Policy Slippage

A primer on the Austrian approach to the business cycle…and why the conventional après-bubble ‘cure’ doesn’t always work as planned…if at all. Apogee Research’s Andrew Kashdan reports, below…

When someone characterizes the current state of the economy as "the ultimate vicious circle," you may want to listen. Particularly when that someone happened to warn of vicious circles just before the boom went bust…and chances to be Morgan Stanley’s Stephen Roach.

What is bothering Mr. Roach is the rise in nominal interest rates amidst disinflationary pressures – which portends an even more damaging rise in real rates. "While a temporary quickening in the pace of global activity may now be at hand," writes Roach, "two key problems endure – the risk of deflation and the likelihood of a U.S. current-account adjustment."

Roach is surely right to worry about ‘policy traction’ – in this case, the ability of the central bank to boost economic activity effectively. But even more interesting are the uncertain consequences of a dramatic drop in the dollar…and the historically unprecedented adjustment in the current account that would result. In fact, Roach suggests that such an adjustment might intensify global deflationary pressures – and that the U.S. could also be sending deflation abroad through rising long-term rates and a weakening dollar.

As the Daily Reckoning’s Paris-based editors are keen to remind us, the dollar’s devaluation is inevitable…even desirable to many on the homefront. A low U.S. dollar is good for U.S. exports, which might explain why Treasury Secretary John Snow seems to have cast aside the rhetorical ‘strong dollar’ (while also, apparently, taking lessons from Mr Greenspan himself when it comes to including useful information in his commentary. "A strong currency is one that has all the attributes of strength" is a recent example). If the dollar were to fall significantly, its devaluation would effectively ‘pass the buck’ to U.S. creditors abroad.

Stephen Roach: No Globalized Deflation

But not all financial gurus see globalized deflation on the horizon; au contraire, says Chen Zhao, chief emerging markets strategist at Bank Credit Analyst Research Group. In an op-ed article for the Financial Times, Zhao writes that "the Fed is in a dangerous game with China," which he describes as a "silent but active partner in the Fed’s pump-priming. It would not be possible for U.S. Treasury bond yields to be at current [low] levels were China not a willing and able supplier of savings to the U.S." (Even allowing for the recent rise, yields remain historically low.)

In effect, Zhao argues, China is trading goods for U.S. paper, creating a "hyper-stimulative" environment for both countries. Thus, contrary to popular belief, Zhao sees inflation in China’s future. Intervention to prevent a rise in China’s currency has fueled monetary expansion, and the country’s CPI has already reached an annualized rate of about 1%. That’s still low by most standards, but if the rate reaches 3%-4% – which, according to Zhao, could happen in the next six months or so – the central bank will be forced to revalue the currency.

If that happens, the floated Chinese currency could lead to another surge in U.S. Treasury yields, as well as increased inflationary pressures in the United States.

But no matter what policymakers say or do – and no matter if or when deflation and inflation strike the global economy – if U.S. asset markets continue to rely heavily on foreign funds, the adjustment will be painful.

Then again, we at Apogee Research never expected that the after-effects of the great stock market levitation and its sudden descent would be anywhere near pain-free. Nor did we think it should be. And when ber-Keynesian Paul McCulley, managing director of PIMCO, recently observed that "we are indeed all Keynesians now," not quite all of us were ready to join the crowd.

Stephen Roach: Garrison and Callahan

Roger Garrison, professor of economics at Auburn University – and the modern guru of the so-called Austrian school of macroeconomics – recently co-authored an article with Gene Callahan in The Quarterly Journal of Austrian Economics. Happily for us non-Keynesians, the pair show how Austrian business cycle theory provides the best explanation of the dot.com boom and bust.

Long-time Daily Reckoning sufferers will be familiar with the main thrust of the theory, which can be neatly summed up with a single maxim: "[M]aintaining an artificial interest rate, like all price-fixing, will have unintended consequences that the price fixer can do little to control."

In the case of the recent stock-market bubble, extra liquidity led dot.com start-ups and others to bid up certain capital goods, the increased prices of which eventually made the start-ups’ plans unfeasible. The easy money also led to over-consumption.

Garrison and Callahan speak not of macroeconomic aggregates like GDP and CPI, but of the repercussions of newly created money and the changes in relative prices it brings about. The recent boom and bust is deemed the ‘ideal type’ of business cycle to explain with the Austrian theory (which criticizes central bank meddling in the money supply), because it was engendered by central bank expansion.

