The First Panacea

“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”

– Ernest Hemingway

America’s total debt load is already so big that the nation must spend more than $1.7 trillion a year, or about 15 percent of the nation’s GDP, on debt service. But it’s starting to grow rapidly once again.

The price tag on invading and occupying Iraq, for example, will likely soar to more than $700 billion. Meanwhile, the Pentagon is asking for a $380-billion budget next year to upgrade the military’s intelligence corps and rapid- response teams.

That is more defense money than the combined spending of Russia, China and all of Europe.

Given all of its commitments, plus President Bush’s tax cut, the federal government is adding half a trillion dollars in additional debt each year. By 2005, the federal deficit will be about $8 trillion, or roughly two-thirds of the nation’s GDP. Given these rapidly growing federal liabilities, it’s no wonder the Fed is hell-bent on reflating. Uncle Sam would love to repay today’s debts with tomorrow’s cheaper dollars, especially because it would be paying much of it to foreigners.

Devaluing the Dollar: $749 Billion in US Treasuries

Foreign central banks own $749 billion in U.S. Treasuries, or more than 20% of the entire market. Holdings of U.S. assets by foreign central banks have risen by $163 billion in just the past year, with the Bank of Japan buying a record $34 billion in Treasuries this past May.

Foreigners now own more and more of America – about “$8 trillion of U.S. financial assets, including 13% of all stocks and 24% of corporate bonds”, according to Bridgewater Associates.

Given America’s growing reliance on the “kindness of strangers,” the United States would not dare to renege on its debt in any way, shape or form. But that doesn’t mean it has any qualms about repaying its debt with devalued dollars. The deflationists [present company included – Addison] argue that that federal government hasn’t the wherewithal to devalue the currency; that if Washington tried, the bond markets would react immediately and severely. What those deflationists fail to take into account [ahem] is that most of the world has too much wrapped up in U.S. financial instruments to do anything that would contribute to their demise. [What some deflationists argue is that the Fed doesn’t have the wherewithal to correct historic levels of consumer debt…but they appear to be hell-bent on destroying the currency while trying – Addison]

The massive eight trillion dollars of U.S. financial assets held by foreigners means that all foreign central banks and foreign institutions have good reason not to liquidate stocks and bonds, even if the U.S. were to systematically debase its currency. Liquidating U.S. assets could create a vicious cycle of dollar weakness, leading to additional asset sales that would lead to additional dollar weakness, on so on it would go. What Washington really has then, is tacit permission from foreign investors to devalue the dollar; albeit slowly.

And this is precisely the path that the Fed is pursuing. In my advisory service, Outstanding Investments, I am predicting the Fed will succeed in rekindling inflation. After all, history shows that central banks have an unblemished record of currency destruction. Central banks can destroy any currency, if they set their minds to it…even the U.S. dollar.

Devaluing the Dollar: Tripling the M2 Money Supply

Let’s examine the historical record. Between 1970 and 1981, M2 money supply tripled! For 11 straight years, a record amount of liquidity was injected into the economy.

Yet as the 1970s proved, money is not wealth. From the beginning of 1971 to the end of 1979, GDP growth was extremely sluggish, rising by about 2 percent per year. Meanwhile, consumer prices during the same span rose by a staggering 6.5 percent per year. By 1980, the greenback had lost half the purchasing power that it had just 10 years earlier!

Reflation is no friend of the stock market. In the summer of 1971, when President Nixon severed the Gold Standard, the Dow was trading at 900.

In hindsight, 1971 was an excellent time to get out of blue-chip stocks and to load up on hard assets. But hardly anyone realized it. In the spring of 1980, the Dow was trading at 759. Not too severe a loss from the highs of about 1,000 that the Dow reached in 1966…unless you factor in inflation. The 1980 Dow, measured in 1966 terms, was trading at 404. In real terms then, the stock market had lost nearly half its value during the 1970s and two- thirds of its value from its 1966 high.

