No Magic

Caroline Baum quotes Chris Low, chief economist at First Tennessee Capital Markets: “‘Greenspan has become completely reactive. Either we’ll have a recession, and he’ll get blamed for being slow to ease, or he’ll engineer a recovery, which will be accompanied by an inflation problem. Take your pick. Steering a middle course would be a miracle.'”

Caught between the Charybdis of inflation and the Scylla of recession – there is no doubt about which way Mr. Greenspan will push the tiller. He would rather risk the whirlpool of escalating prices than be eaten alive by recession.

Habit and experience…as well as theory…tell us what Greenspan will do.

The Fed chairman has few tools in his workshop. He can regulate the quantity of money, or its price, says Jim Grant, “but not both at once. For the past 20 years, the Fed has chosen to regulate the price, i.e., the federal funds rate. The quantity, i.e, the monetary base, is what it doesn’t control.”

Faced with the onset of a business slowdown, falling stock prices, and the possibility of a recession, the Fed did just what everyone expected – it reduced the price of money. In fact, it did so more aggressively than any other time in history.

Greenspan explains: “Because the advanced supply- chain management and flexible manufacturing technologies may have quickened the pace of adjustment in production and incomes and correspondingly increased the stress on confidence, the Federal Reserve has seen the need to respond more aggressively than had been our wont in earlier decades.”

“The Fed is doing what it said it would not do,” Jim Grant remarks, “easing policy in the teeth of rising inflation rates.”

Why? Because it believed inflation would not be a problem. Rising levels of productivity – providing more and more goods and services per unit of input – were supposed to offset increases in the supply of money.

And because Milton Friedman says that that’s what you’re supposed to do in a slump. Before Friedman, economists believed in a Newtonian economic world. A boom could be expected to produce a nearly equal and opposite reaction. The more people got carried away in the up part of the cycle – that is, the more they borrowed and spent unwisely – the more they would have to suffer in the ensuing downswing. Economics and moral philosophy were in harmony. The Great Depression was seen as an inevitable repercussion of the ’20s boom – made worse by governmental interference with the market’s corrective mechanisms.

But with the publication of their book, “A Monetary History of the United States” (1963), Milton Friedman and Anna Jacobson Schwarz re-interpreted the Great Depression. They offered policy-makers and investors the hope of resurrection without crucifixion…Easter without Lent…gluttony without fat…boom without bust…

“The U.S. economy’s collapse from 1929 to 1933 was by no means an inevitable consequence of what had gone before during the boom,” wrote the future Nobel prize winning economist. “It was a result of the policies following during those years. Alternative policies that could have halted the monetary debacle were available throughout those years. Though the Reserve System proclaimed that it was following an easy-money policy, in fact, it followed an exceedingly tight policy.”

Friedman/Schwarz: “The monetary authorities could have prevented the decline in the stock of money – indeed, could have produced almost any desired increase in the money stock.”

Mr. Greenspan is determined not to repeat this mistake. But what if Friedman is wrong?

I had lunch with Mr. Friedman a few years ago and attempted to engage him in a conversation on this point but was soon lost in the details and returned to small talk. If only I had had Kurt Richebacher at my side. [Friedman’s explanation for the Great Depression, writes Dr. Richebacher, “has but one little snag. It completely belies the facts!” The good Doctor then goes on to provide more facts than you and or I care to know.]

Dr. Richebacher’s argument is that the Crash and Depression were not merely monetary phenomena, but market and economic ones. “It was not the banking crisis that caused the losses in the markets,” he writes, “rather the losses in the markets produced the banking crisis.”

After having spent too much…gone too deeply into debt…and invested too much in business plans that couldn’t succeed – people had to cut back. This reaction was inevitable – equal and opposite to the preceding boom. Changing the price of money would have made little difference.

A lower fed funds rate – the rate that the Fed charges member banks to borrow money – allows the banks to lend at lower rates too. In a deflationary downturn, money becomes hard to get. People lose jobs, the values of stocks and other investments fall, sales and profits decline…and there are still big debts to pay. Lowering the price of money may have some effect, but not necessarily the desired one. People who are out of work and owe too much money do not make good candidates for additional lending. Nor do businesses want to borrow for capital improvements when the price of capital itself is in decline.

In Japan, the price of borrowed money has been reduced to zero – with little effect. In America, Fed policies were so accommodating and the bull market so enriching that the real cost of borrowed funds could be said to have been below zero for many years. An investor could borrow at 8% on a home equity line, and invest the money in the stock market for an 18% return. The net cost of money – minus 10%.

But, if you put the price of money low enough, it is argued, people will see that it is worthless and want to get rid of it quickly. The government can always “crank up the printing presses” it is said. But this is a little like ending a war by committing suicide. What’s the point?

The Fed has vast power. “But it’s not magic,” writes Doug Casey. “Greenspan…is the subject of laudatory paeans like ‘Maestro.’ A generation ago, when interest rates and reported inflation were 12%, the previous Fed Chairman, Paul Volcker, had reason to fear for his life. Was Volcker an idiot? I think not. Rather he was just a victim of the business cycle.”

Your writer,

Bill Bonner
Paris, France
May 10, 2001

*** Hmmm…what’s important today? The big news yesterday was the movement in the gold market. The price of the yellow metal rose $5.10. And the gold mining stock index, the HUI, rose 10%. The XAU Gold and Silver Stock Index rallied a robust 6.5%. Bellwether Newmont Mining showed the way with a 10% advance.

