November 19, 2005

International Precious Metals & Commodities Fair - Munich, Germany
Transcript of Dr. Kurt Richebächer's Lecture

Ladies and Gentlemen,

My first journey to the United States occurred in the year 1962. (By the way, I stayed in the Moritz Hotel at South Central Park and it only cost me ten dollars.) I had a recommendation from the German Central Bank to the US Secretary of Treasury, who asked me when I approached him, "Would you like us to meet together?" I said "Well ok, - yes please". Immediately, he called somebody and there came a very tall, young man and it turned out to be Paul Volcker.

Now, Paul Volcker had arranged my appointments with the other economists and from that time forward we kept in close contact. It was also through him that I was able to meet with leading economists. I had been in contact with leading economists in America for about 40 years, but that practically ended in the 80's. The discussion in the 90's became so crazy, that I stopped wanting to speak with any American economists. In particular, it was the time of the "new paradigm economy".

If I may, I would like to begin with a quote from Paul Volcker from his Washington Post Letter, which appeared about two or three months ago. He wrote: "I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crises rather than a policy foresight that will force the change." Note: www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html

I am looking at the world economy and I can identify three groups among the industrialized nations. The first group are the Asians, led by China, and a group with very high investment savings and investment ratios. China is the leading country of this group, and is running a big surplus with America while having a big deficit with other Asian countries. So far, China is the economic and financial leader of Asia.

What I am most interested in is the difference between the two other groups. The first group are the Anglo-Saxon countries; in particular, the United States and the other group are the European countries. During the past years, we have read a lot from the Anglo-Saxon community, boasting of their superior growth, efficiency and flexibility compared to the inflexible, stupid Europeans, i.e., Germany as an example.

I have a very strong disagreement with this statement. In fact, I would say the most inflexible countries in the world are the Anglo-Saxon countries. I wouldn't say the Europeans are very flexible, but they are certainly, in my opinion, more flexible than the Anglo-Saxons.

What exactly is the particularity of the Anglo-Saxons? Well, they all have asset bubbles. I mean economic growth in the Anglo-Saxon countries during the past years has been, without exception, fuelled by asset bubbles, notably, the housing bubble. Then the housing bubble translated into a credit bubble which in turn led to the bubble in mortgage refinancing and equity extraction. The striking symptoms of this economic growth are big deficits in foreign trade. All of the Anglo-Saxon countries, except for Canada, have huge trade deficits and collapsing savings. These countries are booming on the back of consumption and they are in a pure consumption boom.

It is the opposite of Europe. They have had higher growth than in Europe, but the quality of the growth in these countries is the worst ever. Actually, I will explain later more about the development in detail but I do want to make a remark about flexibility, at this time. The general explanation is that Europe is completely flexible. We are flexible and therefore we have higher growth and they have lower growth. But that premise has nothing to do with flexibility.

First of all, I would define flexibility of a country to be the ability of coping with imbalances in the sense of improving them. If you look at the Anglo-Saxon countries, you see no flexibility in the sense of adjustment. To the contrary, you see only imbalances ever growing and growing. I mean they are completely incapable of making the slightest adjustment. It is true of all of them and America is certainly among the worst because they even glorify this anomaly.

On the other side of the coin, we see Europe with its unique problem. That problem is high saving ratios. America and the Anglo-Saxons have collapsing savings ratios but Germany has an 11% savings ratio. France and Italy are likewise in the same category, i.e., very high saving ratios and these ratios have remained high despite the weakening economy.

What has actually happened is this: we have a sharp decline in investment in all of the industrialized countries but investment in Europe is higher than in the Anglo-Saxon countries. However, it is still low to the still very high level of savings. In this regard, I am astonished that the Europeans have never explained this. The European savings ratio is the main reason for their slow growth.

In the global economy, America, of course, has played the leading role. It has played the leading role because it's running a trade deficit that has increased since year 2000 from about USD 400 billion to an approaching USD 800 billion. Now, USD 800 billion is a large amount even for an economy like the United States. The main beneficiary of this American spending and consumption boom has been China. China with a surplus of about USD 180 billion ­ more than half of that is lost again to the other Asian countries.

