THE RICHEBÄCHER LETTER

The Monthly Missive of The Richebächer Society

NUMBER 435 — LAST ISSUE DECEMBER 2010

“Fearful and protracted economic and financial trouble looms when the spending excesses
during the boom… involve soaring indebtedness of consumers and corporations. Historically, the
worst excesses of this kind have typically occurred in association with more or less pronounced
asset 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, the
implicit ravaging of balance sheets impels borrowers as well as lenders to greater prudence and
measures 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 LINE

As 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 from
Irish bank solvency concerns and Chinese authorities urgently clamping down on accelerating inflation following the
credit boom they originally engineered to avoid the Great Recession, the relevance of Dr. Richebächer’s credit-based
economic analysis is more obvious than ever. Yet unfortunately, despite our combined best efforts, the economics of
newsletter publishing has proven less than favorable, and this will mark the very last issue of the monthly letter. As
such, 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 is
warranted. 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 challenge
in 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 trade
deficits. We appear to be reaching the end of the line on the current system — even Fed Chairman Ben Bernanke
recognizes 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 developments
likely to influence financial market and economic outcomes in the United States and around the globe over the next
year 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 believe
represent some of the core perspectives that Dr. Richebächer developed during his career. We hope to boil his
contributions down sufficiently so that you may use his unique perspectives to guide your own independent thinking
through 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
2

ineffective responses to rising global

competition. The first wave of this U.S.Consumption Grew Faster
became apparent in the 1970s when Than Labor’s Income
both German and Japanese production 7.5
capabilities had been rebuilt enough
over the prior two decades to
undermine U.S. competitiveness. 5.0 U.S.Consumption Grew Faster
Added on top of this were a number
of commodity shocks as more
Than Labor’s Income
7.5
households in the world reached for
U.S. standards of living, and some 2.5
fairly aggressive labor movements in
the West that attempted to keep wages 5.0
rising with inflation — a combination 0.0
that yielded a stagflationary result.
Rising inflation and rising
2.5
unemployment rates stalked many
-2.5
nations until the tight monetary 80 85 90 95 00 05 10
policies and industrial restructuring of Real Personal Consumption Expenditures
the early ’80s took root. 0.0 % Change — Year to Year SAAR, Bil. Chn. 2005$

The sobering up of Western Business Sector: Real Compensation Per Hour

% Change — Year to Year SA, 2005=100
management after the stagflationary Sources: BEA, BLS /Haver
binge of the ’70s led to a renewed -2.5 80 85 90 95 00 05 10
emphasis on cost control, innovation
Real Personal Consumption Expenditures
and productivity improvement. Labor discipline was%reasserted,
Change — Yearbut theSAAR,
to Year aspirations of consumers often were not
Bil. Chn. 2005$
adjusted sufficiently. For example, when we compare real consumption growth with real hourly compensation growth
U.S.Private
for labor in the United States from 1980 onwards, we%find a big
Change
Debt
Business Sector:
disconnect.
— Year
Plugged
Real Compensation
to Year SA, 2005=100
the Gap,
Per Hour
Trade Deficit Widened
Sources: BEA, BLS /Haver
16 typically grew less than 2.5%, after adjustment for inflation. Real
Hourly compensation growth for labor
consumption growth typically grew more than 2.5%, with the exception U.S. Domestic Private Nonfinancial
of recessionary Debt
periods. Consumption
growth in excess of hourly compensation Growth % Change — Year to Year
12
growth can only be sustained under
five conditions: More people can join U.S.Private Debt Plugged the Gap,
the work force. More people can work 8 Trade Deficit Widened
longer hours. Personal tax rates can be 16
U.S. Domestic Private Nonfinancial Debt
continuously cut. Households can 4
Growth % Change — Year to Year
continuously reduce their saving rate. 12
And more people can rely on debt to 0
maintain improvement in their 8
material standards of living. -4
Most of the increase in the 4 U.S.Trade Balance as a Share of GDP
employment-to-population ratio was -8
completed by 1990, as more women 0 80 85 90 95 00 05 10
entered the labor force. Average Source: Haver Analytics

weekly hours of nonfarm production

-4
and nonsupervisory workers have
U.S.Trade Balance as a Share of GDP
been declining steadily since 1965.
Tax cuts can only go so far when fiscal -8
80 85 90 95 00 05 10
deficits have ballooned. Having Source: Haver Analytics
exhausted the first three options, it

