l I C or res

DR. KURT RICHEBACHER

pon.de nts:
i Hahn. Capital Partners loe.
Frankfurt
1
GERMANY
j CAN.IDA
! ) CURRENCIES AND CREDIT MARKETS
~
~
~
f No. 220 I August 1991
~
~
!

I If
In order to form an opinion on the policy of deflation and liquidation, it must first be recognized
i that every depression is a depression of profits occasioned by the fact that the price
curve and the
I~ I:.
cost curve cut. If
!.-,
t:
Wilhelm Ropke, Crises and Cydes, p. 186
W. Hodge & Co. London, 1936

.~
i
HIGHLIGHTS
f

I Trends in U.S. credit and money haven't been so anaemic and unsupportive ever before in the

I
j
.
entire post-war period. These figures reveal an extremely inhospitable monetary environment
that's still deteriorating.

The collapse of U.S. money growth is not a statistical freak. (t's a fundamental reality because
I the bleak money numbers dovetail perfectly with equally drab credit statistics. The obvious
driving force of the money contraction is a spreading credit crunch both inside and outside the
I banking system.
I
I
What the whopping contradictions in the indicators of Fed policy and the monetary aggregates
I ) reflect is a vast gap between what the Fed intends and what it has achieved. No
matter what the
I
I
best intentions of the Fed may be, the fact is that
monetary conditions are punishingly restrictive.
!
~
f So far, in 1991, loan expansion has been dead-zero. The commercial banks, too, along with the
~
i S&L's, ace out of the loan business and now insurance companies add to the financial
l troubles.
f On balance, only investments in government securities have increased.
;
i
j
I Irving Fisher's famous "debt deflation theory" is manifesting itself in the nation-wide
f
i
collapse of
i real-estate values and is crushing capital across the whole financial system. There's little doubt:
I this is a massive credit contraction.
1
~ A
t little more easing will hardly alleviate the pressure of the meltdown in the value of
real estate
i collateral on the U.S. financial system. Policy-makers, creditors and debtors are keeping their
I fingers crossed in the hope that these values will miraculously recover.

I The corporate sector's long-running profit squeeze was a

major factor that drove the C.S..
! economy into recession. Any potential for recovery crucially depends on the health and strength
of corporations. They are the key, not the consumer.

It's one of the many Wall Street myths that foreign capital is being
drawn into the United States
by unusually high levels of profitabilit},. It's a mockery of reality.

A deepening U.S. recession will compel a desperate Fed to ease nlonetary policy even
more.. That
action when it unfolds will claim two main victims: the U.S. stock rnarket and the
U.S. dollar~
Both can be expected to plunge.
 2

NO CREOn\ NO MONEY, NO RECOVERY

Confusion is back. No sooner had economists and policy-makers reached near-unanimity in declaring
the happy message that the U..S.. recession was over, than did the latest batch of economic and monetary
data again rain on the parade. As might be guessed, though, the expC(;ted recovery has only been
pushed out to yet another rain-date. Inexplicably, this deep-seated optimism demonstrated no less -

by Fed forecasts of an imminent recovery stubbornly ignores one of the blackest clouds on the
-

horizon in memory: persistent and chronic weakness in the money and credit numbers. If there's one
inviolate econooúc law, it's that recoveries need money. Yet, all kinds of theories abound arguing that
slow money growth presents little or no risk to an expected recovery.

1tsync" persistent ravings about a liquidity-driven bull market due

Even more out of are Wall Street's
surplus
to the fact that money growth exceeds nominal GNP growth" The clever theory goes that the
propels
of money not needed for transactions in real commerce instead flows into financial assets and
their prices higher. That's why Wall Street tends to party when the economy weakens.

liquidity on the stock market appears nicely plausible, reality is

While the fantasy effects of tfexcess"
strikingly different. Actually, the exact opposite is happening. Ever since early 1987, money growth
unprecedented
has been running well below GNP growth and in the meanwhile has cumulated into an
1980s is no less than
shortfall of money supply. The contrast of the present period to the earlier
picked M2 for our illustration because
overwhelming as the figures in the table below show. (We have
that's the monetary aggregate which Fed policy deliberations tends to focus upon).

