The Daily Reckoning Australia

Paris, France - Melbourne, Australia

Monday, 9 February 2009

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From Dan Denning on the Gold Coast:

--U.S. stocks were up on Friday along with the Aussie dollar. It looks like everyone is expecting the good times to roll once Washington passes a stimulus. Blah blah blah.

--Really. It's getting hard to take the economic press seriously anymore. No one asks how you save an economy by "boosting aggregate demand" when the problem is too much debt and too little production.

--If anything "boosting aggregate demand" in Australia merely stimulates profits for overseas companies. After all, much of what Australians will buy with the government handout money is made abroad. Remember that pesky trade deficit thing?

--The stimulus-both here in Australia and there in America-looks like a done deal. It's no use whinging about it. But it does show you how far we have lost our way economically. An economy grows when you produce goods and services you can sell to other people at a profit. This profit becomes the surplus savings that finance other risk taking, which creates more jobs and incomes and profits.

--Productivity increases help a lot too. But the main point is that "stimulating" people to buy stuff doesn't accomplish much in the long term. You need to make stuff. And it has to be stuff for which the demand is real and sustainable. Ripping off future generations to avoid a few quarters of negative growth is not a strategy. It's a cop out.

--But markets appear to like cop outs! Either that, or stocks in the U.S. like the one-two combo of Tim Geithner and Warren Buffett. Geithner unveils his magical mystery package of government goodies on Tuesday (pushed back a day so that President Obama can scold as "irresponsible" anyone who criticizes wasteful government spending.)

--Swarm Trader Gabriel Andre does not pay much attention to the value investors or policy makers. He works in the language of numbers and charts. We shot him off a not last night asking what the charts show and got this reply back, "This week is likely to be a positive week for the Australian equity markets."

--Hmm. Really? "The last few days of the week were good, from a technical perspective," he went on. "The indices should move further up. But only if investors and traders think a low has been put in. And maybe one has. The ASX 200 fell to 3,342.70 points twice two weeks ago. This low may be the second leg of a double bottom, while the first leg was the low of last November."

--A two-legged low? We'll have more details, and charts, tomorrow.

--What about Warren? Buffet, reports Fortune magazine this weekend, has an old rule that you should buy stocks if the market cap to GDP ratio falls below 80%. It was 75% at the end of January.

--Hmm. There are a few moving parts to that metric. For more on Buffett's original comments, check this out. But in general, you have two variables. The first is the GNP, the total value of all the goods and services produced in an economy. The second is the market cap, the total market value of publicly traded businesses.

--When market cap exceeds GDP by a lot (as it did in 2000) it means investors either thing earnings will continue to grow faster than the economy, or that they are willing to pay more today for tomorrow's earnings (because they believe earnings will keep growing faster than the economy).

--Of course, shareholders should never expect to take out more in gains from a stock than the company's after-tax earnings. In fact, long-term investors prefer to see a firm retain earnings and reinvest them in growing the business. Or, if management can't find anything better to do with the cash, then it ought to pay it back to shareholders in the form of a dividend.

--Individual investors can judge a management team by how it manages earnings and cash-flow. There are other metrics for this. But in the aggregate, what does it mean that stocks are trading below GNP? Does it mean, for example, that investors are under-pricing future earnings growth today?

--Well, that's what you'd tend to think it means if you accept the ratio. After nearly two years of bad news, investors are not willing to pay much of a premium for risky stocks. They also have a fairly bleak view of the earnings recovery potential for U.S. firms. All of which would prick your ears up as a contrarian.

--Then again, in that same article linked to above, Buffett reported that rising share prices and booming GDP are not synonymous. "To break things down another way," he wrote, "we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points. "

--From 1964 to 1981, a time of economic progress, the Dow gained one-tenth of one percent. Over the next seventeen-year period, it gained 949% (875 to 9,181). Yet during the period of near-zero stock market returns, GDP grew nearly twice as fast as the period with huge stock market returns.

--Frankly, the scariest thing about all of that is that you can go seventeen years and make no money in stocks, regardless of what's happening in the real economy. But if you take the past as a kind of prologue, perhaps we are on the verge of a period with large gains in GDP growth, accompanied by consistent investor pessimism about corporate earnings.

