RCH Last Letter

“Fearful and protracted economic and financial trouble looms when the spending excessesduring the boom… involve soaring indebtedness of consumers and corporations. Historically, theworst excesses of this kind have typically occurred in association with more or less pronouncedasset price bubbles, as the soaring asset prices provide the collateral that facilitates and fosters

the borrowing binge.

When the bubble bursts and asset prices plunge in the face of persisting high debt levels, theimplicit ravaging of balance sheets impels borrowers as well as lenders to greater prudence andmeasures to adjust their balance sheets. Correcting the maladjustments… intrinsically requires an adjustment process far more protracted and painful than the regular inventory correction.

Recessions of this kind might be specified as ‘post-bubble’ or ‘balance sheet’ downturns.”

— The Richebächer Letter, February 2001

END OF THE LINEAs we exit 2010 with the Federal Reserve frantically engaged in another large-scale monetary experiment

designed to artificially lift asset prices, eurozone policymakers desperately trying to quell contagion effects fromIrish bank solvency concerns and Chinese authorities urgently clamping down on accelerating inflation following thecredit boom they originally engineered to avoid the Great Recession, the relevance of Dr. Richebächer’s credit-basedeconomic analysis is more obvious than ever. Yet unfortunately, despite our combined best efforts, the economics ofnewsletter publishing has proven less than favorable, and this will mark the very last issue of the monthly letter. Assuch, we propose the following departure from the norm.

First, a quick diagnosis of the long-term developments that led to the current set of economic challenges iswarranted. Knowing what needs to be fixed requires acknowledging what went wrong, and here is where Dr.Richebächer’s analytical framework can be most illuminating.

Second, we will take a closer look at one of the underlying issues that we believe will remain the core challengein the decade ahead — namely, unresolved trade imbalances. Under the current international monetary regime, price,income and policy signals have not proven strong enough to prevent some nations from running chronic tradedeficits. We appear to be reaching the end of the line on the current system — even Fed Chairman Ben Bernankerecognizes it is in need of replacement.

Third, we will highlight some of the key fault lines we find in place as we exit 2010. These are developmentslikely to influence financial market and economic outcomes in the United States and around the globe over the nextyear or two, and we wish to leave you with our perspective of how they may play out.

Finally, as a guide to help you navigate your way through the years ahead, we will summarize what we believerepresent some of the core perspectives that Dr. Richebächer developed during his career. We hope to boil hiscontributions down sufficiently so that you may use his unique perspectives to guide your own independent thinkingthrough these tumultuous times.

THE PATH TO DISRUPTION

At the risk of oversimplifying, we can trace the arc of the current challenges facing many Western nations to their

THE RICHEBÄCHER LETTERThe Monthly Missive of The Richebächer Society

NUMBER 435 — LAST ISSUE DECEMBER 2010

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The Richebächer Letter, December 2010

ineffective responses to rising globalcompetition. The first wave of thisbecame apparent in the 1970s whenboth German and Japanese productioncapabilities had been rebuilt enoughover the prior two decades toundermine U.S. competitiveness.Added on top of this were a number of commodity shocks as morehouseholds in the world reached forU.S. standards of living, and somefairly aggressive labor movements inthe West that attempted to keep wagesrising with inflation — a combinationthat yielded a stagflationary result.Rising inflation and risingunemployment rates stalked manynations until the tight monetarypolicies and industrial restructuring ofthe early ’80s took root.

The sobering up of Westernmanagement after the stagflationarybinge of the ’70s led to a renewedemphasis on cost control, innovationand productivity improvement. Labor discipline was reasserted, but the aspirations of consumers often were notadjusted sufficiently. For example, when we compare real consumption growth with real hourly compensation growthfor labor in the United States from 1980 onwards, we find a big disconnect.

Hourly compensation growth for labor typically grew less than 2.5%, after adjustment for inflation. Realconsumption growth typically grew more than 2.5%, with the exception of recessionary periods. Consumptiongrowth in excess of hourly compensationgrowth can only be sustained underfive conditions: More people can jointhe work force. More people can worklonger hours. Personal tax rates can becontinuously cut. Households cancontinuously reduce their saving rate.And more people can rely on debt tomaintain improvement in theirmaterial standards of living.

Most of the increase in theemployment-to-population ratio wascompleted by 1990, as more womenentered the labor force. Averageweekly hours of nonfarm productionand nonsupervisory workers havebeen declining steadily since 1965.Tax cuts can only go so far when fiscaldeficits have ballooned. Havingexhausted the first three options, it

U.S.Consumption Grew FasterThan Labor’s Income

10050095908580

Sources: BEA, BLS /Haver

7.5

5.0

2.5

0.0

-2.5

Real Personal Consumption Expenditures% Change — Year to Year SAAR, Bil. Chn. 2005$

