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The Consumer Bubble

Financial Sector Credit Market Borrowings
Total Credit Market Borrowings
Fannie Mae Assets
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The reality of a protracted earnings recession took its toll on U.S. stock prices. For the week, the Dow and S&P500 declined about 2%. The Morgan Stanley Cyclical index dropped 3% and the Transports declined 1%. Defensive issues outperformed, with the Utilities ending basically unchanged and the Morgan Stanley Consumer index slightly in the black. The broader market suffered, as the small cap Russell 2000 dropped 3% and the S&P400 Mid-Cap index declined 2%. With even industry heavyweights reporting disappointing earnings, the technology sector was battered. For the week, the NASDAQ100 and Morgan Stanley High Tech indices dropped 5%. The Semiconductors sank 8% and The Street.com Internet index was pounded for 10%. The NASDAQ Telecommunications index declined 6%. The Biotech sector also suffered a drubbing, sinking about 8%. Financial stocks were mixed, with the AMEX Securities Broker/Dealer index dropping 4%, while the S&P Bank index was largely unchanged. Despite bullion dropping $4.30, the HUI Gold index added about 1% for the week.

It was another unsettled week in the Credit market, with positive economy data, weak equity markets, and conflicting comments from Fed officials keeping participants on edge. For the week, 2-year Treasury yields jumped 14 basis points to 2.87%. Five-year yields increased seven basis points to 4.16% and 10-year yields added two basis points to 4.89%. Long-bond yields declined one basis point to 5.36%. The wild mortgage-back sector saw benchmark Fannie Mae yields jump 16 basis points, while agency futures implied yields rose three basis points. The spread on Fannie Mae's 5 3/8% 2001 note widened 2 to 68. The benchmark 10-year dollar swap spread widened 5 to 71, as negative sentiment led to wider spreads throughout the industrial sector. The dollar gained just under 1% this week as things went from very bad to worse in Argentina.

Jan. 18 Bloomberg - "Argentine banks are insolvent and face $54 billion of losses -- more than twice earlier estimates -- after the government devalued the peso and stopped most financial transactions, Moody's Investors Service said. 'We believe the Argentine financial system could be bankrupted in the very near term,' Jeanne Del Casino, a Moody's banking analyst, said in a report. To avert a collapse, President Eduardo Duhalde's government may have to take control of banks, boost their capital by turning all deposits into devalued pesos or long-term peso bonds and then try to sell them. In addition, the banks would have to default on all international dollar debts, Moody's said."

Today's University of Michigan confidence data was interesting, with the composite index adding a better than expected 5.4 points to 94.2 (highest reading in 12 months). Most noteworthy was the "economic outlook" component that jumped 9.4 points to 91.7, the highest reading since November 2000. Helped by lower crude oil prices, the November trade deficit was reported at a somewhat better than expected $27.9 billion. Yesterday, December housing starts were reported at an annualized rate of 1.57 million, down 3.4% from November but up 2.5% y-o-y. While there was an apparent aberrational 26.5% decline in multifamily starts during the month, single-family starts jumped 3.6% to the strongest pace since April. December housing completions have bounced 11% from November lows and are up 6% y-o-y. There were 1.6 million new housing starts during the year, up 2% from year-2000. For comparison, 1991 saw housing starts at 1.01 million (1990 and 1992 were about 1.2 million).

Jan. 16 MarketNews - "Standard & Poor's Wednesday revised its outlook on J.P. Morgan Chase & Co. and its units to negative from stable. The ratings on J.P. Morgan Chase, including the double-'A' long-term counterparty credit rating on JPMorganChase Bank, and the double-'A'-minus rating on the parent company, are affirmed. J.P. Morgan Chase's fourth-quarter loss is symptomatic of a series of negative developments that have affected the bank in the course of 2001, including: -- Private equity portfolio losses; -- Mounting credit problems, notably its large concentration of exposure to Enron Corp., and modest Argentine exposure; -- Continuing need to downsize after the merger with J.P. Morgan & Co. as revenue trends have proven disappointing; and -- Poor environment for the investment banking business."

