Law found that he lived under a despotic government, but he was not yet aware of the pernicious influence that such a government could exercise upon so delicate a framework as that of credit...
- Charles McKay on the Mississippi Bubble;
Popular Delusions and the Madness of Crowds
Imagine yourself in Larry Summers' shoes. After building an empire, Rubin finally hands the reins over to you, his nearest protègè…er…patsy. Sounds pretty exciting, don't you think? The economy is growing swiftly, there is no sign of this core CPI inflation stuff, your CEO claims that the budget is now balanced, the Dollar is used and accepted everywhere in the world, and virtually everybody is working. American capitalism has won the world over, and lest we forget the most important legacy of all; over 120 million Americans think that they have, or will, become richer. What a glamorous job it must be to be the Treasury Secretary at such a triumphant moment in history. He had better enjoy it, because in all likelihood, a moment is all that it will be. Mr. Rubin took his golden parachute and jumped, in what might amount to the best trade of his life. As for Mr. Summers, well, he hasn't even seen the 'empty' cockpit yet. He may soon find out that you can't fool all of the people all of the time.
In this discourse, I will first update you on recent gold market related developments, where the tape is beginning to feel much more unyielding, to the bears. Then I will attempt to demonstrate how the Achilles' heel in the dollar's fundamentals can, and probably will, shift the global balance of political power away from the United States.
- Section I: Gold Market Update - what an enormous bottom Section
- Section II: What is wrong with the Bank Stocks?
- Section III: The American Consumer is the Achilles' heel
- Section IV: The Increasing Politics of the Dollar
Could This Be A Two-Year Bottom?
Weekly $GOLD; August 1997 to Present
If so, I can't wait to see what the rally will look like. Anyhow, the $270 handle appears pretty firm, and the $250 level seems like a long shot, at the moment, for hopeful bidders at the next UK auction. The dollar rally in May pushed at $270 gold, but when that snapped, gold fought its way back towards $300. Even with the perpetually selling bullion banks and the Swiss National Bank pounding away at the market in between the UK auctions, rising global interest rates, and a soggier looking US economy, prices were firm. This market wants higher. And there is plenty of reason for it to go higher, but first the ambush, then the laundry, and finally, the bull market. Of course, the technical picture cannot veto an equal likelihood that the next 120-point move might just as well be down, but that would shut down an enormously unrealistic amount of production. The most important observation that the investor can make, as this pattern develops, is whether Gold starts to act like a hard asset once again.
The FOMC's decision to leave the Fed Funds rate unchanged in June clearly reflects a desire to assess the impact of previous tightenings as well as to re-liquefy the market's current liquidity dearth. However, whether deliberate or not, Mr. Greenspan will actually be subjecting the productivity hypothesis to a test, by virtue of allowing for the higher long term growth rate assumption into his policy deliberations.
In the meantime, the conveniently bullish progression of recent events begs an explanation other than, well, unrelated coincidence. Hopefully, there exists some kind of strategy between the Fed, the Treasury, and the President. After all, they are a team, whose most recent motif is, above all, that the glorious investment merit of dollar denominated securities is simply unable to coexist with an oil crisis.
"If the price does not decrease, Saudi Arabia, in conjunction with other producers, will increase production by 500,000 bpd, within the next few days. WE HAVE SOUGHT, and will continue in any way we can, to bring the prices down from their current level to the target levels of $25 per barrel of OPEC basket of crude's,"
- Ali al-Naimi, July 3rd, 2000
That news came out of the blue on Monday, without warning, and just shortly after Saudi Arabia's ex-oil minister denounced the future utility of oil. The current Saudi Oil Minister, Ali al-Naimi, who told the Saudi Press Agency just before it hit North American wires, delivered the quote. Pretty serious about face over there, don't you think?
What do you think motivated strong words like this? American pressure is hastily thought to be behind this. Like what? "Hey, If you guyz over there don't get on side, you'll be sorryâ¦Bush Jr. will actually win." Here's a brilliant one..."You know, we'll just have to start selling our last two months worth of Strategic Oil Reserves into the market." How do you think Saddam would like that? Whatever the case may be it is clear that the Saudis are prepared to act independent of OPEC objections.
Consider, however, that since it is a Saudi initiative rather than an OPEC initiative, could it be that the up and coming Saudi Arabian Monetary Agency wants to make a play for the big leagues here, and that Mr. al-Naimi is simply making a gesture to the big boys? I am in no way an expert, or anything close, on Middle Eastern Affairs, but with the little knowledge that I have about international finance, it seems too logical. Indeed, the SAMA must have already gained from the generally higher activity in oil markets, and there is no question that an economy, which is currently 70% dependent on oil revenues, needs to diversify away from its oil dependence. This could very well be an opportunity for the bank to gain some political leverage in the world of finance, even while there is no guarantee that oil prices will stay down. The Fed, for example, has been threatening the stock market for years, to no avail. In fact, oil prices will probably stay generally sticky around the $25 to $35 range, and could go higher, unless the Fed itself can get itself out of its current monetary predicament. Let me explain.
