The Calm Before the Storm (The all Nighter Economy)

When economic times are good, people pay very little attention to the work of economists. Only when an economy experiences a downturn do people come to economists asking how this latest disaster happened and how do we get out of it. Unfortunately, All politicians and most economists having a political agenda of Blame either won't or can't give you a straight answer so what you get is a lot of double speak a la Greenspan. In order to overcome this obstacle, perhaps an explanation and an analogy may help.

In the course of a business cycle, the economy moves through five phases:

• Falling interest rates, easy credit,
• An Investment boom,
• A Credit crunch & rising interest rates,
• Bad investment Liquidation & recession, and
• Stabilization , the beginning of the recovery phase.

One theory (Austrian) postulates that the main cause of all business BOOM AND BUST Cycles is brought about by an artificial lowering of interest rates and its concomitant large injection of easy credit into the economy. These below market rates of interest produces confusing and false market signals which induce entrepreneurs, investors and speculators to engage in investment projects that are not in true alignment with the needs of the economy and the consuming public. A perfect example is our current housing Bubble which was only made possible by the reduction of interest rates down to 45 year lows and which can only continue as long as rates remain low and falling or stay Negative (below the inflation rate). Now after 17 consecutive ¼% increases in interest rates, the pigeons are coming home to roost, as the latter projects called "mal-investments." While other the (bad) mal-investments are under construction, there is a boom in the economy. However, this artificial high cannot last forever and sooner or later there is a crunch. The economy either hits a credit crunch (with rising real interest rates), a real resource crunch (with rising commodity prices), rising labor costs and general increases in inflation or worse a combination of them allas we are beginning to now witness.

As the mortgage rates rise and the amount and time of unsold and vacant condo's, houses and office buildings increase, their prices first flatten out and then, as the negative cash flows start to hurt, it's not long before forced sales cause prices to begin declining in earnest. All those mal-investments must eventually be liquidated, as they begin to lose tons of money and in the face of rising interest rates, without any hope of ever making any, (most were in a negative cash flow position to begin with and it was only the hope and greed of fast rising prices that brought about these investments "The Greater Fool Theory").

We could very well have a repeat of the 1980's savings and Loan crisis. A great deal of pain is involved in the liquidation process as the pain spreads through the economy. First to the late comer investors, then to Real estate & mortgage brokers, Banks, Builders and their suppliers and finally workers and all the way down the line, until there are very few places to hide. Only after ALL the mal-investments are cleared from the system will the economy then be on a solid foundation from which to recover.

The All Nighter

Let's try an analogy to help explain this phenomenon. Suppose that, in his 8:00 a.m. economics class, a student was assigned a paper at the beginning of the term, which is now due tomorrow. In order to finish the paper on time, he decides he will have to pull an "all-nighter." After 2 hrs or so he starts to feel sleepy, so he takes some No-Doze and chases it down with a double Cola. (The equivalent of loose money and easy credit) The artificial stimulant puts him on an artificial high. But around 1:00 a.m., the effects of the sugar and caffeine start to wear off. He has a choice: either take more pills, more caffeine and more sweets or go to bed. Since he is not done with his paper, he chooses to take more stimulants, but this time he has to increase the dosage in order to get the same effect, so he pops a few more pills eats a few jelly donuts and puts on a fresh pot of coffee.

The additional credit in the economy has the same effect as the caffeine and sugar. The economy is sent into an artificial boom: The effects of the newly added liquidity eventually wears off as the stimulus on real business activity is transformed into increases in prices and/or massive increases in capacity. The monetary authorities face a choice between continuing to easing credit and expanding the money supply, risking inflation or letting the economy "go to sleep." (Recession) However, an economy doesn't just go to sleep, instead it must clear out the effects of the stimulus through the process of liquidation (recession), with its accompanying rise in unemployment which is never politically acceptable, especially with an election coming, so the independent (LOL) monetary authorities must continue to expand the money supply, so as to counter act their inflation fighting increases in interest rates., only this time the rate of increase must be far greater, in order to get the same effect. Now our procrastinating student's roommate comes back from a late date and finds his friend asleep at the keyboard. Knowing his friend's grade depends on this paper, the roommate wakes him. The student gulps down more pills, more caffeine, & more sugar and gets back to work. However, his mental processes are no longer functioning very well, his body is reaching its limit. Again his roommate finds him asleep and again the student is jarred back to consciousness. Again our hapless student is in spite of more and more stimulants, not working productively. When interest rates turn negative the economy is acting in the same manner as the persistent roommate. The economy attempts to get back to previous levels of growth, but because there are so many mal-investments using up highly valuable scarce resources that are tied up in not very productive activities; the economy cannot possibly achieve its potential. The student constantly prodded by his room mate, is finally done with his paper and rushes to his 8:00 a.m. class to hand it in. Now, he can sleep. However, the economy is not so lucky. It is never able to sleep, but it can "crash". There comes a point where there are so many resources tied up in mal-investments (negative cash flow investments) that a real resource and credit crunch occurs. There are too few resources and money to complete all the current projects. Despite the monetary authorities best efforts to keep the economy "awake " it just can't get back to its previously high levels of growth. It just hobbles along at what becomes a jobless slow growth expansion. It must go through the liquidation process (sleep) before it can again recover on a solid foundation.