Garrison and Callahan begin their study with the Reverse Plaza Accord of 1995. At that time, the U.S., Japan and Germany all agreed to take various measures to strengthen the dollar, largely in an effort to undo the previous distortions created by the Plaza Accord a decade earlier. The advantage was that the Fed could maintain an easy money policy without raising the CPI. The increased liquidity then found its way into U.S. and East Asian asset markets.

Stephen Roach: Less and Less Convincing

Of course, "every bubble needs a story," as Garrison and Callahan relate. It just so happened that the Netscape IPO occurred in August of 1995, its stock price rose beyond all expectations. Because the presidential election was also less than 18 months away, Garrison an Callahan argue that Greenspan’s easing during this time was at least partially influenced by politics – a suggestion few would quarrel with.

At the time, the continued drop in the unemployment rate to well below what had previously been considered ‘full employment’ was attributed to a sudden rise in productivity – i.e., the birth of the ‘new economy’ – a theory advocated most notably (and repeatedly) by the Fed chairman himself. Some of the arguments sounded plausible at first, but they became less convincing as the rate continued to fall. The trend suggested "a cyclical rather than a secular pattern," say Garrison and Callahan, and "the lows of 1998 through 2000…were unsustainable."

What Greenspan and other policymakers seem to have overlooked, or failed to understand, is that borrowing costs artificially lowered by Fed actions can cause certain industries to increase capital spending more than they would otherwise. This, in turn, can lift productivity. "But concurrent productivity gains in select industries are more likely to be indicative of an unsustainable boom than of an end to booms and busts," Garrison and Callahan assert. Furthermore, a significant portion of those gains were subsequently revised away; for example, annual productivity growth in 1999-2000 is now put at an average of 2.6%, instead of the headlined 3.4%.

As it happened, a series of economic crises – East Asia, Russia and Brazil, the Long-Term Capital Management affair and the Y2K scare – kept the Fed’s printing presses running at full speed. Meanwhile, the groundwork was being laid for some of the now-familiar features of the boom, such as the surge in IPOs, the rise in consumer and corporate debt, the drop in savings and the unprecedented increase in liquidity and asset prices.

In the beginning, low interest rates led to an increased demand for lendable funds and a lengthening of the production process. But then monetary expansion created a wedge between higher investment and lower savings, and, eventually, there were insufficient resources to support all of the investment plans.

The adjustment process became a recession. But the so- called ‘recession’ – hampered, eased and spread thin at every turn by Greenspan’s Fed – was not allowed to run its course; it remained incomplete.

In other words, those who had it coming 18 months ago…still do.

The Austrian approach to the business cycle is instructive about the source of great economic booms. But more importantly for those living through the aftermath of the subsequent bust, it explains why the conventional ‘cure’ doesn’t always work as planned…if at all.


Andrew Kashdan,
for The Daily Reckoning

August 13, 2003

P.S. Casting aside our wet blanket for a moment, there was some encouraging news last week about both consumer spending and nonresidential fixed investment in the second quarter, while a sharp drop in inventories points to a further boost in GDP in the quarters ahead. Consumer spending increased 3.3% vs. a 2% decline in the first quarter, propelled by a 22.6% increase in durable goods purchases (all the numbers are annualized).

Advance estimates of second-quarter GDP showed growth of 2.4%, annualized, which was up from 1.4% in the previous two quarters.

But before you break out the champagne, hark back to the volatility of past growth statistics and the disappointments. You’ll see that while this GDP report, and possibly the next few, will be welcomed by those who take comfort in a nice headline-making number, the long-awaited self-sustaining recovery has still not arrived.

In 2002, for example, the first and third quarters registered growth of 5% and 4%, respectively, while the second and fourth periods mustered only 1.3% and 1.4%, respectively. In similar fashion, growth of private fixed investment soared at 4.4% in the 2002 fourth quarter, only to plummet to minus 0.1% in this year’s first quarter.

In other words, while there may well be some encouraging signs, continued spending by consumers and the Pentagon will not be enough to ignite a full-fledged recovery, especially in this unique post-bubble climate.

Andrew Kashdan is a top analyst at Apogee Research – positive proof that with reputable, independent investment research, consistent profits of 166%, 154% and 134% are still possible.

In today’s Daily Reckoning, we try to give you more than your moneysworth – which should be a cinch since you paid nothing for it.

First, the essential insight: inflation begets deflation; deflation begets inflation.

