DR.

KURT RICHEBACHER
EngUsh Correspondents: Frankfurt
) Hahn Capital Partners IRe.
CANADA
GERMANY

CURRENCIES AND CREDIT MARKETS

No. 219 I July 1991

As amatter of fact, the intensity and length of a crisis depend largely on the resistance which the
banking structure is or is not able to otTer. An illiquid structure leads to a crash which a liquid
one not only avoids for itself, but may actually soften for the rest of the community, by being able
to 'come to the rescue'."

Liquidity, Melchior PaIyi

Committee for Monetary Research and Education

HIGHLIGHTS

In trying to assess the future 'course of the U.S. currency it is essential to distinguish between
two,
sometimes highly-divergent, sets of forces: long-term secular developments and medium-term
cyclical fluctuations around the secular trend.

In our view, it's all too obvious that the U.S. dollar is in a long-term
downtrend. The decline,
though, has taken place in waves that are clearly linked to the ups
-) cycle.
and downs of the U.S. business

Again we see shades of 1989 only with one little difference: The same economists who didn't see
any recession approaching in 1989-90, now claim that the U.S. downturn is already over.

Irrespective of the odd statisticalup-tick, our view about the U.S. economy's u.nderlying
weakness
remains unchanged. Every single fundamental monetary, financial and economic indicator speaks
against any possibility of a sustained, strong, re_covery from recession.

Any such recovery depends on two all-important processes in the

monetary and financial sphere:
sufficient money creation by the banking system and business reliquefication. Neither are in
evidence.

The great theme that-has served to boost the dollar is scaremongering about Germany excessive -

unification costs and associated fiscal and monetary- policies are supposed to drag down the
German economy and extolling a certain U.S. rebound. We have come across many silly
-

theories in our life. The unification hex beats them all.

The credit crunch in the U.s. has turned into a credit deadlock. Bank credit growth, including
bank investments, has been virtually zero.

What, then, is driving the stock market? It definitely isn't excess liquidity in the monetary
sense,
as so many Wall Street gurus like to assert.
)
The chronic compression of profit margins in the U.S. suggests that
any recovery might quickly
run into rising inflation as businesses try to improve their profit margins.
 2

NOBODY TO FINANCE THE U.S. RECOVERY

Viewing the television screens showing rolling Yugoslavian tanks and reading the bullish reports
about the U.S. economy and the dollar, somehow it all appeared so familiar. Suddenly, it struck us.
Heck, it's June-July 1989 all over again bristling tanks and bustling dollar euphoria.
. . .
guns and
. .

giddiness.

Almost exactly to the day two years ago the end of June 1989
-

we found ourselves in Norway.

-

A shipowner there had invited us to discuss the currency situation. The U.S. dollar was soaring then
against the D-mark just as today. He had bought a ship payable in dollars and didn't know whether

to buy or to' borrow the U.S. currency.

Late in the evening, watching the television newscast, we saw tanks rolling through the streets, just
as today. However, it was nowhere near the German border, but far away in Tiananmen Square,
Bejing.. Nevertheless, the "infant lemmings" an expression borrowed from Mr.. Denis Healey,
-

meaning the young men who dominate currency trading nowadays revelled in their usual "safe
-

haven" catch-phrase, pushing the dollar toward DM 2.00 just as today. Highly bullish forecasts
targeting.DM 2.40 and 180 Yen were rampant until September 1989, just before the dollar's descent
started.

Apart from the ubiquitous IIsafe haven" standby, a number of other slogans contributed to the mid-
1989.dollar surge: a soft landing add resilient U.S. econonúc growth, an improving U.S. trade
b~ance, the expectation of a permanently tighter U.S. monetary policy relative to that of the \
Bundesbank and the Bank of Japan, falling U.S. inflation and last but not least how could we
~ )

forget -

the PPP mantra (Purchasing Power Parity). A typical headline of September 1989 read as
follows: The Dollar Powering its Way to Purchasing Parity.

As always, dollar bullishness was a reflection of the optimism on the U.S. economy; its improving
fundamentals versus underlying bearishness about economic growth and inflation in Europe.

