(Un)Constrained Discretion

In the "current environment of ‘guess what Greenspan is feeling today,’" as John Mauldin puts it below, how’s an investor to know where to place his bets?

The Fed and Greenspan have been given a free ride for quite a long time. All throughout the bull market, in fact. As long as things were going well, who wanted to rock the boat, other than some bond traders and a few Austrian (economist) curmudgeons?

But now that the economic weather is no longer as fair, a chorus of doubting analysts calls louder and louder for ‘transparency’ in what they see as inscrutable Fed policy. As Pimco’s Paul McCulley put it:

"In a nutshell, Mr. Greenspan’s management style is best described as ‘trust me’ – sometimes known as ‘constructive ambiguity.’…Greenspan disagrees [with specified policies], when it comes to carrying out his job mission. His definitions of the Fed goals are what his gut says they are, but what he cannot bring his lips to say, subject to change when he has an undisclosed stomach ache."

McCulley goes on to argue for "constrained discretion" on the part of the Fed. By that he is not arguing that the Fed should not have discretion to make decisions and even to change its mind as the facts change. But these decisions should be constrained (limited) by a set policy, which everyone understands.

"If Mr. Greenspan ever wanted evidence of the cost of his infectious hubris," writes McCulley, "he need not look any further than the money market futures market, as displayed on the cover. Unconstrained discretion, as Mr. Greenspan advocates, is not a free good, because it raises risk premiums for uncertainty about monetary policy, acting as a headwind to the FOMC’s accommodative will."

Why is Greenspan resisting such a reasonable guy like McCulley’s request for transparency? Why is he saying "trust me" is a better policy than understandable parameters? And why, if the economy is growing so well, is the Fed telling us that rates will remain low for a ‘considerable’ period of time?

Let’s look at some uncomfortable long-term facts facing the Fed.

First, Fed governors must clearly mistrust that the currently forecasted economic growth spurt has ‘legs.’ In my opinion, if they thought for one minute that the economy was going to grow on its own at 5% real growth for the next 18 months, I cannot imagine they would not begin to raise rates, if for no other reason than to have some room to lower them the next recession.

Why mistrust this growth? Because much of the growth is from stimulus that is not lasting. This growth is caused by (1) Bush’s tax rebates, which are clearly kicking in (Wal- Mart’s sales are up 5-6% year over year), (2) a huge government deficit spending (more than half the GDP growth last quarter was government [mostly defense] related) and, (3) massive mortgage refinancing which was done in the second quarter which produced a huge amount of spendable cash, which is now being spent.

But where are the jobs? With productivity at 6% plus (a number about which I think there is reason to doubt), you would need somewhat more than 5% growth to produce jobs. A jobless recovery is not sustainable, and the Fed knows it.

Greg Weldon slices and dices the numbers from last week’s ugly jobs report for us. Employment is down 113,000 since June. Unemployment is down 453,000. That means 340,000 of those formerly classified as unemployed have now dropped out of the labor force. Part-time employment is down 200,000 in the month of August. Thus, the ‘lower’ unemployment rate does not reflect any real growth in jobs, but statistical games.

He does an analysis of the breakdown by sector and sex and comes up with this conclusion: "Bottom line…there is one macro-conclusion of significance to be gleaned from today’s labor market input: ‘second income jobs,’ many of them part-time jobs, held primarily by women, are being eliminated."

In addition, the Fed is all too aware that even as GDP was revised upward for the 2nd quarter, housing investment was cut by half from the first quarter. And this before rates began to rise.

Thus it comes as no surprise that the Fed governors are out and about, trying to talk rates down. It is apparent to me that they feel the recovery is fragile and thus are willing to risk a return of inflation.

But the really uncomfortable dilemma faced by the Fed hails from foreign shores. The yawning U.S. trade imbalance – and the plethora of disastrous consequences that would result should a ‘correction’ occur – are at the forefront of every Fed governor’s mind.

But it’s not just the bankers who are biting their nails. GM, Ford and Chrysler, for example, watch their domestic auto sales drop year over year by a respective -8.2%, – 27.7% and -28.6%(!) as sales for Nissan and Toyota rise by over 17%. Thus, it must be frustrating in Detroit to see Snow rebuffed in Tokyo, while even as he was talking about letting the market set the exchange rates, the Bank of Japan was massively intervening again and again to force the yen lower, making Japanese automakers more competitive.

