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Storm Watch: Let's Face Facts (Oct 12, 2001)

by James J. Puplava / Financial Sense Online

There is no question that even before the September 11 attacks, the economy was headed towards recession. Having peaked in the 4th quarter of 1999, it began its descent in the third quarter of 2000. While the manufacturing sector of our economy was the first to be hit, the downward slope was hidden by the strength in consumer spending and in housing. A boom in real estate replaced the boom in stock prices. Lower interest rates ushered in a wave of refinancing that helped to bolster consumer spending. So while manufacturing and technology spending began to falter, and stock prices began to crumble, the economy was buoyed by rising real estate prices and strong retail sales. This served to mask the general weakness in the economy.

Where We've Been...
The rise in home values helped to offset the loss in the stock market, so consumers still felt wealthy enough to continue spending. Spending habits were supplemented by adding additional debt from credit cards to refinancing mortgages. This allowed homeowners to pull additional equity out of their homes to pay for cars, big screen TVs, DVDs and vacations. The economy was still growing, but not at the above-average rates of 1998 and 1999. Because consumer spending and the housing sector still remained strong, economists and analysts remained optimistic towards 2001. Nobody was predicting a recession at the beginning of the year. Earnings were anticipated to rise this year and the economy was expected to slowdown to a more sustainable growth rate of 2-3 percent.

By the first quarter of this year, it became obvious that all was not well in the economy and in the financial markets. Stocks were in negative territory, companies began to report a slowdown in earnings, job layoffs began to make front-page headlines again and economic growth rates began to falter. This was explained by most as a simple inventory build due to a slowdown in sales. Once the inventory was worked off, the economy and profits would begin to pickup again. This theory became known as the second-half recovery scenario. Economic growth and earnings estimates were simply postponed until the second half. Everyone was still bullish on stocks and the economy. Everyone, that is, with the exception of the President. The President's advisors had warned him that he had inherited an economy and weakened financial market that was headed towards recession. Once sworn in, the President made an economic stimulus package a priority. Unfortunately, the full package was watered down. Tax rate reductions were strung out over a decade. All Americans got was a measly rebate.

The debate in Congress was over the size of the surplus. Even up until the attacks on the Trade Center, the Left was still arguing over the size of the surplus numbers. The debate over missile defense the week before the attacks was portrayed as unnecessary. Our cities were in no danger. Who would even dare attack the U.S.? The President was criticized for even considering such a plan. There was even talk of repealing the tax cuts because of a shrinking deficit. House Minority Leader, Dick Gephardt, vowed to make tax increases a priority if his party regained the House in 2002. The missing argument in the debates was the fact that the shrinking deficit was due to an economy that was already heading towards recession. Much of the huge surplus of the preceding years was due to the stock market boom and the resulting tax on capital gains and personal income tax on stock options granted to employees of public corporations.

Attention Shift
This debate and American priorities shifted dramatically in the aftermath of the September 11 attacks on the Trade Center and the Pentagon. Before this event, most Americans knew very little and seemed basically uninterested in foreign affairs. Afghanistan, Uzbekistan, Turkmenistan, Tajikistan and Pakistan were countries learned and forgotten from grade school. According to public opinion polls, education was the number one issue for most Americans. Now all Americans, including the students, are being given a geography lesson every evening on the nightly news. Security, the economy, foreign affairs, military and defense issues have replaced education, the patients' bill of rights and prescription drug benefits. Before the attacks, fewer than one in five Americans said foreign affairs was important. The first battle on American soil in 136 years changed all of that. The nation is now at war. What once seemed trivial has now become important and what was important then seems trivial.

Priorities Changed
Defense and homeland security have now been given new priority with emergency spending by Congress. There is also a renewed emphasis on revitalizing the economy. Inventory liquidation is always the superficial cause of most recessions. This time the problem is now recognized as being more serious than just an inventory work-down. Our leaders are more concerned about what has happened to consumer confidence. It has been shaken and is reflected in the slowdown in spending. The aftershocks of September 11th are now being felt. At first we saw the immediate collateral damage. In the first week following the attacks, Americans were in a state of shock. They spent their days and evenings glued to their television screens. They wanted to understand why. Spending patterns changed. Entertainment and escape occupied the minds of most people. The obvious casualties were airline travel, the hotel industry and retail sales. When you're watching television and staying at home you aren't spending money.