Jan. 16 - "Moody's Lowers Ratings of Ford…Approximately $150 Billion of Debt Securities Affected. Moody's…lowered the credit ratings of Ford Motor Company and related entities. The rating actions included Ford Motor Company - senior debt to Baa1 from A3; Ford Motor Credit Company (FMCC) senior debt to A3 from A2, and commercial paper to Prime-2 from Prime-1; and Hertz Corporation - senior debt to Baa2 from Baa1. Hertz's Prime-2 commercial paper rating is confirmed at the current level. The rating outlook for all of the affected companies is negative. The downgrade of Ford's ratings reflects Moody's expectation that the time frame for re-establishing a competitive operating model in the U.S. and generating appropriate levels of earnings and cash flow will be protracted, despite the implementation of its revitalization plan."

Jan. 17 Bloomberg - "Ford Motor Co. plans to pay yields as high as junk-rated companies to sell $3 billion of convertible securities as investors demand higher returns because the second-largest automaker's credit has become riskier. The largest maker of pickup trucks, whose credit rating is three levels above junk, has indicated it will pay a dividend yield of between 7 percent and 7.5 percent on the 30-year securities. Those are similar terms to those recently paid by Xerox Corp. and Lucent Technologies Inc., both junk-rated companies."

From Standard&Poor's report, "Rating Transactions 2001: ABS Credit Ratings Endure the Test of the Recession: For U.S. asset-backed securities (ABS), 2001 was an eventful year with a mixed bag of achievements…annual downgrades of credit ratings proliferated to a record high and substantially outnumbered upgrades… Incidents of default, which have long been rare in ABS, became vividly visible… A little over 10 years ago, as the ABS market was first tested by an economic downturn, there were only 366 credit classes outstanding when the recession started. In contrast, by the beginning of 2001 ABS credit classes had expanded nearly 10 times to just under 3,600. During the 1990-1991 recession rating changes totaled only 37, with 35 downgrades and 2 upgrades. During 2001 rating changes amounted to 322, with 247 downgrades and 75 upgrades… In 2001, CDOs (collateralized debt obligations) experienced an unprecedented 53 downgrades… The credit performance of franchise loans was also the worst in their history with a series of 48 downgrades… For the first time in ABS history, (retail) credit cards experienced ten downgrades in a year, more than all downgrades recorded over the past 15 years… By the standards of ABS, one significant credit event in 2001 has been the significant increases in the incidences of default. A total of 18 defaults occurred among four different types of underlying assets: synthetic securities (six), franchise loans (nine), retail credit cards (two), manufactured housing loans (one). For comparison, during the 16-year period between 1985 and 2000, ABS only experienced 11 defaults."

Earnings season is in full swing, with the aggressive financial lenders posting some impressive headline numbers: "Fannie Mae Reports Record 2001 Financial Results; Operating EPS up 21.2%"; Capital One Financial's "Earnings Per Share Rise 30% Over Year Ago Period"; Household International's "Revenues Grow 18% for the Year" (EPS up 15%); AmeriCredit's "2nd Quarter Net Income up 66%"; "Metris Reports 46 Percent Increase in New Income";

"Fannie Mae's business volume - mortgages purchased for portfolio plus mortgage-backed security (MBS) issues acquired by other investors - totaled $615 billion in 2001, a 137 percent increase compared to 2000." Fannie enjoyed record business volume of $77 billion during December, up 25% from November. During the fourth quarter, Fannie Mae expanded total assets by $33 billion, or at a 17% annualized rate, while its total book of business (retained portfolio plus guaranteed mortgage-backed securities) jumped $60.5 billion, or a16% rate. For the year, total assets increased $124.7 (18%) billion to $800 billion. This was 25% above year-2000's record $100 billion asset expansion and three times 1997's $40.6 billion increase. Fannie has expanded assets by $396 billion over the last 15 quarters. During the past three quarters, Fannie Mae mortgage-backed securities held in the marketplace have increased by an unprecedented $133 billion, or at a 24% growth rate. Even during 1998's massive refi boom, outstanding mortgage-backs expanded at about a 10% annualized rate. Fannie Mae's total book of business surged by $250 billion (19%) during 2001 to $1.564 trillion, more than double the $112 billion increase during year-2000. Despite the explosion in assets and mortgage exposure, Fannie Mae has not made a positive provision to add to its reserve for credit losses since the third quarter of 1997. Fannie Mae ended 1997 with an allowance for losses of $803 million, and since that time the allowance has increased $3 million to $806 million. Fannie reported lower credit losses across the board for 2001, with a stated single-family delinquency rate of 0.47% during December.

