“Affluenza” and the Fed game

“Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it” - Mark Twain

Economic growth in the US today is built on a lie.

I do not mean that GDP statistics have not been added up correctly, although there are some issues with methodology. I am simply challenging the notion that all and any type of economic growth is “good”. Economic growth is typically regarded as a sign of growing wealth and prosperity, but is that really true? Recently General Motors had strong and growing sales, and no-one seemed to care that it’s balance sheet was being destroyed. However, with just a small decline in sales recently, its solvency is now suddenly being questioned and its bonds have now been downgraded to junk. They used to say “As goes GM so goes America”. Maybe that’s still true.

In the US today a new and virulent epidemic is sweeping the nation. “Affluenza” has turned logic on its head. All the things we took for granted before are no longer true. Now economic growth more truly represents the speed at which the US is ruining itself. This kind of growth doesn’t go anywhere good. What is Affluenza? How could it have happened and what is being done about it?

Affluenza

Affluenza is a disease that was first diagnosed by Eric Fry of “The Rude Awakening”. Although the disease manifests itself in a variety of ways, it often produces behaviour characterized by reckless borrowing and insatiable consumption. The disease has infected millions of Americans already, but has reached epidemic proportions among California homeowners.

The onset of symptoms is often accompanied by a sense of euphoric invulnerability. Unfortunately, this delusional rapture promotes additional high-risk behaviour, which usually worsens the infection. Many folks – because they are oblivious to their condition – continue borrowing and spending until the disease reaches its final and most serious phase, also know as insolvency. 

Take, for example, a family with a $100,000 income. In order to get by and live the life they choose, it’s hard to keep spending down below $120,000. But this is OK, because credit is freely available anywhere you go, and after all this is only a temporary deficit this year, at least they hope so, and after all their house price is rising and eventually those investments will work out in the end. Right?

 

It is all too easy to understand and empathize with this situation. But the tragedy is that this is not a good long term predicament. House prices in the US are now over 2 standard deviations above their normal relationship with earnings levels, and earnings are no longer rising in real terms. House prices, one must assume will eventually revert to a more normal relationship with earnings. Those “paper” gains from rising house prices could easily evaporate at some point. The family’s investments have gone nowhere for almost a decade and stocks in general are still expensive, so their few current investments are hardly a guaranteed solution. In reality debt levels have increased and, of course, there is no way that any savings can be made. Not only is there very little set aside for a “rainy day”, there is simply not enough being saved or being accumulated for their pension.

Recently, the family has been able to increase its spending each year, on credit, and so they have managed to contribute to growth in the economy. But do you really believe that they are becoming more wealthy and prosperous?

How typical is this example of America in general? Well fortunately Dr. Kurt Richebacker has some numbers for us.

The Numbers

We pick up the story just after the stock market bubble burst in 2000.

Between 2000 and 2004 credit expanded by $10 trillion while nominal GDP grew only by $1.9 trillion. Consumer spending on durables and housing, plus government spending amounted to 123% of real GDP growth. Savings rates collapsed and debt soared. In 2000 $368 billion in mortgages were written and by 2004 this amount had doubled.

The so called strength in the US economy and to a large extent the world economy has stemmed from the most recklessly expansionary policies we have seen in our life time. Negative real interest rates, and an explosion of government and private sector debt growth have created an environment where it appears that money is endlessly free and available. No wonder that asset prices, and property in particular, have soared. No wonder that consumer spending has reached record levels. No wonder also, that the world economy has become critically dependant on this spending for its growth.

Unfortunately, the numbers tell us that debt and consumption are rising much faster than the economy. America as a whole is just like the family we have described above. However, no-one seems to complain. The reason is that as long as the economy seems to be growing, polls have consistently shown that voters care little about few if any economic indicators. Until citizens see tangible negative effects they are reluctant to demand action.

So why is this happening and what is being done about it? Why isn’t the Federal Reserve warning us about this and putting it right?

The Fed Game

The great tragedy of recent times is the role played by the Federal Reserve. This institution is supposed to safeguard long term prosperity, with both its actions and advice, and to operate as far as possible as civil servants independent of politics or any political bias.

Increasingly, in recent years, the Federal Reserve has become so much less than it should be. So much so that it is now becoming open season on pointing out its deficiencies. First Paul Volcker, the previous Federal Reserve chairman, has declared his deep concerns over the current state of the US “economy on thin ice”, with his April 10 Washington Post article. We should all ask ourselves why it is that this account differs so markedly from Alan Greenspan’s accounts that the economy is doing so well. Then we recently had a full attack on the credibility of the Federal Reserve from Stephen Roach, chief economist at Morgan Stanley. His account can be found at:

http://www.morganstanley.com/GEFdata/digests/20050425-mon.html

The Federal Reserve has many constituencies, and we should never forget that the chairman is appointed and reappointed by the President, and is accountable to congress, formally twice a year but in practice far more regularly. The extent to which the Federal Reserve can genuinely be regarded as politically independent is clearly compromised, and a great deal rests on the choices made by the chairman himself.

