A Flood in the World Markets

The Daily Reckoning PRESENTS: Some people never learn from the past – and are doomed to make the same mistakes over and over again. Our Federal Reserve exemplifies this, as they continue to direct the credit expansion, which not only has turned housing into a large bubble and rekindled the stock market, but also has given rise to a voluminous foreign trade imbalance. Dr. Hans Sennholz explains…


Central banks live by a simple financial principle: Whenever economic activity stagnates or declines, they quickly lower their interest rates and expand their credits. But when business seems to improve, they hesitate and vacillate in removing the rate cuts. The consequence is a permanent addition to liquidity. According to calculations of the German central bank, between the end of 1997 and September 2006 the stock of world money nearly doubled, but nominal economic production rose only by some 60 percent. Such an imbalance is bound to either cause consumer prices to rise or create price bubbles in stock, loan, or real estate markets. When they finally burst they are likely to inflict many personal losses and force businesses to repair and readjust.

Every week we may hear and read about new corporate mergers and acquisitions. Flush with cash, private equity firms are ever ready for more deal making, bidding for and acquiring another company. The merger and acquisition boom is buoying stock prices across the board, which is benefiting most investors. Moreover, as some corporations are being taken private and others are engaged in stock buybacks, thereby reducing the overall supply of corporate shares, the stock market is enjoying an extraordinary boom, which many investors hope will never end.

Some economists are scoffing at such optimism; they like to point at the bursting of the bubble in 1929, which led to the Great Depression of the 1930s. They also remember the bursting of the Japanese bubble in the early 1990s, which kept the Japanese economy depressed for nearly a decade. And they cannot forget War II and postwar monetary policies which, by the beginning of the 1970s, had flooded the world with U.S. dollars. Some countries finally removed their currency ties to the dollar, and the oil-exporting countries cut their supplies of oil, which caused raw-material prices to soar. In the early 1980s, it took major Federal Reserve restraint to restore some measure of stability and several years for business to repair some damage and allow the American economy to expand again.

At the present, government planners and central bankers are making the same mistakes all over again. They all seem to like low interest rates, thereby rendering capital less expensive. When real interest rates are depressed, as has been the case all over Europe and in the United States early in the present decade, the economy loses a sense of direction, which may allow even unproductive producers to remain in business. In the long run, without the guidance of true market rates of interest, economies lose efficiency and productivity.

In a free economy, interest rates play a role similar to those played by prices and wages. They all spring from the people’s choices and value judgments, giving rise to “demand and supply” and guiding producers in their decisions. The market rate of interest is a gross rate usually consisting of three distinctive components: the pure rate, the depreciation rate, and the debtor’s risk premium. The pure rate is the very core stemming from man’s very nature which forces him to view economic phenomena in the passage of time. He ascribes a lower value to future goods and conditions than to present provisions; the difference is the pure rate. The depreciation component appears whenever government or its central bank inflates, thereby depreciating the currency; the rate of currency depreciation determines the size of the component. The debtor’s risk premium, finally, reflects the reliability and trustworthiness of the debtor.

Central bankers rarely pay attention to the market rate. Their policies are guided by popular doctrines calling for stimulation of national employment and income. They seem to be unaware that all rates other than market rates give false signals to producers and consumers alike; they cause maladjustments. Rates that are lower than market rates promptly increase the demand for credit. With all recent rates below the market rate it cannot be surprising that total American debt has surged by several trillion dollars. Last year, household debt alone rose by more than one trillion dollars. The federal government itself has been adding more than two billion every day. The Federal Reserve System, together with some 7,900 commercial banks, provided the funds; and foreign central banks and commercial banks invested their dollar earnings in nearly one-half of the federal government’s debt.

Such credit expansion, unsupported by genuine savings and capital formation, generates illusionary gains making people believe that they are more prosperous than they actually are. Stock and real estate prices soar, tempting people to spend their gains, improve their homes and build mansions. Actually, they all – businessmen and stockbrokers, executives and workers – may consume their material substance. But no matter how low the Federal Reserve may set its rate, the boom is bound to come to an end as soon as the maladjustments inflict losses on business. As more and more businesses face difficulties or even fail, the readjustment begins, forcing them to respond to the actual conditions of the market.

