..

DR. KURT RICHEBACHER

) English Correspondents: Müblegasse 33
Hahn Capital Partners IDe. eH-SOOt Zürlcb
1175 N. Service Rd. Switzerland
OakvUle, Ont., Canada
L6M2Wl CURRENCIES AND CREDIT MARKETS

No. 20S I May 1990

"The effects of these capital Imports are clear: not only were adjustments prevented, but the...pulse of . .
business became
.

spending
dependent on the rate offtow of foreign funds; wltb roreIgn banks financing a considerable part of Investment and current
propeUed; and of course, a financial situation was
..
.. the policy of the central bank was checkmated; the consumption boom was
..

collapse on comparatl vely SlDal provocation.. the foreign credits camouflaged" Inflation"
created that was in constant danger of ...
II
by produdng its results under the surface of an apparently very sound" monetary system.."
Joseph Scbumpeter, Business Cycles

HIGHLIGHTS

Surveying world inflation trends, an anomaly seems apparent: the weaker the economy the
higher the inflation. That's a strong hint that inflation problems do not find their
customary cause in overheated demand.

"high yield"
Large external deficits and -a reliance on capital inflows on the part of the
countries has caused currencies to playa large role in that anomaly.
-)
The stabilization of domestic prices through currency overvaluation in the past has carried
a price. It benefits the consumer at the expense of the producer and boosts consumption at

the expense of investment.

If currency is overvalued it should first show up in the falling profits of the country's
a
"high deficit"
manufacturing sector. Sweeping drops in business profits indicate that the
countries lack international competitiveness. Obviously, the currencies of these countries

must be overvalued.

Judging purely from the objective fundamental facts, we would say that the dollar is ripe
for another major slide at least against the D-Mark and the European currencies.
·

The policy dilemma for some of the deficit nations is becoming acute. Weakening economies
prompt a monetary easing yet the prospect of a dropping currency makes central banks
hesitate. Canada and Australia, particularly, are textbook cases.

America's current inflation uptrend is deeply embedded. It finds deep roots within two
long-term trends on the supply-side of the economy: continued abysmal
investment/productivity performance, and unfavourable demographics in the labour market.

Most observers have yet to realize that lower a U.S. economic growth potential in-the 2-2.5%
'\ range (or lower!) is
not merely a cyclical matter but a function of a deeper secular
__J- weakening in available resources.
WORLD BOND MARKETS IN TURMOIL

fuflation fears have beset global financial markets. Within just a few months, recession worries
have been eclipsed by this new fear for five reasons: Firstly, the continuing horror stories over
future inflation in Germany due. to the uncenainties of a fast-approaching East-West German
econollÚc and currency unification (Gemu); second, the perception that the U.S. economy is now
strengthening rather than weakening; third, recent discouraging inflation data, particularly in the
United States and Britain; fourth, more worrying news about accelerating inflation in Japan
further .compoWlded by a weak yen; and finally, a new upturn in non-oil commodity prices.

Taken together, these factors seem to present quite a convincing picture. Yet, we have to realize
that the underlying economic, monetary and financial conditions in each of the major countries
differ quite markedly.

The Averages Hide the Extremes. Looking at the global economy as a whole, countries can be
divided into three groups: first, recession candidates including among them the countries of the
United States, Britain, Canada, Australia and some Scandinavian states: second, countries with
continuing strong growth Continental Europe mainly qualifies here; and third, countries where
-

growth is still high, though slowing significantly. This last group is mainly comprised of Japan
and the Far Eastern countries.

As far as the world economy is concerned, two obsetvations can be made presently: the economic
cycles of different countries are getting out of "sync", and, on average, economic growth is
distinctly slowing. These two trends should prevent price pressure on resources, yet, inflation
has clearly accelerated. The following two tables show the divergent developments in inflation
and economic growth among various countries. At fust glance, an anomaly seems to be apparent:
the weaker the economy the higher the inflation.