China said, "We will allow the yuan to rise when we decide it is in our own best interests and not a moment sooner."

This competitive currency devaluation cannot go on forever. As Bill Gross of Pimco points out quite succinctly:

"…The hundreds of billions that the Japanese and other Asian countries have been buying in order to keep their currencies competitive with the Chinese Yuan (Renminbi) and the U.S. dollar will be subject to a sanity check…The currency/bonds/stocks of a reflating [U.S.] economy engaged in guns and butter, Hummer and Hummvee spending of near historical proportions are bad investments. Sooner, perhaps later, our Asian creditors will wake up and smell the coffee.

"Perhaps their java will take the form of dollar or Treasury Note sales. Perhaps the aroma will resemble a revaluation of the Yuan and then the Yen. Either way we pay the price: higher import costs, a cutback in spending on cheap foreign goods, rising inflation, perhaps chaotic financial markets, a lower standard of living.

"Mark these words well for what they’re worth (not much some will say): China holds the keys to our kingdom, and our Hummers. Their willingness to buy our bonds, their philosophy of fixing their currency to the U.S. dollar will one day be tested. And should their patience be found wanting, all of their neighboring Asian China wannabes will move in near unison. Reflation’s second round will have begun, U.S. interest rates will rise, our goods in the malls and the showrooms will be less affordable, and the process of national belt tightening and increased savings will have begun."

The Fed is between the devil and the deep blue sea. If the trade imbalance keeps to current levels, then foreign holding of U.S. bonds will rise dramatically. At low interest rates, this is not a huge drag on the economy. But what if rates rise and we start having to send $100 billion or $200 billion to foreign bondholders, which would only add to our trade deficit? Can the Fed really allow rates to rise prior to a drop in the trade deficit?

What’s a central banker to do? The above problems, if allowed to develop before the recovery is clearly established, will mean a recession and deflation. Thus, the Fed must feel, as evidenced by their policies, that they have to do everything possible to get an economy to grow its way out of the problem, even if it means a little inflation.

And there is the disconnect. The bond market can see exactly what I have described. Inflation will ultimately mean higher rates. The Fed does not think we can afford higher rates, which might possibly choke off a fragile recovery. Thus, just as Volcker caused a recession to bring down inflation, the Fed is willing to risk inflation to try and avoid the scenario Gross describes.

Do you think the Fed governors do not see the same imbalances that Gross and a hundred other analysts – including your Paris and New York editors, as well as yours truly – see? However, rather than acquiescing to the decline of our "hegemonic rule," as Gross terms it, central bankers seem genetically compelled to at least attempt to fight the tides of said decline.

And thus, establishing a ‘reasonable’ set of policies, such as Paul McCulley suggests, would mean the Fed may to all too soon feel forced to abandon them in order to deal with the potential crisis resulting from today’s imbalances. Such a reversal has the potential for creating far more havoc than the current environment of ‘guess what Greenspan is feeling today.’ Since the exact nature of the potential crisis is unknown, how can you set a proper course? Better, says Greenspan, to allow them ultimate flexibility than adopting polices. Trust me.


John Mauldin,
For the Daily Reckoning

September 11, 2003

P.S. Maybe there won’t be a crisis and we will grow ourselves out of the problems, at least for a while. The current economic growth is very for real, at least for the next 6-9 months. What if oil then comes down in price? Rates drop again? Jobs pick up and the economy gets on sound footing. A new round of technology investment ensues. There are lots of good things that can happen in the short term on the road to balancing the twin deficits. If you are a central banker, you are counting on them.

At the end of the day, it does not matter whether McCulley, Mises or Greenspan is right. Greenspan is going to win this debate, as he holds the cards until someone takes them away. Rates will stay low until the recovery is on a sound footing and producing jobs or inflation is truly back. We will know when that moment is when he tells us. And therefore risk premiums are going to stay high.

John Mauldin is a prolific investment writer and analyst and president of Millennium Wave Investments.