Today, the Federal Reserve is doggedly ignoring the market rate of interest. It continues to direct the credit expansion, which not only has turned housing into a large bubble and rekindled the stock market but also has given rise to a voluminous foreign trade imbalance. Both domestic and foreign maladjustments are inflicting growing pains on commerce and industry.

Some economists are convinced that central banks may have a ready escape from the dilemma: they may gradually return to higher rates of inflation which forces all fixed-income receivers and bond holders to bear the most losses. Optimists even like to point to the impact of globalization, which seems to limit the inflationary effects to real estate and the booming mergers-and-acquisitions market. But most economists are fearful of a recession which is a normal part of a business cycle. Fear may take hold of the minds of businessmen, production may be curtailed, and unemployment may rise. Government is bound to embark upon employment programs and assume increased public welfare responsibilities. It may even reduce some taxes, increase its budget, and force its central bank to lower interest rates another notch. The rate of inflation is bound to soar.

A few pessimistic economists are convinced that a devastating economic cataclysm lies ahead. They usually point to three threats that may have a serious impact on the American economy. There is the burgeoning tower of public and private debt resting on a foundation of greed and overindulgence. There are a multimillion dollar list of promises to a retirement system and a vast building of government guarantees and promises that are bound to be unkept. There even is a world of complex derivatives, the value of which depends on something else, such as stocks, bonds, futures, options, loans, and even promises. They all, according to these economists, will be the victims of the coming cataclysm.

This economist, who has observed central bank policies since the 1950s, is in basic accord and feels sympathy for these pessimists. They seem to have a clear view of the principles of money markets and the policies conducted by governments ever since they discarded the natural money order, that is, the gold and silver standards. But these pessimists tend to ignore the countless ruses, devices, and strategems used by government officials and central bankers to hide the consequences of their policies. Long before there will be a financial Armageddon, there will be a myriad of government regulations, controls, edicts, and rulings that hide the consequences of monetary policies. Policies will be readjusted frequently to cover the actual effects. Given the public confusion and unfamiliarity with monetary policies and their consequences, a large majority of the public is likely to accept official explanations and welcome the regulators and controllers.

After a short period of price and wage controls, the voices of reason, which at the present are barely audible, may be heard again. They may even be allowed to get the American economy moving again, by abolishing the myriad of price and wage controls and allowing wages and prices to readjust to market forces. They may even have to conduct a currency reform, that is, issue new money at various ratios to the old. Most countries all over the globe have suffered currency reforms in recent decades; it would be a new experience for Americans.

This trend of policy and its harmful effects is contravened by the worldwide movement toward globalization. As trade doors open all over the globe and business capital is free to move to friendly countries enjoying rapidly rising levels of productivity and living, it will be difficult for American political controllers and regulators to hold on to their powers and move toward a command system. They cannot douse the light of economic freedom shining in so many places.


Dr. Hans Sennholz
for The Daily Reckoning
May 30, 2007

P.S. We cannot tell what the future will bring, but we must always prepare for it. This economist is bracing for a gradual increase of political controls over economic life, leading to countless maladjustments, distortions, and stagnations.

Editor’s Note: We couldn’t agree more with Dr. Sennholz – you never know what’s around the corner. Hope for the best and plan for the worst…especially where your retirement is concerned. Christopher Hancock has been telling his subscribers about a little know “pension pay-out plan.” Why trust your retirement money to the government? Take matters into your own hands, and start managing your nest egg now.

Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy. You can write to him at this address: hans@sennholz.com.

Hold on tight…this is one helluva ride!

Wow! Maybe it really is a new era. The world has never seen anything like it…at least not on this scale.

Like everyone else, we are standing back in shock and awe. How much farther can this go? How much longer can it go on? That is, we wonder – how new is this new era?

We’re talking about the Great Big Bucking Bubble, of course.

Get this: on Memorial Day alone, 455,111 new brokerage accounts were opened in China. That’s as if every man, woman and child in the city of Luxembourg had opened an account, and it’s happening every day.

This puts the number of investment accounts in the People’s Republic at over 100 million. Naturally, the market reflects all this new buying pressure from The People. Stocks in Shanghai have doubled since the spring of 2005…and doubled again. Just look at the chart. Prices have gone parabolic – rising almost straight up. It’s the Peoples’ Own Bull Market…when the people are enjoying their own precious moment of happy delirium.

“It is glorious to get rich,” said Deng Tsaio Ping. And now, millions of Chinese are getting gloriously rich.

