WEEKLY COMMENTARY

December 24, 2002

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INTERVIEW WITH DR. KURT RICHEBACHER

Dr. Kurt Richebacher has shown an uncanny ability to spot future economic problems. This former chief economist of the Dresdner Bank warned about the recession and the NASDAQ crash months before they happened. He forecast the collapse of the Asian Tigers in 1998 and blew the whistle on corporate profit tricks long before Enron. When virtually everyone was certain of a V-shaped recovery, he argued that it was impossible.

A master of classical economics, and perhaps, the best analytical economic thinker in the world today, Dr. Richebacher writes a monthly newsletter, "The Richebacher Letter." Given his impressive record of accurate warnings and predictions in the face of almost unanimous disagreement from establishment economists, we think the following interview should be read with deep thought and reflection.

Q Back in March of 1997 you warned that serious problems loom in the heavily indebted miracle economies of the Far East. What caused you to spot this problem?

A Their boom was credit induced. They went heavily into debt to overbuild.

Q Same old story?

A Yes, runaway money and credit growth and the typical symptoms associated with overheating economies – inflation, speculation and financial excess.

Q Then in June of 1998 you said, "Later this year the U.S. economy will abruptly slow down." What did you see?

A Earnings were faltering and corporations were favoring self-defeating financial tricks and accounting ploys, including heavy speculation and leveraging. I wrote that a few were immensely enriched by exploding paper wealth, but savings and capital formation were deplorable.

Q Then you predicted the collapse of the stock market and the technology bubble. How?

A The great speculative manias in history were connected with innovations that generated great popular excitement. That was the case with the Internet and, along with it you had the ever-present deluge of money and credit. Yes, I wrote that a bear market was inevitable.

Q Late in 1999 you were calling it a classic speculative blowoff. Why you and nobody else? I mean, Lawrence Kudlow was saying the Internet was more important than the Fed, and the Dow would be 30,000, then 50,000 and higher.

A Yes, this kind of nonsense was helping to fuel the Wall Street boom. We expected that a sharp decline in tech stocks would be a death blow to the greater U.S. stock market bubble, and it was.

Q In the fall of 2000 the belief was widespread that the U.S. economy would have a soft landing. What were your thoughts on that?

A Well, I wrote hopes for a soft landing in the U.S. economy were completely misplaced. The credit excesses of the late 1990s were many times worse than those in the 1980s and even those of the 1920s. So were the imbalances in the economy and the financial system. You only needed to notice the zero personal savings rate and the stupendous trade deficit. To speak of the U.S. economy’s excellent fundamentals in the face of these disastrous facts required a lot of stupidity.

Q Was it the worst credit bubble in history?

A Absolutely.

Q What did you say about the V-shaped recovery that all the experts were predicting back then?

A I wrote that it will come as a great surprise how fast the U.S. economy weakens in the near future.

Q What did you base the prediction on?

A Profits were collapsing, heavily indebted corporations were slowing their spending and new investment in capital goods had caved in. Serious problems were everywhere.

Q That brings us up to today. Will we tip over into recession again?

A Yes. Drastic weakness of the U.S. economy is the great shock waiting to happen for the world. A slumping dollar will turn it into a nightmare.

Q How can you be so certain? Most economists see a recovery.

A I am dismayed at the low level of U.S. economic thinking. Elementary insights into economic processes that have been accepted by all schools of thought for more than 200 years are unknown, discarded or even put on their head. The facts are that you have serious structural problems that exclude any possibility of a sustained economic recovery.

Q Such as?

A A profits decline, a record savings shortfall, a capital spending collapse, an unprecedented consumer borrowing and spending binge, a massive current account deficit, ravaged balance sheets and record high debt levels.

Q Sounds terrible. Is one just as bad as the other?

A Tops among them are the depression of profits and capital spending. They propel each other downward in a vicious spiral.

Q Why are there no mainstream economists saying anything like this?

A Not only economists, but U.S. policymakers and the public are in denial of the gravity of the economic and financial situation.

Q But why?

A The main problem is a lack of understanding and blind faith in the omnipotence of the Federal Reserve.