Shui pao!

Our friend Jim Rogers says that if you want your family to succeed in the 21st century, you’ll teach your children to speak Chinese. So, we’ll begin with the phrase for ‘bubble.’

Bubbles eventually blow up…but while they are swelling, they draw admiration, investment, envy, and resentment. (Daily Reckoning readers who want to gamble on the Chinese bubble might want to buy in now – while it is still expanding. More below…)

So it was when Japan swelled to Godzilla proportions in the ’80s. People rushed to get in. Others rushed to protect themselves. In America, business school students wedged so many Japanese words onto their resumes that employers needed interpreters to pry loose what they were trying to say. But in Congress, Senators railed against the invasion of Japanese products as if Pearl Harbor were being attacked, not realizing that the assault on U.S. markets was financed by America itself.

And now, it is China’s turn. The great wash of consumer credit – created by the Dollar Standard system – has made its way across the vast Pacific, sloshed over Japan, and now floods up the Yangtze and Pearl rivers.

And now, once again, we see the sordid spectacle of U.S. senators rising to defend American commercial interests by claiming that competition from China is ‘unfair.’

"This legislation is a tough-love effort," explained Senator Charles Schumer of the great state of New York, sounding a bit like Richard Nixon, "to get the Chinese to stop playing games with their currency in order to level the playing field for American companies trying to compete with goods and services coming from China."

The specific injustice with which China stands accused is leaving its currency too low against the dollar. How Mr. Schumer knows what the exchange rate between the dollar and the yuan should be has not been revealed to us. But, while we have no laser transit, a brief gaze at the lay of the land suggests that the senator desires not so much to level the playing field as to tilt it further.

China fixed its yuan to the world’s reserve currency – the dollar – nearly 10 years ago. It has kept its word ever since, faithfully exchanging 8.3 yuan for every dollar that came its way. No one complained about this arrangement; it seemed almost laudatory.

Now, China is accused of failing to adjust its currency upward against the devaluing dollar. Bernanke can print all the dollars he wants…but as long as the yuan is pegged to the dollar, when the later goes down, so does the former. Cheapening the dollar gave American companies a slight selling edge against other countries…but not against China. More than $125 billion of Chinese-made goods came into the U.S. last year, and the total continues to rise sharply.

Other foreigners, whose investments and credits were denominated in dollars, lost trillions as the dollar went down. But not the Chinese; in yuan terms their dollar assets remained unchanged. In the words of one eminent Senator, whose malignant pensées were reported by several newspapers, this is ‘cheating’ on the part of the Chinese; presumably, they should stand still and let themselves be robbed along with everyone else.

Oh, those crafty inscrutable Chinese. They work around the clock in unheated factories for $5 a day. And as the dollar goes down – against gold and other currencies – the $5 shrinks; they receive less and less real value for the goods they sell to America. Still, they don’t complain; they continue stuffing containers for shipment to the U.S.. Is that slick, or what? What devious plot will they get up to next? Maybe they will just give away their TVs and geegaws?

Sooner or later the yuan will be revalued upward, we predict. When that happens, investments in China will go up in dollar terms, perhaps considerably so.

Friend and colleague Porter Stansberry has developed a unique strategy to profit from what he terms "the inevitable yuan revaluation." Daily Reckoning readers wishing to take a gamble on the yuan and China’s shui pao might want to do so now; we can’t say how long this opportunity will last…

A lower dollar, however, will not stop Chinese imports or suddenly make U.S. companies competitive. Even if the dollar fell to half its current value against the yuan, it would only increase the real wage rate in China from, say, $5 a day to $10.

Elsewhere in the news we read that this year, American workers are getting the smallest pay increases in 27 years. Is it any wonder?

Eric, give us the latest news, please:


Eric Fry, writing from lower Manhattan…

– Overcoming the "Curse of Septembers Past" is easier said than done. The Nasdaq Composite tumbled 2.6% yesterday to 1,824, while the Dow slumped 87 points to 9,420. After yesterday’s selloff, the major averages cling to very slim gains for the month. Perhaps the market is taking a well- deserved rest…or perhaps it is going into hibernation for the winter…or the rest of the decade.

