DR.

KURT RICHEBÄCHER
Frankfurt
Correspondents: GERMANY
Hahn Capital Partners Ine.
) CANADA
CURRENCIES AND CREDIT MARKETS

1991
No. 221/ September

that the country had

"On January 15, 1931, Harrison (President of the New York Fed) explained
experienced the most drastic deflation of bank credit in history, and that
the policy of the Federal
but to halt deflation."
Reserve System was not to stimulate inDation,
The World in Depression 1929-1939
Charles Kindleberger,
p. 184, Penguin Press London

HIGHLIGHTS

in the U.S. and a number of other

World markets are coiled in anticipation of a sustained recovery
Evidence we see suggests it couldn't be
countries, while expecting a slowing European economy.
more different.

M3 and M4). Though

Most worrying in the U.S. is a virtual collapse in broad money growth (M2,
is general zeal to explain it away as more or less
unprecedented in the post-war period, there
irrelevant.
) as explained in this letter, lead to the
opposite conclusion. The money
Our own investigations, private credit.
crunch is a very serious matter because it reflects a worsening crunch on

which makes up a sizable

Above all, precipitous declines in the prices of commercial real estate,
is eroding capital and liquidity.
chunk of the financial system's collateral,

Another important question is the monetary effects of

the thrift bailout. Many consider it as a
is grossly mistaken. It cuts the money supply and drives
mere bookkeeping" exercise. That, too,
tt

up long-term interest rates.

A combination of a crowding-
What are the ultimate causes of the money collapse? Our answer:
supply side.
out and a credit crunch the latter a function of both the demand and the
-

~.
is far devastating real estate crisis and to permit any
too low to alleviate the
u.s. monetary growth
aggravating financial woes, we venture
kind of sustained economic recovery. Considering all the
its most dangerous period since the Great Depression.
to say that the U.S. economy has entered

A ballooning budget
The U.S. bond market faces its most adverse supply/demand condition ever.
deficit coincides with sharply lower private savings and capital inflows.
The savings necessary to
absorb the current deluge of bonds are simply not there.

The greatest oddity in this picture is the buoyant U.S. stock market.
It can't last.

) situation between today and the

In conclusion, we reflect on the differences in the international
1930s.
 2

i(
WAITING FOR GODOT \.

After a time of relative quiet -

at least since the failed Russian coup -

markets are all poised for

major moves to the upside everyone thinks, of course.
. . .
Expectations for the dollar and markets
worldwide have been buoyed by legions of forecasts cooing the message that the recession-economies
importantly the U.S. are on the verge of a sustained recovery.
- -

Without doubt, the question of whether or not there will be a sustained recovery in the U..S. and the
a

other recession economies is the pivotal element underpinning market expectations.. It's exactly that
point, though, that keeps us so worried. Why and what's our point of focus? U..S.. money and credit
is mired in a protracted and progressive weakness which has caught most experts, including the Fed, by

surprise.. The fact that not too many are convinced that
its something to
worry about probably explains
the present calm of markets ..
.... before the storm..

The growth rate of M2 has fallen off sharply from an annualized 6.4% between January and April of
this year to just 0..7% since then. The M3 growth rate for the two periods, respectively, has fallen fro~
has been the performance of M4 (or L), which,
an annualized 4..4% to a negative 2.1 %.. Worst of all
in addition to M3, includes savings bonds, short-term treasuries, bankers' acceptances and commercial
paper held outside of Imancial intermediaries.. M4 has grown 1.1 % against a year ago but has dropped
$25 billion between March and June this year. In real inflation-adjusted terms, these figures speak of
a drastic contraction. In fact, such a contraction has not occurred since the 1930s. Irrelevant?
Hardly.

TRAIL OF THE MONEY CRUNCH {

'\_-

To start, at issue are two Why is money and credit growth not responding to the Fed's
key questions:
drastic easing measures and what are the implications of such sluggish money and credit growth for the
real economy?

Wall Street has been quick to provide happy answers to the second answer while skipping the analysis
of the first.. The most prevalent and comforting notion is that low monetary growth is more likely to
reduce inflation than GNP growth (read: good for corporate earnings and financial valuations). But, the
facts just don't measure up.. As of mid-1989, when economic growth peaked, exactly the opposite has
been occurring. Ever since, inflation has proved more resilient that GNP output.