COMPARISON: CONSUMER PRICES INDUSTRIAL PRODUCTION

(% Changes at annual rates) (% Changes at annual rates)

Country 3 Yr. Country 3 Mos. Yr.

Mos.

United States 8.5 5.2 United States -0.4 1.0

Britain 7.3 8.1 Britain -4.9 0.3
Australia 7.7 7.8 Australia -8.5 0.1
Canada 4.2 5.4 Canada -0.5 -0.2
Germany 2.8 2.3 Germany 9.6 4.4
France 2.8 3.4 France 0.7 2.2
Japan -0.5 3.6 Japan 2.8 3.4

Inflation and Growth Somewhat Unlinked. The consensus view is that inflation rates will
converge this year. Prices in Japan and in Germany particularly are supposed to rise, while those
in the Anglo-Saxon countries are supposed to falllUlder the weight of slowing econollÚes. As
~)
such, all these inflation rates are expected to meet in the 4% range. Many economists interpret jl
these expectations as bullish for the U.S. dollar and bearish for the D-Mark.
 3

they overestimate the underlying economic strength

~ They are mistaken. In the case of the U.S..t
is only one thing that might
and underestimate its underlying inflationary bias. In theory, there
be able to save the Itrecession candidates" from recession: an export boom, with exports
compensating for faltering domestic demand. but, that's nowhere in sight..
.
..

might think that such an export boom

Given the boom conditions of Europe and the Far East, one
should be feasible at least for America. But the hard fact is that U..S. merchandise exports have
exclusively from
stagnated for a full year.. Improvements in the trade balance have resulted
slower imports which are mainly a reflection of weak domestic demand.. It does not seem that
be essential to improve
domestic producers are winning back home market shares. That would
GNP growth..

Why it that these countries are unable to more profitably take advantage of the boom in Europe
is
they lack international
and the Far East? Sweeping drops in business profits indicate that
competitiveness.. Obviously, the currencies of these cOWltries are overvalued..

that is still comforting

Currencies and Capital Flows Obscure the View. The one thing
nothing else, will at least reduce
investors in these countries is that an economic slowdown, if
inflation. That may be true up to a point, but on the whole, we think these hopes will be rather
disappointed. There is more inflation embedded in the econonúes of these cOWltries than meets
deficits have,
the naked eye. The fact is that these countries with large trade and current account
quite literally, borrowed lower inflation from abroad.. If it weren't for large trade deficits, huge
capital inflows, and overvalued currencies, inflation in these countties would have been far worse..

) They only affect the

Large trade overvalued currencies don't cure inflation..
deficits and
symptoms and not the cause.. The true inflation
tendency will remain suppressed as long as these
begin to fall, the
two conditions prevail. When the trade deficits finally shrink: and the currencies
might say that the "borrowed" inflation
true underlying inflation will surface.. In away, one
stability has to be paid back.

POLICY CLASH: BALANCING CURRENCIES AND ECONOMIES.

high interest
All the major deficit countries now face triple dilemma: weak economies, relatively
a

rates and the threat that any monetary

easing might trigger a sharp fall in their currency which
in turn implies more inflation. These developments would also
surely unnerve fmancial markets..
Each of the respective central banks are therefore more hesitant than usual to ease. Canada and

Australia, particularly, are textbook cases of this situation.

negative growth. As short-term interest rates have

Australia has already recorded one quarter of
US $0.79 to $0.75 even
dropped 350 basis points or so, the Australia dollar has fallen from
though the currency has already seen sudden decline earlier
a in 1989 from the level of US $0..89.

In the meantime, long-term interest rates moved up from 12.8% to 13..8%..

