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The Fed Is Culpable, Part II
The Daily Reckoning
Paris, France
Friday, 15 November 2002
-------------------
*** Nothing but good news...spending up...stocks up...
spirits rising...
*** Positive omens: the Presidential cycle and years
ending in '2'...
*** 'The Great Deflation Debate', revisited...'The River
Of No Returns' keeps on rolling...The travesty of hideous
architecture, encore...and more...
-------------------
Nothing but good news yesterday.
Consumers spent more freely in October than most
economists expected, and much more freely than we
expected.
Unemployment went down in the most recent period.
Alan Greenspan opined that Congress should give Americans
a permanent tax cut - adding fiscal stimulus to his rate
cuts.
Intel says it is buying more of its own shares. The
company is spending $1 billion per quarter helping to
drive up its stock price.
"LA Housing Still Hot," says the L.A. TIMES. Bonds went
down. Thrift, which we thought we saw setting in
recently, seems to have been delayed.
Investors were encouraged. They've heard that stocks hit
a low every 20 years - in 1942, 1962, 1982, for example.
Now, let's see, the next low should be...2002! And it's
almost over. There's also the Presidential Cycle, that
says stocks bounce after the mid-term elections. And
there's the old Wall Street saying: 'Sell in May and go
away'. Stocks always do better in the winter months, they
believe.
And here we are near the end of 2002, after the mid-term
elections, with winter approaching...and nothing but good
news. Can you blame investors for getting a little giddy?
Who knows? This market was ready for a major bear market
rally. If anyone knows how far it will go, he isn't in
the Daily Reckoning office this morning.
Greenspan noted that the economy was improving. But bear
markets teach humility, and even the Fed chief seems to
be learning.
"There is a probability, small as it may be," he said,
perhaps underestimating, "that we may be wrong."
Eric, your update from New York, please...
---------
Eric Fry, back at home in the Big Apple...
- Wow, that Mr. Consumer is a cagey critter! He's been
"playing dead" so convincingly that the financial press
has published his obituary several times.
- Then...suddenly...comes a tapping sound from inside the
casket?...He's alive! Mr. Consumer isn't dead after
all!...
- Retail sales rose 0.7% last month, according to the
Commerce Department. This itty-bitty number doesn't seem
like much of a reason to get too excited, but 0.7% was
more than double the gain forecast by all those nameless
"economists." As such, the retail sales report heralded
the resurrection of the U.S. consumer - perennial savior
of the American economy.
- Investors ecstatically rushed into the stock market to
snap up their favorite symbols. The Dow advanced 144
points to 8,542 and the Nasdaq jumped nearly 4% to 1,411.
The U.S. dollar also celebrated this spontaneous "Fˆte du
Consumer" by gaining about half a percent against the
euro to 100.4 cents per euro.
- However, as is often the case, one market's pleasure is
another market's pain. And yesterday, the bond market
suffered pain aplenty. The prospect of a revitalized
consumer, and therefore, a resurgent economy, blindsided
bond investors. The 10-year Treasury note took a beating,
as its yield soared from 3.83% to 4.02%.
- Until yesterday, talk of deflation had been all the
rage on CNBC, which was reason enough to start preparing
for the next great inflation. But CNBC's near-perfect
record as a contrary indicator is not the only reason to
suspect that the prices of goods and services may start
rising, rather than falling.
- To be sure, prices for some products are falling. And
it's also true that personal bankruptcies are rising,
corporate bond defaults are soaring and Treasury bond
yields are close to 40-year lows. But these deflationary
symptoms should not be confused with the real McCoy -
deflation itself.
- The 4% 10-year Treasury yield, for example, does not
necessarily signal a coming deflation. It may simply
"signal" that lots of investors prefer a certain 4%
return on their money to the risk of losing 20% to 30% of
it in the stock market. At the moment, the most
persuasive signals emanating from the financial markets
seem to be pointing to the 'in' kind of 'flation' rather
than the 'de' kind. Specifically: the dollar has been
slumping for almost a year, while gold has been climbing.
- As I stated in the "Great Deflation Debate" between
Bill and Myself in New Orleans, "Deflation is a bad bet.
We may not see runaway inflation, but deflation is a bad
bet." (Bill disagreed, but I'll let him speak for
himself.) Therefore, positioning for higher long-term
interest rates is probably a good bet, especially with
the money supply expanding as briskly as it is.