Jude Wanniski, one of the original supply side economists in the Reagan camp, convincingly demonstrated how the oil crisis is a function of poor monetary policy in the first place.1 I will try to show you how many potential crises loom over us now, if that is indeed the case. Higher US interest rates are not going to matter much to oil demand if there is any kind of notable financial destabilization that explicitly undermines the Dollar. I have a hunch that the SAMA well understands the US predicament; hence, the Saudi's don't have much to lose and everything to gain from this kind of position, including much bigger export market shares. It is a fact, ceteris paribus, that a major oil price spike from these already lofty levels would be counterproductive, as it would kill off demand. However, if this is a monetary problem, a hoarding mentality could evolve that would put the SAMA right smack in the middle of global finance ceteris paribus need not apply.
As you will see later, it is my contention that, due to the irreversible nature of foreign claims on US assets, US foreign policies may have to become increasingly accommodative. Even Mr. Greenspan, while he may be able to drive interest rates to the moon, must know that he no longer has control over the dollar.
Allow me to devise a hypothetical political "strategy," that is not only entirely plausible, but also profitable under the circumstances:
Mr. Greenspan, perceiving that another hike in interest rates might undermine the dollar at the moment, chooses this to be a good time to give Larry Summers another chance to demonstrate his capabilities with respect to the strong dollar directive. Assuming that Mr. Greenspan is not political then, his main concern must lie with the acute fragility of the financial system. Larry has his instructions. He wastes no time in getting on the horn to the current Saudi oil minister, Ali al-Naimi, who of course will look back to Mr. Greenspan for the nod. Mr. Greenspan, in return, takes the Saudi Arabian Monetary Agency more seriously, while the Saudi's return the favor by at least appearing to be putting a lid on the oil market, and hence, capping a monumental psychological concern for US credit market players. Concurrent with the benefit to bond markets, banking titans Wachovia and Union Bank triple expensed their reserve accounts, possibly to demonstrate leadership, and to facilitate the coming changes in capital adequacy rules, which all involved, hope can only be taken by dollar investors, as a long term positive.
Wow, what all just happened there? The Saudi's gained a political favor. Larry Summers got to play with the big boys again. US Banks got their interest rate relief. Wall Street got easier credit and lower oil prices. Clinton hopes that the public will get cheaper gasoline prices so that he's not forced into more decisive action. The Fed, meanwhile, thinks it may have gotten what it wants - a stable financial background for the transition to better capital adequacy standards across the board. Of course, this might manifest itself as an ambush in gold prices if it turns into a boon to US financial markets and particularly the dollar exchange rate.
An organized cartel, however, might be wise to take advantage of such an ambush in gold prices to wash all of their bad short positions out of the market, if there were any, while firming up their long positions. Such a cartel might then have less reason to pressure gold prices going forward, knowing that in the end, they will have to let it go anyway.
Speaking of Laundry, let's discuss the Banking business
At first glance, the actions taken at Wachovia and Union Bank in June look defensive. Separately, one can assume that they convey, perhaps, that bankers view the current credit climate a little riskier than usual, but taken together with other recently evolving monetary actions and debate, a whole lot more may be inferred from them. Particularly if the discussion on policy is resolving itself in the manner that Mr. Greenspan has chosen to resolve the productivity issue; with faith. Essentially, since the LTCM fiasco, Mr. Greenspan has had his attention brought to the regulatory framework of the derivatives market. However, I suspect that his true concern remains the systemic response of these markets to new regulation, which explains his "don't touch" position on them.
Three-year chart of the US Bank Index
For a little perspective
Let's consider some of the things that are happening in the banking business today, and especially since the somewhat guarded bank meeting in Paris just ahead of the Banque de France's Bicentennial Symposium in Paris on May 30...
First, it is important to understand that the whole focus of new regulation is driven toward mitigating credit risk, a worthwhile pursuit, but much more effective when there is little credit risk in the first place. As usual, the government is reactive to public outcry, and so perhaps the most significant outcome of this belated focus is the identification of the degree of systemic risk implied in the financial system today. It is significant because it reveals a potential reflexive relationship developing, where normally the remedial actions are deflationary. However, these are not normal times. It seems that where the new, presumably tougher, standards are already being phased in, through a little moral suasion, the FOMC decision to leave rates alone prompted a sudden expansion in bank credit. The credit data for the last week in June exposed acceleration in fresh bank credit, as well as brokerage credit, consumer credit, and mortgage credit. That happens to be a common Greenspan sterilizing modus operandi.
