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The
Broken Cycle Everything has changed. Nothing is the same. Much talk has centered on the business cycle and the radical stimulus to kick it into gear. Popular expectations are linked closely to events unfolding in a prescribed manner, according to the past cycles. Stimulus during this cycle has advanced a monumental degree of speculation, rather than business investment. The trend within the US Economy over the last two decades has been toward massive speculation in both financial markets and residential real estate. Loose money accessible at low interest rates, the earmark of past cycle stimulus, has built new bigger bubbles. Resolution of past bubbles has in no way taken place. Instead it has allowed massive refinances of mortgage, extending home equity debt so as to sustain consumption. Mainstream household spending has been supported in the process. Regrettably, stimulus has led to every imbalance becoming more dangerously out of kilter. This cycle is not producing the expected outcomes during the recovery. The delay in the arrival of jobs has become the most visible missing element in the recovery so far. Jobs are not being created in volume like in past cycles. Recent jobs reports are packed with the same old small business assumptions of questionable nature. While nothing is similar with past cycles, expectations remain firmly held according “to the business cycle.” However, the business cycle has been severely altered by globalization, by debt burdens, by foreign dependence, and by technology itself. The high valuation of the USDollar has resulted in systemic lack of competitiveness. This is not your father’s business cycle anymore. BROKEN BUSINESS CYCLE SYMPTOMS:
Our entire economy has undergone such radical change that it bears no resemblance to a properly functioning system that builds things, fixes things, employs our people, and elicits checks & balances on credit. Debts in excess are not punished at the national level, as Asians eagerly recycle vast trade surpluses in order to retain their export prices abroad. The economy has dysfunctional structural features in almost every corner and pocket. A fiat currency, financial speculation, globalization, outsourcing, credit abuse, and addictive spending have rendered the economy a structural nightmare with no easy remedy. An effective correction to the imbalances, sufficient to right the structural deviations, would require a recession if not a depression, and a considerable period of time to bring order to the entire debt composition. All natural market forces working toward adjustment are resisted. Now more dangerously extreme imbalances threaten the entire world economy. Observers note the changes to sectors within the economy, without recording any significant modifications to their overall cyclical expectations. Therein lies the basis for wholly incorrect and faulty economic forecasts. The much heralded recovery will hardly proceed according to any past established pattern. The power of aggressive monetary policy has been thoroughly exhausted. Structural dislocations have not been addressed, let alone reversed. Next comes desperate official policy as the broken cycle screeches in futility. Most if not all of the distortions we must deal with originate from untethered money and loose credit, fully permitted by fiat currency. Nowhere is this more evident than with the USDollar. The ability to print money and extend credit appeals to the darkest chambers of humanity, greed and the desire for power. The United States has caused turmoil with exported paper money of dubious value worldwide for over 30 years, exporting financial cancer while putting forth an innocent face. The Japanese stock, real estate, and bank debacle was the first major disaster in 1989. The Asian Meltdown in 1997 was the next major fallout. The US tech-telecom stock bust in 2000 followed as the latest major victim, a full round-trip around the globe. Blame is slowly coming to the US doorstep by world ministers. As the process has de-evolved, the world economy has become horribly imbalanced. The US Economy has itself de-evolved into a queer distended obese malnourished disfigured beast, whose mechanisms and functions are no longer even remotely healthy. The cycle of expansion and contraction used to be volatile but predictable, with stimulus followed by belt tightening. Now it has become outright broken. The source of the problem is the monetary system and its undisciplined issuance of credit, aggravated by central bank steroid-driven printing of money. Von Mises claimed that once fiat money entered the world economy, competing currency devaluation would proceed until one by one, economies would be killed off. Japan and Argentina are the most visible victims. The tragic decline of the United States is in progress. Despite the denial, we are seeing exactly what he preached. Aristotle had this to say about fiat money back in 340 B.C. "In effect, there is nothing inherently wrong with fiat money, provided we get perfect authority and god-like intelligence for kings." Stimulus from both the banking system and the federal government has been unprecedented. The reflation initiative is underway. Residential housing gains have supported the economy. Household spending has revived. Corporate earnings appear to have revived. Capital investment seems to have begun anew. National aggregate statistics indicate some degree of recovery, despite exaggeration. Job loss bleeding continues, even as new job creation proceeds at a slower than required pace. A lower USDollar has allowed exporters to more capably compete abroad. Productivity is strong. The US Economy is growing again. Can we attribute a supposed recovery to the business cycle