But the key point to remember is that China with its fixed exchange rate runs an export surplus. The problem is now, or better put, the key question is what happens to the export surplus? You know, when you think of our own experience in Germany we used to have an export surplus. The export surplus in turn liquefied the banking system which in turn led to booming investments and those booming investments even add to an export surplus. This was the general development at that time.

I now see the same development in China and China is going to succeed in my opinion. China is turning the export surplus into a credit bubble. By buying dollars, they liquefy the banking system. Then the liquefied banking system expands credit and the expanding credit forms an investment and real estate bubble. This is the development in China now. But China has an enormous savings ratio and an enormous investment ratio. Moreover, China is really going the way Japan is going. What you see in China is very much a repetition of what has happened in Japan. Both countries have bought dollars, liquefied their banking systems which in turn have created a credit bubble that has fed into an investment and real estate bubble. My question therefore is: how long can this go well for China?

Okay, let's turn back to the United States. The United States has the worst credit bubble in history. It is simply unprecedented, unimaginable, as regards to what's been happening there. When Greenspan took over, total indebtedness of the United States was USD 10,000 billion. Today, total indebtedness is 37 trillion dollars and something. I mean indebtedness has more than tripled in the United States and the question is: where did all this money go?

It didn't go into the price indexes. The Americans only really look at the price index. A stable price index means financial stability and with regard to this stability, we have strong growth. Well, for me I check the numbers. Credit expansion is always a key component to look at in an economy. When you look at the credit expansion in America from the late 70's and over these past decades, America has had a credit expansion of 1.4 dollars credit for 1 dollar additional GDP. The relationship was 1.4 to 1. Recently, the relationship is 4 to 1. For every dollar added to GDP, there are now 4 dollars added to indebtedness. This is the worst performance in terms of credit expansion in history and of course in comparison to any other country.

The question is: how is this possible? Well, one problem is that you have to question where does this credit go to? In the past and until the late 70's, I said there was 1.4 dollars additional debt for 1 dollar additional GDP. At that time, credit expansion borrowing went completely into spending by firms or consumers. Consumers and firms borrowed practically for one single reason and that was to spend money in the real economy. This changed in the 80's. There were two developments that ensued. Firstly, more and more borrowing went into financial markets. This led to the first beginnings of a stock market bubble. This all developed gradually but the connection between credit and income creation and spending loosened, thus, it became interrupted.

There was a gradual development in the sense that more and more credit expansion went into other channels, into other outlets, than GDP. And this turned wild in 1998. You remember in 1998, there was the Asian crisis, the Russian crisis and the LTCM crisis and that was a period when the Federal Reserve intervened to save LTCM. Also, since 1998 there has been an explosion of financial credit. In other words, more and more credit went into the buying of assets which drove up asset prices and in particular the stock market.

Secondly, another development/outlet was the trade deficit. The trade deficit means a contraction of domestic income. What happened in particular is that consumer spending no longer went to domestic producers where it creates income. Instead, it's going to foreign producers and is creating income for Asia. The end result means a complete loss of income. A trade deficit means dollar for dollar an equal loss of spending and income for the country with the deficit. America is now losing every year about USD 800 billion to foreign producers and of course that has an undesirable effect.

The usual argumentation in America goes something like this: "Oh, the trade deficit plays no role. We even have higher growth than the Europeans with a trade deficit, so therefore it can't be a problem." There is not even a brush of an analysis regarding how a trade deficit affects their economy. In essence, what happens is that America has had a big drain in its big income and spending stream, hence, a trade deficit that would drive the economy into recession if not depression. However, in order to prevent the weakening of the economy, it needs easy money. The trade deficit forces the Federal Reserve to create alternative credit allowing for alternative spending that creates income, and, by the way, this has happened all the time.

So the fact is this alternative credit creation must go on. That means, ultimately, a deficit country needs easy money. Let's say it like this: a deficit arises from easy money and then the Federal Reserve reacts/responds by printing easy money in the effort to compensate for the income losses. So, the result of course is, that the trade deficit has been growing and growing and has needed more and more credit to compensate for the losses.

