The Grand Illusion
Through the magic of the printing press, the Fed has convinced investors that the healing balm of "gentle" inflation will soothe away our economic troubles…
"Inflation tends not only to pressure, but to increase, the maldistribution of labor between industries, which must produce unemployment as soon as the inflation ceases."
– F.A. Hayek, Open or Repressed Inflation, 1969.
The failings of the Macromancers who dominate contemporary economic reasoning can be encapsulated as follows: if you can’t leave the house because the trousers Granny has bought for you are too long for your legs, you can solve the lack of fit by trying them on while standing on a chair.
To explain what we mean by this, let us start by conceding that both Keynesians and Friedmanites – as well as the majority of their derivative sub-cults – realize that if there is a seeming surplus of labor, it is because it must be priced too high in relation to the value to which it will give rise.
Being politically cynical enough to presume that reducing labor rates in money terms is more problematic than making the money in which they are paid worth less, the recipe for any business setback is thus the application of a little judicious inflation. This doctrine is now so well ingrained that the Norges Bank of Norway recently stated proudly that its policy aim was "higher inflation" because the prevailing rate was "too low."
This simplistic, aggregate approach overlooks at least one critical fact: a general rise in prices carries no guarantee that a struggling firm – which, presumably, is struggling only because it has misjudged the relationship prevailing between resource costs and consumer preferences – will right itself, any more than the act of flooding a lock can be reckoned to right the capsized dinghy floundering inside it.
Temporary Prosperity: Addicted to Inflation
While we know a new inflation will build its usual distortions under the veneer of a temporary prosperity (mostly localized among those favored to receive the first use of the new means of payment), we must remember also Hayek’s point that those dependent on the artificial stimulus of inflation for their continuance will become so addicted to it that they will sicken and die if that inflation slows or is redirected.
To date in this so-called "jobless recovery," U.S.-driven inflation has, in fact, succeeded in leading to more labor being hired. However, to the collectivists’ dismay, the new labor is largely in China, where the labor distribution is better adapted to U.S. spenders’ needs and where total relative labor costs are substantially lower than they are in the U.S..
In this, U.S. consumers – sustaining their lifestyles not from sufficient production of exchange value, but by using borrowed money they have not earned – have been exhausting the fruits of others’ labor via the consumption of present capital and the alienation of future income. Neither of these trends can be maintained indefinitely in real terms, though they can be monetarily disguised for long enough that the damage can become severe before it is fully recognized.
When their Chinese suppliers were saving a goodly proportion of these proceeds and buying U.S. securities with them, the secondary beneficiaries of the inflation, thanks to this act of misguided largesse, worked in the U.S. housing market and in what Robert Higgs calls the Military-Industrial-Congressional Complex. Thus, America’s homebuilders, realtors, mortgage lenders, government contractors, etc. all did well at home.
Temporary Prosperity: A Subtle Shift
Further, the inflation made service providers such as banks and insurance carriers, with their less open markets, all the more lucrative, while poor old manufacturers were made simultaneously to bear increased costs at home and heightened competition from abroad.
Now, however, there has been a subtle shift. China, at least, is saving much less and spending much more of the money. Hence, commodity prices are up while the dollar is down sharply.
Those businesses serving Asia’s new retail clientele and its emergent yuppies – as well, some allege, as those serving China’s own MICC hierarchy and its members’ desire for strategic stockpiles – are now the redirected inflation’s main beneficiaries, rather than the importunate U.S. householder.
For China’s booming industrial concerns – and, by extension, for their Asian suppliers and investors – a triple threat may emerge from this transformation:
* A policy of deliberate central bank restrictionism, instituted in addition to the likely slower acquisition of those dollar foreign exchange reserves that have so boosted domestic money supply this far
* The burden of higher import costs due to the renminbi’s link to the sagging dollar (though a partial subsidy is being granted by the currency interventions of such players as the Bank of Japan)
* Greater competition for labor and capital resources from domestic consumer industries whose customers’ requirements may, furthermore, be widely misaligned with the tastes of their international counterparts who have been so well served until now.