Four Weeks Later...
Now the aftershocks are being measured and assessed. We have seen that the damage has been much greater. The fallout has impacted consumer confidence, housing and now the service sector. During the initial stages of the economic downturn housing activity remained unusually strong. In a normal downturn, housing usually falls and is a leading indicator of a downturn. However in this recession, the Fed's aggressive rate cuts and money pumping, combined with mortgage credit expansion by GSEs, made credit easily available. This fed into a real estate boom. Instead of housing leading the downturn, it was led by a drop in capital spending in what was apparently a reversal of roles leading into a recession.

Bunker Mentality
However, the attacks dealt the final blow to consumer confidence. Collapsing stock prices, layoffs, the cuts in overtime and hours worked and now security have zapped what once was the one strong remaining sector of the economy. The drop in confidence has impacted not only consumer spending, but along with it, the related strength in the housing market. The greatest evidence of this is the shift in consumer priorities. As the nearby graphs indicate, personal income went up by 1.7% during July, but spending only rose 0.1%. Instead of spending the tax rebates, consumers chose to save the money. The Saving Rate has jumped dramatically to the current rate of 2.5%. Personal savings had been gradually rising since the beginning of the year as uncertainty in the economy and the stock market increased. The consumer could no longer count on the 20% annual returns from the stock market to replace the need for savings.

Another Day Older and Deeper in Debt
Surprisingly, at the same time that consumers have been increasing their savings, they have also been going deeper into debt as reflected in the graphs of consumer installment and mortgage debt to disposable personal income and the rise in consumer credit. Americans are still borrowing money to maintain a lifestyle they can no longer afford. In its second-quarter credit data, the Fed reported that net credit market borrowing increased at an annual pace of $1.8 trillion to $28.3 trillion. Non-federal sector borrowing was the second-heaviest on record at $1.25 trillion. It was led by private sector household borrowing of $661 billion on an annualized basis a growth rate of 9.3 percent. Non-financial corporate borrowing increased by $424 billion through net bond offerings an annualized increase of 7.4 percent. Despite a stagnating economy, consumers and corporations continue to take on new debt.

Housing Market Indicators in a Downturn
Meanwhile the housing sector, which has been a key factor in keeping the economy in positive territory, is starting to turn down. It has remained strong up until this point thanks to low mortgage rates. As this graph indicates, mortgage rates have fallen significantly since peaking in the first quarter of 2000. In past cycles, the sector usually turns down as it falls victim to Fed tightening. Despite last year's Fed tightening, housing starts remained strong until this August when they began their descent. They remained high because of the early drop in mortgage rates last year. Lower mortgage rates makes buying a home more affordable. Even as housing prices escalated in what became a real estate boom that supplanted the stock market bubble, affordability remained high. The National Association of Realtors has reported that its affordability index is still high by historical standards.

Source: National Association of Realtors

What drove this market was aggressive lending by government-sponsored lenders known as GSEs. Fannie Mae and Freddie Mac expanded their balance sheets through the securities markets and allowed down payments as low as 3%. Other lenders were advancing as much as 125% on a house's value. Low mortgage rates also mushroomed as homeowners took out equity out of their homes to finance spending. The result has been a downward trend in equity as shown in the graph below.

With plenty of credit to lend, home ownership expanded. The problem now is that there is too much debt, which will cause further problems for lenders as the recession unfolds. Subprime mortgage foreclosures are rising. Many lenders in this market are either retrenching or withdrawing from the market. Bank of America is quitting the subprime lending business, while others, such as First Union, are writing off bad loans and increasing loan loss reserves.

Housing has now started to soften. Housing starts fell 7% in August even before the terrorist attacks. Vacancies for commercial buildings are rising to levels approaching the last recession. The Conference Board, which tracks consumer confidence, reported that intentions to buy homes within the next six months fell in September. The luxury home market has been hit the hardest. With the dot.coms turning into dot.gones the McMansion prices are starting to come down. As the equity base in homes evaporates, individual bankruptcies are scaring away lenders. Given the sharp drop in consumer confidence, and the mounting job losses following the Trade Center attack, the drop in housing prices could turn into self-feeding liquidation cycle bringing leading to lower prices and foreclosures. The fall in housing, combined with the plunge in consumer confidence, and the concomitant drop in spending, will remove the last legs supporting the economy.