(currently at U.S. $0.857) is still

Canada is more timely case-study since the Canadian dollar
a

hovering near the decade-high of $0..8641

against the U.S.. dollar. In the meantime, the economy

has begun to decelerate. Canada has engorged itself with capital inflows in recent years to the
\
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4

point where 38% of its bond market is held by outside investors. Last year alone, foreign -)
investors bought CDN. $23.9 billion worth of marketable stocks and fIXed-income securities.

something of the predicament that faces all

In January of this year, the Bank of Canada learned
of the deficit countries. On the evidence of a slowing economy, the Bank eased slightly by
triggered a sharp
allowing short-term interest rates to drop from 12.2% to 11.9% and inadvertently
drop in the Canadian dollar from US $0.862 to as low as $0.8275. The Bank was quickly forced
to tighten again in order to cushion the fall of the currency. The outcome of the saga was that
short-term interest rates ended up rising to as high as 13.55% and
the bond market saw a serious

disaster. During this period, domestic long-term interest rates rose faster than short-term interest
rates jumping from 9.6% to 11.6%.

THE U.S. DOLLAR

speaks of a monetary easing any more. That

In the United States, for the time being, no one
mood swing has stabilized the dollar.. But looking at the different demand components, there is
simply no basis for a sustainable, however modest, recovery in the economy. Manufacturing
weakness is gradually but relen~lessly spreading to the service sector.

According to market folklore, Chairman Greenspan has master-minded the soft landing of the U.S.
economy by the timely easing in llÙd-1989. Reacting to a flow of soggy econollÙc data and rising
9% during June and July
fears of recession the Fed had lowered its Fed funds rate from 9-7/8% to
and further to 8-1/4% in October-November.

-in the
)
As matter of fact, the weakening of the economy did not materialize in either the second or
third quarter.. Real GNP grew 3.7% in the first quarter, 2.5% in the second and 3.0% in the third.
For the markets, this was confinning evidence of the Fed's fme-tuning skills as well as evidence
of the U.S.. economy's great responsiveness to any monetary easing. On closer examination, this
experience proved rather the exact opposite: namely, the shortcomings of fine-tuning.

good? The
What was the inflation picture when the Fed eased to rapidly? Did it look so
1989, after
consumer price index (CPI) rose at an annualized rate of 5.2% in the second quarter of
having risen 4.8% during the frrst quarter. Similarly, the producer price index (PPl) increased 6%

and 5.1%, respectively. That was well above the rates of a year earlier.

If the Fed was in hurry to ease,

a the credit markets believing that inflation had been quelled
-
-

bullish about both the

were in an even greater hurry.. During May and June, markets were wildly
poured into dollar-bonds, attracted by the promise of
dollar and U.S. bonds. Foreign money
certain capital gains. While the dollar soared from DM 1.85 to DM 2.04, long-term U.S.
government bond yields plummeted from 9.25% to a little below 8%. Many, if not most
yields would
commentators, predicted a dollarlDM rate of OM 2.40 and that U.S. long-term bond
fall to 7% and lower.

It was nothing but a brief speculative bubble based on grossly fallacious forecasts and equally
fallacious theories. The main underlying theory had been that a recession would be bullish for
the bond market and the dollar as it would improve the trade balance and attract foreign capital
{\
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Currea.c1.ad Credit Markc1l\t.bJ 1990
 5

in search of capital gains as interest rates fell.

.., As it turned out, the economic data had given false signals. The soggy economic data dissolved,
not really through the Fed's fine-tuning, but through subsequent, considerable upward revisions.
Included among these was the revision of second-quarter real GNP growth from 1.7% to 2.5%.
Memory loss, however, led to the rosy notion that stable growth was achieved through the magic
I. touch of the Fed's deft monetary skills.

I While logic would say that this experience should have undermined confidence in the Fed's fine-
tuning abilities, market adulation actually strengthened, paradoxically. At the same time, the myth
that the U.S. economy is virtually recession-proof and that any threatening recession could be
prevented by promptly cutting interest rates was further etched into legend.

For our part, we draw three lessons from this

episode: first, of course, it is further proof that the
high-riding confidence in the Fed's (and the market's) ability to rme-tune the economy is utterly
misplaced; second, that while the Fed is undoubtedly concerned about inflation, it has betrayed
a tendency to ease significantly at the first evidence of a weakening economy in other words,
. . .

fighting inflation only has priority as long as a recession appears improbable; and third, that there
is a remarkable complacency abou~ inflation in the United States at the current 5-6% range.

