An Open Mouth

The people who expect a double dip or worse in the United States certainly represent a small minority. Among policymakers and economists in America, it is a virtual consensus view that the Great Depression of the 1930s as well as Japan’s present, protracted economic quagmire have their decisive cause in one crucial policy mistake: both central banks were much too slow in lowering their interest rates when the economies began to weaken.

All this really boils down to one key question: When do central banks make their decisive mistake? Is it during the boom and the bubble? Or is it in their aftermath?

Convinced he had learned from history, Mr. Greenspan slashed the Fed’s federal funds rate with unprecedented speed from 6.5% to just 1%. Establishing thereby a steeply sloped yield curve, his aggressive rate cuts had sweeping effects also on long-term rates, as investors and speculators stampeded into highly leveraged purchases of higher-yielding longer-term bonds.

In principle, central banks have but two instruments at their disposal to influence money and credit growth with the ultimate aim to curtail or to stimulate economic activity: adjustments in bank reserves through open market operations; and adjustments in its key short-term rate or rates.

Bond Bubble: The Open-Mouth Policy

Yet there is still a third, unconventional instrument of which central bankers have made very different or no use of at all. It has sometimes been called a central bank’s open-mouth policy. Mr. Greenspan is definitely the world’s one central banker who has practiced this extraordinary tool with unusual abundance and aggressiveness. He, apparently, regards it as perfectly legitimate for a central banker to bend expectations in the economy and the markets in a direction he wants.

During America’s boom and bubble years, Greenspan was effectively the most prominent and also the most pronounced New Era Apostle. In various speeches, he developed arguments or “theories” plainly rationalizing and fanning the euphoria in the stock market.

In his famous Boca Raton, Fla., speech on Oct. 28, 1999, just a few months before the stock market’s crash, he suggested that the unprecedented equity valuations seemed to be the appropriate response of investors to the economy’s advanced information technology:

“The rise in the availability of real-time information has reduced the uncertainties and thereby lowered the variances that we employ to guide portfolio decisions. At least part of the observed fall in equity premiums in our economy and others over the past years does not appear to be the result of ephemeral changes in perceptions. It is presumably the result of a permanent technology-driven increase in information availability, which by definition reduces uncertainty and therefore risk premiums. The decline is most evident in equity risk premiums.

Bond Bubble: Manipulating Market Expectations

“But how long can we expect this remarkable period of innovation to continue? Many, if not most, of you will argue it is still in its early stages. Lou Gerstner (IBM) testified before Congress a few months ago that we are only five years into a thirty-year cycle of technological change. I have no reason to dispute that.”

Having learned nothing from his past blunders, Mr. Greenspan is at it again. To quote Fed mandarin Vincent Reinhart: “The Federal Reserve has always appreciated the importance of correctly aligning market expectations.” Putting it rather more bluntly, the Fed endeavors “to manipulate market expectations in the direction that the Fed desires.”

During the late 1990s, Mr. Greenspan was keen to foster the stock market bubble by aggressively manipulating both market rates and market perceptions. After the equity crash of 2000, he has become keen to foster the three new bubbles he kindled in fighting the burst of the stock market bubble – the house price bubble, the mortgage refinancing bubble and the bond bubble.

Together, these bubbles are plainly indispensable for maintaining some zip in consumer spending.

But among the three bubbles, one is of crucial importance because it drives the other two. That is the (now hard-pressed) bond bubble. Refinancing activity tends to pick up significantly whenever mortgage rates drop below previous lows. Importantly, Treasury yields guide the movements of mortgage rates. In essence, it was the sharp drop of Treasury yields over the past two years that led the simultaneous, steep decline of mortgage rates. The recent, renewed sharp drop in Treasury yields gave mortgage refinancing another strong boost.

Within barely six weeks, 10-year Treasury yields plunged from close to 4% to close to 3%. In sympathy, mortgage rates fell to 5.21%, the lowest rate in more than four decades.

The astonishing thing about this sudden decline in market interest rates was that it happened at a time when the stock market was, on the contrary, being carried upward by spreading hopes for the economy’s imminent recovery. What happened to make this new, sharp decline of longer-term interest rates possible?

Bond Bubble: Growing Post-Bubble Economy

In its May 29 editorial, The Wall Street Journal praised the Fed chairman for his wily gamesmanship. “Merely by talking about deflation, he’s made the markets anticipate easier money; long-term interest rates have fallen accordingly, helping to keep housing prices afloat and to spur one more round of home mortgage-refinancing. This in turn feeds consumer confidence and helps keep the post-bubble economy growing. As a monetary gambit, uttering the word deflation has so far been a great tactical success. We suppose that’s worth the price of scaring people about an economic threat that isn’t very likely.”