Q Well, the Fed has aggressively lowered rates. It’s worked in the past hasn’t it?

A This downturn differs dramatically from all previous postwar recessions. It hasn’t been brought about by tight money, but by unsustainable spending excesses that have left behind an overextended financial system.

Q You mean low interest rates aren’t working?

A For the first time in the whole postwar period, the U.S. economy and even the stock market has slumped against a backdrop of the most aggressive rate cuts by the Federal Reserve and the most rampant money and credit growth ever. The forces depressing the U.S. economy this time are radically different from those that fueled past recession.

Q In what respect?

A The profits implosion is the most obvious and the most important.

Q The Fed has pushed down rates to prop up spending. You say low rates aren’t working, but people are taking advantage of the low rates to keep spending, aren’t they?

A That’s right. America is fighting the recession with still more consumer spending excesses.

Q Could the consumer keep the ship afloat?

A Consumer sentiment has been falling. More importantly, the economics data for the past several months conclusively suggests that the American consumer has started to retrench.

Q You never hear that.

A Nobody wants to believe it. One reason may be that there is nothing else in sight to prop up the U.S. economy.

Q But isn’t the consumer’s income still growing?

A No, growth has stalled and a lot of the growth that there was came from the tax cut.

Q So, consumer spending may stagnate?

A Especially if the consumer continues to rebuild savings, which has just recently been running at three to four percent of disposable income. This will probably increase in the future. That’s the kind of thing that will end the borrowing and spending excesses of the boom.

Q Why?

A Any rise in savings exerts a drag on economic growth and this squeezes profits.

Q Well, so far the consumer hasn’t slackened measurably.

A They have postponed the day of reckoning by loading themselves with more debt. Much of this debt can’t be repaid.

Q As you say, people have faith in the monetary authorities. That’s one reason they keep spending.

A This faith is utterly amazing. It overwhelms the facts. It’s based on the Federal Reserve creating money and credit with reckless abandon and the consumer borrowing and spending with reckless abandon. Nobody seems to understand the extraordinary excesses of these two and how they have been responsible for the present economic and financial mess.

Q I have to agree with you. People don’t see anything foreboding in these developments.

A It’s time they did. The economic news is going from bad to worse. Never before has the world experienced such massive destruction of stock market wealth and never before have business profits and business capital spending suffered such steep declines.

Q You see business profits as key to the whole crisis don’t you?

A We have continually warned of the economy’s unusually poor profit performance during the prior boom years. As the economy sharply slowed during 2001, it turned into a virtual profit implosion. Profit margins are at their lowest since the Depression in the 1930s. Moreover, there is nothing in sight that might reverse this progressive profit erosion.

Q What are the consequences?

A CEO’s have capitulated to the profits disaster. Their solution has been a savage curtailment of their investment spending.

Q Why are investment spending and capital formation so important?

A In the end, it is all about capital investment. It is the critical mass in the process of economic growth that generates all the things that make for rising wealth and living standards. Capital investment means the construction of new buildings, plants and equipment. This creates demand, employment, income, profits and tangible wealth. The installation of these capital goods creates growing supply, productivity, employment, incomes and profits that, by the way, also repay the debts. Always remember that capital formation is strategic for generating general prosperity.

Q Okay. So, what’s causing the profits decline that’s ruining capital investment?

A First, let me say that when you consider the key role of profits in shaping economic activity, it’s puzzling how little attention this exceptional profits carnage is getting. Especially since there is nothing in sight that might improve U.S. corporate profitability and stimulate business capital investment.

Q Give us the cause of the profits problem.

A Corporate cost cutting, for one. The widespread measures that individual firms take to improve their own profits have, in the aggregate, the opposite effect on the profits of other firms. Business spending is the key source of business revenues, not consumer spending. A retrenchment in business spending cuts business revenues. Higher profits and higher prosperity cannot possibly come out of general cost cutting.

Q What else impacts profits?

A Rising depreciation charges on plants and equipment are a drag on profits.

Q And?

A Corporations took on an enormous amount of new debt and the interest charges are a record high expense. For example, in 1997, interest expense accounted for 23% of manufacturing profits; in 2001 for almost 100%.

