 Greenspan's
Wishful Thinking?
David Chuhran
Archives
February 13, 2004
It was with great interest
that I read the transcript of Alan Greenspan's Monetary Policy
Report
to the Congress on February 11, 2004. I must admit, I found portions
of the speech to be refreshingly open and forthright. And, while
I don't share some of his more optimistic views, I can understand
why many would. The engineers of this "recovery" have
the "pride of authorship" and stake their reputations
on its success, while the rest of the country just wants it to
succeed so they can return to business as usual and enjoy the
next "good ole days' boom." For the overwhelming majority,
any scenario that includes a sharp, deep, and prolonged economic
decline is unimaginable. It's especially hard for those with
children. Suggesting such possibilities is met with hostile,
innate self defensiveness as they refuse to consider leaving
such a horrible mess for their children to solve. Their reaction
is understandable.
My specific interest was aroused
last summer. I was in the process of moving back to my hometown
and had a contract on a beautiful lake house. In researching
the house, I found out that the owner bought the house 4 years
earlier and was asking 4 times what he paid. Everyone said it
was a steal after I knocked him down to just over 3 times, but
he couldn't go any lower because he had refinanced 3 months earlier
up to the max. Initially, I felt a little sorry for him until
I realized he had spent the money and would be forced to write
a check at closing to escape alive. I know where the money went
by just looking at the property with its 3 wave runners, boat,
and new SUV on the outside, as well as a big screen TV and new
stereo on the inside, but no furniture. Now that's a set of priorities!
Then the bond market coughed, choked, and gagged on a mere few
words from the Fed that appeared to withdraw support for low
interest rates. It spooked me! I didn't have to move, so I pulled
the plug. I think the poor guy found some other schmuck to buy
his house a few months later. I'm sure it was a steal!
This is not an isolated
incident.
The basis for this Greenspan
directed recovery has always appeared to ride on the back of
the American consumer. The idea apparently being that if monetary
policy remained accommodative for long enough, then consumers
would carry the economy forward on a rising tide of consumption
until growth could once again become self-sustaining. This is
obvious as Greenspan says, "Once again, household spending
was the mainstay, with real personal consumption spending increasing
nearly 4 percent and real outlays on residential structures rising
about 10 percent." Not only does he admit that this
is a consumer-based recovery, but he subtly acknowledges the
rapid rise in residential housing in the same sentence. Greenspan
is counting on that 10 percent per year growth rate in home prices
and people have come to expect it. It's unrealistic to assume
growth of this sort is sustainable, because it would result in
a doubling of the average home price every 7.2 years. The fact
that these two statements are married reveals with pinpoint accuracy
exactly what the Fed was aiming for all along, consumption based
on inflated home equity.
He continues, "And it appears that the impetus from fiscal
policy will stay expansionary, on net, through this year."
This is the deep breath before several more voluminous bellows
of hot air are blown into the housing bubble. It also sends the
message to the interest rate carry traders that the rate spread
will remain intact allowing them to continue feeding at the "free
money" trough throughout this whole year. This has the effect
of calming the bond market while keeping trillions of derivatives
locked into position for the now, somewhat defined, "foreseeable
future."
Greenspan reiterates that,
"household spending was the mainstay," and that
"The very low level of interest rates also encouraged household
spending..." In other words, had it not been
for their policy of low interest rates, we would likely be in
much worse shape. So, what does that mean for us if interest
rates do rise through either a Fed hike or unplanned market action?
And, what happens if the "mainstay" consumer is unable
to continue at even the current level of consumption? He acknowledges,
"The lowest home mortgage rates in decades were a major
contributor to record sales of existing residences, engendering
a large extraction of cash from home equity..." Greenspan
thinks this is good? We want to encourage people to ante up their
futures in a desperate attempt to fill this economic inside straight?
This is hardly sound policy.
He talks very casually about
how, "many households took out cash in the process of
refinancing," which, "freed up funds for other
expenditures..." This resulted in, "Home mortgage
debt increased about 13 percent last year, while consumer credit
expanded much more slowly..." So, rather than run up
the credit cards people took their over-inflated appraisals to
the banks, took their "free money," and restarted
the clock on their home loans giving rise to, "the ratio
of overall household debt to income continued to increase..."
He almost seems to gain satisfaction from the fact that consumer
credit expansion slowed while people were lured into taking his
gift of "free money" through low interest rates.
This was his miracle!
Never mind the fact that many
now owe more than they originally paid on their homes and
they'll owe it for 30 years - again! What happens when interest
rates rise? Will home prices continue to rise? That's not very
likely. What about the homeowners with Adjustable Rate Mortgages?
When interest rates rise, their disposable income will certainly
fall. In my opinion, this whole situation is not sustainable.
