»The Daily Reckoning by Bill Borner

What happens when an economy goes into correction?
4 AUGUST 2011

Poitou, France

We're spending the month of August out in the country. This is the house where most of the children grew up - a huge, stone, shambling place, built in the 16th or 17th century and rebuilt at the end of the 19th. The floors are like roller coasters. The ceilings sway like an old mare's back. The plumbing snorts and gurgles.

What fun to be back! More below...

Meanwhile, in the world of money, life goes on. It has its ups and downs, too, just like our hallway. And we are now in one of its down phases. Stocks have fallen for 8 of the last 9 sessions...with a small rise in the Dow yesterday to break the trend.

This long stretch of losses should give rise to a bounce back in the short-run. But a long stretch of losses is still what the stock market needs. Somehow, it has to get from where it is down to where it should be. Stocks should be cheaper. Markets go up and down. It started down more than 10 years ago. But it has never completed its rendezvous with the bottom. The bottom for this bear market - the one that began in January 2000 - is probably down around 5,000 on the Dow. So, we have a long way to go...and probably a long time to get there.

Yesterday, the Dow rose 29 points. But gold shot up $21.

Gold is amazing; it's up 18% in 2011. And now the emerging market central banks are loading up. They've got plenty of paper money already - mostly dollars. But they're no dopes. They've read the history books. They know what happens when economies get in trouble....and they know what happens to paper money too. They read the papers too. They know what a fix the advanced economies - particularly the USA - are in. And they know too that leading, respected economists - such as Ken Rogoff at Harvard...not just clowns like Paul Krugman - are recommending higher levels of sustained inflation in order to reduce American and European debt.

South Korea, for example, just bought 25 tonnes of the yellow metal - more than a billion dollars worth. This was its first purchase of gold in 13 years. We doubt that it will be its last.

Gold follows power. Gold follows wealth. Right now, emerging economies have very little gold. Makes sense. They were too poor to afford it. But now, they are getting rich and the advanced economies are getting poor. What happens next is inevitable - gold will emigrate...from the old rich countries to the new rich countries.

Who can blame it? The latest news shows the US economy is practically dead in the water. GDP growth per capita has stalled. Consumer spending dropped for the first time in almost 2 years. And layoffs rose 60% last month.

The Wall Street Journal has more on the employment front:

U.S. businesses hired modestly in July, while service-sector growth slowed and factory orders weakened, sapping an economy already in a deep rut.

U.S. private-sector payrolls rose by 114,000 last month, according to a report Wednesday by payroll firm Automatic Data Processing Inc. and forecaster Macroeconomic Advisers.
One thing we're beginning to realize is that when an economy goes into a correction, everything seems to go into reverse.

In a healthy, growing economy, consumer sales go up...but business profits often go down. Why? Because costs rise, particularly the cost of labor. Raw materials costs go up too. And competition increases, squeezing margins.

But when the economy goes into a correction, sales go down...but business profits can still go up. Businesses cut labor costs aggressively. They become more efficient, desperately trying to make and conserve cash. The time for expansion is over.

Are they worth more? No. They're worth less. Because as the correction continues, margins go back to normal...but sales do not. Today's stock prices rest largely on profit reports, which have misled investors into believing all is well. But all is not well. This is a correction...a Great Correction...and in a correction, asset prices go down.

Here's another thing that goes into reverse. Stimulus measures. In a healthy economy, lower rates and/or more government spending will cause the economy to pick up speed. Businesses will borrow to expand. Consumers will borrow to spend.

But in a correction, stimulus measures don't work at all - or work in reverse. Businesses borrow only to build up cash hoards. Consumers borrow only to pay off old debt with new debt. The problem in a correction is debt (and all the bad decisions associated with it). Stimulus spending adds debt. The situation gets worse, not better.

And of course, government finances go into reverse too. In a healthy economy, tax revenues rise with GDP and social welfare spending declines (fewer people need unemployment comp or food stamps, for example). Then, when the correction comes tax revenues fall...while more people stand in line to get 'benefits.'

And then, it gets worse. Because, as governments run deficits to try to combat the slump, more bad things happen. Debt rises compared to GDP. This makes government debt less attractive to investors, so they have to pay higher real rates to borrow...and they have to borrow more! Plus, as the total amount of debt rises, the debt itself weighs the economy down...slowing GDP growth even further.

Yes, dear reader...when a correction comes...everything goes bad.

But we're happy, optimistic, forward-looking people. We're not going to get too gloomy about it.

In fact, in the spirit of civic generosity we offer some insight and advice to policymakers everywhere.
When a correction comes, let it be. Let it happen. Let the correction do its work as fast as possible. Let bad investors suffer losses. Let bad banks and bad businesses fail. Let bad debt die...
And remember, a good debtor is one who reneges on debt he can't pay...not one who borrows more.

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*** "Welcome back," said Damien, seconds after we drove up.

The house has been sitting empty for 6 months. Damien, a part-time gardener, has been keeping an eye on things. He had just mowed the lawn and opened a few shutters. The place didn't look bad.

Damien had gone to the hospital recently to have his prostate examined. They found nothing wrong with it. So, Damien was in a good mood.

"Let's have a drink to celebrate your return," he proposed. Gardeners - at least French gardeners - are always ready to sit down with a glass of alcohol. So, we got out a bottle of whisky and drew up a couple of chairs to an outside table.

"What's new," we asked.

"New? Nothing really. Nothing ever changes here."

Then, after a couple more glasses...

"You know that Mr. Blanchard got remarried? You remember him. He sells cheese at the market. His wife committed suicide a few years ago. It was very sad. They have small children. I don't know what got into her. But they found her in the river.

"Then, I noticed Mr. Blanchard hanging out with that English woman. I don't know what she was doing here. But the English are funny. They come to France and get divorced. I think it's the strain of living in a foreign country. Or maybe it's because they only have each other to talk to. You know, they are semi-retired or something. They dream of leaving their jobs and troubles in England and coming to France, where the weather is better and the prices are lower. And so they come. And they bring their troubles with them.

"The weather is better here. But the pound went down and so now it's more expensive for them here. And they are isolated. They only talk to each other...and I guess they get bored. So, one of them eventually gets sick of it and goes back to England. And the other one stays here and doesn't know what to do with himself...or herself.

"Well, I noticed Mr. Blanchard getting very friendly with this English woman. She's a nice looking woman, too. And then she was with him behind the table, selling cheese at the open air market. And they'd go behind the truck and I heard them giggling.

"Well, they got married. And they seem very happy together. I hope it works out. He deserves a break."

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