Q But this borrowed money went into productive assets that improved profits, didn’t it?

A Very little went to net new investment. It’s great bulk went into mergers, acquisitions and stock repurchases, adding nothing to the economy’s productive capacity. Huge amounts were dissipated in worthless goodwill, reflecting absurdly high payments for acquisitions.

Q None of this borrowing helped profits?

A No. As profits went down, corporations effectively devastated their balance sheets and credit ratings. The deterioration in credit quality has been unbelievable.

Q Let’s get back to the discussion about the profits problem. Any other big drags on profits?

A The most important one of all. The U.S. trade deficit has ravaged U.S. business profits. In four years this deficit has soared from $128 billion to $450 billion annually.

Q How does the trade deficit squeeze profits?

A By directing current income and spending away from domestic producers to foreign producers. The trade deficit implements a direct transfer of profits from the United States to foreign countries. Considering the deficits monstrous size, it massacres U.S. profits.

Q What does this profits decline imply for the stock market?

A U.S. stocks today are still overvalued. The worst part of the bear markets is still to come and it will result in the wholesale destruction of the financial wealth derived from the bubble economy.

Q Only a few years ago we heard stories about an endless boom and a new era. What went wrong?

A Americans new brand of capitalism didn’t work. Corporate managers concentrated on creating shareholder value through stock buybacks, cost cutting, mergers and acquisitions. This strategy helped drive share price to absurdly high levels, but the effects on the economy were destructive.

Q Why?

A Mr. Cook, these strategies do not build factories. They do not increase business revenue. To the extent that they curb new investment, which they do, they reduce profits.

Q Could you elaborate?

A Rising prosperity and rising living standards do not come from existing factories, but from new factories. It’s not productivity that creates wealth. It’s investment spending alone and not consumer spending that propels economic growth. The wealth effects of free enterprise have always accrued through the building of factories, not through the stock market or reckless consumer borrowing and spending.

Q You mean these companies used their capital for financial engineering and speculation rather than building productive facilities?

A Absolutely. As an example, most of the profits in the high tech sector came from huge gains in the stock market.

Q Are you saying the new information technology didn’t deliver profits?

A Yes, and it’s the greatest irony that the worst profit numbers have come from the high tech sector for which Wall Street was trumpeting unprecedented miracles of productivity and profit growth. These poor profits subsequently turned into a profits collapse.

Q What’s your explanation for this failure?

A The importance of information and information technology for production and wealth creation was ridiculously overestimated.

Q Doesn’t high tech have the greatest productivity gains?

A Such productivity growth is statistical hot air.

Q I won’t go there. I know you think hedonic pricing is statistical nonsense.

A When you see this statistical fudging, it makes us wonder if systematic delusion lies behind these practices.

Q Okay, let’s move on. You didn’t mention the effect on corporate balance sheets of the new era financing of mergers, acquisitions and stock buybacks.

A Corporate managers leveraged their balance sheets with the recklessness of desperadoes who have everything to gain in the short run and nothing to lose in the long run. They ruined their balance sheets to conceal and offset the increasingly disappointing profit performance.

Q Sounds ugly.

A They substituted more expensive debt for equity. The trick was to fool investors by shrinking the number of shares.

Q I have to say that you were blowing the whistle on these dubious practices long before anyone else.

A The sudden outbreak of profit chicanery was based on the common desire to hide a disastrous profit performance. That’s the key point to recognize.

Q Some would argue that it lifted share prices?

A Only temporarily. At best they are saddled with debt that depresses profits and at worst they’ve ruined their reputations and their future.

Q What are the ramifications of taking on so much debt?

A Declining credit availability for corporations and the possibility of a credit crunch. Badly ravaged, highly fragile balance sheets and very poor profit performance have severely reduced corporate creditworthiness. I cannot imagine a good outcome from this predicament.

Q Let’s talk for a moment about savings. What are your concerns about the low savings rate?

A Savings is the indispensable condition for economic growth. Without savings out of current income there can’t be an increase in productive facilities or capital stock.

Q How come economists here don’t see this as a problem?

A There’s a general refusal to see reality. The total carnage of national savings is the U.S. economy’s most important predicament. This is the economy’s supply of capital.