What these figures clearly show for

~).
the last year is a cwnulative shortfall COMPARATIVE U.S. GNP AND MONEY j
of money relative to GNP not the-

(Annual % Change)
excess money machine that Wall
Street is so delirious about. How is GNP MONEY GAP
it then that stock pricesrecovered GROWTH GROWTH(M2)
from the lows of the October 1987 1981 8.9 10,,0 1.1
crash and that the economy
U.S.. 1982 5.2
3.7 8.9
continued to grow despite money 1983 7.6 12.0 4.6
growth persistently trailing GNP 1984 10.8 8..6 -2.2
growth? 1985 6.4 8,,2 1,,8

1986 5.4 9.4 4.0

COURTESY OF FOREIGN 1987 6.7 3.5 -3.2
CENTRAL BANKS 1988 5.5
7.9 -2.4
1989 6.7 5.0 -1.7
How did the U.S~ economy rebound 1990 5.1 3.3 -1.8
so smartly in 1988-90 despite
1991* 3.4 2.2 -1.2
anaeuúc money growth? Through
two channels thanks to the courtesy ·
Annualized figures for the first half of 1991 preliminary.

of foreign central banks and

investors andforeign stimulated
demand. These forces delivered the needed stimulus and liquidity which more than offset the internal
enjoyed an export-led expansion.
monetary restraint within the U.S.. For the first time ever~ America

Qt.. .

Currencies and Credit Markets \ August

1991 '..
...
 3

Almost 50% of U~S. GNP growth between 1987 and 1990 can be directly attributed to surging U~S4
þ ) exports4 In short., the strong pull of exports propping up the U4S~ economy allowed the Fed to take a
back seat~

But what about the bullish stock market? Isn't it proof of the existing excess liquidity that most Wall
Unfortunately., it proves nothing of the kind. The simple explanation
is
Street pundits like to assert?
that it requires very linle cash to drive a stock market higher compared with the vast stream of money
that are needed to buoy GNP. That's more true than ever in today's markets which are influenced by
highly-leveraged, derivative-product rrading.

A FUNDAMENTALLY NEW SITUATION FOR THE FED

[n any case" the Fed is now facing a fundamentally new situation~ Ragging economic activity in many
of the United States' major trading partners has derailed the American export locomotive~ 1ñis shift
is significant. It essentially implies that the task of restimulating the U.S. economy out of recession
isback on the shoulders of Mr. Greenspan and the Fed~ As the export stimulus fades., internal money

and credit growth again assumes overriding and critical imponance.

Wall Street at ample bank reserves" extremely low shon-term interest rates and a steep yield
-looking
curve hyped
-
isby the notion that the Fed's money stance is extremely easy and therefore, like
always, guarantees a continued bull market in stock and bonds and an economic recovery~ Others, like
ourselves, have our eyes glued on past and current trends in credit and money grOWth4

Undoubtedly., trends in credit and money haven"t been so anaemic and unsuppoItive ever before in the
I o whole post-war period. Statistics point to the conclusion that monetary conditions are now punishingly
restrictive not extremely easy
-

irrespective of what Fed policy may intend.

-

What these whopping contradictions in the monetary indicators indeed reflect is a vast gap between
what the Fed intends and what it has achieved. To be sure, the Fed has eased aggressively~ Yet, the
crucial point is that it has failed miserably to infuse any life into the monetary and credit system.
What"s worse., despite one easing move after another., the credit and money figures signal a
progressively deteriorating situation on the money side. Were it not for the rising budget deficit, U4S,
money supply would be collapsing.

.1':
FRIGHTENING MONEY NUMBERS

~
,~\
While some wilful believers in the u~s. recovery are beginning to admit some perplexity
bit worry in response to the plunging money-supply growth, others still shrug off the
-

and explain it away as some insignificant teclmicality.

if not a
phenomenon
-

.;r_~

Beware! The collapse of money growth is not a statistical freak~ It's a fundamental reality because

1.......1.1
:.Ji

~
the bleak money numbers dovetail perfectly with credit numbers that are just as drab~ The obvious
driving force of the money contraction is a spreading and intensifying credit crunch., both inside and
outside the banking system.