Another anaesthetized interpretation of the weak monetary aggregates is that they mainly reflect portfolio
shifts due to sharply uneven interest-rate declines. Since bank deposit rates have fallen faster than the
yields of intermediate- and long-term securities, the view is that investors have shifted from low-yielding
bank and S&L deposits, which are counted in the money supply, into higher-yielding assets which are
not. Such a shift, it is argued, does not matter for the real economy even though
it depresses
monetary
growth..

No doubt, such shift has taken place at a large scale, particularly into bond and equity funds wmch
a

aren't part of the money aggregates. However, what's left out of the account, is the fact that such an
asset shift is the regular pattern of all recessions. Yel, never before has it happened in the context of
a pronounced and protracted monetary sluggishness..
(--
\0.

'<,.

Currencies and Credit Markets \ September 1991

 3

) In order to appreciate the present abnormalities one has to fust know what the normal behaviour of
money is before a recovery ensues. The chain of developments starts with easier money pushing down
short-term interest rates. The steepening yield curve acts as a powerful force, driving investors and
corporate borrowers into bonds and shares. Bond and stock prices soar. and, in the process, contribute
tremendous wealth effects to the consumer. This shift in corporate financing. away from the. banks to
the security markets is a crucial element since the soaring issues of bonds and shares -serve to strengthen
corporate balance sheets.

Then, the second crucial element enters: Given slowing private credit demand and .ample reserves, the
banks rush to expand their holdings of government bonds and cause longer-term yields to fall. Although
it is true that bank loan demand typically weakens during recessions, accelerating money growth. is still
assured by virtue of soaring bank investments, which, also help implement the necessary .lowering of
long-term interest rates.

Clearly, two things are abnormal today and demand explanation. During the 12 months preceding the
previous five post-war recessions, the broad monetary aggregates grew at an average pace of around 7%.
That compares dismally to rates of 2.5% for M2, 1.6% for M3, and 1.1 % for M4 this time. The other
abnormality is the sticky long-term interest rate.

Why this unusual monetary weakness? In order to understand the monetary processes, it is essen~ialto
analyze credit and money flows together. Why? Because the obvious cause behind.this exceptional
money crunch is a gathering credit crunch both inside and outside the banking system.,

') THE LINK TO THE THRIFT BAILOUT

One main actor in the credit crunch, despite the bailout operations, are the thrifts. After having e
expanded their assets and liabilities by about $80 to 90 billion annually between 1985 and 1988, the
thrifts have since shed about $250 billion, most of it having been near-money .and part of the money
stock. That's a lot of money by comparison when one realizes that M3 rose by $56 billion and M4 by
only $66 billion in 1990. Yet, Wall Street econofiÚsts and even the Fed seem to believe that money can't
get lost; that other parts of the financial system must be soaking it up and putting it to work.
The prevailing view of the S&L bailout is that it represents nothing more than a "bookkeeping" exercise
with no real-life affects on interest rates or the money supply. That couldn't be further from the truth.
Yet, here are some official statements that endorse this line of reasoning:

The January 1991 Economic Budget Outlook of the Congressional Budget Office reads like this on page
73: "Although financing the thrift bailout will add substantially to federal borrowing requirements in
the nextfew years, this borrowing does not put much additional pressure on interest rates. The money
that the government borrows to resolve insolvent thrifts and banks (less the administrative and interest
costs) is returned to financial markets. The money is redeposited in new accounts or invested directly
in income-earning assets."

Barron's of May 28, 1991, also catches Mr. Greenspan in the slipstream of the same logic. He is quoted
as saying: "While the size of the S&L crisis is lastronomical', Federal Reserve Chairman, Alan
Greenspan, contended that the overall effect of the increased financing on interest rates is ~moderate'.
That's because the bailout borrowings don't represent any new credit; U nele sam's liabilities. are

)
Currencies and Credit Markets \ September 1991
 4

substituted for those of the busted thrifts." (

\-.

Well, those may be cosy notions, however, brief dissection of the sequence of effects that are involved
a

in the bailout operations reveals otherwise. The starting point, of course, is found at the thrifts and the
banks that have suffered huge losses on their assets and collateral values. These losses necessarily imply
corresponding losses for stockholders and depositors. Essentially, their money has vanished.

Next, the government decides to take over the losses of the depositors. Actually, what it does is to
replace the vanished deposits. But whence do the hundreds of billions of dollars come from with which
the government pays off these depositors? Does the money rain from the sky? Is it a product of the
legendary printing press? Not at all. The government borrows the money in the markets, and in doing
so, essentially drains these funds from the existing pool of liquid savings. The funds for the bailouts
are withdrawn from other uses. The net effect, then, is a corresponding contraction in the overall money
supply.

