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Financial Debacle for Dummies

Money Supply (M3)

It was a difficult week for the stock market, as the liquidation of technology shares runs unabated. For the week, the Dow, S&P500, and Transports declined 2%. The Morgan Stanley Cyclical and Morgan Stanley Consumer indices declined 1%. The Utilities reversed course, jumping 5% this week. The broader market was under pressure, with the small cap Russell 2000 dropping 3% and S&P400 Mid-Cap index declining 2%. The NASDAQ100 and Morgan Stanley High Tech indices sank 5%. The Semiconductors were hammered for 8%, The Street.com Internet index 7%, and the NASDAQ Telecommunications index 3%. The major Biotech index was down 1%. Financial stocks were also under pressure, with the AMEX Securities broker/dealer index dropping 4% and the S&P Bank index declining 2%. With bullion up $9.80, the HUI Gold index surged 19%. We saw no indication this week that our view of unfolding derivative problems is incorrect.

The Credit market was excited by developments. For the week, 2-year Treasury yields dipped 14 basis points to 3.23%, while 5-year yields declined 16 basis points to 4.45%. The 10-year yield declined 11 basis points to 5.14%, while the long-bond saw its yield drop 9 basis points to 5.67%. The yield on December Eurodollars dropped 16 basis points to 3.02%. Mortgage-backs underperformed, as benchmark yields generally declined 7 basis points. The implied yield on agency futures dropped 13 basis points. The spread on Fannie Mae's 5 3/8% 2011 note was unchanged at 54. The benchmark 10-year dollar swap spread narrowed one to 52. The dollar index could muster only a small gain for the week. European bonds enjoyed their best week in almost a month.

Pressure is mounting on the Bank of England. UK April retail sales rose at the strongest pace since in 16 months, surging 6.9% y-o-y. Sales of consumer goods excluding food were up 9.5% y-o-y, the strongest performance since the late 1980s. This is consistent with recent data indicating that home price inflation has accelerated to the strongest pace since the 1980s housing Bubble.

This week from Fitch: "Rating actions in the corporate sector continued on a downward trajectory, as downgrades outpaced upgrades at a rate of nearly nine to one. Global power and telecommunications continued to account for more than their fair share of total downgrades in the sector, due in part to defaults, liquidity concerns, and economic troubles in portions of Latin America."

Broad U.S. money supply (M3) surged $33 billion last week to a record $8.132 trillion, and is up $104.6 billion in four weeks. For the week, savings deposits jumped $21.2 billion and institutional money fund assets increased $17.3 billion, while repos declined $2.7 billion and demand deposits declined $5.1 billion. We don't view it as coincidence that money supply returned to rapid growth simultaneously with the heightened systemic risk that developed over the past month. As we have discussed often, the U.S. financial sector enjoys, for now, the capacity to create its own liquidity. Bloomberg's tally of domestic debt issuance had $34.8 billion of new securities sold last week. The asset-backed security issuance boom runs unabated, with $12 billion sold last week. Year-to-date issuance of $138 billion is running 16% above last year's record pace. Issuance of securities backed by home equity loans is up 62% to almost $51 billion.

Freddie Mac's April numbers are out. The company expanded its total book of business (retained mortgage and mortgage-backs sold to the market) by $20 billion, a 23.6% annualized rate. Interestingly, Freddie's retained portfolio actually declined by $4.5 billion, as the company choose instead to issue mortgage-backed securities. Mortgage-backs held in the marketplace increased a staggering $23.5 billion to $700.5 billion, an annualized growth rate of 41.6%. Freddie sold a net $40.7 billion of mortgage-backs over the past two months (37% annualized), with year-to-date issuance of $54 billion (25% annualized). Year-to-date, Freddie and Fannie's combined "book of business" has increased $168 billion (20% ann.) to $2.68 trillion, compared to $95.8 billion for comparable 2001. If this pace continues, Fannie and Freddie would combine for $504 billion of mortgage credit growth, up 18% from 2001's $425 billion and up 137% from 2000's $212 billion. We've all become numb to the enormity of these numbers, but recall that total home mortgage growth was $238 billion for all of 1997, and averaged $194.2 billion for the first 8 years of the "Roaring Nineties". Those arguing against a mortgage finance Bubble have a job ahead of them.