So, at the moment the key question is: how weak or strong is the American economy? I am thinking of the press releases regarding the various rate hikes. In these press releases, the FED explains how it sees the economic situation. It says we have temporary weakening influences, i.e., hurricanes and rising oil prices which are only temporary influences. On the other hand, we still have an accommodative monetary policy and robust productivity growth and when we think of the rebuilding of the devastated areas, the economy will be stronger. And that is obviously the general expectation in America: the economy is strong and it can only become stronger, because of the building in the devastated areas.

Well, I have made my own calculations. What is my opinion? For the time being the last number that interested me very much was the retail trade numbers which were published on Tuesday. It indicated - 0.1. At the same time they announced a 4.3 % inflation rate. If you take that together you have a declining number in retail sales in real terms of about 0.5 %. But the market took it positive by saying, "We expected ­ 0.7 and instead we have ­ 0.1 which means the economy is better than expected." You know, this is a trick which they use all the time. Bad news is buried by saying, "better than expected." You can turn the worst news into the way of the best news.

I did my own calculation and was curious of what's happening because automobile sales have collapsed. The collapse began in August. July was very strong, but it fell steeply in August and it fell further in September and still further in October. And I made my calculation and it says that consumer spending fell in these three months to October by an annual rate of 7%. The fact is that the BEA ­ (Bureau of Economic Analysis) publishes every month very detailed figures about consumer spending and I use these monthly figures which are different. The quarterly figures are averages where you compare average to average. However, I find it more important to look month to month and according to these numbers, consumer spending has been in a deep slump during these three months.

My question at the moment is: will this slump in consumer spending continue or not? Let me make some remarks about the whole recovery. This recovery has been praised as a great success or a successful policy. The fact is it's the weakest recovery of all times in the United States. It is by far the weakest in every single aggregate. However, it differs according to various aggregates and I shall explain from where it comes. This impression of a successful policy and a successful recovery is created by comparing it with Germany, Europe and Japan. They say: "Look there, they are weak when we are strong."

The fact is, like I said, it's the weakest recovery of all times in the United States. When you draw this comparison you have to take into consideration that America has had the biggest fiscal and monetary stimulus of all times. The tax reductions were USD 860 billion from 2001 to 2003 - the biggest tax cuts of all time. In addition, you had the rate cuts leading to the 1 % interest rate of several years. With this entire stimulus they still had the weakest recovery of all times. No, when you compare all the different components, you see that there was a catastrophe in two areas. The first one was in unemployment and the second one was in investment. The fact is they were not satisfied with the recovery until 2003 and they decided that they had to do more.

So, they began to rapidly cut the interest rates from 6.5 % to 2 % and then later to 1 % in expectation that this would stimulate the recovery in combination with the tax cuts, but it didn't really fly. The employment rate continued to fall and then in 2003 they saw it was necessary to take further action, whereafter, they developed their systematic bubble policy, eg., the bond bubble. You know, they declared that deflation existed and that there was a need to lower interest rates at the long end with the promise to investors: "We shall keep these low rates for a long time. You can speculate on the year's growth in peace and we shall not disturb you with rate hikes."

Well, as the facts turned out, they succeeded in bringing the 10 year long-term yield rate down to 3.1 %. That was the lowest yield in the whole period and it was achieved by encouraging yield curve playing. As a result, they had developed a whole composite bubble system. The first was the credit bubble. The second was the mortgage refinancing bubble which later led to the third bubble, i.e., the consumption bubble. Since then, all economic growth has been consumption led. One has to realize that this was an unusual development and it was all based on bubbles. The bond bubble emerged which ignited the carry trade bubble which later spawned the housing bubble. As you can see, one bubble is dependent on the other one and they all work in tandem with each other.

The question now is: "How does this continue to work further?" Making these comparisons with the past, one has to take into consideration, that American economists in the past years have undertaken great changes in the measurement of aggregates. These changes have taken place in those aggregates which have the most political expediency. For example, they changed the inflation rate. Then, a commission structure came along which invented all kinds of changes. The main proposals were: "We must channel product quality improvements into price reduction." That has already existed a long time for computers, but now they have extended it over the whole economic system. Price reductions were mainstay and another thing was the substitution effect.