After the wild currency gyrations of June-September, during which the dollar briefly hit a peak of
DM 2.04 despite heavy U.S. and Japanese interventions, it swiftly sagged toward DM 1..70 by year-
end 1989. What followed was a grinding decline to OM 1.44 by early February this year.

What was it that so thoroughly deflated he dollar's heady steam of mid-1989? Simply, all the
assumptions underlying the move proved to be glaringly wrong. fu reality, the U.S. economy was
weakening not strengthening
-

and was weakening even in association with a drastic monetary

-

easing by the Fed.. Europe, on the other hand, was on the verge of a boom in tandem with a
progressive monetary tightening. Instead of rising to the expected DM 2.40, these two sets of forces
acted together to push the dollar to a new post-war low of DM 1.44. Again, the predominating rule
of currency markets prevailed: namely, that the dollar falls when the U.S. economy weakens relative
to Europe.

We thought it'd be instructive to recall that episode of 1989 simply because the arguments fuelling
the new "bull run" of the dollar this year are almost a carbon copy. There is only one little
)
Currencies and Credit Markets \ July 1991
 3

~
,) difference: The same economists who didn't see any recession approaching in 1989-90, now claim
that the downturn is already ave'r. Besides, they assert," the recession, though short and shallow, did
have wonderful curative effects for the U.S. economy, particularly for inflation, as well as the trade
deficit and the U.S. dollar.

A CYCLICAL DOWNTURN OR A SECULAR STALL?

In trying to assess the future course of the U.S. currency it is essential to distinguish between two,
sometimes highly-divergent, sets of forces: long-term secular developments and medium-term cyclical
fluctuations around the secular trend.
I
In our view, it's all too obvious that the U.S. dollar is in a long-term downtrend. The decline,
J though, has taken place in waves that are clearly linked with the U.S. business cycle. often We have
l explained that the dollar tends to be strong when the U.S. economy pulls out of recession ahead of

I Continental Europe, especially so when accompanied by a fmn monetary policy. Conversely, the
~. dollar has always weakened during u.s. business-cycle downswings.

I Looking at the long-run fluctuations of the dollar, the dollar made new lows against the D-mark every
successive cycle both declining highs and lower lows. The low in the late 1970s was marked at
-

I DM The next low, in late 1987, was

1.71.
mentioned, was even lower at DM 1.44.
DM 1.56, and the last low, in February 1991 as already

~ The downward tendency of the dollar has probably been greatly understated considering that it always

Î)
~
,~
~
garneredmassive central bank support during its critical phases. The extent 9f this support can be
measured by the increase in dollar reserves held by foreign central banks with the Federal Reserve.
Between the end of 1985 and early 1991 foreign-held reserves rose from $121 billion to $286 billion.
Just how low would the dollar be without the benefit of the central banks' safety net?

MYTHS AND FACTS. . .

During the dollar's surge of 1989, it was widely argued that superior prospects for U.S. inflation and
trade balances particular, relative to Japan and Germany
-

would accelerate capital inflows to the

-

U.S. and thus strengthen the dollar.

A substantial improvement in U.S. trade has occurred, but the inflation petformance has turned out
to be a great disappointment. Even while the U.S. economy has progressively weakened since 1988,
the inflation rate has persistently risen.

. . . ABOUT INFLATION

More recently, both the u.s. trade and inflation pictures have improved more markedly while
Germany, on the other hand, shows rising inflation -
possibly rea~hing or exceeding 4% coupled-

with a drastic deterioration in its trade balance.

English-speaking economists are making a lot of hullabaloo from these facts . . .

far too much, in our
)
Currencies and Credit Markets \ July 1991
_i

~\
view. The salient point is that these economists misrepresent the time-limited effects of plain cyclical }
influences as new sustainable long-term trends.

Apparently, we are not alone in observing this deception as the following quote from Samuel Brittan
in the Financial Times of London reveals: "There is indeed more than a 50-50 chance that for a few
months from this autumn, headline German inflation rates may exceed headline British rates. One
cringes in advance at the way in which the more partisan British tabloids will celebrate. But this
completely artificial crossover.will reflect nothing more than the different cyclical
positions of the two
economies, plus the deficiencies of the British Retail Price Index, which produce wild gyrations
around the underlying inflation rate."