New home sales were reported today at a stronger than expected annual rate of 915,000 units (estimates were for 885,000). This was about 2% above year ago levels, with year-to-date sales running only slightly below last year's record pace. The average price rose to $226,800, up 10.4% y-o-y. From Bloomberg: "Spending on new housing rose at a 14.6 percent annual rate in the first three months of the year, the fastest since the second quarter of 1996."

In another in my ongoing "More Detail Than You Want to Know" series, we'll dive this week into April's "Monthly Treasury Statement of Receipts and Outlays of the United States Government." With tax returns due, April is always the Treasury's big surplus month for the year. This year's monthly surplus of $67.2 billion was down 65% from April 2001's $189.8 billion. For comparison, April surpluses averaged $147 billion during the past four years, with last month's surplus the smallest since 1995. The amazing disappearing surplus was made possible by the combination of a 28.4% year-on-year decline in April receipts and a 19.8% jump in spending. The monthly numbers can fluctuate significantly based on the timing of receipts and payments, so we prefer to look at year-to-date data.

For the first seven months of the fiscal year, receipts declined 11% to $1.116 trillion. Meanwhile, spending jumped 9% to $1.182 trillion. Fiscal year-to-date, last year's surplus of $165 billion has been transformed into this year's deficit of $66 billion. The perception is that a "moderate" deterioration of the government's fiscal position is due to the recession and jump in defense expenditures. Well, should a mild recession have had such major impact? We think there is much more going on here than a brief recession or increased military expenditures. Indeed, the alarming aspect of the rapid fiscal deterioration is the broad-based character of spending increases.

Year-to-date by major category, Interior Department spending increased 33% to $6.1 billion, State Dept. 23% to $6.07 billion, International Assistance 16% to $10.7 billion, Energy Dept. 15% to $10.9 billion, Dept. of Justice 16% to $14.6 billion, Civil Defense 3% to $20.5 billion, Housing & Urban Development 9% to $19.9 billion, Labor Dept. 61% to $34.4 billion, Education Dept. 11% to $26.4 billion, Veterans Affairs 10% to $28.7 billion, Transportation Dept. 24% to $33.9 billion, Office of Personnel Management 3% to $30.7 billion, Agriculture Dept. 7% to $48.1 billion, Defense 14% to $187.2 billion, Health and Human Services 11% to $266.3 billion, and the Social Security Administration up 7% to $280.4 billion. Partially offsetting increased spending, interest expense declined more than $20 billion y-o-y, or 10%, to $181 billion.

Itis interesting to dig a bit deeper into the surge in defense spending. Personnel expenses are surging, with y-t-d personnel spending up 18% at the army, 16% at the navy, and 20% at the air force. "Operation and Maintenance" expenses are up 10%, 10%, and 9%, respectively, while surging 43% at the "Defense Agency." "Procurement" costs jumped 11% for the army, 8% for the navy, and 25% at the air force. Defense Dept. research and development expenses are up 8% y-t-d. Looking at the Dept. of Health and Human Resources by major category, spending at the National Institute of Health jumped 20%, payments to health care trust funds surged 24%, and grants to states for Medicaid increased 14% y-o-y. At the Dept. of Labor, y-t-d unemployment insurance benefits are up 77%. The Social Security Administration saw benefit payments jump 5% and disability disbursements rise 10%.