The broader monetary aggregates have virtually disintegrated. 'Iwo of them. M3 and M4. are

I fI Currencies
and Credit Markets
\ August 1991
 4

experiencing negative growth for the first time ever in the post-war period and ~t's before
.. . .

adjusting for inflation! M4 (or L)~ worst of all, has plummeted at an 3Illlual rate of 5% during the past
three months and M3 has sagged at a rate of 1.5% since the end of March. Taken over the past twelve
months. M4 has increased only $40 billion or 0.8%. That can only be seen as a sharp down-shift when
viewed in the context of the more usual rises of about $300 billion per annum over previous years..
M2 growth. while still positive, has slqwed down to a meagre rate of 1% since the end of March 1991.
Not only do these figures reveal an extremely inhospitable monetary environment, it's even worse since
these numbers continue to deteriorate.

Confirming our concern, something else is hitting new post-war lows. That is private credit growth,
which includes both business and consumer loans.. Over the past year, private credit expansion has
slowed to 3.9% and by all accounts is still slowing.

There is one striking exception to this dominating monetary sluggishness which we've described. The
narrow money stock, Ml~ shows persistent buoyancy, having expanded at an annual rate of 8% over
the past six months. Understandably, Wall Street "bulls" are taken in by the strong Mi..

STRONG Ml VERSUS COLLAPSING M3 AND M4

What more relevant for the economy, buoyant Ml or the sliding broader money and credit
is

aggregates? Our answer9 undoubtedly, is the latter. Why? Because the broader aggregates are
overwhelmingly and inextricably connected with spending on goods and services while Ml is more
strongly correlated to financial activity.

The trade of a financial asset obviously

requires the same quantity of money as the
CREDIT EXPANSION OF U.S. NON-
purchase and sale of an equal volume of
BANK FINANCIAL INSTITUTIONS
national product. Considering the feverish
(In $U.S. billions)
activity on Wall Street, it's easy to see
why MI is out of tune with the other
1983 1984 1985 1986 1987
aggregates and the broader economy.. The
only conclusion we draw from higher MI
350 504 527 656 434
growth is that Wall Street is out of tune
with the economy.. 1989 1990
1988 1991

To this point9 complete credit figures are

443 383 304 91*
only available to the end of the fIrSt
quarter of 1991. The recent collapse of ..
Annual rate 1Q 1991. Flow of Funds Account
the broader aggregates, though~ parallels a Federal Reserve

worsening ttend since then.

The adjacent by the way, also answers the question of why the broad money
table, and credit
aggregates are so particularly
weak now after years of over-proponionate strength. It's mainly a
reflection of trends in lending outside the banking system. As non-bank lending surged during past
yearsè9 broader aggregates were boosted. Now, as this lending plunges, it depresses the broad money
and credit aggregates.

Currencies and Credit Markets \ August 1991

,
 5

',,~'-"
I)
-

,:

UNITED STATES: M4 (OR L)

"

GRO~H
(Year-over-year Percent Change)
14

12

10

4
..: ~ECo VERt
5-rA~r
2
M4 =Liquidity=t\tt3 +T-ßills +
Comm.Paper+ Bankers' Accept. + Savings Bonds.

t ,r,J',
")
o

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90

Source: International Strategy and Investment, June 17, 1991

IF PAST IS PROLOGUE, MONEY MATTERS

We repeat our question: How is it possible to have a sustained

U.S. economic recovery with such
forbidding money and credit
nwnbers? Current trends suggest a degree of monetary stringency that
has no parallel during the entire post-war period. As the chart above
illustrates. M4 grew at an average
rate of 7.0% at the beginning of previous recoveries. The present M4
growth pace of 0.8% couldn~t
compare more dismally. And what's more, to repeát ourselves again, the
monetary contraction still
seems to be gathering force.

What astonishes us even more than the exceptionally weak

monetary facts is the near-total silence on
this subject
by Wall Street analysts. While analysts elaborate endlessly
can on every statistical blip.
they are steering a wide arc around this issue of most critical
importance. It's a topical taboo. Any
conclusion falling out of any 'monetary analysis, of course, \vould fly in the face of
the rosy story of
f1excess liquidity" fuelling the stock
market boom. More probably, many analysts simply lack the
theoretical underpinning to understand the causal mechanism behind this
squeeze. Most monetarists
know everything about money supply except how it is created and destroyed. If they
did, they wOlÌld
take a more careful Look at the role of credit.

t \

__J Currencies and Credit Markets \ August 1991

"-""""'''',,?'''-'''~f~
. .~- .". 7', -
.,' .,
~ . .

