“What is this madness?”
Former Chairman, Salomon Bros.
A year ago, dear reader, we wondered about the first
rate cut. Today, we wonder about the 11th one.
Readers who are tired of wondering about rate cuts – or
who have made up their minds – may comfortably pass over
today’s Daily Reckoning. For we have nothing to offer
but more of the same…
Except that, today, we explain what not one economist in
100 seems to understand: why rate cuts don’t always
Not that we want to take the mystery out of the market.
We would no more attempt to do that than we would try to
turn women into lifeless mannequins or round off Pi to a
whole number. That is never our purpose at the Daily
Reckoning. Instead of making things simpler…we aim to
make them more complex, like…well…life itself.
You see, not all recessions are created equal.
Yesterday’s commentary on The Prudent Bear.com referred
to a research paper from HSBC: “The research paper also
noted the difference between planned and unplanned
recessions. HSBC defines a planned recession as one
where vigorous steps are taken to combat inflation, like
the early 1980’s recession. Conversely, an unplanned
recession “are associated with collapsing private sector
expectations for economic growth and profits and, from a
policy perspective, are very difficult to turn around.”
Back in 1959, notes the Prudent Bear, Alan Greenspan
thought something very similar: “Once stock prices reach
the point at which it is hard to value them by any
logical methodology, stocks will be bought as they were
in the late 1920s – not for investment, but to be
unloaded at a still higher price. The ensuing break
would cause a panic psychology that cannot be summarily
altered or reversed by easy-money policies.”
There is no trace of “panic psychology” in today’s
markets. Investors are calm and confident. They are
standing their ground, to use Schumpeter’s phrase…but
the ground is giving way beneath them.
Alan Greenspan, now the world’s most powerful and
celebrated central banker, tries to shore up the economy
with easy-money policies. The first 10 rate cuts have
done little apparent good. The HSBC research paper, we
believe, tells us why…and why the latest cut will do
no better: Because the Fed neither caused the bubble,
nor did it end it. Can it revive it?
There are “planned” recessions – brought about
intentionally to cool inflation in an “over-heated”
economy. And there are unplanned recessions – which
happen spontaneously, when individuals and businesses
begin to realize that they have invested too much money
in too many projects that are not too likely to pay off.
They may or may not panic. But they always sell.
“From an operational viewpoint,” explains Ravi Suria, in
Grant’s Interest Rate Observer, “the excess capacity
created by excess capital is a highly deflationary
force. This combined with high fixed interest costs is
going to keep equity returns suppressed for a long time.
“The Fed’s not going to help capital spending come back.
Why? It was not the Fed rates that spurred capital
spending in the first place. It was the money coming
from the capital markets. The Fed was not lending you
money at 4% or 6%. It was the capital markets…In the
telecom industry at the low, the low on the absolute
yield was 8.9%…Right now, the yield is about 17%.”
The nation’s most aggressive industries – those that led
the capital spending boom of the late ’90s – never
borrowed at the Fed funds rate anyway. And even though
the Fed has cut the cost of money to its member banks 11
times in the past 11 months, the cost of borrowing for
the telecoms has approximately doubled.
And it is not just the junk bond issuers who are paying
more for capital.
“Just in the past six months,” reports Suria, “Ford
Motor Co. actually paid more in absolute yield for its
latest debt offering…than it paid six months ago.”
Despite about 300 points of rate cuts from the Fed.
Businesses pay more for capital following an unplanned
“break” because lenders see the same thing investors
see: that they may never get their money back.
During a boom, it hardly seems to matter. Investors –
cocky and greedy – provide too much easy money. At the
beginning of a boom, investors tend to invest for the
right reasons in the right projects. Then, encouraged,
they invest for the wrong reasons in the right projects
– paying too much for investments in sensible
industries. And finally, they invest for the wrong
reasons in the wrong projects – paying outlandish prices
for investments that can never be profitable
The only solution to this problem is to let nature take
its course – giving investors what they deserve, as we
say here at the Daily Reckoning. Bad investments need to
get marked to a cynical, hard-bitten bear market.
Unprofitable companies need to cut back or go out of
Easy money policies merely make the situation worse –
postponing the eventual reckoning and making it more
painful. That is why zero rates for the last five years
in Japan have done no good; they’ve only helped to slow
down the correction and spread the (greater) pain over a
longer period of time.
“…the former ‘maestro’s’ increasingly desperate effort
to keep American consumers borrowing and spending is a
strategy doomed to fail,” writes Chris Wood in his “Greed
& Fear Report.” “For, like the carmakers, all he is doing
is borrowing from the future…In other words, stronger
consumption today means weaker consumption tomorrow.”
In a “planned recession”, the Fed increases rates, which
strikes immediately at interest-rate sensitive
industries such as housing and autos. Sales in these
sectors fall. Then, when the economy is “cooled off” a
bit, rates are cut and autos and housing lead the
“This cannot happen on this occasion,” notes Wood,
“because housing and autos have not really gone down
“…the Greenspan approach,” Wood concludes, “should be
viewed, therefore, as an effort to cheat nature and the
business cycle, since there is nothing more natural than
for American consumers to slow down after their decade-
long shopping spree. Like any effort to cheat, it is,
ultimately, not going to work…”
Your devoted correspondent, signing off for this week…
December 14, 2001
There was both good news and bad news from Wall
First, the latest unemployment figures came out
showing new claims falling more than expected – more, in
fact, than they have fallen in the last 9 years. That’s
definitely good news.