The revenue side is also rather illuminating. Y-t-d individual tax receipts are down 19% to $536.5 billion. This is basically a return to the levels of Oct. 1998 to April 1999. And while personal withholding tax receipts declined 6% year-over-year to $463.9 billion, "other" personal tax payments sunk 26% to $198 billion. Clearly, the transformation of enormous stock market capital gains to losses is conspicuous in the data, as the $70.5 billion y-o-y decline in "other" (non-withheld personal income taxes) explains half of the y-t-d decline in total receipts. In this regard, it is worth noting that "social insurance and retirement receipts" - taxes calculated based on wages up to a maximum - actually increased 2% y-o-y. We'll take this as evidence that the average wage earner made it through the shallow recession relative unscathed, while the upper-income equity market-exposed took it on the chin. At the same time, y-t-d corporate tax receipts are down 15% to $88.2 billion. For comparison, corporate tax receipts were $103.3 billion for the comparable period Oct. 98 to April 99.

We are not of the view that government deficits directly cause inflation, as much as they tend to be a reflection of, as well as augment, underlying inflationary pressures. Clearly, federal spending is playing a role in what we view as the changing character of inflationary forces. For years, the keenest inflationary pressures were found in the stock market and within the "upper end," whether it was executive compensation, employee stock option proceeds, or luxury home prices. Such inflationary manifestations for the most part bypassed consumer goods prices. Today, with lower-end housing prices outperforming, wage growth remaining resilient, huge government spending increases, and a weakening dollar, we see additional support for our view that the surprise going forward could come in the form of heightened traditional consumer price inflation. At the minimum, it is worth noting that while enormous stock market gains were quite beneficial for state and federal government coffers during the boom, the tax structure is not so helpful for governments in regard to today's housing Bubble.

While the housing Bubble may not be great for tax receipts, it does wonders for consumption. It is worth noting a flurry of improved forecasts from retailers including AutoZone, Home Depot, Lowe's, Cost Plus, William-Sonoma, Limited, Footlocker, Target, and Wal-Mart, to name a few. So we were not necessarily surprised that the two large Californian ports released very strong data this week. Combined April imports into the Port of Los Angeles and Port of Long Beach surged 24% from March to 485,926 containers, the third strongest month on record. It was a record April for imports and the strongest month since October. April inbound containers were up 18% from April 2001 and 2000, and 48% above April 1999. April exports were down 1% from March to 179,014 containers. April outbound container shipments were up 9% from April 2001, 2% from April 2000, and 27% from April 1999. Last month saw 229,359 containers returned empty (47% of inbound), up 10% y-o-y and 49% from April 1999.

Champion tax cutter and ardent "supply-sider" Arthur B. Laffer provided an interesting commentary, Keep the Dollar Strong, in Monday's Wall Street Journal. From the opening paragraph: "...The value of the dollar is moving center stage in policy debates. The basic issue is whether the U.S. economy is benefited or hurt by the extraordinary strength of the U.S. dollar in the foreign exchanges." We'll take exception immediately. The issue of whether a strong dollar is helpful to the economy or not would have been meaningful debate a few years back, and we would have argued forcefully for policies protecting a sound and stable dollar. But the issue is today basically moot, as dollar strength or weakness has been left in the hands of market dynamics. We owe several trillion to foreign-sourced lenders and it is they who will now dictate the exchange value of our currency. The time to protect the soundness of the dollar was back when the U.S. financial sector began to create dollar claims in gross excess; claims increasingly accumulated abroad. We don't remember the likes of Art Laffer, Larry Kudlow, or other proponents of "king dollar" being very helpful on the policy front when it mattered. Actually, they were too often leading the cause of misunderstanding, making a mockery out of analyzing the processes that have for years worked quietly to put our currency at today's significant risk.

From Laffer: "Americans invest in America merely by accumulating capital. But foreigners can only invest in America by moving goods to the U.S. in exchange for claims on U.S.-located assets. More simply, higher returns in the U.S. induced foreigners and Americans to move capital to the U.S., causing an international capital surplus for the U.S. A larger U.S. capital surplus is one and the same as a larger trade deficit. It's as simple as that."

