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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Storm Watch:
The Economic State of Our Union
(July 19, 2002)
by James J. Puplava / Financial Sense Online
Most individuals see their doctor once a year
for a physical. The purpose of the annual checkup is to review
the body's vital signs to make sure there are no problems on the
horizon. The exam serves as a guideline for year-to-year comparisons
and can also be seen as preventative in nature. If there are problems,
the physician usually prescribes diet, exercise or medications.
More serious illnesses may require greater intervention and further
examination or procedures.
In the management of our nation's affairs, various government officials undertake a similar process each year. The President reports to Congress on the condition of our nation in his annual State of the Union Address each January. The Fed Chairman performs a similar function by reporting to Congress twice a year on monetary policy as well as the Fed's view of our economic condition. The Board of Governors of the Federal Reserve System submits its Monetary Policy Report to the President of the Senate and the Speaker of The House every February and July pursuant to section 2B of the Federal Reserve Act. In effect these reports are similar to an annual physical. They reflect economic conditions and what response or remedy is recommended to improve the economy.
The problem with economic reports is that although full of facts and charts, they are ambiguous. In frustration over economic advice from his advisors President Truman complained that he wished he could find a "one-arm economist." He was referring to the tendency of economists to hedge their advice. The current Fed economic report to Congress is filled with the same ambiguity. On the one hand, there are positive comments about economic activity picking up during the first half of the year. On the other hand, there are crosscurrents at work that cloud the outlook for economic activity. In other words, we still have a two-handed forecast. The forecast is still positive and optimistic, but there is room for doubt. This week most media reported Greenspan said two things: the economy is on the mend, but corporate accounting issues could undermine it.
In my estimation, closer examination of the Fed's monetary policy report reveals many troubling aspects for the future prospects of this nation's economic health. They can be summed up in one word: DEBT. Inexplicably, it seems to be glossed over in the Fed's report. In fact, whether it is Washington or Wall Street, debt doesn't seem to be a concern to anyone outside the credit agencies who have gotten a wake up call since Enron, Global Crossing, Kmart, and WorldCom. I've also noticed a growing number of popup ads on the Internet for "get out of debt" services. Entrepreneurs have picked up on this growing issue and seem to be ahead of the game.
Counterbalance: Positive to Negative
The Fed's July 16th report begins with good news on the economy. Economic activity picked up during the first six months of the year. Inventory levels at most businesses have been worked down and many firms have begun to increase production to replenish stocks to bring them in line with sales. The Fed acknowledges that although businesses have increased production to replace the draw down of inventory levels, there has been no sign of capital spending by business. This is a key ingredient for a sustainable economic recovery. It is conspicuously absent.
At the same time, the real strength of the economy continues to be the consumer. The Fed believes its policy of flooding the markets with money to keep interest rates low has been effective by the evidence of increased spending on durable goods and the strong housing market. Yet, that spending has not been strong enough to forestall a rise in unemployment. The crosscurrents the Fed refers to that remain a cloud over the recovery are the reluctance of businesses to hire new workers (they are still firing them) and a similar hesitation to increase capital spending. There is also the nagging problem of the stock market, which refuses to cooperate with Fed policy by continuing to decline with devastating effects on household net worth.
Fed Prescription for Second Half Recovery
Against these negatives, the Fed lists four main factors that are likely to boost economic activity during the second half of the year. They are as follows: 1. Low interest rates, 2. Expanding fiscal policy, 3. Foreign economic growth, and 4. The decline in the dollar.
The Fed believes its loose monetary policy has allowed businesses and consumers to strengthen their balance sheet by refinancing their debt at lower rates of interest, thereby lowering the cost of debt and freeing up additional income for spending. The Fed also cites the reduction in tax rates and a major increase in government spending as a positive stimulus on aggregate demand. The minor increase in economic growth overseas may also be viewed as positive since stronger growth overseas would hopefully generate greater demand for U.S. goods and services. The final element is the dollar, which would reinforce U.S. exports. A cheaper dollar makes U.S.-made goods more competitive, which would likely bolster U.S. exports. These are all of the positives to which there are counterbalancing negatives.
