Can anything stop stocks and gold?

Trees do not grow to the sky, dear reader. And for every bounce there is a bust.

"It's amazing; the US is doing everything that Japan did wrong," said a friend yesterday.

Let's see, in the 1980s Japan's corporate leaders thought they were going to take over the world. Investors thought so too. They expanded. They wheeled. They dealed. Prices shot up and they all thought they were geniuses.

In the '80s, everyone wanted to be Japanese. Management consultants used Japanese words to describe commonplace insights. For example, instead of saying that businesses always need to try to do things better, they referred to "kaizen" as if it were the secret of success. And US economists urged the Reagan Administration to have an "industrial policy" - because that was what Japan had. Japanese businesses were the envy of the world. Japan was the world's second largest economy. But in growth and stock prices it was Numero Uno.

It turned out, as it always does, that Japan did not have the secret to everlasting success. Instead, what it had was what comes before a fall. The stock market crashed in Tokyo in 1989. The Japanese economy entered a recession. At first, the experts believed it was temporary. They urged investors to take advantage of the opportunity to buy into Japan, Inc. at record low prices. They thought Japanese industry was unstoppable...unbeatable. It would recover in no time, they said.

But Japan, Inc. didn't recover. Instead, it went into a long, drawn-out recession that lasted year after year...with on-again, off again deflation...and several stock market rallies. Each time stocks rallied, they fell again. Each time the economy began to grow...along came another setback. This continued for the next 20 years...until March of this year...when Tokyo stocks hit their lowest point for the whole bear market. A generation of investors had been nearly wiped out. Over two generations they had made nothing. Trillions worth of wealth had been erased.

What did the Japanese authorities do during these last two decades? They fought the correction every step of the way, with the boldest attempt at fiscal and monetary stimulus every undertaken up to that point. Interest rates came down to effectively zero. And government spending soared, creating the largest deficits in Japanese history. Now, Japan's national debt approaches 200% of GDP - a peacetime record. If it continues to grow at this rate, it will hit 300% of GDP in just a few more years.

Sound familiar? It should. The key US interest rate is now effectively zero. The Fed says it will leave it there for "as long as it takes." And deficits have reached staggering levels - 13% of GDP. At this rate, the US debt/GDP ratio will hit 100% in just a few years. And if it continues, US debt/GDP will reach 200% not long after - as recession- reduced tax revenues meet stimulus-increased outlays.

But wait...the feds say they won't let it happen. They'll turn this thing around. The economy will begin to grow. Tax revenues will rise. Prices will go up.

Hey...that's just what the Japanese said!

So far, the US is doing almost exactly what the Japanese did...propping up zombie companies and stimulating the economy as best it can.

But if it does the same thing the Japanese did, won't the US get the same results the Japanese got?

Here is where it gets interesting. Because the US economy is not exactly like the Japanese economy. Japan had high savings...and a positive trade balance. It could run up huge government debts and "owe it to itself." It could finance its government debts with the savings of its own people, in other words. It never had to worry about foreigners refusing to buy its bonds...or selling them suddenly.

America's government debt is different. The US doesn't save enough to finance its own deficits. So it depends on the kindness of strangers. And if those strangers ever lose faith in America's ability or willingness to repay its debts, they'll drop the dollar like an annoying girlfriend. And when they do, the whole global monetary system will come crashing down.

But suppose savings rates go up in America - to, say, 10% of GDP, like they were before the bubble years. That would make $1.4 trillion of savings available to finance the feds' deficits. And suppose the slump continues...as we think it will, with another big scare in the investment markets. People will seek safety in...yes, you guessed it...US bonds. This will take the pressure off the dollar and permit the US to finance its countercyclical spending without depending heavily on foreigners. The recession/depression will be annoying...but not insufferable. And Bernanke will figure he has more to lose by undermining the dollar than to gain from it. In that case, the Japan- like slump could go on for many years - just as it has in Japan!

Bill Bonner
for The Daily Reckoning Australia

• Recession for the Japanese Economy Once Again
• Japan “Wasted Trillions” on Stimulus Programs
• Difference Between the Dollar and the Yen
• How Will the United States Finance the Biggest Deficit of All Time?
• U.S. Government Must Roll Over $3.4 Trillion in Debt Over Next Four Years

"The Great Depression in the United States," wrote Milton Friedman, "...is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country."