C'~~-'. -c
 6

For us, it's not a question of whether or not the Fed should come to the rescue but rather whether the
Fed still has the power to throw a floating life preserver.. Who's kidding who? A little more easing )
will hardly alleviate the pressure of the meltdown in the value of real estate collateral on the U..S..
financial system..

Policy-makers, creditors and debtors are keeping their fmgers crossed in the hope that these values will
núraculously recover.. They fully realize that a permanent, if not progressive, decline in real estate
values could conceivably create an Armageddon scenario.. Yet, exactly that progressive decline is what
the plunging money numbers are mirroring..

It one cannot emphasize enough the fact that the ongoing money and credit crunch is
seems
ftmdamentally different from anything that has gone before.. Firstly, the credit squeeze is unusually
prolonged and severe.. Secondly, and more importantly, the crunch is. cle~ly not the result of a
deliberate tightening of monetary policy.. Contrarily, monetary policy has been eased aggressively as
measured by the decline in the Fed funds rate and the rise in excess bank reserves.. Never before has
there been a
recession preceded by such a prolonge<j monetary easing -

not in all of modem history.

FROM THE S&L DISASTER. . .

The top question remains: Where is.

the origin of this credit and money squeeze that's spreading and
still growing in severity? Is it a ftmction of credit supply or waning credit demand?

Most probably it's vicious circle that reinforces itself from both sides of the credit equation as lenders
a

and borrowers mutually strive to reliquefy their balance sheets by selling assets (at falling prices) and
curtailing expenditures. Irving Fisher's famous "debt deflation theory" is manifesting itself in the
nation-wide collapse of real-estate values and is crushing capital across the whole fmancial system.
_)}
~

The sober reality is that the past credit boom was excessively based on the collateral of commercial
real estate values.

As the American financial system's weakest link, savings and loans associations (S&L's) were only
the first visible casualty of these lending excesses.. Yet the staggering costs of the S&L bailout by the
federal government are only part surely the smaller part
-

of the total costs.. Far more ominous

-

are the potentially open-ended costs of a crippled fmancial system to the nation and the economy as
a whole.. The Resolution Trust Corporation (RTC)
has over $300 in real estate for sale.. Trying to
unload it spreads the savage deflation in the commercial real estate market and its destructive impact
on capital right across the whole financial system. In addition, there's a back).og of another $300
billion in banks and S&L's which have not been taken over simply because there's" no money available
from either the RTC or the Federal Depositary Insurance Corporation (FDIC).

From general monetary and economic point of view, the most crucial and immediate effect of the
a

S&L crisis is the massive contraction of financial assets and deposit that it triggers. Since the end of
1988, S&L assets have fallen from $1.35
trillion to $1.05 trillion (ending February 1991).. Month after
month, an average of $10 to 20 billion pour out of the S&L's.. How long can the contraction continue?
One might do well to remember that the boom in S & L assets during the 1980s grew from a base of
only $560 billion.

Currencies and Credit Markets \ August 1991 JJ /'

 7

.
.. . TO THE BANKING MESS
t ,.
\I While the S&L's are being dismembered~ the commercial banks
credit system with total assets of $2.75 trillion
collectively the key engine of the
-

have also come to a virtual lending halt for the first

-

time in almost six decades. Compare these numbers: Banks expanded their loans by $145 billion
in
1988~ $162.5 billion in 1989., and by $76.6
billion in 1990. So far in 1991, loan expansion has been
dead~zero. The commercial banks~ too, along with the S&L's are out of the loan business.. On balance,
only investments in government securities have increased.

While it is often stressed that the commercial banks are in much better shape than the S & L's, the

~ comparison really conceals more than it reveals. The American banking system is at its shakiest since
the 1930s. Many banks, fighting for survival, are squeezing the availability of credit.
The bad Loans
of the past years are now coming home to roost The problem is that the recession itself, by causing
more and more loan losses, creates more and more troubled banks that in turn are cunailing credit
further and further.

