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Forget Iraq!

By Kurt Richebächer
April, 2003

From what we read about the U.S. economy, we have to conclude that its enormous bubble-related, structural problems are still little understood.

Too many economists in America possess an extraordinary ingenuity to discard the greatest imbalances in the economy as irrelevant. Record-high trade deficits, record-low savings and record-low profits do not matter in their eyes. It is by definition an economy that cannot have serious problems.

We like the statement that Rep. Bernard Sanders recently made to Fed Chairman Alan Greenspan after a testimony: "Mr. Greenspan, I always enjoy your presentation because, frankly, I wonder what world you live in." It is a question that we would like to ask numerous Wall Street economists and analysts.

Not only Mr. Greenspan, but most economists are clearly overstating the role of the Iraq jitters in slowing the economy. In the same vein, they flatly ignore the implications of the severe economic and financial maladjustments that the bubble-related borrowing and spending excesses have inflicted on the economy, among them in particular the profit implosion. There is no debate, no discussion, no questioning about this unprecedented profit calamity, just lamenting that increasing oil prices and the looming war with Iraq are causing companies and consumers to postpone big spending decisions. This explanation has, of course, the great virtue to make believe that the economy and the markets will resume booming as soon as this uncertainty is lifted, war or no war.

For the great economic thinkers of the past, it was uniformly apodictic that healthy economic growth depends on three key attributes: a high share of saving, a high share of investment and a high share of profits. But the U.S. economy's strong growth during last year badly lacked all three attributes.

Looking for the effective quality of the U.S. economy's strong growth in recent years, we noted the following facts: In 2002, consumption accounted for 87% and government spending for 32% of GDP growth in current dollars. On the other hand, business fixed investment diminished GDP growth by 23.6%. Another sizable cut by 20.2% derived from the further worsening trade deficit. In the fourth quarter of 2002, by the way, government spending accounted for 39.4% of GDP growth. If this was a recovery, it was a very sick one that lacked everything for sustainability.

During the preceding four years, 1997-2001, nominal GDP grew altogether by $1,763.8 billion, or 21%. Consumption accounted for $1,457.7 billion, or 82.6%, of the total. That share was about 15 percentage points above the long-term average. Government spending provided $370 billion, or 20.9%. An unusually small contribution came from business fixed investment with $202.2 billion, or 11.4%, of the total. The soaring import surplus diverted a huge $259.6 billion of domestic spending abroad.

According to official interpretation and general perception, the U.S. economy's growth during these years was led by strong investment and productivity growth. The ugly reality was consumption-led growth as usual, with one important difference: this time the consumer borrowing binge went to an unprecedented extreme. Just as clear was its decisive propellant: the skyrocketing wealth effects of the booming stock market.

By definition, it is the essence of a bubble economy that rising asset prices fuel specific borrowing and spending excesses. In the case of Japan, these went mainly into commercial construction and business fixed investment. America's bubble economy had its decisive, big structural distortion in the borrowing and spending orgy of the consumer.

Consumption's steeply rising share in GDP was the manifest hallmark of the U.S. bubble economy that developed in the late 1990s. Essentially, a sharp rise in one GDP component implies the looting of other components. In the U.S. case these victims were fixed investment and foreign trade.

There is a widespread, hopeful view that the bubble-related imbalances and distortions are being rapidly corrected. In this view, the U.S. economy's main problem from the past boom years has been a protracted excess in business spending on fixed investment that has resulted in vastly excessive production capacity. Boosting potential supply in relation to slower demand growth, it is also supposed to be the main cause behind the profit carnage by destroying pricing power. From this perspective, the drastic retrenchment of business fixed investment represents a highly desirable correction of the prior investment excesses.

It is the consensus view. Yet it is absolutely ludicrous.

Over-investment may, indeed, be true for Asia but definitely not for the United States. As explained and documented, America's overwhelming structural maladjustment in the past few years has been bubble-driven over-consumption that plainly bombed out business investment and the trade balance.

What the slide in business fixed investment truly reflects from this perspective, our perspective, is not at all a desirable and necessary correction of a prior maladjustment but a dramatic worsening of chronic corporate under-investment in the United States, its obvious cause being the profit carnage.

What obviously saved the U.S. economy from a crushing recession was the housing and mortgage refinancing bubble that developed with consumer debt growth beating record after record. In the third quarter of 2002, it ran at an annual rate of $770.7 billion, as against $661.3 billion in the same quarter a year ago, and $571.4 billion another year back.

Everybody is hailing this acceleration of the consumer borrowing binge because it has prevented a deeper recession. But in essence, this, too, represents an increasing maladjustment in consumer spending.

Kurt Richebacher,
for The Daily Reckoning

Editor's note: Dr. Kurt Richebächer's articles appear regularly in The Wall Street Journal, Barron's, the U.S. edition of The Fleet Street Letter and other respected financial publications. France's Le Figaro magazine has also done a feature story on him as 'the man who predicted the Asian crisis.'

A version of this essay was originally broadcast in:
The Daily Reckoning
www.dailyreckoning.com