--For that to be true, a new period of innovation-coming from an unexpected direction investors are sceptical about-would have to transform the economy in unpredictable ways. That's a lot of unknown unknowns to count on. Then again, we live in a time when one set of institutions for the old world order is failing. Something is going to have to replace them.

--We're up on the Gold Coast for a few days last week and tuned into watch the local news. It was filled with stories about the bushfires in Victoria. It was pretty shocking. Our thoughts and prayers go out to everyone in the fire zones.

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And now over to Bill Bonner in Paris, France:

We live in a world run by simpletons.

In this morning's paper is a front-page article describing how Japan "wasted trillions" on its various stimulus programs.

The International Herald Tribune :

"Japan's rural areas have been paved over and filled in with roads, dams, and other big infrastructure projects, the legacy of trillions of dollars spent to lift the economy from a severe downturn caused by the bursting of a real estate bubble in the late 1980s."

Public spending was so aggressive, it boosted Japan's government debt to 180% of GDP - more than two times the current U.S. level. But did all that cement buy Japan out of its slump?

You be the judge. Housing prices in Japan are now back down to where they were in 1975 - nearly 90% below the late-'80s peak. And stocks? The Nikkei index is back down to where it was a quarter century ago. Stocks sell for half their book value - and they're still considered too expensive for beaten-down, hyper-fearful Japanese investors. The downturn began in 1990. Over the following 19 years, it did more property damage than the Great Tokyo Fire of '23 and the Enola Gay combined, wiping out wealth equal to three times the country's GDP. This was despite interest rates at zero...and a heroic effort at Keynesian stimulation.

If America were to follow Japan's example, it would have to leave its interest rates near zero for the next decade...and add about $10 TRILLION to its public debt. And if it got the same results, you'll be able to sell your house in 2026 for the same price you paid in 1992.

But the simpletons have no other idea.

"In a nutshell," continues the IHT report, "Japan's experience suggests that infrastructure spending, while a blunt instrument, can help revive a developed economy, say many economists."

Are these, perhaps, the same economists who thought America's super-consumption, eternal-debt economy would never fail? The same economists who thought the bankers were providing a public service, by offering so many people so much credit...and then planting their debt bombs all over the planet? The same economists who forecast rising stock prices in 2008?

Probably.

The Dow gained 106 points yesterday. The dollar gained ground too - rising to $1.27 to the euro. And gold rose too...plus $12 to $914.

In the United States, jobs are being lost at the rate of 6 million per year. New jobless claims just rose to a 26-year high.

Little by little, the word "depression" is creeping into the press. Yesterday, GE's top man warned that the downturn could turn into a depression. And Britain's Prime Minister, Gordon Brown, let slip the d-word during a parliamentary session.

The TIMES of London reports:

"Gordon Brown appeared to acknowledge for the first time today that the world economy was heading for a 1930s-style 'depression'.

"Mr Brown stumbled slightly over his words at Commons question time, just a week after admitting that Britain was facing a 'deep' recession.

"As the financial gloom deepens, he told the Tory leader David Cameron today: 'We should agree, as a world, on a monetary and fiscal stimulus that will take the world out of depression.'"

But not to worry...the simpletons are on the case. The price tag on Obama's emergency plan had risen to nearly $1 trillion last time we looked. The Senate bowed to global scorn and ridicule, taking out many of the "Buy America" provisions. Of course, they didn't do it as a matter of principle...they don't have principles. Instead, someone must have warned them that if Americans insist on "buying American" the Chinese might insist on "investing Chinese." And then the whole game would be up. The Ponzi scheme that is U.S. finance requires new money from foreigners in order to pay off the old money that foreigners put in last year and the year before.

The news this morning is that the senators burned the midnight oil...taking out the protectionism and putting in more boondoggles - including a $15,000 tax break for people who buy houses.

So, here at The Daily Reckoning, we have no worries. The feds are on the case. And they're going to spend, spend, spend...until daddy takes the T-bird away!

*** Wait a minute. The feds are on the case...but haven't they been on the case for the last 18 months...ever since Bear Stearns went broke? And wasn't Tim Geithner right there in the room when they decided to let Lehman Bros. go broke...while saving AIG?

