HOW TO IDENTIFY A BUBBLE by Kurt Richebacher

Dr. Kurt Richebacher, former chief economist and managingpartner for the Dresdner Bank in Germany has analyzed worldeconomies for 60 years. Author of The Richebacher Letter, amonthly look at the state of world currency and credit markets,Dr. Richebacher has helped his readers protect -- and even grow-- their wealth during times of prosperity and volatility.

In the old days, central bankers were always mindful of the necessary balance between available domestic savings and credit expansion. For them an early indicator of a developing imbalance between the two aggregates was a deteriorating trade balance, responding typically long before prices.

It is, as a matter of fact, the central axiom of the Austrian school of economics that the movements in the price level can be a misleading guide to monetary policy. What crucially matters is the inflation of credit, exerting a much deeper and fundamental influence on the whole economy through distortions and dislocations in its whole demand and output structure.

From a policy perspective, to stress the key point, the decisive evil thing is the credit expansion that exceeds available domestic savings. That is the regular, cardinal culprit behind all dangerous economic and financial imbalances, and also behind all inflations. What the Greenspan Federal Reserve refuses to accept is that their beloved wealth-creation reflects incredibly dangerous inflation in the asset markets.

Putting it differently, in a balanced economy, credit expansion is fully matched by available domestic savings. This used to belong to the elementary knowledge of economists. Mr. Greenspan shocked us with his public remark that an asset bubble can only be recognized after it has burst. Outrageous credit inflation was the infallible and most spectacular hallmark of America's equity bubble in the late 1990s. But instead of feeding into the price indexes of goods and services, which continued to fall, it fed into soaring imports and soaring stock prices.

To repeat: All asset bubbles and bubble economies have their highly visible and also compelling trademark in exploding credit. The distinction between the two is important. An asset bubble simply reflects a rise in asset prices out of proportion to underlying yields. A bubble economy is an economy where soaring asset prices fuel a borrowing/spending binge that may be concentrated in real estate, business fixed investment or consumption.

At year's end, during the discussion about the U.S. economy, it has been repeatedly mentioned that interest rates are at their lowest in 45 years. It made us curious about differences in the underlying conditions in the two periods.

Comparing the two eras was a most interesting exercise.

The common feature between them is low inflation rates. But in every other respect, the comparison reveals radically different economic and financial universes, and also radically different causes for the record-low rates.

In 1959, the private sector's total net savings amounted to $44 billion, of which personal saving accounted for $26.5 billion and business saving (undistributed profits) for $17.5 billion. With the government sector in surplus by $21 billion, the three components added up to net national savings of $61.1 billion, or 12% of GDP.

Imagine: In 1959, the business saving rate net of depreciation - undistributed profits, in other words - was 3.4% of GDP. Compared to today's GDP, that would amount to undistributed profits of around well over $350 billion.

And today? The reality during the third quarter in the case of the nonfinancial sector was $49 billion in the negative. American businesses are dissaving, and so, of course, is the government sector with the soaring federal deficits. According to National Income and Product Accounts statistics, private households are running a savings surplus, but looking at the rampant housing and mortgage refinancing bubble and considering that saving represents in essence unspent income, we wonder how that surplus comes about.

All in all, it seems a fair guess that today's America has gotten rid of any savings.

If the difference in savings between the two periods is ludicrous, the difference between credit growth defies description. In 1959, total net borrowing in the United States increased by $56.8 billion, perfectly in line with available net national savings of $61.1 billion. For perspective, nominal GDP increased by $39.5 billion to $507.4 billion.

Now to the credit horrors of the present. Keep in mind: Net national savings are at best close to zero, if not negative. Nonfinancial borrowings ballooned in 2002 by $1,374.6 billion, of which $771.8 billion was on account of the consumer. For perspective, this was about seven times the simultaneous GDP growth of $364 billion.

We have drawn this comparison between the two periods not just by impulse. We think it is most important to realize the incredible difference that exists between today's financial conditions in the United States and those of the past.

In the late 1950s, America's record-low interest rates were clearly and soundly founded in high domestic savings and moderate credit growth. Today's record-low interest rates are just as clearly founded in unprecedented monetary looseness accommodating unprecedented financial leverage.

The relevant issue, however, is not the bubble as such, but what happens in its wake to the real economy and the financial system. In general, policymakers have become fearful of asset bubbles.

America is the only country in the world where asset bubbles have become the panacea of monetary policy.

Regards,

Kurt Richebacher,