Friday, October 16, 2009

Dow 10,000 a Bubble, Not a Boom

Whenever we see a bubble, we want to think it's a bag of gold. And when we enter the eye of a storm, we like to kid ourselves that times of peace has come at last.

Now that the Dow Jones Industrial Average has once again surpassed the 10,000 mark, we want to believe that the hard times are finally over and that ten to fifteen years of unbroken prosperity lies before us. Brace yourself.

The New York Times reminds us ("10,000: The and Now") that when the Dow first passed that point on March 29, 1999, the economy was roaring through it's eighth year of wild prosperity, and unemployment was about as low as it could be. This ten is not the same as that ten.

Yes, unemployment today stands at 9.8 percent. But is that just the economy lagging behind the first indicators of economic recovery? Sorry. No.

The spike in the Dow is the result of huge profits that the banks have posted from their recoveries. But they are still not lending, and without that there will be no recovery for the rest of us. But don't get angry. Get answers. Why are these shrewd people still not lending? Isn't it their business to lend? No, it is their business, as in any business, to make money. They must have reason to believe that if they lend, e.g. to small businesses or to prospective homeowners, they will lose money. So look around for what they are seeing.

Look here. David Malpass, the president of Encima Global LLC, points us to our collapsing dollar as a source of our vanishing prosperity ("The Weak-Dollar Threat to Prosperity"). The Bush administration was devaluing the dollar throughout the decade. That corresponded with runaway government spending. When faced with large debts, government must either cut spending (unthinkable), raise taxes (impolitic and counterproductive), or devalue the currency. How do they do this? By keeping interests rates low, they encourage public and private borrowing, such as government bonds and home mortgages. If anything becomes oversupplied, it's value decreases. As dollars lose their value, it takes more of them to buy things, both at home and abroad. Prices rise across the board.

How much value has the dollar lost? Is this a big deal? You can see how dramatic the fall has been by looking at the price of gold over the past decade. Gold has a stable value. The fluctuation in its price reflects the relative value of the currencies that are used to price it. So as the dollar loses value, it takes more of them to buy an ounce of gold. When President George W. Bush came into office, gold was selling at over $250 an ounce. When he left office eight years later, it was about $850 an ounce. The price climbed steadily over those eight years.

President Obama is making his predecessor look like the king of thrift, and he's not done. The present government has popped the roof off an already large public debt, spending trillions, and preparing to spend trillions more. As a consequence, the dollar is falling faster than ever. Since Barack Obama took office less than a year ago, gold has gone from about $850 an ounce to roughly $1,050. You should expect it to go higher. Much higher. Adjusted for inflation, gold's historic high is over $2,000 an ounce.

As Obama pumps trillions of dollars into the economy, and the economy does not respond proportionately with a vigorously growing GDP (still no sign of that), more dollars chasing the same number of goods will mean inflation. A ridiculous increase in the money supply on top of a stalled economy will give us a devouring plague of inflation further devastating people's lives.

You might be wondering, however, about the upside to a weak currency. Doesn't it make our exports cheaper, and thus boost domestic production and launch us into recovery? Malpass explains how historically this has always been a losing strategy.

As the pound slid in the 1950s and '60s and the British Empire crumbled, the corporations that prospered were the ones that borrowed pounds aggressively in order to expand abroad. Though British equities rose in pound terms, they generally underperformed gold and foreign equities. At the end of empire, the giant sucking sound was from British capital and jobs moving offshore as the pound sank....No countries have devalued their way into prosperity, while many—Hong Kong, China, Australia today—have used stable money to invite capital and jobs.

None of this indicates the American economy returning to boom times any time soon. In fact, this window onto the future reveals just the opposite.

The other place bankers are looking is the second wave of residential mortgage defaults and, on top of that, the coming collapse of the commercial real estate market. Charles Gasparino helps us there ("The Next Bank Crisis").

[The banks are] still holding trillions of dollars in ailing mortgage loans and commercial-real-estate debt that they have yet to fully write down. They're hoping they won't have to -- but continued joblessness is squeezing those portfolios. The banks will tell you that they've written down a good chunk of their consumer loans. But the problem, according to banking analysts like Mike Mayo, becomes acute if unemployment passes 10 percent and nears 11 percent. That's the point, according to many economic models, that American consumers start defaulting on loans in such a way that trillions of dollars in consumer-related loans and debt that haven't been written down start to implode.

And that doesn't account for the trillions in commercial-real-estate loans and bonds that have yet to take any significant hit at all -- but (most analysts predict) will be crashing in the months ahead even if unemployment stabilizes at 10 percent.

Bottom line: If unemployment goes higher than 10 percent, the banks' numbers get even worse. As losses begin to mount, the big banks may well find themselves back begging the government for more bailout money.

So beware of jumping on the bank profit driven bull market, thinking that you are going to ride it into the Obama Boom Years. There is much pain to come, and with it much tragic loss. It is tragic because wise leadership could steer us through it more safely by stabilizing the currency and tightening up on government spending. The administration is doing just the opposite. It's like physics. If you torch your house, it will burn down. We are already feeling the heat.

1 comment:

R.B. Glennie said...

excellent post, Prof.