Business Sector: Real Compensation Per Hour% Change — Year to Year SA, 2005=100

U.S.Private Debt Plugged the Gap,Trade Deficit Widened

U.S. Domestic Private Nonfinancial DebtGrowth % Change — Year to Year

U.S.Trade Balance as a Share of GDP

10050095908580Source: Haver Analytics

16

12

8

4

0

-4

-8

U.S.Consumption Grew FasterThan Labor’s Income

10050095908580

Sources: BEA, BLS /Haver

7.5

5.0

2.5

0.0

-2.5

Real Personal Consumption Expenditures% Change — Year to Year SAAR, Bil. Chn. 2005$

Business Sector: Real Compensation Per Hour% Change — Year to Year SA, 2005=100

U.S.Private Debt Plugged the Gap,Trade Deficit Widened

U.S. Domestic Private Nonfinancial DebtGrowth % Change — Year to Year

U.S.Trade Balance as a Share of GDP


16

12

8

4

0

-4

-8


turns out the households primarily relied on lower savings rates and higher consumer debt growth to plug the gapbetween more subdued increases in labor compensation and continued increases in consumption.

Debt allows a borrower to deficit spend in monetary terms — that is, to spend more money than he earns — andto consume more than he produces in real or unit volume terms. Governments are not the only ones who deficitspend. Companies and households can deficit spend, and when enough of them do, private nonfinancial debt willtend to grow rapidly. Private-sector debt growth surged in the recovery up to 1985, surged again through most of the’90s and expanded once more in the first half of the last decade. Accompanying each of these surges in private debt,you will notice the trade deficit as a share of GDP widened roughly in concert with private debt growth.

As will be spelled out in more detail later, Dr. Richebächer distinguished between the use of productive andunproductive debt. Debt issued to finance new plant and equipment has a chance of producing new income in thefuture — income that can be used to service the interest expense and pay down the principal of the debt. Debt issuedto finance the purchase of a consumer good, or to finance a residence that will be owner occupied, has no such chance.The former is productive, in the sense that a future income stream is likely to be generated to service debt, while thelatter is unproductive, as no capacity to service the debt issued is apparent in the actual use of the borrowed funds.

In addition, through the variousmerger waves and share repurchaseefforts, much of the business debtissued was for financial engineeringpurposes, not for expansion of the capital stock. Debt allowedhouseholds to consume more thanthey were producing. The choice of business to use debt forrearranging control and boostingshort-term earnings growth had littleto do with expanding productioncapacity, and so left U.S. globalcompetitiveness further at risk.

Absent sufficiently strongreinvestment rates in the U.S.tradable goods sector, the push forhigher labor productivity meantjobs in the manufacturing sectorshrank over much of the past threedecades. While the first contractionin 1979–82 is most widely known, the deepest cuts in manufacturing employment have been over the past decade,with two sharp and prolonged contractions accompanying the last two recessions. The failure of firms to findprofitable reinvestment opportunities in the United States, and the failure of the United States to attract foreign directinvestment in U.S. production facilities, has become dramatically apparent.

By 1999, it finally got to the point where the number of people employed in the manufacturing sector fell belowthe number employed by state and local government. The productivity of manufacturing workers has tended toexceed that of government employees, and the products of state and local government employees are generally nottradable goods and services. The production structure, at least as revealed by the composition of employment, hadbecome skewed after two decades of minimal reinvestment of profits (with the notable exception of the tech/telecombubble, which ended poorly).

In addition, the revenue to pay state and local government employees inevitably comes from taxes on workers,consumers and homeowners. State and local bond issuance also claims private savings that otherwise could go tofinance capital equipment in the tradable goods sector. Such taxes increase the effective cost of employing U.S. labor

3


20000

18000

16000

14000

12000

10000

w Faster

U.S.State & Local Government EmploymentOvertook Manufacturing Jobs

100500959on Expenditures

hn. 2005$

pensation Per Hour00

U.S. Manufacturing Employees(in thousands)

U.S. State and Local Employees(in thousands)

ed the Gap,

ic Private Nonfinancial Debtange — Year to Year

hare of GDP

1005005


in the tradable goods sector, so from a variety of perspectives, this shift in the structure of production compounds theproblem of international competitiveness.

THE UNDERLYING ISSUE

This is a story not only appropriate to the U.S. situation, but one that roughly conforms to the difficulties facingmany European nations as well. The adjustment mechanisms to force chronic trade-deficit (and, of course, trade-surplus) nations to reverse course at some point appear either very weak, thwarted or altogether missing. In contrast,under the gold standard, trade-deficit nations would eventually find their accumulated gold reserves drained, and theywould either have to allow falling domestic prices to make their exports cheaper on world markets or they wouldhave to curtail their importing for lack of means of settlement. Under the current system, where money and creditcan be created out of thin air, often on the back of recurring asset bubbles, and where intervention in foreign exchangemarkets is openly practiced, the leash on trade imbalances is much longer and quite clearly frayed.

