-->The Perils Of Success

The Daily Reckoning

Paris, France

Monday, 13 January 2003

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

*** Dollar down, gold up - the trend that wants to be your
friend...

*** Dow up 5% in 2003...but bad year for bonds...

*** Jobs disappearing...manufacturing in trouble...world
economy too. But don't worry, the bureaucrats will save the
world...

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

Dollar down, gold up.

Two years ago, you could buy an ounce of gold for $255. Now
it takes 355 dollars.

Of course, on the 30th of January, 2001, you could have
bought a share of the newly combined AOL Time Warner for
$54 and change. Now, it takes only $14 and change...and AOL
Time Warner CEO Steve Case is resigning.

We guessed that selling stocks and buying gold would be the
Trade of the Decade. So far, so good. So we'll keep
guessing.

Our guess is that this is a major trend, not a minor one.
In the short term, gold has probably gotten ahead of
itself. It will probably fall back and disappoint
investors. But over the next few years, gold is likely to
be a winner and the dollar a loser. Since Alan Greenspan
has been Fed chief, $6,250 new dollars have been created
for every new ounce of gold. People were perfectly happy
with this as long as the new money was going into the stock
market. Nobody complains about inflation on Wall Street.

But now there's a problem. The boom on Wall Street is over.
State governments are running huge deficits; New York says
it will run short by $10 billion. California's deficit
equals $1,000 for every man, woman, and child in the state.
And the Federal government is beginning a large spending
program - $600 billion over the next 10 years.

Meanwhile, Americans continue to buy more from foreigners
than they sell to them - about $1.5 billion per day.

Getting the money was easy when the going was good. But now
the going isn't so good...and the U.S. economy needs more
money than ever. Government deficits have to be
financed...as well as consumer spending.

Already, foreigners own 18% of all U.S. stocks and 42% of
our treasury bonds. In total, they own as much as $9
trillion worth of U.S. dollar assets. Instead of adding to
their U.S. dollar positions, a falling dollar suggests
they're lightening up. Trouble is, they might decide to
lighten up a lot...and switch at least some of their money
from the world's most recent currency of first resort - the
dollar - to man's ancient currency of last resort - gold.
More below...

But first, the latest news from our man on Wall Street,
Eric Fry:

-----------

Eric Fry, reporting from New York...

- The stock market party train keeps chugging along,
looking every bit like the little train that could. The
farther it chugs uphill, the happier folks become...There's
just something about making money, rather than losing it,
that brings smiles to investor's faces. Last week, the Dow
added 183 points to 8,785, while the Nasdaq raced ahead
4.3% to 1,448.

- After less than two weeks into 2003, the Dow has advanced
5%, while the Nasdaq has jumped an impressive 8.4%. This
strong January performance puts the stock market well on
its way to delivering the kinds of gains in 2003 that Wall
Street strategists optimistically predict. But Mr. Market
may not be so accommodating all year. Like a rebellious
teenager, he often refuses to do what is expected of him.
By December, Mr. Market may be sporting several tattoos and
multiple body-piercings - behaving nothing like the sweet,
investor-friendly lad he seems to be currently.

- Stocks may be rising, but life is not perfect in the
"land of rising share prices." Despite the strongly
performing stock market - a factor that typically supports
the dollar's value - the beleaguered greenback is losing
value faster than a Wall Street strategist loses
credibility. The dollar dropped about one and a half
percent against the euro last week to $1.0579.

- Bad news for the dollar, however, is good news for gold.
Gold for February delivery advanced $3.40 to $355.00. But
as noted recently in this column, the speculative bullish
interest in the yellow metal has become quite substantial.
Whenever bullish investors in any financial market become
as numerous as sunglasses at the Grammy wards, a sell-off
is often close at hand.

- According to the latest Commitment of Traders report from
the Commodity Futures Trading Commission, the speculative
traders in the gold market have amassed one of their
largest long positions in many years. (I.e., they own a lot
of the stuff). Meanwhile, the commercial traders in gold -
considered the"smart money" - have amassed their largest
short position in many years. In other words, whatever
gold's long-term virtues may be - and we here at the Daily
Reckoning think gold's virtues are considerable - the
short-term sentiment indicators suggest the yellow metal is
ripe for a sell-off.

