Faber Article

Folks,

There is a side argument in this article which says innovators shine at a
particular time; by his description, that time is drawing near.

John



THE MONETISATION OF THE AMERICAN ECONOMY
by Dr. Marc Faber

Although there are a number of different "business cycle" theories, it has
always been my view that economic expansion and contraction phases
are caused by a number of different factors, and that their durations can
vary considerably, depending, again, on many different social, economic,
and political conditions. That said, I'll try to explain what I believe is
happening today in the U.S. Economy.

In the 19th-century, the U.S. economy was still a predominantly agrarian
economy. In 1900, despite America's rapid industrialization, agriculture
still employed twice as many people as did manufacturing, with farm workers
making up close to 40% of the U.S. labor force, down from 70% in
1840. Today, farm workers account for less than 3% of the labor force.

The relative importance of agriculture versus manufacturing in the 19th
century is also evident from American export figures, which show that in
1850 over 83%, and in 1890, 75%, of exports were agriculture- based. It is
thus easy to see that, in the 19th century, agriculture was by far the
most important sector of the U.S. economy and that, therefore, movements in
agricultural prices were the dominant factor for the entire economy.
When, for whatever reason, farm prices rose (poor harvests, droughts, wars,
etc), the agricultural sector thrived because farmers' incomes would
rise.

When agricultural prices fell, farm incomes would decline. Declining farm
incomes would then reduce the purchasing power of farmers and lead
to less demand for manufactured goods. Periods of weak growth or recessions
followed. But to explain 19th-century American business cycles
purely as a function of agricultural price movements is an
oversimplification.

During times of rapidly rising agrarian prices, what was the incentive for
farmers to innovate and to lower costs by producing more efficiently with
new production methods?

In periods of falling commodity prices we find all the great waves of
innovations in periods. The reason? During such times the only way to
increase one's income was to produce more cost-effectively through the
application of new inventions and innovations. The canal boom in the
1830s, the railroad boom of the 1870s, and the 1920s' electricity,
chemistry, and motor booms all occurred during times in which commodity
prices fell.

All these periods of great innovations were, however, driven not only by
the desire to cut costs and improve productivity in order to boost profits,
but also by a favorable environment for financial assets.

Declining commodity prices led to falling interest rates and, therefore,
rising bond and stock prices. In turn, the combination of declining interest
rates and rising equity prices lowered the cost of capital and improved the
profits of the manufacturing sector. Hence, all major financial manias,
such as the canal and railroad booms, and the 1920s' and 1990s' U.S. stock
market manias, also occurred in a weak pricing environment! But at the
same time, each innovation and stock market boom period preceded financial
busts, which led to recessions or depressions. Why?

During periods of weak prices, monetary conditions remain very
accommodative, since there is no inflation. Moreover, the combination of new
inventions, rising corporate profits, vibrant financial markets, and easy
money is a powerful tonic for capital spending. Both rising stock prices and
declining interest rates are obviously reducing the cost of capital and, by
themselves, lead to more capital investments.

Easy-money monetary policies bring about, through a combination of a wave
of innovations and booming financial markets, massive
over-investments and a gross misallocation of capital because the profit
opportunity expected to arise from the innovation is so great that it leads to
excessive borrowings by consumers as well as businesses. The downturn or
bust is ushered in when the over-investments lead to excess capacity
and a collapse in prices, which in turn drive down profits and, along with
them, stock prices, which then weaken the economy even more. Thus, you
have negative wealth effect and cutbacks in capital spending due to rising
capital costs.

This is where we stand today. The weak pricing and easy money environment
of the 1990s led to a huge stock market and capital-spending boom,
which was largely financed by debt and foreigners who bought U.S. real
assets, equities, and bonds.

However, today the situation is more complex because we are faced with a
fundamentally totally different set of economic and financial, and now
suddenly also geopolitical, conditions than ever before in economic
history. Why? Every economy has a dominant driving force. I explained above
that in the U.S. economy of the 19th century, agriculture was the dominant
sector, which would largely drive economic activity according to rising
or falling prices for agricultural commodities.

In the Middle East, since the 1970s, rising or falling oil prices bring
about, in the absence of an important and efficient manufacturing or service
sector, vibrant or sluggish economic conditions. For countries like Taiwan
and South Korea, exports are the engine of economic expansions and
contractions. So, what is now the driver of the U.S. economy? Certainly, it
is no longer agriculture!

