-->Pacific Symbiosis

The Daily Reckoning

London, England

Tuesday, 16 September 2003

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*** No end for the Blairs or the boom... Not yet... not
now... but every day the international monetary system comes
one day closer to extinction...

*** America's middle class groans under credit card
debt... stocks go down... buy insurance...

*** Shui pao! Euro up... Financial Reckoning Day
(update)... and more!

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Not yet. Not now.

No, dear reader, the end of the world has been postponed.

How do we know? We read it in the paper!

First, we left you on the edge of your seats yesterday. Would
guru Carole Caplin tell all she knows about the Blairs... thus
destroying America's only major ally in the Iraq war? Would
she bring a sordid and 'cataclysmic' end to Britain's charmed
couple with details on their personal lives not even they
were aware of?

'No!' says she on the front page of today's Times of London.
Speaking by way of her lawyers, the former topless model said
she would not betray their secrets. At least not today... and
not for a million pounds. A million two? We'll see...

As for the English economy..."House prices are rising
strongly," says the Times, after a weak period in the spring.

And in America,"hopes of a full-blown upturn are in the
air," says Stephen Roach.

But hopes do not an upturn bring. For that it would take
consumer buying or corporate investment. Not that either is
impossible, but where would they come from?

Normally, an upturn happens when savings are released.
Consumers, who have held back during the downturn, begin to
spend. Their washing machines and automobiles have worn out.
They are ready for something new... and they have the money to
buy them. Businesses sense the rise in spending and rush to
provide new and better products. They invest savings in new
plant and equipment. And they hire new workers to man the
assembly lines during the extended hours.

And thus begins the up part of the business cycle.

Today's"upturn," by contrast, is an imposter; like a cross-
dresser, it has all the attributes of a pretty woman - except
the essential ones. There are no savings and no pent-up
demand.

Instead, the U.S. economy depends upon the kindness of
strangers, mostly those in Asia, just to keep going.
Foreigners now own nearly half of all Treasury bonds. It is
they who fund the mortgage market in the U.S.. And they who
pay for the Iraq war. And they who allow Americans to
continue spending.

They produce; Americans consume. They lend; Americans borrow.
They accumulate credits; Americans build debits.

And we wonder... how long can this go on?

A USA Today article elaborates:

"Credit-card debt for middle-income families is soaring - up
75% to $5,031 between 1989 and 2001, according to a new
report by Demos, a non-partisan public policy organization.
'Middle-class families are using credit cards to fill in a
gap between their income and costs,' says Tamara Draut,
director of the economic opportunity program at Demos. 'It's
more about maintaining their standard of living than
frivolous consumption... '

"Average card debt declined somewhat in 2001, according to
Federal Reserve data. But some experts don't see much cause
for optimism. Many families traded high-interest card debt
for lower-rate home equity loans. That lowers debt payments
but puts homes at risk. The percentage of homeowners facing
foreclosure in the second quarter was 1.12%, down only
slightly from the record 1.2% in the first three months of
the year, according to the Mortgage Bankers Association of
America...

"American consumers shoulder more debt; bankruptcy filings
have exploded. Nearly 90% of families with children who file
for bankruptcy cite three reasons: job loss, divorce or
medical problems, according to the Consumer Bankruptcy
Project at Harvard University, the largest study of consumer
bankruptcy in America. About one-third of the families owed
an entire year's salary on their credit cards."

"Not forever" is the answer to the question:"How long can
this go on?"

"The worse it gets" is the predicate to"the longer it goes
on."

"We don't know" is our reply to"When does the end finally
come?"

"Right now," is when we turn this discussion over to our man
in New York, Eric Fry:

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Mr. Fry, getting down with his bad self, in the Big Apple...

- The Dow slumped 23 points yesterday to 9,449, while the
Nasdaq dipped half a percent to 1,846. Bonds barely budged,
the dollar gained slightly and the gold price dropped
slightly. All in all, American capitalism accomplished almost
nothing yesterday.

- This morning, Alan Greenspan and the rest of the Federal
Open Market Committee hope to accomplish something more than
nothing, just by tweaking one itty-bitty interest rate... or
not. The FOMC is convening at this very moment to discuss the
state of the U.S. economy and whether to adjust short-term
interest rates. As it stands, the Fed funds rate sits at a
45-year low of 1%, so there isn't much of an interest rate
left to adjust.

- And besides, the Fed's last rate cut on June 13th has done
far more harm than good to the bond market. Long-term
interest rates have been soaring ever since, in the process
killing the mortgage-refi boom that had been single-handedly
sustaining the economy.

- But the corporate sector is struggling heroically to pick
up the slack. Here in the capital of capitalism, a little
color is returning to the local economy's cheeks. The Empire
State index of economic conditions swelled to 18.4 in
September from 10.0 in August. We don't know exactly what
these numbers mean, but a jump from 10.0 to 18.4 has to be a
good thing, doesn't it?