Albert Einstein: "Never expect the people who caused a problem to solve it."

And aren't the feds' new plans to save the economy little different from their last plans? Bailouts, stimulus, tax breaks, new, looser credit...aren't these the same things that were used not only for the last 18 months...but in the Great Depression in the '30s...and in Japan in the '90s? Have they ever worked? Nope. Never.

Of course, there's a good reason they don't work. As we explained yesterday, you can't really buy your way out of a depression. Because the problem is deeper than that. The economy is not just taking a rest. It is dead. It needs to be restructured, not revived. And for that, the old structures must be destroyed. That's what Schumpeter's 'creative destruction' is meant to do. But the feds don't appreciate it. They talk "change," but the only change they want is for things to go back to the way they were. So, they're trying to stop the correction. And they're using every worn-out trick, every blunderbuss weapon and every claptrap theory they can think of. Bailout the banks...create a 'bad bank'...nationalize the banks...stop the foreclosures...send out checks...lower interest rates...build bridges to nowhere - they'll do it all. But it won't work. All these measures are designed to encourage consumption...in order to support the old structures. But more consumption is just w ha t the economy doesn't need. It is in trouble because people have spent too much. Now, they have to cut back...and when they do, every enterprise, speculative investment, and household that depended on excess consumption is in trouble.

Ah yes, dear reader...that is where we are. In trouble. At the beginning of a depression. The old structures must be swept away to make way for new ones.

Change! Can it be stopped? Yes we can't!

"So, what's the solution?" asked a colleague this morning, after we explained why the stimulus programs cannot work.

"The solution to a depression is a depression," we replied.

*** Here's another idea that won't fly, abolish America's central bank, the Federal Reserve. From our old friend, Dr. Ron Paul:

"From the Great Depression, to the stagflation of the seventies, to the current economic crisis caused by the housing bubble, every economic downturn suffered by this country over the past century can be traced to Federal Reserve policy. The Fed has followed a consistent policy of flooding the economy with easy money, leading to a misallocation of resources and an artificial 'boom' followed by a recession or depression when the Fed-created bubble bursts.

"With a stable currency, American exporters will no longer be held hostage to an erratic monetary policy. Stabilizing the currency will also give Americans new incentives to save as they will no longer have to fear inflation eroding their savings. Those members concerned about increasing America's exports or the low rate of savings should be enthusiastic supporters of this legislation.

"Though the Federal Reserve policy harms the average American, it benefits those in a position to take advantage of the cycles in monetary policy. The main beneficiaries are those who receive access to artificially inflated money and/or credit before the inflationary effects of the policy impact the entire economy. Federal Reserve policies also benefit big spending politicians who use the inflated currency created by the Fed to hide the true costs of the welfare-warfare state. It is time for Congress to put the interests of the American people ahead of special interests and their own appetite for big government.

"Abolishing the Federal Reserve will allow Congress to reassert its constitutional authority over monetary policy. The United States Constitution grants to Congress the authority to coin money and regulate the value of the currency. The Constitution does not give Congress the authority to delegate control over monetary policy to a central bank. Furthermore, the Constitution certainly does not empower the federal government to erode the American standard of living via an inflationary monetary policy.

"In fact, Congress's constitutional mandate regarding monetary policy should only permit currency backed by stable commodities such as silver and gold to be used as legal tender. Therefore, abolishing the Federal Reserve and returning to a constitutional system will enable America to return to the type of monetary system envisioned by our nation's founders: one where the value of money is consistent because it is tied to a commodity such as gold. Such a monetary system is the basis of a true free-market economy.

"In conclusion, Mr. Speaker, I urge my colleagues to stand up for working Americans by putting an end to the manipulation of the money supply which erodes Americans' standard of living, enlarges big government, and enriches well-connected elites, by cosponsoring my legislation to abolish the Federal Reserve."

Keep reading for my today's essay...

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HERE COME THE ZEROS
by Bill Bonner

Zero is a perfidious number. Nobody likes it. Nobody wants to be "a zero." Nobody wants to get a zero on a test...or zero returns on his investments. It is a line that leads nowhere...with no substance in the middle of it. You can add a zero...or multiply by zeros; it gets you nowhere. And is a zero? Is it something? Or nothing? No one knows.