The FED is repeating the exact same actions today as he did through out the late 80's the late 90's and then again beginning in 2002: Only this time despite increasing the money supply by more than 10% a year the economy can't seam to really get back to it's old robust self. Greenspan was doing everything in his power to make sure that the recession didn't start until after he retired. That's why we didn't see any ½ point rate increases. Don't lets those 15 increases fool you, Short rates are still negative and the money supply is still expanding, which is the prime reason long rates fell for over a year in the face of these 17, ¼ point increases.

So what is going to happen next, and why has it not already happened?

Since the last ¼ point increase we may have been witnessing the start of the topping out process, as long mortgage rates bot long and short are now over 6.5%.

While I don't have a Crystal Ball nor am I a fortune teller or a soothsayer, I like to think that I do have a basic understanding of economic theory.

First of all the U.S.A. having the worlds only reserve currency and being the largest and strongest economy, as well as acting as the "customer of last resort", has been able to attract 80% of the worlds savings and has thus far been able to prolong its semblance of growth in the face of record Trade, Budget and Balance of Payments deficits.. As is plain to see, it's taking ever increasing amounts of capital to keep the fires burning, while the Mal-investments all over the world get deeper and deeper into debt and it's been only the extremely low interest rates that are keeping them all afloat. The aftermath of all booms is recession and depending on the size and duration of the Boom, possibly Depression.

NOTICE: Interest Rates are on the rise all over the World

Confusing Cause and Effect:

If you think a reviving Japan or Europe or Asia can bail us out it won't. Japan has a 40% savings rate compared to the USA's -1% and as long as they are mired in stagnation they can lend us most of their savings. However, should their economy begin to recover, they will need their savings to fuel their own new investment boom. What do you think will happen then to our interest rates and our currency; if they just stop buying our new bonds, let alone start repatriating their foreign investments?

The Liquidation Process has begun, just as I have been warning you all since the middle of last year.

In my opinion we are in the equivalent of that mini boom of 1930, Just before the markets final sell off. Just as that final sell off into 1932 was much worse than the initial crash, so too will this sell off be much worse than our initial 2000 -2002 sell off. Please take note that the stock market bottomed in 1932 even though the depression lasted another 14 years.

The Stock Market, as are all futures markets, is a discounting mechanism and it will topple way before it becomes obvious that the economy has turned over into recession. (Look what's happening to oil prices, especially natural gas).

Markets always make their highs coincident with good news and higher earnings and make their lows during the Depths of recession accompanied with dire predictions.

Don't let the spat of good earnings fool you; they are being made through cost cutting and consolidation and bookkeeping magic.. Witness all the stock buy backs and takeovers at their highs, is that the best use of their capital and what does that have to say about their growth prospects? Buying back stock in an attempt to increase shareholder value, is very short term in nature and is an oxymoron, it's a signal that there is not much hope for the future. We all know that Wall Street loves all these takeovers, buy backs and consolidations. Why shouldn't they? They are making a ton of money: But we all know that Wall St. is only interested in themselves and in today and never look to tomorrow. Investment is for other people not them. Watch out! And act accordingly.

Hopefully "to be forewarned is to be forearmed".

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767

August 12, 2006

DISCLAIMER
The above is my personal opinion, and in no way be deemed investment advice to buy or sell anything. It is submitted purely for informational purposes, based upon my understanding of the markets.