In short, being assured by Mr. Greenspan and other Fed members that there would be no interest rate hike as far as the eye can see, investors and speculators, desperately hungry for big profits, stampeded into heavily leveraged bond purchases, giving through the sliding yield a new strong boost to mortgage refinancing.

Closer to the truth: In the guise of worrying about the evil of deflation, Mr. Greenspan signaled to the marketplace his determination to accommodate unlimited leveraged bond purchases. Investors and speculators complied with enthusiasm, giving long-term rates another sharp downward tick. Implicitly, in a country with negative national savings, any decline in market interest rates can only come from financial leveraging.

In this way, the last bit of restraint on financial leverage and speculative excess in the markets was effectively removed. Endless liquidity is available for the taking by the speculating financial community. The obvious result is a credit and bond bubble that meanwhile has vastly outpaced the excesses of the equity bubble.

The fundamental dilemma today is that undefined by every method available – the Greenspan Fed and Wall Street are making desperate efforts to sustain unsustainable bubbles. Of these, the belabored bond bubble is now our greatest fear. Its influences have pervaded the whole economy and the whole financial system, and its bursting may have apocalyptic consequences.


Kurt Richebächer
for the Daily Reckoning
July 29, 2003

P.S. Nobody questions the need for action. But it should be clear that easy money can only be the cure for tight money, not for any other causes depressing the economy. For us, the real and disturbing story about the U.S. economy is that with all its imbalances it has reached the stage where it requires permanent, massive monetary and fiscal stimulus to garner just a tepid economic response – and to prevent the various bubbles from deflating. All this is definitely not prone to create a healthy economy being capable of self-sustaining growth.


For an entire generation, Americans have been the happy beneficiaries of a unique monetary system…in which the world’s bussers and schleppers took American dollar bills in return for their work. The more dollars we exported…the more they bussed and schlepped to get them.

It was a little like the discovery of gold in America by the Spanish in the 16th century. All of a sudden, the Spaniards were the richest people in the world – for they had the world’s money!

Money came in from the New World; it was as if the Spanish had a printing press in the basement and could print up as many dollars as they wanted. Even the word ‘dollar’ comes from that period, as Spanish money was known the world over. As the money supply increased in Spain, the first effect was inflation. Prices rose. But the second effect was the one that hurt. Rather than develop their own economy, the Spanish exported their dollars in exchange for the goods they wanted.

The Spanish thought they were rich. And, for a while, they lived rich. They were the ‘world’s mouth,’ the leading consumers of the 16th century.

But soon the money ran out. And its overseas adventures became cost-centers, rather than sources of booty. And then the Spanish discovered something important: the easy money had been a curse; it deprived Spain of the development needed to become a prosperous country.

After the Spanish Armada was defeated by the English in 1588, Spain fell into a slump. It was the ‘sick man of Europe’ for the next 4 centuries.

And now it is America that is cursed by good fortune. It has become ‘the world’s mouth.’

As long as it has a printing press in its basement, Americans believe, they will never go hungry.

We will see, dear reader; we will see.

Over to you, Eric…


Eric Fry, our man-on-the-scene in New York:

– The bond market meltdown continued yesterday, driving the 10-year Treasury note yield to 4.29% from 4.17% on Friday. Suddenly, government bonds are “toxic waste” in an investment portfolio.

– Triggering yesterday’s selloff undefined according to the pundits undefined was the disconcerting news that the U.S. government plans to auction vast quantities of government bonds between now and the end of the year. Specifically, the government says it will borrow a record $230 billion in the third and fourth quarters in order to plug part of its gaping, half-a-trillion dollar budget shortfall. The $126 billion that Uncle Sam plans to borrow in the fourth quarter is the highest ever for any quarter, topping the $111 billion borrowed in the first quarter.

– The looming Treasury auctions undefined while shockingly large – are “old news”, as are most of the other excellent reasons to sell bonds. One excellent reason, for example, is the palpable threat of resurgent inflation. Another reason is the Federal Reserve’s unequivocal commitment to destroying the dollar…”if need be”. (The greatest threat to the dollar’s continuing supremacy, says James Grant, editor of Grant’s Interest Rate Observer, “is not the cost of war, or looming federal social outlays, or even the arrogance of a unilateral U.S. interest-rate policy.  It is rather the conceit that a paper currency can be managed by the seat of the pants of a committee of government employees.”) Yesterday, the bureaucratically managed greenback jumped half a percent against the euro to $1.149.

