-->Crisis Begets Crisis

The Daily Reckoning

Paris, France

Tuesday, 18 November 2003


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*** A lonely vigil for the Ought school... waiting...
sulking...

*** What can be done? Nothing...

*** Henry is all set... ready to meet the Pope.

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"What can be done?"

We were being interviewed on Bloomberg radio last night. We
had outlined our view: that Americans were getting poorer,
not richer, each year... that stocks would inevitably go
down to more reasonable levels... that the dollar would
collapse... that consumers would have to stop consuming so
much and begin saving and investing.

"What should the Fed do... what should the administration
do... how can these things be avoided?" came the question.
In the America of 2003, every problem is believed to have a
solution. Every crisis is avoidable. Every situation is
win-win. And every knob on the Great Machine has a
function; we just have to know how and when to turn it.

Nothing can be done, we explained. Alan Greenspan can do
nothing but make the situation worse. Nature has to have
Her way.

Here at the Daily Reckoning office, we keep a lonely candle
burning for the Ought School of Economic Theory. What
happens, we believe, is not what people want to happen - no
matter how many knobs they turn - but what ought to happen.
Of course, what Ought to happen doesn't always happen at
convenient moments. We are subject to deep depressions and
frequent sulks when - as now - we have to wait. After all,
we have staked our reputations on the arrival of the Ought
event; thank God, we lost little when it failed to show up.

The structural problem, we continued, is that Americans
spend more than they can afford. They make up the
difference by mortgaging their houses and using credit
cards. Debts mount up - to 32 trillion dollars, or three
times GDP. Never before have they been so high. By any
measure, never before have so many Americans owed so much
to so many.

"We know your listeners would like to avoid any
disagreeable outcomes," we went on in a surly tone of
voice."But people who spend too much ought to suffer
somehow... don't you think?"

There are some things that ought not be avoided... and
shouldn't be. If a man robs a liquor store or beats his
wife, a night or two in the hoosegow might have salutary
effects. Even if he is not caught, he ought to be.
Recessions... and bear markets, too... are similarly useful
and ought to happen from time to time. They are nature's
way of reminding us not to overdo it.

When the recession struck in 2001, it would have been a
good time for reflection and readjustment. Faced with job
losses and stacks of bills, the normal thing to do would
have been to put the liquor away, cut back on spending, and
pay down debts. Instead, the Fed dangled the keys to a new
car... offered more E-Z credit... and practically stocked the
liquor cabinet. In a matter of months, the music started up
and the party continues to this day.

Will the music ever stop? Yes, it will. Will the bills be
toted up? Yes, they will. Will there be headaches and
regrets? You bet. Is there anything the Fed can do to avoid
it? No, there isn't.

Over to Eric Fry, with the market news:

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Our man on the scene in New York City...

- The Empire State's business activity is booming, but the
Empires State's stock market is"bumming." Manufacturing
activity in New York State surged again in November, the
Federal Reserve reported yesterday. But the stock market
responded to the news with a sell-off. The Dow Jones
Industrial Average fell 58 points to 9,711, while the
Nasdaq dropped 1% to 1,910. Gold also skidded yesterday,
falling $6.50 to $391.50 an ounce, after touching a new
high of $399.90 earlier in the session.

- The"general business conditions" index of the New York
Fed's Empire State Manufacturing Survey surged to 41, a new
record, from a revised 34.1 in October. The New York Fed
also said three quarters of respondents expect better
conditions in the future, compared with just 5 percent
expecting conditions to worsen.

- But the Empire State's surging optimism did not inspire
much optimism in the stock market. Maybe that's because the
increasing terrorist activity in the Middle East is
inspiring an offsetting dose of pessimism...

- Is the stock market's disillusionment phase underway? Has
Mr. Market become a glass-half-empty kind of guy?

- We like Mr. Market, but we trust him less than a country-
club smile. For months, he pretended to see a recovering
economy that no one else could see, while pretending not to
see a geopolitical crisis that was brewing right under his
nose.

- Maybe he was faking it all along. Maybe he never really
did see a robust recovery after all... It's true that GDP
soared 7.2% in the third quarter. But the statistically
booming economy is failing to add jobs, failing to generate
sales growth from the private sector and failing to prevent
insiders from dumping their overpriced shares.

-"As any economist will tell you, rapid productivity
growth is the way to economic Eden," said Business Week's
Kathleen Madigan, while on the set of CNNfn with your New
York editor last week."Lately, though, the spectacular
improvement in output per hour worked seems more like the
ticket to a jobless Hell... About a million jobs have
disappeared from U.S. payrolls since the recovery began
nearly two years ago. Now comes word that even though the
economy powered through the third quarter at a 7.2% annual
rate of growth, the strongest in 19 years, productivity
accounted for all of that gain as well. Are we caught in a
kind of productivity trap that will continue to rob job
growth and thus hold back the recovery in 2004?"

