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Leithner Letter No. 16
26 April 2001

The decisive common denominator between the Japanese downturn and the gathering U.S. slowdown is that they are both cycles of over-investment against a backdrop of booming credit growth; with the only major difference being that this time around much of the resulting excess capacity is invisible. History shows that such over-investment cycles nearly always end in. downturns. This is the message now being transmitted by the financial markets.

These points are made to counter those conventional thinkers who argue that comparisons between America today and Japan’s deflating bubble economy then are ‘off the wall.’ Unfortunately, the comparisons are as obvious as they are ominous. What the sceptics should note is that the people who regarded Japan as a bubble economy 10 or more years ago were considered off the wall. What everybody knows is usually not worth knowing; and almost everybody today still thinks they know that such comparisons between Japan and America are idiotic.

In coming weeks and months it will [therefore] be interesting to watch the Fed chairman warning of ‘irrational panic’ in the U.S. stock market, just as he once warned against ‘irrational exuberance’ before succumbing to nouvelle nonsense. In fact the Fed’s mistake in recent years was to ignore money and credit growth data and to be seduced by New Economy rhetoric. This was also the error made by the Bank of Japan in the late 1980s. [A recent Bank of Japan research report about that country’s asset bubble during those years] notes that monetary tightening was delayed because of the then prevailing view ‘that the statistical relationship between money supply and prices had become unstable.’ Accordingly, the ‘large increase in the money supply was not taken seriously.’ This reads like a repeat of the current Greenspan line. ... 

Christopher Wood,
The Asian Wall Street Journal (20 March 2001)

Nightmare on Easy Street

A recent article by Betsy Morris, Nightmare on Easy Street (Fortune, 2 April 2001), makes two good points. First, “there are very real reasons for people to be very nervous right now. They are going into this downturn more heavily indebted than ever. Too many people are perched precariously atop living standards supported by lines of credit and depreciating assets.” Second, “stocks, real estate and 401(k)s are not cash flow. The same thing that happened to so many dot-coms during the recent gold rush happened to consumers too: they forgot about cash flow. People had assets. But now their assets are way down, and the liability is real. Their lifestyles require cash.”At the same time, however, the article also repeats three sets of widely-held and dangerous fallacies:

  • Fallacy #1: “Consumer confidence – and what it portends for spending – is the single biggest factor standing between a mere downturn and a full-blown recession. Fed Chairman Alan Greenspan has made no secret that he is paying close attention to consumer spending levels. Consumption accounts for about two-thirds of GDP. It has been the willingness of people to fork over not just $5 for a latté and a muffin at Starbucks but $50 for an afternoon of skateboarding at the Rampage Extreme Sports Park, $10,000 for a family ski vacation at Aspen, or $100,000 for a home renovation that has kept the economy so strong for so long.”

  • Fallacy #2: Right now, [home mortgage] refinancings and cash-outs are buoying the economy because they give consumers more cash to burn. [Indeed], the refinancing wave could very well turn out to be instrumental in forestalling a more severe economic downturn.”

  • Fallacy #3: “Stocks can have a major impact on the economy through the so-called wealth effect. As stocks rise and people feel richer, they’re willing to spend more. Some economists have argued that the savings rate, defined as the gap between disposable income and expenditures, doesn’t take into account money ‘saved’ through appreciating assets like houses and stocks, or the contributions companies make to employees’ 401(k) plans. If assets appreciate, the thinking goes, there is less need for old-fashioned savings.”

A New Book Worth Reading

A new book by Thomas Sowell entitled Basic Economics: A Citizen’s Guide to the Economy (Basic Books, 2000, ISBN: 046508138X) has been written in precisely this spirit. Sowell, the Rose and Milton Friedman Senior Fellow at the Hoover Institution, Stanford University, is an economist who has experience in the private sector, government and several universities. As detailed in his recent autobiography (A Personal Odyssey, The Free Press, 2000, ISBN: 0684864649), his experiences also include poverty during childhood and racial discrimination as an adult. His most influential scholarly work is Knowledge and Decisions (Basic Books, rev. ed. 1996, ISBN: 0465037380). He is also the author of The Vision of the Anointed: Self-Congratulation As a Basis for Social Policy (Basic Books, 1995, ISBN: 046508995X) and writes a column syndicated to more than 150 American newspapers. 

Basic Economics: A Citizen’s Guide to the Economy uses plain English and contains neither jargon nor graphs or equations. It is written for anyone who wants to acquire a working knowledge of the principles of applied economics. Most relevant to businessmen and investors are Chapters 2 (The Role of Prices), 5 (The Rise and Fall of Businesses), 6 (The Role of Profits – and Losses), 12 (Investment and Speculation) and 13 (Risk and Insurance).

Desperately Seeking Bottoms

“Wall Street is obsessed with bottoms. What it demonstrates is the inherent optimism of investors, especially so-called professionals (they’re the ones who get paid for losing other people’s money). It’s rather a touching fetish, since it bespeaks an irrepressible optimism. For in contrast to such preoccupation with bottoms, interest in identifying a top when the market was in the clouds a scant year ago was not only minute but considered bad form. But in view of the mania for spotting a bottom currently in full rage in the Street, we feel. a little historical perspective [is in order. What such perspective reveals] is that we’re a long way from where most bear markets – and all the truly vicious ones – have ended in the past. Or, to put it rudely, what we’re viewing today bears as much resemblance to a traditional bear-market bottom as a bad bruise does to a blast wound. Let’s change the imagery a bit: True bear markets like the one we’re in don’t end with stocks still greatly overpriced and everyone on the alert for the turn. They end with valuations almost as depressed as those relatively few investors still standing” (Alan Abelson, Up and Down Wall Street, Barron’s 2 April 2001). 

“A shrewd money manager whom we’ve known forever remarked to us over breakfast last week that the vast majority of economists and investment pros were in denial as to the real state of the economy. The truth, though, is evidently beginning to leak out and, who knows, one of these months it may even sneak into the sanctum sanctorum where the Fed does its very private gabbling and monetary dabbling. We’re increasingly convinced, moreover, that this recession, which is the misbegotten issue of excess, will last longer and carry deeper than anticipated, especially by the folks who get paid to do the anticipating. We don’t think that kind of recession is in the market. Which is why we don’t think we’re even close to a bottom” (Alan Abelson, Up and Down Wall Street, Barron’s 9 April 2001).

All best wishes for a pleasant ANZAC Day holiday.

Chris Leithner


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