PROSPECTS FOR THE U.S. ECONOMY

The truth be known, there is "devil-may-care" complacency on just about everything: the re-
accelerating budget deficit, the trade deficit, the record high debt-levels, a still-mushrooming S&L
) crisis, snow-balling default rates, and last but not least
-
the fate of the economy.
-
Some
economists bravely assert that the U.S. may never see a recession again.

Not long ago, some 60% of forecasters surveyed by the National Association of Business
so
Economists (NABE) answered that they didn't expect a recession during the next three years.
Sustained growth has led people to believe it can continue indefmitely. Recent experience begets
simple extrapolation, while history is ignored..

For 1990, the NABE consensus forecast is for 1.75 2% real GNP growth and for inflation to
-

decline to 4-4.5%. The general hope is that a temporary period of economic growth at this rate -

supposedly well below potential will be sufficient to relieve supply tensions and to eventually
-

reduce inflation to below 4%. It seems, at least initially, that markets have embraced these
forecasts.

What can go wrong? The first thing that has already gone terribly wrong is inflation. First-
quarter consumer price inflation was at an annualized rate of 8.5%, and secondly, though Fed
policy is on hold, long-term interest rates are rising. After declining through 8% late last year,
government long-rates broke above 9%. Another element that challenges the consensus view is
that frrst quarter GNP growth expected to be stronger on the basis of employment growth
was
figures.. The preliminary GNP estimate for the quarter, if only slightly higher, came in at 2.1 %.

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6

THE DEEP ROOTS OF U.S. INFLATION

inflation persists, and, in fact,

Most shocking and for many also most puzzling is the fact that
-
-

of the general presumption that lower econonùc

has sharply accelerated. That flies flat in the face
price increases. The immediate conclusion, therefore, has been that
growth would promptly slow
generally thought.
the economy must be stronger than

demand and inflation is false. The

The presumed clear-cut connection between weakening
side. There, the first
obvious answer lies on the cost side of the economy, and not on the demand
thing to take note of is a steady rise in
hourly compensation from 3.7% in 1987 to 5.5% in the
1984).
year ending in the first quarter of
1990 (the highest rate since the 12-months ended March
is that as output softened, productivity weakened
Further aggravating rising employment costs
along with it. As a result, unit labour costs have soared from
2.6% in 1987, to 4.6% in 1989 as
a whole, and 6.7% in the fourth quarter alone.

uptrend in inflation is much more deeply embedded

What these figures tell us is that America's
precisely, it is embedded within two long-term trends on the supply
than most people think. More
is a new one. The old one is a continued
side of the economy. One is an old trend and the other
abysmal invesnnent and productivity performance. The new one is the demographic
underpiImings of a tightening labour market

sharply
A New Problem: Demographics. Due to strong population and work force growth, and
30
had an abundant labour supply in the past. For
rising participation of women, America has
yearsl thiS'SU)PPIYd,has.had.twdo
beneficial effects. Ample labour supply boosted
emp oyment an kept a li on wages. During
the
That was achieved with
GNP growth
seven years of the recovery since late
a núx
1982,
of 3%
(via,)
real GNP grew an annual average rate of 4.3%.
the
employment 1.3% productivity
growth and in other words, employment was
growth. . .
main

source of growth.

period of rapid expansion to much slower

the labour force is moving from a
Now, however,
growth. Between
1976 and 1986, the number of workers aged 20-34 in the United States grew
by 11 million. In contrast, between 1986 and 1996, the number of workers in their twenties will
projects work-force growth of an average 1.3% for
decline by 5 nùllion. The Labour Department
the 199Os.

be cured by limiting current

That brings us back to question the Fed's concept that inflation can
real growth to 1.75-2.0% for a short
period. The suspect idea here is the notion that slower
slack in the labour and product markets to reduce inflation. That's
growth will create sufficient
looks very
a crucial assumption. Compared with the growth rates of the past recovery, this target
but it's anything but modest if one measures potential future
employment and
modest,
productivity growth.

additional econonùc growth would

Given the prospect of future labour force growth of 1.3%, any
consequently have to be contingent on productivity growth. that is, increases in output per
. .

