The Currency Cavalry Rides Again

But we still take a moment to look at the big, wide world of money every day. And when we look today what we see is a monumental, soothing hallucination settling over investors, like a giant cloud of nitrous oxygen.

On Friday, of course, the market bounced – up more than 200 points. A neighbor interpreted this move for us at a party Saturday night:

“Did you see what happened on Friday? Stocks went up everywhere. It’s over. The crisis is over. Because the central banks can always put in more money and credit. That’s what happened. The U.S. Fed cut lending rates and markets came back. I’m not worried. I think we’re going to see higher prices.”

The man speaking was a retired French banker. Like everyone else with any money, he has been watching recent events and wondering what was going on. And like almost everyone else, he has come to the wrong conclusion. As to where stock prices are headed, we are as dumb as everyone else. Many times we have tried to look into the future – even when we were on vacation. But we’ve never gotten the hang of it. It just isn’t possible to know what will happen. But probably a clear majority of the world’s investors now believe in two great delusions: One, that central banking has taken the risk out of investing…and its corollary, that market prices are now on the rebound. Again, they may be right – by accident – about the latter point. But it will prove to be an expensive triumph, in our view, because they are surely wrong about the former one. Central banking has not taken the risk out of investing; it has magnified it.

On Friday, the Bernanke Fed looked a lot like the old Greenspan Fed…riding out to rescue speculators like the cavalry to the aid of desperate pioneers. The trumpet sounded…the rifles fired…and the savages were beaten back.

“Thank god for the boys in blue,” said the pilgrims. “They come along just when you need them. Now, we can go and settle that rich bottomland across the river. They’ll always protect us.”

If only running an economy were so easy! We’re on vacation, so we’re not going to think about it too much. But it was only a week or so ago that the Fed told us that inflation was real enemy. Now, Ben Bernanke has cut the discount rate by half of a percentage point so as to counter the deflationary effects of a credit crisis.

Banks – and other financiers – got themselves into trouble because they had too much money on their hands. They lent it out much too freely. So Bernanke comes to their rescue. And with what? More money of course.

The markets let out a big hoorah on Friday. But how, exactly, is a lower discount rate going to solve the problem? In October of this year, the big hump in mortgage resets comes – with more than $50 billion in mortgages to be adjusted upwards. Then, next year another half a trillion in mortgages is to be reset, with the final peak coming in March.

The typical subprime borrower from 2004-2006 will have to come up with about $400 per month more. Where will he get the money? Who will lend to him? And why would he borrow?

If you think the rate of foreclosures is up now – just wait until October. And if won’t just effect those subprime borrowers. Unfortunately, you could be the best homeowner in the world…maybe you’ve even paid off your mortgage… but if there is a foreclosure near your house, it could lower the value.

Yes, we’re all believers in the Theology of Capitalism now. That is, we don’t think we have to look too deeply into the Holy Mysteries that surround modern markets. The place is full of miracles; that is all we have to know.

But when it comes to real, free-market capitalism, we are all agnostic. People think that central banks can collude to manipulate the markets…and thereby avoid a much-needed correction forever. Our guess is that investors will pay dearly for the delusion.

“The world is flat after all,” a friend wrote us, sending the following item:

“Yi Xianrong, a banking and finance expert at the Chinese Academy of Social Sciences, said Chinese banks had been lax as they built up 3 trillion yuan ($396.2 billion) of mortgage lending.

“‘The quality of housing loans are much worse than the subprime loans in the United States,’ Yi was quoted as saying by the South China Morning Post.

“At least there has been a credit check system (in the United States) but in China anyone can borrow money to buy a house.”

See, dear reader. Americans aren’t the only ones. Now, everyone can take part in foolish trends and fads.

Before we sign off for today, we’ll give you a quick glimpse into our days of ‘leisure’. We are using this vacation to figure out how to simplify our lives. So far, we’ve taken out the windows on the top floor so that we could paint them. And we’ve put up a bit of stonewall near the farmhouse. Now, we just have to figure out how to make an arched doorway.

“And what qualifies you to think that you can make an arch in a stone wall,” asked Jules, with an almost insolent tone in his voice.

“There’s nothing to it. People have been making arches for thousands of years. It can’t be that tough. I’m just going to use a lot of cement to hold it together.”

“Sounds like a lawsuit coming…”

Also, we finished the gypsy wagon…except that when we parked it near the pond, we realized that we would have to make some screens for the windows, as there are mosquitoes down by the water. It is built on an old hay wagon, about sixteen feet long and six feet wide. Inside, there is a little gas stove, a table with two chairs and a bed. It is very cute…a perfect place to have a cup of tea, read a book or take a nap.

“Well, it looks like a good place to shoot the swamp rats,” said Henry. “I can put the rifle out through the window and hit them when they are crossing the pond.”

