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The Daily Reckoning PRESENTS: We live in a bubble economy. And eventually all bubbles run out of steam - the United States economy included. The big question here is: are we in for a hard or a soft landing? Dr. Kurt Richebächer explores...

AN EVASIVE RECOVERY
by Dr. Kurt Richebächer

In the early 2000s, Mr. Greenspan earned himself the honorable title of "serial bubble blower." Fearful of a painful burst of the equity bubble, he aided and abetted a bond bubble in order to boost the housing bubble. Measured by the mildest postwar recession, it appeared a smashing success. But taking measure of the following anemic recovery, and particularly the following dismal employment and income performance, into account, it was an utter policy failure.

Any assessment has to further take into account that the government and Federal Reserve have supported this recovery with unprecedented fiscal and monetary lavishness. Tax cuts reduced government revenue by $870 billion, while the Federal Reserve slashed its fed funds rate to 1%, its lowest level since the Great Depression.

The decisive failures of these policies have been in business fixed investment and in employment, both displaying a drastic shortfall in relation to reported GDP growth.

Historical experience and economic theory leave no doubt that business fixed investment and employment play the crucial role in providing economic growth with the necessary traction to become self-sustaining. Even in its fifth year, the present U.S. economic recovery remains fully dependent on the housing bubble to drive the consumption bubble.

The same, by the way, applies more or less to all Anglo-Saxon countries. Over the past few years, all of them have hung on the steroid of inflating house prices providing the collateral for outsized consumer borrowing-and-spending binges. Their further common features are large budget deficits (except Australia), very low savings and large trade deficits (except Canada).

All of these economies have, in essence, become bubble economies. This means that monetary policy impacts the economy primarily through inflating asset prices, which in turn stimulate and facilitate credit-financed consumer spending.

An important adverse feature of all asset and credit bubbles is that they inherently break an economy's pattern of growth. In all the English-speaking countries, the credit excesses have primarily inflated house prices. Using these as rising collateral, consumers have enjoyed unprecedented borrowing facilities to spend as never before in excess of their current income. What resulted were extremely unbalanced economies.

Distorted demand over time invariably also distorts the economy's supply side. What has actually happened in all these countries is that domestic spending has increasingly outpaced domestic output. On the other hand, low domestic saving and capital investment keep a brake on output growth. The infallible result in all these countries, except Canada, is large, chronic trade deficits. Evidently, all this is structural, not cyclical.

Essentially, the low savings, the low capital investment and the soaring trade deficits act as major drags on economic growth. Over the past few years, these drags have been offset by the rampant demand creation through the housing bubbles. But the trouble with this recipe is that it worsens the structural distortions and imbalances.

Nevertheless, all asset and credit bubbles eventually run out of steam. Plainly, this is going on in all these bubble economies, the United States included. For us, the key question about whether there will be a hard or soft landing is the extent of the prior excesses. They are the worst in history.

The consensus sees new momentum in the U.S. economy from strong retail sales. We focus on the inflation-adjusted monthly figures for overall consumer outlays and observe the opposite. There are sharp fluctuations in spending on durables, but with a distinct downward trend.

As everybody knows, or ought to know, the strong monthly changes in consumer spending have their main cause in the sharp ups and downs of auto promotions. In the quarterly GDP reports, they are even annualized. But comparing the above figures, it strikes the eye that the recovery in the last three months was very much weaker than in the prior downturn.

Any assessment of the U.S. economy's further course has to start with the recognition that the housing bubble is doomed, and in its wake the consumption bubble. Only the vigor of their slowdown is in question. Given this virtual certainty, the U.S. economy urgently needs an alternative source of growth.

Unfortunately, there is but one possible alternative source, and that is sharply rising business fixed investment and exports. The consensus, apparently, takes a strong revival of business fixed investment for granted.

Assessing the relevant figures, including profits, we take for granted that business investment and hiring are going to fail in the future even more than in the past. First of all, the record-sized fiscal and monetary stimulus of all times has been exhausted; second, business fixed investment in the United States, even though heavily bloated by hedonic pricing of computers, recently accounts for a record low of 11.5% of GDP, as against more than 70% for consumer spending; third, consumer demand is weakening; and fourth, nonresidential investment has slumped from double-digit growth rates in 2004 to just 2.6% in the fourth quarter of 2005, after 10% in the first half.

Common arguments in favor of a comeback of capital investment are high business liquidity and high profits. Plainly, they have recovered from their lows, but growth has sharply slowed from 2004, when tax incentives gave a strong impetus.

New orders for machinery are up over the year, but by far not enough to suggest a developing investment boom. Given for many years a preponderance of short-lived investments, it needs moreover large and ever-higher capital investments just to replace worn-out plant and equipment, as reflected in rising depreciations. There is every reason to assume that the rise in new orders of capital goods barely reflects rising depreciations.

Most impressive is definitely the following chart reflecting the U.S. economy's profit performance. Since 2000, it is the greatest profit boom in the whole postwar period. Strikingly, it even compares most favorably with the profit performance during the "New Paradigm" boom years, from 1995-2000.

Profits of the whole nonfinancial sector were $401 billion in 1995 and $413.4 billion in 2000. But from 2001 to late 2005, they have almost trebled, from $322 billion to $868.5 billion. Wall Street, of course, eagerly seizes them. For us, these numbers are so absurd as to require investigation.

First of all, it was an extremely imbalanced profit boom reflecting an extremely imbalanced economic recovery. This recovery had literally nothing in common with the business cycle pattern of the past. Intrinsically, this shows in a radically divergent profit pattern.

The profit boom of the last few years was narrowly centered in the category "other." The fact is that the housing bubble has been crucial not only in creating demand and GDP growth, but also in creating employment and profits.

Most astonishing is, of course, the steep jump in profits from $534.2 billion in 2004 to $863.3 billion in 2005. Two phony causes are easily identified. One is a sharp decline in depreciations, from $804.3 billion to $668 billion. Depreciations are a business expense, of course. If a firm stops investment, it increases its profits. But this is hardly a desirable way toward higher profits. The second major cause of the sudden profit surge was a tax incentive that induced companies to repatriate a large amount of foreign profits into domestic profits.

Leaving aside the grossly distorted profit figures for 2005, we focus on the period from 1997-2004, the former marking the U.S. economy's prior profit peak in the postwar period. Over these seven years, including the "New Paradigm" boom years, overall profits barely rose.

The next thing to recognize is the tremendous differences in profit performance between sectors. For all sectors producing or moving goods, manufacturing and transportation, it has been seven years of profit disaster, and moreover of steady deterioration.

In contrast, it has been seven years of profit bonanza for retail trade, wholesale trade and in particular for the branches captured under "Other." Here construction and real estate agents have been the main contributors.

We would say that overall this is a dismal profit performance, definitely giving no reason for a booming stock market. Measured against nominal GDP, which has risen 41% between 1997-2004, it is a profit collapse.

Very poor profits in the aggregate are the one big problem. An extremely lopsided pattern between sectors is the other. Manifestly, this lopsidedness in the profit pattern perfectly reflects the extraordinary lopsidedness of the U.S. economy's growth pattern during these years. The housing and consumption bubbles rule.

It always amuses us when Mr. Greenspan and Mr. Bernanke criticize the government for its budget deficits. The irony is that the chronic deficit spending by the consumer, induced by their monetary looseness, is doing far greater structural damage to the economy.

Regards,

Dr. Kurt Richebächer
for The Daily Reckoning

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Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

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