In late May, the Bank for International Settlements published the results of its research into the effectiveness of current capital adequacy standards, particularly with respect to tests on leveraged portfolios, and the effect of random exogenous financial shocks to these portfolios. The best representation of what will come of these conclusions was likely delivered in a speech, by Mr. William McDonough, President and CEO of the Federal Reserve Bank of New York, in London on June 19, titled the Progress Of The "Major" Initiative To Revise The 1988 Capital Accord (or Basel Accord, named after the Basel Committee on Banking Supervision, which he chairs).
Rumor has it that the financial world has changed somewhat since 1988; "to the point that the Accord's efficacy has eroded considerably. Its broad-brush approach to differentiating credit risk encouraged banks to undertake regulatory arbitrage transactions. Furthermore, as banks have developed innovative techniques for managing and mitigating risk, credit risk now exists in more complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently calculated, less useful to banking supervisors," he said. Thanks Bill. A few more points were presented, which I felt noteworthy to comment on:
On Capital Adequacy Standards
One of the solutions to this problem, which was discussed, and which idea of course came mainly from within the banking industry, is an "Internal Ratings Based Approach," which has already been used by the larger banks in one form or other. As far as I can tell, this means that banks will internally rate their own credit risk (exposure), which their custom capital adequacy ratios are then based upon. Great.
Additionally, he suggests that, "Our analysis indicates that a wider range of institutions could be eligible to use the internal ratings approach, than the narrower set of large sophisticated institutions...including small and medium sized institutions provided such ratings systems are accompanied by strong internal controls, supervisory oversight, and ample disclosure." Of course, he said that the Fed would issue "guidelines to ensure that internal ratings appropriately reflect the credit risk in each category of exposure."
In discussing the standardization of the credit rating structure, McDonough asserts his view that "the global financial system needs to move toward addressing potential credit problems preemptively - before these problems have time to grow from minor disturbances to major disruptions." No wonder that these guys are perceived as moving r-e-a-l-l-y slowly. He spoke about final proposals to make capital charges more reflective of risk mitigation techniques, which gave me some insight into Wachovia and Union Bank's recent moves.
To be sure, some of the ideas are potentially good policies, but arguably, their timing is too little too late. Besides, there was no mention as to whether the new standards ought to be applied to the Government Sponsored Entities (GSE's), where much of the riskier stuff tends to get packaged up and sold to the public, or even better, back to the banks as less riskier stuff. In any case, the banks have until the New Year to clean up their act, so I would expect to see even bigger write-downs as we approach the New Year. I would also expect to see renewed calls for the GSE's to absorb the less credit worthy bank debt, which of course will show up in a further widening of credit market yield spreads.
Many economists would agree that banks should minimize the business of taking risks in the first place, because it only encourages even greater risk taking leadership within the ranks of the institution, among other things. Nevertheless, along with the fact that the systemic risk is now assumed to be calculable, comes the confidence that we can unwind the previous four or so years of miscalculated excess. Indeed, the newly proposed framework includes three central pillars -- new minimum standards, better supervisory review of banks' capital assessment methodologies, and market discipline -- which can only be built right on top of the old paper pyramid, if disaster is to be averted. Possibly this is a dumb question, but I can't help but ask, how are you going to unwind the previous excesses if every remedial action is sterilized with more credit expansion?
However, ultimately more important to the core foundation of the entire monetary system, in my humble opinion, is the topic of the speech given by Mr. Urban Backstrom, President of the Bank for International Settlements, titled "Asset Markets and Monetary Policy" on June 16 in Stockholm, just a few days earlier at a conference organized by the Riksbank and the Stockholm School of Economics.
A likely topical focus of debate for years to come
The first issue he observes is "how monetary policy should respond to movements in asset prices?" At the moment, he suggests that policymakers address this issue only in so far as asset prices have a noticeable wealth effect.
I repeatedly submit that policymakers need to first recognize that asset price inflations effect broad resource misallocations in an economy, before they can prevent massive economic imbalances from occurring in the first place. To date, the only objections I ever get about this observation are from analysts quoting me general textbook theory via email, such as, inflation is the CPI not asset prices. My all time favorite is the Kudlowian use of the term, where Friedman's obvious but, nonetheless, true correlation between money supply and the general price level is conveniently twisted into a causal relationship and interpreted as such, "inflation is simply too much money chasing too few goods." I'll get into more of that later, though.
As for economic imbalances, over consumption is only one. Over investment in non-economic and unproductive ventures is another, even if by euphoric accident. Deterioration in the nation's terms of trade and in its general savings habits is equally irreversible. Poor quality control on credit, and credit excess is yet another, and perhaps the most discernible, if not dangerous current imbalance of the century. Increasingly, it seems plausible that at least the last four years of this bull market are more likely a result of monetary policy cracks, or flaws, than they are reflective of real productivity return today. Sadly, therefore, we may have already spent tomorrow's awaiting productivity gains.
