Uneven Economic Development is the Essence of Capitalism

Monthly Market Commentary: October 1, 2015

The late Kurt Richebächer opined that, “Capital and wealth increases when a community produces more than it consumes. Capital and wealth decreases when the community consumes more than it produces. What is happening in the United States is the latter - with the consequences of general impoverishment.” In an earlier report I explained how Friedrich Hayek gained fame among English-speaking economists at the London School of Economics in 1931, because he made the distinction in the use of credit for investment or consumption his key theme. At the time he explained in detail how excessive consumer spending brings about “a shortening or shrinking of the production” and so causes recession. What shrinks is the economy’s capital base. In essence, production that uses capital gives way to production using little or no capital. In other words, the whole economy adjusts to the changes in the pattern of demand implemented by the credit excess. Looking at changes in employment in the US over the years, I note that employment in capital-intensive manufacturing has plummeted, while employment in all kinds of low-paying services has soared.  

There is a difference between excessive credit growth (defined as an “increase in money capital from credits which do not originate from savings but are created out of nothing through the banking system”) flowing into capital investments, and excessive credit growth flowing into asset inflation and financing consumption. Once the boom comes to an end, the severity of the downturn can be equally severe (most likely more severe in the case of a capital spending boom), but the capital spending boom leaves the entire system with investments such as railroads, canals, and other infrastructures, and new technologies. It is a well-documented fact that all canal companies, including the most successful of them all, the Erie Canal Company, went bust. Equally, by 1895, 95% of all US railroads were either in default or bankrupt; however, the transportation network that had been built by the canal and railroad companies was a huge boon to the expansion of commerce and trade within the American continent.

Similarly I would argue that, while there certainly has been capital spending excesses in China, at least there is now infrastructure in place whereas there was none 20 years ago (unlike in India, where infrastructure is still decrepit and extremely poor). On the contrary, in the case of an asset boom and excessive credit creation which financed consumption, the system is left with hardly any new capital structures but an over-indebted consumer. In addition, consumer credit allowed the consumer to advance consumption, which then leads to reduced demand once the consumer exhausts his borrowing capacity (as is now the case for the majority of American families).

This report explains why under current fiscal and monetary policies the global economy will likely enter a recessionary phase and why equities will unlikely perform well.

With kind regards
Yours sincerely  
Marc Faber 

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