Sunday, May 23, 2004

FSO Editorials: "Flash Bubbles" by Dan Denning 05.21.2004

FSO Editorials: "Flash Bubbles" by Dan Denning 05.21.2004

Flash Bubbles
by Dan Denning
Contributor, The Daily Reckoning
May 21, 2004

The Daily Reckoning PRESENTS
In theory, the Federal Reserve can print as much money as it likes. Reflation should be assured. Unfortunately, the wise men overlooked one small detail...wage stagnation. If consumers cannot afford to pay higher prices, you don’t get higher prices...

If you’re like 99% of the world, you expect the Fed to raise rates.

But somewhere along the way, in its perfect plan to “reflate” the American economy and prevent a Japan-style soft depression, the Fed made a fatal miscalculation: It caused a simultaneous asset bubble in stocks, bonds, commodities, housing, and real estate. We stand on the edge of the great collapse of the “reflation rally.” Some assets will come through relatively unscathed. Others will deflate. What the Fed is about to reap is a lot different than what it thought it was sowing.

The Fed thought it could make money cheap and keep the stock market high (and households feeling wealthy). It was right. It thought it could keep money cheap and force savers to abandon money market funds and CDs. It was right. It thought it could keep home prices rising by keeping interest rates low (and mortgage rates low in sympathy). It was right.

It also thought it could create so much money that raw material prices would rise. It was right. The Fed’s cheap money caused a series of “flash bubbles” in the commodities sector, especially in base materials, and even in gold. It also thought it could keep money cheap and force up producer prices. Producers have to buy raw materials, after all. It was right.

And it thought that the whole chain of inflation - or the ladder, if you prefer - would be completed in the form of rising consumer prices. It thought it could prevent deflation by first forcing up raw materials prices, then producer prices, and finally consumer prices. If the Fed couldn’t make consumers borrow, it thought it could make them spend by inflating. It was wrong.

This essay is not going to be a long explanation of the failures of monetary and fiscal policy, though it would be fitting if it were. Never before has an American government been as irresponsible with its citizens’ money as the current administration. And never before has the Federal Reserve done more to undermine your standard of living than this Federal Reserve has.

The government has borrowed beyond its means and spent even more. It has made promises it can’t keep - and probably never intended to. And the Fed has encouraged the financialization of the American economy. It’s made borrowing money and using leverage so cheap that there is virtually no sense of risk in the market...risk of taking on debt...risk of buying too high...risk of the whole financial economy falling apart.

To be fair, the irresponsibility of the American government is perfectly in tune with the irresponsibility of governments everywhere. We live in an age of increased government action in the economy. Economic policies (deficit spending, tariffs, currency manipulation) are seen as the tools of economic warfare. Nations wield them against one another to gain relative advantages in a world marketplace thick with competition from numerous low-cost producers.

The American government has made three unique blunders. First, it has taken the good will of the rest of the world for granted. America is a debtor nation. It depends on the rest of the world investing in America to keep the value of the dollar up. Take away investment in American stocks, bonds, and real estate, and the Great Inflation begins.

Second, our government has preached to you the benefits of globalization, namely lower prices and more choice. What they didn’t mention is that true globalization means a permanent change in the structure of the American labor market. This is how free markets work. Production moves to the lowest-cost centers. This is not a cyclical phenomenon, but a structural one: It means that America is becoming a service economy. The wages of excessive consumption are the loss of an economy that produces new investment and wealth.

Third, however, and greatest of the policy blunders is the assumption that monetary policy can cause wage inflation. Because of this error, the Fed is about to discover that its entire effort to reflate the economy through low rates has failed. And it is nearly out of interest rate bullets.

What do consumer wages have to do with monetary policy? The Fed has succeeded in causing inflation nearly everywhere in the economy EXCEPT in consumer wages. But without rising wages, consumers can’t afford to pay rising prices.

Think about it. Gas prices are high and rising. Long-term interest rates are rising, increasing the amount of discretionary income the average consumer has to pay on his adjustable rate mortgage or credit cards. Now add to those two forces rising consumer prices. What is a consumer to do? If his wages aren’t rising, can he afford higher prices, along with already high energy costs and debt service costs?

Greenspan knows that without rising wages, there can be no real “reflation.” In congressional testimony that was overlooked in the press accounts, the chairman said, “Remember that more than two-thirds of the consolidated underlying domestic costs in the United States are unit labor costs...And unit labor costs, as best we can judge, are still going down.”

In other words, everything is going up in price...but consumers can’t afford to pay those prices. This, ironically, is deflationary. As prices rise, consumers cut back on spending. The more prices rise on the margins, the less consumers consume. It is nothing less than the end of the consumption-driven American model - the model the rest of the world has tolerated because Americans have been buying on credit. The credit crunch is coming.

If reflation were really going to show up in the economy, you’d see big price markups across the board in all sectors. But in a recent Financial Times article, only three big U.S. companies reported success in passing high raw materials prices on to the consumer. The companies were Ford, Honeywell, and Hormel, the company that makes SPAM. Not exactly a burst of reflation in the economy.

It must be hard for the Fed to realize this. It’s the end of the line for the reflation model. The Fed can’t cause consumer price inflation because it doesn’t control the key element of the whole inflation ladder, namely the labor market. In reality, labor market changes are a function of globalization (aided and abetted by the Fed’s cheap money policy).

The Fed has thus made it possible for a huge spike in prices, leading to the deflationary collapse of the American consumer. The normal policy response to skyrocketing inflation would be to raise rates (what the market expects). But raising rates puts the consumer in even worse shape than he is now and threatens the main source of household balance sheet wealth: the house.

If it seems to you like the Fed doesn’t have any good choices left, I agree. It’s backed itself into a monetary corner from which there is no apparent escape. It does have some options. But it will be exercising them without any historical precedent of success.

For example, the Fed may decide it wants to set long-term interest rates, too, either on the 30-year bond (which would be reintroduced) or on the 10-year bond. Granted, this would be considerably disruptive to the bond market. But in an era of government intervention, it’s just another form of price control.

More likely is that the Fed will start to "monetize" outstanding debt by buying U.S. bonds. There would probably be a lot of sellers, if it got to that. The Fed would be acting as buyer of last resort, trading newly printed cash for U.S. bonds, which it would then own or retire. The whole goal would be getting currency in circulation, getting the consumer to spend.

That, of course, is something the Fed probably can’t do, even if it wanted to. Spending is as much a psychological process as a fiscal one. People spend now when they think the future is getting better, with less risk. But when people are cautious, they spend less, they cut back, they downsize. They scale back expectations. They think differently.

It’s hard to predict what will happen to the American economy when this happens. A dollar sell-off is coming. Standards of living are going to fall. Land values will suffer, all because...

The American government was just another government that couldn’t pay its bills.


Dan Denning,
for The Daily Reckoning

P.S. I’ll be in La Jolla over July 15 and 16 for the Agora Wealth-Currencies & Resources Seminar. It will be a blast. John Myers, Chuck Butler, Karim Rahemtulla, Eric Roseman, Steve Belmont are all coming down, as are many others. You’ve got to make it:

Wealth-Currencies & Resources Seminar


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