By all appearances, U.S. inflation is stuck around 5%. That's the highest level since 1982, showing
aslow but steady uptrend ever since 1986.

In our view, despite the almost unanimous optimism over U.S. inflation prospects, there is at least
one compelling reason for pessimism: that is the savage compression of corporate profit margins
from a peak of 7% in 1985 to barely 3.5% recently. That profit squeeze, by the way, 'well predates
the start of recession. Quoting Keynes: "Cheapness which means the ruin of the producer is one of
the greatest economic disasters which
can possibly occur."

The chronic compression of profit margins in the U.S. suggests that any recovery might quickly ron
into rising inflation as businesses try to improve their profit margins.

. . . AND TRADE BALANCES )

In short, those flattering comparisons of falling U.S. inflation andrising
German inflation are a joke.
What's even more pathetic are the far-reaching conclusions that are drawn from the reversals in the
trade balances in regard to international competitiveness. Here, too, it's blatantly evident that these
trade-balance movements chiefly reflect a dramatic reversal in domestic demand growth between
America and the rest of the world and particularly Germany.

The bottom line is that domestic demand growth in Europe and Japan has outstripped U.S. domestic
demand growth ever since 1987. During 1988 to 1990, domestic demand for all industrial countries
overall (excluding the U.S.) increase4 by 13% against only 5.5% for the United States. More
recently, the greatest contrast is between
Germany where domestic demand growth has accelerated
to 5% and higher while U.S. domestic demand has been shrinking at an annual rate of 5%.

As a
matter of fact, it is
rather scary to think that both the United States and Britain still have
substantial trade deficits in the depth of recession. Recession is not a lasting substitute for lacking
competitiveness.

COMPETITIVENESS IN PERSPECTIVE

One glance at Table I on the next page puts the international competitiveness debate into sharp focus.
It shows the cumulative move of prices, wage rates, productivity and unit labour costs for Britain,
)
Currencies and Credit Markets \ July 1991
 5

() Germany
Purchasing
and the
Power Parity, pales
last five years. The pet theory obsessing Anglo-Saxon economists,
u.s. during the
when one puts these sharply diverging performances into perspective.

Looking at these and

many other figures, COST AND PRICE TRENDS

we are awe-struck at Cumulative, 1985-1990
the sophistry and
bamboozling skill
Britain U.S.A. German v
with which British
and American Hourly Wage Rates 49% 24% 31%
economists have been 38% 25% 9%
Consumer Prices
painting doom and Productivity 8% 4% 16%
gloom about the 45% 17% 10%
Unit Labour Costs
German economy and
euphoria about their
own economies.

Is that too harsh of an assessment? Just for fun, can you recall the comments several years back
when the United States and Britain had soaring trade deficits and Germany was sporting a soaring
surplus? The media and analysts then extolled these deficits as virtuous emblems of economic
dynamism while German surpluses were decried as the sorry symptom of "euro-sclerosistl. The
conclusion, of course, was the same as now: the dollar and the pound should therefore be strong and
the D-mark should be weak.
)
/

SELECTIVE WALL STREET ECONOMICS

Many Wall Street and City of London economists operate with two different sets of economic
theorems one for their own economies and another one for non-English-speaking countries. As
-

long as inflation accelerated in Britain and the United States, this was interpreted as being bullish for
their two respective curr~ncies on the ~sumption that it would necessitate higher interest rates. Now,
as inflation rises in Germany, another set of economics applies, of course, supporting a bearish stance
on the D-mark.

One of the worst aspects of the U.S. economic develop'ment, no doubt, is the collapse of net fixed
capital investment in manufacturing. For good reasons, Wall Street has treated this severe problem
just like any other with silence. But to our boundless astonishment, we have now learned from an
-

article by the chief economist of Morgan Stanley, Stephen Roach, that record-low investment is not
only non-problem but rather a blessing. He writes: "The anaemic pace of capital formation in the
a

1980s means that, going into this recession, businesses did not make the classic mistake of bringing
new plants on line precisely when the economy was about to hit the skids.... For you "double-dippers"
[forecasters of a second economic down-leg], capital spending does not seem to be a leading suspect
that might prompt another leg down in the current recession." Simply paraphrased, because industry
investment is already at low levels, investment cannot fall further.