But the bad news is that the number of people who
are unemployed keeps going up – meaning that people
losing their jobs are having a harder time finding a new
one. More than a million people have gotten pink slips
this year, bringing the jobless rate to its highest
level in 6 years – 5.7%.
Investors were encouraged by news that inventories
fell 1% in October – the biggest drop in 19 years. Good
news. Many said that an economic revival was almost
assured, since businesses would have to rebuild their
But why would they do that? The bad news is that
sales fell faster than inventories in October – down
1.4%. And in November, retail sales dropped 3.7% – the
most they have ever dropped since record-keeping began
Bonds continue to be weak, which is good news.
“Fixed income markets are flashing signs of a V-shaped
recovery,” writes Stephen Roach. Bond buyers expect a
more robust economy and mildly increasing inflation.
But November wholesale prices went down 0.6%,
after a drop of 1.6% in October – which looks
suspiciously like deflation, not inflation.
Investors want to believe in the “new bull
market”, just as children want to believe in Santa
Claus. But they keep finding traces of “Santa” in
closets and attics around the house. And the older kids
keep telling them: “Don’t be a fool; there is no Santa.
You gotta look out for yourself.”
“This is a major bear market,” says old-timer
Richard Russell. “The primary trend is now down…the
tide has turned.”
“I would be extremely reluctant to conclude that
the recent rise in the stock market is a signal of
improving business conditions,” adds Marc Faber, another
sage and scarred veteran. “It is common for any market
that has become very oversold after a steep decline to
Eric is headed back to New York. But he left a
diskette taped to my door…
– Mr. Market looks like he got hit by a “daisy-cutter.”
But it was not a 15,000-pound bomb that blew 65 points
off the Nasdaq Index yesterday and 128 points off the
– Causing the devastation was an itty-bitty economic
report, itself no bigger than a daisy, when displayed in
– As Bill mentions, November retail sales fell a record
3.7%. The shockingly bad report dealt a wicked body blow
to the “imminent recovery” theory.
– The root of the problem is obvious: not enough
patriotic consumers out there spending money they don’t
have. Come on people…loosen up those wallets!
– The November retail sales number may be – like Lipton
tea – “the pause that refreshes.” Or it may be the pause
that keeps on pausing.
– The interpretation we favor is that the sluggish sales
report tells the very predictable tale of indebted and
anxious consumers who are reluctant to spend. It will
not be easy coaxing purchases out of this crowd, no
matter how many times Greenspan lowers interest rates.
– And now, some propitious prognostications for those of
you in Bill’s “Camp Deflation.” The Economic Cycles
Research Institute’s (ECRI) future inflation gauge
registered a 26-year low last week.
– “Inflation plunge now unfolding,” proclaims the ISI
Group’s latest missive. “The world economy will flirt
with deflation in 2002,” says ISI. (Bill, these guys are
stealing your material!) “The CPI for the U.S. is likely
to be below 1% year-over-year by February. The French
CPI is already down just 1.2% year-over-year,” ISI
reports. And the British inflation rate has likewise
fallen below 1%.
– And from the East…more deflationary auguries.
“Japan’s economic woes seem to know no end,” writes
Moody’s John Puchella. “For the quarter-ended October
2001, Japan’s industrial output contracted by 13%
annualized from the quarter-ended July, while sinking by
12% yearly. For a protracted economic slump that began
10 years back, the yearly slide by Japan’s industrial
production is the deepest yet. To a considerable degree,
the whiffs of price deflation that occasionally pass
through the world economy can be ascribed to the
seemingly never-ending travails of Japan’s economy.”
– So I guess that settles it, right? Inflation is flat-
– And yet, the 10-year Treasury bond seems to be
offering a contrary forecast. Its yield has rocketed
almost one full percentage point higher over the past
several weeks to 5.15%. Does Mr. Bond Market know
something that the ECRI doesn’t, or he is merely reading
his map upside down? Or maybe Mr. Bond Market keeps tabs
on the money supply growth, and doesn’t like what he
sees. The so-called M3 money supply surged $11.3 billion
last week, equal to a scalding 20% annual growth rate.
– You know, if somebody were to bring inflation back
from the dead – intentionally or otherwise…somebody
like, say, the central banker of the world’s largest
economy…he might begin by rapidly expanding the money
– Don’t get me wrong, everyone says that inflation is
dead and gone – may it rest in peace – so I suppose that
it must be. I’m merely saying that if anything could
conjure inflation back from the grave, 20% money supply
growth might be just the right magic.
– Still, it could be a long wait before the very active
Greenspan Mint succeeds in rolling away the stone from
inflation’s tomb. Bridgewater Associates observes that
even after the economy starts to bottom, “inflation
continues to fall for almost three years as the economy
uses up existing slack. It is probably premature to
expect inflation to bottom soon, even if the economy
– However, it is probably not premature to prepare for
Meanwhile, back to Bill…
*** America seems to be calming down.
*** The Afghan restaurant on Charles Street in
Baltimore, owned by the brother of the new Prime
Minister, has been packed every night. So are other
restaurants in the area.
*** No one mentions the attack on the WTC or the war in
Afghanistan. Instead, Osama jokes are becoming popular.
A recent email, for example, pretends to be a
housekeeping memo from bin Laden to his companions in
the cave…in which the accused terrorist demands to
know who took his box of Cheez-its. A cartoon in The Sun
shows bin Laden relaxing on a beach near a sign that
says “Welcome to Bora Bora.”
*** Poor Osama. He has become a joke.