- That said, we don't try to tell the markets how to
behave, they tell us. Furthermore, if the dollar keeps
falling, the gold market won't care what the"smart money"
thinks; it will keep soaring higher anyway...

- A funny thing about the recent rally on Wall Street is
that it completely ignored Friday's grim unemployment
report. In fact, the report wasn't simply grim; it was
disastrous. The unemployment rate remained at an eight-year
high of 6%, as payrolls tumbled a whopping 101,000 jobs -
that's the biggest one-month drop in nearly a year.

- Meanwhile, the sickly U.S. economy continues to gut
manufacturing jobs as if they were sea bass. The
manufacturing sector slashed 65,000 in December, capping a
forgettable year in which the manufacturing industry lost
nearly 600,000 jobs.

-"All the portents suggest that even worse news on the job
front is shaping up for the months ahead," says Barron's
Alan Abelson."Factories are limping along at 75% of
capacity and, not unrelatedly, capital spending is plain
punk...Peer as hard as we can, we just can't see a
plausible driver to employment. It's also very tough, then,
to envisage the economy doing more than straggling along."

- Perhaps Abelson simply lacks imagination. An investor
lacking imagination might find it baffling that the stock
market would be rising, despite its still-rich valuation,
despite an eroding dollar and despite a stubbornly rising
unemployment rate.

- But IMAGINATIVE investors are not so constrained by
empirical data and deductive analysis. At the moment,
imagination is ascendant on Wall Street. Stocks will go up,
the lumpinvestoriat believe, because the economy will
improve. How and why the economy will improve, they cannot
say. But they know it will happen just the same.

- The imaginative investor knows that nothing in the world
ought to be cause for concern, as long as stocks go up. In
fact, a rising stock market is proof that no serious
financial problems exist in the economy.

- If President Bush, Alan Greenspan and Abby Joseph Cohen
all promise higher share prices, what could go wrong?

-----------

Back in Paris...

*** Business lending is at a 3-year low, and inflation is
at its lowest level in half a century...savings too...

*** Is this the bottom? At bottoms, stocks tend to sell for
1 times book. But U.S. stocks currently sell for 4.7 x book
value. And current book values include a lot of 'goodwill'
from the boom years, which will eventually be written off
as worthless. In terms of 'hard' book value, price-to-book
ratios are even higher.

*** Want a cheap stock? Try India. Stocks are selling for
only about 10 times earnings. Mutual funds targeting Indian
shares are closing down.

***"The world economy needs help," says an editorial by
Jeffrey E. Garten, who has"held economic and foreign
policy positions in the Nixon, Ford, Carter, and Clinton
administrations."

Here at the Daily Reckoning, we begin each day by reading
the editorial page of the International Herald Tribune. The
absurdity of it helps prepare us for the investment
markets.

Don't worry about the world economy; Garten knows just what
the world needs now.

"The world economy is in trouble," he explains."Corporate
investment and trade are slowing, factories are producing
more than they can sell, and deflation is threatening many
regions. Germany and Japan are stagnating. Big emerging
markets, from Indonesia to Brazil, are in deep trouble."
What's the solution?

Garten:"Washington must bring together its economic
partners - the Group of Seven nations made up of Canada and
Japan and four in the European Union - to get the global
economy moving again."

What a marvelous world Garten inhabits. Got a problem? Just
get a group of policy hacks together. Garten thinks they
can decide - among themselves - to alter the entire world
economy.

The U.S. is already doing all it can, he says. Interest
rates have been lowered. The nation is"already running
huge budget deficits," he notes with approval. But what
about those Europeans? We've got to encourage them to lower
rates too, and spend more too. And oh yes, we can also
"push Japan to restructure its growth-strangling bank
debts."

Hey, that ought to do it. But wait, if you're going to fix
the globe's economic problems, why stop there?

Remember, we will have to reconstruct Iraq, he says. That
could cost $1.2 trillion, an amount"that does not include
the costs of the administration's vision of spreading
democratic and free market institutions in the Gulf
region."