Unfortunately, anaemic manufacturing investment transcends this recent cycle and has already lasted
)
Currencies and Credit Markets \ July 1991
 6

for more than a decade.

In any case, focusing narrowly on
manufacturing non-investment
ignores the huge malinvestments in real estate
and the associated wholesale
destruction of S &
completely):
banks and insurance companies. Not a single L's,
word about such little calamities
Roach's article. We call this "selective are found in Mr.
Wall Street economics".

GERMANY: UNIFICATION A SCAPEGOAT

Ever since German unification

became a
reality, international pundits
journalists have been the worst
-

British economists and

-

have persisted in painting a picture of impending

financial disaster for the German economic and
economy and its
currency.
A quote from a
recent article in the Financial Times
captures the mood: "It is
reasons why east Germany will become Germany's easier to think of
mezzogiorno, with the
or its Ireland without them, rather than why it current level of transfers,
will succeed. The persistent optimism
partly explained by an unwillingness to contemplate "
seems to be
failure.

If the author had

ever looked
at a map, he might have
Leipzig and Messina: discovered an important difference
between
namely, rather different distances from
invest in east Germany? Europe's centre. Why should businesses
Because it is centrally located and because it
people. has a reservoir of skilled

Admittedly, the German economy is split

into two pans with singularly contrasting
old West is boOming with conditions. The
growth rates last seen in the early 1970s;
the old East is
However,the parts are not equal in
COllapSing.)
size. As measured by real GNP, the booming
an overwhelming 90% of the total. But most West comprises
international analysts and gossip sheets
for the 1O%-slice of Germany only have eyes
that's on the operating table.

Nevertheless, the
great theme that has served to spread
doom and gloom about
excessive unification costs Germany is that
and associated fIscal and
monetary policies will drag down the
economy while the U.S. rebounds. We German
have come across
them all. many theories in our life. This one beats

Precisely the opposite is

true, both over the short
effect is a powerful demand boost run and the long run. Unification's first obvious
from the East to the West,
fmanced by huge
from West to East. While most of the East's demand is being immediately transfer payments
Germany, there is a large and growing recycled to West
by the rapid spill-over effect on the whole of West Europe
as measured
disappearance of Germany's former
current-account surplus of DM 107 billion in 1989.
That shift mainly reflects
soaring German imports from the rest of Europe
into Europe's and has turned Germany
growth locomotive.

A MOST SUCCESSFUL OPERATION

One thing is clear: Unification

means that West Germany will have to plough
of resources into what was East an enormous amount
Germany. In order to achieve this adjustment
without launching

Currencies and CredJt Markets \ July 1991

o

_._n_O"T""'F"".....;--.'. .......'....,....:~7"~~~

..,;;t
..:.....:-=-:~
 7

) inflation against the background of ån already booming West Germany, such resources must be
withdrawn or "crowded out" from somewhere else.

Right from the beginning, it has been eminently clear that the natural and prime target for such
a

"crowding out" in favour of unification would have to be Germany's huge export surplus. Neither
domestic consumption nor domestic investment need to be bridled. Rather, the resources tied up in
producing the export surplus had to be redirected towards the domestic market.

What was it that implemented this rapid, whopping resource transfer? It was a combination of three
things: tight money, a soaring budget deficit and a highly responsive German investor who massively
switched his new investments from foreign to German bonds. Considering the speed and the scale
of the operation, we can only say that is has proved to be a smashing success.

A SILVER LINING FOR EAST GERMANY

Fuelled by an mvestment boom- in the West and by consumer demand in the East, the West German
economy has continued to boom with an inflation rate well below that of other countries mired in
1991 rose
deep recession. Compared with the last quarter of 1990, real GNP in the rrrst quarter of
at an annual rate of 10%.

But what about the economic collapse and depression in East Germany? For the time being, no
though real incomes have been
doubt, soaring unemployment and uncertainty cause human duress
boosted. But the economic and financial problems are manageable when seen against the nation's
t:: huge pool of capital reserves, thanks to high savings and investments. Even the pessimists agree that
in the longer-run, unification will unleash new economic energies for Germany as
a whole. When

will the long run start? That's the key question.

