There are some days when we want to call up the late Dr. Kurt Richebacher and ask him to clarify something for us. Dr. Kurt was our economic mentor in the last ten years. Not only did our publisher publish his newsletter, but the good doctor lived in Cannes during the time your editor lived in Paris.
We always looked forward (and somewhat dreaded) Dr. Richebacher’s phone calls at our desk in Paris. He would call and be quaking with anger at the bogus statistics and lack of proper intellectual rigor in American economics. He was an old school moral philosopher, who understood that economics was a study of human behaviour as much as it was the study of statistics.
Dr. Kurt came to mind this morning when we ran across a couple of columns from Anatole Kaletsky and Gerard Baker in the Times of London. We respect both men and generally find their columns useful. But not this week.
“Grapes of wrath or raisins of bother,” was the title of Baker’s article. “Well, it’s early days, to be fair, but so far the Great Depression of 2008 is shaping up to be a Great Disappointment. Not so much Grapes of Wrath as Raisins of Mild Inconvenience,” Baker writes.
And on and on. “Should we be putting out the bunting, declaring victory over the Depression, offering prayers of thanks that we have avoided another Munich or Dunkirk? Not quite. The depression scenario was always overdone, of course, but it is still not clear that the US will actually escape as lightly as this.
“The principal challenge remains the health of the American consumer. House prices are still falling and there is plenty of evidence that many Americans, suddenly scared about the value of their house as a nest egg, are retrenching… The picture is starting to look quite encouraging. Even if the US has a recession this year, the chances that it will turn into a full-blown slump are not high. Another disappointment for the hyperactive scribbling masses. But rather welcome news for everybody else.”
It’s not like we are hoping for another great depression. But Baker inadvertently hits the nail on the head when he brings up the “health of the American consumer.” The American consumer is not healthy at all. He still believes consumption is the road to wealth… rather than the road to serfdom (to borrow a phrase). More on that in a moment.
Kaletsky says, “Chicken Littles lose heart amid gloom.” He claims that what we’re really seeing is not financial Armageddon, but a changing of the guard in the drivers of global growth. This changing of the guard hugely favours Australia because it’s a shift from the West to the East, from Europe and America to China and India.
But it’s not so good news for the Old World of Europe and the Old New World of America. Kaletsky says, “global growth can no longer rely on these economies [the U.S. and Europe] and must depend on consumption and infrastructure investment in China, India and other emerging markets. These are momentous changes, and while they are quite far advanced in the US, they have hardly started in Britain and Europe.”
Kaletsky writes that with order being restored in the credit markets, “the really important story in the world economy today is not the threat of a sudden collapse in the financial system, but a gradual long-term adjustment in the world economy in favour of emerging markets. This may at times be an uncomfortable process – but the sky will not fall in.”
It may not be falling like a lead weight. But the sky is definitely compressing the American economy. Both men are relieved-as we are all-that the credit crisis has not resulted in massive bank failures and a recession in the real economy. But the absence of that particular crisis doesn’t mean there is not a deeper rot in the American economy.
We believe Dr. Richebacher would call that rot the decline in America’s capital formation over the last twenty years. He would point out that a nation with declining savings rates and credit-financed consumption not only transfers the ownership of its assets to foreigners, but it loses the capacity to create new wealth.
Dr. Richebacher would never just make a claim, though. He would back it up. So briefly, we will back our claim up by citing the figures from a paper called “Analytical Perspectives: Budget of the United States Government, Fiscal Year 2009 [PDF].”
Pore over it at your own discretion. But buried in that document is a table that shows “Trends in National Wealth.” Without getting metaphysical, we will simply note that by “wealth” the government does not mean money, it means capital. And just what is capital?
We’ll be brief again. According to Nobel Prize winning economist Simon Kuznets, “In modern society, capital is the stock of means, separable from human beings and legally disposable in economic transactions, intended for use in producing goods or income.” An economy with high saving rates directs those savings into investment. The investment is productive when it produces assets that produce other goods, or production assets as Kuznets calls them.
But trends in the national wealth of the United States show a nation of non-savers pouring money into financial assets, or worse, consumption assets (their house). The trouble with a nation of non-savers who believe consumption is the way to wealth is that it will not, in the long-run, produce real wealth. The numbers bear this out.
The table below shows just how America has been forming (or de-forming) its capital stock. You can see that from the table that between 1960 and 1973, the largest percentage increase in America’s national wealth came from investing in non-residential plant and equipment, otherwise known as factories.
A factory is the ultimate capital asset: a collection of goods that produces other goods, income for workers, profit for shareholders, and taxes for the government. That’s why manufacturing wealth is the back bone of all the world’s great economic hegemons.
Between 1995 and 2007-Alan Greenspan’s tenure as the rate-cutting Czar of American monetary policy-investment in residential structures grew at a faster rate than any other single component of national wealth. On the household balance sheet, this investment in real estate and houses shows up as an asset, carried at the market value of the asset.
But here is the real question dear reader: has this decade long investment binge in residential real estate been the single greatest misallocation of capital in American history? It depends on whether you view a man’s house as a consumption asset or a production asset. Kuznets viewed houses as production assets.
We view houses as sources of consumption – via home equity lines of credit. House price gains stimulated U.S. consumption. To some extent, all asset inflation (in shares and real estate) stimulates consumption. And to the extent that it increases production (more houses built, more investment products for sale) you have to wonder if its the kind of production that is good for an economy’s long-term health, or has merely set America up for a mighty fall.
Tomorrow, we will show you that not only has America not invested in productive assets, but that more of its existing stock of capital assets are owned by foreigners than ever before. The income and wealth from these assets accrues to their foreign owners and not their American operators. Australia should pay close attention to this phenomenon.
Kurt Richebacher could probably have explained it much more clearly. But in late 2005, he wrote about the trend of investing in stocks and bonds as opposed to real capital assets, and believing that it leads to wealth. “American economists have never been as strict as European economists in making this distinction in wealth creation between rising market valuations and rising capital stock through saving and investment,” he wrote.
“Yet what has happened lately in this respect puts economic reason on its head. Protracted house price inflation, deliberately engineered by the Fed, is presented to the public as a virtually wondrous new policy stance in creating wealth and economic growth. It is hard to believe that such a grotesque perception is possible.”
Hard to believe, perhaps, but not impossible. Reactions like Baker’s and Kaletsky’s reassure the public that the current financial system is durable and not compromised by some conceptual flaw. But the flaw is simple: you cannot spend or borrow your way to wealth. You have to make things to make money.
Markets and Money