Indeed, Mr. Backstrom suggests that there are "situations where monetary policy has reason to react to movements in asset prices even though the effect on inflation is negligible. One such reason is the central bank's responsibility for the stability of the financial system."
Wow, does he allow that asset prices may then, actually be unstable? Mr. Soros, I think that they are finally listening to you. I believe that Mr. Backstrom certainly presented some of the correct questions, such as
"How does a speculative asset price bubble get started and how do we spot it? And if we spot it, what do we do about it?"
That is exactly the direction this debate ought to take, however, he fumbles the ball when he suggests that in most countries, the banking system is more exposed to real estate than paper investment, and therefore more vulnerable to property price bubbles. While this is mostly true outside of the United States, it isn't true for the United States. In fact, not only is the banking system overly extended in paper assets in North America, but also equally are the banks in Europe overly extended in North American paper. If not for that, he deserves a lashing for offering the next statement as support.
"The US experience from the 1987 stock market crash seems to be that, with an appropriately conducted monetary policy, the effects on real activity can be relatively small. With NYSE order flows grossly out of balance on 19 October 1987, with the solvency of brokerages and clearinghouses in doubt, banks were growing nervous and reluctant to lend. This was a clear case of systemic risk and before the market opened on 20 October the FED affirmed its responsibilities to serve as lender of last resort and also substantially eased monetary policy. A financial meltdown was avoided and the effects on the real economy seem to have been negligible. "
Rather than extrapolating from this, the ultimate deflationary exposure of the global banking system to Wall Street's paper machines, he suggests that property bubbles are simply more risky than equity bubbles, because equity bubbles at least have a lender of last resort? So much for the right direction, this statement is full of contradiction and it is a weak rationalization for the "lender of last resort" model, which today, is probably as large as it is going to get.
It is clear that the big error, which monetary policymakers still make today, is in refusing to accept that general asset prices do inflate as well as just rise, and hence, ought to be integrated into a definition of price policies, in the name of general price stability in the financial system. I do not mean that prices cannot go up, and that bull runs cannot happen. I only mean that inflation induced asset price rises do not undermine the quality of the monetary base, and that they do not force a reflexive reinforcing relationship between the need for ever more credit/capital and the inflation of asset prices, where each causes the other to grow. As Mr. Greenspan recently said, "nostalgia for the relative automaticity of the gold standard is sure to rise among those of us engaged to replace it."
By the way, it is worthwhile to note that there is in fact a lender of last resort in the real estate business, at least in the United States. A few of them, in fact. The most prominent of which are Fannie Mae and Freddie Mac. Of course, the government doesn't acknowledge their role in the credit creation process, but rather in the credit allocation process. So you see, not only speculative excesses have to be unwound, but also, so does plenty of present-day, fashionable economic thought. These institutions are widely thought to be government sponsored, if not guaranteed, and have certainly used that privilege exhaustingly, to acquire cheap capital for investment in higher risk loans and securities. Their investment decisions are not accountable in the same ways that are those of the banks. Nor do they have strict capital adequacy requirements applied to them, yet they control more than 80% of the American mortgage market with very little capital. Arguably, until policymakers understand how these cowboy institutions contribute to the credit creation process, they will make zero progress in affecting correct policy directives.
Frankly, what we've got here is an aggressive banking system that has dressed, packaged, or recycled its garbage loans or portfolios, in collusion with government sponsored entities (more accurately; intermediaries), and have hedged them on a giant pyramid of "risk less" paper. Then, claiming this monetary subsidization as profit growth, they sell new securities to the stock market economy, for even more risk-less funding. This is a value-added system of insanity. In light of this predicament, perhaps nothing better explains the motive behind Mr. Greenspan's gradualism better than the recent credit market assessments of notable speculators. Mr. Noland's catchy epiphany explains the current state of affairs:
And, of course, over the years the financial infrastructure developed to profit from credit creation and asset inflation has grown to possess immense power...
A Final Discourse on Asset Inflation
Economists are a lot like geologists. They usually have much more to disagree on than they have to agree on. The reason is that neither subject is really as much a science as it is an art, at least in its applications.
The definition of inflation according to classical economic textbook theory is, "A general rise in prices; an increase in the supply of money is usually regarded as the cause." Hence, Larry Kudlow commonly quips, "too much money chasing too few goods!" So, if I produce some useless, but rare good, it will have value simply by virtue of the existence of too much money? Actually, someone has got to want it, which means that patterns of consumption, or demand, are in fact relevant in defining the character of the rise in prices.