How much could productivity growth possibly add over the

long run? In 1989.
person.
productivity growth was 0.9%, and, as already mentioned, averaged 1.3% in the 1980s. G"^-"
~'..:
..,'
'.,:
.~
..
.r-;-;

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 7

Retarded Productivity Growth.

., For unexplained reasons,
American forecasters assume that
many
Labor Force Growth Slows
Annual growth; three-year moving average in percent
productivity growth will accelerate
3.0l"k · . .

again.
basis for this
We don't see the slightest
assumption. True,
t-1':<<<~::Estim~ted
I
productivity growth has improved 2.5% ....... .~. .. ~... .. ~.. -. .! · · · · . . . .

..
· · · · · . · · · · . . . .

.
.
.. ..

since the 1970s when it was

. . -

.. .
.
..
. .
..
. . .

practically nil. But it's absolutely

. . .

....
.

.,.
.
..
i
.... ..; .
.. .
,. . .
.. .
-i .
.. .... ·
.. · ·
.. ·
,. · · · · ·
,.. ... .
..
...
·
.. I- .. · . . . . · . ... · . . .
.. .
.. ..

...
incorrect to regard this improvement
,
..
...
....
.

....
'"
. .

The obvious fact is

.

new trend.
.

as a . .

of the productivity
J that most
improvement in the 19808
was
attributable to capacity
rising
utilization of existing capacities, not -

'90 '95 2000

'70 '75 '80 '85
to increased new investment Aside
business Sources: Bureau of LabOr Statistics and NPA Data Services Inc.
from the effects of the
cycle, probably Wall Street Journal
there was no
progress at all.

productivity growth.
There is, after all, a compelling reason for this negative assessment on future
It lies in the abysmal performance of U.S. savings and investment during the 19808. Given that
there has been practically zero net investment in manufacturing over the past ten years which -

is -the wellspring of productivity growth. it's hard to-see how the underlying.
-
productivity trend
could really have improved.

SPLIT INFLATION. SPLIT ECONOMY

Most observers have yet to realize that, given the poor savings and investment ratios,- the U.S.
is
economy is heading for a decline that is neither cyclical nor temporary. It secular. This
decline in potential growth will certainly have many adverse
implications. Low growth will boost
the budget deficit. Most importantly, there is a vital relationship between inflation and
productivity. Increased productivity is me only way to absorb higher wages without driving up
prices. In short, America's inflation bias is worsening.

That explanation also sheds light on the question of why the slowing of the U.S. economy so far
\ has blatantly failed to cool inflation. If 2% growth is barely within
loday's capacity limits, it

'I' essentially fails to create any econonúc slack. Rather, it keeps the economy overheated. The
most obvious point in this respect is the tight labour market condition.

spread
Nevertheless, American inflation optimists take comfort fro~ the fact that inflation is not
they point to subdued pressures in
evenly. While inflation may be rampant in the service sector,
prices which is up only
manufactured goods.. Their favourite evidence is the index of materials
2% year-over-year, down from almost a 7% rate a year ago. For many, materials prices represent
the true underlying trend.

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ClIn'CACJaa4 Credit MarkcuVda7 U90

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II
;" ; A recent article in ,Business Week (April 30th), under the heading Inflation's
SplitPersonality, ~~))1
point cause of
,

addressed this dichotomy in inflation. The article makes an important about the
must emphatically dispute. Their point leads to the
this divergence in the price structure that we
by the
To quote them: "Prices for manufactured goods, subdued
:-1

wrongest of conclusions.
'II Federal Reserve's tight money, grow gently at-a 3.5% annual rate". In
other words, it's all to
mysterious reason that service-sector prices seem
.Il! the credit of the Fed. But then, what is the
conclusion is that, sooner or later,
il[ impervious to the Fed's dampening measures? The comforting
III Fed's tight-fISted policy.
!í!
service prices will also succumb to the
Id
'\\ in the United States and all
there is nothing mysterious about this inflation disparity
jll.
I.
I!
In reality.
the other deficit countries. The basic point is that under a system of flexible exchange rates, a
Ji! "excess" capital flows and a higher exchange rate
monetary tightening through the medium of
-

J -

T
Iii
II
Ii
impacts different sectors of the economy very differently.

