-->Inflationistas At The Helm

The Daily Reckoning

Paris, France

Tuesday, 10 December 2002

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*** Stocks down...gold down...dollar down...What next?

*** More on the Fed's rookie...who is this guy anyway?

*** Festooned street in Paris...a 'bespoke' suit on Saville
Row...cheap-o gee-gaws...and more...


Our mouths hang open, almost dumbstruck.

Some people watch the markets for profits. We watch them
chiefly for entertainment and moral instruction. Yesterday,
we felt like we were watching Gone with the Wind and The
Ten Commandments at the same time.

Not that anything particular happened yesterday. Stocks
went down...people said things they should be ashamed of...
gold eased off...the dollar fell...it was a day like any
other.

But the tension is building. Fed governor Bernanke has said
the most amazing thing - that the Fed stands ready to
destroy the dollar in order to save the economy. How in the
world will this story turn out, we wonder?

Ours is a consumer economy. It is driven, or so it is
believed, by people who buy things. The more they buy, the
stronger the economy. In a slump, Fed policy is simple -
make sure consumers have the 'money' to keep buying.

The Fed has no money, of course. It only has credit. So it
makes more and more credit available to people, who mistake
it for 'money' and pass it off to shopkeepers, who in turn
spread the counterfeit cash around the economy as if it
were manure in a vegetable patch.

But what is this strange 'money' that the Fed creates?

Bernanke tells us that the"U.S. government has a
technology, called a printing press" and that it can print
as much money as it wants. What kind of money is it whose
supply - like air or water - is infinite?

In fact, little paper is actually printed. Most of the
'money' the Fed creates is only electronic - it is only
information.

Since WWII to the mid-'90s, America's consumer economy
required roughly $1.40 in new credit to produce $1 in extra
GDP. But the more of this strange 'money' you put into the
system, the less impact it has. Since '98, the Fed has
created $9.1 trillion in new credit, which has produced
only $2 trillion more of GDP. So, now it takes $4.50 to
produce an extra dollar of output.

Where is all this extra credit going? Since the middle of
2000, it seems to be going mainly into consumer gee-gaws
made in China and housing prices made in America. The gee-
gaws get cheaper, while the houses get more expensive. So,
the consumer feels comfortable borrowing and spending more
money...because his main asset, his house, is increasing in
value. His own money supply, he figures, is the price he
thinks he could get for his house.

What if, suddenly, he notices that his neighbors are having
trouble selling their houses? What if his money supply goes
down 10%? What good is the Fed's printing press then? How
many trillions of hot new credit would it have to produce
to offset the clammy cold of a decline in house prices?

What would happen to the dollar? The economy? Stock prices?
Gold? The post-Bretton Woods, post-Nixon managed currency
monetary system? Life as we have known it?

We don't know. But we're on the edge of our chairs, waiting
to find out.

Over to our man on the street...Wall Street, Eric Fry:

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Eric Fry writing from the islet of Manhattan...

- Hey, what happened to the new bull market?...The Dow
dropped 172 points yesterday to 8,473, while the Nasdaq
tumbled nearly 4% to 1,367...Repeat after me:"It's just a
healthy correction."

- The dollar also continued to slide, sinking deeper below
parity with the euro. It now costs $1.01 to buy one euro.
Gold dipped 60 cents to $326.50 an ounce.

- The higher stocks climbed throughout October and
November, the more Wall Street urged investors to buy them.
"Surely, the market has fallen far enough," they said."And
besides, the economy is recovering." If those weren't
reasons enough to enter a buy order, the Wall Street crowd
would say,"Look! Corporate profits are rebounding!"

- Markets make opinions, as the saying goes, and the bear
market rally that started in early October made most
opinions bullish. Unfortunately, out in the real world,
nothing much has changed since October 9th, when the bear
market rally began.

- Stocks are higher than they were two months ago, but so
is unemployment. Meanwhile, corporations are still
struggling to make money; which means they are in no hurry
to invest in either new capital equipment or new personnel.
We seem to be in the midst of what John Mauldin calls the
"muddle-through economy."