Since the ’30s, the U.S. has begotten nothing but inflation. Will deflation be gotten next? We think so.

But not necessarily the deflation you might expect. Consumer price inflation has been coming down since the late ’70s. Recently, it has been approaching zero. That it might slip below zero, as it has in Japan, would not surprise us…nor would it disturb our sleep.

What will bring sleepless nights to many Americans is the coming deflation in asset prices. Nobody complains when stocks, bonds, or real estate rise at double-digit rates. But they’ll howl when the downturn finally comes.

We are in the midst of a Huge Top in asset prices. Stocks rose for nearly 20 years…and now are trading at 32 times earnings. They’re more than 4 times more expensive than they were when the bull market began. Until about two months ago, bonds had been in a 21-year bull market. Yields are still the lowest they’ve been in more than 30 years. And the dollar, too, went up against real money – gold – for 20 years. All these things – and select real estate, too – are ready to be deflated.

Another way to look at it, suggests England’s "Business Standard" is as a ‘Global Debt Bubble.’ Private debt as a percentage of GDP is up to 189% in the UK, says the Standard. In Germany and the U.S., it is 145%. Debt (made inevitable by the Dollar Standard system) is behind everything…all the asset bubbles were inflated with debt, which has just kept increasing, even through the recent slump. Consumer credit (and especially mortgage refinancing) gave people money to spend. It was credit that brought profits to U.S. corporations, too. In 1982, less than 10% of corporate profits came from financial activities (financing and so forth). Now, the figure is 40%.

"The market is dependent on low and falling interest rates," says the Standard.

But now long rates are rising. And a headline in the L.A. Times tells us that "Loan requests fell 22% in July."

Somehow, sometime, the inflation of the past 2 decades will beget deflation. When? How? That is the theme of this daily chronicle…so stay tuned.

We found no message from Eric this morning. Instead, we received news from our esteemed sarong-wearing analyst, Dan Denning…



Daniel Denning in Paris…

– And you thought deflation was dead.

– Filling in for my New York colleague (who’s on his way to San Francisco a day ahead of me) I warn today’s readers that today’s notes will have a distinctly Francophile flare. That’s right, we wear sarongs here in Paris [see July 16th’s Daily Reckoning for details…]. At least I do, when it’s hot enough to kill off a statistically valid percentage of Bill’s countryside village. There is a virtue though. Looking different (in a sarong) sometimes helps you think a little differently.

– Yesterday, the Fed opted to keep interest rates at a 45- year low. Announcing that it would leave its overnight rate unchanged at 1%, the Fed did everything it could to avoid naming that ‘unwelcome’ guest at the economic policy table in its statement. No mention of deflation. Of course not. In Fed-speak, deflation is the monetary crisis that dare not rear its head. But even though you won’t see the word, it’s clearly on the Fed governors’ collective mind.

– Here’s the money paragraph: "The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the committee believes that policy accommodation can be maintained for a considerable period."

– Just how much do Greenspan, Bernanke et al. feel that the probability of an "unwelcome fall in inflation exceeds that of a rise in inflation"? They declined to answer…but the stock market had plenty to say. The Dow demurred most of the day. But when the Fed said it would keep rates low for a "considerable period", the blue-chip index danced up nearly 100 points to close at 9,310, just 96 points below its high on June 17th.

– Even Microsoft (MSFT), which lost a $521 court verdict for a patent violation, and whose Windows browser is suffering from a yet another global computer virus, managed to eek out a half a percentage gain to close at $25.73. It was the power of ‘positive thinking’ at work (see als ‘delusion’).

– But the most important number of the day is the one you’ll only read about here: 1,385. That’s how many points I forecast the Dow could fall by the end of the year, taking it to around 7,925…a full 15% lower than yesterday’s close.

– This is not, as my colleague Addison implied this weekend, a gratuitous prediction. There is a reason for it. In each of the last two years, the Dow has made a huge decline from its intra-year high to its intra-year close. Right now, we’re right on the cusp of a new high for the year. But with August being, as a matter of record, the cruelest month on the stock market, and with nothing but the real news from the real economy ahead, my forecast is that the financial economy is in for a shellacking.

– If you’re skeptical, look at the bond market. Yesterday’s Fed announcement drove bond yields up and bond prices down even more. The yield on the benchmark 4.25% 10-year note rose 6 basis points to close at 4.42%. Put buyers on bonds in the last month (including my readers) have making out like…well…bond traders. But without actually BEING bond traders.