Ii:! by capital inflows. In recent years, it became a

!\ Every current-account deficit has to be fmanced
Ii! deficits and high interest rates attracted
common feature world-wide that countries with large
III ttexcessive" capital inflows that drove their currencies to artificially high levels.
Smaller inflows
Perversely, the
a constant exchange rate.
II~ would have been sufficient to finance the deficits at
)
I
!
i
effect was that deficit countries ended up with the strongest currencies
while surplus countries
i
were characterized by weak currencies.

THE CUTTING EDGE: THE EXCHANGE RATE

that everybody loves:
A strong and appreciating currency has three ~edia.te beneficial effects _-_.
inflation by diverting domestic demand abroad and lowering the cost of
frrst, it moderates
capital inflows dampen pressure for higher interest rates; and third,
imported goods; second, the
attractive to foreign investors. For good
they make assets denominated in that currency more
setters for the fmancial markets; a strong currency
reasons, currencies have become the pace
generally depresses them. Putting it more
generally buoying markets while a weak currency
have artificially low inflation, artificially low
bluntly, one could say that the deficit countries
interest rates and artificially high asset
prices.

is that they are not spread evenly

The trouble with the positive price effects of strong currency
a

is price competition from

.

over the whole economy.. The cutting edge dividing the economy
competition while most
foreign suppliers. Broadly speaking, most goods are exposed to foreign
is split with high inflation in the
services and construction activities are not. As result, inflation
a

services .sector and low inflation in the

goods sector..

It's not only the price system that is split by an overvalued currency.
It splits the whole
is that
economy: goods versus services and producers versus consumers. The basic point to see
one sector of the economy: the manufacturing sector.
an overvalued currency squeezes only
on the profitability of the
Indeed, rises in the exchange rate have a much- stronger impact
corporate sector than do increases in interest rates..

at all, except to the extent that

strong currencies do not squeeze the consumer
Conversely,
the consumer benefits greatly
unemployment results over the longer-term. Until that point arrives, -tr~
~1k...'
-

J..'
~

Currau:y lad Credit Marteú\May 1990

 9

in two ways: frrst, with an overvalued currency, the consumer can buy more foreign goods. And
. in the process, low import prices help to keep a price-lid on domestically-produced goods. The
second major beneficial effect for the consumer arises in the financial arena. Disproportionately

large capital inflows have the effect of buoying the bond, stock, and real estate markets of the
deficit countries and contribute corresponding wealth effects.

To sum up, an overvalued currency serves the consumer at the expense of manufacturing and
boosts consumption at the expense of domestic investment. That is precisely what we see in the
United States as well as the other countries with persistently large external deficits including
Australia, Britain and Canada. In all of these nations, consumption overexpands relative to
investment in general and manufacturing investment in specific.

In the United States, business profits and manufacturing investment are at their lowest ever as a
share of GNP. In other deficit countries, the development is similar. To quote Keynes on this
subject: "But cheapness which means the ruin of the producer is one of the greatest economic
If
disasters that can occur.

