Despite Monday's drubbing, the broader market ended the week with gains. The small cap Russell 2000 added 1% and the S&P400 Mid-cap index gained about one-half percent. With today's nearly 4% gallop, the Utilities posted a 5% rise for the week (up 29% from February lows). The more "speculative" issues continue to outperform. The Amex Biotech index added almost 3% today (7.5% for the week), increasing year-to-date gains to 28%. The Biotechs are now up 41% from March 12th lows. Yet despite a reasonably strong showing through much of the week, the major averages were unable to dig fully out of Monday's hole. For the week, the Dow, S&P500, and Transports declined 1%. The Morgan Stanley Cyclical index dropped 2%, while the Morgan Stanley Consumer index shed one-half percent. The technology sector gave back a portion of recent strong gains, as the NASDAQ100 and Morgan Stanley High Tech indices declined 2%. The Street.com Internet (up 32% y-t-d) and NASDAQ Telecommunications (up 24% y-t-d) indices gave up 1%. The Semiconductors declined 3%. The recent highflying Securities Broker/Dealers dipped 3%, while the resilient Banks declined about 1%. With gold surging an impressive $13.90, the HUI Gold index jumped 5%.
The Treasury "melt-up" became noticeably more unsettling for the Credit market this week, with mortgage-backed securities said to have posted their worst performance in two months. For the week, two-year Treasury yields added four basis points to 1.35%. But that was the exception in the government market, as 5-year Treasury yields declined another seven basis points (2.32%) and 10-year yields dropped eight basis points (3.34%). The long-bond saw its yield sink 15 basis points to 4.26%. Benchmark mortgage-back yields actually saw yields rise one basis point, although agency yields declined in line with Treasuries. The spread on Fannie's 4 3/8% 2013 note narrowed two to 35. The benchmark 10-year dollar swap, however, widened 4 to 34.75. Corporates generally could not keep pace with surging Treasuries, with spreads widening marginally. Junk spreads widened moderately. The dollar index sank another 1%, and the CRB index declined 1% this week.
Freddie Mac mortgage rates dropped 11 basis points to a record low 5.34%, with one-year adjustable rates declining six basis points to 3.61%. Housing stocks are on fire, with the S&P Homebuilders index up 7% this week and 39% y-t-d.
The corporate issuance boom runs unabated: Fannie Mae priced $4 billion of 5-year benchmark notes at a spread of 24 basis points over Treasuries. Johnson & Johnson issued $1.0 billion, General Motors $425 million, Gillette $300 million, Texas Gas $250 million, Enbridge Energy Partners $400 million, Consumer Energy $250 million, TGT Pipeline $185 million, Alliance Pipeline $300 million, Pulte Homes $400 million, Fifth Third Bank $500 million, Hartford Finance $250 million, Cox Communications $600 million, PPL Electric $100 million, International Lease Finance $325 million, and ABN Amro $400 million.
May 22 - Bloomberg: "Vertis Inc… and Apogent Technologies Inc… were among borrowers that sold more than $1 billion of high-yield, high-risk notes, as May sales of so-called junk bonds approach record levels. Demand for low-rated bonds has boomed as companies' debt-reduction efforts have made investors more confident they'll be repaid. Junk-rated borrowers pay interest of 6.7 percentage points more than U.S. Treasuries on average, down from 8.5 percentage points at the beginning of the year… Today's junk-bond sales pushed issuance in May to about $15.7 billion, the most since Bloomberg began tracking the data in January 2001. Sales for the month could end up a record, narrowly topping a few months in early 1998…"
Junk issuers this week included Laidlaw International $400 million, El Paso Production $1.2 billion, Georgia-Pacific $650 million, Hard Rock Hotel $140 million, Iasis Healthcare $100 million, Providian Finance $250 million, Graham Packaging $100 million, Apogent technologies $250 million, HLI $250 million, Province Healthcare $200 million, Centerpoint Entertainment $400 million, Universal Compression $175 million, Thomas & Betts $125 million, Ingles Markets $100 million, Advanced Accessory Systems $150 million, Salt Holdings $180 million, Transmontaigne $200 million, Kaneb Pipe Line $250 million, Smithfield Foods $350 million, Rent-way $205 million, and Turning Stone $160 million.
May 22 - Bloomberg: "Siemens AG's sale of 2.5 billion euros ($2.9 billion) of convertible bonds is Europe's biggest sale of equity-linked securities since Novartis AG raised 2.8 billion euros through Deutsche Bank AG in November 2001."
