The Daily Reckoning
Ouzilly, France
Thursday, August 03, 2006
The Daily Reckoning PRESENTS: Dr. Richebächer's look at how central banks
manipulate the interest rate. With zero savings and runaway credit
expansion, the United States ought to have sky-high interest rates, but
with a little "help" from our Asian central-bank friends, we've managed to
keep an absurdly low long-term rate. The good doctor explores...A CREDIT MACHINE RUNNING AMOKby Dr. Kurt Richebächer
The Anglo-Saxon countries have been the high-growth economies among the
industrialized economies. By definition, strong economic growth implies
that domestic investment exceeds domestic saving. Actually, Mr. Bernanke
and others have repeatedly justified the capital inflows with the fact
that capital investment exceeds domestic saving.
On the surface, this is true. But this description represents a grotesque
distortion of the economic reality. What has truly happened in the United
States and the other English-speaking countries is that private
households, in response to inflating house prices, have slashed their
savings even faster than businesses slashed their capital investments. As
a result, minimal investment exceeds nonexistent domestic saving. This
explains their stronger economic growth.
To illustrate this with a comparison: In France, the personal saving rate
is hovering lately at around 11.4% of disposable income, literally the
same level as in 2000. This stability in savings has prevailed despite
sharp rises in house prices because everybody in France regards this as
inflation, not as saving. Living systematically beyond one's means is not
a way of life in France and many other countries.
In the United States, personal saving over the same period has slumped
from 2.3% of disposable income to -1.6%. The key point to see is that the
stronger growth of the Anglo-Saxon countries had one single overriding
reason, and that was to boost consumption at the expense of savings. If
the United States had the savings rate of most European countries, it
would be in depression.
Now to the U.S. economy. With zero savings and runaway credit expansion,
the United States ought to have sky-high interest rates. Thanks to large
bond purchases by the Asian central banks and the virtually limitless
availability of carry trade in dollars and yen, implemented by the two
central banks, U.S. long-term interest rates have held at absurdly low
levels. On the surface, interest rates are determined in the markets. In
these two countries, they are heavily manipulated by the central banks.
Strikingly, the Fed's 16 rate hikes over the last two years have done
nothing to curb the recorded domestic credit expansion. Yet dollar carry
trade, which also has played an important role in funding highly leveraged
asset purchases, is dead in the water, simply because short-term rates
have caught up with long-term rates. Astonishingly, the bond market has
only minimally reacted.
Barely noticed, the U.S. credit machine ran amok again in the first
quarter of 2006, revealing the Fed's tightening as a farce. Nonfinancial
credit expanded $2,914.0 billion, annualized, up from the prior quarter's
$2,434 billion. Together with an increase in financial credit by $1,479.2
billion, the total adds up to $4,392.8 billion.
Compared with an increase by $827 billion in 2000, credit and debt growth
has quadrupled. Total outstanding indebtedness rose to $41.8 trillion,
equal to 334% of nominal GDP and 376% of real GDP. In the first quarter,
$4.30 of additional debt was added for each dollar added to nominal GDP
growth and $7.50 additional debt for each dollar added to real GDP growth.
Until the late 1970s, this credit-to-GDP ratio had held at a steady rate
of 1:1.4 for over 30 years.
In a country without domestic savings, the money for such a runaway credit
expansion must implicitly come from credit creation through the domestic
financial system and foreign investors and lenders.
Strikingly, in the first quarter, U.S. commercial banks boosted their "net
acquisition of financial assets" by a blistering $957 billion, annualized,
as against $791.1 billion in 2005 and $472.4 billion in 2000. Net
acquisitions of security brokers and dealers surged at an annual rate of
28%, to a record $611 billion. Foreign net acquisitions of financial
assets in the United States rocketed to $1.492 billion, against $889
billion in the prior quarter.
Sorry for all the figures, but knowing them is of greatest importance.
They contain the solution for the famous "conundrum" of stable U.S.
long-term interest rates defying all the rate hikes. There were rate
hikes, yes, but measured by the pace of the credit expansion, there has
not been the slightest monetary tightening. Instead, the Fed has
accommodated runaway and permanently accelerating credit growth.
Nevertheless, as explained, the rate hikes at the short end of the yield
curve have cut off the dollar carry trade. But it has been replaced
through sharply accelerating U.S. domestic bank credit expansion, and
further highly leveraged carry trade in yen, but perhaps also in euro and
the Swiss franc and bond purchases by Asian central banks.
Of course, rate hikes are generally applied to put a brake on credit
growth and price inflation. The fact that in the United States the credit
expansion sharply accelerated exposes the rate hikes as an outright sham.
The point is that the Fed kept the banking system liquid enough to
continue an aggressive credit expansion.
In the case of private households, the lure of higher house prices has
plainly more than offset any restraint from higher interest rates, what a
central bank ought to take into account. We doubt that they ever wanted
true significant restraint in borrowing and spending, because they are
afraid of it happening. They want lower inflation, but not lower
spending.