From what we hear and read from competent people, we would say that an upturn in East Germany
should be under way by early next year at the latest. Then, we think, good news items will increase
relative to the incidence of negative articles. Some research institutes expect that industrial
production will bottom this autumn and then rise by 10% annually between 1992 and 1995. That
1990 and an expected 20% in 1991.
compares with a decline of 13% in

So far, services are the main pillars of growth, especially so financial services, retail trade and
communication. Already, available telephone lines have been quadrupled. Later this year, as
institutional obstacles are overcome, many and varied incentive and pr~motion programs should
trigger off a considerable upswing in corporate and public investment. A
double-digit growth rate
is considered a realistic possibility as of 1992.

sides: first, from

Inflationary pressures, in the meantime, are building up in West Germany from two
it seems
a general 7%
wage rise; and second, due to recent increases in indirect taxes. As result,
a

is
reasonable to expect a temporary inflation-peak of 4% to 4.5%, a rate which intolerable for
tightening by the
Germany. If inflation were to rise that high, further measures of monetary
Bundesbank would be a virtual certainty, whatever the economic situation. At the very least, there's
no hope of any relaxation in any monetary policy.
~)-_._~
t - .

\
Currencies and Credit Markets July 1991

.
 8
--l
~r/

UNITED STATES: GNP GROWTH

(Year-over-year, percent change)
6
:
:
:
:
~ I
. . . I .
~
. < . .
'1 .
.
,,,
.

; I
. :
.

4 . .
: "
,
~ . . . . I
-t ." . I I . .
,,,
:

:
.
:

3 . ".
.
. ,
IIIIi
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:
:

2 ;
II
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I
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I:
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.
:

1 : ~

-11 I:
. .

..
. . .
'I'
: f

:
ø

:
~I
:

-1 .1 ge~- 1986 .1987 1986 1999 i 99Ø 1 991

Source: Datastream

RELATIVITY: VIIS.A. VERSUS GERMANY

))
Week after week, we have been reading a load of reports, all of which ring the same refrain: The
dollar must rise because the U.S. economy is recovering while the D-mark must fall because the
gauging by the two facing
German economy will relapse throughout the course of the year. Well,
distinguish between economic weakness and
charts, we have some semantic problem trying to
economic strength. We can't help but wonder about relativity.

It seems to us that most economists put too much emphasis on incremental growth percentages,
completely disregarding economic levels. If German GNP growth were to slow to 3% in 1991 from
4.6% in 1990, or even to 0% growth later in the year for that matter, it would still be at boom levels.
By contrast, if U.S. domestic demand increases 2% after falling almost 5% at an annual rate over the
last two quarters, it would still be at recessionary levels, although not as low as before. Obviously,
these different absolute levels of economic activity must also have differing implications for interest
rates.

THE BIG QUESTION: A U.S. RECOVERY?

The central question for the world economy and world financial and currency markets is whether
there will be solid and sustained recovery in the U.S. economy. Irrespective of the odd statistical up-
ticks, our view remains unchanged. Immutably, unquestionably, every single fundamental monetary,
financial and economic indicator speaks against any possibility of such a recovery.

The potential for a sustained, strong recovery from recession depends on two all-important processes
:..1\-....
_f'....-..'.
V
Currencies and Credit Markets \ July 1991

L
 ","J"

-...-:"""
~

-)
GERMANY: GNP GROWTH
(Year-over-year, percent change)
6

~ . . . . . , .
. . . . .

q , . . . . . .
"'

f . .

:) r .
. . r . . .

2 . . . . , .

1 . .
. . '.

ø
I I 1
1
1'9~ 986 1 SJB'7 199 1999 1
'90 991

Source: Datastream

in the monetary and fmancial sphere: sufficient money creation by the banking system and business
) reliquefication. Neither is in evidence.

FROM CREDIT CRUNCH TO A CREDIT DEADLOCK.

As elucidated in the last letter, overall liquidity and money supply growth is determined by the
expansion of bank lending and bank investments. No other fm"ancial intermediary shares this ability
of the banks to create liquidity. That's why the banks hold the key to money supply growth.

