-->Policy Slippage

The Daily Reckoning

Ouzilly, France

Wednesday, 13 August 2003

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*** Inflation begets deflation... are the Japanese begetting
inflation, right now?

*** The global debt bubble continues to inflate... At least,
there's a whole lot of huffin' goin' on...

*** Dow, Nasdaq up... Fed sticks with 1%... An investment
recommendation: buy Japan... and more!

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In today's Daily Reckoning, we try to give you more than
your moneysworth - which should be a cinch since you paid
nothing for it.

First, the essential insight: inflation begets deflation;
deflation begets inflation.

Since the '30s, the U.S. has begotten nothing but
inflation. Will deflation be gotten next? We think so.

But not necessarily the deflation you might expect.
Consumer price inflation has been coming down since the
late '70s. Recently, it has been approaching zero. That it
might slip below zero, as it has in Japan, would not
surprise us... nor would it disturb our sleep.

What will bring sleepless nights to many Americans is the
coming deflation in asset prices. Nobody complains when
stocks, bonds, or real estate rise at double-digit rates.
But they'll howl when the downturn finally comes.

We are in the midst of a Huge Top in asset prices. Stocks
rose for nearly 20 years... and now are trading at 32 times
earnings. They're more than 4 times more expensive than
they were when the bull market began. Until about two
months ago, bonds had been in a 21-year bull market. Yields
are still the lowest they've been in more than 30 years.
And the dollar, too, went up against real money - gold -
for 20 years. All these things - and select real estate,
too - are ready to be deflated.

Another way to look at it, suggests England's"Business
Standard" is as a 'Global Debt Bubble.' Private debt as a
percentage of GDP is up to 189% in the UK, says the
Standard. In Germany and the U.S., it is 145%. Debt (made
inevitable by the Dollar Standard system) is behind
everything... all the asset bubbles were inflated with debt,
which has just kept increasing, even through the recent
slump. Consumer credit (and especially mortgage
refinancing) gave people money to spend. It was credit that
brought profits to U.S. corporations, too. In 1982, less
than 10% of corporate profits came from financial
activities (financing and so forth). Now, the figure is
40%.

"The market is dependent on low and falling interest
rates," says the Standard.

But now long rates are rising. And a headline in the L.A.
Times tells us that"Loan requests fell 22% in July."

Somehow, sometime, the inflation of the past 2 decades will
beget deflation. When? How? That is the theme of this daily
chronicle... so stay tuned.

We found no message from Eric this morning. Instead, we
received news from our esteemed sarong-wearing analyst,
Dan Denning...

Dan?

--------------

Daniel Denning in Paris...

- And you thought deflation was dead.

- Filling in for my New York colleague (who's on his way to
San Francisco a day ahead of me) I warn today's readers
that today's notes will have a distinctly Francophile
flare. That's right, we wear sarongs here in Paris [see
July 16th's Daily Reckoning for details... ]. At least I do,
when it's hot enough to kill off a statistically valid
percentage of Bill's countryside village. There is a virtue
though. Looking different (in a sarong) sometimes helps you
think a little differently.

- Yesterday, the Fed opted to keep interest rates at a 45-
year low. Announcing that it would leave its overnight rate
unchanged at 1%, the Fed did everything it could to avoid
naming that 'unwelcome' guest at the economic policy table
in its statement. No mention of deflation. Of course not.
In Fed-speak, deflation is the monetary crisis that dare
not rear its head. But even though you won't see the word,
it's clearly on the Fed governors' collective mind.

- Here's the money paragraph:"The Committee perceives that
the upside and downside risks to the attainment of
sustainable growth for the next few quarters are roughly
equal. In contrast, the probability, though minor, of an
unwelcome fall in inflation exceeds that of a rise in
inflation from its already low level. The Committee judges
that, on balance, the risk of inflation becoming
undesirably low is likely to be the predominant concern for
the foreseeable future. In these circumstances, the
committee believes that policy accommodation can be
maintained for a considerable period."