- When it comes to faith in the nation's productivity
miracle, the Daily Reckoning's New York correspondent is an
atheist. Even though we Americans type on laptops while
driving and wear cell phones to bed, we have less"down
time" than ever before. It's true, we have become extremely
productive... at the expense of destroying weekends and
vacation time.

-"Productivity" always feels like a kind of statistical
mirage - comforting from a distant macroeconomic
perspective, but disappointing up close. Touchy-feely
statistics like productivity don't drive a great big
economy; gritty data like industrial production and export
growth do.

- Based on the gritty data, the U.S. economy seems to lack
an engine of sustainable growth. Earlier this month, when
Cisco Systems released its third-quarter earnings, CEO John
Chambers wondered aloud about the strength of the U.S.
economic recovery,"What sort of legs will it have? How
strong will it be? And how long will it last?"

- Chambers had good reason to ask these questions. Cisco's
dazzling earnings report relied upon a very unspectacular -
and unsustainable - foundation: sales to the government.
"Over the past couple of weeks, I've listened to scores of
tech company conference calls," says Fred Hickey, editor of
The High Tech Strategist."In nearly every case, from Cisco
to Foundry to Motorola to CDW, the story was the same -
their best customer was the U.S. government."

- Obviously, a tech-boom fueled by government spending is
not exactly the sort of boom that powers sustainable
revenue growth."If, as Cisco and others suggest, Uncle Sam
was doing a lot of the heavy lifting, where does that leave
the economy?" wonders Terry Keenan of the New York Post.
"You guessed it - back in the hands of the over-leveraged
consumer."

- Cisco's Chambers, for one, does not seem convinced that a
long-term recovery is underway. We infer as much from the
fact that he pocketed $38.3 million Thursday selling Cisco
shares as they hovered near 52-week highs.

-"The move comes just days after the executive voiced his
strongest prediction yet of an emerging tech-spending
recovery," notes TheStreet.com."Adding to the brilliant
timing, the networking chief is selling at a time when his
San Jose-based tech juggernaut just happens to be buying
back shares at a record clip.

-"Cisco spent $2 billion last quarter on stock buybacks,
doubling its $1 billion in cash flow for the period. And
executives on the earnings call last week told analysts
that 'we intend to be active in the market,' as the company
has $10.2 billion in buyback funding remaining."

- Hmmm... the demand for Cisco shares may be as
unsustainable as the demand for Cisco routers.

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Bill Bonner, back in Paris...

*** A soothing message came to us from colleague Dan
Ferris, editor of Extreme Value:

"Aren't you the most idiotic investors, waiting for your
buy price in gold. It's a classic error.

"If you're waiting for some kind of wonderful price before
you buy gold, think of it this way. If you bought gold for
$400, and it fell to $300, what action would you take, if
any?

"If the answer is 'buy more,' then you are either being
presented with the chance to buy gold before it really
takes off, or you'll be presented with the chance to lower
your average cost sometime hence. Either possibility is
attractive.

"You can't expect dirt cheap prices for something like gold
to prevail for long. (Everyone who hears that will say it
was dirt cheap for the better part of 20 years, but nothing
like that is the truth.) When it went to $370 or whatever
it was a few weeks back, that was your chance. I don't know
that you'll see it again for a while... like years.

"Investing is not a game whereby you pick the precise
moment, after which the price will only go up.

"If it's down-and-out bargains you want, then you need to
either be extraordinarily patient and stick to your gold
strategy (how did you arrive at your target buy price,
anyway?), or go where the down-and-out bargains are, like
Latin America, or someplace like that."

*** The price of gold fell $6.50 yesterday. But it remains
above $390 an ounce. How high might it go? The price hit a
bubble high of $850 an ounce back in 1980. It would have to
rise over $2,000 to hit that level again, adjusted for
inflation. Of course, the supply of dollars multiplied many
times in the last 20 years too. What is a reasonable price
for gold? Who knows.

*** All around us, a bullish tide continues to surge. But
the music will stop, we believe; eventually, the illicit
party will come to an end. Then, there will be plenty of
hangovers, wish-I-hadn'ts and if-I'd-only's...

We cannot foresee all that lies in wait for us. But we have
a hunch: the U.S. dollar's predicament is at the heart of
the matter. As of yesterday, the greenback wallowed in
misery at nearly 1.18 to the euro.

