In Jim Cook's Archive

After Us The Deluge

Once every week or two I call the South of France and talk with my favorite economist, Kurt Richebacher. His last newsletter spells out the looming crisis for the U.S. economy. Here’s a synopsis of what this important economic thinker has to say.

According to mr. Richebacher, people will be shocked at how fast the U.S. economy declines once the bull market ends. So far this year the economy has looked good because companies are building inventories and other one-time factors. This hides a deepening weakness in the economy. All signs point to a growing profit squeeze. In fact, the economy is weaker than GDP figures indicate.

Contrary to popular opinion, America’s profit performance is poor. U.S. business after-tax profits over the past 3 1/2 years average a meager 7.5% rise per year. Compare this to Wall Street’s crazy consensus of 25% earnings growth every year. Furthermore, the booming stock market has been a supplementary source of profits for corporations. This source has now dried up.

Corporate America’s stingy profit figures have been boosted by the highly-favorable impact of employee stock options. They take the place of wages that are charged as an expense. These now-worthless stock options will to some extent be replaced by wages. Corporate profits have also been helped by a big decline in corporate contributions to pension funds because of the large capital gains these plans have experienced. Companies must once again pay cash into their corporate pension funds.

Despite creative accounting, stock options, stock buybacks and other gimmicks, corporate profits are paltry. mr. Richebacher calls stock buybacks “economic folly.” It makes no sense for a company to buy back its low-yielding stock with the proceeds from selling much higher yielding bonds. He deplores debt financing at the expense of equity financing. Managers are maximizing their company’s share values over any other consideration. Corporate America has embarked on the most reckless leveraging of its balance sheets in history. It’s the acme of the short-run principle.

mr. Richebacher summarizes, “Wall Street likes to justify corporate stock buybacks by arguing that it is the best way to make use of available cash. Like so many aspects of the shareholder value culture, this one, too, is badly flawed. It begins with the fact that the available cash needed to pay for the stock buybacks does not exist. After paying out dividends and covering their investment expenditures, the U.S. corporate cash flow overall is in the red. So in reality the huge stock repurchases have to be financed by borrowing at interest costs that are generally several times higher than the rock-bottom equity yield. How can a corporate manager in his right mind do this? …. from a long-term perspective this reckless pursuit of debt financing is, clearly, economic insanity.”

In his last letter mr. Richebacher showed that personal income has stopped growing. In August the personal savings rate made a new record low. With stagnating personal incomes any further rise in consumer spending would have to come from consumers spending their savings. This can’t last. Brace for a hard landing.

Financial engineering in America not only includes stock buybacks, but acquisitions, mergers, creative accounting, cost cutting, and downsizing, all of which create a bias against long-term capital investment. That’s because rates of return in the real economy are inferior to returns in the financial markets.

It’s a desperate kind of capitalism where savings and capital accumulation have fallen into oblivion. Richebacher calls it’s a capitalism that an educated nation should be ashamed of. Maximizing share values imparts negative consequences to economic growth, income and profits. It causes rampant over-consumption at the expense of future generations who inherit depleted capital formation, a mountain of foreign debt and lots of worthless stocks and bonds. “The motto of this capitalism,” says Richebacher, is “after us the deluge.”

But doesn’t the U.S. have high capital investment? Yes, but almost two-thirds of this capital spending boom went into computer hardware and software which only accounted for 2% of GDP growth. This tiny fragment is supposed to have worked miracles in the U.S. economy. Furthermore, hardware and software investments represent a shift away from manufacturing towards services. In fact, investment in manufacturing has risen a meager 8% over the past four years. Outside of the small high-tech sector, new investment is stagnant. Says mr. Richebacher, “The wealth effects of the free enterprise capitalism have always accrued in the economies through the building of factories. The wealth effects of the ‘new’ American capitalism have accrued overwhelmingly in the stock market, fueling the most reckless consumer borrowing and spending binge in history.”

mr. Richebacher also warns about the dangers of corporate “restructuring”. The emphasis on downsizing and cost cutting to achieve a quick earnings fix runs into something called “the fallacy of composition.” The cuts and savings that eventually benefit a single company are harmful when many companies do the same thing. When overall corporate spending diminishes, business revenues decline, thus reducing profits.

