Fed Speak for Dummies
We’re suffering from paradox overload this morning.
We read in the paper that June saw the lowest inflation gains in five months. Ben Bernanke, speaking to the U.S. Congress, dumbed-down his remarks, in a message dumbbells wanted to hear:
“Core net inflation should edge a bit lower,” he said.
(More on the Federal Reserve, in today’s guest essay, below…)
But food has been rising this year at three times the rate of a year ago – or 6.2% per year. And gasoline already sells for a price 30% more than it did last year.
Meanwhile, from Las Vegas comes word that house sales are collapsing – they’re down 42% from a year ago. Nationwide, new housing permits are at their lowest in 10 years. And in Southern California, house sales are at their lowest volume in 14 years. But while houses weren’t selling, when they did sell they sold for slightly higher prices.
Go figure again.
Up the mortgage loan food chain, on Wall Street, the big fish at Bear Stearns say that investors are out of luck. There is trouble galore in the CDO market. But over at the equity trading desks, things have never been better. What trouble, ask the stockjobbers? What housing problem, they want to know? The Dow is near an all-time high. Neither housing slump…nor subprime slump…nor any kind of slump is going to stop this market, say the pros.
Dick Gaylord, who will become the nation’s top REALTOR next year, claims that the market “isn’t down, but just returning to normal.”
“I don’t know that there’s ever been a bad time to buy,” adds Gaylord sagely. “If people will hold on, there’s no bad time to buy in real estate…”
Many in the real estate market agree with Mr. Gaylord, and think that we’ve hit the bottom as far as the housing bubble is concerned…but some, like Mish Shedlock, think we have a ways to fall yet.
The whole financial world is full of paradox and contradictions.
Dollars are losing value. But that doesn’t seem to stop people from wanting more of them. In exchange for gold, you can tender 673 dollars and get a single ounce. This is 7.80 dollars more than the rate on Tuesday. But it’s still lower than the rate at the end of January one score and seven years ago, that is to say, the day Ronald Reagan was first sworn in as President of the United States of America. But that was before the United States had a $9 trillion public debt…and a financing gap over $60 trillion. People still had affordable mortgages…and only half as much debt, generally speaking. The United States was at peace…and still a net-creditor to the rest of the world. Its trade with the rest of the world was still more or less in balance. Derivatives had barely been invented. And the money supply – that is to say the number of dollars in circulation – was hardly a quarter of what it is today (we are just making an educated guess).
You’d think the price of gold ought to be a bit higher. Go figure.
And pity the poor investors in Bear’s hedge fund – all their dollars have disappeared. Yes, dear reader, The Greatest Economic Boom Ever is fueled by dollar creation…and yuan creation…and yen creation…and euro creation. My god, this boom has seen a genesis of money everywhere. But just as the great boom giveth, it also taketh away. We are preparing an essay for tomorrow on this subject, so we don’t want to give away the whole story, but readers need to be prepared. Just as we watched the geniuses at Bear and the other financial firms create wealth; we can also watch them destroy it. In a flash, billions…no trillions…of presumed, ersatz wealth can vanish.
Money that is created “out of thin air” – courtesy of central banks and financial firms – tends to go back from whence it came. For every genesis of wealth creation…there is an exodus of wealth destruction. Watch out for it…
The Daily Reckoning
Thursday, July 19, 2007
Addison Wiggin, reporting from Baltimore:
“The euro, pound, and Chinese renminbi all furthered record highs versus the greenback yesterday. The kiwi and Aussie dollars traded at 20- and 16-year highs, respectively.
“These record highs, and the concomitant bummer sentiment that goes with them, are putting contrarians in a quandary… including yours truly. Could it be time to go long the dollar?”
For the rest of this story, and for more insights into today’s markets, see The 5 Min. Forecast
And more thoughts…
*** “Fed, States to Start Mortgage Crackdown,” says the Associated Press. We report it to you because it is in our notes. A little late in the day is our observation.
So, what to make of it? Ah – that we really don’t know. So, instead, we’re going to give you our feelings about the matter.
Our feeling now is that everything is turning on its toes too fast. There are too many paradoxes for us to digest. We need to lie down for a while to digest them.
The whole world seems to be racing ahead. But we wonder if it would be going at such a fast clip if it knew what it was racing towards. The underlying presumption must be that the future will be better than the past. Otherwise, why not slow down a bit?