GERMANY: PROFIT RATIO US CORPORATE PROFITS

I I uf fill
7
34.' 3-t.!5

8
33.0 33.0
6
31.5 31.5

) 30.0 30.0
4

3
29.8 28.t5

2
27.0 27.0
1
eð.ð ~.ð
2~.O a
2.4.0 89 90
&:) 81 B2 B3 a.t 85 U6 87 88 89 90 80 81 82 13 14 III 86I ff1 89
01 mP
Profit, (H) II X of Hat. Inca_ r=:::J Corpor.t. pl-O'1t. a.
c:=l

THE DEUTSCHEMARK

Currencies are always subject to two different ~ets of influences: domestic on the one hand, and
external on the other. Judging purely from the objective fundamental facts, we would say that
the dollar is ripe for another major slide -
at least against the D-Mark and the European
currencies. U.S. inflation is twice as high as that of Germany, while cmrent real GNP growth its

w
is half as high. Meanwhile, Germany has a huge current-account swplus and the United States
a huge deficit. Yet, short and long-term interest rates of the two countries are practically at par.

What then, other than sentiment, is supporting the dollar? For the time being, there are apparently
three influences:

1. Concerns over the inflationary impact of East-West German currency ll:llification;

2. The yen's protracted slide mainly caused by a prolonged domestic monetary
)
CurrCIICJ' Markcll\M.,
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overexpansion;
-)
the monetary stance of the Federal Reserve.
3. A highly positive perception of

Fears of an uncontrolled rise in German inflation and government borrowing

in the wake of

German monetary unification have halted the rise of

the D-mark and triggered plunge in bond
a

highs of 9%. Inflation concerns are 'heightened by the

prices, as ten-year yields soared to
Expectation of downward
booming economy, capacity pressures and difficult wage negotiations.
boosting the yield premium demanded
pressure on the D-mark may be a major factor currently
by foreign Bund investors.

Interestingly, of foreign and domestic investors has been diametrically different.

the reaction
seized the
While foreign investors unloaded German bonds in sheer panic, German investors
opportunity to lock in such high yields and bought as never before. Their net purchases of DM
30 billion in the first two months of 1990 compares with total net purchases of DM 47.2 billion
for the whole of 1989. Obviously, German investors have no doubt about the determination
of
relentlessly as in the past And for currency
the Bundesbank to fight inflation in the future just as
markets, the future action of the Bundesbank is also the key question.

Credibility As explained in the last letter, these stories about the

of the Bundesbank.
Bundesbank losÙlg control are misplaced. Actually, these stories are ridiculous.. There can be
justification. At the
no question that the Bundesbank would tighten immediately if there
is any

moment, though, there isn't any need to

tighten.

One has to go back more than rwo decades to find ~ combination of

and low inflation (CPI 2.3%) as desirable as today in Germany.
fast econQInic growth
Maybe it's incomprehensible for(4%))
The important point to see
-.'

some people that a booming economy can have such low inflation.
is that it is not monetary policy alone that accounts for this extraordinary peñormance. Further
key determinants were stable unit labour costs, and a drastic turn-around in import prices since
mid-1989. After a rise of 7.5%, import prices have since fallen 2.8%.. During the last three years
only 2% (as compared to 10% in the
as a whole, Wlit labour costs in the economy increased
United States).

productivity
Subdued labour costs have been the result of relatively low wage growth and strong
gains. Surging profits led to surging capital spending which in turn assured continuing
productivity growth. Business profits as a share of GNP have been restored to the lofty levels
compared
of the 19~Os. In this respect, the difference of the growth pattern of Germany when
profits) is
to that of the United States (overconsumption, under-investment and low fundamental.
GNP yet they of over-riding
These differences don't necessarily show up in the totals, are
importance for economic growth and inflation over the
long run.

dynamics of high profitability and

In the last analysis, it is these general observations about the
high capital spending that makes us basically optimistic for German markets and the D-mark and
pessimistic about the currencies and markets of the United States, Britain, Canada and Australia.
of economic policy is its impact on capital formation and profitability, and
The crucial test every
in this respect, the verdict on the United States and the other deficit countries is devastating.

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 11

. No doubt, some pressure on wage costs and profit margins will develop as the year progresses.
For Germany, that likely means that CPI inflation will be on a modestly rising trend in the second
half of the year. But any weakness in the D-mark or any sign of accelerating inflation would
trigger a monetary tightening. In this situation, in fact, the Bundesbank has one great advantage
over the Fed and other central banks. In Germany, there is no policy conflict because the
economy is booming. For the same reason, the public would more readily accept any tightening
if it were necessary.