The Richebächer Letter, December 2010

 3

turns out the households primarily relied on lower savings rates and higher consumer debt growth to plug the gap
between 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 — and
w Faster to consume more than he produces in real or unit volume terms. Governments are not the only ones who deficit
spend. Companies and households can deficit spend, and when enough of them do, private nonfinancial debt will
tend 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 and
unproductive debt. Debt issued to finance new plant and equipment has a chance of producing new income in the
future — income that can be used to service the interest expense and pay down the principal of the debt. Debt issued
to 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 the
latter is unproductive, as no capacity to service the debt issued is apparent in the actual use of the borrowed funds.
In addition, through the various
merger waves and share repurchase U.S.State & Local Government Employment
efforts, much of the business debt
issued was for financial engineering
Overtook Manufacturing Jobs
95 00 purposes,05 not for10 expansion of 20000
the capital stock. Debt allowed
on Expenditures
hn. 2005$ households to consume more than
18000
pensation Per Hour
they were producing. The choice
00
of business to use debt for
rearranging control and boosting 16000
short-term earnings growth had little
to do with expanding production
capacity, and so left U.S. global 14000
ed the Gap, competitiveness further at risk.
U.S. Manufacturing Employees
(in thousands)
Absent sufficiently strong 12000
reinvestment
ic Private Nonfinancial Debtrates in the U.S. U.S. State and Local Employees
(in thousands)
tradable
ange — Year to Year goods sector, the push for
higher labor productivity meant 10000
jobs in the manufacturing sector 80 85 90 95 00 05 10
Source: Haver Analytics
shrank over much of the past three
decades. While the first contraction
in 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 find
profitable reinvestment opportunities in the United States, and the failure of the United States to attract foreign direct
investment 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 below
the number employed by state and local government. The productivity of manufacturing workers has tended to
hare of GDP exceed that of government employees, and the products of state and local government employees are generally not
tradable goods and services. The production structure, at least as revealed by the composition of employment, had
5 00 become05 10 two decades of minimal reinvestment of profits (with the notable exception of the tech/telecom
skewed after
bubble, 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 to
finance capital equipment in the tradable goods sector. Such taxes increase the effective cost of employing U.S. labor

The Richebächer Letter, December 2010

4

in the tradable goods sector, so from a variety of perspectives, this shift in the structure of production compounds the
problem 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 facing
many 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 they
would either have to allow falling domestic prices to make their exports cheaper on world markets or they would
have to curtail their importing for lack of means of settlement. Under the current system, where money and credit
can be created out of thin air, often on the back of recurring asset bubbles, and where intervention in foreign exchange
markets 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 a
trade-deficit nation, and so it is accumulating liabilities issued by the trade-deficit nation. These liabilities require
future payments of interest expense, principal and dividends. Unless the trade surplus nation reinvests some of its
earnings in the productive capacity of the trade-deficit nation, or companies within the trade-deficit nation maintain
a high rate of reinvestment, the income needed to service the liabilities of a trade-deficit nation will tend to eventually
come 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 is
likely to be required by the trade-deficit nation. Alternatively, they must recognize an implicit default will be
attempted through rampant money creation by the trade-deficit nation. In many ways, the first path is the one most
likely to unfold in Europe, while the second path appears to be the way the United States, and eventually the United
Kingdom, 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 and
monetary arrangements. For a variety of reasons, reinvestment rates in the tradable goods industries have remained
too low in a number of chronic trade-deficit nations. They have lost their competitiveness in global markets. By
default, domestic service sectors and government hiring have picked up some of the slack in these economies. The
ability of these economies to generate the income required to service their liabilities held by foreigners is now open
to question. And there is no quick fix beyond monetization or debt rescheduling. Large trade-surplus nations like
Germany and China are slowly realizing they have a choice: find ways to buy more goods from the rest of the world
or continue accumulating claims on the rest of the world that will eventually be met with either explicit or implicit
default.
What is needed is a global rebalancing of consumption and investment, and a price or policy mechanism that
enforces ongoing global rebalancing, preferably in a pro-growth fashion. Dr. Richebächer touched on this when he
wrote 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 domestic
consumption demand… in China, with banks generally government owned, the lending excesses and
malinvestments 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 be
missed by protectionist forces in the future, the greatest beneficiary of liberalizing global capital and trade flows is
an economy that still has some of the greatest government intervention around.) Given the resulting distortions in
structures of production across countries, and the thin gruel that comes out of international negotiations like those in
Seoul recently with the G-20, it is likely to take time before a common solution can be found between nations with
large and chronic trade imbalances. The risk along the way, of course, is that the inability to find common ground