Many econonùsts, though, have the bright notion that the U.S. banking
system has become redundant,

arguing that its role has been superseded by other fmancial intermediaries. The fact is that an
expansion of financial assets say for insurance companies or pensions funds
-
doesn't add a núte -

to the money supply. These intermediaries can only shift money. They cannot create money.

Lately, talk about credit crunch has waned. However, the banking figures actually show that it's
a

getting worse and worse, not bener. The credit crunch has turned into a credit deadlock. Bank credit

growth, including bank investments, has been zero. At the end

of May, total loans and security
investments of all commercial banks stood at $2,750 billion as against $2,750.9 at March-end. And,
since the end of 1990, these assets have only risen at an annual rate of 2.3%. Such a credit blockage
is absolutely unprecedented. Table II below draws out the relevant comparisons.

aggressive monetary easing has

Measured by the decline in the Fed funds rate, it may seem that an
lending activity of the commercial banks,
occurred. But, measured in terms of the and investing
money and credit are tighter than ever before. even tighter than under the helm of Paul Volcker's . .

p )
/

Currencies and Credit Markets \ July 1991

rTP
 10

)
U..S.. OOMESTIC F1NANCIAL STATISTICS: LOANS AND SECURITIES
(BIUlons of dollars, all ngureS annualized)

~ ~ 1982 1983 1984 ~

Total Loans andSecuritJes 1239.6 1316.3 1412.0 1568.1 1716.8 1895.5
(percent Change) 9.13% 6.19% 7.27% 11.06% 9.48% 10.41%
U.s. Government Securities 110.0 111.0 130.9 188.0 260.3 270.1
(percent Change) 16.40 0.91 17.93 43.62 38.46 4.00
Total Loans and Leases 915.1 973.9 1042.0 1132.6 1316.5 1450.3
(percent Change) 1.67 6.43 6.99 8.69 16.24 10.16
Commerdaland industrial 326.8 358.0 3923 413.7 469.0 488.6
(percent Change) 12.23 9.55 9.58 5.46 13.37 4.18
Real Estate Loans 2526 285.7 303.1 335.5 376.2 423.2
(perct21t Change) 8.47 8.80 10.69 12.13 12.49
6.09

1986 1981 1989 1991*

12M ..!22Q

Total Loans and Securldes ,

2089.8 2233.0 2417.2 2577.4 2723.6 2150.0
(percent Change) 10.25% 6.85% 8.25% 6.63% 5.67% 2.33%
U.s.. Government Securities 309.8 335.0 361.4 454.2
396.9 484.9
(percent Change) 14.48 8.10 7.88 9.82 14.44 16.22
Total Loans and Leases 1583.0 1703.6 1861.9 1999.2 2093.8 2091.1
(percent Change) 9.15 7.51 9.30 7.37 4.73 -0.30
Commercial and Industrial 541.4 562.4 601.9 634.2 648.1 633.2
(percent Change) 10.81 3.88 7.02 5.37 2.19 -5.52
Real Estate Loans 489.0 588.4 672.0 754.8 836.5 854.7
(percent Change) 15.55 20.33 14.21 12.32 10.82 5.22
·
To May 1991 percentage changes annualized.
Source: U.s.. Federal Reserve BUUedn
)

ferocious squeeze of 1980-82. What, then, is driving the stock market? It definitely
isn't excess
liquidity in the
monetary sense, as so many Wall Street gums like to assert.

CORPORATIONS ARE ANOTHER IMPORTANT KEY

The potential for recovery, as already cited, also depends critically

on the health of the corporate
sector. If banks are the engine of money and credit creation then corporations are the chief engine
of employment, income and GNP
growth. A key cause of this recession has been a prolonged period
of severe job-cutting by corporatio-ns which has
given rise to a curtailment in consumer incomes and
spending. In this respect, the corporate sector holds a key role in laying the
groundwork for
consumer spending and an economic recovery.

No, we have to say that

U.S. corporations are not at all ready for a recovery, least of all the
manufacturing sector which is exposed to the combination of a liquidity and
profit squeeze. Most
of the corporate profit gains since 1981-1982 have
occurred abroad. Since 1988, domestic profits
have plummeted from $106.5 billiqß to a level of barely $70
billion..

