The Great American Economic Lie

The idea that the economy has grown at roughly 5% since 1980 is a lie. In reality the economic growth of the U.S. has been declining rapidly over the past 30 years supported only by a massive push into deficit spending.

From 1950-1980 the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less than 150%. The CRITICAL factor to note is that economic growth was trending higher during this span, going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust, which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing, which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates, which peaked with economic expansion in 1980.

As we have discussed previously in "The Breaking Point" and "The End Of Keynesian Economics" (PDF file), beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier effect, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances, which, while advancing our society, plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment prior to 1980, the post 1980 economy has been plagued by a steady decline. Therefore, a statement that the economy has been growing at 5% since 1980 is grossly misleading. The trend of the growth is far more important, and telling, than the average growth rate over time.

This decline in economic growth over the past 30 years has kept average Americans struggling to maintain their standard of living. As their wages declined, they were forced to turn to credit to fill the gap in maintaining their current standard of living. This demand for credit became the new breeding ground for the financed-based economy. Easier credit terms, lower interest rates, easier lending standards and less regulation fueled the continued consumption boom. By the end of 2007 the household debt outstanding had surged to 140% of GDP. It was only a function of time until the collapse in the "house built of credit cards" occurred.

This is why the economic prosperity of the last 30 years has been a fantasy. While America on the surface was the envy of the world for its apparent success and prosperity, the underlying cancer of debt expansion and lower personal savings was eating away at core.

The massive indulgence in debt, what the Austrians refer to as a "credit induced boom", has now reached its inevitable conclusion. The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out "real-time" in everything from subprime mortgages to derivative instruments that were solely for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

When credit creation can no longer be sustained, the markets must began to clear the excesses before the cycle can begin again. It is only then (and must be allowed to happen) that resources can be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

The clearing process is going to be very substantial. The economy is currently requiring roughly $4 of total credit market debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $30 Trillion reduction of total credit market debt. The economic drag from such a reduction will be dramatic while the clearing process occurs.

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed and the costs of living rise. However, only by clearing the excess can the personal savings return to levels that can promote productive investment, production and ultimately consumption.

The end game of three decades of excess is upon us, and we can't deny the weight of the balance sheet recession that is currently in play. As we have stated in the past — the medicine that the current administration is prescribing to the patient is a treatment for the common cold — in this case a normal business-cycle recession. The problem is that this patient is suffering from a cancer of debt, and, until we begin the proper treatment, the patient will continue to wither.

China's Biggest Bubble Warning Ever

It's the biggest and clearest sign yet: China is a giant bubble waiting to burst.

With Europe in the spotlight, few are thinking about China these days. And when China does come up, it is typecast as the wealthy uncle with deep pockets -- the one player rich enough to help keep Europe afloat. (We saw that earlier this week, on hopes that China would buy Italian debt.)

Chinaitself, though, is in the grip of a dangerous bubble, complete with "ghost cities," infrastructure overload, Ponzi finance schemes and the potential for trillions in bad bank loans.

China's finances are very opaque -- and deliberately hidden from the public. It is hard to see from the outside in. This can make it hard to determine just how far things have gone in the bubble department.

But there are clues, just as there were with Japan's monster bubble in the late 1980s.

If you'll remember: For a window of time, Japan was going to dominate America and take over the world. The Japanese way of doing business was considered superior, unstoppable even, in comparison to the weaker Western way.

At one point -- the peak of the frenzy -- the ground under Japan's imperial palace in Tokyo was deemed more valuable than all the real estate in California. Anecdotes like that one, amid other tales of mind-blowing excess, marked a multidecade top.

So what is the comparable China bubblesign?

Take a look at the building below (click to enlarge)...

View larger chart

What is it?

One could be forgiven for thinking the Palace of Versailles... or British Parliament... or some grand old Austrian estate dating back to the Habsburg Empire.

The source will be revealed in a moment. But first, below see two shots of the building's interior -- which is, if anything, more elaborate than the outside...

OK, enough of the suspense.

So what is this place? Some powerful new government ministry? A cultural center? A seven-star hotel to rival the Burj Al Arab in Dubai?

No. It's a Chinese pharmaceutical plant. As in, a factory that makes pills...

The images come from ChinaSmack, a website that translates and reports popular Chinese news and trends. Via Chinese television anchor Li Xiaoming -- as translated by ChinaSmack -- we get the following:

Initial reaction, Harbin Pharmaceuticals Six is a state-owned enterprise... It is said that state-owned enterprises are the people's enterprises, so the people should know how the enterprises' money is used. This "palace," would the people be delighted to see it?

It does look like a beautiful place to work:

The trouble with this sort of thing is, one rarely gets "a little bit of excess." Wasteful spending tends first to come in trickles, then in floods -- especially when funded by gushers of cheap capital.