With very expensive needs-and-wants, the Americans switched to cheaper things. They changed the whole pattern of items in the index. They made it flexible. Conservative estimates put these changes in the measurement of inflation at 1.5 % while others put it at 3 %. Jim Willie quoted somebody who spoke of the 3 % figure as the more accurate one. Well, whatever the exact rate really is, when you deduct that from the growth rates, there is nothing left. When you have 3 % growth while having a measurement change of 2 to 3 % that means there was no growth. Did you catch this point? I mean there is no growth. I shall explain that a little later.

The other thing of interest was that they changed the measurement of unemployment. Clinton, before his second election, wanted lower numbers for unemployment. In that regard, they drafted another question for calculating employment figures. Did you know for instance that they measure unemployment by asking 50.000 people every month about: "Have you lost your job?" "Are you unemployed?" And so on. Now, interestingly enough, they have added another question to the tableau which asks: "Have you been active in looking for a job?" Translation: "Have you written a letter for a new job ­ or have you been to a company asking for a new job?" And if the person says "Yes", guess what , he is no longer unemployed.

The sad fact of course is that there are many people who have been unemployed for so long, that they have just plain given up. Translation: By giving up, they are no longer unemployed. The Federal Reserve in Boston has made calculations and has published them. These so-called 'discouraged workers' count for more than 5 million people. If you count these folks in, the real American unemployment rate is at about 8 % to 9 % rather than the touted rate of 5 %.

Another point of interest has to do with employed people. The fact is, in a normal past recovery it took 21 months for total employment to recover from a recession. In the jobless recovery of the early 90-ies, it took 31 months, which, incidentally, shocked people because it took so long. This time, it has taken 46 months. In other words, the average of past economic down cycles, employment within the private sector grew by 8.6 % but this time it has only grown by 0.8 %. The growth of employment measured by the labour department is 1/10 of the average for past recessions. However, when you read these numbers, you have to be aware that they have a special method to calculate for employment. Government statisticians say: "When you have a recovery, you have a lot of employment statistics that go uncaptured by our inquiries." By the way they have a formula for this: namely, recovery equals 900,000 employed people per year.

So, they call it the net worth ratio. It's all been explained before in detail and is no secret. This recent recovery has seen 2 million people get jobs through this statistical model. If you take that away, employment is really lower than it was in the recession. The result is that you have minimal employment growth with minimal wage growth. Basically, one can say that for the American working population, there had never been a recovery and if you take the inflation rate into account, the incomes of the working population have been falling, year by year. So then, for these people, there had never been a recovery and I would say there had never been a recovery, all around.

So now, how do we account for these differences? The cheating methods that determine employment numbers are not the most reprehensible. You get tremendous inconsistencies for sure, i.e., GDP shows big growth while employment shows zero growth. To reiterate, how does this come about? Well, the fact is, you have the biggest cheating activity going on to determine the numbers for GDP and so, in consequence, the understatement of the inflation rate. It makes all the difference, whether you say, the inflation rate is 1 % or 2 % or 3 %. That explains everything.

In the case for employment, these tricks are also evident, but they don't play the same role. I personally would say the key for measuring economic performance is the income of people. The question is: "Why is that?" First of all, it's the weakest of all recoveries measured by various aggregates, but, depending on which aggregate you take, it was a disaster or mildly put: worse than in the past.

The other point is the pattern of growth was totally different from the past. In the past, recessions came from monetary tightening responding to inflation rates which reduced investment spending on housing. But that also created the pent-up in demand. This time, there was an easing without any tightening, so, I mean there was never any restraint in demand. What happened was, the investment collapsed for some reasons which have nothing to do with monetary tightening. The credit expansion was running at full steam in 2000, but investment suddenly collapsed faster than ever. So, I mean to say the unusual weakness in investment was the beginning. At the same time, however, the drastic monetary easing led to higher spending on Housing and Eurobonds. So there was never any pent- up demand issues to have countervailing force. The fact now is that business investment has never quite recovered. Business investment today is barely at the level of 2000. On the other hand, Housing and Eurobonds are up by 35 %. Consumption has taken an ever growing larger share of GDP. Measured again, GDP growth reached 81 % compared to the long term number of 67%.

