A Recipe for Disaster

There’s something funny going on – the Fed is creating all of this money-out-of-thin-air – but who is getting richer? Certainly not the Mogambo…and he has a strange suspicion as to whose pockets this magic money is filling…

It was a week of extraordinary excess (WOEE) everywhere you looked in the shadowy world of modern money. At least, that is the way that it looks to me, as I nervously peer out of the periscope of the heavily fortified Mogambo Bunker, cowering in abject overpowering fear.

First off, the Federal Reserve has apparently started down the dismal path to economic hell of Ultimate Money Debasement (UMD), namely the last-ditch desperation move classically known as direct monetizing of debt. They have now sunk so low that they are now engaging in the worst behavior that a central bank can engage in, namely creating money to buy government debt, which is commonly known as "monetizing" the debt.

In effect, the Federal Reserve (which is, I hasten to point out, a private bank) creates money – poof! – for itself and buys government debt with the money. It’s that simple! Magically, money has appeared out of nowhere! The total, aggregate debt load has not, unfortunately, changed, but the total amount of money sloshing around is greater!

The Fed and the Money Supply: Who DOES Have More Money?

If you keep a close eye on your finances, you realize that you do not have more money. Likewise, I do not have more money. So if YOU do not have more money (I point to you) and I do not have more money (I point to myself) then, (audience shouts in unison) "Who the hell DOES have more money?"

The answer is, of course, that the BANKS have more money! I know what you are thinking: "Wow! What a racket, huh?" This brings us to today’s timeless gem from the Mogambo’s Famous Treasure Trove of Valuable Lessons In Life (MFTTOVLIL), and this lesson is that when you get a chance to make a wish, maybe by wishing upon a star, or blowing out the candles on your birthday cake, or rubbing a magic lamp and a genie pops out or something, you should wish to own a country’s central bank. You can create money out of thin air, anytime you want, and buy anything you want with it! Cool!

But so much money has already been created, so achingly much money, so damnably impossible much money, has been created and borrowed. Reluctantly, I rise up from my chair and stagger over and look out the window, and I cry out in horror as I note that MORE money and credit are STILL being created right now, every minute of every day, all around the freaking world! And a lot of that the money is being used to buy some of everything, sometimes a LOT of everything, including stocks and bonds and houses and government, which drives prices up. And when a bond goes up in price, then that automatically means that the imputed yield goes down. Thus, interest rates are low! It’s as simple as that!

And so long-term rates, which are most affected by market forces, have gone down, but short rates, which are more affected by Fed actions, stayed up. The difference in interest rates between the short and long terms narrows, and thus the yield curve flattens.

The Fed and the Money Supply: The Inverted Yield Curve

Now, if long-term interest rates keep falling and falling, and eventually fall below the interest rate on short-term debt, you get the famous inverted yield curve. That means you have achieved the absurd condition where you are getting paid less money for loaning your money for a longer term, and at higher risk! Hahahaha!

Of course, Alan Greenspan thinks that this is not necessarily bad, according to Reuters, which reported that the Federal Reserve chairman said that an inverted yield curve was not necessarily an indicator of a recession these days. He admitted that it USED to mean exactly that, back before the Federal Reserve got into Permanent Liquidity Mode (PLM), when he said, according to Reuters, "It’s … certainly the case that history suggests that it’s usually, or has been, an indicator – a forward indicator – of softening economic activity." See? He actually admits that an inverted yield curve always has been an indicator of what he calls "softening economic activity!"

He went on to say, "I suspect, however, that we have changed the structure of flow of funds and relationships amongst the various interest-rate tranches by maturity such that I’m not sure what such a configuration, should it occur, would mean."

You are going to be surprised that I agree with him 100%. He is exactly right. Interest rates are no longer the result of a tug-of-war between borrowers and savers. There are no savers anymore. Savings have been replaced by instant liquidity, as part of the Federal Reserve’s new Permanent Liquidity Mode (PLM) philosophy and practice. What the Federal Reserve has done is to produce more "liquidity" all the time, which gets borrowed by someone like you, although not as good-looking as you, and the borrower (you) uses the money to play the spread between different pieces of debt, in effect borrowing money short-term at low rates, and lending the money long-term at higher rates. You then pocket the difference! What a racket, huh?

And when it comes time to make a payment on that first loan, you merely saunter into a bank, and borrow some more just-created "liquidity"! You then use this second, bigger loan of instant liquidity to do the interest-rate spread thing TWICE more; once to pay the interest on the first loan, and the other one to provide some more pocket money for yourself! Sweet!