Contrast this enviable situation in Germany with the imbroglio that faces the authorities in the
deficit countries with their near-stagnant economies, high inflation rates and vulnerable currencies.
Dreadful policy conflicts are in the offing.

In the last letter we said that the key question for currency markets over the next two or three
months is the trend of the U.S. economy. If it rebounds with tighter money, the dollar will
strengthen. But if it continues to weaken, implying easier money, the dollar will suffer a major
slide with the Canadian and Australian dollars close in its wake.

While many are once again conjuring up the IIsoft landing" of the U.S. economy,
commentators
.

we see nothing but trivial up and downs. Clearly, none of the fundamentals that support
economic growth has changed for the better. As already pointed out in the last letter, there are
horrible contradictions and distortions in the recent economic data. Here's a latest example. It
concerns consumption which is supposed to be the backbone of economic growth.

) On Monday, April 30, the Wall Street Journal in a comment on fIrst quarrer GNP growth, wrote:
"Consumer spending picked up considerably in theftrst quarter, growing $16.4 billion compared
with a $3.6 billion rise in the fourth quarter.." One day later, Tuesday, May 1, the same Wall
Street Journal commented on consumer spending for March: IIAdjusted for inflation, March
personal spending dropped by 0.2% after increasing 0.2% in February and remaining unchanged
in January." Both reports, of course, came from the same source: the Commerce Department.

CONCLUSIONS

The U.S. economy is teetering on the edge of recession. Once the markets come to realize this,
the dollar will suffer its next major slide. The past actions of the Fed have clearly shown its bias.
Everyone knows that the Fed will be unable to maintain its restrictive policy stance in that
situation. What makes the U.S. dollar particularly vulnerable, is the fact that the German and
European economy is booming. Since that reality precludes any possibility of a European
monetary easing, U.S. monetary policy is really between a rock and a hard place.

A recession will certainly raise hopes for declining inflation and lower (perhaps sharply lower)

U.S. interest rates. Yet, it's becoming more doubtful that the bond market will react favourably
.
after all, the fundamentals are truly awful. As tax receipts begin to fall in a slowing economy
. .

and the Savings anq Loans bail-out requires massive funding, the budget deficit will balloon.

High interest rates in Germany and Japan are squeezing the U.S. and the other deficit countries
( '..).....
--," from the outside. A tumbling dollar will scare the u.s. financial markets and further spike
\ ..-
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Currcucy lad Credit Markcû\MaJ U90

 12

generally
inflation fears. And, today's type of inflation will prove more stubborn than is
o
expected. All these factors dim the outlook for the bond. market.

Given this extremely adverse environment, ~e Fed essentially has no room to ease. Yet, faced
with a sinking economy, it will have no choice but to do so and thus risk a plummeting dollar.
America faces economic, financial and monetary problems of a type and severity that have never
been experienced before. Too much of the past economic achievements were simply borrowed.
The bills are now coming due.

Japan's yen and financial markets have stabilized, but the inordinate excesses of the past (see our
related comments of the past two letters) and the continued double-digit money expansion make
these markets accident-prone.

There is no question that Continental Europe. is in the best shape by far of all the world
economies. It isn't an exaggeration to say that Europe is experiencing a renaissance. While the
sensational opening of the East may be capturing today's headlines, the hard groundwork for this
optimistic outlook has really been laid over the past years. Restraint in government spending,
capital spending, those
wages and consumption have paved the way for rising profits and surging
being the drastically improved structural features of Continental Europe. While the Anglo-Saxon
was only Continental Europe that put
countries trumpeted and preached supply-side rhetoric, it
these policies into practice.

<)

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PubUsber, D.... Kurt Rlcbebãcher
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Editors: Hahn Capital Partners
OakvUIe, Ontario, Canada

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Copyright: Dr. Kurt Rlchebãcher

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