The Richebächer Letter, December 2010

 5

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 international
system, though not without first promoting more discord. We do, however, find it at least encouraging that he has
become willing to name the underlying issue. Such was the case in his November speech in Frankfurt where he noted
rather candidly:
As currently constituted, the international monetary system has a structural flaw: It lacks a
mechanism, market based or otherwise, to induce needed adjustments by surplus countries, which
can result in persistent imbalances… In particular, for large, systemically important countries with
persistent current account surpluses, the pursuit of export-led growth cannot ultimately succeed if
the 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 international
monetary system that more consistently aligns the interests of individual countries with the interests
of the global economy as a whole. In particular, such a system would provide more effective checks
on 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 have
the blueprints for a new system. But this is the underlying issue that global investors and policymakers will be
wrestling with over the next five to 10 years. In the meantime, the path of least resistance is likely to take the form
of more money creation and eventual debt restructuring by Western nations — and with any luck, a more rapid
emergence 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. dollar
status as the international reserve currency is brought increasingly under fire. In addition, history suggests the largest
creditor nation eventually gets to define international monetary arrangements. China’s leaders are unlikely to cede
control of the yuan to market forces they still distrust. We would not, however, be surprised if somewhere along the
way they propose a new international reserve currency backed by a basket of durable commodities — many of which
they 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 be
addressed 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 predicament
has not been resolved. Our contention has been that the attempt to reduce government bond risk through prolonged
fiscal retrenchment will tend to shift credit risk over to the private sector. Tax hikes and government expenditure cuts
are designed to drain cash flow from households and firms. Unless trade balances improve quickly, or confidence
improves enough to get firms reinvesting profits at a higher rate, the more highly leveraged sectors of the private
sector will tend to head deeper into delinquency and default on their debt as fiscal retrenchment proceeds. This has
a nasty way of showing up on bank balance sheets, and eurozone banks remain highly leveraged and highly
interconnected.
In addition, absent offsetting improvements in trade and investment, economic growth will tend to remain subpar
or even reverse, leading to tax shortfalls. A vicious cycle can ensue as more fiscal cuts are required for prior deficit
reduction targets to be achieved. Ireland has been one of the most diligent nations in pursuing fiscal retrenchment over
the prior two years. It has yet to exit recession, and home prices have fallen over 35% from their peak. While its trade
balance 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

The Richebächer Letter, December 2010

6

contagion effects to other European banks with loans out to Ireland (especially to Irish banks), no doubt some sort of
loan 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. We
expect the eurozone will be maintained, but only at the price of eventual public and private debt restructuring once the
game 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 monetary
policy that simultaneously seeks to raise inflation expectations by creating money out of thin air, and then using it to
bid up the prices (and lower the yields) on Treasury bonds. Investors are bound to ask themselves why they would
want to buy Treasuries at historically low nominal yields while facing the prospect, if the central bank achieves its
stated goal, of escalating inflation. This strikes us as a mug’s game — a recipe for instant losses once nominal yields
rise to accommodate inflation expectations. We suspect this is why PIMCO officials, who represent one of the largest
institutional 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 that
accompanied the latest foray into quantitative easing is problematic. Not only is it likely to act as a supply-side shock
on a number of producers who may find it difficult to pass on higher costs (and U.S. consumer staples stocks, like
the food processors, are at risk here — see Dan Amoss’ work in Strategic Short Report in this regard), but absent a
large improvement in household income growth in the West, the commodity price increases that do get passed
through 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. By
mid-November, investors had begun to recognize the wall of new supply likely to be issued in 2011, and municipal
bond mutual funds and ETFs were reporting heavy outflows. States and municipalities are likely to run out of smoke
and mirrors unless quantitative easing promotes a much stronger recovery in the United States. On that subject, New
York Fed President and former Goldman Sachs economist Bill Dudley recently noted, “It’s going to make the
economy grow a little bit faster. It’s going to generate a little bit more employment growth. But you know, we have
a 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 down
in 2011, are unlikely to get bumped higher anytime soon. State and local employment cuts are just beginning to
mount, and these will have ripple effects on state income growth. For those who are in a tax bracket that forces them
into municipal bonds, owning only the highest quality bonds is the watchword.
Finally, China’s economy now has the unenviable combination of overinvestment, malinvestment and escalating
inflation. The credit boom China engineered to avoid getting dragged down during the events of 2008–09 has come
back to haunt it. While food prices are the main culprit, minimum wages are reported to have been lifted some
10–20% over the past year, and wage gains in the coastal manufacturing regions have been reported to be quite high
of late. Administrative price controls and reduction of commodity stockpiles are under way, but a series of hikes in
reserve requirements, as well as policy rates, suggests Chinese officials are not convinced price controls will do the
trick. Over the years, we have found it expensive to bet on China slowing down. However, there is a chance Chinese
inflation 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 the
United States.
While we still expect Chinese officials to back off before slowing the economy too much with monetary policy
tightening, the waves of new capacity coming on line that may not find domestic Chinese buyers suggests tradable
goods markets could get glutted. This, of course, will tend to exacerbate the international competitiveness issues we
highlighted earlier across many Western nations. We would suggest solar panels are one area in which the surge in
Chinese 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