The amazing Capital One Financial (COF) saw total managed assets surge $8 billion to $52.5 billion, an annualized growth rate of 72%. COF expanded its balance sheet by $4.7 billion, almost 80% annualized, to $28 billion. Total assets have now tripled since the beginning of 1999 (12 quarters). And while such extreme growth does continue to mask true underlying credit performance, it is certainly worth noting that net charge-offs surged during the quarter to $457 million, up $94 million (100% annualized growth rate) from the third quarter. COF added 10 million new accounts during the year to end with 43.8 million. Elsewhere, Household International reported a $5.2 billion increase in managed receivables during the quarter to $100.8 billion, a 22% annualized growth rate. Subprime lender Metris saw its managed credit card portfolio expand by $880 million to $11.9 billion, an annualized growth rate of 32%. The managed delinquency rate jumped 50 basis points during the quarter to 9.4% (although there was a change in policy that makes the comparison convoluted), while the charge-off rate jumped a troubling 110 basis points to 11%. This is one more subprime lender that could easily find itself in serious trouble.

We're going to agree with Alan Abelson's assessment that this year's Barron's Roundtable (1st installment) was the most interesting we've read in awhile. No small amount of Credit goes to our good friend Marc Faber, whose addition to the group was instrumental both for his great insight and provocative approach. "Job well done!" to Dr. Faber and "hat's off" to Barron's! This is also a good opportunity to praise Marc Faber's The Gloom, Boom & Doom Report. Especially considering the current extraordinary environment, his always-valuable monthly report has become invaluable.

This year's Roundtable was fascinating for the wide-ranging views. There was Abby Joseph Cohen's belief that "right now the economy is blessed with several things: We have the world's most productive workers, low inflation and flexible monetary policy. We also have an incredibly strong financial system;" to Felix Zulauf's view (which we share) that "the Fed keeps trying to cure the problem with the same medicine that caused the problem." Then there's the candid Marc Faber, "the American economy is a disaster waiting to happen." While a noted panelist held the exact opposite view, believing "we will see 3% - 4% GDP growth this year. The consumer is in great shape… For the past 20-odd years fixed payments - home mortgages, car loans and other obligations - have stood at 12% to 14% of income. They're 14% right now."

Is there analysis that reconciles or at least makes some sense of these widely divergent opinions from these leading market prognosticators? On one subject there is today little disagreement. From this panel to the economic community at large to Alan Greenspan, there is today about as close an analytical consensus as one will ever find that a great deal is now riding on the American Consumer. Yet when it comes to the true underlying position of the U.S. household sector views then diverge spectacularly. So, is the "consumer in great shape" or the consumer-based U.S. economy "a disaster waiting to happen"? First of all, we are not fans of using the ratio of debt payments to income as a measurement of consumer financial health. This line of reasoning is uncomfortably reminiscent of the habit for comparing technology P/E ratios to company growth rates during the NASDAQ Bubble. On the surface such "analysis" appears reasonable and becomes only more dangerous when it functions as a quite effective indicator during the boom years. But the consumer debt-to-income ratio, like the simplistic P/E-to-growth rate comparison, will bury the extrapolators at key inflection points.