Ironically, bailing out the thrift depositors by borrowing the necessary funds from the markets has
exactly the same contractionary effects on the money supply as the banking crisis of the 1930s when
the Fed and the administration did nothing to rescue the depositors. What's worse, the rescue operation
massively swells the supply of government bonds which tends to force up longer-term interest rates~

GOOD MONEY AFTER BAD

It's truly ludicrous to think that the bailout-related government borrowing is some kind of free lunch.
This type of public borrowing is really comparable to the private-sector example of a corporation
borrowing to fmance its losses. The government is doing precisely that
(
borrowing to fmance the
- .

losses incurred by the S&L's.

Keynes called this type of financing "distress" borrowing. Quoting him: "The slump itself produces a
new queue of 'distress7 borrowers who have to raise money to meet their losses. The thing will never
. .

cure itself by the lack of borrowers forcing down the rate; for it absorbs just as much savings to finance
losses as to
finance investment." The point to recognize is that savmgs spill over into losses . . ~
good
money follows bad.

In one highly important aspect, Mr. Greenspan

and all the others that belittle the' implications of the
thrift bailout are right. The pay-outs to the depositors of the busted thrifts have no stimulative effect
on the real economy at all. Their great error is the conclusion that the whole operation therefore doesn't
matter for interest rates and the money supply.

Summing it up: The new borrowing has no real stimulative impact, yet, at the same time, tends to force
up interest rates and to contract the money supply. It's hard to imagine a fiscaVmonetary mix that could
be more restrictive.

A CROWDING-OUT. TOO

The administration itself concedes that next year's fiscal deficit will hit $368 billion, of which $100
billion or more will be needed to fix the thrifts. That forecast, as pessimistic as it is, assumes a healthy

<-
Currencies and Credit Markets \ September 1991
 5

-,} economic growth rate of 30/0.

In the event of an economic u.s: MONEY AND CREDIT TRENDS
relapse and rising thrift and
bank failures, the market may
16
well have to finance a federal
budget deficit of between
$400-500 billion. 14
BANK LOANS + SECURITIES Year-to-YeaC'

All of this must be considered 12

against the background of an

increasingly disastrous savings 10

environment. The ballooning

budget deficit coincides with 8

declining household and

corporate saving and, last but 6
not least, a virtual desertion
by foreign investors. In
4
1989, foreign net bond
purchases amounted to $63
2
billion and last year fell to
4
$20 billion. Given the
generally higher bond yields
8
abroad, it's hard to see any

) foreign interest in the U.S.

6
bond market for the
foreseeable H3 Ye81'-to-Year.
future. Taken
altogether, U.S..
the bond 4

market faces unprecedentedly

adverse supply and demand 2

conditions.
o

MONEY CRUNCH 74

LINKED TO CREDIT
Source: International Strategy and Investment
DEMAND SLUMP

It goes without saying that the thrift bailout can only be a partial explanation of the protracted monetary
weakness. Were it not for the burgeoning budget deficit, U.S. money supply would be collapsing.
Although increased bank lending activity is the predominant avenue of expanding money supply, it's
not the oilly way. During recessions, as already explained, banks regularly spur money and deposit
creation by stepping up investments in government bonds.

During the first seven months of 1991, as nùght be expected in a recession, commercial banks have
increased their bond holdings by $48 billion. What's new and unprecedented is that over the past few
months this money creation through bond investments has been largely cancelled out by shrinking loans.
At the end of July, total loans and securities at all commercial banks amounted to $2,758 billion as
compared to $2,751 billion at the end of March.

Currencies and Credit Markets \ September 1991

 6

deposit contraction at the thrifts, and a shrinking

Observing the decrease in bank loans, the massive
cause of the monetary
commercial paper market, it's immediately obvious what the overwhelming
collapse for the private sector. Year-over-year, private debt
sluggishness is a virtual
-
of credit creation
(business and consumer combined) has increased 3.4% which is by far the lowest growth rate of the
is accelerating towards double-digit
whole post-war period. Government debt growth, on the other hand,
rates.

private credit demand out of

What's going on here government borrowing is squeezing
is that soaring
development of government and private credit
the markets. The following table showing the relative
is being perpetuated at an unexampled scale. In
demand speaks for itself. In short, a crowding-out
effect, the Fed's aggressive monetary
easing is being more than offset by sticky long-term interest rates
and plunging business profits resulting in shrinking private credit and money supply and nipping any
recovery in the bud.