The most important profit source in a capitalist economy is capital investment. Ongoing investment spending in an economy creates immediate business revenue. So why, with record high investment, are business profits so poor? For one thing, when computers are taken out of the investment mix what’s left is mediocre. The best profit performance for any industry sector has been retail and wholesale trade. This reflects a consumer borrowing and spending binge. The worst performing industry sector has been manufacturing and within this category the poorest profit performance came from electronics. In other words, new technology was the least profitable industry. It was only retail and finance that benefited from the credit-driven consumer spending boom that provided any significant investment stimulus.

But the unrecognized big profit killer in the U.S. economy is a soaring import surplus now running over $400 billion a year. Wages paid out by corporations are lost to them when this money goes overseas. Dollars spent on imports are dollars that to U.S. producers don’t receive. That’s why the growing trade deficit ravages business profits.

But didn’t profits rebound in 1999-2000? Yes, but that came through consumers spending their savings. Personal savings plunged from $265 billion in late 1998 to minus $40 billion (annualized) in August 2000.

mr. Richebacher summarizes, “Rising prosperity and rising living standards do not come from existing factories, but from building new factories. It’s not productivity that creates wealth; nor is there such a thing as a productivity-led expansion. It’s spending, and spending alone, that propels economic growth. But it’s the kind of spending that makes all the difference. Credit-financed consumer spending or credit-financed investment spending, that’s the question. An economy’s wealth has but one source: the confluence of saving and investing which, together, are also the most important source of productivity growth. Not vice versa.

“As a matter of fact, more than anything else it is this recognition of the all-important role of investment spending and capital formation in generating solid, profitable economic growth and prosperity that has long ago made us highly critical of the potential profitability of the new information technology. True, we see virtual technological wizardry, yet where are the profits and the prosperity of this technology, except in the stock valuation? Neither will they materialize in the future, and the reasons for that failure lie in the various, specific characteristics of this technology.”

Ironically, the great advantage of high tech is its minimal capital requirements but that’s the same reason for its inability to create prosperity and profits. The smaller the capital input, the smaller the wealth and profits. Capital formation is the one and only source of wealth creation and general prosperity. The new information technology lacks the extensive capital investment that is indispensable to long-term success, profits and wealth.

Concludes mr. Richebacher, “The U.S. economy is already far weaker than most people realize because they fail to see that the good-looking GDP numbers for the second and third quarter have been heavily propped up by record-high inventory building. When that stops, recession will hit.

“Economic imbalances and financial excesses of unprecedented size have made the U.S. economy and its financial system more vulnerable than ever before. There are serious problems everywhere: in the credit markets, in the banking system, in stock valuations, in credit availability, in profit performance, in debt burdens of corporations and consumers, in negative personal savings, and in the huge trade gap and grossly overvalued dollar. Confidence in the dollar has been the one linchpin that has held this disintegrating system together.

“High saving and heavy capital accumulation were paramount in boosting wealth and living standards in the course of the Industrial Revolution. For too long have too many people believed that the new information technology offers a free lunch by delivering huge gains in equity prices. In reality, this paper wealth creates the exact opposite: financial claims on existing resources.

“Hopes for a soft landing of the U.S. economy are completely misplaced. We have witnessed the worst financial bubble in history. Just as misplaced are the hopes that mr. Greenspan will again save the day by promptly opening the Fed’s money spigots. Fear of a weak dollar will constrain his scope for action in the first place, and the need for painful balance sheet adjustments on the part of heavily indebted consumers and corporations will severely impede the effectiveness of monetary easing in the second instance.”

Dr. Kurt Richebacher, a former central banker is the world’s preeminent living Austrian Economist. For most information on his monthly insight into global credit and currency markets, please visit

The Richebacher Letter
1217 St. Paul Street
Baltimore, MD 21202

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