The insurmountable dilemma with the technology boom was that it was a Bubble, with surging business and speculative returns inciting - in the context of general Credit and monetary excess - a flood of additional sector finance. There is just no easy way around Bubbles once they commence. Surging speculative flows stoked tech sector earnings growth, fostering even more extreme reinforcing flows and maladjustments. Similar self-feeding forces are today at work throughout the Consumer sector, a conspicuous fact that, like the tech Bubble at the time, goes conveniently ignored with the proclivity for concocting New Era justifications. The technology Bubble eventually developed to such a magnitude that even extreme speculative flows could not sustain profitability in a desperately overbuilt industry. Returns for marginal tech players began faltering in increasing numbers, marking the critical inflection point for the historic Bubble. Today, despite record levels of additional Consumer Credit, we see rising delinquencies and charge-offs, particularly with the marginal "subprime" lenders. This likely signals that a key inflection point for The Consumer Bubble is in the offing.

All the same, we cannot dismiss that consumer finance remains the hot ticket within the enormous lending and speculating spheres. With manufacturing and general corporate profitability and financial position in structural decline, the Consumer does wins by default. But it goes much beyond that. The powerful financial and speculating industries, having risen to incredible prominence during this boom, clearly have no intention of abandoning the party. And with 1.75% short-term borrowing costs, high-yielding consumer receivables are simply irresistible. Moreover, the scheme of contemporary "structured finance" is extraordinary in its capacity to transform endless (and increasingly) risky consumer loans into pristine top-rated securities. It then becomes a confluence of powerful and incessant forces that facilitates extreme ease in Consumer Credit availability, to which the borrower responds forcefully. We should definitely not understate the role of unrelenting speculative fervor for Consumer-related securities in explaining the resiliency of the U.S. housing market and household spending generally.

It is, furthermore, today critical to appreciate that surging Consumer sector borrowings have become THE major factor both underpinning the consumption-based U.S. economy and also fueling continued household sector income growth (and additional borrowing capacity!). Is this Bubble sustainable? In the short-term, sure, as long as interest rates remain low - and, better yet, declining (the Greenspan Fed will remain under extreme pressure to keep rates very low). This creates the appearance that the Consumer enjoys unending borrowing capacity, as additional debt is seemingly mitigated by rising incomes. But we see through this Bubble illusion. There is as well the increasingly pertinent issue of how festering debt problems are hidden in aggregation, with those taking on additional debt often not those enjoying strong income growth. But the overriding issue is the Bubble characteristics of the Consumer boom.

First of all, total mortgage debt (consumer and commercial) expanded during the third-quarter at a record $752 billion annualized rate (10%), with 2001 the fourth consecutive year of near double-digit lending growth. For comparison, late 1980's mortgage lending boom peaked with 1988's $321 billion (11%) increase. The early 1990's recession and real estate downturn then saw total mortgage lending growth dwindle to 1992's $114 billion (3%). With total mortgage debt surging $2.63 trillion, or 54% over the past five years, it is reasonable to expect that considerable excesses have developed that will need to be corrected. Over this same period, U.S. financial sector Credit market borrowings have jumped $4.5 trillion (97%) to $9.1 trillion. During the third-quarter, the financial sector borrowed at an annualized pace of $1.09 trillion (12%), compared to 1991's trough of $171 billion (7%). The excesses fueling the consumer Bubble are conspicuous on two fronts- the consumer and financial player. Indeed, there has been a volatile matrimony with consumer borrowing excesses having found his financing soul mate; the reckless profligate borrower and spender having wedded the ambitious leveraged speculator.

Let's not forget the dynamics of the technology Bubble, and particularly developments that led to speculative financial flows petering out and then reversing. We read a lot of wishful thinking that we can get through recession without the consumer pulling back. Such ponderings completely miss the point. The consumer has for years enjoyed the greatest period of borrowing and consumption extravagance in history. These excesses have only been matched by the degree of U.S. financial sector leveraging and speculation. As Barton Biggs so aptly stated, "the big bubble that still exits in the world is the U.S. consumer." There is one major unavoidable financial and economic adjustment in store that will be both painful and protracted. It will involve the Consumer and the financial sector.