The underlying issue is that a trade-surplus nation is by definition selling more goods than it is buying from atrade-deficit nation, and so it is accumulating liabilities issued by the trade-deficit nation. These liabilities requirefuture payments of interest expense, principal and dividends. Unless the trade surplus nation reinvests some of itsearnings in the productive capacity of the trade-deficit nation, or companies within the trade-deficit nation maintaina high rate of reinvestment, the income needed to service the liabilities of a trade-deficit nation will tend to eventuallycome up short.

Trade deficits become unsustainable, in other words, if they are associated with unproductive debt issuance.Eventually, the holders of foreign assets in trade-surplus nations will recognize an explicit default or restructuring islikely to be required by the trade-deficit nation. Alternatively, they must recognize an implicit default will beattempted through rampant money creation by the trade-deficit nation. In many ways, the first path is the one mostlikely to unfold in Europe, while the second path appears to be the way the United States, and eventually the UnitedKingdom, will proceed, via quantitative easing measures.

We have, in other words, come to what appears to be the end of the line in current international trading andmonetary arrangements. For a variety of reasons, reinvestment rates in the tradable goods industries have remainedtoo low in a number of chronic trade-deficit nations. They have lost their competitiveness in global markets. Bydefault, domestic service sectors and government hiring have picked up some of the slack in these economies. Theability of these economies to generate the income required to service their liabilities held by foreigners is now opento question. And there is no quick fix beyond monetization or debt rescheduling. Large trade-surplus nations likeGermany and China are slowly realizing they have a choice: find ways to buy more goods from the rest of the worldor continue accumulating claims on the rest of the world that will eventually be met with either explicit or implicitdefault.

What is needed is a global rebalancing of consumption and investment, and a price or policy mechanism thatenforces ongoing global rebalancing, preferably in a pro-growth fashion. Dr. Richebächer touched on this when hewrote about China in the November 2006 letter:

But what about the Chinese economy’s pattern of growth? Is it sustainable? It is definitely not.The main reason is that the permanent investment boom gets increasingly out of line with domesticconsumption demand… in China, with banks generally government owned, the lending excesses andmalinvestments can go to extremes unimaginable in free market capitalistic economies.

Chronic overinvestment in China requires it to sell output to foreign markets that it cannot sell domestically.Currency intervention is one tool China uses to help ensure a trade surplus. (As an aside, and one that will not bemissed by protectionist forces in the future, the greatest beneficiary of liberalizing global capital and trade flows isan economy that still has some of the greatest government intervention around.) Given the resulting distortions instructures of production across countries, and the thin gruel that comes out of international negotiations like those inSeoul recently with the G-20, it is likely to take time before a common solution can be found between nations withlarge and chronic trade imbalances. The risk along the way, of course, is that the inability to find common ground

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will lead to an escalation of protectionist responses and a balkanization of trading blocs around the world. Already,the proliferation of capital controls in emerging nations is pointing in the latter direction.

Chairman Bernanke’s controversial return to quantitative easing may force the issue of a new internationalsystem, though not without first promoting more discord. We do, however, find it at least encouraging that he hasbecome willing to name the underlying issue. Such was the case in his November speech in Frankfurt where he notedrather candidly:

As currently constituted, the international monetary system has a structural flaw: It lacks amechanism, market based or otherwise, to induce needed adjustments by surplus countries, whichcan result in persistent imbalances… In particular, for large, systemically important countries withpersistent current account surpluses, the pursuit of export-led growth cannot ultimately succeed ifthe implications of that strategy for global growth and stability are not taken into account.

Thus, it would be desirable for the global community, over time, to devise an internationalmonetary system that more consistently aligns the interests of individual countries with the interestsof the global economy as a whole. In particular, such a system would provide more effective checkson the tendency for countries to run large and persistent external imbalances, whether surpluses or deficits.

We have no illusions that such a rebalancing can happen overnight. Nor would we for a moment pretend to havethe blueprints for a new system. But this is the underlying issue that global investors and policymakers will bewrestling with over the next five to 10 years. In the meantime, the path of least resistance is likely to take the formof more money creation and eventual debt restructuring by Western nations — and with any luck, a more rapidemergence of domestic consumption and infrastructure spending in the developing nations.

Through the disruptions and disarray, we would expect precious metals holdings to be favored as the U.S. dollarstatus as the international reserve currency is brought increasingly under fire. In addition, history suggests the largestcreditor nation eventually gets to define international monetary arrangements. China’s leaders are unlikely to cedecontrol of the yuan to market forces they still distrust. We would not, however, be surprised if somewhere along theway they propose a new international reserve currency backed by a basket of durable commodities — many of whichthey may have substantial control of by then.

REMAINING FAULT LINES

If Dr. Richebächer’s approach suggests global rebalancing is the main underlying issue that will need to beaddressed over the next 3–5 years, what should investors be focused upon over the next 12–18 months?