Devaluing the Dollar: Incredible Gains in Real Assets

It was the opposite situation for hard assets. Excess dollar-creation and fiscal irresponsibility led investors into real assets and the companies that produced them. The first wave of investors was simply looking for something to shelter their investments from inflation. But as more and more money moved into real-asset stocks, their value began to climb at a rate that more than compensated for the declining value of their investment dollar.

While most Americans were absorbing big losses in the stock and bond markets, a few forward-looking investors were racking up incredible gains in real assets. The stocks of companies that explored and produced base metals, precious metals, lumber and petroleum saw their stock price appreciate throughout the decade. Some junior gold companies rose by a factor of 10 or more, while even major petroleum companies saw their stock price double or even triple.

Thirty years later, the cycle has come full circle. Mountains of debt can only be repaid in devalued dollars. Monetary growth is rampant, and the dollar has begun to weaken. Meanwhile, commodity prices are beginning to stir, even though with a weak economy, they should be falling. This tells me that the financial markets have already heard the hooves of approaching inflation. It’s time to saddle up!


John Myers
for the Daily Reckoning
June 25, 2003


The Fed prepares another rate cut pronunciamento. Will the 13th succeed where the other 12 failed?

But what kind of world would it be, dear reader, if you really could create money out of thin air? “You can’t get something for nothing,” we keep saying. But what if you could? Would there be any eternal verities left? Would there be any laws, any principles, or any rules you could still count on? Would there be a single moral rock solid enough to lean against…or any natural dirt hard enough to hold your weight…or any God left in heaven to press his thumb upon the scale of divine justice?

If the hacks at the Fed really can make us all wealthier simply by lowering the Fed Funds rate, what can’t they do? Why don’t they make our women all look like Hollywood starlets and our kitchen faucets run with good Scotch!

The Fed has added $5 trillion in new dollars since Alan Greenspan became chairman. Is there no price to pay for this new wealth? Or is the Fed chairman divine…bringing manna down from the skies as if he were an air traffic controller landing DC-7s full of bon-bons on an island of weight-watchers?

It is all just too absurd to take seriously. But here at the Daily Reckoning, as we explained in a final note yesterday, we are optimists: we think the Fed will fail. Eventually, somehow, the heavens will have their way…

All over the world, the authorities are trying the same monetary and fiscal claptrap. Rates have been cut everywhere. In Japan, there are no rates left to cut. In the U.S., there remain only 125 basis points; in Europe, there are only 200.

All the major countries of Europe are spending more than they can afford, in violation of the 3% deficit limit established by the Maastricht Treaty. In America, the deficit has reached 4% of GDP. In Japan, the government deficit is up to 7%. But for all this easy money – out of thin air it comes – there is no evidence that anyone actually gets richer. In Japan, for example, the monetary base has increased by 84% since ’97. But GDP went down 6%.

And now the whole world seems to be slouching towards deflation – despite officials’ best efforts to create inflation. Today’s news brings word that even in Latin America, prices are falling. In May, CPI figures for Mexico, Argentina, and Chile all declined. And in Israel, the cost of living dropped at a 5% rate in the last 3 months. What’s more, with prices falling in Germany…2 out of 3 of the world’s biggest economies are either in deflation or close to it.

We remain optimistic, however. We have no doubt that central banks will eventually destroy the currencies they are supposed to protect. But maybe not when or how they choose.

Over to you, Eric:


Eric Fry in New York…

– The Dow Jones Industrial Average climbed 36 points yesterday to 9,109, while the Nasdaq Composite slipped 5 points to 1,605. In the commodity markets, gold for August delivery plunged $6.70 to $346.70 amid strength in the U.S. dollar, which hit a five-week high against the euro of $1.152.