But it's not that simple, and Mr. Laffer's analysis has actually been quite flawed. First of all, Americans and foreigners "invest" in American assets using basically the same means: liquid dollar balances. Domestic investors don't trade "capital" for securities. Rather, they generally exchange bank and money market fund deposits. Similarly, foreign financial players don't call Goldman Sachs and say, "I have 100 containers loaded with DVD players arriving in Long Beach next week that I'd like to trade for that hot convert deal you're bringing to market." Foreigners use liquid dollar balances also, and we would argue that most exporters of goods to the U.S. likely exchange dollar balances at home for their local currencies, leaving these dollar-denominated claims to be accumulated by financial players quite removed from commerce and goods trading. As the dollar today sinks and our trade deficit is poised to widen, it is even more nonsensical to hold to this boom-time fallacy that foreign financial flows ("capital surplus"?) are the cause of our trade deficits. Foreign flows should be recognized as more generally the "effect" of the recycling of domestically generated Credit excess.

It is an inarguable fact that we have been running unmatched current account deficits, while accumulating unprecedented foreign liabilities. Any use of the word "surplus" is inappropriate at best. It often appears the bullish consensus goes out of its way to confuse this basic issue. That unrelenting trade deficits can be painted as a sign of economic health goes far in illuminating the power nowadays of economic spin.

The key to better understanding these processes is to focus on how dollar balances are created. Specifically, new financial assets come into existence through the creation of new financial liabilities - through the lending/Credit creation process. We can avoid the chicken or the egg dilemma by directing our attention to the U.S. financial sector and recognizing the key borrowing and lending mechanisms. Since we have been in the midst of unprecedented domestic Credit creation (new financial liabilities), additional dollar balances (corresponding new financial assets) have been created in great excess. There is a common misperception that the exchange value of dollars previously created by the Fed is the current concern, when in fact the critical issue of dollar vulnerability involves various dollar-denominated claims created in gross excess by myriad financial institutions and market participants. Largely, these claims have been created through the intermediation of American consumer and corporate borrowings. In the case of U.S. households, we have found it advantageous to take on additional mortgage and consumer debt, while at the same time funding retirement accounts and playing the stock market. As is evidenced by the $2.5 trillion increase (44%) in broad money supply during the past four years, dollar balances have accumulated throughout the U.S. financial system.

As one would expect, this enormous consumer-lending boom has fostered over-consumption. Household borrowings have financed unprecedented trade imbalances, with current account deficits mushrooming to surpass $100 billion quarterly. Consequently, unprecedented dollar balances have also accumulated throughout the global financial system. These dollar balances, by their very nature, are a means of payment for dollar denominated assets - real and financial - and by and large return to the U.S. financial sector (where they originated) in exchange for U.S. financial claims (to purchase securities or accumulate bank/money market deposits). The ongoing accumulation of financial claims - domestically and internationally - is the residual of unrelenting Credit excess, and using the terminology "capital surplus" is silly and only unnecessarily confuses a most important issue.

We will admit to being rather intrigued by the timing and content of Dr. Laffer's article. For a number of years we have had to listen to the erroneous analysis that our trade deficits were a sign of economic health, caused by what were trumpeted as sustainable foreign capital inflows. It pained us to listen. We'll cut to the chase a bit by highlighting his concluding sentences.

"Higher returns abroad and lower returns in the U.S. mean reduced U.S. capital inflows, lower U.S. trade deficits, and, yes, a weaker dollar. If the U.S. wishes to maintain our leadership role in the world economy, we've got to proceed undaunted in our pro-growth agenda. Just talking about a strong dollar won't cut it. In the words of Nobel Prize-winning economist Robert Mundell, we need tight money and tax cuts -- and then we'll have prosperity, asset appreciation, employment growth, and a strong dollar."

Dr. Laffer is either incredibly naive, surprisingly misinformed, or possesses one heck of an optimistic soul. If our goal was to maintain our leadership role in the world economy, we should have been more mindful of how much we borrowed and how it was spent. We should have over the years also been champions for a stable global financial system committed to addressing and rectifying imbalances. As the leading instigator of excess, we did nothing of the kind. The consequences of years of unsound financial boom today leave the U.S. system virtually assured of enormous state and federal deficits and vulnerable asset markets. There will be no tax cuts. Previous extreme Credit and speculative excess render the U.S. system acutely fragile. There will be no "tight money." The highly leveraged U.S. financial sector would buckle. The Fed today sees little alternative than to bet the ranch and run with an extended period of extreme accommodation. There will be no strong dollar. There is a price to be paid for previous gross excess.