“Dr. Wilson was 103 when she died,” mother informed us recently.
There was something very healthy and reassuring about the way Dr. Wilson practiced medicine. When you went to see her, she already knew everything about you. She had been practicing there for more than a decade before we arrived. She had treated our grandmother, grandfather, mother, father, sister…she knew the breed already; by the time she got to us, the dog before her was as familiar as fleas.
There was something healthy about the way in which she charged for her service, too. You went to see her; she sent you a bill. We don’t remember the rates, but there was no HMO involved…no health insurance…no forms to fill out…and no thought of going to see a tort lawyer if it didn’t work out.
There were certainly poor people around back then. On the tobacco farms of rural Maryland there were many people – usually black – who worked as “tenant farmers” and lived in “tenant houses,” often little more than shacks. They worked for the landlord in exchange for the rent, and earned a few dollars more. They had very little money for medical bills. Still, we never heard of Dr. Wilson turning anyone away. What happened if they couldn’t pay?
“I don’t think Dr. Wilson worried about it too much,” came mother’s reply.
But that was back in the ’50s…and things have moved on. Have they gotten better? Certainly, there have been advances in medical science. The alert and well-informed doctor has more tricks up his sleeve. But the system of practicing medicine was more to our liking a half-century ago, at least as we remember it.
Why then, race into the future?
*** London is a long way from Maryland.
Last night, we watched a group of people in what looked like black chicken outfits dancing on the roof of the Royal Festival Hall. A bit later…we heard the voice of an opera singer.
There seems to be some strange cacophony of artistic expression coming out of the RFH. Earlier in the week, people walked on a sort of conveyor belt while reading their own prose. And out in front, there is a group of what look like tool sheds, each with some artistic purpose. As near as we could tell, one of them really was a tool shed.
London is a big city. In fact, it is a new world. The world that is modern London has nothing to do with the world that was rural Maryland in the 1950s…or even much to do with London circa 1950. It is a globalized city…with globalized industries…and a globalized population. In the center of town, police sirens wail at all hours…helicopters often hover overhead. Police boats zip up and down the Thames.
People are young…usually unmarried…and often very wealthy. They seem to want to find ways to distract themselves…or make money.
Back in the ’50s, we were too young to sense it perhaps, but we don’t recall making money as such an important motivation. There were people who did make money – but not many. Most people just got along as best they could. Few could imagine getting rich. The best you could do was to earn a good living, when the price of tobacco was high…take to the Chesapeake when the crabs and oysters were thick…(a good oysterman could earn as much as $100 a day at the height of the oyster boom of 1968…but already, the money economy was coming to the tidewater area). People had more free time. We just can’t remember running around so much or so quickly. We spent less time in cars. We spent more time admiring ripe tomatoes in the summer and wood fires in the winter. We didn’t know anyone who read the Wall Street Journal…nor anyone who could tell us what the Fed’s key lending rate was. These things just didn’t seem to matter.
Is it a better world now that they do? London certainly seems like a gayer city…from the grim metropolis that we imagine it was in the ’50s. Maryland, on the other hand, seems worse, not better.
Will the future really be better? Should we really be in such a hurry to get there?
We don’t know. Heck, we aren’t even thinking about it anymore.
We’re just feelin’…nostalgic…
The Daily Reckoning PRESENTS: The Federal Reserve has been around since 1913, and in that time, we’ve seen Fed Chairmans come and go, but no made as lasting an impression as Paul Volcker and his successor Alan Greenspan. Tom Au looks at the policies of both, below…
A BROKEN ACCORD
The Federal Reserve Board (or Fed) was established in 1913, pursuant to the 16th Amendment to the Constitution to oversee the nation’s money supply. But it took almost four decades before it could truly perform this function. In fact, in its early years, the Fed acted almost as an adjunct to the Treasury Department. Specifically, it was called upon to keep bond yields low by buying Treasury bonds, thereby artificially increasing the money supply.
By the late 1940s, the Fed balked at being a de facto arm of the Treasury Department, and in 1951, managed to reach the so-called Accord with the Treasury. This allowed the Fed to use its own discretion in buying Treasury securities, and otherwise become a financial policy-maker independently of the executive branch; effectively creating a fourth branch of government. As a sop to the Treasury, William McChesney Martin Jr., originally a Treasury official, was appointed chairman of the Fed, where he became its longest-serving head (Alan Greenspan was a close second). In this role, he was supposed to be as a “Trojan Horse,” for the Treasury, but surprised everyone by upholding the Fed’s independence more than any chairman before or since.