– Meanwhile, the stock market retreated a bit, as the Dow dipped 18 points to 9,267 and the Nasdaq added five points to 1,735. Reflecting the financial market’s newfound volatility, gold rallied $2.10 yesterday to $364.90 an ounce, building on last week’s $15 dollar-per-ounce advance. Gold prices have rallied almost $30 an ounce since their low of $340.80 on July 17. What does the precious metal know? Does it know that the dollar is overvalued? Or maybe it knows that most U.S. financial assets are overvalued – the dollar as well as U.S. stocks and bonds.

– Concerning the overvalued bond market, the mystery is not that bond yields are soaring, but that they ever dropped so low in the first place. It’s not every day that you see phrases like “soaring federal deficits” and “lowest interest rates since 1956” in the same sentence. But that’s exactly what we grew accustomed to seeing as recently as two months ago, before the epic bond bubble sprung a leak.

– It’s true that bond yields have spiked dramatically over the last month and a half, but they could still jump much, much higher. Remember that the 10-year Treasury yielded almost 7% back in January of 2000 and that the average yield on the 10-year during the 1990s was 6.69%. Net-net, we suspect the bond market’s shiny new bear market will be hurtling down the road for many years to come…

– When appearing before Congress last week, Chairman Greenspan crowed about how his policies enabled to the consumer to continue spending money he doesn’t have on things he doesn’t need, thereby taking on even more debt he doesn’t have a prayer of paying off.

– “On the liability side of the balance sheet,” the chairman noted, “despite the significant increase in debt encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt. Households have taken advantage of new lows in mortgage interest rates to refinance debt on more favorable terms, to lengthen debt maturity, and, in many cases, to extract equity from their homes to pay down other higher-cost debt. Debt service burdens, accordingly, have declined.”

– The flip side of all this wonderful debt accumulation is that rising interest rates, especially rapidly rising interest rates, constrict around household balance sheets like a hangman’s noose. The weight of heavy debts will snap the neck of some balance sheets immediately, while merely suffocating others slowly and painfully. Already, rising interest rates have begun to restrict the flow of household cash flow to the “extremities” like debt service and discretionary spending.

– Is it any wonder that bankruptcies are soaring, despite the lowest interest rates in a generation? There were 31,408 bankruptcy filings in the U.S. last week – up 9.9% from a year ago. Now that rates are soaring again, we wouldn’t be surprised to see bankruptcies soar as well, even with the “recovering” economy that Greenspan predicts.


Back in Ouzilly…

*** We are hosting a conference. With no time to write, we pass along this letter from a dear reader:

“First, full disclosure – I like the country of France very much. But I disdain the way the French treat Americans.

“On the American Hospital. My experience several years ago was dismal with this institution. Fortunately it turned out not to be a life threatening situation.

“On the dollar standard. I’ve traveled a lot to Europe and some to the far East. Several years ago, after Mongolia was free of the USSR, I visited the outer reaches of that country. I was very surprised to find that the traders that did cross-border business with the various bordering “istan” republics had wads of US$100 bills. It was “the” means of exchange.

“We determined that many of them had never seen an American before, but they knew the value of our money. Many financial institutions had machines that would read a U.S. bill and determine instantly if it was counterfeit. I’d never before seen such a machine in any other country. Still haven’t.

“We encountered a young Canadian girl traveling alone with Canadian $s and British pounds, who could not find any place to accept or convert them. She was desperate. We traded some for her to help out.

“A couple of years ago I verified that the situation was the same with the traders. Still using US$100 bills for exchange. When these guys switch to another medium for exchange, I’ll believe there is a crack in the dollar standard.

“A final observation. I often encounter French citizens at political or educational social events that are complaining about some situation here in America. On numerous occasions I’ve offered to pay their way back to France with a first-class airline ticket on the carrier or their choice. Only two stipulations.

1. They must leave by noon tomorrow.

2. They must not return for a minimum of 10 years.

To date I have not had an acceptance.

“To end. I like your content. I’m sorry you chose to live among the French.”

*** Editor’s comment: At the Daily Reckoning headquarters, we like the cheese, the wine, the architecture. Paris is a beautiful city and hardly a day goes by that we don’t appreciate it. We like the way things are put together in France. When we need to repaint a door, for example, we like the way it lifts easily off its hinges. We like laying up stone walls, too, and like having them around us. We also like the fact that there are few mosquitoes and few traffic cops. As for the people, we find the average Frenchman every bit as lunkheaded as the average American, German, or Lithuanian. We have no prejudices.

We also hear the blackmarketeers in Russia are now asking for euros.

The Daily Reckoning