And with a plain-Jane pharmaceuticals outfit -- a pill factory no less -- pushing such limits, one can only wonder what the other SOEs have done with their cash.

China's "command and control" approach to keeping up employment and maintaining the boom involved staggering sums of lending from the state-controlled banks.

When determined bureaucrats push loans out the door on a quota -- to the tune of trillions no less -- the development of "palaces" (or other boondoggles) is not such a stretch.

It would be a stretch, however, to think Chinacan get through its self-created real estate and finance bubbles unscathed.

As with invincible Japan in the 1980s and crack-up Japan post-1990, there is the initial perception and the aftermath. We may shake our heads over many more tales like Harbin's after the smoke clears.

"Dr. Copper" Could Be Sending An Urgent Warning

CLICK ON CHART TO ENLARGE

Copper ETF (JJC) signaled softness was ahead back in 2008, as it broke down from a series of highs along line (1). Railroads lagged, yet confirmed broad market weakness was going to take place. Turning the page forward 3 years, Copper (JJC) created a series of lower highs along line (2). Rails lagged Copper again, then played a gain of catch-up to the downside.

JJC this morning finds itself on a very small shelf of support. A breakdown in JJC would be suggesting further softness in the Rails, BROAD MARKET, FCX and Silver (SLV). As usual, keep a close eye on the price action of Copper/JJC for bigger macro messages.

Two weeks ago the "Power of the Pattern" was suggesting that FCX and IYM were hitting a key hurdle of resistance (see hurdle post here) At that time FCX was trading at $46.73 per share, this morning it is in the $41 range. The pattern at hand was suggesting the counter trend should be about to end. I remain of the belief that FCX, JJC and IYM are worth watching for Macro/Bigger picture messages.

Unprecedented Times ... Treasury Edition

Last August (2010), I outlined why I thought those claiming Treasuries were in a Bubble was Blasphemy, but even I didn’t expect how much more room there was for Treasuries to run.

Reuters details:

Treasury debt prices rose on Friday, taking benchmark yields to the lowest in at least 60 years as investors looked for a safe haven on revived worries a European debt crisis could have a significant global impact.

Note the “at least” 60 years. The chart below shows the ten year Treasury yield over the last 110 years combining monthly data from Irrational Exuberance and daily data from the Federal Reserve once available.

The 1.91% (update: 1.87% intraday-low yesterday) reached last Friday appears to possibly have been, a new all-time low (assuming there was no intra-month low pre-1962 lower than the end of month print).

Greenspan: Inflict Pain to Correct Fiscal Problems

Former Fed boss Alan Greenspan told a Senate panel “tax reform” will be required to fix the economic problems besieging the economy.

“There is no credible scenario of addressing our current fiscal problems without inflicting economic pain,” he said in a prepared statement. “We have been procrastinating far too long in coming to grips with the retirement of the baby-boomer generation, a fiscal problem that has been visible for decades.”

He called for “reforms” to the Medicare health program for the elderly and the Social Security and endorsed tax and entitlement reform recommendations made last year by the White House’s so-called Bowles-Simpson commission that met in secret.

Democrats called it the “cat food” commission because proposals would have eliminated key portions of the so-called social safety net and forced the elderly into such dire poverty that they would only be able to afford to eat cat food.

Co-chair Erskine Bowles was criticized for sitting on the panel because he also serves on the board of Morgan Stanley. The IMF proposed taxing the financial industry but no such recommendation was included in the Bowles-Simpson report.

Honeywell CEO David Cote was appointed by Obama to make sure Pentagon expenditures remained in place.

“What impressed me most of Bowles-Simpson is that it addresses tax expenditures,” Greenspan told the panel.

The plan calls for massive tax increases – specifically $100 billion in increased tax revenues through various “tax reform” proposals, including a 15 cent per gallon gasoline tax and eliminating a number of tax deductions such as the home mortgage interest deduction and the deduction for employer-provided healthcare benefits.

The recommendations that were ultimately shelved also contained proposals for a VAT or so-called value-added tax.

Although 154 Republicans signed a letter opposing the VAT proposal, a few “conservatives” pushed for increased taxes, including establishment script-readers Glenn Beck and Bill O’Reilly:

5 Less-Risky Ways to Buy Europe at a Discount

It seems no investor wants to touch Europe, the world's riskiest investment region.

Old Europe may boast a model for democracy (Switzerland), innovation (Italy) and economic might (Germany), but the cradle of Western civilization (Greece) is bringing down the entire euro area and infecting the rest of the world.

Still, anyone willing to take a chance on the continent can pick up plenty of European-themed exchange traded funds at deep discounts. Morningstar ETF analyst Timothy Strauts isn't big on European investments these days, but says investors could generate outsized returns if -- and "if" is the operative word -- "European governments can actually come together and stem the tide on the Greek crisis."