– The stock market rally since March 11 has been a delightful interlude – a delicious respite from the sturm and drang of our painful three-year bear market. But all pleasures end…especially the fleeting pleasure of bear market rallies…

– From its intraday low of 1,108 last October 10th to its intraday high of 1,677 on June 18th, the Nasdaq gained a breathtaking 51%. “That’s as good as it gets,” insists Jay Shartsis, a professional options trader with R. F. Lafferty in New York. “Sometimes you get rallies of 40% or 50% after a bubble bursts – and you have to still believe that we are in a post-bubble environment – but that’s it…And guess what, from bottom to top, the Nasdaq has gained about 50%.”

– The funny thing about the Nasdaq’s 50% rally is how little business has improved for tech companies since the rally began. Semiconductor companies are still struggling to sell computer chips, as AMD’s revenue-shortfall announcement yesterday testifies, and consumers are still hesitant to buy PCs, even though they do not hesitate to buy the richly priced shares of PC vendors…

– Et tu, Fannie Mae? First comes the news that fellow mortgage-lender Freddie Mac has been “massaging its numbers” to produce steady, cosmetically-pleasing earnings results. Then comes the shocking allegation that Fannie Mae “hid” a few billion dollars of losses. We all know that bad news comes in threes…What’s next? Is Microsoft about to file for bankruptcy?

– The unnerving disclosure of corporate malfeasance at Freddie Mac alarmed the legions of gullible investors who trusted in this government-sponsored enterprise’s (GSE) “predictable” earnings growth. Scarcely had the disillusioned masses regained their composure when the rumor mill kicked out a shocking story about Fannie Mae, the other mortgage-lending GSE.

– According to the New York Times, a bevy of accounting experts and money managers believe that Fannie Mae’s assets – when shown at fair value – suffered a loss of several billion dollars last year due to a drop in interest rates. But thanks to some handy accounting rules, the company managed to divert these hefty losses away from its income statement.

– Is it a mere fluke that these two massive, but still rapidly expanding, GSEs are both pushing the accounting envelope in the pursuit of impeccably manicured – and therefore, share-price-boosting – earnings results? “Unlikely,” scoffs Apogee Research’s lead analyst, Robert Tracy. “I smell a rat…or at least something that smells very much like a rat…We’re digging into this thing right now. So I’ll keep you posted.

– “Ya know,” Tracy continued, “I’ve done a lot of digging into Sallie Mae’s financials (that’s the student-lending GSE) and I’ve found a number of suspicious accounting practices. And I’ve expressed my suspicions about the company’s accounting in print, as part of Apogee’s skeptical analysis of Sallie Mae.

– “As you might guess, the company’s CFO has called me and provided some very reasonable-sounding explanations for their bizarre accounting practices. But I just can’t buy it. Net-net, Eric, my guess is that aggressive accounting, the type that skirts the edge of legality, is simply part of the GSE’s corporate culture…To be clear, I’m not accusing any of them of illegality. But their accounting practices definitely mask the huge volatility that is part of today’s mortgage and lending market. So the effect of this game – whether intended or not – is to deceive investors about the massive risks that these GSEs are dealing with day in and day out.

– “The mortgage market can be a volatile marketplace, and it is becoming an increasingly dangerous place for big lenders like Fannie and Freddie. So, best case, honest earnings reporting will likely lead to lower share prices for these companies. Worst case, I shudder to think…maybe some sort of derivatives debacle.

– “But to repeat, I’m looking into this now and will be issuing a report shortly.”

– We suspect that the Freddie Mac affair is more than just a financial fender-bender. So far, investors are shrugging off the twin scandals at Freddie Mac and Fannie Mae, just like they shrugged off the initial reports of scandal at Enron, WorldCom and Tyco. Unfortunately, in each of these instances, the “First sale was the best sale!”

– What’s more, anything that causes difficulties for Fannie and Freddie, by definition, causes a problem for the housing market. Could the Freddie-Mac-cum-Sallie-Mae scandal be the pin that finally bursts the bubble that some people say has become the nation’s housing market?

– “Questions about Freddie Mac’s finances could spark investor concerns about its mortgage-backed securities, which are crucial to providing funds for banks and other mortgage lenders,” says CNN/Money. “If Freddie Mac’s problems mount, that could drive up mortgage rates, which could hurt the housing market and possibly lead to a sharp drop in home prices.”