First, as we discussed in a recent weekly, despite investor hopes through the summer, the eurozone predicamenthas not been resolved. Our contention has been that the attempt to reduce government bond risk through prolongedfiscal retrenchment will tend to shift credit risk over to the private sector. Tax hikes and government expenditure cutsare designed to drain cash flow from households and firms. Unless trade balances improve quickly, or confidenceimproves enough to get firms reinvesting profits at a higher rate, the more highly leveraged sectors of the privatesector will tend to head deeper into delinquency and default on their debt as fiscal retrenchment proceeds. This hasa nasty way of showing up on bank balance sheets, and eurozone banks remain highly leveraged and highlyinterconnected.

In addition, absent offsetting improvements in trade and investment, economic growth will tend to remain subparor even reverse, leading to tax shortfalls. A vicious cycle can ensue as more fiscal cuts are required for prior deficitreduction targets to be achieved. Ireland has been one of the most diligent nations in pursuing fiscal retrenchment overthe prior two years. It has yet to exit recession, and home prices have fallen over 35% from their peak. While its tradebalance has been one of the first to swing into surplus, the swing has not been fast enough to lead to a recovery.

As a consequence, private debt distress has visibly burned a hole in Irish bank balance sheets. In order to avoid

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contagion effects to other European banks with loans out to Ireland (especially to Irish banks), no doubt some sort ofloan package and bank capital contingency fund will be allocated out of the European Financial Stability Fund (EFSF)before long. Our analysis leads us to believe Portugal and Spain will be next to tap the EFSF for similar purposes. Weexpect the eurozone will be maintained, but only at the price of eventual public and private debt restructuring once thegame of repeatedly socializing bank losses has reached it inevitable limit with eurozone taxpayers.

Second, regarding quantitative easing, we have never quite been able to understand the wisdom of a monetarypolicy that simultaneously seeks to raise inflation expectations by creating money out of thin air, and then using it tobid up the prices (and lower the yields) on Treasury bonds. Investors are bound to ask themselves why they wouldwant to buy Treasuries at historically low nominal yields while facing the prospect, if the central bank achieves itsstated goal, of escalating inflation. This strikes us as a mug’s game — a recipe for instant losses once nominal yieldsrise to accommodate inflation expectations. We suspect this is why PIMCO officials, who represent one of the largestinstitutional fixed-income shops around, have openly declared the end of the bull run in Treasuries.

Beyond the question of exit strategies facing the Fed, the shift in portfolio preferences toward commodities thataccompanied the latest foray into quantitative easing is problematic. Not only is it likely to act as a supply-side shockon a number of producers who may find it difficult to pass on higher costs (and U.S. consumer staples stocks, likethe food processors, are at risk here — see Dan Amoss’ work in Strategic Short Report in this regard), but absent alarge improvement in household income growth in the West, the commodity price increases that do get passedthrough are more likely to act like a tax. Absent stronger employment and stronger household income growth,discretionary spending is likely to be cut as prices go up on nondiscretionary items like food, clothing and energy.Prices on discretionary items will tend to fall as the commodity price shocks are passed through to consumers.

Third, we have previously highlighted Fred Sheehan’s work on risks in the U.S. municipal bond market. Bymid-November, investors had begun to recognize the wall of new supply likely to be issued in 2011, and municipalbond mutual funds and ETFs were reporting heavy outflows. States and municipalities are likely to run out of smokeand mirrors unless quantitative easing promotes a much stronger recovery in the United States. On that subject, NewYork Fed President and former Goldman Sachs economist Bill Dudley recently noted, “It’s going to make theeconomy grow a little bit faster. It’s going to generate a little bit more employment growth. But you know, we havea long, bumpy road to travel. Modest effect. It’s not a fantasy. It’s not a magic wand. This exit could be years away.”

With the new House composition, federal appropriations to states, which are already programmed to wind downin 2011, are unlikely to get bumped higher anytime soon. State and local employment cuts are just beginning tomount, and these will have ripple effects on state income growth. For those who are in a tax bracket that forces theminto municipal bonds, owning only the highest quality bonds is the watchword.

Finally, China’s economy now has the unenviable combination of overinvestment, malinvestment and escalatinginflation. The credit boom China engineered to avoid getting dragged down during the events of 2008–09 has comeback to haunt it. While food prices are the main culprit, minimum wages are reported to have been lifted some10–20% over the past year, and wage gains in the coastal manufacturing regions have been reported to be quite highof late. Administrative price controls and reduction of commodity stockpiles are under way, but a series of hikes inreserve requirements, as well as policy rates, suggests Chinese officials are not convinced price controls will do thetrick. Over the years, we have found it expensive to bet on China slowing down. However, there is a chance Chineseinflation is so much higher than reported that monetary tightening will need to be pursued more aggressively in 2011.In this regard, we are told the monetary stock in China, following the recent credit boom, now exceeds that of theUnited States.

While we still expect Chinese officials to back off before slowing the economy too much with monetary policytightening, the waves of new capacity coming on line that may not find domestic Chinese buyers suggests tradablegoods markets could get glutted. This, of course, will tend to exacerbate the international competitiveness issues wehighlighted earlier across many Western nations. We would suggest solar panels are one area in which the surge inChinese capacity coming online is likely to clobber global pricing.