Temporary Prosperity: A Boost to Some Industries
The corollary to all this is that, as the dollar falls, there will be an initial boost to some – though not all – U.S. industries. The greenback’s decline should be particularly beneficial to those firms that are relatively sparing of energy use and that do not include a high degree of import content (whether raw materials or components) into their own final products.
With the effects of U.S. inflation having the potential no longer to be so disguised and indirect as when it formerly underwent an interim Asian transformation, housing and finance may both suffer – at least, in the absence of a more concerted effort on the part of the Fed to take up the slack (more below). Conversely, makers and sellers of manufactured goods might find the cost-price balance tilted a little less heavily against them from here onward. Indeed, manufacturing has shown tentative signs of stabilization of late: sales, hours, and head count have begun a slow ascent, and even inventory registered an uptick last month.
Whichever industries best represent the various categories, certainly there would now be scope for the creation of a marginal extra incentive for employing capital and/or labor in the U.S., as opposed to sending it all to the coastal entrepots of the South China Sea.
But these tenuous "benefits" of inflationist policy in the U.S. are illusionary at best. They will almost certainly falter should the Fed step down its monetary efforts. The Fed’s actions are, in fact, analogous to wrapping a corpse in an electric blanket, and then expecting that delaying rigor mortis will also bring about a resurrection.
Before too long, the Fed may well find itself faced with the dilemma compelling it to yield to the necessary correction of recent monetary excesses – or else to fully monetize every price increase in order to ensure that its "grand illusion" of increasing prosperity continues.
Yet a continued resort by Western central banks to running the printing presses at full speed will prove less and less successful at distracting attention from the hole at the heart of the Western – and above all the U.S. – economies. The descent of both the internal and external value of the dollar might begin to accelerate, threatening more upheaval and potentially triggering inherently unpredictable cascades of loss in the murky and highly nonlinear world of international financial speculation.
For the Daily Reckoning
December 30, 2003
Sean Corrigan, the Daily Reckoning’s "man- on-the-scene" in the City of London, is a graduate of Cambridge University and a veteran bond and derivatives trader. Corrigan is the founder of Capital Insight, a London-based consultancy firm which provides key technical analysis of stock, bond and commodities markets to major U.S., U.K. and European banks. He is also a co-manager of the Bermuda-based Edelweiss Fund.
A version of this essay was featured as a Mises Institute Daily Article on 29 December 2003.
We see today’s headlines…and maybe tomorrow’s.
The Dow rose 125 points yesterday. Stocks are speeding to the finish line this year – after a fine run.
Can so many millions of investors be wrong? "Clear sailing ahead," they say.
"Don’t forget to put on your life-jacket," we counter.
It has been a great year for stocks – if you ignore the currency in which they are calibrated.
It has been a great year for real estate, too…subject to the same objection. In fact, it has been the best year ever for real estate – ever in history.
* A record 6.1 million homes were sold…up from 5.56 million in 2002. * A record 1.1 million new houses were sold. * A record $3.4 trillion in new mortgages were taken out – equal to a third of the entire U.S. GDP. * And the median house sold rose 9.1% in price during the last 12 months.
Of course, adjusted for the drop in the dollar, the median house is actually worth less now than it was at the beginning of the year.
But who’s in the mood for quibbles? The voters are having their say; they want stocks and real estate to rise, while they spend, spend, spend their way wealth. Hold the kvetching…stop fretting about China or gold…who cares about the deficits, debts, or the dollar?
The dollar fell again yesterday. It dropped to nearly $1.25 to the euro. The rent on our Paris apartment has risen nearly 50% in the last 2 years. How low will the dollar go? $1.50 is our near-term guess.
Gold rose to $415. How high will it go? $500 is our near- term guess.
The big surprise, we continue to warn, may be a sudden collapse of the dollar – beyond what anyone expects. Then, like an unexpected eclipse of the sun…the world’s economy would see a darkness at noon that would astonish and alarm almost everyone. Stocks, bonds, and real estate would all crash. The U.S. economy would go into deep recession. The whole world economy might follow. One way or another, Americans will be forced to adjust to lower living standards. Normally, we would expect a long, disagreeable period of bear market, a falling dollar, and on-again, off- again recession. But a short, vicious shock might be able compress the pain into a few short years.