UNITED STATES: TOTAL NET BORROWING

($U.S., Billions)

1987 1988 1989 1990 1991 01

144.9 157.5 151.6 272.5 55.8
u.s. Government
542.1 603.3 526.6 368.7 18.2
Total Private

Source: Federal Reserve, Flow of Funds

In this last analysis, we've shown that any money creation in the
United States is presently
budget
the result C
deficit have
of new government debt being taken up by the banks. But why does the soaring
~

the crowding-out effects

so little stimulative effect on the teal economy? In short, because apart from
rapidly portion of government spending and borrowing
on private borrowing and spending, a growing
is unrelated to GNP. The two biggest expenditure items now are an annual
interest bill of almost $200

billion and a thrift bailout of more than $100 billion..

The crowding-out is one side of the problem; the supply side of the credit crunch
is another.. If it's true
institutions have reasons
that consumers and others may be reluctant to borrow, banks and other financial
to slow or halt their lending, too.

DECLINING COLLATERAL VALUES AGGRAVATE THE CREDIT CRUNCH

A new plague across the whole U.S. financial system: precipitous declines in real estate
is sweeping
drops,
prices which happen to make up a sizable chunk of loan collateral. As the values of collateral
capital is impaired and the ability of banks, thrifts and insurance companies to expand new loans
becomes severely restricted.

As financial institutions,individuals and corporations scramble for liquidity, in the process dumping
assets on an illiquid market, they progressively undercut each others values and solvency.
Irving
"debt is playing out in the nation-wide depression of real
Fisher's famous textbook deflation" real-life,
its wake.
estate values, destroying capital, liquidity and money supply in

'-
Currencies and Credit Markets \ September 1991
 7

) Considering the gigantic overhang of vacant commercial real est~te, the real estate deflation
is certainly
to
only in its first phase. The salient point to see is,. that over time, asset deflation will be transITÙtted
adjusted to reflect the depressed
the whole of the real estate market as lease and rent renewals are
just as the reverse happened on the upside during the asset inflation of the 1980s.
prevailing market -

1930s REVISITED

Most observers, it appears, have yet to realize that the U.S. banking system of today is far more shaky
is that altogether
than it was during the early 19308. The most memorable statistic of that earlier crisis
more than 9,000 of some 30,000 banks crashed between the- four years of
1930 through 1933. By that
abyss.
measure, it seems that about one-third of the banking es~blishment fell into the

Those statistics are deceptive,. however. With. one single, but infamous
exception the Bank of the
-

United States in New York the rest of the failed banks were
-
comprised mostly of fiÚcIoscopic
capital
institutions in agricultural communities. Well over 60% of the crashes were among banks with
loss
of $25,000 or less and were located in towns of no more than 1,000 inhabitants. Overall, the total
approximately $2.5 billion
borne by depositors,- stockholders and other creditors amounted to
-

depositors taking the brunt for roughly half representing hardly more than 3% of total bank- and thrift
deposits. By comparison, estimated stock market losses towere_d to about $85 billion over the same four

years.

The larger banks, particularly the New York money-centre banks, weathered the storm with strong
capital positions and extremely high liquidity. Citybank, for example, the .predecessor to modem-day
Citicorp, had a ratio of liquid assets to net deposits of 63% in 1929. lbroughout the entire banking
) contraction, this ratio never fell below 59%. Banks then were roundly criticized for fear that their
penchant for liquidity was preventing Today, this liquidity ratio is often well
an economic recovery.
below 30% for the big banks.

1929 and
Another well-known fact of the 1930s is that a savage monetary contraction ensued. Between
supply by Much less
1933, banks deposits plunged by over 42% and money contracted over one-third.
appreciated, though, is that this monetary collapse didn't start in earnest until March-April of 1931.
$55.5 billion to $54.9 billion.
From year-end 1928 to year-end 1929, broad money only declined from
By March of 1931, broad money was only marginally lower at $53.8 billion. That was a pretty mild
decline and much less than the coincident decline in the consumer price index. On that basis, even in
the frrst Depression year, there was no decrease in the real supply of money. And, compared to the
wholesale price index, the real money supply actually soared.

