American Disease, 2010

Ann Elk: Where? Oh, what is my theory? This is it. My theory that belongs to me is as follows. This is how it goes. The next thing I'm going to say is my theory. Ready?

TV Interviewer: Yes.

Ann Elk: … This theory goes as follows and begins now. All brontosauruses are thin at one end; much, much thicker in the middle; and then thin again at the far end.

(From Monty Python’s Flying Circus)

I too have a theory, which is to say it is a theory and it is mine. I hope it’s a bit less silly than Ann Elk’s theory, but in any case let’s try it on. The next thing I’m going to say is actually not my theory, but another theory, which is someone else’s and got me to thinking about my theory.

This other theory is something called Dutch Disease, which is an economic diagnosis of the Netherlands’s loss of competitiveness in goods producing industries following a 1959 discovery of natural gas off its North Sea coast. In the simplest terms, this led to inflows of investment, which pumped up the exchange rate and altered terms of trade in such a way that exports became uncompetitive. In this perverse fashion, Dutch Disease describes how a lucky strike in natural resources creates not employment and growth but unemployment and stagnation.

America, my theory proposes, has a version of that, only the resource is money. I want to name the problem “American Disease,” but I read in an article by Bryan Caplan that that's the name of a syndrome of Americans living beyond their means. Actually the problem I pose is closely related, just as H1N1 influenza is closely related to other strains of the flu. Perhaps I can say “American Disease, 2010” to differentiate it from old established strains, or should I call it “California Disease” to reflect the fact that the disease has advanced furthest in the Golden State?

America is a country with real natural resources, of course, but the high costs of extraction and environmental compliance and restrictions on land use places them increasingly out of reach. In the days when the country did produce resources and processed them into manufactured goods which foreigners bought, the U.S. generated a vast amount of wealth, much of which was invested in buildings and infrastructure. These remain visible in the present day, residual wealth as monuments to our peak of economic power.

(Exactly the same is true of Argentina, by the way, which was the wealthiest country in the world 100 years ago and still has the buildings and boulevards to prove it, even though Mr. Juan Peron and the generals set the country on an unusual course from first world to third world status.)

Now, even after the financial crisis, America’s most important industry is finance, broadly defined. The financial industry differs from the auto industry and the chemicals industry in one interesting respect. The auto industry inputs steel, glass, and plastic and outputs autos; the chemicals industry inputs primary and intermediate materials and outputs finished chemical products – in other words, they work on raw and intermediate goods and change them into something else. Most industries do this. But the finance industry has money both as input and output – it changes money’s form but not its nature in its processes. Money is both the input and the output, the resource base and the finished product.

The American finance industry is competitive, one of the nation’s success stories in terms of services exports. Our political class, which increasingly impedes us from taking coal out of our mountains, irrigating our farmlands, and manufacturing products with processes that are not squeaky clean, has long promoted clean, non-polluting financial services, and it has prospered as the industry prospered.

However, I believe that too much money in an economy based on financial services has given us a condition akin to Dutch Disease. It could probably be shown that the maintenance of the U.S. as a financial center has made the American dollar stronger than it would otherwise have been, reducing our competitiveness in global markets for tradeable goods and services. Moreover, the high level of compensation in the financial industry and supporting services has probably driven up wages and benefits right across the U.S. labor economy, another blow to the competitiveness of any entrepreneur bold enough to defy the odds and manufacture a product for sale in America.

While the American political class stands in the way of development of our (real) natural resources and domestic manufacturing, it does see the residual financial wealth of the nation as a resource that it can cut and drill and strip mine – endlessly, in fact, as it recognizes no restraint on the size of resource, but treats it as effectively infinite. The people entrusted to run the country give no thought to the necessary diminution of the resource as taxes, penalties, and compliance costs leave less and less to reinvest, even as the potential returns on investment are inevitably being reduced. They use static models that fail to capture the fact that producers will not produce – or innovate, or hire – out of sheer altruism and public spirit while the returns on their capital and labor are collapsing.

The impoverishment of the United States by the Argentine model is thus well under way.

Oh, and why do I say California has the most advanced case of the “American Disease, 2010?” Well, just look at the Golden State. There is oil offshore, but its development is not permitted. Manufacturing is being driven out. And the Central Valley is experiencing 40% unemployment in agriculture in order to protect mudfish habitat; but California's fiscal position continues to deteriorate as its political class absolutely will not live within its means, as dictated by the state’s reduced economic circumstances.

As California is the United States only more so, California’s political class is America’s in microcosm, with all its pathologies subjected to magnification.

The mindlessness with which the American money resource is to be run down puts me in mind of a passage from Atlas Shrugged:

As they proclaim their right to consume the unearned, and blank out the question of who's to produce it—so they proclaim that there is no law of identity, that nothing exists but change, and blank out the fact that change presupposes the concepts of what changes, from what and to what, that, without the law of identity no such concept as 'change' is possible. As they rob an industrialist while denying his value, so they seek to seize power over all of existence while denying that existence exists.

Standard and Poors 500 Index going to 100?

My correspondent Ted Kavadas writes great stuff at Prosperity by Pen, which is on the blogroll. He has an article entitled "A S&P500 Target of 100? Impossible, Improbable, or Impending?" It relies on the fact that there is little technical support between recent S&P 500 Index lows and 100, and little in the way of current earnings to prevent the index from crashing to such a level.

It's interesting as his work always is. And from the point of view of gaining publicity for an idea it never hurts to be extreme . . . wasn't Harry Dent calling for Dow 45,000 before he decided that the Dow has strong support down around zero? (I did this myself once, calling for an Indonesian Rupiah at 10,000 to the dollar at a time when it was around 1,700 -- but I was not extreme enough as it ultimately went north of 15,000)

The first material critique I make to the argument is that markets do not look only at current year (year 1) earnings, but look beyond the earnings trough, whether that is this year or next year or whenever. Market participants can be wrong about that and need to reset expectations, but there is no way they drive the S&P to 100 based on current year earnings estimates, without other things happening (e.g. the financial system collapses despite all efforts, terrorism hits us at home in a spectacular way, Obama embraces Chavez-ism.)

Second, market participants have already largely discounted the work product of the analysts, who have proven again that as a group they are no use under deeply cyclical conditions. The shock value of their downgrades is more limited now. Certain analysts who have made particularly good calls are exempted from the criticism that they don't know how to analyze in this economy, but even they are finding it hard to shock the market at this point.

Third, given the cyclical conditions, participants will prefer to consider earnings over a longer segment of a full cycle than just one year. I have heard of people calibrating valuation to an average over ten years. No one can forecast year 10 earnings for any company, but if investors are finding this approach works for them that's great.

Fourth, and maybe the big one. Let's not forget that current earnings are heavily penalized by non-cash charges. This is the central problem of our markets today, the fact that charges required by mark-to-market accounting have demolished the capital of the financial system, requiring markdowns and charges on assets even if they are performing. It's madness, but it's the system we have now. If you are of the opinion, as I am, that much of this capital destruction is unreal and unnecessary, then true earnings, though depressed, are still higher than reported. It is not only financial companies that are taking these charges because they are forced to. Other companies are "kitchen-sinking" their earnings in order to get out whatever bad news they could conceivably ever have at a time when markets are inured to bad news. Hence Nike recently wrote down Umbro, which they bought mere months ago and now declare impaired, taking a heavy hit to earnings in the current period. This charge is wholly discretionary. They did not have to take it now or probably ever. This is why some participants prefer cash flow to manipulable reported earnings. Earnings lie, cash flows tell the truth.