Moreover, whereas the manufacturing sector may have been the engine of the
U.S. economy in the 1920s and probably still was in the 1950s,
today it only accounts for slightly more than 20% of GDP and, therefore, it
doesn't have a very meaningful impact on the economy as a whole.

Compare manufacturing to, say, the U.S. financial markets and you will
realize that it is the financial markets, and financial transactions, that
are the
key driver of the economy.

Just think of the U.S. stock market capitalization, which at its peak in
March 2000 reached a stunning 183% of GDP, more than twice the level
prior to the crash in 1929 when it reached 81%, and significantly higher
than the Japanese stock market capitalization as a percentage of GDP in
late 1989.

Prior to the vicious bear markets that followed the speculative excesses
leading to both the 1968 and early 1973 tops, stock market capitalization as
a percentage of GDP stood at 78%. Compare this to major market lows, when
stock market capitalization as a percentage of GDP stood at 16% in
1942, 34% in September 1974, and 34% in July 1982. Even after its decline
over the last 18 months, the U.S. stock market capitalization as a
percentage of GDP - at present amounting to more than 130% of GDP, compared
to an average of 50% since 1926 - is still extremely high and
supports my view that the equity market, along with the credit market, is
the economy's largest, albeit certainly not "strongest", lever for the
economy.

The rising importance of the financial sector in the U.S. economy has also
been reflected in the strong performance of U.S. financial stocks. The
performance of the S&P 500 Financial (Diversified) Index - which includes
stocks such as American Express, American General, Fed Home Loan
Mortgage, Federal National Mortgage Association, MBIA, MGIC Investment
Corp, Morgan Stanley Dean Witter, DSCVR&C, and SunAmerica -
reveals that their resilience in an otherwise rather weak market - at least
until last fall - is striking.

On the debt side, the evidence also points to a disproportionately large
debt market compared to the real economy. Total U.S. market debt which
does not include loans by financial and non-financial institutions)
currently amounts to about 270% of GDP, compared to an average of
approximately 145% of GDP between 1950 and 1980.

At the stock market's peak in 1929, total market debt reached 160% of GDP!

If, indeed, a substantial part of economic growth over the last 20 years or
so, not only in the U.S. but all over the world, was driven by an
expansion of the financial markets - most notably the credit market - then
it follows that this disproportionate financial expansion must go on at all
costs in order to sustain further economic growth.

The almost endless supply of money available for the corporate and
household sectors leads to poor investments by corporations - projects that
don't make any sense - and to personal consumption growth that outpaces
income growth declining savings rate.

The turning point of this financial pyramid then occurs when it becomes
evident that the corporate sector over- invested. Competition then drives
down prices as a result of the additional supplies, which in turn bring
about the profit deflation in the corporate sector we are presently witnessing
among industrialized countries. The profit deflation subsequently leads to
a reduction in employment and lowers the value of equities, which
brings about a deterioration of the consumers' leveraged balance sheet.

When the economy weakens, this increased leverage on the part of the
consumer leads to a substantial rise in the number of personal bankruptcies,
as happened recently.

Faced with these conditions, the consumer has two choices. He will either
be forced to borrow even more in order to maintain his consumption,
thus leveraging his already shaky balance sheet even further, or he will
cut back on his spending.

The strong, and in the long term unsustainable, growth in consumer finance
may sound alarming, but when you consider that in the first seven
months of 2001 the credit card industry mailed out more than 2 billion
solicitations, an increase of 61% over a year ago, this expansion of credit
should come as no surprise. Capital One was responsible for 29% of all
solicitations. (Note that for every man, woman, and child in the U.S.,
seven credit card solicitations were sent out in just seven months, with an
average response rate of only 0.4%!)

Another disaster in waiting concerns other government- sponsored
enterprises such as Fannie Mae and Freddie Mac, which are currently
benefiting from a deluge of mortgage refinancing. According to the Prudent
Bear's Doug Noland, over the last three years, Freddie Mac's assets
grew by US$308 billion (134%), while shareholders' equity only increased by
US$5.6 billion.

In the present situation, Mr. Greenspan's accommodative monetary policies
will remain largely ineffective for the U.S. economy. Corporate profits
will continue to slide and disappoint. Poor corporate profitability and
negative cash flows will lead to further cutbacks in capital spending and to
additional layoffs in the U.S.

And when it becomes obvious to everyone that further layoffs are on the
cards and that the U.S. economy will fail to recover in the next six
months, retail and car sales, along with the housing market, will finally
cave in as well.

Marc Faber
for The Daily Reckoning

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