Some analysts and officials remain confounded by the atypical character of the current downturn. Yet the resiliency of the consumer and housing sectors is easily explained. The critical (confounding?) anomaly is that the U.S. economy can experience an historic NASDAQ collapse and significant job losses with thus far minimal impact on the general Credit worthiness of U.S. Consumer sector. We will conjecture that in the past - as was the case during the early '90s downswing - bankers would have some time ago turned cautious, hence initiating a consumer lending and spending downturn. But as we recognize, contemporary finance has relegated the traditional banker to a spot on the bench. The securities markets are today's star Credit athletes. And not only are aggressive financial players not running for cover, they remain absolutely enamored with Consumer asset and mortgage-backed securities. In this regard, we are unquestionably in uncharted waters. It is as well critical to appreciate the momentous role of the government-sponsored enterprises, and structured finance generally. As the key financial intermediaries throughout this Bubble, they have on the one hand thus far buffered the marketplace from what otherwise would have been a quite problematic deterioration in Credit quality for consumer-related securities, and, on the other hand, they have become an even more aggressive lending mechanism in the face of deepening financial and economic uncertainty. Again, we are talking about a striking deviation from the historical norm. The bottom line remains that the U.S. financial sector maintains its capacity to fabricate basically unlimited Triple-A securities that to this point have been easily financed by a financial system creating demand for its own securities.

To listen to Fannie Mae's Franklin Raines, we can expect near double-digit mortgage debt growth to continue as far as the eye can see. It has, after all, worked wonders for "prosperity." And as we have stated previously, in this regard we take Mr. Raines at his word. Although the execution of this Master Plan does become immensely more difficult in a rising rate environment. A flurry of data supportive of a strengthening economy was, not surprisingly, being poorly received in the bond market prior to Greenspan's week ago comments: "But I would emphasize that we continue to face significant risks in the near term. Profits and investment remain weak and, as I noted, household spending is subject to restraint from the backup in interest rates, possible increases in unemployment, and from the effects of widespread equity asset price deflation over the past two years." For good reason, an eagerly attentive marketplace interpreted these comments as Greenspan signaling that he was prepared to indefinitely extend his policy of erring on the side of low rates and extreme accommodation - beautiful music to the sensitive ears of a fully positioned leveraged speculating community. In the meantime, there has been more positive economic news along with curiously less dovish musing from other Fed officials. We also have the specter of British and European central bankers warning of the possibility of moving away from overly accommodative policies as recovery takes hold.

So, is it possible that another year of record mortgage lending growth fuels continued real estate inflation, robust Consumer spending, and continued income growth? The short and inconclusive answer is "maybe," but even if they stretch this out it would not be positive news. I will again underscore pertinent analysis drawn from Harry E. Miller's Banking Theories in the United States Before 1860 (1927):

"In reasoning, on the basis of the quantity theory, that banks cannot lend more than they have received from depositors, the early writers passed incautiously from the way in which banks make loans to individuals to the way in which they provide a general circulating medium. They failed to give adequate attention to the mechanism through which media of payment are furnished. They assumed that the added media of payment brought into existence when the bank expands its loans are diffused throughout the channels of circulation, but virtually neglected the redistribution of purchasing power attending the process of diffusion.

In some measure, probably, the confusion may have been incidental to the fact that banking theory emerged out of the doctrines built upon government coins and government paper money. If a government finances its needs by the simple resort to the printing press, the added monetary units enter the general circulation and raise prices without a great and direct increase in the relative purchasing power of any particular individual. At least there is no such direct shifting of purchasing power as when banks add to the media of payment by lending. In this latter process, certain individuals receive claims upon the community's wealth which are added to the preexisting claims."