All the same, with definitions like these, it is no wonder that asset inflation is not properly considered under the stable price policy mantra. Also, a general (broad) rise in stock prices can just as easily occur when the market price mechanism (the invisible hand) is working efficiently. What's more, nobody is going to object to this kind of "inflation." Perhaps, instead, the definition of inflation should attempt to go beyond the kind of good or service that is observed, or the quantity of goods and services that are participating in the price rise. Perhaps the character of the rise is what is important. Indeed, the (Oxford) definition of the word "inflate," is an artificial price rise. Furthermore, reflection on why inflation is actually regarded as counterproductive in the first place is in order. There are two unwelcome results of inflation:
- Erosion in the purchasing power of the currency will impair the unit's capacity to function as a store of value.
- The distorting effect on the price mechanism, or "invisible hand," results in a misallocation of scarce resources.
The former will usually emerge as a result of the unwinding of large economic imbalances, as it did in the early seventies, and become a monetary problem. The latter, on the other hand, obviously helps to add to the imbalances or create new ones entirely, and it usually results from a policy miscalculation. Either way, nearly all economists agree that inflation will cause dysfunction in the price mechanism, which in turn will set off the wrong signals to participants - buyers and sellers - in the economy.
The decision by Richard Nixon, in 1971, to shut down the US Treasury gold window and hence, break the dollar-gold link, was pivotal in that it forced a reversal in nearly thirty years of cumulative economic imbalances. So the seventies resulted in the former point above, as the world lost confidence in the US dollar's "capacity to function as a store of value," and thus, a worthy reserve currency. When Volcker came in, the correction in global monetary imbalances may have already run its course. Just when everyone was throwing away their last remaining dollar, he "inflated" the return on them via higher interest rates, creating a strong disincentive to spending them as well as borrowing them.
In fact, it is becoming an increasingly clear theme to me that US monetary policy has really just become a game of promoting the dollar. This way it is possible to buy the other country's goods and services with less work than the people in that country can, and even with less work than would be required to produce them in the United States.
Volcker essentially took control of the situation and equilibrium was quickly found, but the monetary problem was not resolved. The problem being that there was still this lack of a reliable standard of value for the currency. No big deal, as it was to be resolved with a deliberate management of its exchange value, mandated under the guise of a strong dollar policy and the illusion of freely floating exchange rate regimes. Hence, Mr. Soros discovered that the concept of reflexivity worked well on the dollar, if only because of its unique globally central position. Therefore, by virtue of net vested interests in the dollar, foreign owners are also accountable to it. The dollar, conversely, is not accountable to anybody. The more that are printed, the greater the vested interests only become, and as long as they exist, it is the job of the US political establishment to keep them vested and happy. Unfortunately, today that means attracting an increasing amount of net capital inflows in order to seal the crack in the trade account.
Asset inflation has not only become desirable, it will now be necessary just to preserve our current way of life. It is itself an imbalance, likely resulting from a flawed monetary definition of inflation and the almost arbitrary manufacture of credit and assets, as well as it is a conduit to even more imbalances such as a disproportionate misallocation of labor to the fickle vocations of stock speculation or risk management. Is there any surprise that your derivatives strategies are offered by your ex taxi cab driver, eager to participate in the new economy? Just joking, I think.
Still, some economists contend that the oil crisis had developed from a supply/demand "imbalance" created by a misfiring monetary policy in the first place. According to Jude Wanniski, the strong dollar directive eventually dislocated foreign capital markets, as it continued to suck net liquidity from foreign economies at the expense of their currencies. This ultimately resulted in slacker global demand and cheaper oil prices, at least in the United States. Essentially, the market signaled producers to stop their exploration and marginal production, while it spoiled the consumer with cheap oil and gasoline products. Less than one year ago, the world seemed awash with oil and gas that nobody wanted, today production capacity the world over, except for maybe in Saudi Arabia, is running at full capacity. Perhaps he is right, because an efficient market ought not to be so out of sync with its nearby fundamentals like that. So, possibly the oil price spike is an example of an imbalance that is trying to unwind itself. Possibly, it is the first of many that will directly affect the standard of living in North America.
Inflation Redefined in terms of its Character
Clearly, when all the prices in an economy are rising together at the expense of the nation's currency, you have got an inflation problem. However, that observation is simply the indicator. Our current accepted definitions of inflation, therefore, are only an indicator that inflation exists in the economy. However, it is in the nature of the price rise that is important, because it is there that you will discover what inflation actually is. It theoretically begins at the moment that the price mechanism becomes out of sync with the underlying fundamentals of its market, when it begins to send the wrong signals to participants. That is when the artificial price rise begins. True, it is easier to discern these imbalances in hindsight, but if we want to maintain a floating exchange rate regime, we're simply going to have to recognize them in the moment.