[Ed note: More on the problems facing the U.S. currency in
a DR guest essay, below... discovered as we researched
what's in store for the dollar. Watch this space for a new
special report - written expressly for you by your DR
editors - on how you can profit from the dollar's
ineluctable decline.]

*** We met with Father Varengo yesterday. Henry is expected
to go to the Vatican at Easter to do his Profession of
Faith, the only class of 7th graders in all of Christendom
so privileged. But his mother was worried: Henry was not
baptized Catholic. What if church authorities noticed?

Your editor argued that high church Episcopalians were
already Catholic."At least, we are not really
protestants," he continued,"since we never protested
anything... and in fact, we seem willing to go along with
just about anything... as recent events in New Hampshire
prove."

His mother took a different line of argument."He has done
everything to become Catholic. He goes to a Catholic
school. He is an altar boy in church. He goes to mass and
has been confirmed in the church. And besides, we would
like him to be Catholic. At least, the doctrines are clear.
In fact, I was thinking about it myself."

"Don't worry about it," said Father Varengo. Henry is a
practicing Catholic, even if he is not, shall we say,
'legally' or 'officially' a Roman Catholic. He has been
confirmed in our church, after all. There should be no
problem."

"Henry," his father reported the news to the 13-year-old,
"you're all clear. All set. No problem. But if you get to
St. Peter's square and you see a stake with firewood around
the base, run!"

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The Daily Reckoning PRESENTS:"If ever there was a crisis
that could shake the global economy," Richard Russell told
the audience at the New Orleans Investment Conference a few
weeks back,"this is it." But in a fiat money world,
explains Christopher Mayer, currency is always in crisis.


CRISIS BEGETS CRISIS
by Christopher Mayer

"The world is in permanent monetary crisis," Murray
Rothbard once observed (in Making Economic Sense),"but
once in a while, the crisis flares up acutely, and we
noisily shift gears from one flawed monetary system to
another." Monetary systems built on floating fiat
currencies are fragile things. Most of the world currently
operates under this arrangement.

The only thing worse, in Rothbard's estimation, is fixed
exchange rates based on fiat money and international
coordination. Markets are fluid and changing. The
government fixed exchange rate is bound to be either too
high or too low - with problems in either case. The history
of attempting to maintain certain fixed exchange rates by
international agreement has a long, rich history of
failure, once again illustrating that government power is
no match for the relentless and merciless forces of the
market. All of which does not bode well for China's ability
to maintain its own fixed exchange rate against the dollar.

Our own dollar has led the life of a tempestuous teenager,
seemingly unable to stay within the bounds of the rules
laid down for it by the powers that be. The Bretton Woods
Agreement lasted from 1944 to 1971 and was a form of a
fixed exchange rate system based on international
coordination. The dollar was defined at 1/35 ounce of gold;
all other currencies were fixed in terms of the dollar.
Importantly, the dollar was only redeemable in gold for
foreign governments.

As expected, the U.S. government inflated the currency - as
governments are prone to do. Dollars grew rapidly; the
supply of gold did not. Inevitably, as foreign governments
began to turn in their dollars for gold, Uncle Sam found
out that his gold stash was getting light. And so he
decided to break the agreement.

In 1971, Nixon closed the gold window. In its place came
the Smithsonian Agreement, which called for an 8 percent
devaluation of the dollar, among other things. But that
could not stop the push of market forces, which, like the
swollen Potomac River in the days before hurricane Isabel,
simply ignored whatever man put in its way. In February
1973, the dollar was devalued again. By March, the
Smithsonian agreement was no more.

Ever since, the dollar has been a fluctuating fiat currency
with no ties to gold.

Europe, too, has been unable to build a durable system
based on fiat currency. The European Economic Community
established one of the better-known pegged rate exchange
systems in April 1972. EEC members decided that their
currencies were to be maintained within established limits
of each other.

This initial arrangement became colorfully known as"the
snake." But market pressures busted the snake, as
governments were unable to keep their currencies within
these bands.

The next step was the European Monetary System, in March
1979. Here currencies were held together by the European
Currency Unit (ECU) - a unit of account based on a weighted
average of the exchange rates of member countries. That
went bust in the fall of 1992, after experiencing severe
problems and despite the attempts of numerous European
Central Banks to maintain it by intervening directly in the
foreign exchange markets. Again, government dictates held
up like straw houses in gale force winds - which is to say,
they didn't.

The latest system created the euro, which began in 1999.
The euro is relatively young even by monetary standards.
There are not yet actuarial tables accurately devised for
the life expectancy of paper money, but theory and history
agree that it's something less than permanent.