Yesterday, we also saw a headline that we thought we might need to get used to. "Grocery workers agree to slash pay," reported the Detroit paper. Elsewhere, the news came out that few people got large holiday bonuses this year.
Americans are going to have to adjust to a smaller share of the world’s pie. They gobble up 86% of the entire world’s savings, but only create a third of its output. Year after year, they consume more than they produce, spend more than they can afford, and borrow more than they should.
Meanwhile, the foreign competition grows stronger day by day. Chinese peasants – who, a few months ago, had never even seen a computer – migrate to the cities and take up jobs putting them together. Thanks to Americans’ reckless spending…they find a ready market for nearly everything they make. And the more they make, the more they CAN make…and fewer areas are left where Americans have a clear and decisive advantage. In a globalized economy, how can Americans hope to continue earning 10 times more than their competitors?
We’ve already noticed the effect of competition at the low end of the scale. Factory workers in America have seen almost no increase in their real hourly earnings in the last 30 years. Now, the competition is moving up the socio- economic ladder. Even the middle class are finding themselves on slippery rungs…
But so far, few notice…
Here’s Eric with more news:
Eric Fry in the City that Never Sleeps…
– Yesterday, Eli Lilly won FDA approval for Symbyax, a new drug to treat "bipolar disorder," also called manic depression…Mr. Market could use a prescription. The drug is a combination of two older Eli Lilly drugs: antidepressant Prozac and anti-psychotic Zyprexa.
– Imagine, a pharmaceutical cure for bear markets!…A regularly medicated Mr. Market might not subject investors to the mood swings they’ve come to expect and to fear. By taking Symbyax, Mr. Market could advance, point-by-point, in carefully measured steps toward Abby Joseph Cohen’s 2004 S&P 500 price target of 1,300.
– But what fun would that be? Without a bit of psychotic behavior, the stock market would become as tedious as a presidential debate. What’s more, for the last several months, the stock market has been far more manic than depressive…and what investor doesn’t love a good, old- fashion mania?
– Stocks have been advancing so steadily for so many months that most investors have forgotten all about the pain of three-year bear markets. Once again, they are enjoying the delirium that share prices will rise forever. Yesterday, the Dow added to its gains for 2003 by jumping 125 points to 10,450, while the Nasdaq vaulted 33 points to 2,006 – its first close above 2,000 in nearly two years.
– Meanwhile, gold and the dollar continue waging their epic monetary battle. Day-by-day, the forces of good – a.k.a. gold – gain ground against the forces of evil – a.k.a. the dollar. Gold jumped $2.50 to $415.30 – its highest close in nearly eight years. The dollar slipped another half a percent against the euro to a new record low of $1.248 per euro.
– Curiously, the lumps don’t seem to care about the crumbling dollar. As long as American stocks are rising, the withering value of America’s currency is no big deal. Net-net, the stock market bulls are firmly in command, and there seems to be enough pent-up bullishness and irrational exuberance floating around to buoy share prices into the first part of next year.
– "It’s hard to see what might prevent the market from retaining its upside bias at the start of the year," Barron’s remarks. "Economic numbers have improved and investors are happy to extrapolate them into a continuing upward arc. Market technicians report that the index charts lack serious vulnerability." The bulls also have the presidential election cycle on their side. Election years often produce stock market gains.
– Fundamentals aside, the stock market’s greatest asset may be the sheer momentum of rising share prices and giddy bullish sentiment. Stocks are rising, simply because stocks are rising…and the most speculative stocks are rising the most of all.
– Perhaps stocks will rally throughout 2004, or perhaps they will crash on January 2nd…We have not seen the script. But we did come across a scenario that seems plausible to us: Smith Barney’s chief U.S. equity strategist, Tobias Levkovich, expects the market to continue higher early in the year, then slide lower thereafter. Rising interest rates, he predicts, will halt the market’s rally and drive share prices lower.
– 2004 could resemble 1994, says the cautious strategist. Stocks fell that year, even though GDP grew 4.2% and corporate earnings surged 20%. "In that mournful year," Barron’s recalls, "benchmark Treasury yields rallied three percentage points, as the Fed tightened credit."
