The Fed is Culpable, Part II

Any administration, suggests Dr. Hans Sennholz, that walks in the footsteps of Presidents Hoover and Roosevelt – who practically closed the national borders to trade and commerce, doubled the tax burden, and imposed numerous business regulations and restrictions – undoubtedly will create another "great depression."

The American money and credit system now resembles an inverted pyramid that rests on legal-tender Federal Reserve notes and credit. These support various forms of bank money, such as commercial bank deposits, savings accounts, large-time deposits, and other liquid assets.

The base of some $672 billion may expand rather moderately, presently at some 6% a year, or by $40 billion; the layered superstructure of $8.333 trillion in bank money (M3) may grow at a similar rate, or by $529 billion.

Commercial banks tend to ‘securitize’ their loans, converting them into marketable securities for sale to investors, which enables them to grant new loans in a continuing process of lending, securitizing, selling, and lending again.

Massive non-bank credit constitutes the upper layers of the money pyramid. There are Federal Home Loan Banks, thrift institutions, life insurance companies, brokerage firms, mutual funds and other credit grantors. Last but not least, offshore banks in the Bahamas, the Cayman Islands, Panama, Hong Kong, and Singapore, enjoying favorable regulatory and tax treatment, constitute the top layer of the multi-trillion dollar money pyramid. And high above the American pyramid hovers the international pyramid, which builds on the U.S. dollar standard.

The Chairman and his fellow governors are expected to balance it all with their high-powered Federal-Reserve- dollar base. They are expected not only to manage this monstrous pyramid of fiat money and fiduciary credit, but also to safeguard the stability of the American economy, to maintain asset prices, protect the value of the dollar, and avoid the business cycle. They are supposed to manage a monstrous structure which politicians have built for their own use and glory. That’s too much to ask of any mortal.

"Money will not manage itself": this is the very rationale of Federal Reserve existence.

Its sponsors and managers usually refer to the days when gold and silver coins were the principal media of exchange. The supply of money, they assure us, depended more on the discovery and exhaustion of gold and silver mines than upon the needs of business. Moreover, many abuses developed, such as debasing the coinage, "clipping" and counterfeiting.

Unfortunately, the Fed sponsors and managers hate to admit that the clipping of a few coins in ages past was a negligible abuse when compared to the continuous ‘clipping’ of all forms of money today. Even in moments of ‘stability’, all U.S. dollars in the form of cash or deposits lose at least two to three percent every year. They have lost some 95% since the Federal Reserve introduced its dollar in 1914. They probably will lose more in the coming years.

Fed sponsors and managers point to the recurrence of business cycles prior to the inauguration of the Federal Reserve System. They may turn to the crisis of 1873 and the depression that followed, or to the crash of 1893 and the aftermath, or the crisis of 1907 and the "creeping depression" which lasted until the World War brought an unprecedented boom. Unfortunately, Fed supporters hate to recall the cyclical instability that has characterized the economy ever since. We count at least eight boom-and- bust cycles since 1914, in addition to the Great Depression, which held the country in its grip from 1929 to the outbreak of World War II in 1939.

Surely, no one can contend that the Federal Reserve System has brought economic stability or conquered the trade cycle. On the contrary, its critics are convinced that a politically conceived and administered money monopoly, such as the Federal Reserve System, is the worst of all money systems. It will breed business cycles as long as it lives.

Stock market cycles are the most spectacular offspring of central banking and credit creation. There are several others, less sensational, such as the cycles in precious metals and objects of art and collection. They affect only small groups of affluent clientele, which usually suffer in silence. The most ominous of all cycles, which touches millions of people, is the boom-and-bust sequence in real estate. Just as in equity markets, these bubbles are clearly visible in their price-earnings ratios or price-rental ratios greatly exceeding those of healthy markets.

