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Storm Watch: Debt Valley
(July 12, 2002)

by James J. Puplava / Financial Sense Online


Another Day Older And Deeper In Debt

The headlines are repetitive and the stories seem to be the same. The best that can be said is that they are consistent. Accounting scandals, profit warnings, bankruptcies, currency devaluation and threats of terrorism, fill the evening news broadcasts. Against this background is news of an improving economy. The unemployment rate is still climbing and profits are still declining albeit at a slower rate of descent. So if there is going to be a recovery it will be devoid of jobs and profits.

The economists and analysts seem perplexed as to why the stock market hasn't recovered given the news of improving economic conditions. So they cite everything from terrorist attacks, geopolitical tensions and accounting scandals as reasons why their forecasts for a market recovery haven't occurred. The consensus view is the Fed has created all of the monetary conditions for a recovery by lowering interest rates. If the economic numbers are improving, then it only follows that the financial markets should be tagging along. That hasn't happened and the only advice that can be given is that the markets will improve during the second half of the year. It has become a familiar refrain.

As the daily headlines capture investors' attention, there is a growing sense of unease that there is something wrong and more serious with the financial system. Investors and voters cry out for Washington intervention to fix things and make them better. However, that is like putting the fox in charge of the henhouse. It was Washington intervention, and especially the actions of the Federal Reserve that created this mess.

The Making of a Bubble

The expansionary monetary policy of the Greenspan Fed during the 1990's created a bubble in the financial markets. Every time there was a crisis, the Fed flooded the financial markets with money to fix the problem -- whatever its source -- the peso or the insolvency of a hedge fund. The standard solution was always to create more money. Throughout the 1990's the supply of money and credit in the system expanded nonstop.

As the graph above shows, each new financial crisis was met with money and credit. Beginning in 1994 with the peso crisis the Fed has pumped money and credit into the financial system. Then in 1995, the rate money and credit began to expand grew faster than the economy. During the second half of the decade that money went into the financial markets, mainly in the large cap stocks in the Dow, the S&P 500, and the Nasdaq.

The majority of that money found its way into the financial system. The rest of it went into debt creation at the corporate and consumer level as shown in these graphs. The money that the Fed created flowed into the financial markets and debt induced consumption. It created the illusion of prosperity. This prosperity turned into a full-fledged boom, then turned into a bubble, producing malinvestments in the economy and speculation in the financial markets. The secondary effects of that bubble were a grossly inflated stock market, rising debt levels at all levels within the economy, an expanding trade deficit, and a negative savings rate.

These were not the symptoms of a "New Paradigm." They were more manifestations of growing imbalances in the economy. The rising stock market, the boom in real estate, the rising level of debt, the trade deficits, the growth in consumption were not signs of economic health as originally construed. Instead, the excess consumption and the degree of financial speculation in the markets were signs of a patient that was terminally sick.

A New Bubble is Born

In response to this illness, the standard prescription of more money and credit failed to produce an improvement in health. The patient didn't responded as planned. The stock market went down instead of up. Instead of resurrecting the stock market bubble, a new bubble was created in the real estate market. This helped to extend the consumers ability to borrow and spend through the refinancing of mortgages and home equity loans. Today money and credit are still flowing into consumption and the new bubble in housing is kept inflated by artificially low interest rates. Therefore, instead of reinflating the bubble in the stock market as hoped, a new bubble in the housing market took its place.

Each month passing, there is more evidence that the consumer continues to go deeper into debt. The consumer has added new mortgage debt through new and more expensive home purchases or home equity loans. In addition to mortgage debt, installment and credit card debt is also expanding rapidly.

Economists and analysts hail the increase in debt as a sign of consumer confidence in the economy rather than a sign that the consumer is financially over stressed. At the same time, the number of delinquencies and bankruptcies are ignored even though they are at record levels. Credit has replaced savings and this is now viewed as a positive. Today we have multiple bubbles in the housing market, consumer spending, the bond market, the dollar, and a monstrous trade and current account deficit. These resemble signs of high blood pressure more than they do a healthy heart and circulatory system.