- M3, the so-called broad money supply, jumped $32.6
billion last week - its biggest weekly increase since
August. And over the past six months, M3 has swelled at
an annualized rate of 7.8%. Bank credit is also soaring.
"Total bank assets have surged $493 billion over the past
28 weeks to almost $6.9 trillion, an annualized growth
rate of 15.6%," observes the Prudent Bear's Doug Noland.
"ABS (asset-backed security) issuance continues to be
eye-opening as well...Home equity issuance of $122
billion is up 73% from last year's record level...
Consumer Credit expanded by $10 billion during September,
a 6.9% annualized rate. Revolving Credit expanded at a
9.3% annualized rate during the month and 9.5% for the
quarter."
- What do all these big numbers mean? Namely, that the
supply of credit is booming. Normally, that is an
inflationary augury. In other words, America in 2002 is
not like the Japan of the 1990s...at least not yet. (If
Bill's theory is correct - that U.S. economic trends are
trailing about 10 years behind those of the Japanese -
it'll be about seven more years before we wake up one
morning with an uncontrollable urge to save money, eat
sushi and ride on a jam-packed commuter train.)
- For now, Americans are still borrowing money - lots of
money - just like they've always done. And they're
spending this borrowed money, just like they've always
done. Sure, U.S. corporations are reigning in their
borrowing a bit, but that's not true of either the U.S.
consumer or of Uncle Sam himself.
- For evidence that money-borrowing is still in a bull
market, take a peek at the latest self-congratulatory
report from Countrywide Credit: "The mortgage loan
pipeline reached a new milestone of $52 billion, an
increase of 86 percent over last year. October fundings
surpassed all previous company records reaching $34.7
billion, exceeding last month's funding high of $25.3
billion by an impressive 37%."
- Here's a few more eye-popping highlights from the
report: Total fundings jumped 134% year-over-year, with
purchase fundings up 84% to $9.4 billion and non-purchase
(refi) fundings surging 159%. Can you say, "mortgage-
finance bubble?"...How about, "Inflation is coming." Can
you say that?
---------
Back in Paris...
*** No sooner had your editor gotten back to his office
in Paris than his colleagues started reinforcing
suspicions we've had about efficiency in the information
age...
"We ordered those books weeks ago," said Philippa. "And
they still haven't come. I thought Amazon was supposed to
have such good customer service..."
The big River of No Returns just keeps rolling along...
In fact, the stock has been one of the year's best
performers, up 75% this year, while the Nasdaq lost 33%.
Is Amazon a buy?
The company reported a pro-forma loss of 2 cents a share
in the first 9 months of the year. But had it used more
conservative accounting, writes Andrew Bary in Barron's,
it would have lost 40 cents.
One of the internet's biggest success stories, Amazon.com
is still a remarkably bad business with a remarkably
over-priced stock. It has operating margins of only 4%
and its shares trade at 80 times next year's estimated
earnings, 800% greater than competitors Barnes & Noble
and nearly twice as high as other internet success
stories, such as Expedia and eBay.
"Amazon trades in a world of its own," Bary concludes.
*** Lower interest rates are supposed to spur spending by
consumers. But in "The Dark Side of Low Rates", MONEY
magazine reports that consumers receive more interest
than they pay. Last year, households - particularly those
of older Americans who have paid off their mortgages -
received $1.1 trillion in interest, against only $600
billion in interest expense.
Lower rates help debtors, not creditors.
"The low interest rate environment has also encouraged
lots of credit risk borrowers to come out of the woodwork
looking for loans," says MONEY.
They found the money. But now they are having a hard time
paying it back. Bankruptcies are at a 40-year high.
*** Americans are supposed to have the highest standard
of living in the world. But, after a trip that took your
editor to Baltimore, West Virginia and New Orleans, he is
not so sure.
The standard of living is usually computed by dividing
national GDP per person. But GDP only measures financial
activity, not real wealth, Doug Casey explained in New
Orleans. A nation of spenders will have a higher GDP than
a nation of savers. A nation in which people eat at
McDonalds rather than cook for themselves at home will
also have a higher GDP. So will a nation in which people
pay illegal immigrants to cut their lawns, rather than
taking care of them themselves. But the lawns won't be
any better kept, nor the food more appealing, nor the
balance statements any more attractive.