Source for all charts: Monetary Policy Report to the Congress
The Average American Borrower
The fact that interest rates
have been kept low has allowed consumers and corporations to refinance
their debt. This lowers monthly debt payments and frees up additional
cash for spending. However, that is where the positives end. Although
cash flow has improved for most consumers through lower interest
rates and lower taxes, the consumer is still going deeper into
debt. Household debt last year increased by an annual rate of
8 percent.
As interest rates have become more favorable, the consumer has taken on even more debt. Household debt burdens are still rising albeit at a lower rate because of falling interest rates. The Fed says that the accelerating debt burden has been offset by lower interest rates.
In addition to elevated debt burdens, delinquency rates for subprime borrowers have risen further for auto loans and mortgages among the subprime borrowing class; while overall delinquencies for all households remain little changed.
The Average
Corporate Borrower
At the corporate level, lower interest rates have allowed many
companies to replace short-term commercial paper with long-term
bond debt. Many companies have done this to improve cash flow
and lower interest payments.
Others
have been forced into the long-term debt market because of the
inability to tap the commercial paper market due to lower debt
ratings. This is especially pronounced in the telecom sector and
with many other non-financial corporations, who have lost their
investment-grade ratings.
Banks have also become more restrictive in their lending. Many banks have now tightened lending terms and standards; while others have imposed stricter underwriting standards and higher fees on backup lines of credit.
With a plethora of high profile bankruptcies such as Enron, Kmart, and Global Crossing, banks have increasing concerns over the creditworthiness of issuers and the prospects for credit lines being tapped with distressed borrowers.
There are other visible signs of stress in the system with the ratio of net interest payments to cash flow trending upward since the early 90's.
The default rate on outstanding corporate bonds is also quite elevated as shown in the graph below and the delinquency rate on commercial and industrial loans at banks is also in an up-trend. Many banks have reported the necessity of increasing loan loss reserves as losses mount in commercial and industrial loan portfolios.
The risk of default is also widening credit spreads between high-yield bonds, Treasury debt and investment grade corporate debt as shown below. Credit spreads between corporate bonds and Treasuries have remained unusually high and have risen considerably recently. This reflects growing stresses in the telecom industry and also concerns over accounting issues and the quality of earnings.
The United States as Borrower
As far as the pickup in foreign economic growth, it hasn't made
a substantial impact on the U.S. trade and the current account
deficits. The U.S. trade deficit widened by $27 billion during
the first quarter, reflecting a $380 billion annual rate. Imports
of foreign goods overwhelmed exports by a wide margin as consumers
bought more cars, electronics and luxury goods from overseas.
This impacts the economy negatively since the money being spent
is on foreign goods rather than domestically-produced
goods, which reduces GDP growth. It may be one reason why domestic
manufacturers have been so reluctant to expand capital investments.
In
addition to a widening trade deficit, U.S. net investment income
declined by $33 billion. The U.S. deficit in other income and
transfers widened by $9 billion to an annual rate of $70 billion.
The current account deficit, which reflects a summary of the trade
and investment deficits, widened to a record annual rate of $450
billion. This increased by $70 billion from the previous quarter.
The current account deficit is now at 4.3 percent of GDP. The
real value of exported goods contracted at a 3 1/2 percent annual
rate. If there is an improvement in foreign GDP growth, it hasn't
shown up in our trade or current account deficit.
Foreign Investment in The U.S. Dwindling
Even more ominous, as a result of these deficits, is the fact that international financial flows are reversing. This trend began in the second half of 2001 reflecting increased economic uncertainty, accounting issues and corporate governance, falling U.S. equity markets, and perceived risks of terrorism. Foreign purchases of U.S. Treasuries from abroad have slowed down considerably. Foreign investors are showing a preference for corporate bonds, which offer considerably higher returns than agency or Treasury bonds.