The Richebächer Letter, December 2010

 7

financial market and economic outcomes. Each of them is tied, in one way or another, to the credit imbalances that
Dr. 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 his
archives at Agora Financial has given us a deep appreciation of his unique approach. Nothing short of a book could
possibly capture the full complexity of Dr. Richebächer’s thinking, but in the spirit of encapsulating some of the
legacy he left behind, so that it may be carried forward by you and others you share it with, we offer the following
condensed 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: a
theoretical 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 search
for profits as the key driver of new investment. Absent new investment, there was little chance of sustaining the
process of economic growth. As he noted in the September 2001 letter:
What determines the growth of production? The short answer is: profit prospects that stimulate
business capital spending. Profits are the key driver of capital investment and rising capital
investment 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 figuring
in 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 places
shareholder value on a pedestal.
Most economists put consumption paramount, since consumer spending tends to make up the largest share of
GDP, but as Dr. Richebächer noted, “In order to spend, the consumer must first earn the necessary money from
employment… 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 analysis
throughout 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 and
unproductive. Only credit that finances new plant and equipment is productive credit. It adds to the
existing capital stock that, in turn, earns future debt service. In other words, it is self-amortizing and
self-financing debt.
By the same logic, the exponential rise of U.S. corporate indebtedness during the past several
years implicitly suggests its overwhelming use for unproductive purposes. Of these, two are
particularly well known: the acquisition binge and share buybacks…
Credit excesses: Under current monetary arrangements, central banks and commercial banks can create money
out of thin air, and nonbank financial intermediaries can create liquid assets and pyramid credit on the basis of the
resulting money stock. Rapid credit growth can easily fuel economic distortions. Dr. Richebächer commented in his
February 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 of
their later bust, and second, the length and severity of the following “adjustment crisis” depend
largely on the magnitude of the prior credit excesses and the associated imbalances that they have
created in the economy and the financial system.
Following the Austrian School, Dr. Richebächer believed it was essential to recognize where credit entered the
economy in order to determine the nature of the resulting distortions in both the structure of demand as well as the
structure of productive capacity. Writing in the August 2001 letter, he noted:

The Richebächer Letter, December 2010

8

The structural distortions arise from the fact that the credit excesses do not spread evenly across
the whole economy. They always concentrate on certain areas — real estate, business investments in
plant 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 and
equipment. 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. The
resulting distortions in the composition of demand implicitly evoke corresponding dislocations in the
economy’s output and investment structure. In order to meet the credit-drive surge in demand, those
sectors in the economy that largely attract the inflated demand for their products tend to step up their
investment 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 prospects
under 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 in
investor portfolio preferences favors a particular asset class, the spot prices of that asset will rise, and all the holders
of 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 prospective
borrowers control, credit excesses often have a symbiotic relationship with asset bubbles. Each can enable the other
in 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 prices
inherently provide ever more collateral value for more and more borrowing… If monetary policy
accommodates 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 and
land prices simply devastated the collateral to these loans, leaving behind corporations and banks
with appallingly overextended balance sheets.
Financial versus real wealth: Contemporary economists frequently confuse the monetary value of financial
claims on tangible assets, and the productive capacity of the underlying plant and equipment. This is actually an old
dispute going back to Adam Smith, who recognized the wealth of nations has more to do with their capacity to
produce 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 key
source and the benchmark of a nation’s prosperity. It generates growth and wealth through four
different effects: first of all, producing the capital goods creates jobs and incomes; second, the
finished capital goods add to productive capacity; third, the new machinery tends to improve
productivity; 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 the
economy. 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 other
words, reduce its expenditures relative to its income), this can be achieved only if the remaining sectors of the