When it comes to getting and spending, no group does more
of it than Americans. But money isn't everything, we
remind ourselves. For all their furious financial
activity, the quality of life in America is uneven at
best. At worst, it is pathetic.
Reducing quality to its essentials, what matters is what
you see, what you eat, what you live in, and the comfort,
elegance, and security of everyday life.
Arriving in New Orleans, a passenger takes his place in a
disorderly mob to get a taxi. The cab is usually a
clunker of a car which takes you through the small, squat
houses of the suburbs, dilapidated commercial areas and
then into downtown. Traveling along St. Charles avenue or
the Esplanade, a visitor finds many graceful trees and
respectable houses. But no sooner have his spirits lifted
than a boarded-up house, abandoned lot, or a Popeye's
outlet comes along...and he is right back where he began.
We do not fault the convenience or efficiency levels in
U.S. cities. Almost anywhere you go, you can buy a
handgun or a pizza at almost any hour of the day. It is
the architecture that bothers us most. Whether you are in
the backwoods of West Virginia or the streets of New
Orleans, the defect is right in front of you, like an
open can of Draino on the breakfast table. It is
especially annoying in New Orleans - not because the
architecture is worse, but because it is better. The old
houses, with their high ceilings, classical proportions,
columns and shutters are an abiding reproach.
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-----------------------
The Daily Reckoning PRESENTS: Any administration,
suggests Dr. Hans Sennholz, that walks in the footsteps
of Presidents Hoover and Roosevelt - who practically
closed the national borders to trade and commerce,
doubled the tax burden, and imposed numerous business
regulations and restrictions - undoubtedly will create
another "great depression."
THE FED IS CULPABLE, Part II
by Hans Sennholz
The American money and credit system now resembles an
inverted pyramid that rests on legal-tender Federal
Reserve notes and credit. These support various forms of
bank money, such as commercial bank deposits, savings
accounts, large-time deposits, and other liquid assets.
The base of some $672 billion may expand rather
moderately, presently at some 6% a year, or by $40
billion; the layered superstructure of $8.333 trillion in
bank money (M3) may grow at a similar rate, or by $529
billion.
Commercial banks tend to 'securitize' their loans,
converting them into marketable securities for sale to
investors, which enables them to grant new loans in a
continuing process of lending, securitizing, selling, and
lending again.
Massive non-bank credit constitutes the upper layers of
the money pyramid. There are Federal Home Loan Banks,
thrift institutions, life insurance companies, brokerage
firms, mutual funds and other credit grantors. Last but
not least, offshore banks in the Bahamas, the Cayman
Islands, Panama, Hong Kong, and Singapore, enjoying
favorable regulatory and tax treatment, constitute the
top layer of the multi-trillion dollar money pyramid. And
high above the American pyramid hovers the international
pyramid, which builds on the U.S. dollar standard.
The Chairman and his fellow governors are expected to
balance it all with their high-powered Federal-Reserve-
dollar base. They are expected not only to manage this
monstrous pyramid of fiat money and fiduciary credit, but
also to safeguard the stability of the American economy,
to maintain asset prices, protect the value of the
dollar, and avoid the business cycle. They are supposed
to manage a monstrous structure which politicians have
built for their own use and glory. That's too much to ask
of any mortal.
"Money will not manage itself": this is the very
rationale of Federal Reserve existence.
Its sponsors and managers usually refer to the days when
gold and silver coins were the principal media of
exchange. The supply of money, they assure us, depended
more on the discovery and exhaustion of gold and silver
mines than upon the needs of business. Moreover, many
abuses developed, such as debasing the coinage,
"clipping" and counterfeiting.
Unfortunately, the Fed sponsors and managers hate to
admit that the clipping of a few coins in ages past was a
negligible abuse when compared to the continuous
'clipping' of all forms of money today. Even in moments
of 'stability', all U.S. dollars in the form of cash or
deposits lose at least two to three percent every year.
They have lost some 95% since the Federal Reserve
introduced its dollar in 1914. They probably will lose
more in the coming years.
Fed sponsors and managers point to the recurrence of
business cycles prior to the inauguration of the Federal
Reserve System. They may turn to the crisis of 1873 and
the depression that followed, or to the crash of 1893 and
the aftermath, or the crisis of 1907 and the "creeping
depression" which lasted until the World War brought an
unprecedented boom. Unfortunately, Fed supporters hate to
recall the cyclical instability that has characterized
the economy ever since. We count at least eight boom-and-
bust cycles since 1914, in addition to the Great
Depression, which held the country in its grip from 1929
to the outbreak of World War II in 1939.
