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May 27, 2008

The Fed's Medicine Is Toxic
by Richard Benson

In medicine, good ethics go as far back as ancient Greek culture. Part of the Hippocratic Oath translates to say..........."I will prescribe regimens for the good of my patients according to my ability and judgment, and never do harm to anyone". Any good Doctor knows that a well-intended medical procedure can go wrong and unpredictably cause more harm than good to a patient, and that the side effects from medications can unintentionally make them even sicker and weaker.

In economics or central banking no one is ever asked to take such an oath, so when the Federal Reserve uses the only tools they have available to stimulate the economy and increase economic growth - lowering interest rates and generating easy money - they currently are administering a deadly procedure and prescribing toxic medicines to cure an ailing economy that is really hurting. Here's what I mean.

At the end of the 1990s, the easy money prescription drug worked so well for the previous Fed chairman, he never really tightened interest rates. In 2000, we experienced a wonderful stock market bubble and investors around the globe cheered. But when the NASDAQ bubble crashed, Alan Greenspan cut interest rates and called out for even more easy money, causing the housing market to boom and, ultimately, bubble. (To this day, Easy Al has yet to admit there was a bubble). Anyway, the Fed's moves had mass appeal to homeowners back then who took advantage of the situation by borrowing against their houses to live beyond their means. The economy absolutely roared ahead as real estate prices escalated to the moon.

Let's fast forward to 2008. The housing bubble has collapsed and Dr. Ben has been forced to cut a deep incision into interest rates, and goose the money supply to keep the ailing economy rolling. Today, real interest rates are actually negative (the Fed Funds rate less the rate of inflation). Moreover, if the Fed still reported the broad money supply measure, M3, the growth rate would look like 15 percent. Now we have too many dollars chasing too few goods. What happened? The US Treasury and the Federal Reserve were counting on a weak dollar to boost exports and the economy, but the policy blew up in their face. The dollar has collapsed and oil, grain, food prices, and many metal prices, have doubled.

With a weak dollar, inflation is now imported from everywhere. The Gulf Arabs like Saudi Arabia have figured out that oil in the ground is far more valuable than an investment in US Treasury paper yielding two percent. (If the US wants oil, the Saudi's make us pay through the nose!). Also, with China's rising Yuan and higher labor and material costs, the American consumer can expect to pay more at Wal-Mart now and over Christmas for things like toys, shoes or pants. The easy money policies created by the Fed will not cure our economic woes because the reduced purchasing power of money dwarfs any economic benefit derived from increased exports.

Also, most world central banks decided to play "follow the leader" with the Fed and cranked up their money supplies. In Russia, China, Venezuela, and the Gulf Oil countries (to name a few), double-digit inflation is common. Inflating food prices mean famine stalks the land of less developed countries, while the middle class in more developed countries are learning what it feels like to be poor.

Inflation means that people are buying less goods and services. Many can no longer afford even the basics without maxing out their credit cards. The Fed has yet to realize that the inflation they have created is robbing an unprecedented amount of purchasing power from the average consumer. The rising cost of living is so bad that it is taxing Americans about three times the equivalent of the $100 billion tax rebates that were supposed to save America!

Government-induced inflation comes with a horrible price as it erodes savings and salaries. It makes us feel poor because even if our wages have gone up, we can only afford to buy less. Businesses are discovering that the poor and unemployed make lousy customers because they don't spend enough. Lower real spending cuts into corporate profits and many businesses are starting to fail. Worse yet, the solvency of entire industries, including the airlines, automakers, retail stores and restaurant chains is on the line. We are saddened each time we read about yet another company that has been around for over 50 years, that is closing its doors forever.

Meanwhile, it's ironic to see the Congress blaming inflation on the speculators. With interest rates well below the rate of inflation, the Fed is paying commodity speculators to buy things that will go up in price with subsidized borrowed money! With low interest rates, a depreciating currency, and rapid money growth, inflation is not a surprise, it's a guarantee! Indeed, many people aren't speculating but are acting rationally by getting out of a depreciating currency, rather than being robbed by their government.

If you own gold and silver, fear not. The Fed is years away from ever admitting a mistake, like printing too much money. Moreover, this is America. Congress will never call out for tight money. As long as the Chairman of the Fed still believes in the economic tooth fairy, rising inflation is guaranteed.

Unfortunately, the outlook looks grim. Inflation causes stagnation as people can afford to buy less and less. At the same time, a weak economy only encourages the Fed to print more money that will continue to rob me of my savings, and generate even more inflation. Bernanke may have been educated at Princeton but from what we have seen, he still knows very little. And in turn, this means we all get to learn firsthand what stagflation is all about.

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2009 Richard Benson

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