"as a
In their book, The Monetary History of the United States, Friedman and Schwartz admit that
fraction of total wealth, the losses produced by bank failures were minor and would deserve no more
attention than losses of a comparable amount in, say, real estate." They then continue: "If the bank
failures deserve special attention, it is clearly because they were the mechanism through which the
important
drastic decline in the stock of money was produced and because the stock of money plays an
role in economic developments."

conspicuous contrasts: In
But in comparing the situation of 1990-91 with that of 1930-31 we note two
they were back then.
terms of real money growth, today's monetary conditions are more stringent than

\ September 1991
Currencies and Credit Markets
 8

More vivid and sensational is the difference in the behaviour of the U.S. stock market. In 1929-30, it ('
was the first to collapse while today it remains
resolutely and stubbornly optimistic.

over the longer run

There can be no doubt as to what will be the most detenninative influence
-

buoyant stock market may,

virtually inescapably, it'll be the weakening money supply. All the same,
the

as long as it lasts, provide a prop to confidence in

general.
~

ARRESTING THE DOWNTURN

lasted no longer than
Wall Street likes to comfort itself with the idea that post-war recessions have
eleven months on average. On that basis the recession-should already be over. It cart't be overlooked,
though, that all of these recessions have ended with an indispensable forerunner a strong monetary
-

expansion through the aegis of credit and money creation

by the banking system. If that fails to
materialize, a recovery is simply impossible.

of
The important question really is what has to happen to arrest and reverse this cumulative process
contraction. The short answer is that a rapid credit and money creation is required that would finance
is the opposite: a financial
increased spending on both goods and assets. What's happening, though,
deepest profit squeeze in decades
system in the midst of a capital squeeze, corporations witnessing the
and the consumer immobilized by an income squeeze.

DECLINING MONEY SUPPLY MATTERS

Earlier, we asked what would be the implications of a

prolonged sluggishness in money and credit. C
Inexorably, it implies a deepening asset
price deflation and a deepening recession. Since the epic entre
has such
of this rumbling asset and credit deflation is a shaking real estate market, and since real estate
a broad impact on money and credit flows, it's
only a matter of time until this contractive force also hits

the stock market with a vengeance.

of things that support its rosy expectations.

Yet, Wall Street has a happy disposition to only take notice
The one and only such thing that fits that optimism on the money
side is
Ml, the narrowest of monetary
aggregates which is presently growing at a strong clip of 8%.

ignored. The rise in the

There's a hitch inherent in the Ml numbers, though, that is being conveniently
offset by its collapsing velocity of circulation. The total flow of
quantity of Ml has been more than
in theoretical terms "MV", representing money times velocity
-
is therefore shrinking and
money -

MV did not fall, there

.

that the in M 1 not being spent on goods and services. If

indicates increases are
could and would be no recession. That's elemental arithmetic which doesn't need further statistical
verification.

is a sign of easy money which

Many assert that the big spread between short and long-term interest rates
is sure to revive the economy sooner or later. Indeed, in the past, it always has, but it overlooks the true
sticky due to the government's soaring budget
cause of the current spread. Long rates have remained
deficit while short-rates have plunged. Long rates have been kept excessively high during time of low
a

yields this time

The normal effect of declining short-term interest rates on bond
business profitability.
is being impeded by the heavy supply of government bonds resulting in a "crowding out."
l
'- r)
\ 1991
Currencies and Credit Markets September
 9

-) NO SAVINGS: MYSTERY BOND BUYERS

The savings necessary to absorb the current deluge of government bonds are simply not there. New
private savings are running at $150-160 billion annually as compared to a budget deficit of more than
$300 billion. From that perspective, U.S. long-term interest rates should rise over the longer run.

In the meantime, then, who is buying all of those bonds? As already mentioned, the commercial banks
background.
are big buyers. But there's an even bigger buyer operating in the
That's the securities

brokers and dealers who are arbitraging out huge profits by borrowing short in the fepo-market and
employing the funds in the longer-term, higher-yielding bond markets.

additional $37 billion last year.

Dealer purchases of bonds amounted to $90 billion in 1989 and an
1991, expected they turned into heavy sellers
During the first quarter of when economic recovery was
a

acting to depress the market. We would guess that dealers are back again as big buyers, now that

economic recovery prospects evaporating.

are That's probably one of the main sources of the recent
bond market rally massive interest rate speculation based on the repo-market. Needless to say, any
-

bubble, thus boosting

prospect of a monetary tightening, for whatever reason, would quickly prick this
long-term interest rates and nipping any recovery in the bud.