What a wonderful time to be alive! We get to see things we had only read about in the history books...such as a Great Depression. A depression, of course, is a natural and recurring feature of capitalism. But a Great Depression usually requires lobbying.

The grubby facts are not in dispute and are hardly worth recalling. The Fed dumped on the fertilizer. Asset prices grew like weeds. Investors got carried away. Consumers let themselves go. Wall Street and the City lost their heads.

Then, the capitalists lost their money. Big deal. That's the way it's supposed to work. Capitalism is inherently dynamic and unstable...full of sturm and drang, boom and bust, creativity and destruction. It's always prone to blow itself up just when people count on it most.

As for the present crisis, even a central banker could have seen it coming. When you lend money to people who can't pay it back, you have to expect trouble. But that doesn't stop capitalists from whining to the authorities when trouble comes. Half fool, half-knave, governments mobilized; $14 trillion, or thereabouts, has been put up to prevent capitalism from correcting itself. Protectionism is on the increase - even while heads of state rail against it. Banks have been bailed out. In Europe they are shortening the life expectancy of automobiles. In America, the feds are effectively running the largest automobile industry...the largest insurer...and the largest mortgage finance business too. Soon, they may have a chain of hamburger joints. More mistakes...more chicanery - in other words, just what you'd expect.

Even their supposed friends say free markets have been exposed as a failure and a mountebank. That is why the G20 met in London yesterday - they are meant to decide what to do about it. Peter Thal Larsen in the Financial Times:

"The global financial system as we know it was forged by deregulation underpinned by a belief in free markets. That approach failed. The task now is to prove it can be set running again with better brakes and steering... By the end of the week, the world will have a clearer idea whether the system can survive."

William Pesek at Bloomberg: "There's no doubt the world that Reagan envisioned didn't work out. The 'Washington Consensus' of free markets, small government and unfettered globalization that characterized the 1990s also is over."

Meanwhile, over in the other camp, they are sitting around open fires...realizing that they are lost in the woods. The Nation magazine has a feature on "Re-imagining Socialism," in which Barbara Ehrenreich and Bill Fletcher write: "Do we have a plan, people? Can we see our way out of this and into a just, democratic, sustainable (add your own favorites adjectives) future? Let's just put it right out on the table: we don't."

With no ideas from the usual do-gooders...the world turns its lonely eyes in a novel direction. Who can save capitalism? The communists!

"Market forces, if left unchecked, will lead to asset bubbles and ultimately a disastrous market clearing in the form of a financial crisis like the current one," says a report from the Chinese central bank.

Everyone wants to be Chinese. Because the Chinese have money. And because they don't have free markets. It is widely believed that the Middle Kingdom can more effectively fight a downturn without democratic, consensus-driven institutions staying its hand.

But here is where we gasp for air. What theory holds that central planning - whether by Chinese communists or American Democrats - can do a better job of allocating capital than the people who own it?

There is none. That is why the world's leaders - and most of its economists too - permit themselves a luscious fib; they say they don't need theory at all. "Pragmatism" was the word on every pair of lips in London this week. Free from chains to dead economists, they say they will try "whatever works." Oh, the loveable lunkheads! Naïve enough to believe anything; receptive as a trashcan. "Pragmatism" in economics is as phony as the men who preach it. Every one of them has a dog-eared copy of Keynes' General Theory of Employment, Interest and Money in his briefcase and an ace up his sleeve. And every supposedly new, pragmatic idea they come up with is merely a version of the same quack cures that kept the economy in the hospital last time.

Perhaps you can paint a bridge pragmatically. If you don't like the color, you can change it quickly. But if you're building a bridge, an airplane or an economic system, you can't make it up as you go along. You have to have an idea of how it works before you start. Besides, results from fiscal, monetary and regulatory policies don't happen overnight. The feedback loop takes years. It took the Bolsheviks seven decades before they realized they'd been had. Friedman's critique of America's Great Depression policies didn't appear until 30 years after the event. In Japan, they still don't know what they did wrong. And by the time the feds catch on this time, they will have turned an ordinary depression into a great one.