And this can, theoretically, go on, and on, and on, forever. So therefore the actual interest rates are immaterial! The only important thing is that there is a difference between short-term interest rates and long term interest rates! That’s it!

The only difficult thing is that it takes massive amounts of leverage to make it worthwhile when the yield curve is flat. Borrowing a million dollars at 4% to buy a bond that pays 4.0001%, resulting in a cash-flow of a measly $100 a year, is hardly worth the trouble. But let me leverage up, maybe putting up only $10 as my part of this deal, and suddenly I have made ten times my initial investment! I only put up ten stinking bucks and made a hundred! All it takes is a bank that is willing to do it.

The Fed and the Money Supply: Inflation

That, sadly, is how it is nowadays. And to everyone who thinks that this can work out in the long run, I say, "Look at my face to see my contempt for you, and hear my mocking ridicule echo in your ears as I say hahahahaha!" because, and you might want to write this down because it seems to be some big secret or something, eventually the money gets to be SO huge that it starts going into those things OTHER than stocks, bonds, houses, and government, and they start showing up as price inflation, and everybody gets all crazy, and it gets worse and worse, and people are screaming bloody murder, and the nightly news is full of people rioting because prices are so high.

Or perhaps you would rather listen to Eric Fry, of the Rude Awakening column, who writes, "For starters, throughout the ages, bond yields and commodity prices have tended to move up and down together – not at every single moment, but over long sweeps of time. Over the last few years, however, bond yields have strayed from commodity prices like an unfaithful spouse. But we expect this philanderer to return home fairly soon, in which case, bond yields would rise." Which means bond prices would fall, handing a lot of people some hefty losses, losses so big that not even Superman could lift it.

Stephen Roach, on the same subject, writes, "Real interest rates – both short and long – are still far too low for sustainable growth in the global economy and for stable conditions in world financial markets. Yet central banks – especially America’s – have been reluctant to lead the charge in normalizing the rate structure. The best we have gotten from the Fed is a policy rate that has gone from negative to zero in real terms over the past year. I continue to believe this is ultimately a recipe for disaster."

Nevertheless, he reluctantly acknowledges, "At some point over the next year, I wouldn’t be shocked to see yields on 10-year governments test 3.50% in the US, 2.50% in Europe, and 1% in Japan."

Whew! After all that, and notice how I am drained and winded from the ordeal, to make matters even worse, the Treasury printed up and issued more actual dollars. How much? I will wait until you are seated. Comfy? Okay, two weeks ago they printed up another $6 billion in actual cash! Where in the hell is $6 billion in cash going all of a sudden? I have no idea, personally, but I am sure that it is due to government corruption, and it also adds to the overall money supply, which will, once again, cause just that little bit more inflation down the road. It just never stops.

Regards,

The Mogambo Guru
for The Daily Reckoning

June 13, 2005

Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter, an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron’s, The Daily Reckoning and other fine publications.

Conundrums. Conundrums. Conundrums.

Alan Greenspan used the word to describe the curious goings-on in the bond market. Greenspan raises short-term rates, but long term yields fall! It’s not supposed to happen that way. The Fed is supposed to be raising rates in response to strong growth, which is supposed to be pushing up inflation and bond yields.

Here at The Daily Reckoning we had an explanation: the world economy is weakening, not getting stronger…more specifically, the U.S. economy is still sinking into the long, slow, soft slump we warned about three years ago.

Another way of looking at it is that long rates are falling because people see little risk of inflation. They’re happy to take 6%, or even 5%, for 30 years.

Alan Greenspan had an explanation for the interest rate conundrum last week. He finally noticed that there were a lot of people in Asia willing to work for a lot less than people in America. This "glut of labor" is inherently deflationary. It pulls real prices down. (Nominal prices, of course, are another conundrum. No matter how fast Wal-Mart can cut prices, the U.S. treasury can – theoretically – cut the price of the dollar. If it wanted to do so, the Fed could drop dollar bills from helicopters as Fed governor, Ben Bernanke, has suggested. Or it could hide it in tin cans all over town, for little boys to find, as John Maynard Keynes once whimsically suggested.)

But the real conundrum was why it took so long for people to see what was obvious all along – you can’t really build a sustainable, healthy economy on consumer spending in excess of consumer wages. You have to earn it before you can spend it. If you do it the other way around, there comes a time when you must stop spending it so you can repay what you already spent.