DECOY AND CONFIDENCE PROP: THE STOCK MARKET

its persistent peppiness has played

While a resilient U.S. stock market is of little economic significance,
a key role in fostering the perception of an economy that's basically strong and healthy. A sliding stock

market, though, would quickly deal a shattering blow to confidence.

picture t?f the trends

Could it happen another stock market drop, we mean? Considering the grim
..
.

in money, credit, business profits, real estate and available savings, there's little question that the stock
market strength stands out as an flagrant oddity. a year ago, the average price-earnings
Compared to
ratio has soared from 12.2X to 23.3X for the Dow Jones Industrial stocks and from 14.8X to 21.6X for

the component S&P 500 stocks. The average earnings/yield (the inverse of the price/earnings ratio) for
500 from 6.74%
the Dow Jones Industrial stocks has slumped from 8.20% to 4.29& and for the S&P
to 4.63%.

12 months; a period during which

Just think of some of the things that have happened in these past
A thrift and
stocks prices have skyrocketed in terms of the price-earnings ratio by some 60-80%.
liquidity, broadly shrinking real
banking crisis has loomed, a real estate crisis ravaging capital and
money, a virtual doubling of the federal deficit, and a savage profit and income squeeze.

forecasting recession-ends
But, Wall Street looks away and boasts of the stock market's perfect record of
and the onset of economic recoveries during the past 70 years. Stock market wisdom, of course, is a
modest circumscription for Wall Street wisdom.

CONTINENTAL EUROPE VERSUS THE UNITED STATES

its
Presently, favourite view among American and British economists that Germany, through
it's a
is dragging Europe into
combination of high interest rates and a sharply weakening domestic economy,

Currencies and Credit Markets \ September 1991

 10
recession while the U.S. economy is on the mend. The London-based Economist captured the sentiment
(
best with the following headline: "Will Germany Tow Europe into Trouble?"
While Germany is supposedly ailing, its GNP is up 4..8% against a year ago. In contrast, U..S. GNP has
only risen 0.8% over the same period.. Retail sales volumes are up 13.2% in Germany; they're down
2.1% in the United States. At the same time, the demand burst associated with German unification has
turned the economy into Europe's. locomotive as Germany has showered the rest of its European
-
ne~ghbours with export orders the extent of this stimulus being reflected by the abrupt decline in its
current account surplus.. According to official estimates, 0..8 percentage points of the European
-
Community's expected growth rate of 1..4% in 1991 is accounted for by the effects of German
unification..Without the unification, more European countries would be in or on the brink of a
recession..
It's only arithmetically logical that the initial East-German demand boost will even~ally taper down into
lower trends in current income and output But this passing of the bulge represents nothing more than
-
a normalization certainly not a Automobile sales, for example, are up 53% (yes, fIfty
recçssion..
three percent) in Germany between January and July; they're down 25% in Britain.. We can already
imagine the newspaper headlines if German auto sales start to stagnate at this high level and British
-
sales hopefully rise 10% Germany Sinks Into Recession, Britain Booms? Even if GNP were to stand
still in the second halfof 199], year-over-year GNP grpwth would still a1nO~t to 3%.
LONGER RANGE GLOBAL ECONOMIC OUTLOOK IS PIVOTAL
In our view, the hectic and near-sighted discussions about the next quarter's GNP. growth in various (-' \
countries isn't worth the candle. What's more important at this juncture is not the current growth rate :,)
-
but, rather, what will play out over the next few years. From that perspective in contrast to the
-
prevailing view, we might add we think Europe will be the source positive surprise where-as North
America will show negative ones.. Why?
Clearly, there is a widespread prejudice evident.. Pessimism is being consistently directed at Europe and
Germany and only optimism towards North America.. Typically, growth projections for Germany have
erred on the low side over the past few years, while being far too high for the United States.
Since the end of 1987, domestic demand has grown a cumulative 15 % in Germany, 13% in the European
Economic Community (EEC) and only 5.2% in the United States.. The EEC figures also include the
Britain, which has been mired in a long recession.
Just how fast will the European economies grow the next and following years? How fast will North
America power out of its slump? Without a doubt, these are the key questions for markets.. The
answers have far-ranging implications for currencies, interest rates, inflation and employment.
Comparing the two continents, the first thing to realize is that the U..S. and Canadian recessions are
purely domestically-driven. Strong foreign demand has so far ameliorated the downturn. In contrast,
the economic weakening in the European Community (EC) is mainly driven externally. Here,
contractingdemand in the U..K.., other Anglo-Saxon and Scandinavian countries are the negative
influence.
(... ":)
;'-,
.....~-?!":/
~)
Currencies and Credit Markets \ September 1991
 11