I haven't thought about this quantitatively yet, but I'd like to propose a theoretical definition of a significant inflationary characteristic, which can be measured qualitatively, perhaps often enough to administer the appropriate policy response. Participants' behaviors need to be taken into account. Unfortunately, it is important to recognize the difference between an appropriately acting price mechanism and one that misfires. Therefore, if some sort of crowd mentality throws the mechanism into an irrational reflexive relationship, it needs to be recognized. This means that we are going to have to admit that while it is always preferable to allow the market the freedom to do its job, in many cases it doesn't. This seems especially true if we have a free market economic system working on top of a free-floating exchange rate regime. Hopefully we have accumulated enough experience with markets to recognize that they aren't always efficient, especially as regards monetary value. Thus it is incumbent upon us to construct policy such that they are.
Far from complete, I think this is at least the right direction for monetary policy. At least it doesn't evade the importance of the issue that all of monetary policy is assembled upon. Again, I argue that the best way for capitalism to work automatically is on a foundation of fixed exchange rate regimes, not so much against each other, but against a stable central measure of value accepted by everyone. It makes sense that gold is at the center of such a system. Besides, wouldn't a gold standard of some kind be much easier? Can you see that a gold standard allows capitalism to do its job, automatically, without interference from human judgment, which itself is sometimes good and sometimes bad?
Isn't it already beginning to sound more like a definition than an indicator?
The Mississippi Bubble Has Arrived in California
If you do not remember the infamous Mississippi Bubble, do not worry; it was before your time. It was about a central banker named John Law and his notorious paper money experiment. To make a long story short, it didn't quite work out. In any case, I'd like to compare an anecdotal account, emailed to me by a friend, of life in Silicon Valley to Charles McKay's account of the lives in Paris at the pinnacle of the Mississippi Bubble at around 1720 A.D. in France.
"...things are out of hand here in Silicon Valley. Even if the .com stocks are down substantially this year the freeways are packed with cars. I wonder what all these people are doing over here? How do they get paid? The Internet companies are not making money and they are paying ridiculous salaries anyway. Where do they get all this money? Are they printing it somewhere in their basements, or what? The prices on real estate are out of control. Yesterday my coworker received a notice from his landlord that his rent will be 40% higher next month (for a 1 bedroom apartment he will be paying $1700 US; he is paying $1200 now). For every decent apartment shown in Silicon Valley there are at least 20 to30 candidates. Ordinary people are big losers in this scheme. I am thinking to relocate somewhere."
Holy smoke, that sounds like a potentially misfiring price mechanism, wouldn't you agree? If not, perhaps a little perspective is in order. Here is a documented account of life in Paris, at around 1720 A.D., during the height of the great Mississippi Bubble, one of the most notorious of all monetary disasters:
" For a time, while confidence lasted, an impetus was given to trade, which could not fail to be beneficial. In Paris, especially, the good results were felt. Strangers flocked into the capital from every part, bent, not only upon making money, but also on spending it. The Duchess of Orleans, mother of the Regent, computes the increase of the population during this time, from the great influx of strangers from all parts of the world, at 305,000 souls. The housekeepers were obliged to make up beds in garrets, kitchens, and even stables, for the accommodation of lodgers; and the town was so full of carriages and vehicles of every description, that they were obliged in the principal streets to drive at a foot-pace for fear of accidents. The looms of the country worked with unusual activity, to supply rich laces, silks, broadcloth, and velvets, which being paid for in abundant paper, increased in price four-fold. The artisan, who formerly gained fifteen sous per diem, now gained sixty. New houses were built in every direction; an illusory prosperity shone over the land, and so dazzled the eyes of the whole nation that none could see the dark cloud on the horizon, announcing the storm that was too rapidly approaching."
Charles MacKay. Extraordinary Popular Delusions and the Madness of Crowds.
According to the California Association of Realtors
The California Association of Realtors recently reported results that acknowledge a vigorous housing sector. The president said, "Despite expectations that the housing market could cool off in a higher interest-rate environment, home sales accelerated to new heights." Median home prices in the state grew 12%, year over year. Many economists are beginning to perceive housing shortages in certain regions throughout the US, which are exerting an even greater influence on prices, thus demand, but also, probably on credit. Regions, where supply/demand imbalances have developed, such as Santa Clara, Wine Country, Monterey, and San Diego, sales volume declines appeared to reflect supply bottlenecks. In these regions alone, the average home price rose between 20% and 35% over the past twelve months. This, in my view, is another example of micro inflations popping up sporadically, throughout the nation.