The convertible bond market is all the sudden hot, hot, hot. Recent issuers include Sallie Mae ($2 billion), Northwest Airlines ($150 million), PPL Energy ($400 million), Silicon Valley Bancshares ($135 million), Regal Entertainment ($200 million) Magma Design ($150 million), and Valassis Communications ($160 million). Also worth noting, CDO (collateralized debt obligation) issuance has said to have picked up considerably over the past month.
May 21 - Bloomberg: "Turkey's central bank said it bought foreign currency from local banks in its second unscheduled intervention in the currency market this month, after the lira posted its biggest gain in almost two months yesterday."
May 21 - Bloomberg: "Indian government bonds rose, and 10-year yields fell to a record, as banks invest the money workers abroad and companies doing business overseas have been sending home. The $141 billion government bond market, the third-Biggest in Asia after Japan and Korea, has been rallying as investors take advantage of higher yields than they can get elsewhere. Investment in India has pushed the rupee to a two-year high and sent foreign-exchange reserves at the central bank to a record… India's currency reserves have risen by almost $23 billion over a year to a record $78.6 billion because the central bank is buying some of the dollars coming from overseas. The rupee rallied for a third day to its strongest level since May 2001. It was headed for its biggest three-day rally since 1998." Five-year Indian government yields this week declined about 20 basis points to 5.30%, down from 8% yields that existed at the beginning of 2002.
Here at home, broad Money Supply (M3) expanded $10.6 billion last week ($120.3 billion over four weeks). Demand and Checkable Deposits declined $5.5 billion. Savings Deposits expanded another $12.4 billion ($85.6 billion in three weeks), while Small Denominated Deposits declined $2.2 billion. Retail Money Fund Deposits added $4.1 billion and Institutional Money Funds added $400 million. Large Denominated Deposits declined $4.2 billion, while Eurodollars added $4.3 billion. Elsewhere, Commercial Paper outstanding increased $8.5 billion (up $36.6 billion over four weeks) to the highest level since early December. Non-financial CP added $400 million, while Financial CP jumped $8.1 billion ($43 billion over four weeks) to the highest level since September. Bank Total Assets jumped $34.6 billion last week ($157 billion over four weeks!). Securities holdings increased $14.4 billion. Loan and Leases jumped $16.4 billion, although Commercial and Industrial Loans inched up only $200 million. Real Estate Loans expanded $2.8 billion, Consumer Loans increased $1.6 billion, and Security loans added $7.2 billion. With this week's $11 billion of new ABS, y-t-d issuance of $169 billion is running almost 17% ahead of last year's record pace.
May 22 - Bloomberg: "General Electric Co.'s NBC, the top-rated U.S. television network among young adults, said it booked a record $3 billion in advertising sales for the next TV season, up 11 percent from last year and higher than forecasts. So-called upfront sales at the six major TV networks probably will rise 14 percent to $9.2 billion, the most ever, from $8.1 billion a year ago…"
May 22 - Los Angeles Times (Meg James): "Network executives have been stunned by the amounts advertisers are paying — in some cases agreeing to rates more than 15% higher than during last year's 'upfront' market, the week when networks sell more than three-fourths of their prime-time commercial inventory for the season that begins in the fall. The executives said they also have been surprised by the lightning-quick pace of the purchases… 'This has moved very, very quickly,' said Fox Television Entertainment Group Chairman Sandy Grushow. 'For whatever reasons, there just seems to be a tremendous amount of money in the marketplace.'"
I would view surging advertising spending (at rising prices!) as an "inflationary manifestation" at the margin - an early indication of reliquefication's "success". It makes sense that management, emboldened by collapsing corporate yields, newfound Credit availability and seemingly endless liquidity, would move quickly to increase marketing expenditures. After all, it's a lot easier and less risky than building plant & equipment and/or adding employees. Some would even consider it sound "investment." For economic "output," such expenditures are constructive near-term for GDP and perhaps even great for the "productivity miracle" (GDP divided by hours worked). Such inflationary manifestations are relished by media franchises (good for asset prices!), advertising agencies and the blessed LeBron Jameses of the world. But most folks, sectors, and the general economy see little benefit from what are really significant expenditures - providing a good example of Bubble distortions and economic imbalances.