With memories of the 1930s Great Depression fresh in peoples’ minds, the Fed’s implicit mandate was to prevent a recurrence. William McChesney Martin Jr. vividly described the Fed’s role as to “take away the punch bowl.” In essence, the Fed was supposed to be the “adult chaperone” at an economic party that was likely to get out of hand. Thus, the Fed was supposed to allow, even induce, if necessary, the occasional recession to cleanse the excesses of the economy. This would ensure that short-term imbalances did not persist for the longer term. The Martin mandate later gave way to one of pursuing steady growth, which would allow full employment (the lack of which was considered the major bane of the Depression). But this new mandate would not address the longer term problems that have since ossified into intractable trade and budget deficits.
Even so, the Fed’s most celebrated moment came around 1980, when a newly-appointed chairman, Paul Volcker, broke the back of inflation by controlling the money supply, come what may for interest rates. It also probably had a major impact in limiting the Presidency of Jimmy Carter to one term. But this was the last time that the Fed dared to “lean against the wind,” of an Administration, to use another expression of its earlier mandate.
Under Mr. Volcker’s successor, Alan Greenspan, Fed policy became increasingly aligned with that of prevailing Administrations, both Republican and Democrat. In part this was because of the nature of the crises, such as Black Monday, in 1987, and the Y2K scare, just before 2000. Both of these were basically one-time shocks, rather than being endemic to the economy, and therefore, it was easy to agree on solutions. And backed by some major political tailwinds (the collapse of the Soviet Union, the 1991 Persian Gulf War victory, and the resulting decade of artificially low oil prices and cheap money), the Fed and the Administration managed in the 1990s to co-operate in creating an unprecedentedly long peace time expansion. It may have been this success that caused the Fed to lose sight of its “check-and balance” role vis-à-vis the executive branch.
But an “Austrian” (economist) might describe Mr. Greenspan’s posture toward the Administration by using a Marlene Dietrich song (the English translation from the original German is mine):
If I’m supposed to dance,
Then I’ll do it.
If I’m supposed to laugh,
Then I’ll laugh it.
If I’m supposed to turn my head,
If you please, then it’s done.
This abdication was most apparent around the turn of the century. I believed then, and am confident now, that the Fed made a mistake when it lowered rates aggressively in 2001 in order to ward off an impending recession. That is after looking at what Fed Chairman Greenspan probably saw; a looming case of “financial bronchitis.” Unlike Mr. Greenspan, (and like Paul Volcker), I would have urged the Fed to “stay the course” with rates and accept “bronchitis” in order to ward off a later “pneumonia.” Mr. Greenspan opted for the other path and avoided the “bronchitis” several years ago. This, however, led to excesses in the U.S. trade accounts and the housing markets that seem likely to soon lead to a far worse “pneumonia.”
In fact, Mr. Greenspan derived his policies from an intensive study of economic data made possible by the revolution in information technology. What was a pipedream in the1960s, “fine-tuning,” had finally been made possible; the Fed is, in fact, very good at solving short-term problems. But that misses the point; that the Fed is not just supposed to manage for the short term, but rather to anticipate longer term problems. Mr. Greenspan’s claim that a bubble in stocks, or housing could not be foreseen until after the fact is a cop-out. The Fed’s main job is precisely to do this, as it did in the 1950s, 1960s, 1970s, and early 1980s under William McChesney Martin Jr., and his successors, Arthur Burns, and Paul Volcker.
But the real problem is that the Fed’s policies are now hostage to those of the Administration. Such policies may be successful or not. But because they mimic those of the executive branch, they will be wise or foolish according to whether the underlying policies of the ruling Administration are wise or foolish; the Fed has resigned its earlier chaperone role. Or to paraphrase Warren Buffett, the Fed’s conduct no longer “rises to that of a responsible bartender, who, when necessary, refuses the profit from the next drink to avoid sending a drunk out on the highway.” The spirit, if not the letter of the 1951 Accord has been violated, and de facto, the Fed is no longer an independent entity.
for The Daily Reckoning
July 19, 2007
Editor’s Note: Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Mr. Au is the author of “A Modern Approach to Graham and Dodd Investing.”