Some remarkable news in the history of zeros appeared this week. Mr. Gideon Gono, head of the Reserve Bank of Zimbabwe, suddenly shifted from adding zeros to subtracting them. Within the space of 76 hours, Zimbabwe led the world in two opposite directions. On Monday, with prices rising at 231 million percent per year, Zimbabwe was the world's hyperinflation record holder. On Wednesday, it led the world in deflation...with prices falling 99.999999999% overnight.

Once again, we are profoundly grateful to the nation of Zimbabwe and to its central banker. The latter has turned the former into a marvelous laboratory for bizarre monetary experiments.

The pile-up on the global financial highway has yielded its toe tags and broken mirrors. More than $30 trillion has been lost. Of course, the world's monetary cops have been on the scene for about a year and a half - trying to get the traffic moving again. But just read the paper. Instead of a recovery...every day brings more skid marks and fresh collisions.

A little bit of the old juice from the central bank will cure a typical recession. It is nothing more than a pause in the inventory cycle, allowing businesses to clear their shelves before they are restocked. But this is not an inventory-driven recession; this is a balance-sheet depression. The problem is not really an absence of credit, but an excess of debt. Throughout most of the post-WWII period, private sector debt in the USA, for example, equaled about 80% of GDP. In the '90s and '00s, debt rose to 140% of GDP. The difference is about $6 trillion. Until this debt is reduced, Americans will be reluctant to borrow or spend.

And it is not just the debt itself that must be eliminated. There are too many factories producing too many goods for too many people who can't pay for them. You can see excess capacity in the unemployment lines too. Suddenly, the world seems not to need so many sales clerks, or welders, or financial engineers. The United States alone may have $1 trillion of excess output capacity and 10 million people too many in the workforce.

Debt and excess capacity can be liquidated quickly - as they were in the panics of the 19th century - through bankruptcies and defaults. But, today, liquidation would have to take place over the dead body of U.S. Fed chief, Ben Bernanke. While that would be our preferred method; alas, it's not going to happen.

Another way to eliminate debt and excess capacity is to work your way out of them. Unfortunately, that process takes a long time - especially with the feds keeping zombie firms alive and fighting the correction every step of the way. Japan has been working off its excess capacity for the last 19 years. Property prices in major Japanese cities began going down in 1991. They fell for the next 13 years, bottoming out in 2004, 87% below their peak.

Few policymakers will want to follow the Japanese example - certainly not those of the USA. Americans lack several things the Japanese had...such as patience, a favorable trade balance and a thick cushion of domestic savings. On the other hand they have one thing the Japanese did not have; America can pay its debts in a currency it alone controls. If it chooses, it can resort to a third way to get the traffic moving; it can inflate away the debt.

"We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation," wrote Bernanke. But with $7 trillion in excess in debt and spare capacity, neither business nor labor has any pricing power. Normally, it would take a long time before inflation returns.

Mr. Gono's experiment, however, proves that if a government is determined enough...it can always destroy its own currency. Only a few weeks ago, Zimbabwe produced a monetary freak - the world's first one trillion dollar note. Then, it had a value of about 26 euros. Now, you can use it to buy a cup of coffee in Harare - provided you also have $3 US. On Wednesday of last week, banks were supposed to begin distributing the new currency - in which all 12 zeros on the trillion-dollar note have been lopped off.

The architect of this monetary madness was recently asked his views:

"I sit back and see the world today crying over the recent credit crunch, becoming hysterical about something which has not even lasted for a year, and I have been living with it for 10 years....I had to find myself printing money. I found myself doing extraordinary things that aren't in the textbooks. Then the IMF asked the US to please print money. I began to see the whole world now in a mode of practicing what they have been saying I should not."

Mr. Gono added so many zeros to the national currency, he practically gave inflation a bad name. But now it is inflation that people want - desperately.

And day by day, the world glances over Mr. Gono's shoulder. First curious...then appalled...and finally, admiringly.

We will do "whatever it takes," says new US Treasury Secretary Tim Geithner.

Here come the zeros.

Bill Bonner