There has also been a steep falloff of direct investment flows into the U.S. as a result of reduced merger activity. Direct investments into the U.S. have plummeted since the second half of last year and continue to remain weak throughout the first half of this year.
What
has been discouraging for foreign investors has been the dismal
returns in the U.S. financial markets. In the fixed income markets,
the rates of return on Treasuries have fallen to multi-decade
lows.
As the graph of Treasury yields indicates, since the beginning of 2000, the yields on Treasury bonds have fallen from around 6.5 percent to today's 5.405 percent.
Yields on short-term T-bills are at 1.7 percent and yields on 5-year T-notes are below foreign sovereign debt, especially euro-denominated debt instruments. This has been one of the main reasons that foreign bond purchases have been on the corporate side because of the significant spread in yields as shown in the graph on the left.
The
most damaging returns for foreign investments have occurred in
the U.S. equity markets. The major U.S. equity indexes have handed
foreign investors double-digit investment losses and double-digit
currency losses from the drop in the dollar.
If you take a 16.1 percent loss for the Dow Industrials, a 23.21 percent loss for the S&P 500, a 30.43 percent loss for the Nasdaq and add that to a 10 percent loss in the dollar, foreign losses on equity investments in the U.S. have been devastating.
It is surprising that Fed officials would review statistics such as these as a reason for optimism that the potential of a falling dollar may be positive for the U.S. Much of the increase in foreign growth has been due to exports to the U.S.
It
could be that U.S. goods may become more competitive. This could
help to eventually decrease our trade deficit. However, there
has been little evidence of this taking place. The increase in
economic growth in the economy during the first half of this year
has been accompanied by a rising trade and current account deficit
that show no sign of abating.
Foreign Withdrawal Could Be Damaging
Fed officials worry about what might happen if foreign investors decide to reverse their holdings of U.S. investments. If we start to get more outflows than inflows in our financial markets, then the Fed will have a very serious problem on its hands.
If foreigners start dumping or reducing their Treasury holdings, interest rates will begin to rise as a result of selling and the Fed may be forced to raise interest rates at a time of economic weakness. The weak dollar may make U.S.-made goods more competitive, but a weak dollar also makes the U.S. financial markets less attractive from an investment viewpoint, which may be the more powerful side of this argument.
Some Good News on Monetary Aggregates
On
another front, the monetary aggregates are starting to decelerate
this year after running on steroids for close to the last decade.
M-2 rose at an annual rate of 4.5 percent compared to 10.25 percent
in 2001. M-3, a broader measure of money, grew at a 3.5 percent
rate during the first half of the year after rising 12.75 percent
last year.
The reason for the decline was a change in investor preference for money markets funds, which had surged more than 50 percent last year. The Fed believes that this is a temporary shift, reflecting precautionary demand for cash after the terrorist attacks, and a temporary delay due to mortgage prepayments resulting from mortgage refinancing.
Money velocity, which has been in decline since 2000, has recently been on the rise. It is my belief that the drop in velocity has reflected a desire by investors to hold cash as a result of uncertain investment markets. If velocity picks up again, it is because investors may prefer to own things versus paper. The decline in the money aggregates may also reflect a deflationary debt contraction that is occurring in the economy.
The Fed has pointed out that the growth in corporate debt has slowed remarkably during the first half of this year. As a result of credit standards being lowered, companies have shown a preference for equity financing to shore up their balance sheets. Companies are paying down debt and continue to shed assets in an effort to get liquid and improve their survivability.
So, What Does It All Mean?