This wonderful analysis is along the lines of what we refer to as "monetary processes." Where is the additional purchasing power being created, and how is it being spent and who is gaining? Analysts today do not give deserved attention to the ramifications to both the economy and financial system for continued rampant mortgage and Consumer Credit excess as the dominant flow of purchasing power throughout the economy. Nor is there appreciation for the consequences from speculative finance playing such a prominent role in the Credit creation process. And as we highlighted in "Financial Arbitrage Capitalism," the proliferation of sophisticated leverage and speculative financial schemes - with an evolving emphasis on the financing of unproductive debt - could not be more destructive to the long-term soundness and vitality of the U.S. economy.

Without a doubt, incredible changes have been imparted on underlying economic and financial structures. Greenspan, Cohen and others would like us to believe that over the past decade "quantum leap" advancements in technologies and information processing have forged a paradigm shift to a highly efficient and productive New Economy. As committed skeptics to New Era notions and esoteric theories, we are not impressed. As monetary and Credit analysts we will first note that at the end of 1991 outstanding Credit market debt and U.S. equity market capitalization combined for approximately $14.4 trillion, or 245% of GDP. By the end of 2001's third quarter (even after NASDAQ's swoon), total outstanding debt and U.S. stocks (financial claims) had surged to almost $41 trillion, or 400% of GDP. Real estate and other asset values have surged as well, only adding to the multiple of real and financial asset values to economic "output". There is absolutely no doubt in our minds that this historic Credit and asset Bubble is at the heart of the "transformed" U.S. economy, not information or technological advancement. Perhaps one can label it "efficient," but it is nonetheless definitely a Bubble economy - no "ifs," "ands," or "buts." In this vein, I will underscore an interesting footnote from Dr. Miller's above-referenced analysis:

"With reference to our own thesis that a measure of involuntary saving on the part of the community is involved, through redistribution of purchasing power favoring producers at the expense of consumers, it is, of course, to be observed that such benefits accrue only when bank expansion is properly limited. Briefly, the productive capacity of a country is relatively inelastic, so that indiscreet expansion of bank loans tends to be absorbed to an increasing degree by higher prices rather than by enlarged production. Stimulus is then being given less to productive industry and trade than to unwholesome speculation. Furthermore, ill-advised bank expansion tends to bring about such abrupt gold movements, in consequence of rising prices, that sudden contraction, perhaps precipitating numerous business failures, becomes necessary. Whatever benefits resulted from the preceding expansion are then liable to be offset."

This analysis hits almost directly upon some key concepts that shed valuable light on today's highly unusual (and unappreciated) system dynamics. Dominant contemporary U.S. monetary flows - lending and speculative excess throughout Consumer-related securities markets - have, over time, necessitated redistribution of purchasing power favoring consumers and speculators at the expense of domestic producers. These are deleterious if not easily recognized monetary processes. Massive mortgage/Consumer lending excesses have fostered unprecedented over-consumption and resulting current account deficits, with consequent affects on underlying economic structures. We are now to the point where we have accumulated untenable foreign liabilities, largely holdings of U.S. Consumer-related securities. The priority of monetary and economic policy is now dictated by the necessity of sustaining dysfunctional speculative monetary flows. It has become a requirement of the Bubble to sustain an over-valued dollar at the expense of a globally uncompetitive manufacturing sector.

Dr. Miller also noted the "inelasticity of productive capacity", appreciating that an industrial-based economy has certain obvious limits as to the amount of additional output that can be achieved through money and Credit expansion. In such a circumstance, monetary excess can be expected to feed directly and conspicuously into rising prices (likely evoking a response from central bankers!). In this regard, the U.S. economy has truly experienced a paradigm shift that goes a long way toward explaining a list of anomalies that Dr. Greenspan, Ms. Cohen and others misinterpret as financial system "efficiency" and economic "productivity." The U.S. financial sector is indeed highly "elastic" for its ability to absorb (finance) the tremendous amount of borrowings necessary to sustain the U.S. Credit Bubble. As importantly, the structure of the service sector-based U.S. economy is highly "elastic" to financial excess like no other in history. With rising asset prices (real and financial) supplanting goods production as the economy's cornerstone, money and Credit excess manifest surreptitiously into income and "output" as measured in GDP. An example of this phenomenon is apparent with the rising share of "financial services" in GDP, with rapidly increasing income for a myriad of individuals working directly in the asset markets including investment bankers, stockbrokers, real estate agents, mortgage brokers, insurance agents, attorneys, consultants, and accountants. We have as well the related proliferation of inflated media property values, with huge gains in income for professional athletes, entertainers and the likes of Katie Couric, Larry King and Bill O'Reilly. And how about the "productivity" of the $700 million Boston Red Sox? But what are the true cash-flow characteristics of these underlying "businesses" beyond inflating franchise values? How vulnerable are the attendant financial structures to an interruption of what has been unrelenting monetary excess?

