“Credit Crisis Hits Home” / “End of the Croupiers”

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Both the first article and the second article (which cannot be found electronically) are from the April 21, 2008 issue of Forbes magazine. The purpose here is not to discuss these in detail, but to simply point out inconsistencies or pure fallacies by the authors. The first article is by none other than David Malpass, Chief Economist at Bear, Stearns, & Co. The second article is by New York money manager Lisa W. Hess.

Comments and corrections:

David Malpass: “..global income will hit $53 trillion in 2008, double the rate in 1995,…”

This statement is meant to show that world incomes are rising. But the fact is that this statistic is completely meaningless. Income, or GDP, is a worthless measure, unless comparing GDP from country to country. GDP growth is a worthless measure any way you look at it. GDP basically consists of the total number units of goods sold times the price of each good. If the amount of money in an economy doubles, prices will approximately double. If prices become twice what they were, and one multiplies this higher price times the same number of units sold, then voilà!, GDP just doubled. GDP is for the most part a measure of the amount of money in an economy, not the real standard of living of individuals.

David Malpass: “Others think the dollar can’t be strengthened, that it’s no longer credible enough to invite buyers.”

Any currency can be strengthened. If the government quit printing money, the dollar would quit falling. It’s as simple as that. Any country (such as Switzerland), which creates new money more slowly than other countries will see its currency rise relative to the other countries (but not against gold, unless no money is being printed). Buyers will buy a currency which they believe will hold its value. If they feel it will not, they will exchange it for other currencies. The only problem with the dollar is our government devaluing it intentionally.

David Malpass: “Washington’s actions should stop the financial crisis.”

The printing of more money to shape up bank balance sheets, the subsidizing of mortgages which many individuals cannot really afford, and the forcing of mortgage lenders to rewrite contracts, could possibly stop the financial crisis for now. But it would be at the expense of a larger crisis later. Distortions in the economic system caused by the Federal Reserve do not just go away. Their effects can be stalled only by the printing of more money, which causes inflation and causes more problems in the future, on top of the current problems.

David Malpass: “Funded by millions of U.S. taxpayers, the government will mail checks to millions of households hoping they’ll spend their rebates to lift the economy.”

This is shockingly incorrect. The rebates are not at all funded by taxpayers, but by the Federal Reserve. This means they will print money to give to us. The result is that prices will rise as we all go and spend our $300. Additionally, the whole idea that spending money can help an economy grow, much less get one out of a recession is fallacious. If we spent everything we had, we would waste all our capital and could no longer produce anything. Wealth comes from saving money which is then used to purchase machinery, technology, and other tools which help us to be able to produce more goods per person.

Lisa W. Hess: “The decline in interest rates didn’t just raise stock prices, to the benefit of all of us.”

It’s not so much that lower interest rates per-se raise stock prices. It’s the printing of new dollar bills that both lower interest rates (increased supply of funds reduces the price of funds) and raises stock prices. As more dollar bills are created, many of them find their way (partially because the cost of borrowing funds to invest becomes lower) into the stock market. If everyone had their money invested in the market, how could the market go higher? It couldn’t, unless new funds became available with which to bid prices higher.

It’s true that with a lower cost of capital they should theoretically be valued more highly. But this effect is much diluted. How do we explain the fact that P/E ratios now average about 20 whereas they used to average 10-15, with the same level of interest rates? The explanation is that stocks are now permanently more expensive because more money is chasing them than before. Previously, an interest rate reduction of 100 basis points might have meant that P/E ratios should rise from 10 to 12, based on fundamental analysis. Now, a 100 basis point reduction could mean that P/E ratios rise from 20 to 24.

Similarly, analysts value stock prices higher when profits rise. But profits can only rise because of new money being created. New money loaned out becomes new revenues for companies. Costs necessarily lag revenues for reasons such as 1) depreciation expense, and 2) the fact that they occurred in the past before prices/revenues rose, and widen the revenue-to-cost spread. This results in increased profits. You can start to get the picture of how much of the stock market “fundamentals” are driven by credit expansion.

Lisa W. Hess: “The U.S. market continues to be the best relative performer of the world’s bourses, with the S&P down 8% this year versus Germany’s Das, down 19%, and Japan’s Nikkei, down 17%.”

This is a terrible misrepresentation of the truth. The U.S. market is not down as much as the European markets because it did not have the spectacular bull run that those markets had. In other words, markets that increase higher and faster, fall further and more sharply. I would much rather have had the higher returns Europe had and the steeper correction they have had along with it. Their total return of the last 5 years far exceeds ours.

Additionally, she makes no mention (with respect to sock market performance) of the fact that our currency has declined against theirs by over 50% in the last 5 years. The REAL returns, from the perspective of other countries, means that our market has gone down in real terms. In fact, on average, one would have gained more money over the last five years by simply putting their money in a European bank account and had it sit there in cash, than having had it invested in the U.S. market. The Dow Jones has seen an increase of 52% over this time period, while the Euro has seen an increase of 71%. Now, consider that you had not only invested in European currencies, but in the rising stock markets of European countries. U.S. market returns pale in comparison.

Kel Kelly @ April 21, 2008