The "Fix" Isn't Forthcoming

Meanwhile on Wall Street money managers of equity funds want the Fed to lower interest rates or at least keep them low. Bond fund managers want the Fed to induce banks to keep the credit flowing to businesses that are on the verge of bankruptcy. Voters want the government to fix things.

With the recession producing declining tax revenues, governments at all levels are increasing spending and taxes. Deficit spending is back in vogue. So are tax increases. On the day of this writing, Democrats in Congress floated a new tax bill. We now have massive fiscal stimulus added to massive monetary stimulus in an effort to resuscitate a sick economy and financial system. All that has been accomplished by these hefty injections of monetary and fiscal stimulus is that the economy hasn't fallen deeper into recession. The fact that the housing sector is booming is taken as a sign of the economy's resilience rather than an ominous sign that monetary and fiscal policy are having little impact outside of housing. Rising real estate prices is viewed as a sign of prosperity rather than another inflated bubble that is due to burst just like the Nasdaq bubble that preceded it.

In Washington, there is a call for major legislation, new regulations, and higher taxes. I have written about this in the past, but in times of economic crisis, government can always be counted on to do something stupid. Politicians are a strange breed of human beings. They love to take credit when things are going well in the financial markets or the economy even though they had nothing to do with it. They are also good at distancing themselves and finding a scapegoat when things go wrong or go in the opposite direction. The degree of demagoguery, grandstanding, and hypocrisy displayed over these last few weeks has sunk to levels I never thought possible. At least the left is consistent in its response to a crisis created by government. The standard solution to any problem is always bigger government, more spending and higher taxes. I suppose if we had an outbreak of malaria they would propose a blue ribbon panel to study it, a new government agency to oversee it, and more new taxes to pay for it.

Where were these same politicians during the boom years and the stock market mania of the late 90's? What were the regulators and politicians doing during this time? Does anyone in Washington understand the dangers of debt? Is the degree of economic literacy so low that politicians think they that you can inflate and borrow their way to prosperity? I never heard a word about stocks being overvalued outside of Mr. Greenspan's utterance of irrational exuberance. The Fed Chairman knew better because it was Fed policy that was flooding the markets with money.

The Root of The Matter

Today's headlines of accounting fraud, deceit, and financial manipulation were a product of the boom years of the last decade. At its root was greed. Plain and simple. As long as the markets went up, nobody was willing to question it. It was only when stocks fell that it became a problem. The fact remains that investing has always been an uncertain endeavor. There are no guarantees only degrees of risk.

An American President and Congress can't guarantee investment outcomes. Nor will they be able to replace the trillions of dollars lost in this bear market. The more they try to interfere, the more they try to legislate, the more they try to tax, the worse things will become. There are plenty of laws on the books. We don't need more laws. We need stricter enforcement of the laws we already have on the books.

Regarding the current bear market, there is nothing that Congress or the President can do to prevent it. In my opinion, the greatest risk now lies with government intervention. The risk of moral hazard has never been greater.

The point that needs to made here is that all sectors of the economy -- the government, business, and the consumer -- are addicted to credit to keep them functioning. However, there will come a time when the financial system is unable to provide the ever-increasing amounts of credit to keep the economy and the financial system afloat.

Foreigners who now provide the US with $1.5 to $2 billion a day in credit to finance our widening trade deficit may run out of patience with our proliferate spending. In the end, the markets are going to enforce discipline in one form or another through a collapsing dollar, a collapsing economy, a plunging stock market, or more likely a combination of all three. The simultaneous occurrence of all three events will give us "The Perfect Financial Storm."

$ 6 , 1 2 6 , 4 8 6 , 5 7 9 , 3 0 7 . 9 7
U.S. National Debt Clock as of July 12, 2002, 8:45AM, Pacific
The estimated population of the United States is 287,768,105
so each citizen's share of this debt is $21,289.67.