There is as well the enormous healthcare complex that enjoys an annual increase in its share of GDP. It is also worth noting that during the third quarter almost 60% of personal consumption expenditures were for "services." An "elastic" service and consumption-based economy (importing massive quantities of imported goods) absorbs Credit excess in a manner seductively unlike previous economic structures. From the most recent government data (1999), of the almost 133 million domestically employed, about 19 million (14%) worked in the manufacturing sector. Agriculture and construction comprised another 11 million jobs. The government sector employed about 19 million. Wholesale trade, retail trade, and transportation combined for 35 million, while services employed 41 million. At best, talk of the American worker being "the most productive in the world" is rather meaningless considering the structure of the contemporary U.S. economy. He and she may be very capable in producing U.S. GDP in the midst of rampant Credit excess, but that's a far cry from competing effectively in global markets. I just can't shake the notion that there is a much larger inflation component in GDP than what is being currently measured. And the Fed and GSE may be intent on continuing efforts to inflate their way to more manageable Consumer debt burdens, but this scheme has powerful negative consequences. On the one hand it only further prices the U.S. producer out of global markets and exacerbates economic maladjustments, while on the other it fosters continued over-consumption and the accumulation of problematic foreign liabilities.

Contemporary Credit inflation and related processes have been misunderstood, allowing monetary disorder to develop to previously unknown extremes. How vulnerable is the entire U.S. service sector to any meaningful tempering of monetary excess and Consumer spending? This is a critical issue for the future. Our hunch is that we will find that the U.S. economy has become hopelessly addicted to both Credit excess and asset inflation. Credit excess-induced increases in "output" (GDP) are severely distorting analyses of inflation, productivity and competitiveness. And as wild Credit and speculative excess continue to foment severe economic distortions, productive investment in wealth creating and positive cash-flow enterprises has become detached from monetary processes. I strongly argue that we should look at the technology sector boom and bust as a microcosm of the distorted U.S. Bubble economy. Yes it does maintain the semblance of a miracle in the midst of acute self-reinforcing Credit excess, but when the boom comes to an end one is left with an industry replete with hopelessly negative cash-flow enterprises, $100's of billions of worthless securities, and a big hole in the financial system. Yes, the powerful Greenspan/GSE/Wall Street scheme does have the potential to keep The Consumer Bubble levitated for now, but the costs are growing exponentially. The latest round of plant closings at Ford is only the most conspicuous example of yet another round of gutting the U.S. manufacturing base.

We often note the U.S. economy's dangerous propagation (inflation) of financial claims. To try to bring a bit of clarity to this concept and its dangers, let's think in terms of Providian Credit card receivables. During their boom, aggressive lending practices created a surge in consumer borrowing. These new financial assets appeared very profitable, with Providian calculating its earnings based on the spread between its cost of funds and the interest rates they charge and add to consumer balances. And with Consumers seeing their Credit lines regularly increase and new cards readily available, there was strong incentive to remain current on balances as they spent freely and accumulated rising debt loads. Meanwhile, the greater the debt load the more lending "profits," with peak "earnings" soon followed by severe Credit problems. As Providian is painfully experiencing, when a lender loses access to additional finance and must then similarly draw the line on his borrowers, the aggressive lending game abruptly turns sour. The deceptive appearance of a highly profitable lending enterprise is quickly exposed as little more than a scheme and financial disaster in the making, as scores of what had appeared to be current and sound receivables turn into a mountain of defaults and losses. Previous "profits" were in reality only the accumulation ("monetization") of additional debt that in many cases would never be repaid. And the longer that these claims are accumulated, the greater will be future losses and disruptions.