Wow. For $1.2 trillion, we would expect reconstruction
worthy of a Hollywood tummytucker. That's $49,896 per
person in Iraq - or 20 times the average annual income.
Well, that should go a long way to helping solve the
world's economy. And if it doesn't, well...North Korea
could use some reconstruction. And West Virginia...
Where will the money come from? Here again, Mr. Garten is
helpful:"The Bush administration needs to be working with
Congress to incorporate the requirement [for the $$$] in
planning - something which Mitchell E. Daniels Jr.,
director of the Office of Management and Budget, has been
reluctant to do." We never met Mr. Daniels, but we are glad
to discover he is not as insane as Mr. Garten.

"We are entering a decade of political and military
tension," the latter continues,"and nation-building is
going to be a major part of America's response."
Why not? After fixing the world economy, the hacks ought to
be able to build a nation or two without breaking a sweat.

The Daily Reckoning PRESENTS: The intoxication of central
bankers...and the doom of paper money.


THE PERILS OF SUCCESS
by Bill Bonner

Last month, Alan Greenspan spoke to the N.Y. Economic Club
and sounded, for a while, like his old self.

"Although the gold standard could hardly be portrayed as
having produced a period of price tranquility," he
conceded,"it was the case that the price level in 1929 was
not much different, on net, from what it had been in 1800.
But, in the two decades following the abandonment of the
gold standard in 1933, the consumer price index in the
United States nearly doubled. And, in the four decades
after that, prices quintupled. Monetary policy, unleashed
from the constraint of domestic gold convertibility, had
allowed a persistent overissuance of money. As recently as
a decade ago, central bankers, having witnessed more than a
half-century of chronic inflation, appeared to confirm that
a fiat currency was inherently subject to excess."

Mr. Greenspan was setting the stage. He might have added
that no central banker in all of history had ever succeeded
in proving the contrary. Every fiat currency the world had
ever seen had shown itself 'subject to excess' and then
subject to destruction.

Against this epic background, the new Mr. Greenspan
strutted out, front and center.

Today's essay is not about Mr. Greenspan, per se, but
rather about his trade. Each métier comes with its own
hazards. The baker burns fingers...the psychiatrist soon
needs to have his own head examined. The moral hazard of
banking is well documented. Given the power to create money
out of thin air, the central banker almost always goes too
far. And if one resists, his successor will almost
certainly succumb.

There are some things, dear reader, for which success is
more dangerous than failure. Running a central bank - like
robbing one - is an example. The more successful the
central banker, that is, the more people come to believe in
the stability of his paper money, the more hazardous the
situation becomes.

Warren Buffett's father, a congressman from Nebraska,
warned in a 1948 speech:

"The paper money disease has been a pleasant habit thus far
and will not be dropped voluntarily, any more than a dope
user will without a struggle give up narcotics...I find no
evidence to support a hope that our fiat paper money
venture will fare better ultimately than such experiments
in other lands...."

In all other lands, in all other times...the story was the
same. Paper money had not worked; the moral hazard was too
great. Central bankers could not resist; when it suited
them, they overdid it, increasing the money supply far
faster than the growth in goods and services that the money
could buy.

Asked to produce a list of the world's defunct paper money,
Addison was soon overwhelmed.

"I don't think you want all these," he replied,"looking at
his screen. They're in alphabetical order. But there are
318 of them and I'm still in the B's. And every one of them
worthless."

Against this sorry record of managed currencies is the
exemplary one of gold itself. No matter whose face adorns
the coin...nor what inscription it bears...nor when it was
minted...an unmanaged gold coin today is still worth at
least the value of its gold content, and will generally buy
as much in goods and services today as it did the day it
was struck.

Gold is found on earth in only very limited amounts - only
3.5 parts per billion. Had God been less niggardly with the
stuff, gold might be more ubiquitous and less expensive.
But it is precisely the fact that the earth yields up its
gold so grudgingly that makes it valuable. Paper money, on
the other hand, can be produced in almost infinite
quantities. When the limits of modern printing technology
are reached, the designers have only to add a zero...and
they've increased the speed at which they inflate by a
factor of 10. In today's electronic world, a man no longer
measures his wealth in stacks of paper money. It is now
just 'information.' A central banker doesn't even have to
turn the crank on the printing press; electronically
registered zeros can be added at the speed of light.