- Just how much do Greenspan, Bernanke et al. feel that the
probability of an"unwelcome fall in inflation exceeds that
of a rise in inflation"? They declined to answer... but the
stock market had plenty to say. The Dow demurred most of
the day. But when the Fed said it would keep rates low for
a"considerable period", the blue-chip index danced up
nearly 100 points to close at 9,310, just 96 points below
its high on June 17th.

- Even Microsoft (MSFT), which lost a $521 court verdict
for a patent violation, and whose Windows browser is
suffering from a yet another global computer virus, managed
to eek out a half a percentage gain to close at $25.73. It
was the power of 'positive thinking' at work (see also:
'delusion').

- But the most important number of the day is the one
you'll only read about here: 1,385. That's how many points
I forecast the Dow could fall by the end of the year,
taking it to around 7,925... a full 15% lower than
yesterday's close.

- This is not, as my colleague Addison implied this
weekend, a gratuitous prediction. There is a reason for it.
In each of the last two years, the Dow has made a huge
decline from its intra-year high to its intra-year close.
Right now, we're right on the cusp of a new high for the
year. But with August being, as a matter of record, the
cruelest month on the stock market, and with nothing but
the real news from the real economy ahead, my forecast is
that the financial economy is in for a shellacking.

[Ed note: for more on why a recovery in the real economy is
not in the cards, see Dr. Kurt Richebächer's article on the
DR website:

What Makes A True Recovery?
http://www.dailyreckoning.com/body_headline.cfm?id=3354

More also from Apogee Research's Andrew Kashdan, below... ]

- If you're skeptical, look at the bond market. Yesterday's
Fed announcement drove bond yields up and bond prices down
even more. The yield on the benchmark 4.25% 10-year note
rose 6 basis points to close at 4.42%. Put buyers on bonds
in the last month (including my readers) have making out
like... well... bond traders. But without actually BEING bond
traders.

- By the way, if all this bond market commentary means
nothing to you, you're not alone. Yes, rising yields mean
the Treasury must pay more to foreign lenders who finance
America's consumption addiction. And yes, rising yields
make debt service payments harder for the dozens of U.S.
companies that have subsisted on the Fed's easy-money
policies. But can you as an individual investor profit from
ANY of it?

- Happily, yes. I'll give you the single best investment
tip I've given all month, and for free: TLT and IEF. For
the first time, individual investors and traders can profit
from changes in the bond market buy buying either of these
exchange traded funds. TLT is a bond fund based on the long
end of the yield curve. It mimics the performance of 20-
year notes. IEF mimics the performance of 7-10 year notes.
If you're bearish or bullish on bonds, there is not an
easier or cheaper way to trade your idea and profit.

- Then again, if you're nostalgic, you'll always have the
triple Qs. The Nasdaq raced up 25 points to finish 1.5%
ahead on the day. The big winners for the old loser of an
index were RARE Hospitality Intl. (RARE), up 56%, On Track
Innovations (OTIV), up 33%, and Lynx Therapuetics, up 26%.

- Good work, Mr. Chairman. You've kept up appearances and
obscured the reality. Good luck making it last.

--------------

Bill Bonner, back in Ouzilly...

*** As Dan informs us above, the Federal Reserve met
yesterday and decided to do nothing; its key lending rate
remains at 1%. In a free market, of course, lending rates
are determined by lenders and borrowers. Guided by an
'invisible hand,' they manage to discover the rate that
best matches the supply of credit with the demand for it.

But it is the special conceit of the Fed that it can find
an even better rate (usually lower). Enlightened economists
regard price fixing as either folly or imbecility. But
fixing the price of credit enjoys a special place in their
hearts. Doing so, they think they can do a better job than
God's invisible appendage.

We chuckle to ourselves and enjoy the show... what else can
we do?