These are a few of the fault lines we believe are still not well recognized but will be important drivers of 2011


financial market and economic outcomes. Each of them is tied, in one way or another, to the credit imbalances thatDr. Richebächer placed at the center of his analysis.

DR. RICHEBÄCHER’S LEGACY

While we unfortunately did not encounter Dr. Richebächer’s work until the latter half of the ’90s, access to hisarchives at Agora Financial has given us a deep appreciation of his unique approach. Nothing short of a book couldpossibly capture the full complexity of Dr. Richebächer’s thinking, but in the spirit of encapsulating some of thelegacy he left behind, so that it may be carried forward by you and others you share it with, we offer the followingcondensed guide to some of his key perspectives. In this regard, it is worth remembering Dr. Richebächer’s advice:“In addition to full information, however, something else is needed to make the best use of the available data: atheoretical concept of how the economy works.”

Profit-driven growth: Oddly enough, most contemporary macroeconomists pay little attention to profits. For Dr.Richebächer, this omission was unfathomable. Like both the Austrian School and J.M. Keynes, he held the searchfor profits as the key driver of new investment. Absent new investment, there was little chance of sustaining theprocess of economic growth. As he noted in the September 2001 letter:

What determines the growth of production? The short answer is: profit prospects that stimulatebusiness capital spending. Profits are the key driver of capital investment and rising capitalinvestment is the key ingredient in the economy that provides for everything else that we want:growth in output, in incomes, in productivity and in overall national wealth and prosperity figuringin the economy’s accumulated stock of income yielding tangible assets. Capital investment, in short,is paramount. It happens that it is the great neglect in the Wall Street model, which instead placesshareholder value on a pedestal.

Most economists put consumption paramount, since consumer spending tends to make up the largest share ofGDP, but as Dr. Richebächer noted, “In order to spend, the consumer must first earn the necessary money fromemployment… and that, in turn, is a function of business production.”

Productive and unproductive debt: Credit and credit cycles were a focal point of Dr. Richebächer’s analysisthroughout his career. But not all credit was the same, as he explained in his December 2001 letter:

Talking of debt burdens, it is important to distinguish between two types of debt: productive andunproductive. Only credit that finances new plant and equipment is productive credit. It adds to theexisting capital stock that, in turn, earns future debt service. In other words, it is self-amortizing andself-financing debt.

By the same logic, the exponential rise of U.S. corporate indebtedness during the past severalyears implicitly suggests its overwhelming use for unproductive purposes. Of these, two areparticularly well known: the acquisition binge and share buybacks…

Credit excesses: Under current monetary arrangements, central banks and commercial banks can create moneyout of thin air, and nonbank financial intermediaries can create liquid assets and pyramid credit on the basis of theresulting money stock. Rapid credit growth can easily fuel economic distortions. Dr. Richebächer commented in hisFebruary 2000 letter on a theme he would often return to:

But history holds two lessons in this respect: first, credit excesses inherently sow the seeds oftheir later bust, and second, the length and severity of the following “adjustment crisis” dependlargely on the magnitude of the prior credit excesses and the associated imbalances that they havecreated in the economy and the financial system.

Following the Austrian School, Dr. Richebächer believed it was essential to recognize where credit entered theeconomy in order to determine the nature of the resulting distortions in both the structure of demand as well as thestructure of productive capacity. Writing in the August 2001 letter, he noted:

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The structural distortions arise from the fact that the credit excesses do not spread evenly acrossthe whole economy. They always concentrate on certain areas — real estate, business investments inplant and equipment, consumer durables — and accordingly they fuel specific bubbles of demand.In other words, they distort the economy’s demand structure. There is no fixed pattern for this.During the 1920s, the bulk of the credit excesses in the United States went into private consumption.In the case of Japan’s bubble, they poured overwhelmingly into commercial building, plants andequipment. In the present U.S. case, it is again private consumption and the high-tech sector.

But that’s only the initial part of the maladjustment process impacting the economy. Theresulting distortions in the composition of demand implicitly evoke corresponding dislocations in theeconomy’s output and investment structure. In order to meet the credit-drive surge in demand, thosesectors in the economy that largely attract the inflated demand for their products tend to step up theirinvestment spending, which the economy’s later slowdown will expose as malinvestment.

The ease with which credit can be created, and the failure of creditors to properly assess risk and return prospectsunder contemporary monetary systems, thereby becomes a source of both demand and supply distortions. Eventually,these must be worked off. In the extreme, this can involve the economy entering a balance sheet recession.

Asset price bubbles: Credit excesses are easier to build on the back of asset price bubbles. If a persistent shift ininvestor portfolio preferences favors a particular asset class, the spot prices of that asset will rise, and all the holdersof that asset will experience an increase in net worth, whether the capital gain is realized via sale of the asset or not.Since the willingness of banks and other creditors to lend is often influenced by the collateral that prospectiveborrowers control, credit excesses often have a symbiotic relationship with asset bubbles. Each can enable the otherin a leapfrog fashion. As Dr. Richebächer put it in December 2000:

The particular danger of asset price bubbles rests in the fact that the soaring asset pricesinherently provide ever more collateral value for more and more borrowing… If monetary policyaccommodates these excesses, the business cycle essentially develops into the self-feeding,precarious Bubble Economy… In the case of Japan… when the bubble burst, the crashing stock andland prices simply devastated the collateral to these loans, leaving behind corporations and bankswith appallingly overextended balance sheets.