Given the ease with which new 'paper' money is created, is
it any wonder the old paper money loses its value?

But for a while, Mr. Greenspan seemed to have a light
shining on him. Standing there, center stage of the world
economy like Moses in front of the Red Sea, he believed he
had found the promised land of managed currencies - for his
paper dollars rose in value against gold for two decades,
when they ought to have gone down.

Mr. Greenspan explains how this Exodus came about:

"But the adverse consequences of excessive money growth for
financial stability and economic performance provoked a
backlash. Central banks were finally pressed to rein in
overissuance of money even at the cost of considerable
temporary economic disruption. By 1979, the need for
drastic measures had become painfully evident in the United
States. The Federal Reserve, under the leadership of Paul
Volcker and with the support of both the Carter and the
Reagan Administrations, dramatically slowed the growth of
money. Initially, the economy fell into recession and
inflation receded.

"However, most important, when activity staged a vigorous
recovery, the progress made in reducing inflation was
largely preserved. By the end of the 1980s, the inflation
climate was being altered dramatically.

"The record of the past twenty years appears to underscore
the observation that, although pressures for excess
issuance of fiat money are chronic, a prudent monetary
policy maintained over a protracted period can contain the
forces of inflation."

Until recently, Mr. Greenspan's genius was universally
acclaimed. Central banking looked, at long last, like a
great success. But then the bubble burst. People began to
wonder what kind of central bank would do such a dumb
thing.

"Evidence of history suggests that allowing an asset bubble
to develop is the greatest mistake that a central bank can
make," wrote Andrew Smithers and Stephen Wright in"Valuing
Wall Street," in 2000."Over the past five years or so the
Federal Reserve has knowingly permitted the development of
the greatest asset bubble of the 20th century."

When the stock market collapsed, Mr. Greenspan's policies
began to look less prudent. During his tour of duty at the
Fed, the monetary base tripled, at a time when the GDP rose
only 50%. More new money came into being than under all
previous Fed chairmen - $6,250 for every new ounce of gold.

All this new money created by the Greenspan Fed had the
defect of all excess paper money; it had no resources
behind it. Though taken up by shopkeepers and dog-groomers
as if it were the real thing, it represented no increase in
actual wealth. The retailer and the dogwasher thought they
had more 'money', but there was really nothing of real
value to back it up.

The new money was issued, light on value but heavy on
consequences. It helped lure the lumpeninvestoriat into
their own moral hazard; they no longer needed to save -
because the Greenspan Fed always seemed to make money
available, at more and more attractive rates. And it misled
suppliers into believing there was more demand than there
really was. Consumers were buying; there was no doubt about
that. But how long could they continue to spend more than
they actually earned?

Encouraged by what seemed like almost unlimited buying from
America, foreigners - notably, first in Japan in the '80s,
then in China in the '90s - constructed new factories on a
monumental scale. They sold their products to
Americans...and then invested the proceeds, either in more
capacity at home, or in more assets in the U.S. As
mentioned above, by the end of 2002, U.S. manufacturing was
in still in a 30-year slump...and foreigners owned nearly
20% of the U.S. stock market...42% of the treasury bonds
market...and total dollar assets of as much as $9 trillion.

The effects of this moral hazard are just now being felt.
The consumer is more heavily in debt than ever before - and
seems to need increased credit just to stay in the same
place. State and Federal governments have gone from modest
surplus to flagrant deficit. Where was the money going to
come from? Americans have very little in savings; it must
be imported from abroad. But the current account is already
in deficit by $450 billion annually. Stephen Roach
estimates that the new capital demands will push the
deficit to $600 billion - or $2.5 billion every working
day.

Foreigners may be willing to finance the new U.S. spending
binge. Then again, with the dollar already falling, they
may not. We cannot know what will happen, but we can take a
guess: they won't be willing to do so at the same dollar
price. The dollar ought to fall against gold...and against
foreign currencies. It probably will.


Bill Bonner