Someday, the arrogance and lunkheadedness of the whole
scheme will be plain to everyone. But that is something
else to look forward to...

*** For now, we look across the vast Pacific pond and think
we see the something interesting. Could it be? Have we
caught them in the act... in flagrante delicto...? Is
deflation begetting inflation right out in the open, in
front of our very eyes?

"Growth gathers pace in Japan," says a BBC headline. So far
this year, Japan's GDP is moving up at a hot-and-heavy
speed, 3 times as fast as expected... with a 2.3% rate now
anticipated for the year.

And get this: the Japanese are spending! (What would happen
if the world's savers stopped lending to America and began
to open their own mouths? Ah... a subject for another
day... )

Has the Japanese economy finally bounced after falling for
13 years? Maybe. You'll recall, dear reader, that a huge
inflation of asset prices and debt in Japan in the '80s
begat a big deflation in the '90s. The latest numbers may
be just flirtation or foreplay. Or the sushi-eaters could
be begetting something interesting.

"The unattractive girl at the bottom of the class is
suddenly the hottest date in town and every high-rolling,
big-spending fund manager seems to want to throw money in
her direction," says Joe Thomas in the Investors Chronicle.

"Japan will outperform Wall Street and the European stock
market for the duration of this global rally," adds well-
known London analyst David Fuller, whose current personal
"biggest equity exposure by far" is a long position in
futures on the Tokyo market. Fuller expects the Nikkei
index, currently at 9,328, to go to 11,400 at least.

And Marc Faber:"I think that over the next 12 months, the
Japanese market may have the highest upside potential among
the developed world, which could, as a result of the
irresponsible U.S. Fed reflation, propel the Nikkei Index
to around 15,000."

We have no way of knowing. But if we were placing our bets,
we would much rather bet on a market that has been deflated
out than one that is bubbled out to the limit of its
inflationary stage. Sell New York. Buy Tokyo.

*** And now for a change of pace: Associated Press is
estimating the cost of"rebuilding Iraq" at $600 billion.
Putting the electrical system, alone, back in order will
cost about $13 billion, says proconsul Paul Bremer.
$58 billion is the Pentagon's bill so far this year.
Another $4 billion per month is the on-going cost of
providing near-at-hand targets for terrorists.

Bossing the Iraqis around has gotten much more expensive
than it used to be. The British did the job for only 2.7
million pounds per month, in 1919. At the time, Britain was
the world's super-power. But British power went into
deflation in WWI and never quite recovered. Manufacturing
shifted to the former colonies... the pound was
devalued... and by the early '80s, the sceptered isle was
effectively bankrupt, with bad cars, bad food, bad
teeth... and an average income lower than Hong Kong.

The world turns.

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The Daily Reckoning PRESENTS: A primer on the Austrian
approach to the business cycle... and why the conventional
après-bubble 'cure' doesn't always work as planned... if at
all. Apogee Research's Andrew Kashdan reports, below...


POLICY SLIPPAGE
by Andrew Kashdan

When someone characterizes the current state of the economy
as"the ultimate vicious circle," you may want to listen.
Particularly when that someone happened to warn of vicious
circles just before the boom went bust... and chances to be
Morgan Stanley's Stephen Roach.

What is bothering Mr. Roach is the rise in nominal interest
rates amidst disinflationary pressures - which portends an
even more damaging rise in real rates."While a temporary
quickening in the pace of global activity may now be at
hand," writes Roach,"two key problems endure - the risk of
deflation and the likelihood of a U.S. current-account
adjustment."

Roach is surely right to worry about 'policy traction' - in
this case, the ability of the central bank to boost
economic activity effectively. But even more interesting
are the uncertain consequences of a dramatic drop in the
dollar... and the historically unprecedented adjustment in
the current account that would result. In fact, Roach
suggests that such an adjustment might intensify global
deflationary pressures - and that the U.S. could also be
sending deflation abroad through rising long-term rates and
a weakening dollar.