Whether they realize it or not, the Laffers, Kudlows and ardent "supply-siders" are in the process of losing the battle, and there will be many casualties. They were given an incredible opportunity and blew it. The pendulum will now swing the other way, and they will likely become great finger pointers. We will be in only greater need of economic statesmen.

We were for tax cuts, responsible deregulation of the real economy, and free markets. The problem was that the whole exercise became all about ideology and little about sound economics. They readily accepted an unharnessed Credit system. It was fun to believe in painless economic miracles, but now we are left with the reality of a huge mess. Booms breed brilliance, but going forward it will suddenly seem in very short supply. The irony of the damage done to the cause of free markets by its most vocal proponents recalls George Orwell's Animal Farm.

We do not expect historians will be kind. Sure, there were clear policies for nurturing a boom, but absolutely no parameters or even a willingness to address the potential for problematic excess. It regressed into little more than intellectual economic fascism. Not only was it branded contemptible to consider systemic vulnerabilities, it was outright heresy to contemplate it could all end in a huge bust. Somehow it was lost that lower taxes and business deregulation were only the "means" to stimulate the sound investment necessary for the "ends" of stable and sustainable growth. There is no magic elixir, although at times many seemed to take on the persona of snake oil salesmen.

Along the way sound economic principles were thrown out the window. There was absolute refusal to recognize that over borrowing and consumption might go to extremes, and that these held potential risks as covert archenemies of sound and sustainable prosperity. There was seemingly never a concern for the nature of borrowing (financing consumption or investment) or the composition of economic output. Growth for the sake of growth, as reckless borrowing and spending became the hallmark of economic success. There was blind disregard that Credit and speculative excess - and resulting monetary disorder - are anathema to an effectively functioning free market pricing mechanism.

To question the soundness of the boom was to be an enemy of the faith. The financial system was cut completely loose, with little regard for what should have been obvious consequences. Using George Soros' terminology, "market fundamentalism" took hold in our thinking and policymaking. Just keep the faith, ignore Credit excess, and disregard rampant speculation. Trust that Wall Street acting in its best interest was in the system's best interest. Trust that management was to act on behalf of their shareholders. Whatever it takes to get stock prices higher is what's for the good of the "system." Dangerous asset inflation became, in the words of Larry Kudlow, "wealth creation." Have faith that the accountants will be accountants and rating agencies rating agencies, instead of entrepreneurs in an environment with ultra easy money providing fortunes for the taking. It became an article of faith that leveraged speculation is the epitome of "efficient" contemporary financial markets. Just believe that derivatives are a modern financial miracle. Never question the faith.

A runaway Credit system and wildcat finance were sold as a great victory for deregulation, free markets, and a New Paradigm of "efficient" finance. Enormous trade deficits and the dangerous accumulation of unprecedented foreign liabilities were sold as the wondrous benefits of free trade, globalization, and American might. Apparently, we were forced to over borrow and consume because foreigners were desperate for our dollars to buy our securities. They dumped goods upon us in their quest for our stocks and bonds. All the while, the "fundamentalists" had absolutely no tolerance for opposing views, choosing instead to fashion creative propaganda to convince the public that there really was such a thing as a perpetual free lunch. Even gross excess entailed no cost. Even today, we are encouraged to just keep borrowing and spending.

The most frustrating aspect for us has been this ardent determination to ignore the long history of Credit and speculation-induced booms turned painful bust. Yet, the obstinacy against learning from more distant history has only been surpassed by the fanaticism of distorting more recent financial fiascos. It's been a pathetic case of crafting every potential valuable lesson into a "how to" book for making the same mistakes but only on a much larger scale - "The Idiots Guide to Reckless Excess," or "Financial Debacle for Dummies." The Japanese experience with a runaway Credit system, rampant asset inflation, and a Bubble economy was used as propaganda supporting the superiority of the American brand of Capitalism. Throughout, we were conditioned to hold unwavering confidence in the Greenspan Fed. Alan Greenspan learned from Japan's experience that, above all, never let the boom end.