The Richebächer Letter, December 2010

 9

economy are willing to increase their deficit spending. Absent this — which is nothing but double-entry
bookkeeping — 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 2000
about the Japanese situation:
[T]he personal and business sectors together spend that much less than their total, current
revenues. Instead, they are repaying debts and accumulating financial assets. As a result, private
demand for goods and services keeps contracting. In order to fill the big, chronic demand gap
arising 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 from
the domestic private sector. In order for the private sector to net save — which it frequently attempts to do most
dramatically after an asset bubble has burst — fiscal balances must decrease, trade balances must increase or some
combination of the two is required if falling nominal incomes are to be avoided. Yet few recognize just how these
sector 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 Research
Institute, regarding the unique signature of balance sheet recessions. Koo pieced together the clues from his analysis
of the lost decades since the Japanese asset bubble burst in 1989. Balance sheet recessions, as mentioned in the
opening quote, tend to present more challenges than the conventional inventory-led recessions that characterized
much of the post-World War II period. Dr. Richebächer was early in identifying this distinction — probably well
before 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 sharp
and 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 different
from all prior recession in two ways: first, the boom-related excesses had their brunt not in inventory
excesses, but in huge malinvestments in commercial real estate; and second, it was not tight money
imposed by the Fed that caused the credit crunch, but soaring bad loans that paralyzed the banking
system and the financial markets.
It is the long-tailed quality of balance sheet recessions (as both balance sheet and real capital stock overshoots
must be worked off) that can unfortunately drive policymakers into what amounts to an addiction to serial or
sequential asset bubbles. They see no other way to return economic growth closer to its long-term average in a timely
fashion. In this sense, Dr. Richebächer identified a slippery slope that policymakers enter once they tolerate or
promote an asset bubble that lasts long enough to distort the allocation of productive capital and allow the build up
of debt on business and household balance sheets.
Shareholder driven capitalism: While Dr. Richebächer had great respect for the ability of markets to guide
resource allocation, during his time, he witnessed the transformation of incentive structures for both managers and
investors toward short-term profitability, and he witnessed the corruption of profit and earnings per share
measurement. As described above, his macro view of profits suggested cost cutting and merger activity were no
replacement for net investment in tangible productive capital in securing long-term profit growth. He highlighted this
in the August 2001 letter when he noted,
The one big structural profit depressant is Corporate America’s preference for acquisitions and
mergers at the expense of net investments... Chasing fast profits in this way, Corporate America
undermines its long-term profits. The main source of macro profits… is investment spending in excess
of 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:

The Richebächer Letter, December 2010

10

It’s late, degenerate capitalism in the sense that saving and capital accumulation, the key features
of a capitalist economy, have fallen into complete oblivion… the corporate strategies that result…
impart increasingly long-term macroeconomic consequences to economic growth…What really
happens is rampant over-consumption at the expense of future generations who are to inherit depleted
domestic 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 of
corporate earnings became a frequent sport of managers and the equity analysts on Wall Street who covered their
companies. Institutional investors facing short-term performance pressures increasingly relied on the game of beat
the 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 August
2001 letter,
The main task of today’s American manager is no longer efficient production but efficient
ballyhoo that boosts the company’s share price. The systematic deception was plain to very many
people, 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, he
saw the profession he devoted his life to become more and more of a marketing racket for Wall Street. Back in
December 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 public
opinion are the investment banking economists… The chief qualification of these so-called
economists is not their analytical acumen, but their ability to bring business to their employer with
buy recommendations for stocks and bonds. Besides, the analyst who dares to depart from the bullish
consensus 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 economists
who warned were ridiculed.
These are but a sliver of the perspectives Dr. Richebächer’s unique analysis provided over the course of several
decades of research and analysis. We have found them indispensable over the years in guiding our own attempts to
make sense of an increasingly complex and confused macro and financial market environment. We offer this brief
summary 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 he
implements 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 a
different, revised macroeconomics being practiced by his colleagues. In the middle of November, Princeton’s Paul
Krugman released a paper co-authored with a fellow economist at the N.Y. Fed entitled “Debt, Deleveraging, and the
Liquidity Trap: A Fisher-Minsky-Koo Approach.” You may recognize some of these names — we have drawn on each
of 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 surprise
that we find Paul Krugman and his N.Y. Fed co-author ready and willing to recognize in the opening passages of their
paper 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 now
afflicting both the United States and Europe, the word is surely “debt”… there was a rapid increase in
household debt in a number of countries in the years leading up to the 2008 crisis; this debt, it’s widely