-"Less bad economic data are not the same thing as strong
economic data," observes Andrew Kashdan of Apogee Research.
"And yet, a stock market selling for 49 times the S&P's
estimated 'core' earnings for the 12 months ended in June
would seem to be discounting super strong economic data."
Kashdan points out that the"strong" 4% GDP growth in the
third quarter was conspicuously light on profits. In fact,
the entire so-called recovery has been profits-lite. And as
last week's dismal employment report shows, the recovery is
also jobs-lite.

-"Profits are the lifeblood of sustainable stock market
rallies," says Kashdan,"and the GDP data are very
enlightening on this point - bearishly enlightening. The
jump in third-quarter GDP, to a 4% annualized growth rate
from 1.3% in the second quarter, sounds pretty good - until
you look more closely at its components...Profits from
current production fell $14.1 billion, after a drop of
$12.6 billion in the second period. Current-production cash
flow, the internal funds available for investment, fell
$12.2 billion...Which means, we think, that it's far too
early to declare that a healthy expansion is under way."

- If profits did not power the third quarter's
aesthetically pleasing GDP number, you ask, what did?
Consumption...the great American pastime. Out of the third
quarter's 4% annualized growth, 2.9% came from personal
consumption expenditures.

-"If consumption were self-perpetuating," Kashdan winds
up,"this breakdown wouldn't be so bad. Unfortunately, at
some point, you've got to make money to spend
it...Profitless 'strength' is not the stuff of sustainable
bull markets."

- Here's another interesting tidbit from Kashdan:"'Greed
is good,' Gordon Gekko proclaimed in the 1987 movie 'Wall
Street.' Now comes The Economist to proclaim that war is
better. The British magazine joins the chorus of those
trumpeting the most dangerous myth of all."[M]ost wars in
America's history have - thanks to massive government
spending on defense - tended to stimulate the economy," it
says."All we can do is implore you not to believe
everything you read in the [financial press] - and ask
yourself, perhaps, why we haven't heard economists propose
what would seem to be the obvious all-season remedy:
perpetual war for perpetual growth."
[For more of Kashdan's insights, see: Apogee Research]
http://www.apogeeresearch.com/dr/


- Last week, your editors at the Daily Reckoning exchanged
some of our intermittent banter about deflation and
inflation. While we may disagree about the probable near-
term direction of US consumer prices - Bill favors
deflation, while I'm partial to inflation - we do agree
that the"whole inflation/deflation discussion is a waste
of time"...almost.

- Strictly speaking, engaging in sex that does not
propagate the species is a waste of time. Some of us bother
with it anyway. Debating deflation versus inflation may not
be quite as much fun, but it is at least good theatre.
Furthermore, the process of debating this issue probably
yields a useful insight or two from time to time.

- Even if the conclusions are utterly unknowable, the
debate itself is worthwhile. Stay tuned for more useless
opinions about inflation... below...

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Back in Paris...

*** Well, nothing much new here. The weather has turned
very cold and gray. But the city feels more and more
Christmasy.

Yesterday, on the subway, we noticed shoppers with wrapping
paper and ribbon sticking out of their bags. Holiday lights
festoon many streets and stores. If only it would snow!

*** Your editor is on his way to London this morning. Last
year at this time, he made the mistake of ordering a
'bespoke' jacket from a tailor on Saville Row. The thing
cost a bloody fortune, but his wife insisted. Your editor
may be weak, but he is no fool. He always keeps the women
in his family right where they want him.

He has since realized that you amortize the cost of a
Saville Row tailor over the period in which he makes the
coat, not the period that you wear it. It has been a year
since the measurements were taken. During the wait, you are
able to say to your friends that you need to visit your
tailor in London. Each time you say that costs you about
$200.

Finally, after numerous visits, the coat should be ready.
We will let you know how it turned out.


The Daily Reckoning PRESENTS: Print it! Money, that is. The
Fed's implicit pledge to crank out as many new dollars as
needed to stave off deflation makes foreign currencies and
inflation-protected Treasury notes all the more attractive.
Paul Kasriel wonders how creditors of the world's largest
net debtor nation might react.

INFLATIONISTAS AT THE HELM
By Paul Kasriel

"World's largest debtor [U.S.] pledges to pay you back in
cheaper dollars." In effect, this is what one of the rookie
members of the Federal Reserve Board, Ben Bernanke,
announced to the world on November 21. He said that the Fed
had the tools, and the talent, to borrow a line from that
cinema classic,"Ghostbusters," to print unlimited supplies
of U.S. dollars. So fear not deflation. The Fed has
implicitly pledged, to its dying breath, that it will crank
up the currency printing presses to prevent it.