*** The sages of CNBC repeatedly expressed their collective surprise that the barbarous relic could become a relevant financial asset – even for a single trading day. What does it mean?

*** John Myers’ aptly named Outstanding Investments anticipated the surging gold price. “Gold Set to Soar” the May issue predicted. Explaining his bullish stance, Myers argued that gold is extraordinarily cheap. “Factor in inflation and gold is cheaper today than it was in 1974.” Myer expects that the Greenspan Fed’s easy monetary policy may be just the thing to help gold become less extraordinarily cheap. “The Fed will take its chances with inflation as opposed to letting the nation fall into depression. Simply put, the ’70s are acceptable. The ’30s are not.”

*** The Fed may prefer the ’70s to the ’30s, but does it have the power to choose? Milton Freidman says ‘yes.’ Kurt Richebacher says ‘no.’ More below…

*** Gold investors “who woke up and checked the graph for Anglo American were probably on the verge of a heart attack yesterday…as was I,” John wrote to me. “Several graphs on the Net showed the price plummeting from $60 a share to $15 a share. Not even Bre-X collapsed like that! But there is a simple and calming explanation – the stock had a 4 for 1 split. Unfortunately the company did a poor job of announcing it. All the great fundamentals that existed on Monday are still in place today. We haven’t taken a whipping…we just have 4 times as many shares!” (For more on investing with John Myers please see: Outstanding Investments http://www.realasset.com)

*** Cisco fell 6% yesterday – giving back all of Tuesday’s gains. The Dow fell 17 points. The Nasdaq dropped 42.

*** So far, the biggest story of the week is the drop in productivity. We’re not as productive as we used to be, the Labor Department tells us. But what would government bureaucrats know about productivity? The irony could only be thicker if we asked retired bureaucrats to do the calculation: that is, people who never did anything useful during their working years, and in retirement no longer need to keep up the pretense.

*** The falling productivity story is so awkward few financial commentators have touched it. It doesn’t fit into the neat “2nd half recovery” story they’ve fashioned for their readers. It’s as if a guy had shown up for a funeral dressed as a clown – the falling productivity number calls into question the event’s emotional premise: They don’t know what to make of it.

*** “What we are witnessing,” writes Dr. Kurt Richebacher, “is far more than the bursting of the Great Bubble. It is the bursting of the whole new paradigm myth claiming that widespread and aggressive investment in new information technology created profit and productivity miracles.” Without the new paradigm, there is nothing to explain (or justify) stock prices that are still twice as high as the historical average. And no reason to expect earnings growth beyond the ordinary.

*** Investech Editor Jim Stack calculates that the recently vanishing wealth is equal to about 1 1/2 times the total value of ALL stocks in existence in January 1991, when the final phase of the great bull market began. Further, Stack notes, “To recover the highs of last year, assuming a 15% compound annual growth rate from their recent lows…

…the NASDAQ would require 8 years.

…Cisco Systems would require 13 years.

…Priceline.com would require over 26 years!”

*** But as Warren Buffett points out…15% annual growth is ‘dream land.” When the P/E of the S&P 500 exceeds 22, as it does now, the ordinary return is no more than 5% annual growth over the next 10 years. “What would the numbers be if you used a 5% annual rate?” I asked my side-kick statistician Addison Wiggin.

*** “At that rate,” he replied, “you’ll wait 18 years for the Nasdaq to recover…27 years for Cisco…and Priceline? Let’s see, 30 years from now, it’s still down more than 60%…ah, never mind.”

*** Another major premise of the ‘Dow 36,000’ crowd is that the flood of money coming in from baby boomers’ 401k accounts must raise prices of financial assets. But Cerrulli Associates report that 401 k assets fell – for the first time ever – in 2000. What’s more, 77% of the growth in 401k assets came from stock market gains, not from contributions.

*** “California’s well-publicized energy crisis is just the tip of the iceberg,” the Oxford Club’s C.A. Green tells me. “Many industry analysts feel New York State is likely to be the site of the next big energy shortage…and while potential solutions to the ever-increasing energy crisis are being advanced, there are few realistic alternatives. Enron – a natural gas producer – is perfectly suited to benefit from the crisis…net revenues rose 25% – on 55% higher sales.”

*** Blue Service reader Fendall Marbury writes: “The whirlpool Charybdis may be mythical, but it still exists. On navigation charts of the Straits of Messina, it can be found close to the Italian shore. It is said to be tidal, and to be weakening. In the early 18th Century, a British frigate got into it and was turned around, but not swallowed as described in the Odyssey.”

*** Since I’ve been writing about war…Doug Casey sends this quotation from Gen. Smedley Butler, USMC, 1933, a two-time Medal of Honor winner:

“War is just a racket. A racket is best described, I believe, as something that is not what it seems to be to the majority of people. Only a small inside group knows what it is about. It is conducted for the benefit of the very few at the expense of the masses.

“I believe in an adequate defense at the coastline and nothing else. If a nation comes over here to fight, then we’ll fight…I wouldn’t go to war again as I have done to protect some lousy investment of the bankers. There are only two things we should fight for. One is the defense of our homes and the other is the Bill of Rights. War for any other reason is simply a racket.”