Best of DOUG NOLAND

Starbucks, the "Core," and Conventional Mortgages:

This week’s announcement that Starbucks plans to close 600 stores and fire 12,000 employees is emblematic of the major restructuring that lies ahead for the deeply maladjusted U.S. Bubble Economy. Throughout the real economy, businesses that had previously luxuriated in robust profits during the Credit and asset inflation-induced boom now see earnings and cash-flows rapidly erode. During the boom, Starbucks aggressively spent on capital expenditures, while expanding its employee base, product offerings, and real estate commitments. "Money" was easy, revenues were easy, and growth was easy.

For the economy overall, the enormous expansion of mortgage (and other) Credit poured spending power throughout, especially in the "services" sectors. This purchasing power was "multiplied" by additional borrowings by the likes of Starbucks and others, as well as by the real estate developers borrowing, building and leasing space to tens of thousands of coffee shops, retailers, restaurants, hotels, casinos, nail salons, health clubs and such. It amounted to a historic borrowing and "investment" boom in building out a massive consumption/services-based infrastructure. Now, with the Credit Bubble having burst, the economic viability of broad swaths of this economic structure is in question.

Years of Credit, asset price, and consumption-based investment inflation created a deeply ill-structured real economy. Simplistically, the U.S. Bubble economy was structured for a particular variety of inflation. As long as Wall Street could inflate mortgage and other asset-based Credit, along with real estate and stock prices, additional purchasing power would be created and distributed for spending throughout the economy. Sufficient business and government cash flows ensured adequate household income growth to go along with booming – and self-reinforcing - asset price gains. As such, Household Net Worth (asset values less liabilities) swelled by about $4.0 TN annually for the finale Bubble years 2003-2006.

And as the "world’s reserve currency," our Credit system was able to generate endless new (and mostly top-rated) financial claims that so easily financed our import buying binge. Meanwhile, with business profits generated with such ease in the booming finance, consumption and asset sectors of our economy, the U.S. and global Credit booms worked deleteriously to hollow out our nation’s manufacturing base. But what difference did it really make if the economy’s "output" were goods or services?

For years, we’ve protested this combination of over-investment in consumption-based infrastructure and the hollowing of manufacturing capacity. And for the longest time, most have scoffed at our analysis and pointed to the rising stock market and generally inflating asset prices as indicators of the efficiency, productivity, and profitability of the so-called New Economy. We warned of the eventual perils of over-borrowing and the lack of household savings, while Alan Greenspan and others argued that it didn’t matter because we had become so efficient at investing our limited savings. Besides, the world would always seek the superior quality and liquidity of our securities markets.

Yet the optimists failed to recognize that only massive – and increasing – amounts of system Credit would sustain the inflated boom-time asset prices, household incomes, corporate cash flows, and government receipts that had become essential for levitating the various facets of the Bubble Economy. The deteriorating quality associated with the massive inflation of our financial claims should have been obvious. And today - as symbolized by Starbucks - the required Credit stimulus is no longer forthcoming, leaving scores of enterprises throughout the economy attempting desperate measures to cut expenses and maintain viability.

The finance, automotive and airline industries are also notable for having come to rely on a very different inflationary environment than the one we face these days. And today’s unfolding retrenchment will place only further downward pressure on business profits, household incomes, asset prices, and government receipts - forcing additional spending restraint and deeper retrenchment. At the same time, this self-reinforcing retrenchment will create only greater financial strain on an already impaired Credit apparatus, ensuring even greater Credit troubles and tighter Financial Conditions, especially for the business sector.

And to attempt a response to the above question: What difference did it really make that our economy’s "output" was services rather than goods? It made a huge difference. At the end of the day – at the conclusion of the Credit boom - a finance and consumption-based economy is left with enormous financial claims backed by woefully inadequate wealth creating assets. During the boom, Starbucks could earn seemingly endless profits by selling $4 lattes. The stock price went to the moon; financial wealth was abounding. Now, with discretionary spending being sharply reduced by the confluence of sinking asset prices, tightened Credit, and inflating energy and food prices, the enterprise value of Starbucks and scores of other businesses has been greatly diminished. Worse yet, for the economy overall, there is little in the way of real economic value remaining for billions of "output" Starbucks and other services providers created over the long boom. Only the financial obligations (the original asset-based borrowings) remain, while the market is increasingly suspect of their true state of underlying quality and value.

And the harsh reality is that Starbucks is a microcosm of scores of enterprises that have come to comprise the Core of the U.S. Bubble economy. The economic viability of so many businesses – and even industries – will be in jeopardy in the unfolding Credit and financial landscape. The stock market is still in the early stage of discounting the unfolding Credit and economic bust. And I’ll reiterate that we expect the unfolding economic adjustment to be of such a magnitude as to be classified as an economic depression as opposed to a more typical recession.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.