 Flash Bubbles
Dan Denning
May 24, 2004
The Daily
Reckoning PRESENTS: In theory, the Federal Reserve can print
as much money as it likes. Reflation should be assured. Unfortunately,
the wise men overlooked one small detail... wage stagnation. If consumers
cannot afford to pay higher prices, you don't get higher prices...
If you're like
99% of the world, you expect the Fed to raise rates.
But somewhere
along the way, in its perfect plan to "reflate" the
American economy and prevent a Japan-style soft depression, the
Fed made a fatal miscalculation: It caused a simultaneous asset
bubble in stocks, bonds, commodities, housing, and real estate.
We stand on the edge of the great collapse of the "reflation
rally." Some assets will come through relatively unscathed.
Others will deflate. What the Fed is about to reap is a lot different
from what it thought it was sowing.
The Fed thought
it could make money cheap and keep the stock market high (and
households feeling wealthy). It was right. It thought it could
keep money cheap and force savers to abandon money market funds
and CDs. It was right. It thought it could keep home prices rising
by keeping interest rates low (and mortgage rates low in sympathy).
It was right.
It also thought
it could create so much money that raw material prices would
rise. It was right. The Fed's cheap money caused a series of
"flash bubbles" in the commodities sector, especially
in base materials, and even in gold. It also thought it could
keep money cheap and force up producer prices. Producers have
to buy raw materials, after all. It was right.
And it thought
that the whole chain of inflation - or the ladder, if you prefer
- would be completed in the form of rising consumer prices. It
thought it could prevent deflation by first forcing up raw materials
prices, then producer prices, and finally consumer prices. If
the Fed couldn't make consumers borrow, it thought it could make
them spend by inflating. It was wrong.
This essay
is not going to be a long explanation of the failures of monetary
and fiscal policy, though it would be fitting if it were. Never
before has an American government been as irresponsible with
its citizens' money as the current administration. And never
before has the Federal Reserve done more to undermine your standard
of living than this Federal Reserve has.
The government
has borrowed beyond its means and spent even more. It has made
promises it can't keep - and probably never intended to. And
the Fed has encouraged the financialization of the American economy.
It's made borrowing money and using leverage so cheap that there
is virtually no sense of risk in the market... risk of taking
on debt... risk of buying too high... risk of the whole financial
economy falling apart.
To be fair,
the irresponsibility of the American government is perfectly
in tune with the irresponsibility of governments everywhere.
We live in an age of increased government action in the economy.
Economic policies (deficit spending, tariffs, currency manipulation)
are seen as the tools of economic warfare. Nations wield them
against one another to gain relative advantages in a world marketplace
thick with competition from numerous low-cost producers.
The American
government has made three unique blunders. First, it has taken
the good will of the rest of the world for granted. America is
a debtor nation. It depends on the rest of the world investing
in America to keep the value of the dollar up. Take away investment
in American stocks, bonds, and real estate, and the Great Inflation
begins.
Second, our
government has preached to you the benefits of globalization,
namely lower prices and more choice. What they didn't mention
is that true globalization means a permanent change in the structure
of the American labor market. This is how free markets work.
Production moves to the lowest-cost centers. This is not a cyclical
phenomenon, but a structural one: It means that America is becoming
a service economy. The wages of excessive consumption are the
loss of an economy that produces new investment and wealth.
Third, however,
and greatest of the policy blunders is the assumption that monetary
policy can cause wage inflation. Because of this error, the Fed
is about to discover that its entire effort to reflate the economy
through low rates has failed. And it is nearly out of interest
rate bullets.
What do consumer wages have to do with monetary policy? The Fed
has succeeded in causing inflation nearly everywhere in the economy
EXCEPT in consumer wages. But without rising wages, consumers
can't afford to pay rising prices.