I would further argue that such spending is an excellent example of our contemporary "monetary" economy that is sustained only by continued rampant Credit creation and monetary injection. Sure, our financial sector can create additional claims, and this resulting purchasing power is easily spent on television advertising. But what true economic wealth-creating capacity is being added to support these new claims? What are the consequences if continued enormous new claims (and purchasing power) are not forthcoming? Or, from another angle, what are the ramifications for the dollar if this unrelenting inflation of claims/dollar debasement is sustained?
And in regard to new dollar claims, there is no good news on the federal deficit. The normal April federal government surplus shrank to $51 billion, the smallest April surplus since 1995. The fiscal year-to-date deficit of $202 billion is about three times the comparable deficit from the previous year. Y-t-d revenues were down 5.4% to $1.056 Trillion, while spending was up 6.5% to $1.258 Trillion. Year-to-date by major department, Defense spending was up 15.6%, Social Security was up 4.0%, Health & Human Services was up 9.2%, Agriculture 1.9%, Labor 18%, and Veterans' Benefits 14.4%. Interest expense was down 3.6%.
April data from the Ports of Long Beach and Los Angeles are worth highlighting. Combined Inbound Containers jumped 10% from March to the highest level since August, and were up 7% y-o-y. Conversely, Outbound Containers declined 8% for the month to a level 3% below the year ago level. Containers leaving the two ports empty were up 29% y-o-y, and accounted for 57% of total Inbound Containers for the month.
The Mortgage Bankers Association mortgage application index jumped almost 10% last week to the third highest on record. The Refi index surged 15% (three-week gains of 64%) to almost five times the year ago level. And while the Purchase Application index declined almost 5% for the week, it remained 15.5% above a year earlier. In fact, Purchase Application dollars (as opposed to the number of applications) were up a noteworthy 28% from a relatively strong year ago level. It is worth noting that the average loan was $193,100 last week. The average Purchase mortgage was $201,200, the average Refi $190,500, and the average adjustable-rate mortgage was $316,700. Record numbers of applications should be forthcoming.
Bankruptcy filings declined to 31,165, but were up about 7% y-o-y.
Freddie Mac struggled again during April. For the month, its total book of business declined $12.6 billion (11.6% annualized) to $1.295 Trillion. The company's retained portfolio declined at a 1.2% annualized rate to $569 billion. The Federal Home Loan Bank system reported first quarter Net Income of $456 million, up 1.6% y-o-y. Those are pretty skinny profits on Total Assets that increased 11% to $780 billion. Total Assets increased at a 9% annualized rate during the quarter. The FHLB's Derivative Liabilities item increased to $16.47 billion (up from the year earlier $5.7 billion)
May 20: "Mortgage bankers originated new commercial/multifamily mortgages at a brisk pace during the first quarter of 2003, according to the Mortgage Bankers Association of America's (MBA) quarterly survey of key commercial members. The $18.9 billion volume reported by survey participants was 38 percent higher than for the same period a year earlier."
Official Foreign (central bank) Holdings of U.S. Debt jumped an eye-opening $20 billion last week to $916.8 billion, with these holdings up an unprecedented $170 billion (22.7%) from one year ago. Official Holdings have been expanding at a 25.4% rate since early November. This unparalleled ballooning of dollar reserve positions (as private dollar liquidations are accommodated by local central banks) is a key inflationary mechanism liquefying financial markets globally. In contrast, Federal Reserve Bank Credit is up only about $5 billion so far this year (1.9% annualized) to about $712 billion. Largely because of last December's $31 billion surge, Fed Credit is up almost $70 billion, or 10.5%, from one year earlier. Curiously, I still read capable analysts referring to the growth of Federal Reserve Credit as "the real inflation rate" and the "currency debasement rate" when it is clearly neither. Such analysis misses the very essence of securities-based contemporary finance with its myriad institutions, Credit instruments/vehicles, and markets.
To come anywhere close to garnering insight as to what a true "currency debasement rate" might be, we must first look broadly to the growth (inflation) of new financial claims - Credit creation. In this regard, it is worth noting that Total US Credit Market Debt Outstanding is up almost 50% since the beginning of 1998 to $31.7 Trillion. This $10.4 Trillion increase in claims compares to the $235 billion (50%) increase in Federal Reserve Credit over the same period. The US financial sector increased its liabilities (dollar claims) by $4.9 Trillion, or 90%, since the beginning of 1998, and will almost surely inflate liabilities by an additional $1 Trillion this year. Today, one might look at the Fed's tepid balance sheet growth and discern positive signs for the dollar, when in fact rampant "currency debasement" runs unabated with the inflation of dollar financial claims throughout the U.S. financial sector.