– Who can blame investors if they have tired of paying 30, 40 or 50 times earnings for the shares of companies that are barely growing? Likewise, who can blame consumers if they have tired of buying things they don’t really need with money they don’t really have?

– As we noted yesterday, credit is supporting consumer spending…Folks have been sucking the equity out of their houses to buy dishwashers, Disney vacations and Dell computers. "The consumer has become so debt-dependent that he now borrows 11 cents of every dollar he spends, compared to 9 cents in the 2001 recovery episode," observes Stephanie Pomboy’s Macro Mavens.

– Eventually – whenever that might be – consumers will need actual income, rather than credit, to pay for their consumption. Unfortunately, income growth has stagnated. That’s because payroll employment has dropped for seven months in a row and shows no sign of rebounding. Worse, "the household debt-asset ratio (18% in the 2003:Q1) is the highest on record since Word War II," notes Northern Trust’s Asha Bangalore. "This ratio was 13.3% in 1999. The sharp increase in household debt implies that debt-service burdens will be another constraint on household budgets."

– Is it any wonder that many Americans are reacquainting themselves with the ancient art of saving money?…And now, let’s welcome NYSE chairman Dick Grasso to the nation’s growing roster of savers. Now that Mr. Grasso has agreed to forego $48 million in future compensation, he will have to find a way to make ends meet on only $92 million.

– But at least Mr. Grasso is still drawing a paycheck, unlike many of the unfortunate souls in the mortgage industry. As predicted in this column two months ago, the mortgage industry is launching its first wave of job cuts. This wave will not be the last.

– The mortgage industry was until recently one of the economy’s few bright spots, having added about 175,000 jobs since 2000. But now the industry is starting to wilt under the strain of rising interest rates. Mortgage refinancing activity has fallen by 78% since May, according to a late- August Mortgage Bankers Association of American report.

– "The cooling refinancing boom is claiming its first casualties: employees of the big mortgage lenders," the Wall Street Journal reports. "Rising interest rates already have slowed the refinancing boom that has sustained the industry, raising the prospect that mortgage providers will lose more than 150,000 employees from their payroll over the next six months." Thousands more jobs will likely disappear in supporting industries.

– The economy can ill-afford additional job losses. But what can be done? Even if other industries resume hiring workers, the prodigious job losses in the mortgage industry could restrain the economy’s overall employment growth.

– Speaking of struggling industries, General Motors reiterated earnings guidance yesterday, saying that it still expects to earn about $5 a share this year. But we wonder: how does GM know what it will earn? Does GM management read copies of the morning paper the night before it hits the newsstand?

– GM’s earnings are not simply a function of car sales. Things like mortgage financing volumes, pension plan return assumptions and the rate of health-care cost growth are all important parts of the net income number. GM may have a vague idea of how many cars it will sell and how much money it will make (or lose) per car. And it may have some kind of guess about how many mortgages it will originate this year. But it seems to have absolutely no clue how much health-care costs will rise.

– GM expects health-care inflation to drop to about 5% annually by the end of the decade. But health-care costs are rising much faster than that currently. For perspective, GM’s CFO, John Devine, said the company has held health-care inflation in the first half of the year to an annualized 7.1-7.2 per cent. And health-care price hikes at most companies are much higher still. "Health-insurance premiums climbed 13.9% this year," the Wall Street Journal reports, "marking the third year in a row of double-digit premium increases in the highest jump since 1990." Health- care costs will likely jump another 12% or so this year. So GM faces an uphill climb if it hopes to hold the annual growth of health-care costs to less than 5% by the end of the decade.

– One percentage point may not seem like much, but to GM, each 1% is worth more than half a billion in net profit annually. For example, if long-term inflation runs one point higher than GM hopes, it will cost the company $523 million a year extra – almost a fifth of this year’s expected group profits. It would also add $5.3 billion to the unfunded pension hole.

– Share prices may rise, but the difficulties remain.


Bill Bonner, back in Paris…

*** Rare is the politician, we pointed out yesterday, who will rise and tell his constituents what they don’t want to hear – especially if it is true. Now cometh that rare bird, flapping his lips in the U.S. House of Representatives just last week.