Financial versus real wealth: Contemporary economists frequently confuse the monetary value of financialclaims on tangible assets, and the productive capacity of the underlying plant and equipment. This is actually an olddispute going back to Adam Smith, who recognized the wealth of nations has more to do with their capacity toproduce useful goods and services than with the amount of gold in the bank vaults. In December 2001, Dr.Richebächer wrote:

It used to be common knowledge for thinking people that net capital accumulation is the keysource and the benchmark of a nation’s prosperity. It generates growth and wealth through fourdifferent effects: first of all, producing the capital goods creates jobs and incomes; second, thefinished capital goods add to productive capacity; third, the new machinery tends to improveproductivity; and fourth, the resulting factories and buildings represent the nation’s true wealth.

Earlier, in November 2000, he took on the prevailing view of the time:

The first great myth to debunk is that soaring stock prices represent valid wealth creation for theeconomy. They do so, of course, for the stockowners. From a macroeconomic perspective, though,an economy’s total wealth is in its capital stock of structures, equipment and inventories…

Manifestly, rising stock prices add nothing to an economy’s capital stock. What they create is…soaring claims on the part of the stockowners on the national product and its capital stock.

Financial imbalances: It is not well understood that if one sector wishes to increase its net saving (or, in otherwords, reduce its expenditures relative to its income), this can be achieved only if the remaining sectors of the


economy are willing to increase their deficit spending. Absent this — which is nothing but double-entrybookkeeping — the attempt of one sector to increase its net saving will tend to lead to falling incomes. Dr.Richebächer worked with the sector balance approach most closely in his analysis of Japan. He wrote in May 2000about the Japanese situation:

[T]he personal and business sectors together spend that much less than their total, currentrevenues. Instead, they are repaying debts and accumulating financial assets. As a result, privatedemand for goods and services keeps contracting. In order to fill the big, chronic demand gaparising from the private sector, it has needed ever larger injections of public deficit spending.

It follows from the financial balance approach that budget surpluses and trade deficits both drain cash flow fromthe domestic private sector. In order for the private sector to net save — which it frequently attempts to do mostdramatically after an asset bubble has burst — fiscal balances must decrease, trade balances must increase or somecombination of the two is required if falling nominal incomes are to be avoided. Yet few recognize just how thesesector financial balances are interdependent, as is now being made apparent with the eurozone retrenchment.

Balance sheet recessions: We have frequently referred to the work of Richard Koo, from the Nomura ResearchInstitute, regarding the unique signature of balance sheet recessions. Koo pieced together the clues from his analysisof the lost decades since the Japanese asset bubble burst in 1989. Balance sheet recessions, as mentioned in theopening quote, tend to present more challenges than the conventional inventory-led recessions that characterizedmuch of the post-World War II period. Dr. Richebächer was early in identifying this distinction — probably wellbefore Koo. Writing in December 2000, he noted:

The typical imbalance in the short-term business cycle used to be inventory accumulation.Depending on its size, the liquidation of the stockpiled goods and related debts could be quite sharpand painful. But resulting recessions were always of very brief duration.

In the February 2001 Letter, Dr. Richebächer contrasted this with a balance sheet recession:

America had its first postwar encounter with this type of recession in 1990–1. It was differentfrom all prior recession in two ways: first, the boom-related excesses had their brunt not in inventoryexcesses, but in huge malinvestments in commercial real estate; and second, it was not tight moneyimposed by the Fed that caused the credit crunch, but soaring bad loans that paralyzed the bankingsystem and the financial markets.

It is the long-tailed quality of balance sheet recessions (as both balance sheet and real capital stock overshootsmust be worked off) that can unfortunately drive policymakers into what amounts to an addiction to serial orsequential asset bubbles. They see no other way to return economic growth closer to its long-term average in a timelyfashion. In this sense, Dr. Richebächer identified a slippery slope that policymakers enter once they tolerate orpromote an asset bubble that lasts long enough to distort the allocation of productive capital and allow the build upof debt on business and household balance sheets.

Shareholder driven capitalism: While Dr. Richebächer had great respect for the ability of markets to guideresource allocation, during his time, he witnessed the transformation of incentive structures for both managers andinvestors toward short-term profitability, and he witnessed the corruption of profit and earnings per sharemeasurement. As described above, his macro view of profits suggested cost cutting and merger activity were noreplacement for net investment in tangible productive capital in securing long-term profit growth. He highlighted thisin the August 2001 letter when he noted,

The one big structural profit depressant is Corporate America’s preference for acquisitions andmergers at the expense of net investments... Chasing fast profits in this way, Corporate Americaundermines its long-term profits. The main source of macro profits… is investment spending in excessof depreciation charges — that is, net investments. And they are badly lagging.