Abundant credit at bargain rates of interest causes housing prices to soar, especially in growing communities, which fosters not only feverish construction activity but also enlarges the mountains of debt, even consumer debt. Fannie Mae, the publicly owned and government-sponsored Federal National Mortgage Association, reports that soaring housing prices and falling mortgage rates are allowing homeowners to refinance $1.4 trillion of mortgages in 2002, up from $1.1 trillion last year. In both years, homeowners are estimated to take out some $100 billion in equity.

The real estate bubble is bound to burst as soon as the distortions become visible to ever greater numbers of participants. Commercial construction already has fallen sharply in 2001 and 2002, with the steepest declines in the industries most afflicted by the September 11 attacks, including hotels and office space. Government- sponsored industries, such as public works and health- care facilities, are likely to expand further.

Driven by the same forces of easy credit and falling interest rates, all interest-bearing and discounted government securities have developed fever bubbles. The U.S. Treasury bubble, which few economists have as yet discovered, is still growing under the impact of avalanches of investors’ money seeking shelter in Treasury safety. Tired of losing any more money in stocks, investors are piling into Treasury notes yielding barely 4%. As the federal government will be forced to raise hundreds of billions of dollars in the coming months in order to cover its growing deficits, interest rates are likely to rise. They are bound to increase substantially when the current flood of new money and credit finally aggravates the price inflation. When note rates return to just five percent, the yield of two years ago, the bubble will burst and the market value of all notes and bonds will drop drastically.

The economic maladjustments are numerous and severe, inflicting painful losses on ever more people. The number of job cuts continues to rise, making unemployment a potent economic and political problem. It is compounded by chronic trade and current-account deficits, which are causing many American jobs to move to Asia. The rising rates of unemployment, together with the staggering losses of income and wealth, cast doubt on the ability of debt-laden American consumers to support the American economy much further.

Some pessimists hold to the single notion that the length of a readjustment is determined by the length of the bubble preceding it. Because we experienced the longest and most spectacular financial bubble in history, we are condemned to suffer history’s longest recession. Such notions unfortunately spring from mechanical perceptions of human action and reaction. It is the severity of the maladjustment, not its duration, together with the capacity of correction, not its length of time, that will determine the kind and quality of readjustment.

An administration walking in the footsteps of Presidents Hoover and Roosevelt – who practically closed the national borders to trade and commerce, doubled the tax burden, and imposed numerous business regulations and restrictions – undoubtedly will create another ‘great depression.’ An administration that lightens its burdens and releases the energy of the people will facilitate a speedy recovery.

A Federal Reserve Board which, obedient to public opinion, keeps its interest rates far below market rates and readily finances growing federal deficits will only make matters worse. The popular reduction of its rates on November 6, 2002 was just another popularity ploy, which is bound to aggravate the maladjustment and delay the recovery.


Hans Sennholtz,
for The Daily Reckoning
November 15, 2002

Editor’s note: Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy. You can write to him by sending an e-mail to this address:

Nothing but good news yesterday.

Consumers spent more freely in October than most economists expected, and much more freely than we expected.

Unemployment went down in the most recent period.

Alan Greenspan opined that Congress should give Americans a permanent tax cut – adding fiscal stimulus to his rate cuts.

Intel says it is buying more of its own shares. The company is spending $1 billion per quarter helping to drive up its stock price.

"LA Housing Still Hot," says the L.A. TIMES. Bonds went down. Thrift, which we thought we saw setting in recently, seems to have been delayed.

Investors were encouraged. They’ve heard that stocks hit a low every 20 years – in 1942, 1962, 1982, for example. Now, let’s see, the next low should be…2002! And it’s almost over. There’s also the Presidential Cycle, that says stocks bounce after the mid-term elections. And there’s the old Wall Street saying: ‘Sell in May and go away’. Stocks always do better in the winter months, they believe.

And here we are near the end of 2002, after the mid-term elections, with winter approaching…and nothing but good news. Can you blame investors for getting a little giddy?

Who knows? This market was ready for a major bear market rally. If anyone knows how far it will go, he isn’t in the Daily Reckoning office this morning.

Greenspan noted that the economy was improving. But bear markets teach humility, and even the Fed chief seems to be learning.