kicking into gear? Or should we give full credit to the “cloistered greenhouse of government fiat” (a clever term by another author) as it prints money, issues debt, encourages more speculation, and finds creditors to take the inherent risk? The economic benefits of the greatest coordinated monetary inflation in the history of mankind is meager at best, and a dismal failure at worst. The US money supply has been purposefully expanded by 32% since 2000. Debt levels in every corner of America are worse in than that watershed year. Three years later, we have some tepid growth in the economy, but continued loss of jobs. We are spinning our gears, as new money pours into the economy in futility, only to be discharged to Asia. An image comes to mind. Uncle Sam is struggling under a huge debt burden, even as his subjects struggle under similar huge debt burdens. His legs render him awkwardly able to bear the weight, incapable of walking in a straight line, due to a badly twisted spinal column. Under the influence of extreme doses of pure oxygen and amphetamines, he rises after a painful fall in the year 2000. Since that tumble, he has lost a considerable amount of blood. Now he walks, despite continued loss of blood in what has become a dangerous hemorrhage. His steps are irregular, clumsy, and uneven. Govt statisticians view his gait through an absurdly distorted lens, which wildly amplifies the size, strength, even the direction of his movements. That same lens fortunately provides snapshots, which make his movement appear steady. The children he pulls along are Asian workers, not our own. Every step is borrowed from our new Asian masters, who are now either anxious or angry. With crimped income sources, American subjects watch as their jobs are abandoned and sold out to foreign lands. Globalization has backfired on Uncle Sam, and inflicted perhaps mortal wounds. Our manufacturing base was first to forfeit. Now our vital service sector is in the process of abandonment. As he attempts to walk, what used to be simple headwinds in past cycles are now fierce gale-force squall winds in this cycle, which make balance impossible. GLOBALIZATION PARADIGM SHIFT: Changes are so pervasive, that they are difficult to describe in full. Every single aspect of the US Economy has changed for the worse in the last 15 years, as dislocations have become solidly engrained. Some might argue that we are evolving to a higher order, where the information economy can produce money for profit without the need for work, sweat, and sacrifice. We have cheated our economic mother nature. Past cycles in no way provide insight or guidance for the future recovery course. Old actions produced reactions, which no longer apply or serve in relevance. What has changed? Everything. The better question is… What has stayed the same as in past business cycles? Almost nothing. Then why maintain the same cyclic expectations? By far the most profound metamorphosis in recent degradation has been the outsourcing of manufacturing jobs, and more recently, service jobs.
Our leaders talk about evolution, but in fact, we are dealing with a deep undermine in progress, which has rendered the US Economy to be extremely unstable, out of balance, and vulnerable. Since 1960, we have truly eye-popping changes. Business savings used to be commonplace, in the form of dividends. Those dividends are now either puny or more typically quite the opposite, replaced by enormous corporate debt. The yesteryear federal budget surpluses are now annual crippling deficits, financed largely by foreigners, well beyond safe and innocuous levels. Each year, debt claims to our nation’s wealth grow by 1% of the United States GDP. The trade surplus used to be a badge of honor, worn by a nation steeped in manufacturing strength, competent enough to build what it needs. Now we have massive trade gaps financed by consumer debt for the purpose of buying foreign worker output. Money supply growth used to be managed carefully, not to exceed the growth rate of the economy itself. Now monetary expansion is off the chart, rising by one third in three years, totally disconnected from economic expansion. Our vaunted mfg base has been discarded, forfeited, and abandoned for Asian versions of the same using cheaper labor. Consumption used to be tame and unremarkable. Now retail sales and omnipresent spending make up the central visible pillar of the economy, a sure signal of trouble. Debt service has become an indication of total economic suffocation, as almost 78% of all transactional flow for goods & services is devoted to payment of principal and interest. In every way, this is not your father’s business cycle anymore. The new cycle is not recognizable as anything but the result of financial cancer: excess money growth, excess credit growth. Some I speak with find this 78% debt service figure absolutely incomprehensible, in wonder of how we as a nation have allowed debts to rise. Just ask that question to somebody who is about to pull out a credit card to close a large purchase at a store. Ask the new car buyer taking advantage of a 0% loan with a tiny down payment. Ask the homeowner who is about to sign an equity loan for college loans, a Caribbean vacation, or a second home by a favorite lake. Our population has become homeowners on a massive scale. More importantly, collectivism has enabled them to buy homes and to raid their equity for everyday needs, or for luxuries and indiscreet purchases having nothing to do with needs, and everything to do with excess. A paradigm shift has taken place in the last 40 years. Perhaps a shift has taken place every 10 years. Each successive shift is clearly toward a more dangerous and unstable condition. Asia has been the principal beneficiary, but one cannot