GLOBAL EFFECTS OF THE U.S. SLOWDOWN

The international situation today is diametrically different from that of the 1930s. Then, the United
States absolutely dominated the world both in trade and finance the latter, above all, as the world's
-

greatest lender. In contrast, Europe was financially vulnerable and econoßÜcally weak. As it was,
Germany collapsed immediately when U.S. capital outflows dried up.

Today, America weak while Europe is economically and fmancially stronger than ever
is vulnerable and
before. As already explained, the U.S. bank and S&L failures of our time are just as bad or worse in
relative terms than the banking collapses of the 1930s. Even more ominous than the similarities on the
part of the United States, are the differences. After the World War I, America emerged as the world's
leading creditor nation. Today, it is a
country heavily indebted to foreigners. Today, on top of it all,
America is dealing with a serious and unprecedented budget crisis.

In the 1930s, America drew the whole world into the Depression because it abruptly cut both its imports
and its foreign lending.. Today, the world is more financially independent of America. In fact, to the
contrary, America today is dependent on foreign capitaL

Moreover, American markets have lost some of their importance to Europe's foreign trade. In 1989,
the United States only accounted for 5.9% of EC country exports as compared to a much higher 7.9%
in 19584

THE LULL BEFORE THE STORM

No doubt, deepening U.S. recession will adversely ìrÍ1pact economic growth in the rest of the world..
a

But U.S. trade is only marginal for Europe. In 1989, U.S..-bound exports only accounted for 5.9% of
the EC countries' total. The United States imports little more from Europe than from Canada.

What the world does have to fear from the U.S., however, are the potential world-wide repercussions
of a financial crisis. That, essentially, would entail a currency crisis.

In the meantime, both the dollar and the stock markets worldwide have been buoyed by legions of
forecasts that the recession-economies importantly the U.S..
-

are on the verge of a sustained

-

recovery4 Whether there will be such a recovery is the most important question for everyone policy- -

makers, markets, investors, and people in generaL In the play, Godot never arrives, and that's the end.
If so, however, what would happen?

How will the central banks of countries either in recession or on the brink: of recession respond if their
own economy and that of the rest of the world proves much weaker than expected? The major critical
~ points in this scene would be the United States, Canada, Australia, Britain, France and Italy. For the

time being, markets hail each new easing as a necessary and desirable step towards recovery. There may
well come a time, though, where easing measures will be seen as a sign of weakness and desperate
policies4

It's easy for any government and central bank to stick to a policy of stable exchange rates and tight
money as long as it doesn't risk spreading a recession. That acid-test for these policies will come when

Currencies and Credit Markets \ September 1991

 12

the policy requirements for stable exchange rates begin to clash very harshly with those for growth and )
employment Not all governments and central banks will be able to stand the pressure.

SUMMARY CONCLUSIONS

The more we study the u.s. monetary, financial and economic fundamentals, the more we are convinced
that the U.S. economy is locked in- a recessionary environment. in fact, a long-term downtrend.
. .

Summing it all up: U~S~ monetary growth is far too low to alleviate the devastating real estate crisis and

to permit any kind of sustained economic recovery. Considering all the aggravating financial woes, we
dangerous period since the Great Depression.
venture to say that the U4S. economy has entered-its most

What are the chief factors underlying our negative assessment? No less than unanimous fundamental
Although officials in
indications of the quartet of money, credit, business profits and income growth4
Washington and an army of economists may continue to promise that better times are
just around the
progressively deteriorating.
comer, the hard troth is that all four recovery fundamentals are

a crowding-out, a contractive bailout, a credit

All in all, taking into account the many adverse factors -

and monetary crunch the nonchalance of markets and experts just boggles the senses. There's the
-

strong prospect of an accident

-
just waiting to happen4

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PubUsher and Editor, CurrelKus and Credit Markets: Dr. Kurt Rlchebächer
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Associate Editors: Hahn Capital Partners Ine, International and Domestic Portfolio Managers
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Copyright: Dr. Kurt Richebãcher 1991

.0
Currencies and Credit Markets \ September 1991