Such old-fashioned ideas are as out of style as spats. Everyone now believes the economy can be manipulated, guided, and directed towards any outcome the central planners want. The collapse of the Berlin Wall was supposed to represent the victory of freedom over central planning. But here’s a conundrum for you: why does everyone now believe in central planning?

The Feds think they can find a short-term interest rate better than the one that arises naturally from the actions of lenders and borrowers. It seems to bother no one but us that they, our central bankers, chose a rate far below what lenders would willingly accept.

"Finding a new captain for our economic ship," is a headline from Newsday. It refers, of course, to a replacement for the maestro himself. (Currently, Ben Bernanke is among the frontrunners.) But what is interesting in the headline is the way it presumes that we are all on this economic ship together and we need someone to run the thing for us. The days when people were individually responsible for piloting their own economic barks disappeared with the Old Republic and sarsaparilla. What used to matter was private virtue; if you worked hard enough, saved your money, and used your head…you could improve your lot in life. (More below…)

If you fell into sloth, extravagance or iniquity, on the other hand, you could expect that your economic fortunes would be diminished. But so what? It was your own damned fault. But now, we have a no-fault economy. Now, what matters is having someone in the captain’s seat clever enough to make sure today’s lack of virtue doesn’t catch up to us.

More news, from our currency counselor…

————–

Chuck Butler, reporting from the EverBank trading desk in St. Louis:

"DEFICITS DO MATTER! And one day…obviously not now…but one day, all these geniuses that don’t believe that will wake up and smell the coffee!"

————–

Bill Bonner, with more views from Baltimore…

*** What’s this? The euro is still falling; it’s down to $1.21. Generally, markets shrugged off the "no" votes on the European constitution. But the euro is still under pressure. What will happen to the euro? Who knows…it’s a conundrum.

*** Greg Grillot, with news from the Agora Traders’ Seminar in Boston…

"For two days straight, the finest fundamental, technical and the quantitative investment analysts spoke to a crowd of about 80 eager investors. The spectacle of knowledge and potential profits was overwhelming.

"One analyst named a stock whose share price went up 60% in just over 2 weeks. Now that’s short-term buy and hold profits without any type of leverage or speculation…

"Another analyst named a fundamental leading indicator that gives YOU the power of a CEO’s knowledge – without any illegal insider insights or difficult mathematic analysis.

"Which idea will prove to be the best one? Who knows? Maybe each idea has equal profit potential.

"But that’s for you to decide – and fortunately, you don’t have to sit with me in downtown Boston to make that decision.

"That’s because we’ve filmed the entire conference, including the invaluable Q & A sessions. Such options luminaries as Kevin Kerr, Daniel Denning, Chris Mayer, Karim Rahemtulla, Adam Lass, Lynn Carpenter, and many more will speak, giving the grueling detail behind their proprietary strategies – and some specific trades that can help you grab some potentially sweet gains.

*** The NY TIMES has been exploring money matters in a series of articles. The general drift is as might be expected: the rich are getting richer; the poor are getting poorer! We have to do something!

It must be getting harder and harder to remain poor in America today. "If you can fog a mirror, you can get a mortgage," said a lender recently. And if you can get a mortgage, you can get your little boat onto the great current of wealth that is making everyone in the United States rich – at least, in their own minds. Before you know it, you’ll have been swept along into a McMansion.

But now you can qualify for sympathy no matter how much you make. Beyond subsistence, wealth is relative. "Advocates for the poor say the poverty line is far too restrictive to a be a realistic measure of material deprivation." The TIMES shows us a person who is not really "poor" but still someone we should worry about. Irma Williams was a drug addict, derelict, promiscuous bum eight years ago – with four children she did not take care of. Now, she is a college graduate earning $27,000 a year. Not a lot of money…but still more than 10 times as much as the average person in China or India earns. And naturally, even though the taxpayers paid for her "rehabilitation," detox, and food stamps and still pay most of her rent, the poor woman cannot make ends meet and has run-up $12,000 in student loans and $8,000 in credit card debt. And yet, when we look at how she spends her money, we see that she could easily make cut backs. The photo of her in the paper shows she plainly eats too much. She goes to the beauty parlor and gets manicures. She has a gym membership. If she were Chinese she would walk to work, or ride a bicycle rather than pay for transportation.

We wonder: why should this woman, who has squandered most of her life, earn 1,000% more than the average Chinese? What has she done to deserve it? Compared to 3 billion people in Asia, Ms. Williams is a rich woman.

Yet, the woman is "poor," say poverty advocates. The poverty line should be about twice as high as the current official number, they say. Another conundrum, we guess.