In the November 2000 letter, Dr. Richebächer came to call this beggar-thy-children capitalism, exclaiming:

9


It’s late, degenerate capitalism in the sense that saving and capital accumulation, the key featuresof a capitalist economy, have fallen into complete oblivion… the corporate strategies that result…impart increasingly long-term macroeconomic consequences to economic growth…What reallyhappens is rampant over-consumption at the expense of future generations who are to inherit depleteddomestic capital formation, a mountain of foreign indebtedness and lots of worthless paper assets…

From the time of the first large merger and leveraged buyout waves in the middle of the ’80s, the redefinition ofcorporate earnings became a frequent sport of managers and the equity analysts on Wall Street who covered theircompanies. Institutional investors facing short-term performance pressures increasingly relied on the game of beatthe quarterly earnings expectation to inform their stock selection. The temptation of stock option-laden managers to redefine earnings along the way became all too evident to Dr. Richebächer, who further protested in the August2001 letter,

The main task of today’s American manager is no longer efficient production but efficientballyhoo that boosts the company’s share price. The systematic deception was plain to very manypeople, but nobody wanted to spoil the profitable game. Integrity and reason went out the window.In reality, it was much more than just that. It was systematic fraud.

Corrupted economics: Dr. Richebächer was no stranger to controversy. During the latter part of his career, hesaw the profession he devoted his life to become more and more of a marketing racket for Wall Street. Back inDecember 2000, as the outlines of the burst dot-com bubble were becoming more visible, he wrote:

Today, the stars among private sector economists domineering public discussion and publicopinion are the investment banking economists… The chief qualification of these so-calledeconomists is not their analytical acumen, but their ability to bring business to their employer withbuy recommendations for stocks and bonds. Besides, the analyst who dares to depart from the bullishconsensus is well aware that he is putting his job on the line. Never before has economic “research”been so corrupted… Honest, critical economic research virtually disappeared. The few economistswho warned were ridiculed.

These are but a sliver of the perspectives Dr. Richebächer’s unique analysis provided over the course of severaldecades of research and analysis. We have found them indispensable over the years in guiding our own attempts tomake sense of an increasingly complex and confused macro and financial market environment. We offer this briefsummary as a guide for you to carry into the future.

MEANWHILE, BACK AT PRINCETON…

No doubt Chairman Bernanke has recently been wondering why he did not opt to return to Princeton University,instead of taking on another term as chairman. The political heat, not only from the new House of Representatives,but also from foreign policymakers and fellow central bankers, is only likely to get turned up a few notches as heimplements a second round of quantitative easing.

Assuming he makes it to the end of his second term as chairman, which ends in January 2014, he may find adifferent, revised macroeconomics being practiced by his colleagues. In the middle of November, Princeton’s PaulKrugman released a paper co-authored with a fellow economist at the N.Y. Fed entitled “Debt, Deleveraging, and theLiquidity Trap: A Fisher-Minsky-Koo Approach.” You may recognize some of these names — we have drawn on eachof them over the past two and half years to elaborate and expand Dr. Richebächer’s economic model.

Stepping too far outside the orthodoxy of the day involves a fair degree of career risk. So it is with great surprisethat we find Paul Krugman and his N.Y. Fed co-author ready and willing to recognize in the opening passages of theirpaper the following themes so clearly at the heart of Dr. Richebächer’s contribution:

If there is a single word that appears most frequently in discussions of economic problems nowafflicting both the United States and Europe, the word is surely “debt”… there was a rapid increase inhousehold debt in a number of countries in the years leading up to the 2008 crisis; this debt, it’s widely

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argued, set the stage for the crisis, and the overhang of debt continues to act as a drag on recovery…

The current preoccupation with debt harkens back to a long tradition in economic analysis.Irving Fisher (1933) famously argued that the Great Depression was caused by a vicious circle inwhich falling prices increased the real debt burden, which led in turn to further deflation. The lateHyman Minsky (1986), whose work is back in vogue thanks to recent events, argued for a recurringcycle of instability, in which calm periods for the economy lead to complacency about debt andhence to rising leverage, which in turn paves the way for crisis. More recently, Richard Koo (2008)has long argued that both Japan’s “lost decade” and the Great Depression were essentially causedby balance-sheet distress, with large parts of the economy unable to spend thanks to excessive debt.

Given both the prominence of debt in popular discussions of our current economic difficultiesand the long tradition of invoking debt as a key factor in major economic contractions, one mighthave expected debt to be at the heart of most mainstream macroeconomic models — especially theanalysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite commonto abstract altogether from this feature of the economy.