overlook Mexico. Globalization has on the whole displaced American jobs, created outsized trade deficits, and replaced them with massive debt obligations. In the pursuit of low-cost solutions, the majority of mfg function has been shipped to Asia. In doing so, profit margins on the extremely large cash flow benefit Asian economies, not American. Profits to Asian firms enable further capital investment. Profits are created among American corporations largely from cutting costs, shedding workers, reducing certain employee benefits, and outsourcing of significant functions abroad. In other words, profits among US firms are managed even as they endure liquidation. Abandonment of our domestic labor market and mfg base comes amidst a decade-long appreciation in the USDollar, to the point where our corporations can no longer adequately compete on price. Foreign rivals have a price advantage in the global village we sought so vigorously to erect. High relative labor and health care costs are compounded by an overvalued US currency. With its eye firmly trained on financial markets, our financial leaders engineered a spectacular rise in the US$. The benefits were tremendous in attracting credit funds for our federal debt, and for reducing the costs for our importation of finished products. As night follows day, the tide has turned. Next we will discover funding our govt operations to be more difficult. The surprise though, will be in the rise in Asian imported product prices and the reluctance of Asians to private cheap capital, wholly unexpected from years of conditioning and slumber based in economic illiteracy. A strange piece of evidence hit the airwaves in mid-December. Import price inflation for the month of November rose 0.4%, which is twice what we have seen in previous quarters. Export price inflation for November rose even faster, at a 0.5% rate. Where is the exporter advantage? Is this the harvest of the Fed’s reflation effort? In the spring of 2002, I anticipated that the US$ would decline radically against the Euro currency, with no appreciable impact or remedy to the trade gap. Recent trade figures confirm my forecast, as the monthly gap is almost as wide as any in our history. With rising material costs, rising energy costs (shipping), we are witnessing rising production costs throughout our economy. Exporters do not export in sufficient volume to close the trade gap. And besides, their costs are increasing in the face of a declining USDollar, thus eroding somewhat their exchange rate advantage. The North American Free Trade Agreement brought the offshore manufacturing movement home to our continent in 1994. It began with the migration of mfg plant, operations, and jobs to Asia for the production of finished goods late in the 1970 decade, only to accelerate in the 1980 decade. Most notable were the automobile and consumer electronic sectors. NAFTA reinforced the recovery, lowered costs for participating corporations, and developed free trade zones in Mexico. The 1999 Most Favored Nation status was granted to China, surrounded by great controversy and vitriolic objection by the AFL/CIO. Global trade would never be the same again. Labor within the United States had been not only abandoned, but betrayed. In the next few years, the gutting of the mfg sector was nearly complete, as Chinese labor was made available at less than 5% of the previously borne cost. Worse still, with the aid of technological advances in broadband transmission, computer networking, and fiberoptic connectivity, the service sector was laid vulnerable to outsourcing. SERVICE SECTOR OUTSOURCING: All through the 1980 and 1990 decade, large tracts of the US manufacturing base were abandoned in the United States and installed in Asia. Now in the 2000 decade, a new more dangerous phase has begun, wherein the service sector exploits Asian labor. It started in the last decade with low-level functions like call centers and transaction processing. Now several high-level functions ranging from software programming to electronic design to medical consultation to consulting services to legal services are being outsourced to Asia. Initial transition hiccups are tolerated, noted in the clothing and software sectors. The cost advantage is sufficiently large to overlook temporary problems. My father, a retired university professor, reports from his own literary world. His publisher claims that their copy editor function has begun to be outsourced to India, yet another skilled service. The end product is a floppy diskette sent overseas by FedEx. US industry in all sectors is threatened by the overvalued dollar and by the harness of technology. More importantly, global trade continues to deliver harmful blows to the American labor market. The jobless recovery limps along, even as announcements of outsourcing to Asia continue. One must wonder if desperation both to survive and to eek out short-term profits might endanger future growth prospects. Surviving companies are no more trim on the debt scale, only smaller on their operational side, and might even be at a disadvantage having shed their most expensive and talented workers. Outsourcing seems to coincide with a certain degree of liquidation. Morgan Stanley’s Stephen Roach describes three powerful forces at work, which he calls mega-trends. First, offshore outsource platforms are maturing. Their technical skills, language skills, and installed sophisticated equipment complement lower wage scales in the provision of high quality services on a massive scale and scope. Up until now, their labor force was not considered of sufficient skill to accept the baton from American workers. Second, computer system integration and connectivity now take advantage of the internet in a potent manner. The products