The Trauma to Americans is Personal
This raises serious issues regarding economic recovery. The economic rebound is based on continued strength in consumer spending, and along with it, a robust housing market. A resurrection of capital spending is also factored in to the recovery scenario. But as the graphs above illustrate, a burgeoning consumer debt burden makes a consumer-led recovery unlikely. There is simply too much debt. With the job market uncertainty and Americans feeling increasingly insecure and unsafe, it is doubtful whether continued spending supported by additional borrowing can be maintained. Already banks and mortgage companies are reporting delays in payments; while defaults and bankruptcies are on the rise. Optimists point to previous crises like the Gulf War, as an example for what they believe will be an inevitable rebound. However, unlike previous wars and traumas faced by Americans, this one is different. This one is personal.

Source: Barron's

The attacks occurred on American soil -- not somewhere in Asia or in the Middle East. The attacks came against American symbols of commerce and financial strength. Past crises like Pearl Harbor, Korea, the Cuban Missile Crisis took place offshore. In 1941 we didn't have television to broadcast the visible images of the attack. This war will be much more like Vietnam. The battle won't be easily defined, nor will the conflict's resolution come speedily. This creates more uncertainty -- something that makes the human psyche and the stock market uncomfortable. This war's battles will be fought around the globe and on our shores.

The Unseen Conflict
This will not be a Nintendo war. Many of the battles will go unreported. They will be won or lost by intelligence. Special forces will do much of the work. Their victories will go unnoticed and unseen on television. The pundits will speculate, but the real war will be hidden. Pictures of fighter jets taking off of carriers and satellite photos of bombed sites will still be shown for mass consumption. But the patience for a quick resolution won't be there. The American public's short attention span will be matched against the nearly infinite patience of the terrorists. Our belief in the superiority of our military technology will be disappointing. Our missiles and warplanes are useless against an enemy that lives in tents and is constantly on the move. Even the present bombing campaign in Afghanistan will be short. There is very little to bomb. Our enemies will wait and then they will strike in a way that takes us by surprise. The government has already forewarned the nation that there will be other attacks against our homeland. We live in a target-rich environment.

In this war, our personal freedoms will suffer and government power and intrusion into the economy and into our lives will grow. Government's power always increases in a time of war. Its influence will increase as it begins to repair the damage from the attacks. Airport security and air marshals aboard planes will expand government's role in the economy. Home security issues will also expand the government powers. The budget caps will be busted to pay for increased security, an expanded military and the effort to fight the war against terrorism. The deficit will widen, as the economy contracts. That will provide some stimulus to help offset weakness in the private sector. Efforts have been made to prop up the financial markets and suppress the price of gold. In the end, they will prove to be in vain. The government is running against a tide.

The Keynesian Threat
The real danger here is for monetary or fiscal mismanagement. In an op-ed piece appeared in this week's New York Times by former Clinton advisor and now dean of Walter A. Haas School of Business at the University of California-Berkley, Laura D'Andrea Tyson. Tyson called for the repeal of President Bush's tax cuts. Tyson believes that the tax cuts were never justified and should be repealed. Tyson proposes strong government spending in its place. This kind of New Dealism talk is just the kind of remedy that got us in our last depression. The New Deal programs of the early 30's raised tax rates to over 90% and replaced them with government spending programs in an effort to ramp up demand. They didn't work. It would take a major war to bring the U.S. economy out of a depression. Tax cuts may not work immediate magic, but they do take some of the pressure off overtaxed workers and businesses. Lower tax rates can't prevent the bust that will follow the boom, but it can hasten the recovery. To see the effects of what Tyson proposes, just look at Japan today. The Japanese economy experienced the same bubble-like conditions of the Clinton years in the 1990's. Instead of dealing with them, they have tried the Keynesian prescription for the last eleven years. The results have been similar to what the U.S. went through the 1930's. A decade later, Japan's stock market is still down from its peak by 74%.