It is a travesty! The Fed has purposely inflated the housing
bubble through artificially low interest rates while simultaneously
encouraging our citizens to tap into their home equity. On the
horizon, I see many foreclosures and banks in distress. The banks
will be forced to dump houses back onto the market for pennies
on the dollar in a desperate attempt to remain solvent. Maybe,
this is what Sir
John Templeton sees ahead when he tells investors to sell
excess residential real estate.
Conversely, Greenspan tells us that, "expenditures on
nonresidential structures continued to contract on balance,
albeit less rapidly than in 2001 and 2002. High vacancy rates
for office buildings and low rates of capacity utilization in
manufacturing evidently limited the demand for new structures..."
In other words, the commercial real estate market is deflating.
There's an overabundance of office and factory space driving
the price down. This hardly sounds like evidence of a recovery
that can sustain itself without the "mainstay" consumer.
He proudly offers, "Corporate treasurers took advantage
of the attractive market conditions by issuing long-term
debt to lengthen the maturities of corporate liabilities. As
a consequence, net short-term financing was extremely weak."
It also makes sense for businesses to take advantage of low
rates and refinance. If it works for the consumer, why wouldn't
it work for the business world? Only one problem, as these corporations
rolled their short term debt into longer term debt it caused
the loss of the multiplier effect resulting in a decline in the
velocity
of money and subsequent move toward a contracting money
supply. Further evidence of that is provided when he says
that there was, "slack demand for short-term credit...,"
and it "..declined more than $100 billion over the
year..." This is not insignificant and is cause for
concern as liquidity evaporates.
Greenspan cites, "The strong gains in productivity...
"have allowed businesses" to meet increasing
orders without stepping up hiring." I dispute this outright
and make my case in a previous
editorial where I feel we're taking credit for final assembly
of components produced abroad. This is skewing the Industrial
Production and Manufacturing Output numbers upward. Aside from
that, they continue using fraudulent "hedonic" pie-in-the-sky
additives to the GDP for things like faster computers. And, then
there's their myopic productivity calculations that fail to account
for anything other than GDP per hour worked while discounting
the millions of unemployed.
Nevertheless, he goes on to
say, "In all likelihood, employment will begin to grow
more quickly before long..." That's not a very confident
or definitive statement coming from the Fed Chairman that knows
all recoveries include job gains, not loss. And, how long is
"before long"? This isn't comforting for the unemployed
who desperately want to work.
Finally, he says, "A
consequence of the rapid gains in productivity and slack in our
labor and product markets has been sustained downward pressure
on inflation..." If inflation goes down too far it becomes
deflation. How in the world can you rely on your "mainstay"
consumers to continue the same or higher levels of consumption
when their wages are under pressure? It's not possible, this
recovery is not sound, and deflation is still a threat.
Regarding the dollar, he says, "Against a broad basket
of currencies of our trading partners, the foreign exchange value
of the U.S. dollar has declined about 13 percent from its peak
in early 2002." This statement really bothers me, because
it is so far off the mark that I don't know what to make of it.
I'm baffled! Regardless, it's just patently false. Here's a chart
of the US Dollar Index dating back to early 2002. The drop against
that "basket of currencies" he alludes to is actually
closer to 30%, not 13%, as shown below.
I'm not even going to draw
any trend lines here, because the trend is obvious, down.
Greenspan relates how this trend is being viewed by the international
community, "Apparently, foreign exporters have been willing
to absorb some of the price decline measured in their own currencies
and the consequent squeeze on profit margins it entails."
How can this last for long? Eventually, they'll be forced
to raise prices to avoid revenue shortfalls resulting in ongoing
and unsustainable net profit losses. He explains one of the ways
that they're currently dealing with it as, "Part of exporters'
losses, however, have apparently been offset by short forward
positions against the dollar in foreign exchange markets."
They are not alone. Warren
Buffett and George
Soros are right along with them betting that the Dollar will
continue its decline. They know. The question is, will that decline
remain orderly, or will it spiral? Never underestimate the extremes
a market can travel when fear based panic sets in causing an
eye watering overshoot of any rational, reasonable, or logical
target level.
Greenspan puts a happy face
on it by saying, "Accordingly, the currency depreciation
that we have experienced of late should eventually help to contain
our current account deficit as foreign producers export less
to the United States." Is this what they're hoping for?
Do they hope those foreign exporters are choked out of our markets
by a weak dollar? Do they want them to just close their plants
and quietly retreat? He warns against Smoot-Hawley type protectionism
in this speech, but this currency depreciation is a tariff just
the same, even though it's not targeted.
The falling Dollar is worse;
it's a tariff on everything!
The first thing that'll happen
is merchandise in Wal-Mart will get much more expensive, because
we no longer make the things we need, we import them. And they
still want us to consume. You can't have it both ways. Then other
less subtle things will follow as foreign exporters are squeezed
into failure likely causing excess global capacity, unemployment,
and recession. Do they hope that this is when the factories we
shipped abroad will return and re-open?