The FDIC has a list which isn't publicly available, by the way
-

of "problemtt banks that it regards

-

as being particularly vulnerable to failure. At the end of 1990, there were 1048 banks on this _list
representing $408 billion in
assets. According to competent private estimates, there actually "are some
$750 billion of assets in the hands of troubled banks.

Bank problem-loans are concentrated in three credit categories: loans to developing countries not yet
written off (about $60 billion); highly leveraged loans to cOf.Ilmercíal corporations (about $190 billion);
and commercial real estate (about $400 billion).
e')
þ · TO THE INSURANCE CRISIS
. .

Following the S&L's and the commercial banks, a third big group of lenders is now fanning public
anxiety. Life insurance companies are starting to wobble. This group accounts for total assets of
around $1.4 trillion, having grown explosively from a level of $479 billion in total assets at the
start
of the 1980s. The formerly staid and highly conservative insuran\e industry, too, turned into a
rocketing t1go_g0.H In a rush to compete with the fast-evolving finånci~ investment markets, life
insurers spread their nets wider and wider with new "hybrid" products.

Now, insurance companies are trapped in the same predicament as the S&L~s and the banks. Offering
their customers sharply higher returns, they had to channel more of their funds into
higher-risk and
therefore lúgher-yielding assets. Guaranteed investment contracts (GIC's) promises to pay fixed
-

returns over periods as long as 10 years were sold by the billions to pension funds for which the
-

IJ policyholders plunked down a

one-time fixed sum. That's normal enough for the insurance business.
What wasn't so normal was the fact that exceptionally high interest rates were factored into those
annuities.

To earn these promised high returns, the insurers charmelled an increasing share of their funds into what
were believed to be high~ sure-ftre~ yields real estate~ mortgages backed by sagging commercial real
-

estate values and junk bonds. As the stupendous jump in asset figures shows, piles of money poured
into the insurance companies.

~ Currencies and Credit Markets \ August 1991

I
 8

Just how big is the insurance problem? No one knows~ As of year-end 19907 life insurers had $85
-'-"ì
billion invested in junk bonds against $109 billion in capital surplus and investment reserves. Even
)
more worrisome are an additional $160 billion in near-junk triple-B bonds. And last but not least~ add
to these figures another $260 billion in commercial real estate. Non-performing
mongages those -

that are 90 days overdue~ in the process of foreclosure or already foreclosed during the
calendar year
-

have surged by 70% to $ll~ 4 billion in 1990 from $6.7 billion a year earlier~ Worrisomely 3 1 t

insurance comparùes had ovet;' 50 cents in non-performing loans per dollar of capital and surplus.

Looking at the dozens of insurance companies with high-risk exposure~ the situation seems ripe for
more runs ahead. Worst of all, perhaps~ is that the insurance carriers (and7 therefore7 policy holders)
are not backed by the safety net of federal deposit insurance the way rhrifts and banks are. That makes
the insurers far more prone to a panic nul by their policyholders.

But even if a
panic can be prevented~ insurers are forced to cut their new investments drastically~ thus
contributing to a deepening and lengthening recession. In fact, they have been doing just that since last
autumn.. Since then, mortgages and bond investments have only increased at an annual rate of about
$50 billion as
compared with the roughly $l00-billion pace of past years~

WHO WILL FINANCE THE RECOVERY?

All taken together the fact is this:

What amounted to an expansion of about $400 billion or more on
an annual basis and securities of the commercial banks, S&L's and life insurance
in the loans
companies over recent years has now turned into a sharp contraction.

To all those who still belittle the plunging money supply numbers as being more or less
irrelevant for
the broader economY7 we ask7 "Where is the money fo~ the recovery going to come from?U We
)
can
only recommend that they analyze the credit-side of the monetary aggregates and the crippled state of
the various fmancial institutions. This is a comprehensive credit a crisis which so far has
crisis. . .

shown no evidence of bottoming much less stabilizing. Apparently, the storm is still gathering force.
Taking into account rising interest payments and inflation-adjustment~ there's little doubt about it: this
is a massive credit contraction.

American financial institutions are unable to expand their loan portfolios because they are in the grip
of a progressive capital erosion due to the disastrously declining values of the main collateral of the
fmancial system real estate.
-

All this gets us to the greatest potential for danger: a deepening

recession precipitating and bringing the real-estate crisis to a head.