On a weekly basis I underscore the harsh reality that not only are we experiencing a seemingly everlasting inflation of dollar claims, but that these claims (mortgage and consumption-based borrowings) are increasingly underpinned by little in the way of true economic wealth (non-productive Credit). This, in a nutshell, is the essence of today's intractable dollar dilemma. The dynamics are analogous to the proliferation of initial public offerings - IPOs of increasingly dubious quality - at those fateful late (terminal) stages of equity bull markets. Yet it is the seductive nature of runaway asset inflation that in the midst of heady price gains, near manic demand for these inflating assets can for sometime outstrip surging supply. It is as if the immutable law of supply and demand is suspended for a period, and the longer this abeyance the greater the inflation of increasingly dubious claims. But make no mistake, this suspension waits patiently for manic expectations and bull market extrapolations to be inevitably disappointed - for greed to commence its destined transformation to fear. The consequent reversal of speculative flows then exposes the risks and vulnerabilities associated with the previous inflation of securities (many of suspect value), along with attendant distortions to supply, demand and pricing relationships. The misery of the bear market takes over.
Importantly, the abrupt closing of the IPO spigot is a fundamental aspect of the marketplace's self-correcting mechanism, working to bring the new supply/demand dynamics into better balance. Traditionally, currency markets have operated under similar dynamics. A reversal of speculative flows would see local central bankers tighten Credit conditions to constrain the creation of new claims and restrict liquidity (shut down the "IPO" machine). It may prove quite painful, especially to highly leveraged players, exposed speculators, and vulnerable Bubble economies, but it is a central aspect of the inescapable adjustment process - adjusting to the new supply/demand constraints imposed by the bursting of a Credit/currency Bubble. We have witnessed such dynamics repeatedly with the bursting of past Credit Bubbles in Mexico, SE Asia, Russia, Turkey, Argentina, etc. In all instances - the Argentine experience providing the clearest example - the issue was the bursting of a Bubble of inflating broad financial claims (Credit creation), as opposed to (narrow) central bank Credit and/or government fiat currency.
But in the U.S. today something very different has set course. Despite the inevitable bursting of the dollar bubble and the apparent reversal of speculative flows, the Federal Reserve is only more aggressively accommodating the unyielding inflation of dollar claims (running rampant throughout the financial sector). A mighty bear market is slamming the dollar, yet the Fed steadfastly guarantees that the dollar claims "IPO spigot" will run wide open (with its endless torrent of "crummy deals".) This surely does keep liquidity flowing and the Credit Bubble inflating, but it also dangerously ignores the unfolding new reality. Not only does this recklessly disregard developing (bear market) supply/demand constraints, it sets the stage for the inescapable devastating adjustment for both the Credit system (the creator of dollar claims) and the U.S. Bubble economy (addicted to inflating doses of new claims). Postponing the Day of Reckoning is Central Banking at its Worst. There must be some constraints placed on dollar debasement or a collapse in confidence will usher in irreparable global revulsion to dollar financial claims. There is certainly no inflating away our currency problem.
Greenspan's Wednesday "testimony" before the Joint Economic Committee was especially fascinating, if not constructive to dollar confidence. I have included extensive quotes from the Q&A. Mr. Greenspan again proved that he is lost in a sea of flawed reasoning and economic spin. And our hero Dr. Ron Paul once more demonstrated that he is the only individual in Washington that is operating within a sound analytical framework and truly grasping the seriousness of key issues (dysfunctional monetary regimes, flawed central bank policies, the vulnerable dollar, etc.). Mr. Greenspan went so far as to make the ridiculous claim that central banks "essentially have restrained the expansion of credit enough that many aspects of the gold standard, which induced deflationary patterns in past periods periods, had been replicated in our monetary systems." (Say what?) Dr. Paul gets to the truth of the matter: We deal in the world today with fluctuating exchange rates and all currencies are inflated at different rates… there is no soundness to it, no restraint on the monetary authorities.