Measured in terms of the sky-high stock market prices, corporate health seems to be
at its most hale
ever never mind that mundane things like corporate liquidity and profit margins have hardly
ever been
.;'-).~""
'..
Currencies and Credit Markets \ July 1991
I~-
11

~ ') more miserable.

staff like to argue that corporations don't need the

Wall Street gurus and Federal Reserve Board
liquidity instead through a torrent of stock and bond
banks any more and. that they are getting their
issues. There's
nothing new in the latter channel. It's the normal pattern that U.S. recoveries are
to the
preceded and associated with a drastic shift in corporate fmancing from the banking system
securities markets...

this both bonds and stocks ran at

new security issues since the beginning of
-

To be sure, year -

Accounts for the first quarter of 1991, we

a high tide. However, according the Fed's Flow of Funds
corporations raised new funds .by
figures. ill the aggregate,
notice that there is a lot of air in those
Since this figure includes all external sources'
a net amount of $3.8 billion during the frrst quarter.
liquidity is almost
of funds, including equity and bond issues, the net impact on aggregate corporate
immaterial.

falling
liquidity has shown a deteriorating trend ever since 1988 as
As matter of fact, U.S. corporate
a

external financing coincided with declining internal fmancing. In 1988, total net new internal and
$548 billion. By the fourth quarter of 1990, this figure declined to
external fmancing amounted to
$421 billion at an annual rate. The frrst quarter of this year didn't see any improvement.

A significant cause of this shrinkage in corporate liquidity has been the fact that U.S. corporations
spite of declining profits. In 1989, dividend payments of $80.5
have boosted dividend payments in
billion compared to ato $68.8 billion in undistributed profits. In the first quarter of this year,
þ ) dividend payments ballooned to a level of $115 billion while undistributed
profits from domestic

sources vaporized to zero.

CONCLUSIONS

markedly. Of course, it is easy

Recent data suggests that the slump in the U.S. economy has slowed
a straight line. What guides us more than
to understand that an economic downturn doesn't occur in
influences that
the feverish short-term number mania are the fundamental, cyclical and structural
profit margins, the credit crunch,
caused the recession in the fITst place. Factors such as record-low
falling employment and falling consumer incomes are not
only not improving, they're worsening.

needs lots of monetary and fmancial fuel. That's not

forthcoming
Every sustained economic recovery pivotal point.
this time. Most American banks have neither the profit nor the
capital to expand4 It's a

The
The real estate crisis that destroye<i the S&L's has caught up with the
commercial banks.
undeniably stark. Between 1980 and 1991, U.S. banks
statistics displayed in the table on page 10 are
have increased their real estate loans from $262 billion to $854 billion. That compares to an increase
$32648 billion to $626.5 billion.
in commercial and industrial loans from

add the even bigger crisis dogging the S&L's.

crisis, Here, a rapid
To the smouldering bank
figures speak for themselves. In
expansion turned into a rapid contraction almost overnight. The
1987 and 1988, S&L loans expanded
1988, the S&L's accounted for $1,300 billion in total assets. In
$93 billion and $86 billion, respectively. contracted by $94 billion in 1989, $138
Conversely, loans
þ ,) \
Currencies and Credit Markets July 1991
 12

billion in 1990, and at an annual rate of $166 billion in the first quarter of 1991.

Meanwhile, more and more problems are bubbling up in insurances companies and pensions funds.
With all these crumbling fmancial edifices, we ask ourselves, who will fmance the U.S. recovery?
The answer is nobody.

The structural problems afflicting the U.S. economy alone are sufficient to support our negative long-
term outlook on the U.S. economy. Previous letters have analyzed these structural factors in detail,
including underinvestment, low savings, overconsumpti~n, high unproductive debt, to name a
few.

The spreading financial problems, in isolation, have serious negative implications and are sufficient
to block the U.S. economy all on their own. Adding the structural and financial problems into the
same brew makes the situation all the more intractable. Try as we might, we see no potential for a
sustainable U.S. recovery.

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Q
Currencies and Credit Markets \ July 1991