We do not think it an exaggeration to look to Providian's experience for clues as to how the U.S. Consumer Bubble will play out. As long as new speculative finance provides the U.S. financial sector the wherewithal to continue feeding the American debt mountain, many will argue that Consumer "looks great" and the lending business remains highly profitable. Don't be fooled. There is at this point simply no question that the maladjusted American economy is a disaster waiting to happen. Furthermore, the worst-case scenario is surely that Fed policy and GSE/Wall Street finance succeed in their pursuit of perpetuating dysfunctional and increasingly disastrous monetary processes. There is one especially important and today pertinent difference between the technology Bubble and The Consumer Bubble. As everyone raced to get into the technology game, the resulting highly competitive environment began to wear on the marginal players and hastened the Bubble's demise. A similar rush to participate in the Consumer finance (lending and securities speculating) scheme has to this point worked to sustain easy Credit availability and extend the life of The Consumer Bubble. We will be following developments very closely.

Wednesday Dr. Greenspan averred that the Fed's containment of inflation should be credited for the global trust in the dollar. I am very tempted to argue today the exact opposite. Perhaps it is now more accurate to recognize that the enormous flows into U.S. dollar denominated securities (that underpin the dollar despite a disastrous trade position and acute financial fragility), are now more predicated by global speculators' "trust" that the Fed and U.S. financial sector are both willing and able to sustain rampant Credit inflation. The game is asset inflation and financial arbitrage; the scheme is perpetuating sufficient Credit excess to keep asset markets levitated and the Consumer-based economy expanding at a rate that precludes the Consumer from being buried by his rising debt load. We can almost confidently state that everything we don't like about monetary processes and economic distortions the speculators either cherish or are indifferent. As long as the U.S. system provides attractive spreads and the dollar remains stable, they'll play. They are not today concerned with distant economic performance or the long-term purchasing power of the dollar. And as long as they play the dollar remains a seeming pillar of strength, allowing the U.S. economy to perform as Abby Joseph Cohen describes: "In a service economy you can import all of your lower-cost manufacturing from another nations, but most services are produced locally." Ok, but let's not convince ourselves that this is either sound or sustainable. It is unfortunately neither. Argentina is only the most recent example of the extreme nature of contemporary currency, financial and economic adjustments. Markets will be markets and excesses will be punished accordingly, as much as it may appear at times that they can be managed and manipulated indefinitely.

I will conclude with remarks by Chairman Alan Greenspan at the Opening of an American Numismatic Society Exhibition, Federal Reserve Bank of New York, January 16, 2002: "In the twentieth century, bank reputation receded in importance and capital ratios decreased as government programs, especially the discount window and deposit insurance, provided support for bank promises to pay. And, at the base of the financial system, with the abandonment of gold convertibility in the 1930s, legal tender became backed--if that is the proper term--by the fiat of the state. The value of fiat money can be inferred only from the values of the present and future goods and services it can command. And that, in turn, has largely rested on the quantity of fiat money created relative to demand. The early history of the post-Bretton Woods system of generalized fiat money was plagued, as we all remember, by excess money issuance and the resultant inflationary instability.

Central bankers' success, however, in containing inflation during the past two decades raises hopes that fiat money can be managed in a responsible way. This has been the case in the United States, and the dollar, despite many challenges to its status, remains the principal international currency. If the evident recent success of fiat money regimes falters, we may have to go back to seashells or oxen as our medium of exchange. In that unlikely event, I trust, the discount window of the Federal Reserve Bank of New York will have an adequate inventory of oxen."

As is often the case, we are most intrigued by what Chairman Greenspan chooses not to say. And we have unfortunately lost hope that "fiat money can be managed in a responsible way." But forget the oxen Dr. Greenspan; we'll take gold!

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