And right in the thick of truly astounding mortgage finance excess, Mr. Greenspan fails to deliver even a word of caution. Rather, he once again invokes the wonders of "technology" and innovation emanating from our contemporary Credit system and New Economy. But how is it not possible for our leading financial authority to recognize the clear similarities between the forces fueling today's mortgage boom and the "innovations" that fostered the lending and speculating excess that created recurring global Credit booms and busts, the telecom Bubble, and equity Bubbles just a few short years ago? It doesn't make any sense and lacks credibility, things that all the sudden do matter in The New Era of Faltering Dollar Confidence.
Alan Greenspan: "…It's important to recognize that a goodly part of the extraction of equity has been an ongoing issue related to a very high level of existing home sales, which has not deviated very much, as you well know, in recent quarters. What has changed is a very extraordinary shift in the way the mortgage market functions…. Let me also point out that surveys by the Federal Reserve indicate that equity extraction from homes, especially refinancings - tend to be very significantly employed to repay other debt. And first of all, they're a major source of repayment on home equity loans, but they have also shown up as a major factor in reducing the burden of consumer debt. So all in all, it's turning (out) that the technology, which is obviously at the base here of where this refinancing's coming from, has changed the housing market in a rather fundamental - I should say, the financing of the housing market - and it has made it a vehicle for liquefying household wealth. And it's been a major factor in consumer activity. And I might say to you that my suspicion is that it's going to increase rather than decrease as a factor in the American consumer markets as home ownership continues to increase." (Has our Fed chairman been chit-chatting with Franklin Raines?)
And Mr. Greenspan makes reference to the current "low risk" environment for implementing aggressive Federal Reserve accommodation. This is a view of a central banker fixated on "core" consumer prices, with the blinders fixed to avoid the ghastly sight of gross financial excess. Mr. Greenspan speaks as if there are no risks or costs associated with ultra-easy monetary policies, when they are today expanding exponentially. Yes, central bank interest-rate manipulation immediately affects our speculation-rife markets, but what are the long-term consequences of so abusing this mechanism?
Alan Greenspan: "I still think that monetary policy should take the lead (over fiscal policy) in the short run, largely because we can move on 20 minutes' notice in 10 minutes, if necessary, where that is obviously not feasible in the fiscal ring. Having made the judgments, then the question is, to do what. And there is the obvious problem of short-term fiscal stimulus which we could arrange. In other words, you can get a very significant short-term surge, perhaps in retail sales, with a very marked short-term decline in taxes, for example. The problem is that if you succeed, the difficulty is that it is short term and it tends to fade, and if it creates levels of production which reduce unemployment as a consequence, over time it reverses, and it's not a longer-term phenomenon."
My comment: The use of aggressive "activist" monetary policy over an extended period categorically nurtures speculation, over-lending, asset Bubbles and generally dysfunctional Monetary Processes. The risks and eventual cost of associated Credit Bubbles are manifestly greater than those engendered by fiscal deficits. Importantly, an economy can be much more easily weaned from government deficits than they can from easy money, endemic asset inflation, highly leveraged financial systems, and all-encompassing Credit Bubbles. Fiscal deficits tend to spread conventional inflation throughout the economy, not desirable but at least not unmanageable. Conversely, perpetual monetary ease nurtures divergent inflationary manifestations that are more sectoral, uneven, destabilizing and uncontrollable for the financial system, economy and underlying currency.
Joint Economic Committee Chairman Senator Robert F. Bennett: "Let me just ask two questions. Last November, when you were here, Mr. Chairman, we discussed the downward pressure on prices and options available to the Federal Reserve to combat it. Yet some still seem to believe that low short-term interest rates limit the potency of monetary policy… Could you explain how the Fed could address unwelcome downward pressures on prices through the purchase of long-term Treasury securities?"
Alan Greenspan: "As I and a number of my colleagues have stated recently, we have chosen to act solely in overnight funds, essentially addressing the reserve balances of the banks. There are a number of reasons why we did that, but the point at issue is that there is no legal requirement that we do so, nor indeed an economic one. And should it turn out that, for reasons which we don't expect, but we certainly are concerned may happen, the pressures on the short- term markets drive the federal funds rate down close to zero, that does not mean that the Federal Reserve is out of business on the issue of further easing and expansion of the monetary base. We indeed, as you point out, can merely move out on the yield curve, because as you're well aware, even though short-term rates are something slightly over 1 percent, longer-term rates are up significantly above that. And we do have the capability, should that be necessary, of clearly moving out on the yield curve, essentially moving longer-term rates down and in the process expanding the monetary base and the degree of monetary stimulus. And since there is such a significant amount of potential in that longer-maturity structure, we see no credible possibility that we will at any point, irrespective of what is required of us, run out of monetary ammunition to address problems of deflation or anything similar to that which disrupts our economy."