Now all attention is focused on a falling stock market. Experts are bewildered as to why an improving economy hasn't been accompanied by a rebounding stock market. Wall Street and the investment community are far too complacent. The standing response is that there will be a second half recovery in the financial markets. The economy will get better and eventually stock prices will improve. The accounting scandals will be cleaned up, CEOs will go to jail, and investor wrath will be mollified. Once profits begin to improve and the scandals go away the financial markets will be back to normal and the good times will return. Conspicuously absent from this debate is the fact that this is the most overvalued stock market in the history of this country.

The Problem is Structural

Every measure of valuation is at extreme levels. It doesn't matter what you look at  -- whether it is P/E multiples, dividend yields, price-to-book ratios or price-to-sales ratios -- all are at excessive levels never seen before. By today's standards, the stock market bubble of the 20's, the hard asset bubble in the 70's, and the financial bubble in Japan in the 80's all look mild by comparison. A comparison of these extremes will be the subject of next week's Storm Watch Update. My point today is that every measure for evaluating the market is at an extreme. Too many imbalances within the economy have yet to be corrected. In fact, the unabated expansion of credit will only exasperate an untenable position.

This is no ordinary recession or bear market. The problem isn't cyclical. It is structural. Past recessions were caused by tight monetary policy and a buildup in business inventories. Once inventory levels were worked down and the Fed eased interest rates, the economy would recover. Consumer demand picked up, capital spending by business rose, and profits improved. The financial markets responded with higher stock prices. This has been the pattern throughout the second half of the 20th century. Most recessions and bear markets were cyclical not structural, the exception being the recession and bear market of 1973-74.

This time around, things are different. Loose monetary policy is having no impact. The financial markets have failed to respond and economic growth has been anemic despite the fluff in the economic numbers. What we are witnessing is the evaporation of a mirage. There never was a "New American Paradigm" in the 90's. It was all an illusion created by an enormous spin machine in Washington and on Wall Street to justify the bubble in the financial markets. Rising stock prices masked the credit and monetary excesses of the era. Profit growth was below normal and the product of fraudulent accounting. The miracle economic numbers were the result of manipulated government statistics.

The Mirage of Prosperity

We will shortly get a glimpse of this manipulation when the government releases its revised economic numbers for the years 1999-2001 on July 31st. The boom of the 1990's was created from credit -- nothing more. As these graphs of the savings rate, the trade deficit, corporate debt, consumer debt, revolving consumer debt, mortgage debt, government debt, and total American debt show, the economic and financial boom of the 1990's was the product of the greatest credit boom in the history of the world. There never was a new era. There was simply abundant credit.

What is striking about all of these graphs is that very few in the financial and political establishment see anything wrong with them. In fact, most members of the ruling class are calling for more of the same. Austrian economist Kurt Richebächer described this lack of comprehension in his most recent newsletter. "Symptomatic of today's general incomprehension of macroeconomics is a narrow-minded concern with undifferentiated aggregates, like GDP, credit, money supply and income. But economic problems generally arise from a major shift within these aggregates, for example from shifts between consumption and investment or profits and wages. Or in the case of credit, the critical factor is often not changes in quantity but changes in their use." 1

In summary, the largest credit bubble in history created the boom of the 90's. The American economy rests on a pyramid of debt: debt at the consumer level, debt on corporate balance sheets, government debt, and enormous leverage in the financial markets. The economy and the financial markets are kept alive by a constant infusion of new credit. Stop the flow of credit and the whole system implodes. It is an economic and financial system in badly need of a diet and self-discipline. Until the system is cleansed of all of these credit excesses, there will be no sustainable economic recovery either in the economy or in the stock market. In the words of Peter Warburton, we live in a world of debt and delusion.

© 2002 James J. Puplava

1  Richebacher, Kurt, 

by James J. Puplava
July 12, 2002

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