Surely, no one can contend that the Federal Reserve
System has brought economic stability or conquered the
trade cycle. On the contrary, its critics are convinced
that a politically conceived and administered money
monopoly, such as the Federal Reserve System, is the
worst of all money systems. It will breed business cycles
as long as it lives.
Stock market cycles are the most spectacular offspring of
central banking and credit creation. There are several
others, less sensational, such as the cycles in precious
metals and objects of art and collection. They affect
only small groups of affluent clientele, which usually
suffer in silence. The most ominous of all cycles, which
touches millions of people, is the boom-and-bust sequence
in real estate. Just as in equity markets, these bubbles
are clearly visible in their price-earnings ratios or
price-rental ratios greatly exceeding those of healthy
markets.
Abundant credit at bargain rates of interest causes
housing prices to soar, especially in growing
communities, which fosters not only feverish construction
activity but also enlarges the mountains of debt, even
consumer debt. Fannie Mae, the publicly owned and
government-sponsored Federal National Mortgage
Association, reports that soaring housing prices and
falling mortgage rates are allowing homeowners to
refinance $1.4 trillion of mortgages in 2002, up from
$1.1 trillion last year. In both years, homeowners are
estimated to take out some $100 billion in equity.
The real estate bubble is bound to burst as soon as the
distortions become visible to ever greater numbers of
participants. Commercial construction already has fallen
sharply in 2001 and 2002, with the steepest declines in
the industries most afflicted by the September 11
attacks, including hotels and office space. Government-
sponsored industries, such as public works and health-
care facilities, are likely to expand further.
Driven by the same forces of easy credit and falling
interest rates, all interest-bearing and discounted
government securities have developed fever bubbles. The
U.S. Treasury bubble, which few economists have as yet
discovered, is still growing under the impact of
avalanches of investors' money seeking shelter in
Treasury safety. Tired of losing any more money in
stocks, investors are piling into Treasury notes yielding
barely 4%. As the federal government will be forced to
raise hundreds of billions of dollars in the coming
months in order to cover its growing deficits, interest
rates are likely to rise. They are bound to increase
substantially when the current flood of new money and
credit finally aggravates the price inflation. When note
rates return to just five percent, the yield of two years
ago, the bubble will burst and the market value of all
notes and bonds will drop drastically.
The economic maladjustments are numerous and severe,
inflicting painful losses on ever more people. The number
of job cuts continues to rise, making unemployment a
potent economic and political problem. It is compounded
by chronic trade and current-account deficits, which are
causing many American jobs to move to Asia. The rising
rates of unemployment, together with the staggering
losses of income and wealth, cast doubt on the ability of
debt-laden American consumers to support the American
economy much further.
Some pessimists hold to the single notion that the length
of a readjustment is determined by the length of the
bubble preceding it. Because we experienced the longest
and most spectacular financial bubble in history, we are
condemned to suffer history's longest recession. Such
notions unfortunately spring from mechanical perceptions
of human action and reaction. It is the severity of the
maladjustment, not its duration, together with the
capacity of correction, not its length of time, that will
determine the kind and quality of readjustment.
An administration walking in the footsteps of Presidents
Hoover and Roosevelt - who practically closed the
national borders to trade and commerce, doubled the tax
burden, and imposed numerous business regulations and
restrictions - undoubtedly will create another 'great
depression.' An administration that lightens its burdens
and releases the energy of the people will facilitate a
speedy recovery.
A Federal Reserve Board which, obedient to public
opinion, keeps its interest rates far below market rates
and readily finances growing federal deficits will only
make matters worse. The popular reduction of its rates on
November 6, 2002 was just another popularity ploy, which
is bound to aggravate the maladjustment and delay the
recovery.
Sincerely,
Hans Sennholtz,
for The Daily Reckoning
Editor's note: Dr. Hans Sennholz is president emeritus of
The Foundation for Economic Education (FEE) in Irvington,
NY. His essays and articles have appeared in over thirty-
six major German journals and newspapers, and 500 more
that reach American audiences. Dr. Sennholz is also the
author of 17 books covering the Great Depression, Gold,
Central Banking and Monetary Policy. You can write to him
by sending an e-mail to this address: [EMAIL PROTECTED]
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