of the heralded tech revolution are now being used as the very vehicles to outsource services primarily to India, China, Hong Kong, but to other locations as well. Taiwan, Korea, Ireland, and Australia have also benefited from the exodus of American jobs. The internet and networks have revolutionized global commerce dynamics. Third, cost containment has motivated a new phase which has led US firms to seek outsourced alternatives. Although not stated, health care costs might aggravate management decisions on the fringe of decision making. They represent the fastest growing cost component, growing over 10% per year within our nation. New imperatives of cost control serve as the catalyst, in the words of Roach, which bring global labor arbitrage to life. Once protected, high-salaried service jobs are the recent casualties in an escalating movement to relocate to Asia. Leading US firms such as General Electric, Oracle, and IBM are the most prominent in recent decisions to employ the global service trade. Knowledge-based system output is available for shipment on information highways at broadband speeds, or via overnight delivery. Fiberoptic networks easily connect computer systems across the continents. Domestic service providers are vulnerable to the readily available intellectual capital brought to bear abroad. Seamless integration of highly skilled foreign workers has arrived, thus undermining the US economy, which is based two-thirds on its many service sectors. Imported services can possibly explain the disconnect between rising productivity and absent job growth within U.S. economy, thus yielding poor income growth. Many point to excess capacity being more optimally utilized, when in fact it lies principally unused. The better explanation might be the gains to output from foreign-based service provision. Real goods imports have swelled 11.4% in the first six quarters of this so-called recovery, a figure greatly exceeding the anemic 4.2% rise in domestic demand over the same period. Foreign labor has been substituted, and in the process, our economy glides along in a tepid growth spurt which yields no substantial benefits to income and investment. Our economy may be growing again, and productivity rising, but the main labor beneficiaries lie in Asia, not the United States. The U.S. economy has in effect imported productivity!!! As a result, our US Economy will not participate in the associated benefits, such as making available a capital flow from which to divert funds for capital investment. The profit margins on all those imported products provide far more job income for the Asian producers than for American retail sellers. The early potential is surely present to realize renewed profitability, but not in any sustained manner. Manufacturing capacity utilization has remained stubbornly low. That is because foreign plant is the primary beneficiary of expanded business, not domestic. Think about it. We in the USA have plenty of unused capacity, but expansion is directed to take place elsewhere, in Asia. Data on outsourced jobs is difficult to come by. India currently boasts 650,000 professional workers in the information technology sector alone. In a recent study coordinated with India’s National Association of Software and Service Companies, McKinsey estimates that these numbers will grow by a factor of three in the next five years. IBM has a 3100 headcount in India, with a 10,000 total planned in the next three years. EDS has 300 in India, with a 2400 planned total by 2005. Oracle has 3159, with 6000 planned in the next 12 months. Intel has 950, with 3000 planned by 2005. Computer Sciences has 1200, with plans for a 4800 total by the end of next year. Accenture has 3500, with plans for 8000 by next summer. Outsourcing is not a fleeting phenomenon; the trend is irreversible and gains momentum each quarter and each year. US industry is accelerating its abandonment of America, even as outsourcing broadens in scope across industry sectors beyond its original mfg locus. The Fallacy of Decomposition is hard at work. Micro benefits to the firm are not translating into macro benefits to the nation. Trouble lies on the horizon on the political and legislative fronts. The unfortunate outcome with trade friction, protection, and tariffs is unavoidable since currency mechanisms are being interfered with so thoroughly. The leakage of job creation outside our borders should continue until trade war erupts. I contend that trade war has already begun with China, which is sure to be demonized for political purposes in this election year. ABSENT PENT-UP DEMAND: Mark Zandi calls it more appropriately “spent-up demand” to convey how attractively low interest rates have extended the unprecedented decade of the great American spending binge. In previous business cycles, households and consumers withheld purchases for a sustained recuperative period of time. They paid down debt. Residential housing and automobile purchases were the main areas where buying urges were suspended, demand built up, and a coiled commercial spring was erected. That was in the past pattern. The benefit typically is realized early in the recovery process as demand is held back. Today, the pent-up demand phenomenon is totally and completely absent. The US Economy is now tilted dangerously toward an entire system reliant upon consumption. In fact, figures are hard to come by, but it is widely reported that over 80% of the GDP owes to retail consumption. Why this fact is not reported with alarm is beyond me. We go deeper into debt and spend huge amounts of money on retail consumption, including cars and household furniture. The deals seem too tempting to pass up. It seems the norm is constantly being adjusted toward the more absurd and untenable.