Actually, we are not surprised at all by this glaring omission of credit from mainstream macroeconomics. Whileit is in the nature of all models to abstract from the details and complexities of reality, mainstream economics hasoften made an art form out of omitting salient elements like debt. All too often, its preference is to impose simplifyingassumptions that leave its models in a world that barely resembles the one we actually inhabit. Perhaps by the timeChairman Bernanke returns to Princeton, enough of an investigation of the history of work done in this area ofmacrofinancial dynamics will have been completed that Dr. Richebächer’s contributions will be held up alongsidethose of Fisher, Minsky and Koo.

SUMMARY AND CONCLUSIONS

Lying beneath the reliance on serial asset bubbles to drive growth and large fiscal deficits to contain and reverserecessions is the deeper issue of rising global competition and global imbalances. As Dr. Richebächer correctlyidentified, reinvestment of profits in the productive capital stock is the best driver of growth in capitalist economies.Between the short run-oriented incentive structures that have grown up under shareholder capitalism, thedevelopment of financial engineering and increasing global competition, this normal engine of growth has beendampened, if not thwarted in a number of Western nations.

Resolving this deficiency in the context of correcting chronic global trade imbalances will remain one of the greatchallenges of the years ahead. It has become increasingly clear that current international monetary arrangements havereached the end of the line in this regard. Any sensible replacement will need to address the issues Dr. Richebächeridentified early on, asset bubbles, credit excesses and reinvestment of profits in tangible productive capital, if moresustainable and stable growth paths are to be achieved.

With these parting thoughts in mind, it has been a great honor to extend Dr. Richebächer’s approach through thetumultuous events of the past two and a half years. We trust you have found some of the insights provided by Dr.Richebächer’s framework useful along the way, and we appreciate your willingness to support this project after his passing. Readers wishing to make contact with us regarding any future projects may send e-mail [email protected].

We wish you the best of luck in preserving and growing your wealth in the days ahead, hopefully with some ofDr. Richebächer’s unique insights and vantage points close at hand.

PORTFOLIO OVERVIEWBy Rich Lee

Here is a final look at our open recommendations and some guidance for the months ahead.

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With Ireland accepting bailout assistance from both the greater European Union and the International MonetaryFund, Spain and Portugal will be the next focus. The ongoing crisis will likely mean further downside in the iSharesMSCI Europe Financials ETF (EUFN). It is priced at the top of its 52-week range — not too far from where weinitiated the short position back in May. Although the investment has the potential to reach $18 in the next fewmonths, we don’t recommend holding above $24.50.

We also have faith in our short recommendation of the iShares MSCI Germany Index Fund (EWG). It’sslightly positive as we go to press and should continue to reflect the current concern over European stability. Still,we would be inclined to close the position above $26.

It’s also time to let go of two other bearish euro plays — the UltraShort MSCI Europe ProShares (EPV) andUltraShort Financials ProShares (SKF). Close them ahead of the end of the year.

Continue holding the NASDAQ December euro 110 put until expiration. There is still potential for it to pay off,as the spot currency has moved lower in the past few weeks. Any losses should be minimal at this point, with onlythe premium being lost.

Things are brighter with some of our U.S. choices. Consumers are turning to equity issues with a staple presence —making a long-term case for both Wal-Mart (WMT) and Coca-Cola (KO). Although we expect WMT to continueto rise at a slow and appreciable rate, KO may be nearing the end of its short-term rally. We believe the stock to befairly valued at around $67.

Finally, we come to our high-yield picks. Gains in International Bancshares Corp. (IBOC) shares haveoutweighed the decline in shares of Nordic American Tanker Shipping Ltd. (NAT). Still, with the high-yield trendset to hit a snag in the next couple of months, we suggest closing these positions.

We also say to exit IQ Merger Arbitrage ETF (MNA). It has done little good for us so far, and we don’tanticipate that to change. Mergers and acquisitions will continue to be lackluster as long as the U.S. economy movesalong sluggishly and domestic stock market volatility remains brisk.

[Ed. Note: Rich Lee will continue contributing to The Daily Reckoning website. And don’t forget you can stayin touch with Rob by e-mailing [email protected]. On behalf of the entire Richebächer Society team, thankyou for your loyalty and support!]

Rob Parenteau, Editor Addison Wiggin, Executive PublisherRichard Barnard, Associate Editor Andrew Ascosi, Graphic Designer

The Richebacher Letter is published monthly by Agora Financial LLC, 808 St. Paul Street, Baltimore, MD 21202-2406, www.agorafinancial.com.Subscriptions are US $497 per year for U.S. residents. POSTMASTER: Send address changes to Agora Financial LLC, Customer Service Department, PO Box960, Frederick, MD 21705. Customer Service: 800-708-1020 or 410-454-0499; e-mail: [email protected].

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The information contained herein has been obtained from sources believed to be reliable. While carefully screened, the accuracy of this information cannot be guaranteed. Signedarticles represent the opinions of the authors and not necessarily those of the editors. Neither the publisher nor the editor is a registered investment adviser. Readers should carefully reviewinvestment prospectuses, when available, and should consult investment counsel before investing.

THE RICHEBÄCHER LETTERIn Memory of Dr. Kurt Richebächer

RCH Last Letter

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