Q What’s happened to the savings we’ve already accrued?

A They’ve been squandered to pay for spending the consumers can’t afford from their current income. And corporations have been funding dividend payments out of their retained earnings.

Q What happens to countries with low savings?

A They have low investment, low wages and low profits.

Q But the government economists and the Fed are saying we don’t have to get it done with savings; we can do it with spending and credit. What about that?

A Ha! I don’t think you can turn vice into virtue.

Q Why not?

A Credit creates spending power out of nothing. Credit alone can’t sustain a growing economy for long. Today’s soaring debt load has to be repaid. I have little doubt that a debt crisis lies ahead. When most of the debt is used for unproductive purposes like consuming and speculation, it must eventually lead into a debt trap. The reckless pursuit of debt is economic insanity.

Q A lot of this is mortgage refinancing isn’t it?

A One is tempted to say that the American public is monetizing their homes.

Q And this alarms you?

A I can only say that in Europe to use one’s home as collateral is something that neither homeowners nor bankers would consider, except perhaps in the case of an emergency.

Q I’ve never heard any American economist or Wall Street spokesman speak against it. In fact, they encourage it.

A No doubt. Mortgage refinancing and home equity lending have been at the epicenter of the credit explosion. I must admit to have grossly underestimated this component of the American bubble. I can only say it has removed any doubts that this is by far the greatest and the worst credit bubble that the world has ever seen.

Q But only you and a small handful of critics make mention of it. The public likes it and everybody in the mortgage business is making hay.

A They should enjoy it while they can. The U.S. financial system today hangs in a precarious position. It’s a house of cards built on nothing but financial leverage, credit excess, speculation and derivatives.

Q Are we going to fall down and go boom?

A I would say prepare for much worse to come.

Q What’s the nature of this recession you predict?

A It will prove unusually severe and long.

Q Why?

A The key to fathoming the severity of the future crisis lies in appreciating the vulnerability of an economy and financial system that have for years been exposed to the most reckless financial expansion and speculation in history.

Q That’s Austrian business cycle theory, right?

A Yes, the length and severity of recessions or depressions depend critically on the magnitude of the dislocations and imbalances that have accumulated in the economy during the preceding boom.

Q And that’s why you consistently predicted that the U.S. economy was in for a hard landing?

A Yes. Allow me to summarize. The U.S. economy of the 1990s ranks as the worst bubble economy in history. The boom was built on nothing but leverage upon leverage. A vanishing supply of domestic savings was more than subsidized by boundless credit creation for leveraging asset holdings.

Q And the Fed’s the culprit?

A The all-important thing to see is that the Federal Reserve abandoned any control of money and credit creation. The power of the American credit machine to create credit out of the blue is unique and unprecedented.

Q Well, some would say it’s saved the economy.

A This excessive monetary looseness has only postponed and magnified the coming inevitable crisis.

Q Let’s talk about the dollar. You have said that it will weaken, and to some extent, it has. Is there more weakness to come?

A We regard it as an inescapable event. Growing disillusionment with the U.S. economy is the trigger.

Q But doesn’t the world like a strong dollar?

A It suited the rest of the world because it boosted their exports and it suited the United States as a boost to its financial markets. In actual fact, the huge capital inflows have become the U.S. financial markets’ single most important pillar. Take this pillar away, and those markets will instantly collapse with devastating effects for the U.S. economy, turning quickly into a savage credit crunch.

Q Could it happen that fast?

A The fact is that the exposure of the U.S. financial markets to foreign investors and lenders has grown to such preposterous magnitude during recent years that controlled, gradual dollar devaluation no longer appears feasible. Under today’s extreme circumstances, the alternative is only between a strong and a collapsing dollar.

Q Is there any cure for that?

A In order to avoid the worst, the Fed may be forced to drastically raise interest rates?

Q My goodness!

A The dangers that loom on the currency front are immense. The grossly overleveraged U.S. financial system is hostage to a strong dollar and permanent, huge capital inflows. The U.S. trade deficit and the accumulated foreign indebtedness have reached a scale that defies any possible action by central banks. The fate of the dollar is beyond any control.

Q Thank you, sir.