Representative Ron Paul: "Good morning, Mr. Greenspan. I have two questions. One is generalized and it deals with the dollar system and the monetary system that you're required to operate, and then one more specific, a factor that affects the strength of the dollar. But the big debate now in financial circles is the weak dollar, whether it's good or bad, versus what a strong dollar should do to us, or for us. And I would like to suggest that there should be another alternative rather than arguing a temporary case for a strong dollar to help us, which it seemed to in the latter part of the 1990s, versus whether the weak dollar will now help us on our exports. Rather than this manipulation of the value of the dollar, I would hope someday that we will talk about a stable dollar, one that does not fluctuate so readily. We deal in the world today with fluctuating exchange rates and all currencies are inflated at different rates, and nobody advocates that we have 50 different currencies in this country; that would be totally chaotic. And yet the world is required to operate, and there is no soundness to it, no restraint on the monetary authorities. And the other challenge, I think, that we have to look at some day is whether we should continue to accept this notion that we can achieve positive central economic planning through the monopoly control of money and credit and setting of interest rates, which is really contradictory to true capitalism. And I think that's where part of our problem is. The Austrian economists for years - Mises and Hayek and Rothbard - have argued that this is the source of our problem, that the manipulation of interest rates too low causes the boom, and then eventually the bust has to come. And we see this over and over again, but we talk about productivity and other events that are important, but we fail to talk about the initial cause of the mal-investment, the overcapacity, which then requires the correction. Because we operate the reserve currency to the world, we have the advantage of others taking our money and our dollars and holding them. But currently the expectations are that our current account deficit may soar to $600 billion next year. And we do know throughout history, and most economists agree, that these current account deficits cannot be maintained or it it'll eventually lead to a weaker dollar and higher interest rates. So I think you're under the gun. In one sense, you want to stimulate the economy with low interest rates, which weakens the dollar, at the same time the weak dollar will eventually push up the interest rates. And my question is when do you think, or do you think we will ever, talk once again about sound, stable currency?
And the other question is more specific, because even though what the Fed does in the creation of new money is the key element, other things do have factors. The jawboning and the so-called speculators, for a day or two they have an effect, but they really can't change it. Jawboning doesn't work. Ultimately, in 1979, interest rates had to go to 21 percent to restore some order to the dollar. But you talked about the war and the supposed benefits after the war was over and after it started, but I think what has not been recognized is the ongoing foreign policy of our adventurism and our plans, really -- those same people who planned and argued the case for Iraq are arguing the case for Syria and they're arguing the case for Iran. At the same time we don't have our allies close to us, we don't have people pouring in the dollars like we did in the 1990s. So that in itself has a subjective relationship to the perceived value of the dollar. And I wanted to know whether or not you think that element in foreign policy today specifically has affected the future perceptions of what the dollar's value is going to be."
(Mr. Greenspan's response was hopelessly inadequate at best, although I will include it below for the curious.)
Representative Paul Ryan: "I'd like to put the word (deflation) right smack in the middle of the table and give you an opportunity to talk about it so that we can address the speculation, sometimes wild speculation, that has gone on in many of the columns that say, 'We are on the verge of becoming Japan if we are not, in fact, Japan. Greenspan warns of deflation. And we're looking at 10 years of falling prices and sluggish economy,' and all of the rest of that. Can you just take that particular topic and deal with it in a way that we hope - I hope will put some of these specters to rest?"
Alan Greenspan: "It's a very serious issue and an issue which we at the Federal Reserve are paying extensive attention to. And the reason basically - and this indeed follows on naturally from my conversation with Congressman Paul - with the elimination of the gold standard in the 1930s and the development essentially of worldwide fiat currencies, almost no economists believed that you could create deflation with fiat currencies because the ultimate supply of those currencies, by definition, comes from government fiat. We went through most of the post-World War II period with the expectation that fiat currencies were essentially inflation- ridden and that the major focus of central banks was to suppress inflation. The notion that deflation would have emerged just never entered our minds until the Japanese demonstrated to us otherwise."
(My comment: It is imperative to move beyond a narrow focus on government issued fiat currency in order to comprehend the expansive nature of contemporary Credit inflation manifestations.)