The analyst's reluctance to recommend European exchange traded funds stems from the fact that the Greek government's potential imminent default on its debt has put the euro's survival as Europe's unified currency in doubt.

"A breakup of the euro would have so many unintended consequences that any investment in Europe is highly risky right now, " Strauts says.

But if you're brave at heart, Strauts notes that you can pick up these four European ETFs on the cheap.

IShares MSCI Europe Financials Index ETF: This fund focuses exclusively on European financial companies, "so it's right in the center of the crisis -- and its recent performance has obviously been terrible," Strauts says.

Launched just 17 months ago to mirror the MSCI Europe Financials Index, the ETF is off 36% since July 1.

IShares S&P Europe 350 Index ETF: Strauts says this ETF is less risky than the Europe Financials Index fund because it's diversified into more than just the banking sector.

He added that British companies, which haven't suffered as much as those in continental Europe because the United Kingdom doesn't use the euro, make up the largest share of the Europe 350 Index fund's assets.

Still, French and German firms account for a quarter of the ETF's holdings -- a fact that has sent the fund tumbling. The ETF, which mirrors the large-cap S&P Europe 350 Index, has plunged 25% since July 1.

SPDR Barclays Capital International Treasury Bond ETF: This fund offers 50% exposure to European bonds, but debt from problem countries like Spain and Italy make up just 8% of holdings.

British and German bonds, whose prices have risen recently due to a "flight to quality," account for a far larger piece of the fund's European component. And non-European debt, particularly well-regarded Japanese Treasury bonds, make up half of the portfolio.

So, while this ETF has fallen 3% since Aug. 23, the fund is actually up 6.4% this year.

IShares MSCI United Kingdom Index ETF: This ETF offers a less-risky European play because it invests only in Britain.

"If you want to invest in Europe but want a little more protection, you'll like this ETF," Strauts said. "It'll definitely go down if the European crisis worsens, but shouldn't go down as much as the Europe 350 fund will."

True, the MSCI United Kingdom Index ETF has fallen 18% from its April peak. But the fund, which mirrors the broad MSCI United Kingdom Index, is up 3.5% from a 52-week low on Aug. 8.

Another option: Autoliv.

If you prefer individual stocks to ETFs, Morningstar equity analyst Michael Tian recommends Swedish car-parts maker Autoliv, whose shares have tumbled 37% on the New York Stock Exchange in a little over two months.

"The stock has pretty much fallen apart this year -- but if you believe Europe as a whole isn't going to fall apart, Autoliv is a quality business that you can invest in at a great price," Tian said.

The analyst said Autoliv trades for less than 10 times projected 2011 earnings even though the company has about 11% operating margins.

Morningstar rates the stock at four stars out of a possible five and estimates Autoliv's fair value at $80 a share -- way above its current $50.

Get Ready for the Next Crash

European leaders may stave off a banking crisis for a few more weeks. Markets may even stage a relief rally as Greek debt worries abate. But make no mistake—a deeper crisis in foreign banks is coming.

Financial markets are behaving as if they expect a European banking crisis that would require the bailout or nationalization of some European banks.

That would feel like a replay of the financial crisis that followed the bankruptcy of Lehman Brothers in the fall of 2008. Only this time, the epicenter would be Europe instead of the United States, and the ripples would expand from the Eurozone outward into global financial markets.

How realistic is that fear? Very, I’m afraid. European banks are facing a very real liquidity and capital crisis that could lead to the need for a government rescue of some globally significant banks.

But the crisis isn’t an exact replay of the 2008 crisis. The effects of the crisis would not be limited to Europe, but the likelihood that a European crisis would take down a major US bank—in a mirror image of the 2008 crisis where problems originating in the United States did lead to the bailouts of banks in the United Kingdom, Germany, and Belgium—is relatively small.

On the other hand, the crisis is potentially worse this time around because the European Central Bank is much less able to intervene as a lender of last resort than the US Federal Reserve was in 2008.

Understanding This Crisis
The current European banking crisis is rooted in the Greek, Italian, Spanish, Portuguese, and Irish debt crises. But the repeated collapse-bailout-collapse-again pattern of the prices of bonds of those countries wouldn’t have produced the current mess without a series of missteps by banks, bank regulators, and central banks.

European banks hold a huge amount of government debt from the countries involved in the crisis. German banks, for example, held $22 billion in Greek government debt at the end of 2010, according to the Bank for International Settlements.

If you add holdings of Greek government debt to holdings of private-sector Greek debt, the exposure gets much higher. For example, in May, Fitch Ratings said that French bank Credit Agricole (CRARY) had $35 billion in exposure to Greek government and private debt. BNP Paribas (BNPQY) and Société Générale (SCGLY) had exposure of about $11 billion each.

The exposure of European banks to Greece, however, is small souvlaki compared with exposure to the much larger Italian economy. BNP Paribas, for example, has an estimated $31 billion in exposure to Italian government and private-sector debt. (more)