Tuesday, March 29, 2005


by Dr. Kurt Richeb├Ącher

From the macro perspective, U.S. business profits received their main boost from two flows in recent years. One was the phenomenal decline of personal saving, and the other was the soaring budget deficit accruing from tax cuts and higher spending.

Saving is the unspent part of personal income. To this extent, wage earners reduce total business receipts in relation to total expenses incurred. The net result is a corresponding fall in profits. Conversely, when households run down their saving, business revenues rise in relation to expenses incurred. The net result is higher profits.

In this way, the phenomenal collapse of personal saving in the past few years has been Corporate America's main profit bonanza. This was far more important than the direct and indirect revenue flows from the soaring budget deficit.

But the trouble is that the soaring U.S. trade deficit in recent years has been diverting a rapidly growing share of such spending and its inherent profit creation to foreign producers. In essence, the trade deficit directly transfers spending and profits from domestic to foreign producers, leaving American producers with the wage expenses, which their employees spend on foreign goods. As we have stressed many times, the trade deficit is the greatest profit killer in the U.S. economy.

We come to the most important macroeconomic profit source in a healthy economy. Apparently unknown to most American economists, this is net capital investment. John M. Keynes expressed it with great simplicity and precision: There are two streams of money flowing to the entrepreneurs, namely, the part of their incomes that the public spends on consumption and the expenditures of businesses on net capital investment.

Economists, in general, are completely unaware of the crucial importance of business investment for business revenues and profits. This has a particular and peculiar reason. From the perspective of the business sector as a whole, investment spending creates business revenue without generating business expense.

What seems mysterious has, in reality, a simple explanation. Investing firms capitalize their investment expenditures. No expense is incurred until the first depreciation charge is recorded. For the producers of the capital goods, on the other hand, it involves a sale, producing immediate revenue.

Due to this particular treatment in accounting, net fixed investment is typically the business sector's most important profit source. But in the United States, this profit source has dramatically collapsed in the past few years, as rising depreciations have overtaken gross new investment.

In 2003, net fixed investment amounted to $154.5 billion, after $404.8 billion in 2000. This implies, first of all, a rapidly shrinking capital stock; and second, a disastrous drag on business profits, because depreciations are expensive.

Answering the question of aggregate profit prospects for the U.S. economy in 2005 requires a macro perspective focusing on changes in four aggregates: personal saving, budget deficit, trade deficit and net business investment.

Our crucial assumption is that negative profit influences will grossly outweigh positive influences, suggesting in their wake lower business investment. If the consumer starts to save out of current income, the U.S. economy will slump.

We have characterized the U.S. economy as a bubble economy in the sense that asset appreciation has become its main engine of growth. Courtesy of the prolonged sharp rise in house prices, the American consumer has been willing and able to maintain his spending despite a protracted recession in employment and wage incomes.

But we see a variety of influences tempering the bubble climate. For the time being, the whole set of asset bubbles finds strong support from still exceptionally low short-term rates, still extremely loose money and credit, and high-riding expectations about strong U.S. economic growth and low inflation rates in 2005. Much economic data warn of impending strong disappointment on both counts that will prick the bubbles. Not to ignore, moreover, the Fed's commitment to further rate hikes.

Yet the refusal of long-term rates to rise in response to the Fed's serial exertions to raise short-term rates further is perplexing. Mr. Greenspan himself spoke of a "conundrum." A reported inflation rate above 3% would, by past experience, imply a federal funds rate of at least 5%. But a rate of 3.5% would already be enough to wreck the bond bubble, and in its wake, the stock and housing bubbles.

For sure, the financial community is fully aware of this immense policy risk, strictly limiting the Fed's scope for further rate hikes. The amazing stability of long-term rates suggests the financial community has not only refused to unwind, but has even continued to add to existing carry-trade positions. They are still far too profitable to be abandoned before the Fed makes them unsustainable.

As no one is taking the Fed seriously, it may have to do more than it wants. The frightening point to see is that, given the U.S. economy's heavy dependence on consumer spending for the housing bubble, a mere leveling of house prices would be enough to slash consumer spending and economic growth. We expect worse than price stagnation.

It ought to be realized that a rise in long-term rates by only 1-2 percentage points would rapidly play havoc with all existing asset bubbles - bonds, stocks, housing - and in consequence, with economic growth. Within a matter of months, there would be deep recession.

A crucial question is the inherent impact on personal saving. Voluntarily or involuntarily, private households will sharply restrain their borrowing and return to old-fashioned saving out of their current income. That this will badly depress consumer spending needs no explanation. Unfortunately, when consumption declines, fragile business and housing investment will fall as well.

Most people inside and outside of America have yet to realize two things: First, that among industrial countries, the U.S. economy has by far the worst structural fundamentals; and second, that it is far more vulnerable today than in the first two years of the decade.

Of course, American policymakers and economists have been trumpeting the opposite for years. Having realized their complete disregard of macroeconomics, we are sure that they earnestly believe this fairy tale. With this in mind, we recently, with great interest, read a report from Morgan Stanley about a meeting with customers in late January.

About global economic prospects for 2005, it said: "There was little doubt as to who would take the baton in a post-U.S.-centric world - it would be another encore for America. There was deep conviction that no one comes close to having such an ideal system - especially in terms of technology, the work force and America's unique risk-taking culture. Market depth and flexibility - in both the financial and the nonfinancial realms - was depicted as the icing on the cake for yet another run of U.S.-centric global growth."

Later, it stated, "Europe, which has none of these qualities, is the last place where productivity could take off."

For us, this is typical Wall Street trash, bare of any serious macroeconomic thought. It used to be an elementary truism among economists that a healthy economy is rich in savings, rich in productive investment and rich in profits. The U.S. economy is extremely poor in all three. But it is extremely rich in financial speculation and corporate malfeasance.

To be sure, the enormous structural deficiencies are increasingly impairing U.S. economic growth. For the past three years, unprecedented monetary and fiscal profligacy has been able to overpower their depressant influence through the bubble-driven consumer borrowing-and-spending spree. Yet the "structural drags" are finally gaining the upper hand over the weakening bubble impetus. The U.S. economy's famous resilience had more to do with clever statistics and unprecedented monetary looseness than with true economic strength.


Kurt Richeb├Ącher
for The Daily Reckoning