Alan Greenspan: "As a consequence of that, not having had any experience in the modern world with dealing with deflation and fiat currencies, our knowledge base was virtually non-existent, in the sense that we know how to deal with inflation."
(My comment: This clearly demonstrates a flawed analytical framework. For too long the Fed and economics profession have seemly gone out of their way to ignore valuable lessons that could have been garnered from relevant financial Bubbles such as the Roaring Twenties, Japan, SE Asia and even going back to the John Law fiasco. Financial history is replete with lessons that should have been learned.)
Alan Greenspan: "Inflation, obviously, is something that for a half century we've been struggling with. We know how to suppress it. We know the consequences of suppressing it. We know the impact of various monetary policy decisions on the levels of output growth and of unemployment. So we are familiar with the mechanism. It's not that we can very easily and automatically just suppress inflation; it has been a struggle of very great dimensions for most central banks in the world. What's happened now is that since I guess the middle of the 1990s, we're beginning to see that it is possible for deflation to exist with a fiat currency, and in a way, it's, I suspect, credit to central banks, which essentially have restrained the expansion of credit enough that many aspects of the gold standard, which induced deflationary patterns in past periods, had been replicated in our monetary systems and that, frankly, is quite good. We, at the Federal Reserve, recognize that deflation is a possibility. Indeed, we now have been putting very significant resources in trying to understand, without actually seeing it happen, what this phenomena is all about. We cannot say that in the marketplace that there is a severe increasing concern of deflation. Indeed, the various expectations of price by both business and consumers has been relatively flat for recent years, and the so-called TIPS inflation premium -- that is the implicit forecast of the consumers price index, which is embodied in our TIPS treasury yields - has not changed much over the last three or four years. So this is not something which the markets are beginning to sense is about to erupt and something which we must address.
Nonetheless, even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative. So we have created fairly significant resources to try to address this problem, increasing our knowledge of what actually happens, what's the process and what tools are necessary to fend it off. I think we've made very substantial progress in that intellectual endeavor. We do, obviously, have the problem that we never dealt with this before. We know as a consequence that when we don't deal with something, we have a large element of uncertainty, which strangely we do not have with the implementation of policies against inflation because we've dealt with it over so many decades.
We believe that because in the current environment the cost of taking out insurance against deflation is so low that we can aggressively attack some of the underlying forces, which are essential weak demand. And indeed, we've done that since we started a very aggressive easing in monetary policy in early 2001.
Alan Greenspan: "So long as the costs of engaging disinflation are so low, we have moved fairly considerably and in statements we have made, specifically, as you point out, the statement we made at our last FOMC meeting, to recognize this not as an imminent, dangerous threat to the United States, but a threat that, even though minor, is sufficiently large that it does require very close scrutiny and maybe, maybe, action on the part of the central bank.
Ron Paul: "Earlier we were talking about your (in)ability to talk about the value of the dollar and what it should be. I find that rather ironic. I mean, the Federal Reserve is in charge of the monetary system, and you, as chairman, have a lot to say about what monetary policy is and how much money will be printed and created and what interest rates would be. So we find it a bit ironic that you can't comment on the value of the dollar, and we defer to Treasury. Now, Treasury can play a role, of course, by intervening in the exchange markets, but that's very temporary. But I understand the policy and we don't expect you to change that, but in a way you're really in charge, and it's too bad that we can't get comments about the dollar. I did want to remind you about following up on the question about foreign policy - how foreign policy anticipation of what we might be doing around the world might affect fiscal and monetary policy and trade policy, how that might affect perceptions of the dollar and whether or not that's important. But on the currency issue, I'm still not interested in going back to fixed currency rates, such as the Bretton Woods Agreement. That's not my interest. Because even then Henry Hazlitt, I remember, wrote very correctly back then that Bretton Woods would break down, and it certainly did break down, it didn't work with that so-called gold exchange standard.
But if you have achieved what you hope you have achieved, and that is that central banks now have done such a good job in managing paper money that it's starting to act like a gold standard - now, that would be an historic achievement, you realize that, because it has not been done in 6,000 years of recorded history. And history's on my side of this argument, in that paper money doesn't work very well. Paper money ends badly. And we may be seeing some signs today around the world that paper money is a very shaky system. But a more specific question dealing with that in a return to commodity money, at least on a voluntary basis, if we have a Third World nation that destroys its currency and they don't have the advantages that we have politically, if they destroy their currency and they want to link their currency to gold because they know history, they're not allowed to do it. The IMF prevents them from doing it. There's an IMF rule that says you can't do it. So wouldn't this be a good time for us to become more neutral and not antagonistic toward gold and say to the IMF and to our position that, 'If you choose to go back and get stability and soundness to your currency with a linkage to gold, we ought to permit that?'"