We have huge swamp rats. They aren’t really rats at all. Instead, they are a South American animal – nutria – that somehow got loose in France and now are everywhere. Occasionally, someone will make a pâté out of them which is tasty. And they aren’t harmful, except to the banks of the pound. But we don’t like the look of them.

The gypsy wagon is meant to be painted in bright colors. But when we were painting it, the red we were using seemed almost blindingly bright. So, we decided to go with a sober grey for the main exterior color, trimmed with bright blue and red. Now we regret the decision. From a distance, the thing looks too pale…it looks a little sad; as if it had been abandoned.

“We’ll just have to repaint it,” we told the kids.

“I’m not painting that again,” said Edward. “I already painted it three times, because you kept changing the colors. It’s going to stay that way…”

The quality of our labor is not necessarily what we would like. But we can’t really complain. We pay Edward, 13, just one euro an hour…or 20 euros per week for a 20-hour work week (he is on vacation too). At that rate, we have to accept a little back talk.

“Dad,” said Sophia, in a much more positive mood, “this gypsy wagon turned out pretty well. Maybe we should make more of them and sell them over the Internet.”

Hmmm…gypsy wagon manufacturing…a new business opportunity. That would simplify things!

Until tomorrow,

Bill Bonner
The Daily Reckoning
August 20, 2007

P.S. No man worships capitalism. Instead, if he has any sense, he fears it…and aims to put a stop to it as soon as he is able. In any economy, mistakes are made. People invest in projects that don’t pay off. They pay too much for a stock. They lend to people who can’t pay the money back. If these errors were to go unpunished, the mal-investment and misallocation of resources would continue. Eventually, the whole shebang would collapse into a heap of unwanted products and un-performing assets. That is why we have corrections…bear markets…and panics; they are an economy’s equivalent of natural selection, eliminating the weak and unfit.

And a view or two…

…from Short Fusein Charm City…

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Views from the Fuse:

*** After the Fed stepped in and lowered the discount rate from 6.25% to 5.75% on Friday, Helicopter Ben has been getting it from all sides.

“It was a rookie mistake,” said Kenneth Thomas, a finance professor at the University of Pennsylvania Wharton School. The Fed “underestimated liquidity needs of investors and the fallout from the housing recession. This demonstrates the difference between book smart and street smart.”

Basically, lowering the rate undermined everything the FOMC members had said about economic conditions in their August 7 statement.

Our old friend Marc Faber told Bloomberg.com today that the rate cut was “unjustified.”

“I think its an intervention into the marketplace that is not justified,” he said, “Injecting more money into the system will create an additional set of problems at a later date.”

What kinds of problems? Well, one could argue that the drama in the housing market right now is a reaction to a ‘flood of liquidity’ – in fact, President Bush just pointed that out a couple of weeks ago.

“I don’t know about you, but I have no sympathy for stupid bankers,” Chris Mayer said earlier today. “Mortgage lenders washed ashore like beached whales ought to be left to rot in the sun. Nor do I think we should try to soften the blow on the hedge fund managers and investment bankers who now must sell their yachts and mansions. Let them lose their millions.

“Instead, by propping up markets, we make the sober fellow who was careful with his money foot the bill. Where do the billions come from that the Fed ‘injects into the system’? I will give you a clue. Have you seen a chart of the trade-weighted value of the dollar lately? It is at or near all-time lows. It comes out of your hide – in the form of ever-depreciating dollars.”

Dr. Faber thinks that this market volatility could be good for gold – although you wouldn’t be able to tell right now…

“If I had to make a bet about the market that will make a new high, I would think that the gold market has a chance to make a new high. Because if the Fed cuts interest rates aggressively, in an extreme case they would go from 5.25% on the Fed fund rate down to 3%. Then people will really become concerned about future inflation and the value of paper money and that will boost gold prices.”

Marc Faber correctly predicted the stock market crash in 1987 – and he also urged investors to buy gold in 2001 – and the yellow metal has more than doubled in value since then. It can’t hurt to heed his advice – and at least look into diversifying your portfolio with gold.

And in other news, Hurricane Dean is still picking up steam – experts are predicting a rise to a category 5 storm. Dean headed down to Belize and Mexico’s Yucatan Pennisula this morning.

While it is a near miss for the Gulf’s largest oil-production regions, Kevin Kerr is still a bit concerned.

“We have to remember that the area it’s going to hit is the third-larges oilfield in the world,” Kevin said on CNBC’s Squawk Box this morning.

Global supply and demand over the long-haul also worries him a bit, “I mean, China has a lot of lead toys they have to make…we’ve seen strong demand out of there and I don’t see it waning anytime soon.”

More tomorrow…

Short Fuse
The Daily Reckoning