So that was the development in summary. But, this still begs the question: "Why does the poor employment growth still exist? I mean, measured by past employment performance, the recent round was a catastrophe. America needs every year more than a million new jobs because it has rising labour force. The general explanation is that productivity growth is a reason for the poor development of employment. That sounds plausible. But, if you look into the structural changes of the American economy, it is hard to understand, why there has been such spectacular productivity growth while, alternately, capital formation has collapsed. If you look at the details, the key looser in the economy is the manufacturing sector. The manufacturing sector has lost 3 million jobs out of 70 million since year 2000. The manufacturing sector is also the sector with the highest capital investment. Capital investment in this business sector has completely ceased; there is nothing left.

On the one hand, you have the shrinkage of the manufacturing sector and on the other hand you have the expansion of other sectors. The biggest job creator in the United States has been housing and associated things like Asians ­ you know: "real estate Asians". About 40 % of the poor job creation was associated with the housing bubble. You have an economy where the manufacturing sector shrinks rapidly; it has never ceased to shrink. Every month, the manufacturing sector continues to loose jobs, while on the other side, you have increases in jobs, as I said, in real estate and in services like health services and so on. These are all low paying jobs. Not all, but most of them are low paying jobs, compared to the high paying jobs in the manufacturing sector.

That still leaves the question: "Why is the net result in employment so terrible?" I would say, the reason is that the GDP numbers are fake. They are inflated by the understated inflation rate. I would say, you have to adjust the GDP numbers to the employment number and then you realize that there really was no economic recovery in the United States. The GDP numbers give a completely wrong picture of the true growth that has and is happening in the US economy.

No, the question now is: "what's next?" I told you, the thing to watch is consumer spending. "What is happening there?" That's the important question. But the Federal Reserve says: "Our monetary policy is still accommodative, it is still easy." If you look at the inflation rate compared to the federal funds rate and compared to the interest rate, monetary policy is indeed very easy. Real interest rates are close to zero. But the noteworthy thing is from this point on the economy should continue to grow and obviously, that is the assumption of the Federal Reserve.

But there is yet another problem and that relates to the asset and carry trade bubble. During those years, Greenspan (when you look over his 18 years) has twice used a carry trade bubble; a positive yield curve for his policy. He had a tremendously positive yield curve in the first half of the 90-ies and he lowered interest rates from 10 % to 3 % in connection with the recession of 1991. But the economy boomed in 1994 and he decided to raise rates. He raised them, but to the general astonishment of all, long term interest rates shot up in lock-step with short term rates. In the end, he had raised his short term rate by 3 percentage points and the long term rate by doing the same job. Today, it is exactly the opposite.

I think, the people at that time still took Greenspan, seriously. They saw his tightening and they liquidated their carry trade in bonds which had lowered the interest rates. But this time around, they have refused to do so. They no longer take him seriously. The long term rate is 4.5 % and that is even a little lower than when the short term rate was at 1 %. But the problem is that the yield curve is the most important monetary aggregate because the United States is a country without savings. A country without savings must have financial markets which depend on nothing but carry trades. The total US financial system is built on nothing but carry trades which is part of the huge credit explosion that has taken place.

The problem now is Greenspan obviously wanted a certain rise in the long term rates. He wanted a rise perhaps to 5 % in the hope that this would gradually slow consumer spending and the housing bubble. But the market didn't do that. The market kept the long term rate at 4.5 % and now, any further rise is not virtually flat. Any further rise means that the yield curve becomes inverted. And that is the worst thing that can happen to the US economy because it would force the yield curve players and the carry trade players to sell their bonds. In my opinion, the weakness of the Euro and the Yen has to do with the fact that these players have switched in some part to Euro and Yen to finance their carry trade. However, in the long run, it becomes difficult. For me personally, it's a mystery that these people continue to sit on their large carry trades, waiting and waiting.

In my opinion, the problem is that the FED considers the economy to be very strong. I say, they are the victims of their own propaganda. That is one point. The other point is even the understated inflation rate of more than 4 % forces them to raise the interest rate. They cannot allow short term rates to fall below the inflation rate. They are forced to raise the rates. But the question now is: "What will they do?" They have said that when the economy is weak they have to reduce interest rates. I had my doubts that a reduction in interest rates have the same effect as they had in the past.

