Re: S=I, a new twist

[Rob Parenteau <rwp@xxxxxxxxxxx>]

--=====================_903598929==_

I am surprised nobody on this list has picked up on the Wynne Godley FT piece.

If the current account deficit is getting larger, and the government surplus
is rising, the S=I macroidentities suggest a rising private sector financial
imbalance. Based on flow of funds accounts, this imbalance is nearly 4% of
GDP, the largest it has been since 1970.

In the attached Word document, I argue most of this deficit is coming from
the corporate side, is being financed from abroad, and it is not too hard to
see that their is a giant Ponzi scheme going on in the U.S. equity market.
The similarity to the pre-crisis conditions in Asia is noticeable. I wonder
if anyone can poke holes in this view.

--=====================_903598929==_

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 {\ul The Last Great Ponzi Scheme on Earth
\par }{A Ponzi scheme is usually characterized by the paying off of earlier=
 investors with the cash flows received from later investors in a chain=
 letter type fashion. No value added activity is undertaken with these cash=
 flows, although there is usually a seemingly plausible tale told to targets=
 of Ponzi schemes. Cash flows are simply distributed from one segment of the=
 participants to another, with some sizeable fraction skimmed off by the=
 Ponzi operator. As long as the cash raised from new entrants into the Ponzi=
 scheme is sufficient to payoff the claims promised to the existing members=
 of the Ponzi scheme, the game goes on. Usually, however, a critical=
 threshold is passed and the supply of new dupes is not sufficient to hold=
 up the pyramid of payments. For those not familiar with this mode of=
 generating investment returns, there is a discussion of the World Plus=
 scheme on p. B1 of the 8/13/98 Wall Street Journal, and a front page 8/6/98=
 WSJ article on the extraordinary Albanian follies.
\par Equity markets can occassionally resemble Ponzi schemes. If the planned=
 demand of new investors for a stock outweighs the dollar supply of stocks=
 intended for sale by existing investors, the stock price goes up. Hence the=
 familiar quip from the trading desk when you ask why your stock is up on=
 the day: there are more buyers than sellers. This phenomenon has come to be=
 erroneously know as liquidity, and anticipating liquidity flows has become=
 one of the master arts of financial market analysts.=20
\par However, the outstanding difference between equity markets and Ponzi=
 schemes is that companies receiving funds from new equity issues usually=
 intend to use those funds to deliver higher economic value added. Companies=
 employ financing to purchase raw materials, human talent, and capital=
 equipment that will allow them to deliver a good or service that customers=
 value more highly than the unprocessed inputs to production alone. There=
 usually exists an underlying cash flow, namely profitability from=
 production, which can be used to service dividend and interest payments on=
 financing, as well as to pay off principal as debt instruments come due.
\par Once this distinction is removed \endash  once production activity=
 fails to generate profits \endash  company revenues are not covering=
 expenditures. Companies can enter a mode of Ponzi financing. Existing=
 equity investors come to rely on fresh financing from lenders to plug the=
 existing cash flow gap. They also come to rely on new equity investors that=
 either don\rquote t recognize the earnings shortfall or don\rquote t=
 believe the shortfall will continue for very long. Essentially, existing=
 equity investors come to rely upon two Ponzi schemes running at the same=
 time. Within firms, new financing must be secured to pay off prior=
 financial obligations, and within the equity market, more new equity=
 investors must be attracted to the stock to buy out existing stockholders=
 at a higher price. Funds are simply changing hands, and not being employed=
 to add any economic value along the way. Hence the prevailing emphasis on=
 liquidity flows by current equity strategists, and the prevailing ignorance=
 of fundamentals by momentum based investors.
\par As of the first quarter of 1998, the U.S. equity market now qualifies=
 as a massive Ponzi scheme. The profit margin squeeze we identified in the=
 Spring of 1997 has combined with the slamming of export sales revenue from=
 the Asian crisis to produce a lethal mix to corporate earnings. The=
 conditions of this Ponzi scheme, however, have some unique attributes that=
 make current dynamics especially unstable.
\par First, corporate management has turned a blind eye to the signal=
 offered by the earnings squeeze, and they continue to pursue nominal double=
 digit capital spending growth, as displayed in the chart below. A=
 diminishing or negative marginal return on capital equipment spending=
 should, from first principles of private market economies, establish an=
 incentive for firms to reduce their capital spending. Since the shock to=
 earnings is directly related to rising real wages, perhaps managers have=
 chosen to spend their way out of the profit squeeze by substituting capital=
 equipment for labor. So far, this substitution does not appear to be=
 working, as the recently released weak Q2 productivity report details. We=
 may simply be witnessing the overoptimism that tends to accompany prolonged=