We wonder if ‘easy come, easy go’ is an expression in Mandarin. If not, someone might want to translate it. As far as we know, no market has ever gone up so steeply without going down just as steeply later on.

But, hey…dear reader…this is a new era. Anything can happen.

Meanwhile, the Chinese authorities are getting worried. They may not have seen bubbles up close, but they’ve read about them. So, they’ve tried warnings…increasing reserve requirements…tightening credit. Last week, the Education Ministry came out and told students to forget the stock market and stick to their books. Apparently, a lot of college students are standing in line to open investment accounts, next to the widows and orphans. They’re neglecting their studies, say the authorities.

But who can blame them? Speculating on stocks, especially in a bubble, is so much easier than differential calculus. It is also much more profitable. Why go to the trouble to become an electrical engineer, earning $5,000 a year, when you can borrow, invest in stocks, and earn millions?

But the Education Ministry should relax. We have a feeling that all these green, young investors are about to get a valuable lesson.

And back in the 50 states, another kind of speculating frenzy has got a grip on the market. There, the furies have lit up the pros, more than the Moms and Pops.

Merge…acquire…buy…sell…deals, deals, and more deals. This month of May will see more new buyout deals bloom than any month in history. It is like the Chelsea Flower show! Buyouts so far this month total some $82 billion. The ‘hottest month’ of deal making ever.

“Is deal frenzy nearing end?” asks the Wall Street Journal.

We don’t know. But we read also that the U.S. money supply is still expanding at a 14% annual rate – six times faster than GDP. All that moolah has to go somewhere. For the moment, it’s going into deals. And the deal makers – such as über-dealer Goldman Sachs (NYSE:GS) – are making big, big money. Goldman’s shares have gone up three times in the last five years.

And here comes a report that investors are more confident than anytime in the last five years. But at the same time, a lot of seasoned investors are beginning to speculate on the downside. The street hasn’t seen so much short selling since 1931. Normally, people sell short at the beginning of a bull market. Prices rise and they expect them to come right back down again. But now we have a huge increase in short selling after the stock market has been running wild.

What to make of it? Again, we don’t know…maybe it really is a new era….

More news…


Addison Wiggin, reporting from Baltimore…

“‘Small soda looks like buyout bait,’ says Greg ‘Gunner’ Guenthner, with his eye on the bulletin boards and penny stocks.

“Last week, Coca-Cola plunked down $4.2 billion for Glaceau, maker of Vitamin Water. ‘Even Coke executives are acknowledging a changing tide in the soft drink business,’ says Gunner. ‘The company has admitted enhanced water and energy drinks will probably make up a large portion of the beverage industry’s growth in North America over the next several years.'”

To read more on this story and others, read today’s issue of The 5 Min. Forecast


And more thoughts…

*** Short Fuse, reporting from the City of Angels…

“You wouldn’t believe the amount of construction that’s going on China,” our friend, and director of our upcoming documentary reported upon his return from the Far East. “Construction cranes crowded every street.”

It’s looking like the construction boom isn’t just confined to China; according to the U.S. Census Bureau, “spending on nonresidential construction was up nearly 14 percent during the first three months of 2007.”

Demand for cranes and crane operators is the highest it’s been in 36 years – and to meet this demand, Morrow Equipment Company of Salem, Oregon, has been adding to its fleet of about 500 large-scale cranes that it leases to contractors nationwide, reports the AP.

And what do you need to build cranes? Steel…and lots of it. China’s construction boom is drawing on the same resources needed to manufacture these cranes, says Gary Vosper, Morrow’s advertising director.

“We’ve been told by the factory that they availability of high-grade steel is becoming an issue and affecting their level of production,” Vosper said. “Sometimes we’ll order a crane and we may not get it for 12 months.”

Demand for steel is flourishing right now…after all, not only is it used in the developing of these cranes – but in the buildings…power plants…highways and bridges that are being erected.

“The Sears Tower in Chicago, the nation’s tallest building, contains 76,000 tons of steel. The Twin Towers in New York used 200,000 tons of steel. Can you doubt that there’s money to make when steel demand goes up?” says Free Market Investor’s Christopher Hancock.

“For anyone in America who invested in the early 1900s, steel shot up an average of 66% per year…26 years in a row. This ‘second skyscraper boom’ should have an even bigger effect.”