A PROFIT RECESSION OF MANY DIMENSIONS

Some people have called tills U.S. recession a "balance sheet recession"~ meaning that it is caused by
illiquid balance sheets. Contrarily, others flatly discard the sharp rise of debt levels
over the past as
a non-issue. What
if both camps are wrong? Debts only become onerous over time when underlying
profits and incomes decline and new borrowing falls short of interest payments. This recession is due
to all sorts of causes but surely the lack of profits is playing a
highly-important, if not the ultimate,
role.

~~~
Currencies and Credit Markets \ August 1991
W
 9

Þl 24.0"
u.s. PROFITS: FOREIGN CONTRIBUTION
(AS % or TOTAL PROFITSt INCL. LV.A.)

22..0X

20.0%

18.01.:

16.07.;

14.0X

f
2.0X

10.0%

a.ox
7S , 76 I 17 I 78 I 79 I 80 j 81 J 82 I 83 I 84 J 85 I 86 1 87 I 88 I 89 I 90 I 91 I I

J) J Soorce: Hahn Capital Partners

An important agent in the U.S. economy's sudden slide into recession

was a sharp downturn in
conswner spending. No doubt~ the impact of cutbacks in borrowing and lending
was a factor in
slowing conswner spending~ yet its most unusual cause was the pinch on real disposable
consumer
incomes due to drastic and prolonged labour-shedding by businesses.

Why this ferocious labour-cutting? Answer: uúserable profits. The fact is that
U.S. corporations are
caught in a vicious
long-running profit squeeze. Clearly, this profit squeeze that's strnngling the
U.S.
economy is not merely of cyclical variety. It's a structural and long-term erosion
that didn't just
emerge with the economic downturn that commenced last The profit decline only
sununer. accelerated.

A VICTIM OF LOW PROFITS: CONSUMER SPENDING

This recession was led by sharply declining consumer

spending mainly because employment and wages
fell, but the two fell because corporations slashed them under the
pressure of collapsing profit margins.
To quote Keynes: "Activity of production depends on the business man hoping
for a reasonable profit.
The margin which he requires
as his necessary incentive to produce, may be a very small percentage
of the total value of product. But take this
away from him and the whole process stops. II

In order to understand the deep-seated malaise of the

U.S. economy, one has to look at the profit
ttends. Since 1980 also a recession year, by the way
-

the share of business profits in U.S.

-

national income has tumbled from 9.4% to 6.5% recently~ That's bad enough, but picture is
the true

þ o Currencies and Credit Markets \ August 1991

~
rf,:/-.-:-
 10

l
PROFITS
u. S4 MANUr ACTURING
(AS % OF DOMESTiC PROFIT, INCL. LV.A.)
55.0J:

50.0X

4540X

4.040%

3540"

3040X

2540"

Source: Hahn Capital Partners

strongly embellished by the soaring

much worse because the profit figures of the 19805 have been
profits pocketed by U4S4 companies abroad4 While profits abroad have more than trebled from a level
profits of non-
of about $20 billion in the early 1980s to $68 billion recently, domestically-earned
(Please see chart on previous page).
fmancial corporations have only increased by about 40%.

profits have
As miserable this domestic earnings picture is, it's sobering to realize that even these
as
did that happen? Through
been heavily inflated by the long stock market boom of the 1980s. How
the pension funds. During the 1970s, corporations had to make heavy contributions from current
pension funds. During the 1980s, by contrast,
earnings to meet the funding requirements of their
by the soaring securities markets.
pension plans were adequately funded and in many cases over-funded
As a result, corporations were spared contributions from earnings and in that way boosted their recorded

profits.

Obviously~ also works in reverse whenever the

big capital gains in the stock markets
this mechanism
Such an occurrence, in turn, forces cash-strapped
cease, or even worse, when the market declines.
corporations to kick in additional contributions. Anytime the pension funds suffer a down year,
corporations must make up the difference. TIle rules, though, allow under-funding.

That's the sharply

However, there is yet another OnùnOllS trend in the development of U,S4 protïts.
(Please see chart above).
declining share of domestic profits by manufacturers.

~t
~
\ L991
Currencies and Credit Markets August
 1{~:-~~"~~!"=~~~=~~~
~.:..
~ .

r--
1
j
11

PROFIT DECLINE CENTRES ON MANUFACTURERS

- \
I
~

It is one of the
many Wall Street myths that foreign capital is drawn into the United States by
unusually high levels of profitability. It's clear that many foreign businessmen have
been taken in by
this perception. It's a mockery of reality. Since the
beginning of 1987, foreigners have added more
