Mixed Earnings Point to a Mystery Economy

On Monday we got news from Caterpillar that strong demand for its mining and construction equipment led the company to take a more optimistic outlook about the rest of 2011 and 2012.

Then, today, another giant American company — 3M — filed disappointing results and slashed its outlook for the rest of the year.

So one company sees expansion, the other sees contraction.

It's confusing for investors. It's confusing for smaller businesses that often take their cues from the corporate titans. Are we headed into a new global slump or have we avoided one?

I'm calling it The Mystery Economy.

Now, it is possible I'm reading too much into individual company earnings and forecast. The divergent earnings and outlooks might not tell us any story at all about the broader economy. They could simply be the story of individual company performance.

But these divergent earnings make me nervous. In particular, they track what we might expect from a credit expansion bubble leading to "malinvestment."

According to the economic school known as Austrian Economics, when central bankers keep interest rates too low, businesses are fooled into expecting a higher level of future prosperity. They misread the low interest rates as a sign of higher savings, which means that consumers will have more to spend in the future. In response, they invest in longer-term projects: buying machinery, digging mines, building factories.

To put it slightly differently, credit expansion does not just lead to economic expansion. It leads to a warping of the entire capital structure, with more money pouring into "higher order" goods — those more remote from consumers. These projects require a robust demand growth in the future. When that demand growth doesn't show up — because the savings that were to fund it never existed — much of the expansion turns sour and the investments have to be liquidated (or bailed out by the government).

Caterpillar manufactures mining and construction equipment. It is in every sense a "higher order goods" company. If people are genuinely saving and enabling robust future consumption, Caterpillar should do well. But it also will do well if businesses are mistakenly expanding because of the availability of cheap credit.

By contrast, 3M is much closer to the consumer. Its performance is most likely far more closely aligned to actual consumer spending than Caterpillar. Far fewer purchases of 3M products benefit from a credit expansion.

In short, I'm worried the solution to The Mystery Economy is that this is a credit-driven Bubble Expansion Economy.

We do not need another round of capital misallocation driven by aggressive monetary policy.

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