The Crucial U.S. Imbalance
Source"...In essence, it is the task of central banks to keep new savings and new credit in equilibrium through their interest policy. Implicitly, any lending in excess of current savings essentially causes imbalances and distortions in the economy or in the financial system. It strikes us that Mr. Greenspan and American policymakers do not care in the least about saving... Yet next to high-savings Japan and Switzerland, America now has the lowest interest rates in the world..."
By Dr. Kurt Richebächer
America's crucial and by far single-biggest imbalance is definitely the one between minimal domestic savings and virtually limitless credit growth. It used to be a truism among economists that in a healthy and well-balanced economy, the supply of sound, noninflationary credit is strictly limited to the supply of available domestic savings out of current income.
For the old economists, saving is not only desirable for investment, but indispensable. As people consume less than their current income, they release productive resources for the expansion and improvement of the economy's stock of plant and equipment. These physical facts are basic. In other words, saving is more than money. Without such savings the economy's capital stock will stagnate or shrink. It is the function of credit to make those resources, released by saving out of current income, available to the borrowers.
In 2002, total credit expanded in the United States by $2,286 billion, of which $1,363.7 billion was nonfinancial, and $922.4 billion financial credit. This compared with net national savings of $286.7 billion.
In essence, it is the task of central banks to keep new savings and new credit in equilibrium through their interest policy. Implicitly, any lending in excess of current savings essentially causes imbalances and distortions in the economy or in the financial system. It strikes us that Mr. Greenspan and American policymakers do not care in the least about saving.
In the United States, net national saving -- combining the savings of consumers, business and government -- has always been among the lowest in industrial countries. But lately, it went increasingly out of existence. With the soaring federal budget deficit, it is now on its way into negative territory. Yet next to high-savings Japan and Switzerland, America now has the lowest interest rates in the world.
Another Gigantic Bubble
How is that possible? In short, through the heavily leveraged carry trade, borrowing at the low short-term rates and investing into much higher-yielding bonds. It was a regular cyclical play that positively helped to lower longer-term interest rates in times of slow economic growth. As soon as the economy recovered and a rate hike by the central bank came into sight, the speculators unwound their positions, sometimes with temporary setbacks for long-term rates.
But in the last few years America has broken completely new ground in this respect. In the virtual absence of new net savings, the leveraged carry trade is no longer marginal in the markets. It has become the market.
Looking at the steep decline of U.S. long-term interest rates, it has been a smashing success. In recent weeks, in particular, Treasury yields dived close to postwar lows. It was apparently inspired by one sentence in Mr. Greenspan's recent congressional testimony: "Indeed, we have reached a point at which, in the judgment of the Federal Open Market Committee, the probability of an unwelcome substantial fall in inflation over the next few quarters, though minor, exceeds that of a pickup in inflation."
What was so inspiring in this sentence? Expectations of an imminent U.S. recovery had been suggesting that the Fed was finished with its rate cuts and that the next move would be upward. But by remarking that he worried more about an unwelcome fall in inflation than a pickup, Mr. Greenspan suppressed any such fears, evoking instead the possibility of another cut. Speculators eagerly seized the opportunity to pile up on their carry trade.
Being completely driven by borrowed money, America's booming bond market is in reality just another gigantic bubble, but one that is highly vulnerable to the slightest rate hike, or even only the threat of it. When the Fed moved up its federal funds rate by just one quarter of one percentage point on Feb. 4, 1994, it shattered the bond market by triggering massive forced selling on the part of highly-leveraged speculators. In the fall of the year, the 30-year Treasury bond yielded more than 8% as against less than 6% a year earlier.
Since then, the carry trade bubble has multiplied, essentially implying a far greater shock to the bond market from any rate hike than in 1994. But there is still another important difference between then and today. Then, the bursting carry trade bubble hit a strong and sharply recovering economy that easily absorbed the sudden surge in long-term rates.
This time, manifestly, a far greater shock to the credit markets would hit a far more fragile economy. For us, there can be no doubt that it would nip any possible moderate rebound in the bud.
Massive Stimulus Wasted
It is the consensus view in America that prolonged recessions and depressions, as in the 1930s in America and as presently in Japan, have their key cause in the failure of the central banks to cut their interest rates rapidly enough. Plainly, the Fed is determined to avoid that mistake.
While Mr. Greenspan and many others claim full success to this policy, we see a shocking and frightening discrepancy between the massive overall stimulus and its extremely poor effects on economic activity. Moreover the latest data point distinctly towards double dip, not recovery.
But why? In short, it has its reason in the persistence of the very same aftereffects of the bubble that caused the economy's downturn in the first place. While the Fed's aggressive easing may well have prevented an immediately deeper and longer recession, it has also prevented any correction in the bubble's legacy of growth-impairing imbalances and dislocations.
Between 2001 and 2002, the Federal Reserve slashed its overnight rate 12 times from 6.5% to 1.25%. At the same time, the Bush tax cuts and the economy's weakness have turned a federal budget surplus of $295.9 billion in 2000 into a $257.5 billion deficit in 2002, with the prospect of a further rise to $400-$500 billion in the current year. Together, this represents the most prodigious economic stimulus in history.
Although personal incomes rose in 2001-02 by $671.2 billion, tax payments fell by $180 billion. Plunging mortgage rates and rising house values enabled millions of homeowners to extract approximately $1 trillion from their home equity during those two years. Measured by this number, it was the most potent interest cut under the sun. Yet consumer spending slowed to $715.3 billion overall in 2001-02, from $818.9 billion in the two prior years, 1999-2000. With all the mortgage refinancing, it was down to an annual rate of $309.6 billion in the first quarter of 2003.
There is a widely held view in the markets that the U.S. economy, though performing much worse than expected, is nevertheless outperforming all other countries. Measured in aggregate real GDP, that is true. But the superior quantity of growth has been concealing a most miserable quality in terms of its composition.
Last year, U.S. real GDP grew by 2.4%. Of this total, personal consumption accounted for 2.12 percentage points, or 88.3% of the growth. Further substantial contributions came from government spending (0.81 percentage points, or 33.7%) and from higher inventories (0.60 percentage points, or 25%). Against these three major additions stood two major subtractions: nonresidential fixed investment (-0.68 percentage points, or 28.3%) and net exports (-0.61 percentage points, or 25.4%).
Basically, recessions are the phase in the business cycle in which consumers and businesses, forced partly by tight money and credit, restrain and correct their boom-related borrowing and spending excesses and return to a desired and sustainable consumption-savings-investment pattern. Inevitably, such retrenchment curtails demand and slows the economy. The regular, striking features of the adjustment process, paving the way for the next recovery, are higher rates of personal and business saving.
The U.S. economy is clearly in an adjustment crisis, but its extremely ill-structured growth pattern of 2002 reveals a total lack of the adjustments necessary for more balanced growth. Rather, existing maladjustments keep worsening.
Respected International Banker, Economist and Author
Dr. Kurt Richebächer's articles appear regularly in The Wall Street Journal, Barron's, the US edition of The Fleet Street Letter and other respected financial publications. France's Le Figaro magazine did a feature story on him as 'the man who predicted the Asian crisis.' Dr. Richebächer is currently advising investors on how to profit from Greenspan's mistakes.