Now, I find it remarkable that a representative of the
central bank to the world's largest net debtor nation
would publicly make such a pledge. I don't, however, find
it remarkable that this central bank would privately harbor
such thoughts. After all, isn't a little (or maybe, a lot)
of inflation what debtors want to bail them out of their
financial obligations? Doesn't it imply less of a cut in
your standard of living if you can pay back some
unsuspecting sap in dollars that buy less?

As a nation of net debtors, we want inflation. And this
Fed, unlike the one guided by an"old era" central banker,
William McChesney Martin, aims to please its domestic
constituency. If inflation is what it wants, inflation is
what it will get. (Incidentally, Japan is a net creditor
nation. Creditors, especially those whose credits have
little default risk, generally would opt for falling prices
of goods and services rather than rising prices. Might this
have something to do with the rest of the world being in a
tizzy over Japan's falling CPI, while the Japanese
citizenry is less concerned?)

Currently in the U.S., you can earn about 1&3/8% on three-
month"wholesale" bank deposits. The October reading on the
year-over-year change in the U.S. CPI was 2.0%. So,an
investor is receiving a negative"real" return on this
investment to the tune of 60 basis points. A global
investor could do better by holding comparable paper
denominated in other currencies. For example, at the
beginning of this week, three-month money denominated in
pound sterling was yielding 1.64% after subtracting the
U.K. October inflation rate. That's an inflation-adjusted
pickup of 229 basis points over a three-month U.S.
investment.

Heck, even in Japan, where three-month rates are hovering
just above zero, you can earn a deflation-adjusted return
of 0.76% - a 141 basis-point pickup over dollar-denominated
money. And if Governor Bernanke has anything to say about
this, the odds are, in the next 12 months, that inflation-
adjusted returns on money market investments will favor
those denominated in foreign currencies over those in U.S.
dollars. If global investors need to"park" funds, it would
appear that there are better currencies in the world to do
it in than the dollar. And, if, at the margin, more parking
of funds is done abroad, then the dollar will depreciate,
raising the U.S. inflation rate all the more.

Currently, the spread between the Treasury note maturing on
2/15/11 and the inflation-protected Treasury note maturing
on 1/15/11 is about 1.45 percentage points. These
inflation-protected notes preserve an investor's return
against a rising CPI. With the October CPI year-over-year
change standing at 2.03% and with Governor Bernanke
implying that the Fed would crank up the dollar printing
presses even more than it already is doing if the CPI's
growth should start to weaken, why not buy the inflation-
protected note and short the unprotected one? Isn't the
current spread between the two likely to widen with
inflationistas in control at the Fed?

The rest of the world advances the U.S. about $1.5 billion
a day. Back in the 1990s, when we also were getting
relatively large advances from the rest of the world, we
were using these advances for things that had the prospect
of making our future non-inflationary economic growth rate
higher. If things had worked out, our standard of living
also would have grown faster. This would have enabled us to
pay interest and dividends on these advancements to the
rest of the world - perhaps even pay back a little
principal - without enduring a decline in our standard of
living. Indeed, because global investors thought we were
using their advancements of funds in a way that would
increase the probability of payments to them of principal,
interest, and dividends in"honest"dollars, they were more
than happy to keep investing in America.

But now, we are using a much lower percentage of foreign
advancements for nonresidential fixed investment. Rather,
we are using the $1.5 billion a day from the rest of the
world to buy bigger cars, bigger houses, and cruise
missiles. Bigger cars, bigger houses, and cruise missiles
are not the stuff of productivity growth, and, thus, future
growth in our standard of living. How might we try to
service our foreign debt - debt denominated in U.S. dollars
- without enduring a decline in our standard of living?
Enter Governor Bernanke.

We might put pressure on him to crank up the dollar
printing press. And what will foreign investors, who
already own about 24% of America, do if they begin to sense
they are going to be paid back in"dishonest"dollars?

They will flee from dollar-denominated investments.


Regards,

Paul Kasriel,
for The Daily Reckoning