– …or maybe not. “But,” says Apogee’s Tracy, “I suspect that more shoes are yet to drop from the GSE’s financial statements.”

– [Ed note: for more investment advice consistent with the ideas you read in Eric’s commentary, please subscribe to:]


Bill Bonner, back in Paris…

*** Readers continue to send interesting mail from the world over: “Hillary Clinton will succeed George W Bush as U.S. President,” writes our old friend Martin Spring, from England, “and probably as early as next year.

“The universal expectation in the States is that Hillary Clinton won’t run for the presidency next year as Bush will be unbeatable – she’s planning to succeed Dubya after he completes his second term. However, they said that the little-known governor of Arkansas couldn’t beat Bush Senior. Could another Clinton be about to repeat history?

“Hillary has repositioned herself as a centrist – so much so that her voting record and public statements on hot- button issues such as the invasion of Iraq and homosexuality have severely strained her relationship with the Left. When elected to the Senate she made a point of focusing her attention on the armed services (which mainly interests Rightist males) rather than on health and welfare (seen as female, Leftist issues)…

“Many commentators believe the recent launch of her book was the opening salvo of her presidential campaign in 2008. But she is making such progress in preparing for her bid that the Clintons could well blindside everyone, as they did in 1996, and run next year.”

Here at the Daily Reckoning, we remain steadfast in our optimism. Perhaps Hillary will run against George. But as Henry Kissinger said of the Iran-Iraq war, it is too bad they both can’t lose.

*** Another friend, staying out at our country house south of Paris, sends an amusing memoir in which he recites the lyrics of a mega-hit by Shania Twain: “…climaxing with her own version of Greenspanian economics:

When you’re broke go and get a loan
Take out another mortgage on your home
Consolidate so you can afford
To go and spend some more when you get bored.

…[it’s] a guttural, instinctual premonition that, for the gilded calf of American consumerism…the gig is up. Even our sex symbols are in on the secret. Everyone knows except Messrs. Greenspan, Bernanke, and McTeer. Although, I suspect even this trio senses the sea change – late at night when it’s just them and their MTV. Everyone knows it. It’s just that nobody wants the music to stop.”

The rest of the letter is on the DR web site. See:

*** A Canadian reader comments on the beautiful state of West Virginia and the people who call it home:

Dear Mr. Bonner,

Having suffered with the Daily Reckoning Affliction/Addiction for some time now – and, thankfully, no end in sight for this condition yet – I will try to get some relief by sending this e-mail.

While reading your travel-log about West Virginia some time ago, I thought: Surely, he must be exaggerating.

My jaw dropped however, as I stared in disbelief at the photos put out by the US Ministry of Propaganda, showing the home of Private Lynch after the first airing of that made-for-TV movie: “The rescue of Private Lynch”.

This young woman made the right, and smart choice! Good for her!

Anything, including sandstorms, sandfleas, broken bones, and a hospital bed in Iraq is preferable to the place she came from. Even if it means going to a foreign land fighting people who talk funny, who eat strange food, and probably smell bad (or at least different). Imagine, actually getting paid for getting away from that place, called home.

After seeing those, and subsequent photos, I now know where some of the ‘Boobus Americanus’ reside.

*** And Mr. Fry shares this letter from a friend in Japan: Hi Eric,

This is Paula in Tokyo. The deflation here continues…

Three-bedroom apartment rentals are down from $20,000 a month to just $10,000 a month. Restaurant dinners costing $400 a person 5 years ago are now just $200 (if you order cheap wine).

Kelly Bags which were bought new at $5,000.00 are now being sold at thrift stores for just $3,000.00. Ditto for gold Rolex watches which were $20.000 and are now at prices of just $16,000. Sales of two-bedroom apartments are down from $5 million to unheard of levels of $2 million. Where all of this will end we don’t know…

The Daily Reckoning