It can no longer be doubted that the world economy is heading into a new downturn following a recovery that has been unusually short and weak among the industrial countries. The loss of momentum during the second half of last year was especially pronounced in Japan and several Far Eastern countries. In Europe, the major eurozone economies have been making headlines for some time with very unpleasant growth and employment numbers.
There seemed to be two great exceptions to this unfolding general economic slowdown: the United States and China. That, at least, has been the overwhelming perception. A strengthening dollar largely reflected the consensus view that the growth spread between the United States and the eurozone would considerably widen again, as the US economy maintained its strong growth.
At a conference of the Federal Reserve Bank of San Francisco on April 14, Fed Governor Donald L. Kohn presented a cheerful picture of the US economy, starting his speech: ‘The economy has been performing well of late. Economic activity has shown a good bit of forward momentum as businesses have stepped up their purchases of capital equipment and households have continued to increase their spending on consumer goods and services and on houses.’
Further fuel for the new dollar bullishness arose from the expectation that gradually accelerating inflation would induce the Fed to step up its rate hikes further. In its earlier comments, the Fed’s Federal Open Market Committee has done its best to confirm these high-riding expectations about the economy.
As we have explained in detail many times, we radically disagree with this general unconcern about the US economy. Its stellar aggregate growth rates, particularly since 2000, have masked a dramatic deterioration in the four key fundamental determinants of long-term economic growth: national and personal savings, productive capital investment, profits and the current account of the balance of payments. All four are in shambles.
In essence, recessions are the phase in the business cycle in which consumers and businesses unwind the borrowing and spending excesses of the prior boom. In the US case, the ugly reality is that the excesses and imbalances of the boom years in the late 1990s have grown in the past few years to extremes unprecedented in history.
The big question now is whether the rosy assessment of the US economy is right or wrong. In our view, it is dead wrong, for two main reasons: First, contrary to perception, the flow of economic data since the beginning of the year suggests the exact opposite; and second, and more important, the US economy’s recovery from its recession in 2001 has a precarious foundation in the unsustainable housing bubble and exploding consumer debts, while employment and income growth are calamitously lagging.
While scrutinising the economic data, we first noted a sharp slowdown in consumer spending. Inflation adjusted, it declined slightly in January, by 0.1%. An increase of 0.3% followed in February. Meanwhile, sluggish retail trade figures for March suggest little more than stagnation. With these weak numbers before our eyes, we have been following the public discussion and the Fed’s statements about the strong economy with amazement.
All this has reminded us of a similar experience in 2000. For us, there is an ominous parallel.
In the consensus view, the US economy continued to boom that year. Taking everybody – including the Fed – completely by surprise, the share market and the economy went into a sudden sharp slump, while the Fed kept raising interest rates in order to fight inflation.
We see today the very same uncritical complacency about the US economy. Although its recovery from the 2001 recession has been, by any measure, the weakest by far in the whole post-war period, people are beguiled by juxtaposing the apparent strong US economic growth with a sluggish Japan and Europe. At the same time, we are pondering a question that is, unquestionably, the most important of all: Is today’s US economy in better or worse shape than in 2000?
On the morning of 2 February that year, the Fed’s senior economists started a meeting of the FOMC with a review of recent developments, which confirmed that the economy was still growing strongly. During the policy discussion, the only issue of contention was how far to raise the federal funds rate. Some members of the committee wanted an immediate half-point increase in order to signal the Fed’s determination to get a grip on the booming economy.
After lunch, the Fed announced a rate hike from 5.5-5.75%. In a statement, the FOMC said it remained ‘concerned that over time, increases in demand will continue to exceed the growth in potential supply, even after taking account of the pronounced rise in productivity growth. Such trends would foster inflationary imbalances that would undermine the economy’s record economic expansion.’
On March 21, 2000, the FOMC discussed another rate hike. The consensus saw no sign of an economic slowdown. Consumer spending remained particularly strong. Again, there was a unanimous vote to increase the federal funds rate to 6%. Repeating the formula used after its previous meeting, the committee said, ‘The economic risks weighed mainly toward conditions that may generate heightened inflation pressure in the future.’
The third rate hike followed on May 16, 2000. According to the published minutes, the economy was still seen to be powering ahead. Even though stock prices were sliding, the Fed raised its federal funds rate by 50 basis points, from 6% to 6.5%.
In fact, real GDP inched up during the first quarter by just 1% at annual rate, following a 7.3% jump in the prior quarter. While the second quarter sparkled again with a high growth rate, an abrupt slump of fixed residential and nonresidential investment pushed real GDP growth in the third quarter into negative territory at minus 0.5%. In hindsight, the boom clearly broke in early 2000, when the Fed still saw nothing but a continuous boom requiring higher interest rates. Just look at the data on the previous page.
Just seven months after its 50-basis-point rate hike in mid-May 2000, the Fed started its most rapid and drastic rate-cutting binge in history to prevent a slumping economy and a collapsing stock market from hurtling the economy into a dreaded deep and long recession.
Looking at the very weak first quarter of 2000, the third rate hike by 50 basis points in mid-May is particularly hard to understand. Moreover, the equity market had been sliding since March. That a central bank would tighten the reins in the face of a crashing stock market was definitely unusual. But in its associated statement, the FOMC justified its decision with ‘extraordinary and persistent strength of overall demand’.
In other words, they had no inkling of the rapidly spreading weakness in the economy. It reminds us of a famous remark by Joseph Schumpeter about events in 1929: ‘People stood their ground firmly. But that ground itself was about to give way.’
Yet the Fed had one apparent excuse for its false optimism in early 2000. According to Bureau of Economic Analysis data available at the time, real GDP growth had soared by 5.4% at annual rate in the first quarter, as against the later downward-revised rate of just 1%.Still, the early slide in the stock market, which started in March 2000, suggests on its part a far better ‘smell’.
We have recalled this episode because it seems to us a striking parallel to the present experience. In contrast to the bullish consensus view, we see many signs and problems in the US economy that suggest an impending sharp slowdown.
Regards,
Kurt Richebächefor The Daily Reckoning
P.S. For most economists, economic analysis today is little more than the simple extrapolation of the economy’s most recent growth rates. Economic growth in 2005 must be strong, because it was strong until late 2004. There is literally zero public discussion about the future implications of rock-bottom savings, skyrocketing levels of unproductive debt, a massive budget deficit and a soaring trade and current account gap.
Editor’s Note: 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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