"There is a probability, small as it may be," he said, perhaps underestimating, "that we may be wrong."

Eric, your update from New York, please…


Eric Fry, back at home in the Big Apple…

– Wow, that Mr. Consumer is a cagey critter! He’s been "playing dead" so convincingly that the financial press has published his obituary several times.

– Then…suddenly…comes a tapping sound from inside the casket?…He’s alive! Mr. Consumer isn’t dead after all!…

– Retail sales rose 0.7% last month, according to the Commerce Department. This itty-bitty number doesn’t seem like much of a reason to get too excited, but 0.7% was more than double the gain forecast by all those nameless "economists." As such, the retail sales report heralded the resurrection of the U.S. consumer – perennial savior of the American economy.

– Investors ecstatically rushed into the stock market to snap up their favorite symbols. The Dow advanced 144 points to 8,542 and the Nasdaq jumped nearly 4% to 1,411. The U.S. dollar also celebrated this spontaneous "Fundefinedte du Consumer" by gaining about half a percent against the euro to 100.4 cents per euro.

– However, as is often the case, one market’s pleasure is another market’s pain. And yesterday, the bond market suffered pain aplenty. The prospect of a revitalized consumer, and therefore, a resurgent economy, blindsided bond investors. The 10-year Treasury note took a beating, as its yield soared from 3.83% to 4.02%.

– Until yesterday, talk of deflation had been all the rage on CNBC, which was reason enough to start preparing for the next great inflation. But CNBC’s near-perfect record as a contrary indicator is not the only reason to suspect that the prices of goods and services may start rising, rather than falling.

– To be sure, prices for some products are falling. And it’s also true that personal bankruptcies are rising, corporate bond defaults are soaring and Treasury bond yields are close to 40-year lows. But these deflationary symptoms should not be confused with the real McCoy – deflation itself.

– The 4% 10-year Treasury yield, for example, does not necessarily signal a coming deflation. It may simply "signal" that lots of investors prefer a certain 4% return on their money to the risk of losing 20% to 30% of it in the stock market. At the moment, the most persuasive signals emanating from the financial markets seem to be pointing to the ‘in’ kind of ‘flation’ rather than the ‘de’ kind. Specifically: the dollar has been slumping for almost a year, while gold has been climbing.

– As I stated in the "Great Deflation Debate" between Bill and Myself in New Orleans, "Deflation is a bad bet. We may not see runaway inflation, but deflation is a bad bet." (Bill disagreed, but I’ll let him speak for himself.) Therefore, positioning for higher long-term interest rates is probably a good bet, especially with the money supply expanding as briskly as it is.

– M3, the so-called broad money supply, jumped $32.6 billion last week – its biggest weekly increase since August. And over the past six months, M3 has swelled at an annualized rate of 7.8%. Bank credit is also soaring. "Total bank assets have surged $493 billion over the past 28 weeks to almost $6.9 trillion, an annualized growth rate of 15.6%," observes the Prudent Bear’s Doug Noland. "ABS (asset-backed security) issuance continues to be eye-opening as well…Home equity issuance of $122 billion is up 73% from last year’s record level… Consumer Credit expanded by $10 billion during September, a 6.9% annualized rate. Revolving Credit expanded at a 9.3% annualized rate during the month and 9.5% for the quarter."

– What do all these big numbers mean? Namely, that the supply of credit is booming. Normally, that is an inflationary augury. In other words, America in 2002 is not like the Japan of the 1990s…at least not yet. (If Bill’s theory is correct – that U.S. economic trends are trailing about 10 years behind those of the Japanese – it’ll be about seven more years before we wake up one morning with an uncontrollable urge to save money, eat sushi and ride on a jam-packed commuter train.)

– For now, Americans are still borrowing money – lots of money – just like they’ve always done. And they’re spending this borrowed money, just like they’ve always done. Sure, U.S. corporations are reigning in their borrowing a bit, but that’s not true of either the U.S. consumer or of Uncle Sam himself.