It was a very complicated bubble system that they developed with their short term rates and propaganda to get some growth. It is impossible to re-establish this system. They may reduce their interest rates but the Federal Reserve is sure that when there is trouble they can lower the interest rates and everything will be "ok" again, because there is a blind faith in the ability of monetary policy to steer the economy. This blind faith also exists among the carry trade players. They think: "Greenspan will come into action again and then we'll continue, as always." It's really a mystery! I would say that a weakening would unleash forces that would lead to cracks in the whole system. I would expect a USD crash. The USD is also a component of the carry trade bubble. When this carry trade bubble collapses I wouldn't assume that they would reduce interest rates and everything would be fine again. I can't and won't believe this. No, I would say that there will be a change in perception. We have at the moment a perception that the US economy is in splendid shape. Interest rates make nothing and yet consider the bullishness in the stock market. I think the American economy is at its most critical situation point in the whole of the post-war period because all of the excesses have accumulated. There has never been a pause in this and the savings rates are in negative territory.

By the way, one word which is also unknown is "Incomes". The Americans have a word for this and it is called "Imputed Incomes". The statistics say that consumers and firms get a number of things for which they don't pay for which should count as income. For example, look at the homeowner in the United States. The statistics say: "He has a house, he doesn't pay for it (mortgaged property) so we attribute to him a rent." You have about USD 600 to USD 700 billion which is called 'imputed rent'. The FED publishes this in complete detail; itemising the specifics. They say: "This is imputed income which we calculate, because the consumer gets something for which he doesn't pay." He gets, for example, an imputed income because he doesn't pay for payment service. The banks in America don't charge payments. So, the statistics say, that is a gift of the bank for the consumer and they count this as income. Crazy? You bet!

By the way, for this statistic they calculate the savings rate without imputed income and that is ­ USD 500 billion. The fact is they detail everything but there is nobody who reads this; that is the point. In America, there is zero discussion about all of these imbalances. Why not? Well, the American is not trained to think about these things. In America basically, theory is non-existent. The Americans say: "We don't need theory, we have statistics." Now that has a history. The leading economist of America is a man named Wesley Mitchell. He was born in 1874 and lived until 1948. He said: "We know too little in order to develop a theory. All we can do is we must develop statistics. We must have as many statistics as possible and then we can judge what is happening."

The Americans have more statistics than anybody else and in particular they like to ask people. This is the substitute for theory. Hayek in 1927, when he made his first visit to America, he noticed this. He has written about it. He talked with Mitchell and he said: "They refuse to do any perceptional thinking. They only believe in statistics. He also said: "How can you obtain statistics if you don't have a theory that gives you the ability to distinguish between important and unimportant numbers?" That's why Americans are unable to distinguish between important and unimportant numbers. I personally think, that all those surveys are total nonsense because, in my opinion, what do those people give you? Asking 5.000 consumers is no substitute for doing your homework by analysis. I mean, what do these people say? They tell you what they read in the newspaper which frankly, is worthless. Undergirding this is the belief that expectations are the key determinant for spending. If everybody tells you that he is optimistic, that means we get a rising economy.

Further to this argument is they don't know what is important with consumer spending and investment spending. For Americans, consumer spending is the key to everything because it is the biggest component in GDP. On top of that they say: "Businesses invest only when they see consumer spending." That's even what leading economists - whom I appreciate ­ think. Stephen Roach writes about investment spending and derived demand. I mean, the consumer can only spend what businesses have given to him. The whole thing is so absolutely ridiculous because the consumer can only spend his income that business has already spent.

The beginning of recovery and economic growth is where there are businessmen who spend and where there are consumers who receive the money. But even these simple things are not understandable to the American economists. Basically, I would say that economic theory and macro-economic knowledge are completely absent. To make matters worse, is that the economic discussion in the United States today is dominated by Wall Street Economists. They know nothing about macro-economics because they are trained to look at a single economy as a micro-economy. With this view, mergers and acquisitions are the best substitute for investment, but that of course is micro-economics; it destroys the macro-economics. I would also say that Wall Street economists are corrupt; corrupt in the sense they are not allowed to say critical things. I know that some of the macro-economists write about this but it is very subdued. One economist even wrote that production is much weaker than GDP. They noticed that but they would never say what this statistic is for.

Thank you very much for your time and attention.

Kurt Richebächer