The "hot money" component of the Mexican collapse was conveniently ignored, as the speculators quickly learned that if they were all crowded into the same market (especially if they were accompanied by the major U.S. institutions), the Fed, Treasury, IMF, etc. would be swift with bailouts. A grander collapse caused by a "hot money" exodus from SE Asia was cleverly construed as just comeuppance for the iniquity of "crony capitalism." Again, instead of addressing the danger of Credit-induced financial and economic imbalances and wildcat global finance - as well as examining the true source of the mushrooming and increasingly destabilizing "hot money" and the potential for this powerful virus to infect the U.S. - the emphasis remained creating propaganda glorifying the supremacy of the American system.

Rather than responding to repeated warning signs of a malfunctioning global financial system, it became a case at home of nurturing overconfidence, as well as a reckless determination to push only more firmly on the accelerator. It too often seemed like a case of inviting the hot money speculators to play at our casino, assuring them that we would wine and dine them, while protecting them from the harsh treatment they had suffered at the hands of others. Emerging economies would solve their monetary problems by adopting an Argentine-style U.S. dollar currency board regime or, better yet, completely dollarize. Rules were made up as we went along, even if they made no economic sense whatsoever.

That we have witnessed wild financial excess, increasingly unstable markets, and conspicuous economic imbalances should be absolutely of no surprise. That we have made few friends in the process is similarly no mystery. But it is difficult to believe that we are so far into this process, yet the consensus view holds staunchly that things are fine and it's business as usual. The more vulnerable the system, the more extreme the Fed's accommodation of further excess. We are then told how resilient and strong are underlying fundamentals. Our passions have been running especially high because of our conviction that the current course is certain to turn what would have been a deep recession into a protracted depression with risk of financial collapse.

So we have Dr. Laffer and others trumpeting the "we've got to proceed undaunted in our pro-growth agenda." At the same time he calls for a strong dollar. But the dilemma today is that our acutely fragile financial sector and hopelessly unsound Bubble economy require enormous continued rampant Credit excess. At the same time, indelible monetary processes direct finance specifically to sectors demonstrating an inflationary bias. Finance floods into the housing sector and races to fuel consumption. The system is geared up to create additional financial claims, while little economic value is added in the process. "Undaunted" and content to stay the course? Pro-growth or pro-Bubble? And we expect our foreign financiers to look kindly upon all of this?

Relative returns on U.S. assets are today increasingly unattractive, rendering our trade deficits problematic (as they have not been during recent years). Interestingly, Dr. Laffer admits, "Things have changed. The tech bubble, and every other asset bubble, has burst." Unfortunately, this is a case of wishful thinking, as the Fed and U.S. financial sector ensured that a collapsing technology Bubble only fueled greater Bubbles in mortgage finance and throughout the U.S. Credit market. The problem with disregarding Credit and speculative excess is that they have a proclivity of running completely out of control if not squelched. Instead of squelching, we nurture. The serious dollar crisis commences when these larger Bubbles begin to deflate. We will then likely face the risk of a run on dollar assets. Do foreign players sense that that the Fed sees little alternative than a desperate attempt to inflate its way out of trouble?

What troubled me most as I read through Dr. Laffer's article was not obvious disregard for reality or the weak analysis. Rather, I had the sense that I was reading the initial salvo of what we fully expect to be an ongoing battle with historical revisionism. We will admit to being on guard for a contemporary version of Milton Friedman claiming the "Roaring Twenties" boom was sound - that mistakes were only made later. I can hear it now, "If only the U.S. had stuck with its strong dollar policy and the Fed would have instigated "tight money," continued U.S. prosperity would have been assured." The 1990s will be painted as the golden age of U.S. capitalism. And how could the Fed, the administration, and Congress all have made such a mess of things starting in 2002? We view misanalysis and obfuscation as to the causes of The Great Depression as partially responsible for the "Roaring Nineties." Continued obfuscation of the dangers of Credit and speculative excess is a disservice, and we are ready...