As the Daily Reckoning's Paris-based editors are keen to
remind us, the dollar's devaluation is inevitable... even
desirable to many on the homefront. A low U.S. dollar is
good for U.S. exports, which might explain why Treasury
Secretary John Snow seems to have cast aside the rhetorical
'strong dollar' (while also, apparently, taking lessons
from Mr Greenspan himself when it comes to including useful
information in his commentary."A strong currency is one
that has all the attributes of strength" is a recent
example). If the dollar were to fall significantly, its
devaluation would effectively 'pass the buck' to U.S.
creditors abroad.

But not all financial gurus see globalized deflation on the
horizon; au contraire, says Chen Zhao, chief emerging
markets strategist at Bank Credit Analyst Research Group.
In an op-ed article for the Financial Times, Zhao writes
that"the Fed is in a dangerous game with China," which he
describes as a"silent but active partner in the Fed's
pump-priming. It would not be possible for U.S. Treasury
bond yields to be at current [low] levels were China not a
willing and able supplier of savings to the U.S." (Even
allowing for the recent rise, yields remain historically
low.)

In effect, Zhao argues, China is trading goods for U.S.
paper, creating a"hyper-stimulative" environment for both
countries. Thus, contrary to popular belief, Zhao sees
inflation in China's future. Intervention to prevent a rise
in China's currency has fueled monetary expansion, and the
country's CPI has already reached an annualized rate of
about 1%. That's still low by most standards, but if the
rate reaches 3%-4% - which, according to Zhao, could happen
in the next six months or so - the central bank will be
forced to revalue the currency.

If that happens, the floated Chinese currency could lead to
another surge in U.S. Treasury yields, as well as increased
inflationary pressures in the United States.

But no matter what policymakers say or do - and no matter
if or when deflation and inflation strike the global
economy - if U.S. asset markets continue to rely heavily on
foreign funds, the adjustment will be painful.

Then again, we at Apogee Research never expected that the
after-effects of the great stock market levitation and its
sudden descent would be anywhere near pain-free. Nor did we
think it should be. And when ber-Keynesian Paul McCulley,
managing director of PIMCO, recently observed that"we are
indeed all Keynesians now," not quite all of us were ready
to join the crowd.

Roger Garrison, professor of economics at Auburn University
- and the modern guru of the so-called Austrian school of
macroeconomics - recently co-authored an article with Gene
Callahan in The Quarterly Journal of Austrian Economics.
Happily for us non-Keynesians, the pair show how Austrian
business cycle theory provides the best explanation of the
dot.com boom and bust.

Long-time Daily Reckoning sufferers will be familiar with
the main thrust of the theory, which can be neatly summed
up with a single maxim:"[M]aintaining an artificial
interest rate, like all price-fixing, will have unintended
consequences that the price fixer can do little to
control."

In the case of the recent stock-market bubble, extra
liquidity led dot.com start-ups and others to bid up
certain capital goods, the increased prices of which
eventually made the start-ups' plans unfeasible. The easy
money also led to over-consumption.

Garrison and Callahan speak not of macroeconomic aggregates
like GDP and CPI, but of the repercussions of newly created
money and the changes in relative prices it brings about.
The recent boom and bust is deemed the 'ideal type' of
business cycle to explain with the Austrian theory (which
criticizes central bank meddling in the money supply),
because it was engendered by central bank expansion.

Garrison and Callahan begin their study with the Reverse
Plaza Accord of 1995. At that time, the U.S., Japan and
Germany all agreed to take various measures to strengthen
the dollar, largely in an effort to undo the previous
distortions created by the Plaza Accord a decade earlier.
The advantage was that the Fed could maintain an easy money
policy without raising the CPI. The increased liquidity
then found its way into U.S. and East Asian asset markets.