– By the way, if all this bond market commentary means nothing to you, you’re not alone. Yes, rising yields mean the Treasury must pay more to foreign lenders who finance America’s consumption addiction. And yes, rising yields make debt service payments harder for the dozens of U.S. companies that have subsisted on the Fed’s easy-money policies. But can you as an individual investor profit from ANY of it?

– Happily, yes. I’ll give you the single best investment tip I’ve given all month, and for free: TLT and IEF. For the first time, individual investors and traders can profit from changes in the bond market buy buying either of these exchange traded funds. TLT is a bond fund based on the long end of the yield curve. It mimics the performance of 20- year notes. IEF mimics the performance of 7-10 year notes. If you’re bearish or bullish on bonds, there is not an easier or cheaper way to trade your idea and profit.

– Then again, if you’re nostalgic, you’ll always have the triple Qs. The Nasdaq raced up 25 points to finish 1.5% ahead on the day. The big winners for the old loser of an index were RARE Hospitality Intl. (RARE), up 56%, On Track Innovations (OTIV), up 33%, and Lynx Therapuetics, up 26%.

– Good work, Mr. Chairman. You’ve kept up appearances and obscured the reality. Good luck making it last.


Bill Bonner, back in Ouzilly…

*** As Dan informs us above, the Federal Reserve met yesterday and decided to do nothing; its key lending rate remains at 1%. In a free market, of course, lending rates are determined by lenders and borrowers. Guided by an ‘invisible hand,’ they manage to discover the rate that best matches the supply of credit with the demand for it.

But it is the special conceit of the Fed that it can find an even better rate (usually lower). Enlightened economists regard price fixing as either folly or imbecility. But fixing the price of credit enjoys a special place in their hearts. Doing so, they think they can do a better job than God’s invisible appendage.

We chuckle to ourselves and enjoy the show…what else can we do?

Someday, the arrogance and lunkheadedness of the whole scheme will be plain to everyone. But that is something else to look forward to…

*** For now, we look across the vast Pacific pond and think we see the something interesting. Could it be? Have we caught them in the act…in flagrante delicto…? Is deflation begetting inflation right out in the open, in front of our very eyes?

"Growth gathers pace in Japan," says a BBC headline. So far this year, Japan’s GDP is moving up at a hot-and-heavy speed, 3 times as fast as expected…with a 2.3% rate now anticipated for the year.

And get this: the Japanese are spending! (What would happen if the world’s savers stopped lending to America and began to open their own mouths? Ah…a subject for another day…)

Has the Japanese economy finally bounced after falling for 13 years? Maybe. You’ll recall, dear reader, that a huge inflation of asset prices and debt in Japan in the ’80s begat a big deflation in the ’90s. The latest numbers may be just flirtation or foreplay. Or the sushi-eaters could be begetting something interesting.

"The unattractive girl at the bottom of the class is suddenly the hottest date in town and every high-rolling, big-spending fund manager seems to want to throw money in her direction," says Joe Thomas in the Investors Chronicle.

"Japan will outperform Wall Street and the European stock market for the duration of this global rally," adds well- known London analyst David Fuller, whose current personal "biggest equity exposure by far" is a long position in futures on the Tokyo market. Fuller expects the Nikkei index, currently at 9,328, to go to 11,400 at least.

And Marc Faber: "I think that over the next 12 months, the Japanese market may have the highest upside potential among the developed world, which could, as a result of the irresponsible U.S. Fed reflation, propel the Nikkei Index to around 15,000."

We have no way of knowing. But if we were placing our bets, we would much rather bet on a market that has been deflated out than one that is bubbled out to the limit of its inflationary stage. Sell New York. Buy Tokyo.

*** And now for a change of pace: Associated Press is estimating the cost of "rebuilding Iraq" at $600 billion. Putting the electrical system, alone, back in order will cost about $13 billion, says proconsul Paul Bremer. $58 billion is the Pentagon’s bill so far this year. Another $4 billion per month is the on-going cost of providing near-at-hand targets for terrorists.

Bossing the Iraqis around has gotten much more expensive than it used to be. The British did the job for only 2.7 million pounds per month, in 1919. At the time, Britain was the world’s super-power. But British power went into deflation in WWI and never quite recovered. Manufacturing shifted to the former colonies…the pound was devalued…and by the early ’80s, the sceptered isle was effectively bankrupt, with bad cars, bad food, bad teeth…and an average income lower than Hong Kong.

The world turns.

The Daily Reckoning