In the year 2001 as lending rates dropped, every effort was made to sell cars with 0% rates, then with 0% down payments. In time, in the face of sluggish sales, both incentives were offered. Cash back offers became routine, then withdrawn, finally reinstated. Incentives become permanent to confront Asian competitors, who gain annually in market share. Collateral damage comes in that the used car market has been decimated, with soft trade-in values. That structure is not a vested interest for new car sellers, who depend on volume sales and inventory turnover. The relationship between carmakers and car dealers is tight, according to the franchise model. Detroit needs low rates to continue the rollout from production. Carlos Ghosn, CEO of Nissan, put well the risk to US carmakers. He claims that incentives destroy the brand in the long run, and that American mfrs are eagerly exchanging short-term gain for long-term pain. In no way has the US Economy formulated any pent-up demand for car sales. Jobs in Detroit took a higher priority. An entire vertical integration of accompanying jobs also lies in the balance with component suppliers, subsystem builders, auto part vendors, and finance groups. Housing was quick to respond to the fully stated and anxiously awaited drop in long-term interest rates, with linked mortgage rates. The Federal Reserve was desperate to engineer a mortgage and housing bubble, to relabel it as “wealth creation,” and to unleash newly extracted debt from the inflated asset values. The refinance movement became an instant hit, as well as a critical mainstay for the economy in permitting continued consumer spending. We Americans are unique (except perhaps for the Netherlands) in our willingness to burn our furniture for home heating purposes. Few among our citizenry shun the opportunity to extract cash from home equity for whatever need. Once more the Greenspasm Gambit is felt, as it pats homeowners on the shoulder. Comfort is taken in knowing that the Fed will do all in its power to perpetually inflate the value of residential resident real estate. We spend, refinance, pull out cash, spend more, take home values for granted, and expect values to rise evermore. Yet we routinely fail to recognize that inflation surrounds every facet of our society. What an incredible blind spot!!!
As mortgage rates fell over a full percent, housing sales went into overdrive. Two notable changes were soon seen. Fanny Mae and the Govt Sponsored Enterprises let loose an unprecedented supply of lent funds for the purpose of purchasing homes. Relaxed rules and guidelines toward down payments, income verification, property appraisal, closing cost kickbacks, these all were commonplace. Mortgage applications became a slam dunk. Soon afterwards, solicitation grew prevalent for home equity loans. Loan quality fell in priority, since ample funds were available for mortgages. Audit for quality, by federal law, is possible only in the aggregate. Collectivism has hit mortgage finance in force. Non-performing loans are routinely packaged then sold as “re-performing loans.” Deep discount and cash back incentives continue to support sales, which cannot be discontinued without severe consequences. The guise of govt guarantee for entire packages of mortgage portfolios enable foreign central banks to invest large tranches of trade surplus capital in our agency debt securities. New house and existing house sales set records. In no way did the US Economy formulate any pent-up demand for housing sales. Absolutely insidious exhaustion might properly describe the current state of automobile and housing demand. We have no pent-up demand in either sector of our economy, from which to benefit as the so-called recovery unfolds. On the other hand, housing sales can probably continue with slightly higher mortgage rates. It is uncertain whether restriction on mortgage application rules might hinder housing sales. I expect we will find out sometime in the year 2004. In the meantime, mortgage refinance has stalled as a movement. It is there, but the movement is receding and its support for the economy is being reduced. A refinanced mortgage is given motivation and incentive with falling interest rates, not stable rates. If anything, long-term rates should inch up. Jobs within mortgage finance are also in decline across the nation. Such is the price tag of building a bubble and distorting the economy, which our esteemed Mr. Magoo at the Fed is incapable of recognizing.
In a typical business cycle, interest rates increased in reaction to shortages, allowing for pent-up demand to collect and gather. A torrent would await. Demand would be unleashed as rates fell. This time around, the cycle has managed to exhaust demand on a large scale, as Americans vigorously soak up ample credit supply at ridiculously low interest rates. Instead of culling debts, the Greenspasm Fed has seen fit to encourage a gross extension of debts in every form imaginable. Demand never was permitted to abate. Such is the nature of super-cycle corrections. Pent-up demand is now nonexistent. We have a greater dependence on consumption and a greater surplus of debts than ever before in our nation’s history. Further installments will be forthcoming with certain stock recommendations: The
Broken
Cycle Series
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