Pegged rate systems are great for fueling crises. Like oily
combustibles lying around in a garage, a small flame can
start a great fire and take down a house. Another
instructive case is the peso meltdown in 1994-95, or the
so-called Tequila Crisis.

Before the crisis, Mexico linked the peso to the dollar,
but allowed for a band within which it could float. The
Mexican government would frequently have to intervene in
the market to enforce this band. Mexico experienced a large
trade deficit in 1994, perhaps indicating that pegged to
the dollar, the peso was stronger than it would have been
without government intervention. Money supply growth was
brisk in the years preceding the crisis, and 20% or more
per annum throughout most of 1994.

As always seems to happen in these types of systems, the
Mexican government could not control the growing supply of
pesos, nor could it bolster the weakening demand for pesos.
At the same time, it struggled to maintain the peso's value
in terms of the dollar.

In December, the endgame began for this arrangement.
Mexico's central bank finally devalued the peso by 13% on
December 20. By the end of December, the peso floated
freely and fell another 15%. In the four-month period
beginning on December 20th, the peso lost 50% of its value.

Take another example - who can forget the Asian Crisis of
1997? Originating in Thailand, it spread throughout
Southeast Asia - the Malaysian ringgit, Singapore dollar,
Philippine peso, Taiwan dollar and Indonesian rupiah all
declined. The Asian Crisis sent ripples across financial
markets all over the world.

Prior to the Asian Crisis, Thailand had a pegged exchange
rate tied to the dollar. Again, the Thai baht became weaker
in the marketplace, and investors exchanged the baht for
dollars. The Thai central bank spent more than $20 billion
trying to maintain its pegged rate, but ultimately had to
lift it. Quite simply, the supply of baht exceeded the
market's demand for it and the government's intervention
only delayed and exacerbated the crisis. Over a five-week
period, the Thai baht lost more than 20% against the
dollar. Other Southeast Asian countries also had to
surrender their fixed exchange rates.

This brings us, in a roundabout way, to the current feud
surrounding the yuan and dollar. As we have blazed through
a selective short history of currency blow-ups, it should
be clear that maintaining a peg in disharmony with market
forces is a recipe for a costly disaster.

For ten years, the Chinese have maintained a fixed exchange
rate of about 8.28 yuan to the dollar. As has been well
documented, the U.S. has been a great importer of Chinese
goods. We take their merchandise, and they take our
dollars. According to James Grant,"the dollars pile up on
the balance sheet of the People's Republic of China at the
rate of $10 billion per month." Such trends are
unsustainable. At some point, the Chinese are going to have
to stop acquiring dollars at the fixed rate. The yuan, it
seems, is too cheap at this rate, and the Chinese money
supply is booming. People are eagerly swapping their
dollars for yuan.

Meanwhile, money and credit are booming in China. As Grant
writes,"It is therefore no accident that the Shanghai real
estate market is on fire, that Chinese loan growth is
burgeoning or that frightened Chinese monetary authorities
have been unable to keep the lid on Chinese money-supply
growth. By making the yuan too cheap, they have also,
necessarily, made it too plentiful."

The resulting artificial boom in China is no good for the
Chinese. A bust follows every such boom. If allowed to
float, the yuan would presumably get stronger, and some of
the money flows would slow or even reverse. It may be too
late for China, whose government seems just as intent on
destroying the Chinese currency as American officials seem
bent on destroying the dollar - whether knowingly or not.

Count the yuan dollar fiasco as just another chapter in the
long saga of man's futile struggle to master paper money.
The unattainable dream is to be able to produce as much of
it as possible at near zero cost, while still retaining its
purchasing power in the real world of things.


Regards,

Christopher Mayer
for The Daily Reckoning

P.S. Murray Rothbard wrote,"Governments don't know, and
don't want to know, that the only successful fixing of
exchange rates occurred, not coincidentally, in the era of
the gold standard." The reason is easy enough to
understand. It worked because monetary units, like the
dollar, were fixed in terms of their weight in gold. Gold
has to be extracted, manufactured within the market, and
cannot be created out of thin air. But government planners
don't like gold. It ties their hand. They can't spend so
freely because they know they have to redeem their monetary
issues in gold. It checks their inflating ways.

It's easy to be depressed when you look around and see the
state of monetary affairs. But, as Rothbard noted, and as
the short historical vignettes above show, we have one
great force in our favor. As Rothbard cheerfully remarked,
"Free markets, not only [in] the long run but often in the
short run, will triumph over government power." The
inability of governments to maintain fixed exchange rates
in the face of opposing market forces is only further proof
of their impotency.