The Consumer Is Spent
Have you ever seen a logarithmic chart of money and credit growth in the United States? I hope not, because it looks like the credit markets are saturated! This is not a good thing. The evidence suggests that everywhere else in the world today, where the economy is relatively stagnant, the causal agent is regularly perceived as the result of an excess of debt overhanging the economy. The US economy, however, is apparently different. It has technological innovation going for it. It has a strong dollar policy, which apparently reflects a diverse economy that has just launched itself into a higher internal rate of economic growth. It is the champion of freedom, democracy, and capitalism, a role model for the rest of the world. It has the most advanced capital market infrastructure in the world, and of course, all of this has made everyone richer. But, the consumer is spent.
This chart will look even worse when disposable incomes shrink, and interest rates move beyond 8%, the average level of the Fed Funds rate between 1986 and 1991. Anyway, the government was spent years ago. That is why they need to look fiscally prudent in order to attract votes today. The corporate sector has debt. A whole lot of it, in fact. The accelerated rates of consumption in the United States increasingly reflects an avaricious nation, taking for granted that the fruits of tomorrow, will simply pay for the debt of today, if not more. In the process, it has abandoned the foundation of its own success, and as a result, has been misallocating tremendous amounts of capital and human resources towards pursuits that are largely non-economic, and perhaps even self-defeating.
The Increasing Politics of the Dollar
The seeds of change have already started to bud, and now that the Europeans, the Chinese, and the Japanese have scores of dollars, they will doubtless push their political weight around. Why wouldn't they? We have been doing it for nearly a century. How is the United States going to keep a strong dollar policy when foreigners control its fate now? Particularly, if the US consumer is spent and the stock market is saggy, then of what use is the US dollar to them? Could it be the case that if not now, soon the US will need them more than they need the US?
Did you know that the Hong Kong Monetary Authority and the Chinese Central Bank together are nearly the largest owners of dollars on the planet, behind Japan and Europe? Maybe, that has something to do with China's recent entry into the WTO. In any case, soon it is not the same USA it was, even ten years ago. In the not too distant future, either Al Gore or George Bush junior will be at the helm, Larry Summers will be in charge of the nation's finances, and who knows who, will eventually replace Mr. Greenspan. These people are the new team in charge of America, the Promised Land, where prosperity has traditionally grown in the form of a paper claim on its future, but this claim doesn't even belong to the US anymore. We've already cashed in our chips, and had better hope that our foreign investment interests don't decide to cash in their chips. For, the future is incredulously straddled with the debt of a nation who has pledged its claims on the future, to others in order to live life to it's fullest today. Soon, if not already, we are at their political mercy, at least until we run out of ideas to keep them from calling it a game. Who ever will be President, he had better have good foreign policy capabilities.
I think that the Internet Bubble is about as creative as Wall Street is apt to get any time soon. That said, it has come to my attention that Medley and Associates think that they have latched onto something new. American interests think that they finally won the day in Mexico, through the election of Vincente Fox, the New Mexican President. If Wall Street can stimulate enough interest in Mexican stocks, they imagine, it might just be bullish for the dollar, as foreign investment interests would probably choose to gain exposure through NYSE listed ADR's. The biotech tout that Greenspan, Clinton, and Soros put together didn't quite work for the dollar, but combined with a perceived lid on oil prices, a friendly Fed, a Mexi-play, and a cooperating banking system, it just might work. However, I still don't think it will have any stamina. If I were Mexican, I would be concerned about the favors my northern allies thought that they were doing for me.
Anyhow, the way that this slingshot is stretched I don't think it can sustain. A soft landing will not unwind the current financial, economic, AND social imbalances, yet that is what needs to be done before a sustainable, real bull market can start again.
Instead, Wall Street will deliver even more speculative opportunities through the dollar. They have to, because investment expectations are so high now. In my opinion, the only thing that has a chance to support the dollar conflicts with what is good for the economic bubble, higher interest rates, however, what is not good for the economy is also not good for the dollar today.
Indeed, when Paul Volcker was elected Chairman of the Federal Reserve Board System, he drove interest rates right into heaven, and the economy into a deep recession, but only after a severe devaluation of the dollar. All the same, this was the cost to the US economy for bribing foreign capital owners into supporting the dollar. Perhaps this time, the solution will be more interesting, because it doesn't follow a long torturous era of dollar divestiture. Quite the contrary, it would precede the divestiture. The consensus is growing that it has been irresponsible to allow these bubbles to grow to the extent they have grown. This echoes warnings from the IMF, the Bank of Japan, and a growing chorus of credible money managers. Still, out with the old and in with the new, right? The bulls have been fed bad news through out the decade, and just like a people that are fed small increments of poison to strengthen their immune system, they are taking all of this in stride, let me assure you. They have been right so far, but the bad news is piling on, fast, and perhaps like the Jonestown case, maybe a little too much poison...
Here is why they have got it wrong
"Could a sharper deceleration in America trigger another emerging market crisis? Probably not. Some economies would be hurt, but overall most emerging economies are in better shape than a couple of years ago, with large foreign exchange reserves, and floating, not fixed exchange rates, making it easier for economies to adjust."