Bill Bonner
for The Daily Reckoning Australia

• Capitalism is Inherently Unstable
• The Solution to a Depression is a Depression
• HOORAH FOR CAPITALISM!
• Can China Change the Rules of Global Capitalism?
• Nobody Appreciates Laissez-Faire Capitalism

The two great political figures of the last thirty years were Mrs. Thatcher and Mr. Reagan. These titans from the two sides of the Atlantic led the way to a new idea of how the world should work. Thenceforth, capitalism was king. But it was a new kind of capitalism they had crowned, one with a strange, unnatural face. It was not the old free enterprise, king of the jungle, red in tooth and claw. This new capitalism was more like the owner of a pet shop, where all the animals were cute and cuddly - and didn't eat the customers.

Mrs. Thatcher and Mr. Reagan and their followers had seen how centrally planned economies worked; the Chinese and Russians showed what happened when bureaucrats ran an economy. The free market seemed like the best alternative. But the trouble was, these new 'conservatives' had no real respect for it. Instead of quaking before it in genuine fear and awe, like Moses before the burning bush, they began to believe that they could be its master. Then, they developed a whole host of fantasies about what this tamed beast could do for them.

Not only could the free market solve the problem of poverty, it could solve almost every other problem too. It was a social panacea. Just look at the wealthy countries, they said. Switzerland is clean and prosperous. By contrast, communist China is a dump. People are healthier and happier in capitalist countries, where they have better automobiles and lower birthrates. Science, supported by the free market, would find cures to diseases too...and even help people live longer. The logic was simple enough: free enterprise made people rich. And with their money, they could do wonders - cleaning up the factories, building hospitals and clinics, organizing public day care and Pilates classes...even getting rid of smoking!

Nothing was too absurd or contradictory for the True Believers. Gradually, they began to confuse the fruit with the tree...and then mistake the tree for a lamppost. Financial incentives were thought to be the key to everything. If an executive failed to maximize shareholder value, it was because his bonus was not large enough. If students showed poor test results, it was because teachers were paid by the job, not by the outcome. And if terrorists attacked a building in New York, it was because they lacked financial opportunities in Cairo. (Later, people were dumbfounded when doctors who had worked for the National Health Service tried to blow up cars in Glasgow and London.)

The ideas were slippery but they greased the skids. Soon, the marks were ready to go along with anything. Shareholders consented to hundreds of millions in bonuses and stock options for key executives. Investors signed up for hedge funds, willingly giving managers "2% and 20%" for putting quarters in the slot machine for them. Taxpayers allowed huge tax cuts - widely believed to be aiding the wealthy - because they looked forward to the day when they would be wealthy too. And almost everyone, everywhere eagerly went on a spending spree, in the belief that this new, kindler, gentler capitalism would add wealth faster than they could get rid of it. And if they overspent, hyper-capitalism would soon catch up.

In public finance, this delusion led to Dick Cheney's famous quip: "Deficits don't matter." This, in turn, led to the greatest explosion of government red ink the planet had ever seen. During the first seven years of the George W. Bush administration, about $20 trillion was added to the U.S. 'financing gap' - more than under all America's other presidents put together.

What was good for the top was good for the bottom. Private households, too, ran deficits of their own. Savings rates fell close to zero while U.S. household debt rose from less than $2 trillion in the first year of the Reagan administration to nearly $13 trillion in the 6th year of the present administration.

In Britain the story is about the same. Before the Thatcher revolution, household debt was about 65% of household income. By 1988, it had reached 100%. And by 2007, it was more than 150%.

When a consumer spends a dollar he earned, it is taken in as income to the businesses that receive it. But it offset by a cost too - a wage expense. But if the consumer spends a borrowed dollar, it comes to business like manna from heaven, with no balancing wage cost. Higher profits, greater leverage, more debt - it was all catnip to Wall Street. Financial assets were only 4.5 times GDP in 1980. Now they are 10 times as large. But that is nothing compared to the sugary confections of the credit industry. Credit default swaps, alone, are said to be worth $45 trillion.

The earnings of the financial sector equaled only 10% of total corporate earnings in 1980. By 2007, they made up 40% of the total, even though they still only employed 5% of the workforce.

But, "that game is now up," says the Economist . The "new" capitalism was a fraud. It didn't make people rich. It only allowed them to get rich - or poor - depending on what they did with it. Americans used their economic freedom to ruin themselves. But that's just the way capitalism really works. You don't get what you expect...or what you want; you get what you deserve.

Bill Bonner
The Daily Reckoning Australia

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