– Luvkovich does not anticipate disaster, merely a decline. Noting that the average P/E on S&P operating earnings since 1960 is 15.6, Luvkovich applies a 15.3 multiple to 2005 estimates of $67 to arrive at an S&P target of 1025 for year-end ’04.
– The Smith Barney strategist is alone among prominent Wall Street pooh-bahs in calling for stocks to fall in 2004. The stock market’s lengthy rally has driven the bears close to extinction once again, which, from a contrarian perspective, is one of the very best reasons to distrust this market. The widespread bullish sentiment on Wall Street is one of the best reasons to trust that Luvkovich’s cautious forecast will prove correct…or too optimistic.
– More reasons tomorrow….
Bill Bonner, back in Ouzilly…
*** "We’re seeing another holiday orgy of spending by U.S. consumers," reports the Detroit Free Press. "Everywhere we look, we’re encouraged to spend, spend, spend. Budgets are being squeezed by mounting credit card debt, student loans, mortgage borrowing and, increasingly, by rising out-of- pocket health care costs.
"The big question is: How much longer can we keep this up?
"Experts have mixed views. But a few things are clear. ‘A lot of people are dangerously close to the edge and any minor setback could push them over,’ said Amelia Warren Tygai, co-author of ‘The Two-Income Trap: Why Middle-Class Mothers and Fathers are Going Broke,’ ($26, Basic Books). ‘And everyone should reassess his or her financial condition for the new year and cut back wherever possible.’
"Unlike in past recessions, consumers kept borrowing during the last downturn, which began in March 2001 and officially ended in November 2001. The recession would have been far worse if consumers didn’t opt for zero-percent financing deals and didn’t keep pulling out credit cards.
"But all that spending – on top of a three-year downturn for stock prices – hurt household balance sheets. We only started seeing stock gains in spring of 2003.
"That was after the ratio of household liabilities to net worth hit an all-time high of 22.6 percent in the first quarter of 2003. Outstanding consumer credit, mortgage debt and other debt hit $9.3 trillion by April 2003, up from $7 trillion in January 2000."
Ah, stop your worrying…it will all turn out okay. Millions of Americans will go broke. But so what? Look on the bright side. More may get through the eye of the needle and into heaven.
*** "Will there be a dollar crisis?" asks our friend Martin Spring.
"The most astonishing figure I’ve seen reported in recent weeks is the Japanese provision for currency intervention, essentially to support the dollar. It’s Y100 trillion – about $930 billion at the current yen/dollar exchange rate.
"That’s the amount of yen the Japanese central bank has been authorized to borrow in a year to spend on buying foreign currencies to hold down the yen’s exchange rate.
"The mind-boggling size of the provision – about 50 per cent greater than America’s forecast foreign trade deficit next year – alerts us to two conclusions:
* The Japanese authorities see a significant risk of a major dollar crisis which would send money flooding into alternative major currencies.
* If that happens, they are determined to keep a lid on the yen – which would both help the dollar to resist decline and divert most of the money flood into the euro.
*** Has the "Era of REALLY Big Government" now arrived?" asks the Independent Institute.
"Over the past three years, with inflation at record lows, U.S. government spending has increased by a massive 28.3% – with non-defense discretionary growth of 30.5% – producing the largest deficit in U.S. history and the highest rate of government growth since LBJ’s "Guns-and-Butter" combination of the Vietnam War and "Great Society."
"This explosion of government power has only been possible in the aftermath of 9/11 as politicians take full advantage of a frightened American public.
"During this time, President Bush has become the first U.S. president since James Garfield (serving only in 1881 until he was assassinated) and Millard Fillmore (1850-1853) NOT to have vetoed a SINGLE bill, with the result that we now have record pork spending and corporate welfare in agriculture, education, Medicare, energy, defense, transportation, foreign aid, homeland security, and more. U.S. government agencies have furthermore been given new powers to arrest and detain people indefinitely without charge, legal counsel, or trial; to secretly search anyone’s property; and to intercept phone, Internet, and other communications, as well as access health, financial, and other private records."