Household debt expanded in the first quarter of 2006 to $1,333.9 billion,
annualized, a new record. Business debt soared by $864.3 billion, up from
$611 billion in 2005. Financial credit jumped by $1,479.2 billion, against
$1,036.7 billion in 2005. Any talk of credit restraint is absurd.
Yet the most important credit source for economic activity during the past
few years is running out of steam, not because monetary conditions have
become tight, but because the delivery of collateral for higher borrowing
against rising house prices has slowed sharply in line with their sharp
slowing. Popular year-over-year comparisons, by the way, are deceptive.
What matters are the recent changes.
Purchasing power currently spent comes from income or credit. In times of
yore until 2000, U.S. private households got their purchasing power, like
everywhere else in the world, overwhelmingly from current income, provided
by increases in employment and real wages. During 1995 to 2000, overall
real disposable incomes rose over 4% per year on average.
Yet since the early 1980s, there has been a steadily growing resort by
households to borrowing, as reflected in a steadily falling savings rate.
After 10% of disposable income at that time, it was down to only 2.3% in
2000.
From then on, the relationship between income growth and debt growth has
radically reversed. Debt growth has escalated ever faster in comparison to
income growth. Real disposable income growth, even though heavily
bolstered through tax cuts, averaged only 2.7% until 2004. In 2005, absent
new tax cuts, it grew a mere 1.3%. Over the first four months of 2006, it
has been zero.
This recovery of the U.S. economy since November 2001 has been dominated
by an unprecedented consumer borrowing-and-spending binge. In the first
quarter of 2006, consumer debts had risen 70% from 2000, against an
increase of real disposable incomes by 12%.
American policymakers and economists find it convenient to speak of
"asset-driven" economic growth, in contrast to the "income-driven" growth
pattern of the past. First of all, we object to this juxtaposition.
"Asset-driven" is a euphemism for "bubble-driven," because what matters is
not the existence or creation of assets, but their soaring prices
celebrated as "wealth creation." The second utterly negative point to see
is that this asset price inflation has been manifestly driven by
ultra-cheap and loose money and credit, and not by saving and investment.
Since 2001, surging house prices providing ballooning collateral for
consumer borrowing plus massive fiscal stimulus have been instrumental in
offsetting the contractive effects of the bursting equity bubble and in
generating the following recovery, but a recovery of gross failings.
With short-term rates now up to 5% and the housing bubble slowing down,
the possibilities of borrowing are bound to shrink. To nevertheless
maintain further increases in consumer spending, much stronger income
growth will be needed either through higher real wage rates or higher
employment.
What are the chances? In brief, employment and income growth are
worsening. First of all, wage growth is barely matching the rise of the
inflation rate. So everything depends on stronger employment growth.
This, however, dramatically deteriorated in April and May. Instead of an
expected 400,000 new jobs over the two months, the reported gain was a
miserable 208,000, even though the Bureau of Labor Statistics (BLS)
fabricated record phantom job growth through its dubious "net birth/death"
model - 271,000 for April and 211,000 for May. Yet even including these
482,000 phantom jobs, the reported figures are flatly awful, implying
further income stagnation, if not worse.
With these numbers, the BLS is apparently making the ridiculous assumption
that employment growth among new small firms outside its survey must be
booming, while sharply falling in the economy as a whole, captured by its
survey. It is always amazing how readily the consensus accepts such
manifest nonsense. Wishful thinking prevails over serious analysis.
Looking at the monetary aggregates, something else strikes us as most
ominous, and that is the difference between record-strong double-digit
credit and debt growth and record-low growth of the money supply. M1 and
M2 gained 3.2% and 4.9% over the last quarters. Adjusted for CPI
inflation, this was close to zero for M1 and up just 1.3% for M2. We
regard this as ominous because credit stands for debt, while money supply
stands for liquidity.
Recently, we made an inquiry among American friends, posing to them the
question whether there is any thought or talk in public of a possible
recession in the United States. It occasionally pops up in the press, we
learned. But the consensus opinion, in particular on Wall Street, flatly
discards it as a possibility. It was precisely the answer we had expected.
It is a historical fact that American policymakers and conventional
economists have never foreseen a recession. In 2000, the Fed hiked its
rate twice during the first half, just before the economy began its slump.
Equities already had started to crash in March. Reading several reports
with forecasts published in late 2000, among them the OECD Economic
Outlook, we found nowhere the slightest hint of a coming recession.
There seems to be a general conviction, cultivated not just by Mr.
Greenspan, that the U.S. economy has become virtually immune to recession.
It is widely seen as just a bursting of strength due to ingrained
"flexibility" and "dynamism." In addition, there is, of course, unbounded
faith in the virtuosity of the Fed to avoid a serious recession with swift
action.
Regards,
Dr. Kurt Richebächer
for The Daily Reckoning