The Richebächer Letter, December 2010

 11

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 in
which falling prices increased the real debt burden, which led in turn to further deflation. The late
Hyman Minsky (1986), whose work is back in vogue thanks to recent events, argued for a recurring
cycle of instability, in which calm periods for the economy lead to complacency about debt and
hence 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 caused
by 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 difficulties
and the long tradition of invoking debt as a key factor in major economic contractions, one might
have expected debt to be at the heart of most mainstream macroeconomic models — especially the
analysis of monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite common
to abstract altogether from this feature of the economy.
Actually, we are not surprised at all by this glaring omission of credit from mainstream macroeconomics. While
it is in the nature of all models to abstract from the details and complexities of reality, mainstream economics has
often made an art form out of omitting salient elements like debt. All too often, its preference is to impose simplifying
assumptions that leave its models in a world that barely resembles the one we actually inhabit. Perhaps by the time
Chairman Bernanke returns to Princeton, enough of an investigation of the history of work done in this area of
macrofinancial dynamics will have been completed that Dr. Richebächer’s contributions will be held up alongside
those 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 reverse
recessions is the deeper issue of rising global competition and global imbalances. As Dr. Richebächer correctly
identified, 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, the
development of financial engineering and increasing global competition, this normal engine of growth has been
dampened, 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 great
challenges of the years ahead. It has become increasingly clear that current international monetary arrangements have
reached the end of the line in this regard. Any sensible replacement will need to address the issues Dr. Richebächer
identified early on, asset bubbles, credit excesses and reinvestment of profits in tangible productive capital, if more
sustainable 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 the
tumultuous 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 to
macrostratedge@yahoo.com.
We wish you the best of luck in preserving and growing your wealth in the days ahead, hopefully with some of
Dr. Richebächer’s unique insights and vantage points close at hand.

PORTFOLIO OVERVIEW
By Rich Lee
Here is a final look at our open recommendations and some guidance for the months ahead.

The Richebächer Letter, December 2010

12

With Ireland accepting bailout assistance from both the greater European Union and the International Monetary
Fund, Spain and Portugal will be the next focus. The ongoing crisis will likely mean further downside in the iShares
MSCI Europe Financials ETF (EUFN). It is priced at the top of its 52-week range — not too far from where we
initiated the short position back in May. Although the investment has the potential to reach $18 in the next few
months, 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’s
slightly 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) and
UltraShort 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 only
the 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 continue
to rise at a slow and appreciable rate, KO may be nearing the end of its short-term rally. We believe the stock to be
fairly valued at around $67.
Finally, we come to our high-yield picks. Gains in International Bancshares Corp. (IBOC) shares have
outweighed the decline in shares of Nordic American Tanker Shipping Ltd. (NAT). Still, with the high-yield trend
set 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’t
anticipate that to change. Mergers and acquisitions will continue to be lackluster as long as the U.S. economy moves
along 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 stay
in touch with Rob by e-mailing macrostratedge@yahoo.com. On behalf of the entire Richebächer Society team, thank
you for your loyalty and support!]

THE RICHEBÄCHER LETTER

In Memory of Dr. Kurt Richebächer
Rob Parenteau, Editor Addison Wiggin, Executive Publisher
Richard 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 Box
960, Frederick, MD 21705. Customer Service: 800-708-1020 or 410-454-0499; e-mail: customerservice@agorafinancial.com.
Copyright 2010 by Agora Financial LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This newsletter may
only be used pursuant to the subscription agreement, and any reproduction, copying or redistribution (electronic or otherwise, including on the World Wide Web),
in whole or in part, is strictly prohibited without the express written permission of Agora Financial LLC, 808 Saint Paul Street, Baltimore, MD 21202-2406.
The publisher expressly forbids its writers or consultants from having a financial interest in any security recommended to its readers. Furthermore, all other
Agora Financial LLC (and its affiliate companies’) employees and agents must wait 24 hours prior to following an initial recommendation published on the Internet, or 72 hours after a printed
publication is mailed.
The information contained herein has been obtained from sources believed to be reliable. While carefully screened, the accuracy of this information cannot be guaranteed. Signed
articles 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 review
investment prospectuses, when available, and should consult investment counsel before investing.

The Richebächer Letter, December 2010