What led us to this financial crisis was an expansive monetary policy over the last decade that has created malinvestments in the economy and excesses in the stock market. Fiscal spending during the last two years of the Clinton Administration grew at an annual rate of 8%. The cheap and abundant credit led to companies and consumers leveraging their balance sheet; while the government sucked money out of the economy through massive tax hikes in 1991 and again in 1993.

It was this return to Keynesian economics in the 1990's that created the artificial boom in our economy. Monetary ease and the abundance of cheap credit over stimulated the economy. It produced malinvestments in technology; while ignoring the building and repair of our nation's infrastructure. It was behind the parabolic rise in our stock market. It was behind the housing boom. What we experienced during the last decade was uncontrolled and unchecked monetary expansion. It produced the largest credit bubble in history. We will now have to live through working off those excesses. Like an unwanted hangover we must suffer through it. The kind of medicine that Tyson and fellow Keynesians propose is akin to giving an alcoholic another bottle when an aspirin is what is needed. The President's tax cuts is the boost we need. It was what Reagan used to move us out of the economic malaise of the Carter years. Let us hope that the President prevails. He may not be able to stop the pain of the bust that is upon us, but at least he can lighten the burden and hasten the recovery. The Gephardt, Daschle, and Tyson solution will lead us into depression. Let us pray that wiser heads prevail.

The Jig is Up
On a final note. One of the most disturbing aspects of the markets this week is the apparent manipulation of the gold and silver markets. The price of gold, which rose prior to and after the attacks, has been kept in a narrow trading band all year. The trading band has been capped at $292 an ounce since the Trade Center attack when it made a run for $300 an ounce. It was pushed back by heavy bullion bank selling at every attempt to breach that level. Gold prices have not been allowed to rise above that level because once it does, the jig is up. The losses in the derivative book of certain bullion banks would overwhelm the financial system. Last week I referenced the interest rate position in derivatives for the nation's top seven banks. This week I'll show the other side of the ledger, which is the derivative book in gold. At close to $90 billion, it dwarfs the actual physical market. The gold derivative book is what keeps the other side of the ledger in interest rate positions in balance. A rise in gold prices would bring disaster to interest rate derivatives in most bank portfolios. A rise in gold signals a rise in inflation, which is bad news for interest rates and the bond market.

Source: OCC Bank Derivatives Report, 2nd Quarter 2001

Gold prices are being kept suppressed at a time of fear and uncertainty and supply deficits. Many of the mines around the globe are being shut down because of artificially low induced prices. At below $350 an ounce, most mines are unprofitable to operate. They are shut down, consolidated or merged.  Last year the industry wrote off $5 billion in assets. Even the bigger, more profitable mines are slowing down production. At today's low artificial price, it doesn't make business sense to mine the metal. Before its takeover by Barrick, Homestake Mining was getting ready to shut down its century-old South Dakota mine. The mine couldn't survive the low prices of the last four years. As mines cut back exploration or the development of new projects, the reserve base is falling. This will only make the annual deficits even larger.

As a result of continued low prices, Gold Fields Mineral Services Ltd., a London-based precious metals research firm, estimates that world production will begin to fall next year. The deficits are only going to get larger. This is before there is any significant investment demand. The intelligent investor should be asking why prices have remained so low when demand has outstripped supply for nearly a decade. The answer to that question is the opportunity that avails itself to those who appreciate value. As this graph of the Dow/Gold indicates, we are now close to an inflection point when the pendulum will swing in the opposite direction. When prices are kept below production costs, the result is scarcity. From an economic perspective, scarcity eventually brings back prices to a point of equilibrium again. This is basic economics -- not rocket science. No manipulation or intervention can change an irrefutable law of economics. Financial alchemy has been tried in the past by pharaohs, emperors, prime ministers, and presidents. In the end, it has always failed. Fiat money systems have a history of failure.

Unfortunately, we keep fooling ourselves into thinking that we have found the alchemist's stone. It is a sad lesson of history that seems to be repeated with unintended consequences.  ~ JP

by James J. Puplava
October 12, 2001

Storm Watch Index

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Copyright © 2001 by James J. Puplava. All Rights Reserved.

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