Of course,"every bubble needs a story," as Garrison and
Callahan relate. It just so happened that the Netscape IPO
occurred in August of 1995, its stock price rose beyond all
expectations. Because the presidential election was also
less than 18 months away, Garrison an Callahan argue that
Greenspan's easing during this time was at least partially
influenced by politics - a suggestion few would quarrel
with.

At the time, the continued drop in the unemployment rate to
well below what had previously been considered 'full
employment' was attributed to a sudden rise in productivity
- i.e., the birth of the 'new economy' - a theory advocated
most notably (and repeatedly) by the Fed chairman himself.
Some of the arguments sounded plausible at first, but they
became less convincing as the rate continued to fall. The
trend suggested"a cyclical rather than a secular pattern,"
say Garrison and Callahan, and"the lows of 1998 through
2000... were unsustainable."

What Greenspan and other policymakers seem to have
overlooked, or failed to understand, is that borrowing
costs artificially lowered by Fed actions can cause certain
industries to increase capital spending more than they
would otherwise. This, in turn, can lift productivity."But
concurrent productivity gains in select industries are more
likely to be indicative of an unsustainable boom than of an
end to booms and busts," Garrison and Callahan assert.
Furthermore, a significant portion of those gains were
subsequently revised away; for example, annual productivity
growth in 1999-2000 is now put at an average of 2.6%,
instead of the headlined 3.4%.

As it happened, a series of economic crises - East Asia,
Russia and Brazil, the Long-Term Capital Management affair
and the Y2K scare - kept the Fed's printing presses running
at full speed. Meanwhile, the groundwork was being laid for
some of the now-familiar features of the boom, such as the
surge in IPOs, the rise in consumer and corporate debt, the
drop in savings and the unprecedented increase in liquidity
and asset prices.

In the beginning, low interest rates led to an increased
demand for lendable funds and a lengthening of the
production process. But then monetary expansion created a
wedge between higher investment and lower savings, and,
eventually, there were insufficient resources to support
all of the investment plans.

The adjustment process became a recession. But the so-
called 'recession' - hampered, eased and spread thin at
every turn by Greenspan's Fed - was not allowed to run its
course; it remained incomplete.

In other words, those who had it coming 18 months
ago... still do.

The Austrian approach to the business cycle is instructive
about the source of great economic booms. But more
importantly for those living through the aftermath of the
subsequent bust, it explains why the conventional 'cure'
doesn't always work as planned... if at all.


Regards,

Andrew Kashdan,
for The Daily Reckoning

P.S. Casting aside our wet blanket for a moment, there was
some encouraging news last week about both consumer
spending and nonresidential fixed investment in the second
quarter, while a sharp drop in inventories points to a
further boost in GDP in the quarters ahead. Consumer
spending increased 3.3% vs. a 2% decline in the first
quarter, propelled by a 22.6% increase in durable goods
purchases (all the numbers are annualized).

Advance estimates of second-quarter GDP showed growth of
2.4%, annualized, which was up from 1.4% in the previous
two quarters.

But before you break out the champagne, hark back to the
volatility of past growth statistics and the
disappointments. You'll see that while this GDP report, and
possibly the next few, will be welcomed by those who take
comfort in a nice headline-making number, the long-awaited
self-sustaining recovery has still not arrived.

In 2002, for example, the first and third quarters
registered growth of 5% and 4%, respectively, while the
second and fourth periods mustered only 1.3% and 1.4%,
respectively. In similar fashion, growth of private fixed
investment soared at 4.4% in the 2002 fourth quarter, only
to plummet to minus 0.1% in this year's first quarter.

In other words, while there may well be some encouraging
signs, continued spending by consumers and the Pentagon
will not be enough to ignite a full-fledged recovery,
especially in this unique post-bubble climate.


Editor's Note: Andrew Kashdan is a top analyst at Apogee
Research - positive proof that with reputable, independent
investment research, consistent profits of 166%, 154% and
134% are still possible. For more information, see:

Apogee Research
http://www.apogeeresearch.com/dr

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