Probably the most discomforting thing from Chairman Greenspan
came toward the end of his speech where he plotted his route
to the tall grass and said, "When the future surprises,
history tells us, it often surprises us all. We must,
as a consequence, remain alert to risks that could threaten the
sustainability of the expansion." While there is truth
in what he says and I'm happy they remain "alert,"
I find no great comfort in this seemingly-nonchalant shoulder
shrug about "future surprises." He's covering
his tracks while preparing us for the unknown surprises coming
soon. In my opinion, it's just a matter of time.
In an effort to keep mystery
in the air, Greenspan leaves himself an opening for a course
reversal by saying, "But the evidence indicates clearly
that such a policy stance will not be compatible indefinitely
with price stability and sustainable growth; the real federal
funds rate will eventually need to rise toward a more neutral
level." They certainly can't go down as he just
admitted that "real" interest rates are already negative;
and, he told us we can expect these rates through the end of
this year, unless he changes his mind, I suppose. Watch out if
a course reversal comes without adequate warning, or happens
on its own through natural market forces.
He appears unconcerned about the fact that, "The monetary
aggregate M2 expanded only 5-1/4 percent during 2003, somewhat
less than nominal GDP, and actually contracted during the fourth
quarter." Let me tell you, contraction is not good
when you consider its coming during the Fed's most accommodative
monetary policy ever. One of the reasons for this contraction
was the rolling of short term debt into longer term debt as stated
above, but another contributor is brought to light when Greenspan
says, "However, a significant portion of that growth
was associated with the record turnover of existing homes and
the high level of cash-out refinancing, which are not expected
to continue at their recent pace." This is likely to
cause a further contraction of the money supply from not only
the loss of the cash-out refi multiplier effect, but from the
lack of consumption as the "mainstay" consumer is already
tapped out. He's telling us it's coming to an end and gives no
evidence of who or what is going to fill this consumption void.
He proudly states, "All told, our accommodative monetary
policy stance to date does not seem to have generated excessive
volumes of liquidity or credit." It doesn't "seem"
so, and he thinks they have it just about right. I think we're
in for one of his "future surprises" when I look at
these two charts below.
The household debt looks like
there's no end in sight. It can't continue to rise forever; and
the M3 has been rising without pause, until recently. Unfortunately,
with the imbalances in place, now is the worse possible time
for a money supply contraction as you can see by the hook at
the top.
Regarding the stock market, Greenspan says, "Broad
measures of equity prices rose 25 percent in 2003, and technology
stocks increased twice as quickly. However, history shows
that pricing financial assets appropriately in real time can
be extremely difficult and that, even in a seemingly benign economic
environment, risks remain." Is this the definition of
"irrational exuberance?" Almost a solid year of uninterrupted
rising markets with virtually no bearish sentiment in sight would
tend to suggest more than just an average dose of "risk."
This market action is not normal, or did I miss another one of
those "new paradigms"?
Just to emphasize the "non-political" nature of the
Fed, Greenspan carefully says, "very sizable deficits
are in prospect in the years to come..." and, "to
date no effective constituency has offered programs to balance
the budget..." In other words, deficits are a problem
and none of the politicians have the political will to put forward
a plan to fix it. So, when bad things happen, remember, Greenspan
warned them absolving him of any responsibility.
Furthermore, he says, "The
imbalance in the federal budgetary situation, unless addressed
soon, will pose serious longer-term fiscal difficulties. Our
demographics--especially the retirement of the baby-boom generation
beginning in just a few years--mean that the ratio of workers
to retirees will fall substantially. Without corrective action,
this development will put substantial pressure on our ability
in coming years to provide even minimal government services while
maintaining entitlement benefits at their current level, without
debilitating increases in tax rates. The longer we wait before
addressing these imbalances, the more wrenching the fiscal adjustment
ultimately will be." Finally, I agree with him! He has
this one right and hopefully somebody is listening. The "pressure"
will mount until it becomes unbearable unless we address it now.
For me, Social Security is dead!
Greenspan recognizes the seriousness
of the threat from, "foreign investors, both private
and official, may become less willing to absorb ever-growing
claims on U.S. residents." If foreigners don't buy our
treasuries, we're sunk and he knows it. We can only buy our own
debt with printed money for so long before everyone catches on
to our secret little game. When our creditors have had enough,
they'll all head for the exit at the same time. If this comes
to pass, it will not foster a controlled decline in the Dollar,
but will more than likely bring about collapse. The currency
and bond traders already know and are registering their votes
daily as evidenced by the US Dollar Index above. There's no telling
what was said behind closed doors at the recent G7 meeting, but
if their Central Banks or other large institutional investors
abandon us, then look out below. Regardless, for Greenspan to
think he'll be able to control the Dollar's descent to the lows
that will reignite employment and balance the trade deficit,
is nothing more than his...
...wishful thinking!
I'm thinking lake houses will
be cheap soon.
David Chuhran
goldbull@bellsouth.net
February 12, 2004
Archives
Copyright ©2004 David
Chuhran. All Rights Reserved.
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