"In the short run," explained our friend, Congressman Ron Paul of Texas, "the current [Dollar Standard] system gives us a free ride, our paper [currency] buys cheap goods from overseas, and foreigners risk all by financing our extravagance. But in the long run, we will surely pay for living beyond our means. Debt will be paid for one way or another. An inflated currency always comes back to haunt those who enjoyed the ‘benefits’ of inflation."

And then Congressman Paul rounded on his colleagues…

"Although this process is extremely dangerous, many economists and politicians do not see it as a currency problem and are only too willing to find a villain to attack [China]. Surprisingly, the villain is often the foreigner who foolishly takes our paper for useful goods and accommodates us by loaning the proceeds back to us. It’s true that the system encourages exportation of jobs as we buy more and more foreign goods. But nobody understands the Fed role in this [except us, dear reader], so the cries go out to punish the competition with tariffs. Protectionism is a predictable consequence of paper-money inflation, just as is the impoverishment of an entire middle class…"

*** "Please leave by 6 P.M.," pleaded a French colleague at the office yesterday. "The inspectors are here."

Many are the ways a man can get into trouble in Paris. In other parts of the world, he gets into trouble by claiming to be working late at the office, when he is really up to something else. But here, actually staying late at the office can lead to serious problems.

It is against the law to work more than 35 hours a week in France – subject to various provisions and exclusions that no one seems to understand. Still, few serious people work only 35 hours. Contrary to the impression in the U.S. and England, the Frenchman works at least as hard as his counterparts in the anglo-saxon world. He just does it differently. He arrives at the office at 9 A.M. or so. He takes an hour for lunch, often a business lunch. And then he may work until 7 or 8 in the evening. He does, however, take longer holidays…typically 5 or 6 weeks per year.

The French know they must work hard. But at the same time, they think the man who works too hard is a bit of a fool. He must not be able to get his work done in a reasonable amount of time, they think to themselves. And, since working long hours is illegal, too, many people take work home or work surreptitiously, while they feign to be doing something else.

So, yesterday, we were all set to pretend to work less than we actually do. But just as your editor began packing up his papers, he noticed that the inspectors had left. At least they work 35 hours.

*** An interesting email from a friend:

"A book I just finished tells the story of where the term ‘Pyrrhic victory’ (a win at too high a price), comes from.

"Pyrrhus was a king of Epirus who lived in the third century B.C.. In 279, he decided to take on the mighty Roman Army. But before he sailed for Italy, he had a conversation with Cineas, his chief ambassador.

"Cineas: ‘The Romans are reported to be great warriors and conquerors of many nations. If the gods permit us to overcome them, how shall we use the victory?’

"’That is an easy question,’ responded Pyrrhus. ‘Once we conquer the Romans, there will not be any city in all of Italy that will resist us.’

"Cineas: ‘Once we have Italy, what next?’

"Pyrrhus: ‘Sicily, which is a wealthy island, should be easy to take.’

"Cineas: ‘You speak what is perfectly probable, but will the possession of Sicily put an end to the war?’

"Pyrrhus: ‘Carthage and Africa would then be within reach. And once we have them, who in the world would dare oppose us?’

"Cineas: ‘No one, certainly. And then what shall we do?’

"Pyrrhus did not see where he had been led by this argument, so he said: ‘Then, my dear Cineas, we will relax, and drink all day, and amuse ourselves with pleasant conversation.’

"’What prevents us from doing that now?’ said Cineas. ‘We already have enough to make that possible without any more hard work, suffering, and danger.’

"But Pyrrhus didn’t get the point. He attacked and defeated the Roman Army at Asculum in Apulia. He won, but his casualties were so heavy he observed that, ‘One more such victory and I am lost.’ Later, his weakened army attacked Sparta and lost.

"Pyrrhus was hunted down and killed by an angry mob in the streets of Argos.

"The book this comes from, by the way, is called ‘Buck Up, Suck Up, and Come Back When You Foul Up – 12 Secrets From the War Room,’ by James Carville and Paul Begala. Politics aside, this is a great book. It details how these two have had such success on so many political campaigns."

The Daily Reckoning