- On the other hand, Goldman Sachs' latest information
technology spending survey - taken in mid-to-late August -
indicates that tech spending is recovering slowly, if at all.
"Goldman surmised that technology capital spending would
probably close out the year 'at or slightly below' zero
percent growth," CBS Marketwatch notes."Projections for 2004
currently stand at 3.9 percent growth. Goldman added that the
timing of a spending recovery is being 'pushed out' beyond
the near-term horizon."

- Ironically, the tech-stock buying recovery has arrived
already. The buyers of richly priced tech stocks don't seem
to care that the technology spending recovery lies far beyond
the visible horizon. That's because investors can plainly
see, right here in the immediate foreground, that tech stocks
rise almost every day... What else does an investor need to
know?

- For nearly a year, tech stocks have been rallying, even
while most hi-tech industries have been languishing. The
Nasdaq Composite has jumped a dazzling 65% from its lows of
2002. Perhaps the Fed's single-minded ambition to rekindle
inflation is having an effect... on share prices.

- The Fed's pro-inflation campaign is also exerting a
favorable influence over the gold price. A little bit of
inflation - like a little wildfire - is a difficult thing to
contain. And the gold market seems to have caught a whiff of
inflationary smoke.

-"Gold is not an 'investment' per se," your New York editor
opined last week,"It is insurance." James Grant agrees. The
editor of Grant's Interest Rate Observer not only considers
gold to be a terrific insurance against monetary calamity,
but darn cheap insurance at that."If gold isn't a bargain,
what is it? It is a hedge," Grant explains."However, in my
opinion, it is a hedge bargain. The value of a hedge should
vary according to the cost and evidence of the risks being
hedged against. In the case of gold, the risks are monetary.
They are potentially very costly, and they are more than
imminent. They are upon us in the shape of burgeoning
deficits and a radically reflationary policy stance. Owning
gold, you are insuring not against what may be but against
what already is..."

- In other words, says Grant, the dollar's value is already
slipping away, and yet, gold at $375 an ounce remains a
relatively inexpensive insurance policy against continuing,
perhaps calamitous, dollar depreciation."The price of fire
insurance would be out of reach if the homeowner started
shopping for it after his house was billowing smoke. Yet, in
my opinion, the price of monetary insurance is still
reasonable in view of the risks posed to the purchasing power
of the dollar by the dollar's own stewards...

-"I have been bullish at long, unprofitable intervals during
the gold bear market that began before the birth of Britney
Spears," Grant concludes."[But] I wake up every morning in
the belief that the international monetary system is one day
closer to breakdown. I am certain that posterity will look
back at this episode in monetary history with a mixture of
mirth and amazement..."

- Keep the insurance policy in force, Grant advises. Buy
gold.

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

Bill Bonner, bringing it back to London:

*** The Swedes voted"No" to the euro, practically stepping
over the cold body of the euro's most prominent supporter.
Did the euro collapse on Sunday's news? No, it soared to a
multi-week high of $1.132! Though it fell slightly yesterday,
it is still trading at $1.1270. Sell the dollar, buy the euro
and gold.

***"What would happen if U.S. government debt were ever
downgraded?" The question was put to Jim Bianco, of Bianco
Research at a luncheon hosted by Arbor Research here in
London last Friday.

"It will never happen..." came the reply."That would mean
the end of the modern financial system."

"Jim then," Addison Wiggin reports,"reminded Dan [Denning]
and me that Fannie Mae has issued more debt in the last two
years than the U.S. government... and that because of its
'social charter,' five of its twelve sitting board members
are appointed by the president."

Fannie Mae declared insolvency once, back in 1979... and was
then rescued by the U.S. government, giving rise to the myth
that any time Fannie, Freddie or Sallie got thrown in the
hoosegow, Uncle Sam would come down to the station with his
taxpayer's checkbook and bail them out.

With all that debt... and the mortgage market getting the
kibosh... do you think Uncle Sam will stick out his neck again
for Fannie? Can he afford to usher in 'the end of the modern
financial system'?

*** We reported, many months ago, that the war against Iraq
could cost more than $1 trillion."Ridiculous!" came the
comments."Absurd... b.s....nonsense..." Readers couldn't
believe it. We didn't really believe it ourselves, but we had
read it somewhere...

Well, now it's beginning to look every bit as absurd... but
much less unlikely. $166 billion is the bill so far,
according to the NYTimes. George W. Bush allowed as to how
another $150 billion or so is in the works. A"generational
commitment" is how advocates describe it. 'Loading our
grandchildren with debt' is another way to look at it. But
who cares... it's not our money anyway. As long as the Asians
continue to lend... we Americans will do our part... Spend,
spend, spend... until Daddy takes the credit card away...

