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The Last Analysis

Mr. Greenspan has been hailing the wonderment of the U.S. economy's new resilience, both to the bursting of the stock market bubble and to the various shocks from terrorists and the Iraq war.

But the cause is obvious. What, for the time being, has prevented a deeper and longer recession in the United States is more and more of the very same consumer-borrowing-and-spending bubble, which has been propelling U.S. economic growth over the past several years.

Yet two things have changed. The first one is the collateral behind the consumer borrowing and spending binge. Rising stock prices have been replaced by rising house prices. The second is that it needs more and more rampant credit and debt creation to master just marginal GDP growth.

Our highly critical assessment of the U.S. economy's performance during the past two to three years, in fact, finds its major justification in the atrocious discrepancy that has developed between extremely promiscuous monetary and fiscal stimuli and their extremely poor economic effects.

Between 2000 and 2002, the federal budget has swung from a surplus of $295 billion into a deficit of $257 billion, heading for a $400-500 billion deficit in 2003. During the same two years, total nonfinancial credit zoomed $2,520 billion and financial credit by another $1,879 billion, both adding up to $4.4 trillion.

What was the effect of this credit and debt deluge on the economy? GDP during these two years grew in real terms by $248 billion and in nominal terms by $621 billion. To us, this is an outright policy disaster.

Yet, American consensus economists are definitely consistent in their approach. Undeterred by data that overwhelmingly point to the enduring weakness of the economy, they stick to the same forecast of the U.S. economy's imminent, strong recovery. Though there is no trace of the generally predicted postwar snapback, optimism about the U.S. economy and its imminent, strong recovery remain the order of the day.

Betting on the government's third tax cut, further Federal Reserve easing, a weaker currency, and still more mortgage refinancing, the consensus expects economic growth to accelerate to 3-4% in the second half of this year, compared to the dismal sub-2% in the first half.

In striking contrast, Mr. Greenspan and the Fed have become distinctly more cautious in their utterances about the economy's prospects. The Fed's latest Beige Book admits that economic activity remains sluggish. Although "the unwinding of war-related concerns appears to have provided some lift to business and consumer confidence," the report said, "the effect has not been dramatic."

Consumer spending was said to have "remained lackluster." Labor markets were described as "weak" and manufacturing activity as "mixed." In particular, one remark concerning consumer spending shocked us: "Overall consumer spending was soft in April and May. Retail sales picked up some after subdued sales in March, but most reports indicated that sales remained below the level of a year ago."

This weakness in consumer spending is ominous, considering that new borrowing and mortgage refinancing are setting ever-new records. Both new and existing home sales rose to record highs last year, with mortgage origination totaling $2.5 trillion. According to estimates by the Mortgage Bankers Association, mortgage origination this year is set to reach even $3 trillion, with over $1.7 trillion of refinancings.

This mortgage-refinancing binge has had two effects. One is the change in net new borrowing by the consumer, which rose by a record amount of $768 billion during 2002. The other effect is the amount 'saved' by private households through the refinancing of existing mortgages on their interest payments. Considering that 30-year fixed rates for mortgages have plunged by more than two percentage points over the past 12 months, from well over 7% to almost 5%, these savings have played an important role in bolstering disposable consumer incomes.

Pondering where all this money went, we took a look at the pattern of consumer spending from 2002's first quarter to 2003's first quarter. What we found greatly surprised us.

Apart from a temporary, minor surge in the sale of motor vehicles, expenditures on consumer durables were flat over the year. Among nondurable goods, the major increases in spending were on food, gasoline and fuel. Actually, 63% of the higher consumer spending was on services, and mainly on housing and medical care.

It was a discovery that has shocked us - because we learned that the American consumer's heavy borrowing is largely financing expenditures on essentials.

The other, equally important conclusion to be drawn from these facts is that consumer spending, despite ever-new records in borrowing, is not able to lead a sustained recovery. So far, it has prevented a deepening recession, but it is much too weak for more than that. The obvious indispensable further condition for sustained, stronger economic growth is higher business fixed investment. Mr. Greenspan has certainly realized this, having said in a recent speech, "the central question about the outlook remains whether business firms will quicken the pace of investment."

Scrutinizing the GDP numbers and also the necessary conditions for a broad recovery in business fixed investment, we see no chance for it to happen. But first a clarification of facts:

Over the 12 months to the first quarter of 2003, nonresidential fixed investment has declined in nominal terms by $21.7 billion and in real terms by $17.6 billion. The decline occurred across the board, but it was centered in structures, that is, in nonresidential buildings.

Business investment on equipment and software, measured in current dollars, increased slightly, by $10 billion, or 1.2%, implying virtual stagnation. Measured in real terms, however, one item - computers and peripheral equipment - showed a sharp increase by $56 billion, or 21%. For many bulls, this is one ray of hope in the economy's overall dismal picture. But we see nothing but hedonic pricing. In current dollars, business spending on computers rose by just $4.4 billion.

Pondering the possibility of a broad recovery in business capital investment, we can only repeat what we have stressed many times before. Profit prospects are the key question in this respect. But scrutinizing the various macroeconomic components that ultimately determine aggregate profits, we note a preponderance of negative influences. The greatest potential threat to profits is a return of private households to higher savings, which is sure to happen when the mortgage refinancing frenzy abates and long-term interest rates stop falling.

Positive influences from the macro perspective during 2002 were the sharply widening federal budget deficit and rising residential building. Major negative influences were the continuous rise in the trade deficit and declining net investment, mainly due to the continuous rise in depreciations.

The fact is, there are no reasonable signs of an imminent pickup in U.S. economic growth in general and of business fixed investment in particular. In the last analysis, all the prevailing optimistic forecasts are based on the conviction that the Fed and government have the infallible means to generate a recovery under any circumstances. The chorus calling for the Fed to open its money spigots further has become deafening.

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