~a4 !ge~ 198& 19S7 19sa 15199 form of augmented foreign
Year-aver-year Change (6 mos. smoothed) demand for real assets. This
Source: 0 atastream effect on existing real assets
lies entirely outside of GNP
tabulations. As such, prices of existing assets rise (asset price inflation).

INFLATION HAS ONLY THREE OUTLETS

We have repeatedly stressed that the recent financial excesses in a number of countries -

measured in terms of credit expansion are more extreme than they were in the inflationary
-

1970s.. In can trast to past inflations w h i ch

were always cen tred in an over-expansion of
credit for investment purposes (mainly inventories and real estate) the present "new"
inflation has been far more complex and dispersed. Abundant money was borrowed to buy
paper assets or existing real assets the prices of which were rising rapidly. The faster asset
-

prices rose, the more people wanted to buy them. It's been a delightful inflation that has
made people feel wealthier seemingly without effort. Feeling wealthier, individuals saved
less and borrowed still more, producing the roaring consumer boom. As a consequence, O'.~'.C<;'
~
'.

resulting high interest rates and exchange rates served to crowd out manufacturing.
. 11

THE LURKING THREATOF

us: NEW ORDERS ASSET PRICE DELATION
It is not accidental that all of
15
the countries with large
.~.. ....................... ..................................................... ....... ...".....".
.
'.. _..
external deficits also have
rampant asset price inflation
10 .
in common. Foremost among
these countries we would
include the United States,
:l .

Britain, Canada and Australia.

Persisten t trade defici ts and
ø
asset inflation are the
symptoms of one and the same
cau se: ered i t ex cesses.
-s 196q 1965 J996 198? 1988 1989
-

Year-over-year change (6-mos smoothed)

If
the central banks would
Source: 0 atastream have worried abou t asset price
inflation as much as they
worried about retail price inflation, the consumer
us: LEADING INDICATOR boom would not have careened out of control. The
1S0 decisive point as the quotation on first page says
- -

is that a "credit deflation" follows a credit

14S inflation as surely as a hangover a drinking orgy".
On that theory we have long anticipated the news
140 that real estate prices in the deficit countries have
begun to weaken. Now, all of a sudden, one can
\ 135 read almost daily abou t plu nging commercial
) property and housing prices. Obviously, the real
130 estate slump is spreading as is evident in the United
States.
12'
Don't think that the weakness in real estate prices
120
is just a
temporary softness that w ill evaporate with
easier money. Most observers still cling to that
115 corn forti ng view. To quote the Wall Street J au roal
199 a9
on the su bject: tiThe Federal Reserve in fact, the -

_
Index
whole U.S. government won't stand by and do -

Source: Datastream
nothing." Again and again this incredible faith in
the omnipotence of governments comes to the forefront.

is
Our answer very different. The very people and institutions who supposedly are able to
solve the problem have created it in the first place by their own mismanagement of the
1 h u n d red t i me s m 0 r e
e con 0
my. To st r en g the nth e en t ire rea esta te mar k e tis a tie a s t a
difficult than perking up a stock market. A little easing would not do in any case. What
would be required is a veritable flood of new money. And that won't be forthcoming because
the Fed's hands are tied.

CONCLUSIONS

In au r view, the grow i ng disarray in the U .5. real estate market will, over ti me, h it the U .5.
economy with tremendous force. Both the Fed and the government won't be able to stave off
the inevitable disaster. Past excesses have simply been too great."

It seems, we cannot draw attention to this point often enough: Despite the reassuring claims
that the U.S. economy is healthy and that the Fed has everything under control, in reality,
the economy is more vulnerable than ever before.

Simultaneously, monetary and fiscal policy has little or no room to manoeuvre should they
wish to avoid the dollar's steep fall.
 12 .
The most critical phase for the economy, the banking system, the dollar, and the financial
It
markets begins when debts collide with falling earnings and collapsing collateral values.
might happen soon, yet everybody is unprepared.
the United
A simple recession without any major consequences is a virtual impossibility for
with similarly gross imbalances in their
States. And that goes for all the other countries
internal and external economic structures.

Ou view is th at th e risks in the

r U I
.5. dollar are risi ng rapid y and
th a t the W or5t part of the
decline is still ahead.

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Editor: Hahn Capital Partners

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