From the July 2000 issue of The Economist
The author argues that the European and Asian economies only trade about 3% of their GDP with the United States, and therefore would be largely unaffected from a US hard landing, were one to arrive. Hello...McFly, is there anybody home? How much would a collapse in the Dollar and US stock market affect their WEALTH? After all, their exposure to dollar denominated assets is at historic proportion! Is it at all possible that a version of the wealth effect is behind the glimmer of domestic demand that has suddenly appeared in Europe and Japan over the past ONE year?? Who knows for sure, but it is interesting that their stock markets reflect the same leadership and, to some degree, similar speculative excesses that the US stock market economy currently exhibits.
What in the heck good are vast USD exchange reserves when the dollar is collapsing and they are over-weighted in the bloody currency? Under these conditions, it is not going to be necessary to support the value of the Euro or Yen; it will be necessary to support the dollar. But how are they going to do that if they already have too many dollars?
This is the problem with most economists and prognosticators today. They're too timid to call it like they actually see it. As Eugene Birnbaum has already proven, floating exchange rates don't help an economy adjust nearly as much as they help the derivatives industry grow at the expense of the real economy. It seems that much thought has to be revised on the subject of money before we really get it right. That process will be entirely painful, if human history is any guide at all.
The US Trade Deficit
The bullish argument (can you believe that there is one for this?) is that there is so much more multi-national business done overseas today, than there used to be, that the trade statistics don't really count. That is convenient, but it does not explain the magnitude and volatility in the trade accounts as neatly as does the change in the exchange value of the dollar. Certainly, the change in business "structure" has been a more gradual one than the accelerating chart of the trade deficit implies. Nor does the velocity of cross-border capital flows reflect real multi-national business activity as well as it reflects the speculative excess in the US credit, derivatives, and stock markets. It's your choice to decide whether the cup is half full or half empty, but at a minimum, take the time to observe whether the line is at the halfway mark before you do.
Capitalism and Democracy
One cannot exist without the other. Is it any shock that politics and economics interact, meaningfully? It should not be, for US monetary policy has made an enormous contribution in promoting the benefits of capitalism to the world. Mr. Vincent Ferraro, a Ruth Lawson Professor of International Politics at Mount Holyoke College, South Hadley Massachusetts, in 1996 convincingly proposed "the globalization of capitalism is nearing completion, ending a process, which began in the 15th century."
Noting that the interruptions to its growth always came from opposing factions that manifested themselves in the form of communism, or differing degrees of socialism, he concludes that it has overpowered all of them. To me, there was long ago no question that capitalism would win out the day. There is no other viable alternative to supplant the price mechanism, which comes with the free market system. The views that I share with you are never against capitalism, but against the self-defeating kind of capitalism that exists in the world today. While I appreciate the freedom inherent in the price mechanism's abilities, it arguably, doesn't work efficiently when it is applied to education, healthcare, or defense. Even technological innovation, it has been shown, is not efficiently managed by the private sector over extended periods of time. What's more, a price mechanism cannot work efficiently at all, if there is no transparency in the market for sellers and buyers to be on a level playing field. Especially if at the same time, the informed participants are "managing" the market.
This state of affairs currently exists in foreign exchange markets, credit markets, AND the Gold market. Perhaps, the greatest strength of a capitalistic system lies in its use to democracy via its ability to allocate the nation's scarce resources, in the most efficient, automatic manner that is possible. Mr. Ferraro says as much when he hypothesizes "Market capitalism may induce a commitment to representative democracy." The reverse may be that a failed capitalism is equally likely to pose a threat to democracy. Yet, not a one monetary policy maker wants to connect the dots for you, because then, it will be obvious how they've, unwittingly I admit, taken your future away from you. Anyhow, Ferraro says, "people need both systems in order to succeed. The relationship between capitalism and democracy is indeed strong, and there are good reasons to believe that one cannot have one without the other." I could not agree more.
Just For Fun
How will the taxing authorities view the Internet, when the reality of the budget deficit is finally revealed, as a source of direct tax revenue, or, as it is today, a source of indirect tax revenue?
Perhaps we already live under despotic rule. President Clinton told television audiences recently that the Treasury is going to generate nearly $1.8 Trillion in budget surpluses over the next decade. Yet, the Congressional Budget Office projections, for example, ASSUME that more than $900 billion of that will come directly from tax revenues on capital gains, and I bet that is conservative. Our President is not even going to be here and he's making promises that everyone, except for maybe the 12-year-old day traders, should know he cannot keep. What gonads, and he says it with a big smile on his face because he knows what the next administration is inheriting.
1. You can find the article at Gold-Eagle