Members of our exclusive Agora Financial Reserve get to attend the Symposium for free. This is just one of the many perks our Reserve members are privy to…and on this Friday, we will be reopening the doors of the Reserve – at a very special price. Stay tuned for more info…

*** You want to know something important, dear reader? Something that really matters? Well, read on…

We’ve been saying that the boom is a fraud. It is a speculative boom, not an economic boom. It lifts up asset prices and makes rich people think they are richer than ever. But it doesn’t increase real economic output – at least, not in the United States of America – or make average people any better off.

Of course, the leftists have been saying this for years. But who cares what they say. Even when they do spot a real problem, they invariably come up with a solution – more government meddling – that makes it worse.

Still, this is something they’re not wrong about.

An item from yesterday’s news:

According to data from the Pew Charitable Trust’s Economic Mobility project, a generation ago, American men in their 30’s had median annual incomes of about $40,000. Today, men of the same age, make about $35,000 a year, adjusted for inflation. That’s a 12.5% drop over the last 30 years.

What do you make of that, dear reader?

We begin by asking the obvious questions: how is it possible that the biggest boom in the most advanced capitalistic economy, in history, has not made ordinary people wealthier? How could it be that Reagan’s Supply-Side Revolution…the blissful Clinton years…and the super-debt, super-spending era of George W. Bush…have altogether failed to produce one solitary dollar of extra income for the average working man?

The leftists will have their silly prognoses and their quack remedies…the rightists will have their claptrap excuses and their pass-the-blame apologia.

And the average working stiff? He seems not to have even noticed. He’s living on borrowed time and borrowed money. He sees the new house his family lives in…he looks out in the driveway and sees his new, foreign-made car…and he goes on the Internet and finds new ways to get more credit. What me worry?

On the Yahoo News site, we found the following offer:

$510,000 Mortgage…Under $1,698 per month!

Let’s see, the average guy earns only $35,000. Take some out for taxes and health insurance…yes, he might be able to swing it, if he doesn’t eat.

But even if he could make the payments – interest only – how could he ever put aside enough money to pay it off? But don’t worry, he’s getting used to things he can never get out of – tax obligations that follow him, no matter where he goes in the entire world…credit card bills…mortgages. He has taken what Friedrich Hayek called ‘The Road to Serfdom.’ He is becoming a slave…to his credit cards, to his government, to his mortgage, to his nation’s foreign meddling and domestic commitments. The poor man has no way out.

*** At least our old friend, Ron Paul, now running for President, is offering Americans a fresh ‘narrative’ that explains what is happening to them from a different perspective. On Lew Rockwell we read:

“The explosive exchange occurred during the Republican Presidential debate in South Carolina.

“Ron was asked if he really wants the troops to come home, and whether that is really a Republican position.

“‘Well,’ he said, ‘I think the party has lost its way, because the conservative wing of the Republican Party always advocated a noninterventionist foreign policy. Senator Robert Taft didn’t even want to be in NATO. George Bush won the election in the year 2000 campaigning on a humble foreign policy – no nation-building, no policing of the world. Republicans were elected to end the Korean War. The Republicans were elected to end the Vietnam War. There’s a strong tradition of being anti-war in the Republican Party. It is the constitutional position. It is the advice of the Founders to follow a non-interventionist foreign policy, stay out of entangling alliances, be friends with countries, negotiate and talk with them and trade with them.’

“He was then asked if 9-11 changed anything. He responded that U.S. foreign policy was a ‘major contributing factor. Have you ever read the reasons they attacked us? They attacked us because we’ve been over there; we’ve been bombing Iraq for 10 years. We’ve been in the Middle East – I think Reagan was right. We don’t understand the irrationality of Middle Eastern politics. So right now we’re building an embassy in Iraq that’s bigger than the Vatican. We’re building 14 permanent bases. What would we say here if China was doing this in our country or in the Gulf of Mexico? We would be objecting. We need to look at what we do from the perspective of what would happen if somebody else did it to us.’

“And then out of the blue, he was asked whether we invited the attacks.

“‘I’m suggesting that we listen to the people who attacked us and the reason they did it, and they are delighted that we’re over there because Osama bin Laden has said, “I am glad you’re over on our sand because we can target you so much easier.” They have already now since that time – killed 3,400 of our men, and I don’t think it was necessary.'”