 expansions. After all, this expansion is over seven years old, and has been=
 described in the similar new era terms to the Asian Miracle.
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\par Regardless, the net result of the gap between negative earnings growth=
 and double digit capital spending is a rising demand by firms for external=
 financing. Free cash flow generation based on company financial statements=
 is slipping, as displayed below. By the Federal Reserve\rquote s measures,=
 the nonfarm nonfinancial corporate financing gap has risen from a=
 seasonally adjusted $48b level to an $88b level if 1998 Q1 data is=
 annualized. This is likely to be an understatement of the true financing=
 gap given the perverse treatment of inventory values during deflation. Some=
 $30 billion of inventory valuation adjustment has been added back to Q1=
 internal corporate funds, when in fact any business experiencing a decline=
 in the price of its inventories faces a hit to its money profits on those=
 items. The NIPA accounting assumes lower inventory prices will be met by=
 lower costs of goods sold in the next round \endash  in other words, by=
 construction, it precludes any profit squeeze from deflation of goods ready=
 to be sold.=20
\par Indeed, reflecting this larger than reported financing gap, the=
 corporate bond supply calendar has mounted well beyond most expectations in=
 1998. Fed flow of funds data indicate a surge in the net increase in=
 liabilities for this sector from a $363b level in 1997 to an annualized=
 level of $518b through Q1 1998. Of that, commercial paper increased from=
 $14b to $54b, and corporate bonds increased from $91b to $157b.=20
\par }{\fs20 {\pict{\*\picprop\shplid1025{\sp{\sn shapeType}{\sv=
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\par Second, the ongoing equity share repurchase activity, although stalling=
 of late, precludes new equity issuance as a channel for new finance. That=
 places all the burden on plugging the gap between corporate income and=
 spending on debt markets. Net new equity issues fell at a $115b pace in=
 1997, and a $119b pace in Q1 1998 annualized.=20
\par Now if you stop and think about this for just a moment, you will=
 realize precisely what this flow of funds means. In the aggregate, bond=
 investors are like the late entrants into a Ponzi scheme, and existing=
 equity investors are like the early entrants into a Ponzi scheme \endash =
 they are getting paid off by proceeds from new bond investors, with=
 corporations acting as the intermediary of this scheme. Equity investors=
 are, once again, duping bond investors to hold the Old Maid, but on a scale=
 I doubt we have ever witnessed before in the history of our nation, with=
 the possible exception of the junk bond follies of the late eighties.  We=
 are no doubt experiencing the moral hazard associated with tying management=
 compensation to stock options.
\par Bond investors of late, however, have taken on a decidedly more=
 international cast. Flow of funds data show rest of world corporate bond=
 purchases rising from an $84b pace in 1997 to an annualized Q1 1998 pace of=
 $107b. Not to be outdone, rest of world purchases of U.S. corporate=
 equities have also risen from $65b to $116b. Old market lore is being borne=
 out: advantageous sales of assets can be executed when foreign investors=
 pile into your market.=20
\par This dependence on the kindness of strangers \endash  a result also=
 implied by the combination of a rising current account deficit and a rising=
 public sector surplus, as noted by Wynne Godley in his recent FT article=
 \endash  which has become necessary to finish off the current U.S. Ponzi=
 scheme would be laughable except for the following observation from recent=
 Fed Board of Governors research into prior financial disruptions. As=
 Graciela Kaminsky and Carmen Reinhart conclude,=20
\par }{\i \ldblquote Typically, financial crises occur as an economy enters=
 a recession that follows a prolonged boom in economic activity fueled by=
 credit creation and surges in capital inflows=85Crises are accompanied by=
 an overvaluation of the currency, weakening exports, and bursting asset=
 price bubbles.\rdblquote=20
\par }\pard \s21\nowidctlpar\widctlpar\adjustright {\i=20
\par }{\tab \tab \tab Excerpt from \ldblquote Financial Crises in Asia and=
 Latin America: Then and Now\rdblquote=20
\par \tab \tab \tab Papers and Proceedings of the 110}{\super th}{ Annual=
 Meeting
\par }\pard \s21\fi720\li1440\nowidctlpar\widctlpar\adjustright {of the=
 American Economic Association, January 3-5, 1998\tab=20
\par }\pard \s21\nowidctlpar\widctlpar\adjustright {
\par }\pard \s21\sb240\nowidctlpar\widctlpar\adjustright {While Kaminsky and=
 Reinhart came to this conclusion when applying the lessons from their Latin=
 America research to Asian, European, and Middle Eastern financial=
 disruptions, I invite each reader to go down this checklist with respect to=
 one region the authors seem to have omitted. You will see for yourself that=
 six of the seven conditions  - identified by the Fed itself \endash  are=
 already in place in the U.S. Charles (Carlo) Ponzi would indeed be proud of=
 his prodigies now operating at the other end of the century.=20
\par }\pard\plain \sa240\nowidctlpar\widctlpar\adjustright \f15\fs22\cgrid {
\par }}

--=====================_903598929==_--