*** Shui Pao! The bubble is on in China. McDonald's
franchiser in China, Sanyuan Foods, went public the other
day. Shares skyrocketed 300% on the first day of trading and
now trade at a P/E of 56. In the U.S., meanwhile, Mickey D's
trades at 30 times earnings.

Shui pao! Shui pao! Shui pao!

More from our London correspondent, Brian Durrant, below...

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The Daily Reckoning PRESENTS: The"Sino Bubble" is
beginning to blossom, your Paris editor has warned you.
"Not surprisingly, then," writes the Fleet Street Letter's
Brian Durrant,"the focus of U.S. financial diplomacy has
shifted from the Atlantic to the Pacific..."


PACIFIC SYMBIOSIS
By Brian Durrant

In the era after the Second World War, the U.S.'s most
important overseas relationship was with Europe. Marshall
Aid helped rebuild the west of the continent and Western
Europe was of vital strategic importance during the Cold
War. During the period up to the 1960s, U.S. trade deficits
provided the capitalist world with welcome liquidity.
However, America then embarked on an increasingly costly
war in Asia (Vietnam) and the twin trade and budget
deficits ballooned.

Sound familiar? But back then America's trade imbalance was
principally with Europe, with the continent holding 40% of
global foreign exchange reserves. One country in particular
began to resent the US ability to finance its ambitions by
printing dollars. You've guessed it - France.

The French threatened Washington by selling dollars for
gold, which at the time was pegged at $35/oz. Private
selling followed. For three years, the U.S. used financial
diplomacy to contain European selling pressure on the
dollar. But the U.S. was not willing to accept external
constraints on its economic or military actions... so
ultimately, the dollar-based fixed exchange rate system
broke down in 1971.

Over 30 years on, Europe means much less to the U.S.. The
Cold War is over and Europe's economic star is in decline.
A look at growth prospects for this year rams home the
point. According to the latest IMF forecasts, the US is
expected to grow by 2.4% this year, Japan by 2.0%, Britain
by 1.7% and the eurozone by a measly 0.5%. The reasons for
Europe's malaise are well documented: malfunctioning labor
markets, red tape, mismanagement of the single currency
project, all combined with the strong euro. Meanwhile, the
poor performance of Euroland has a bigger impact on the
U.K. than any other major economy.

But the really bright news is coming from Asia. East Asia
was poised to embark on a full-scale consumer boom at the
beginning of this year, only for confidence to be hit by
SARS and Iraq. Now, Asian economies are making up for lost
time. China is expected to grow by 7.5% this year.

Not surprisingly, then, the focus of U.S. financial
diplomacy has shifted from the Atlantic to the Pacific. The
countries of East Asia now account for 70% of global
foreign exchange reserves. The relationship between the
U.S. and East Asia is symbiotic. Spending considerably more
than it produces, the U.S. has watched its trade deficit
yawn frighteningly wider in past years. The counterbalance
is that East Asian economies produce more than they
consume, giving rise to a huge trade surplus.

But these imbalances do not matter if these economies
remain, of their own free will, happy to finance America's
overspend. As it happens, they are more than happy to do
so, as buying vast quantities of dollars holds down their
currencies, maintaining the competitiveness of their export
industries. Japan, China and other Asian governments buy
roughly $1bn of U.S. securities every single day. Most of
this money ends up in either in U.S. Treasury bonds
(helping to fund Bush's budget deficit) or into mortgage
bonds (helping to keep U.S. mortgage rates low).

The governments and central banks of Japan, China, Hong
Kong, Singapore and South Korea own about $700bn of U.S.
Treasury securities and provide about the same in mortgage
financing for American homeowners. Moreover, the supply of
cheap goods will keep Middle American Wal-Mart customers
happy. At the same time, China does not want to give up 35%
export growth when its banking system is riddled with
problem loans and when state-owned companies would have to
shed even more jobs if its currency (the renminbi yuan) was
revalued.

The high level of economic integration between East Asia
and the U.S. suggests that it is very unlikely that China
will ever use its foreign exchange reserves as a diplomatic
lever against Washington... in the near term.

But keeping the renminbi artificially low against the
dollar does produce unwelcome side effects. There is a
historical precedent. In the late 1980s, Japan fuelled its
booming economy by keeping the yen low against the dollar.
This led to a huge bubble in asset prices, principally
equities and property, but also golf club memberships.

Right now, China's support for the dollar is producing
monetary growth of 20% and a runaway investment boom. It
will no doubt provide the basis for a very persuasive story
that will capture the imagination of investors. But as
always, you should be on your guard... what goes up, must
come down.


Regards,

Brian Durrant
for the Daily Reckoning


Editor's note: Brian Durrant is a Cambridge economics
graduate with nearly 20 years experience in and around the
London Stock Exchange. He's worked as a stockbroker, a
financial journalist and headed the research department of
London's leading futures and options broker. He is also the
lead writer for the UK version of The Fleet Street Letter.