We have been amazed with "analysis" that wants us to believe that the various SE Asian and emerging market economies erred when they "devalued" their currencies. Devalued? They individually suffered post-Bubble runs against their economies' financial assets and currencies, and central bankers were rendered absolutely impotent by brute market forces. Enormous foreign liabilities had accumulated during the halcyon days of boom and faith in miracle economies. But when booms waned and a non-miracle reality led the "hot money" and fearful domestic wealth holders to panic, central bank foreign currency reserves were woefully inadequate to meet the demand of legions of sellers. But this is precisely the risk associated with accumulating large foreign liabilities, and why central bankers should act strongly against ongoing trade deficits and guard against speculative financial flows. Those here in the U.S. so determined to ignore these crucial issues during the boom have made a critical analytical blunder. Almost without exception, when previous booms began to wane, foreign central bankers appreciated the risk of a flight out of their countries' financial assets and currencies. They generally acted aggressively. Interest rates were increased, in many cases dramatically, but to no avail. The damage had been done during the previous boom.

The dollar's performance will not be determined by prospective policies. Rather, we must wait to better gauge to what extent the holders of our foreign liabilities accumulated during the boom are held by long-term investors, as opposed to "hot money" speculators. We must hope that foreign investors remain confident in the underlying economic value of assets supporting dollar claims. We must fear that they will look askance to the continued creation of financial claims as diluting their stake in limited U.S. economic wealth-creating capacity. We must hope that financial players have not borrowed excessively in foreign currencies to finance holdings of higher-yielding dollar assets. Such dynamics are inevitably prone to illiquidity and financial accidents. We are left to fear that dollar risk lies in wait somewhere in the murky world of derivatives, as it did throughout SE Asia, Russia and elsewhere.

It should be recognized as absolutely unacceptable that our nation's financial security today hangs on such a fragile balance. That we just don't know our position- that we must ponder the possibility that we may be at the edge of financial abyss is a travesty. Sound policies simply would never allow our nation's financial position to be so vulnerable. I would like to hear the Laffers and Kudlows of the world admit as much.

The bottom line is that the Fed is today impotent to create the true economic wealth that would lend support to this fragile edifice of dollar financial claims. Instead, the Fed remains trapped in a losing game of aggressively manipulating short-term interest rates, assuring marketplace liquidity, and protecting the wide spreads that so entice the financial speculators. And monetary processes ensure only a greater gap between dollar claims and true economic wealth creating capacity. Perhaps Dr. Laffer will eventually get his way with "tight money." But be careful for what you wish for. For now, extremely low short-term rates keep the leveraged speculating game working. But if this game falters, the Fed may at some point find itself in the same boat as other central bankers. The Fed may be forced to raise rates in an attempt to keep the hot money from turning cold on dollar assets.

We do agree completely with Dr. Laffer when he states, "Once a weak dollar catches hold, it tends to be reinforcing." But that's precisely why it must be the Fed's number one priority to protect the stability of the U.S. financial system and the soundness of its currency. It is not the Fed's role to blindly stimulate growth and to go to extreme measures to forestall corrective recessions. Downturns are a critical and necessary aspect of sound and vibrant Capitalistic systems. As we have witnessed first hand, central bankers' mistakes beget bigger mistakes, and it is incumbent upon our policymakers not to risk catastrophic error. Well, we're in the midst of one. We also agree that the trade deficit will narrow, although we are anything but sanguine as to the circumstances that will force this necessary adjustment. In the near-term, a faltering dollar and continued rampant domestic Credit excess provide a potent combination for escalating deficits. We suspect that market sentiment has changed, and fears of spiraling deficits will work to reinforce currency weakness. It is this type of dynamic that holds potential for an inevitable crisis in confidence.

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