– For evidence that money-borrowing is still in a bull market, take a peek at the latest self-congratulatory report from Countrywide Credit: "The mortgage loan pipeline reached a new milestone of $52 billion, an increase of 86 percent over last year. October fundings surpassed all previous company records reaching $34.7 billion, exceeding last month’s funding high of $25.3 billion by an impressive 37%."

– Here’s a few more eye-popping highlights from the report: Total fundings jumped 134% year-over-year, with purchase fundings up 84% to $9.4 billion and non-purchase (refi) fundings surging 159%. Can you say, "mortgage- finance bubble?"…How about, "Inflation is coming." Can you say that?


Back in Paris…

*** No sooner had your editor gotten back to his office in Paris than his colleagues started reinforcing suspicions we’ve had about efficiency in the information age…

"We ordered those books weeks ago," said Philippa. "And they still haven’t come. I thought Amazon was supposed to have such good customer service…"

The big River of No Returns just keeps rolling along… In fact, the stock has been one of the year’s best performers, up 75% this year, while the Nasdaq lost 33%.

Is Amazon a buy?

The company reported a pro-forma loss of 2 cents a share in the first 9 months of the year. But had it used more conservative accounting, writes Andrew Bary in Barron’s, it would have lost 40 cents.

One of the internet’s biggest success stories, is still a remarkably bad business with a remarkably over-priced stock. It has operating margins of only 4% and its shares trade at 80 times next year’s estimated earnings, 800% greater than competitors Barnes & Noble and nearly twice as high as other internet success stories, such as Expedia and eBay.

"Amazon trades in a world of its own," Bary concludes.

*** Lower interest rates are supposed to spur spending by consumers. But in "The Dark Side of Low Rates", MONEY magazine reports that consumers receive more interest than they pay. Last year, households – particularly those of older Americans who have paid off their mortgages – received $1.1 trillion in interest, against only $600 billion in interest expense.

Lower rates help debtors, not creditors.

"The low interest rate environment has also encouraged lots of credit risk borrowers to come out of the woodwork looking for loans," says MONEY.

They found the money. But now they are having a hard time paying it back. Bankruptcies are at a 40-year high.

*** Americans are supposed to have the highest standard of living in the world. But, after a trip that took your editor to Baltimore, West Virginia and New Orleans, he is not so sure.

The standard of living is usually computed by dividing national GDP per person. But GDP only measures financial activity, not real wealth, Doug Casey explained in New Orleans. A nation of spenders will have a higher GDP than a nation of savers. A nation in which people eat at McDonalds rather than cook for themselves at home will also have a higher GDP. So will a nation in which people pay illegal immigrants to cut their lawns, rather than taking care of them themselves. But the lawns won’t be any better kept, nor the food more appealing, nor the balance statements any more attractive.

When it comes to getting and spending, no group does more of it than Americans. But money isn’t everything, we remind ourselves. For all their furious financial activity, the quality of life in America is uneven at best. At worst, it is pathetic.

Reducing quality to its essentials, what matters is what you see, what you eat, what you live in, and the comfort, elegance, and security of everyday life.

Arriving in New Orleans, a passenger takes his place in a disorderly mob to get a taxi. The cab is usually a clunker of a car which takes you through the small, squat houses of the suburbs, dilapidated commercial areas and then into downtown. Traveling along St. Charles avenue or the Esplanade, a visitor finds many graceful trees and respectable houses. But no sooner have his spirits lifted than a boarded-up house, abandoned lot, or a Popeye’s outlet comes along…and he is right back where he began.

We do not fault the convenience or efficiency levels in U.S. cities. Almost anywhere you go, you can buy a handgun or a pizza at almost any hour of the day. It is the architecture that bothers us most. Whether you are in the backwoods of West Virginia or the streets of New Orleans, the defect is right in front of you, like an open can of Draino on the breakfast table. It is especially annoying in New Orleans – not because the architecture is worse, but because it is better. The old houses, with their high ceilings, classical proportions, columns and shutters are an abiding reproach.

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