than $200 billion to their direct investments in the United
States. Yet, reported income payments on
aU direct investments of foreigners
in the United States are lower today than they
were in 1987.
America has become the graveyard of European and
Japanese capitaL

More ironically. an important reason why the

U.S. current account has improved during this period is
that foreigners are logging more losses than profits on their huge
investments in the United States white
income receipt,> on the direct investments of
U.S. companies abroad are soaring.

It was the corporate sector's profit squeeze

and the ensuing labour-shedding that drove the
economy into recession. Conversely. any potential for a U.S.
recovery crucially depends on the health and
strength of corporations. They are the key. not the consumer. It is difficult to foresee a
sustained rise
in consumer
spending without a strong recovery in employment and real incomes.

Wall Street's cheerful rationale for the bullish stock market is

that the necessary rise in real incomes
wiU corne through falling inflation. is
That, too. another one of those grossly-flawed. simplistic
equations with which Wall Street deceives itself and others. Why?
Because the argument ignores
profits. [t makes a big
difference whether a country sports low inflation with high
corporate profits or
low inflation with vanishing profits.

:> Surveying the evidence in this respect, we note that

any faU in the inflation rate of the Anglo-Saxon
countries (United States, Britain and Canada) has been coming out of the hides
of business profits.
Domestic profits of U.S. manufacturing corporation~ have dropped
to a level of $67 billion. following
$106 billion in 1988. That's a tremendous plunge
and leaves profits little above their previous low in
the deep recession of 1982 ($56
billion). As a share of national income, U.S. manufacturing domestic
profits have plummeted to
an absolute low of 1.5%, against 2.2% in 1982~

CONCLUSIONS

When the U.S. money supply suddenly spurted in February and

March of this year after a prolonged
weakness, it was immediately cited as a conclusive signal of
an economic recovery. Just as soon as
the money supply figures waned again,
however, interest in the importance of money supply faded just
as quickly. Market participants and the Fed comforted themselves with easy-going explanations.
Instead, it was increasingly emphasized that a healthy recovery was assured by the sharp reduction in
the federal funds rate which was by the Fed between October and
engineered
April.

Such equanimity, though, is becoming questionable

given dramatically worsening money figures. Since
the end of December 1990, the Fed's
favourite target, M2 has risen at an annual rate of
2.2%, and since
March-end by a mere I %~

For several years now money growth has been

slowing_ The export boom of 1987 to 1989 served
to
temporarily decouple the economy from money
growth. Now that the export boom is over, the still-

t t' ~.\ Currencies and Credit Markets \ August 1991

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deteriorating monetary picture comes into the foreground.

l
Is there any plausible reason why tlùs is happening even as almost everybody foresees an econoIlÚC
recovery? The obvious reason is a spreading, self-reinforcing credit crunch. Credit tightening has
spread from the S&L's, to the commercial banks, and now further to the insurance companies.
There
isn't one remaining sector in the U"S. economy that has the fman~ial power to help finance a sustained

recovery. That~s a fundamental fact that foreshadows a deepening recession.

A deepening U.S. recession will claim two main victims: the U"S. stock marker and the U.S. dollar"
Both can be expected to plunge. The magnitude of the dollar's prior rally suggests the markets were
counting on a robust recovery in the U.S. economy to be frnanced by an accelerating inflow of foreign
capital.

So far, the recent weakening in the U.S. dollar only reflects a gradual downward adjustment of
recovery
expectaùons to a more lacklustre variety. By and large, gauging from stock market trends and financial
market ratios such as the TED-spread, complacency remains enormously high. Financial markets
remain unruffled despite heightening risks.

A deepening
U.S.. recession, as we expect though, will compel a desperate Fed to an even greater
monetary easing. Such a move would be sure to pull out the rug from underneath the dollar.

.)

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Copyright: Dr. Kurt Rlchebäcber 1991

Currencies and Credit Markets \ August 1991

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