Perhaps the greatest test of the Federal Reserve in recent years was the prospect or risk of deflation. The Federal Reserve’s response could not have been clearer. If you have any doubt then read “Deflation: Making sure “It” doesn’t happen here” by Governor Ben Bernanke, November 21, 2002, available on the Federal Reserve’s web site. In this article there is very little doubt left that the Fed’s determination to avoid deflation is absolute. Take for example the following passage:

“..the US government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.”   

There you have it. Think carefully about what this means. The Federal Reserve is not only politically compromised but it is also in charge of the banking system. Deflation would be a severe blow to the banking system in the US, particularly when debt levels are so high and it would also make the political classes extremely uncomfortable. That makes the Federal Reserve clearly and unequivocally in favour of at least some inflation, and completely opposed to deflation. We can understand why and they have clearly stated this to be the case.

But is this right? From 1800 to 1920 the US experienced zero inflation, so it often experienced at least mild deflation. Yet over this 120 year period the US experienced remarkable long term growth and prosperity as it was transformed from a third world country to the wealthiest nation in the world. Why is it clearly beneficial overall to avoid deflation at any cost, even to point of destroying the value of the currency? I fear that the answer is that it is not clear at all, but at least in the short term it is preferable for the Federal Reserve, and Washington politicians to avoid deflation, and create at least the illusion of continued growth and prosperity even if it is a lie.

This is why real interest rates have remained negative or close to zero in recent years. Affluenza is precisely the required behaviour and is encouraged by free and widely available credit. It is also why interest rates are only rising at minute steps of 25bp. The Feds cannot afford to puncture the illusion and so dare not move too fast, but at the same time they want to raise rates as high as they can in the current cycle so they have as much ammunition as possible to fight deflation again when the next recession occurs, by having as much room as possible to cut rates, when growth fades.

It is just our misfortune that what suits Washington operators as short term expediency, is the path to longer term ruin as a country. The longer this illusion lasts the better it is for them and the worse it is for us. We should also realise that Federal Reserve statements have increasingly become propaganda, as they try to reinforce the status quo. Ben Bernanke recently tried to defend both the non-existent savings rate in the US as well as the record current account deficit. His argument was essentially that foreigners have far too much savings and have no idea what to do with them. So the US is really doing them a favour by going into record levels of debt! Ben Bernanke is however clearly encouraged for his efforts none the less. He has now been promoted to chair of the White House Council of Economic Advisors, and he is widely tipped to be in line as Alan Greenspan’s replacement early next year.

Fortunately, though, illusions can only last so long and it is likely that a turning point is close at hand. So few understand the nature of the current cycle that very few realize how fragile it is.

Turning Point

It can no longer be doubted that the world economy is heading into a renewed downturn. The loss of momentum in the second half of last year was especially pronounced in Japan and several Far Eastern countries. In Europe there is little doubt about economic weakness. Both Japanese and European government bonds have recently hit new multi-month highs reflecting this economic weakness and subdued inflation pressure. The Q1 GDP figures in the US were also a clear sign of a slower pace of growth. Not only was growth the lowest for some time at 3.1% but much of the growth was in inventories, so the composition was weak too.

The usual engines of sustainable growth in the US are simply absent, and are being made up for by a massive debt expansion. This is like a massive sugar shock. Sure there is a boost but then there is the withdrawal phase too. Debt expansion can only go on for so long, and now interest rates are rising and the currency has stopped falling. The economy has less of a following wind just as the sugar shock from the debt expansion begins to fade.

For all these reasons it is now highly likely that we have already passed the peak growth rates in the current cycle. The bond market bears have still not given up but almost certainly we have already seen the peak in bond yields for this cycle. It is now quite possible that new lows in bonds yields could be seen in the next year. Alan Greenspan’s “conundrum” about bond yields never really existed; it is only a “conundrum” in his illusory world.

Summary

Make sure you are not infected with “Affluenza”. Ordinarily it shouldn’t even need to be said, as it is essentially so obvious, but in America today it needs to be clearly stated. The true path to wealth creation, is through living within one’s means, regular savings wisely invested and tight control or elimination of debt. Just because everyone else seems to be behaving differently does not mean that you should too.

As for investments it is crucial to understand that the current economic cycle is quite unlike any other. The growth is based on a lie, born out of obsessive fear of policy makers about the possibility of deflation. Their cure, unfortunately, is no panacea. Indeed I believe that in the long term it is highly likely that they have made things much worse. Record levels of debt creation and consumption, combined with the incentive of negative real interest rates is the main fuel for growth in this cycle, not savings, investment and production.

This also has significant consequences for our investments. More than likely bond yields have already peaked for this cycle and may still make new multi-decade lows. Also the economy is far more fragile than most would have you believe and this means that we may be far closer to the next recession than most people expect. The stock market which has already stalled is therefore highly vulnerable in the medium term.

 

 

 

 

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