Think about it. Gas prices are high and rising. Long-term interest
rates are rising, increasing the amount of discretionary income
the average consumer has to pay on his adjustable rate mortgage
or credit cards. Now add to those two forces rising consumer
prices. What is a consumer to do? If his wages aren't rising,
can he afford higher prices, along with already high energy costs
and debt service costs?
Greenspan knows
that without rising wages, there can be no real "reflation."
In congressional testimony that was overlooked in the press accounts,
the chairman said, "Remember that more than two-thirds of
the consolidated underlying domestic costs in the United States
are unit labor costs... And unit labor costs, as best we can
judge, are still going down."
In other words,
everything is going up in price... but consumers can't afford
to pay those prices. This, ironically, is deflationary. As prices
rise, consumers cut back on spending. The more prices rise on
the margins, the less consumers consume. It is nothing less than
the end of the consumption-driven American model - the model
the rest of the world has tolerated because Americans have been
buying on credit. The credit crunch is coming.
If reflation
were really going to show up in the economy, you'd see big price
markups across the board in all sectors. But in a recent Financial
Times article, only three big U.S. companies reported success
in passing high raw materials prices on to the consumer. The
companies were Ford, Honeywell, and Hormel, the company that
makes SPAM. Not exactly a burst of reflation in the economy.
It must be
hard for the Fed to realize this. It's the end of the line for
the reflation model. The Fed can't cause consumer price inflation
because it doesn't control the key element of the whole inflation
ladder, namely the labor market. In reality, labor market changes
are a function of globalization (aided and abetted by the Fed's
cheap money policy).
The Fed has
thus made it possible for a huge spike in prices, leading to
the deflationary collapse of the American consumer. The normal
policy response to skyrocketing inflation would be to raise rates
(what the market expects). But raising rates puts the consumer
in even worse shape than he is now and threatens the main source
of household balance sheet wealth: the house.
If it seems
to you like the Fed doesn't have any good choices left, I agree.
It's backed itself into a monetary corner from which there is
no apparent escape. It does have some options. But it will be
exercising them without any historical precedent of success.
For example,
the Fed may decide it wants to set long-term interest rates,
too, either on the 30-year bond (which would be reintroduced)
or on the 10-year bond. Granted, this would be considerably disruptive
to the bond market. But in an era of government intervention,
it's just another form of price control.
More likely
is that the Fed will start to "monetize" outstanding
debt by buying U.S. bonds. There would probably be a lot of sellers,
if it got to that. The Fed would be acting as a buyer of last
resort, trading newly printed cash for U.S. bonds, which it would
then own or retire. The whole goal would be getting currency
in circulation, getting the consumer to spend.
That, of course, is something the Fed probably can't do, even
it wanted to. Spending is as much a psychological process as
a fiscal one. People spend now when they think the future is
getting better, with less risk. But when people are cautious,
they spend less, they cut back, they downsize. They scale back
expectations. They think differently.
It's hard to
predict what will happen to the American economy when this happens.
A dollar sell-off is coming. Standards of living are going to
fall. Land values will suffer, all because...
The American
government was just another government that couldn't pay its
bills.
Regards,
Dan Denning,
for the Daily
Reckoning
P.S. I'll be
in La Jolla over July 15 and 16 for the Agora Wealth-Currencies
& Resources Seminar. It will be a blast. John Myers,
Chuck Butler, Karim Rahemtulla, Eric Roseman, Steve Belmont are
all coming down, as are many others. You've got to make it:
Wealth-Currencies & Resources Seminar
Dan Denning is the editor of Strategic Investment, one of the
most respected "big-picture" investment newsletters
on the market. A former specialist in small-cap stocks, Dan has
been at the helm of Strategic Investment since 1999 - where,
drawing from his network of global contacts, he has designed
an investment strategy that takes into account global political
and economic trends. His weekly e-mails and monthly newsletter
give investors the most complete picture of what's shaping investment
markets, what's coming next, and exactly what to do today.
Right now,
Dan says your house may be the riskiest asset you own. To protect
yourself, you must see:
The Coming Housing Bubble Implosion
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