Senator Paul Sarbanes: "On the trade deficit question -- of course, we now have this fall in the value of the dollar. How long can we go on running these large trade deficits and building up these very significant claims abroad on our productive capacity?"
Alan Greenspan: "Senator, as you well know, the issue of how much you can build up net claims against American residents is a function of not only - and this looks at a large function - of the willingness of foreigners to hold and seek those claims. And indeed, what we have found over the years is that when the exchange rate for the dollar is rising, it, of necessity, means that there is a greater demand for dollars, and that's what occurred during a significant part of the 1990s. But the obvious problem that you raise is, over the very long run, the ratio of cumulated claims against the United States, more specifically those which relate to debt, create interest charges which, in turn, are part of the current account deficit, which means that it is quite possible to get into an unstable equilibrium."
(My comment: If Mr. Greenspan believes escalating interest charges is the chief issue he is clearly mistaken. Today's "unstable equilibrium" is associated with Credit Bubble dynamics. The U.S. Credit system and Bubble economy require unrelenting lending, financial leveraging, and speculating excesses - the rampant liquidity that is at the same time creating an unmanageable accumulation of dollar assets globally. It is "unstable" precisely because it is unsustainable.)
Alan Greenspan: "And that's an issue which economists have discussed quite significantly with respect to the United States. And as I think I've mentioned to you, Senator, I've been raising this issue for years and forecasting a major contraction eventually of the current account deficit, and I raise it every five years. I've been wrong every five years."
Senator Paul Sarbanes: "I know, but if we ever hit it, it almost would be like falling off the cliff, would it not?
Alan Greenspan: "No. I would think not, largely because the stock of dollar assets is so huge and the ability to move them around is fairly limited, that I think adjustments don't occur off the cliff… The question is, what do the holders do with those assets? They're so heavily involved in dollar-denominated claims that while obviously they can move out of them, and would, there are limits to how fast these things tend to move."
So we are to be comforted by the fact that foreign central banks have accumulated such "huge" dollar asset holdings that they have today little opportunity to sell. This Financial Twilight Zone becomes only more bizarre and harrowing by the week.
Alan Greenspan's response to Dr. Ron Paul's first question: "Well, Dr. Paul, first, let me address the last question first. As I think you may remember that we in the United States government have made a decision in which the value of the American currency will be discussed only by our chief economic spokesman, which is the secretary of the Treasury. And we at the Fed have adhered to that for quite a good, long period of time and think it's important to have one voice speaking on that issue. With respect to the more general question about the issue of sound, stable currencies, this, as you know, is a very fundamental debate amongst economists. You point out quite correctly that there is a single currency in the 50 states of the United States. The reason why we were able to function in a manner which others are not is that an exchange rate that is a unit-specific currency tends to bring together all of the imbalances in an economy in the exchange rate's price. In other words, at the border the exchange rate essentially rebalances all of the imbalances between two contiguous countries or it might have been in the United States between two states. If you lock the currency in and you cannot adjust the currency at the border, then the adjustments must occur in capital flows or in labor flows; the only two other ways in which you can get major adjustments that are required between two disequilibrium economies.
The advantage of the United States is that, because we have stripped out all barriers to interstate commerce essentially - I should say most - we are able to get equilibria adjusted solely through capital and labor market flows and we have a fixed currency. The reason why it is not, at this moment, feasible in a lot of other areas of the world is that capital and labor flows are not adequate to pick up the full adjustment process. And an endeavor to fix exchange rates in the face of imbalances induces financial breakdowns has occurred."
Representative Ron Paul: "May I just interject? I'm not talking about fixing these rates. I'm talking about a single currency that could be universalized."
Alan Greenspan: "That's the algebraic equivalent of fixing rates. In other words, if you lock in legally all rates, it's irrelevant what you call the currency in one nation and another; it's the lock that matters. And if you have, for example, as we did, the gold standard, which for a very substantial period of time was the single currency of the world, it didn't matter what you called the other currencies, because they were all locked-in in units of gold. And so the notion of a stable world currency requires a degree of flexibility in capital and labor flows, which we have not yet achieved."