From my perspective, the economic state of our Union looks unhealthy and terminally ill. All of the excesses of the 90's, which resulted in a mania in financial assets and a debt-induced spending binge on behalf of consumers, have left the economy with a huge hangover. It is hard to conceive that the consumer, who is already burdened by debt, could be expected to go even deeper in debt in order to sustain a lifestyle. Growing job layoffs and collapsing equity markets should be giving consumers reason for pause. If policy makers and strategists see a booming economy and a surging equity market, it would be hard to find the catalyst outside of war. Companies are reluctant to spend and expand capital investments. They are in the process of reliquifying their balance sheet. This points to further contractions ahead. Consumers are tapped out. Marginal borrowers are already going into default or delinquency on loans. It is just a matter of time before more households find themselves in greater financial dire straits.
The Fed cites the strong housing market as a key ingredient and big positive for the economy. However, what the Fed has done by keeping rates artificially low is to create another asset bubble. Housing has replaced the technology bubble. The Fed is trying to keep the housing cycle going in order to keep the consumer afloat. Rising housing prices have helped to mitigate some of the damage from hemorrhaging financial markets. Consumers have remained optimistic and have held on to financial assets in the belief that the economy will eventually improve.
What has not been reflected upon by most households is that their own debt spending and housing purchases are one of the few lifelines left holding up this economy. The increase in property wealth has made up for the losses in the stock market. What happens when housing prices no longer continue to rise or when interest rates begin to climb? The housing bubble will crumble. The consumer will no longer be able to extract equity from their homes at little or no cost. Tapping home equity has been a painless way to maintain consumption. Even though mortgage debt went up as consumers extracted more equity out of their homes, payments remained the same or went down because of lower interest rates. It was like getting free money. In other words, mortgage debt went up and equity was extracted from the rise in housing values, yet payments remained the same.
More than anything else, this credit and housing boom explains the mild nature of this recession. It is the reason this recession is different from previous recessions. Unlike past recessions when housing declined and led the recession, this time housing remained strong. With the lowest interest rates in over three decades, consumers have been able to continuously tap the equity of their homes to finance consumption. Since 1998 newly refinanced mortgages have been 6-7 percent greater than the mortgages they replaced.1 According to the Fed, this equity extraction has been averaging about $60-80 billion a year. That is why consumption has accelerated, rather than decline, during an economic downturn. This recession has been a business-led recession. The consumer's spending and borrowing binge and government spending have been the only things holding up this economy.
What happens when the final asset bubble in housing collapses? What's next -- a major war? The bubble in housing will come to an end. When it does, the full impact of the debt and spending binge of the 90's, which continues to this day, will hit the economy and the financial markets with full force. The effects will be devastating on households, businesses, and the financial markets, as well as for the country. It is only then we will have learned that there is no such thing as the alchemist's stone. The endgame is drawing to conclusion for central bankers. They thought it could be postponed. But fiat-based money systems have historically ended tragically. The end will be brought about by a financial storm. It is now my greatest fear that we are getting closer to my storm scenario -- a storm front in the credit markets, clashing with storm fronts in the stock market, combining with a storm front in the economy to form The Perfect Financial Storm.
The financial jet stream, which is the international monetary system, is moving the storm fronts towards a collision course. Like the Perfect Storm of 1991, the financial markets could erupt with a force so intense it will be unlike anything present-day investors have ever seen. The Perfect Storm was a rare occasion of fate, a freak act of nature. It was the result of a cold Artic cold front joining forces with a warm tropical hurricane that created a pressure gradient most meteorologists will never see in their lifetimes. Let us hope that we never see its equivalent in the financial markets. ~ JP
© 2002 James J. Puplava
Endnotes
1 Roach, Stephen,
"Still Blowing Bubbles," Global Economics
Forum, www.morganstanley.com,
July 18, 2002.
by James J. Puplava
July 19, 2002
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Copyright © 2002 by James J. Puplava. All Rights Reserved.
Reprinted by USAGOLD with permission of Mr. Puplava. This article may NOT be reproduced without the expressed, written permission of the author. Selective quotations are permissible as long as the author, Jim Puplava, and his web site are acknowledged through hyperlink to: http://www.financialsense.com/
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