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An Open Mouth
Kurt Richebächer
The
Daily Reckoning
August 01, 2003
The Daily
Reckoning PRESENTS: Thus far, the current Fed chief's "wily
gamesmanship" has seen him through the bursting of one bubble
- the late '90s stock market mania - relatively unscathed. But
just how far can his words reach? The good doctor reports, below...
The people
who expect a double dip or worse in the United States certainly
represent a small minority. Among policymakers and economists
in America, it is a virtual consensus view that the Great Depression
of the 1930s as well as Japan's present, protracted economic
quagmire have their decisive cause in one crucial policy mistake:
both central banks were much too slow in lowering their interest
rates when the economies began to weaken.
All this really
boils down to one key question: When do central banks make their
decisive mistake? Is it during the boom and the bubble? Or is
it in their aftermath?
Convinced he
had learned from history, Mr. Greenspan slashed the Fed's federal
funds rate with unprecedented speed from 6.5% to just 1%. Establishing
thereby a steeply sloped yield curve, his aggressive rate cuts
had sweeping effects also on long-term rates, as investors and
speculators stampeded into highly leveraged purchases of higher-yielding
longer-term bonds.
In principle,
central banks have but two instruments at their disposal to influence
money and credit growth with the ultimate aim to curtail or to
stimulate economic activity: adjustments in bank reserves through
open market operations; and adjustments in its key short-term
rate or rates.
Yet there is
still a third, unconventional instrument of which central bankers
have made very different or no use of at all. It has sometimes
been called a central bank's open-mouth policy. Mr. Greenspan
is definitely the world's one central banker who has practiced
this extraordinary tool with unusual abundance and aggressiveness.
He, apparently, regards it as perfectly legitimate for a central
banker to bend expectations in the economy and the markets in
a direction he wants.
During America's
boom and bubble years, Greenspan was effectively the most prominent
and also the most pronounced New Era Apostle. In various speeches,
he developed arguments or "theories" plainly rationalizing
and fanning the euphoria in the stock market.
In his famous
Boca Raton, Fla., speech on Oct. 28, 1999, just a few months before the
stock market's crash, he suggested that the unprecedented equity
valuations seemed to be the appropriate response of investors
to the economy's advanced information technology:
"The rise
in the availability of real-time information has reduced the
uncertainties and thereby lowered the variances that we employ
to guide portfolio decisions. At least part of the observed fall
in equity premiums in our economy and others over the past years
does not appear to be the result of ephemeral changes in perceptions.
It is presumably the result of a permanent technology-driven
increase in information availability, which by definition reduces
uncertainty and therefore risk premiums. The decline is most
evident in equity risk premiums.
"But how
long can we expect this remarkable period of innovation to continue?
Many, if not most, of you will argue it is still in its early
stages. Lou Gerstner (IBM) testified before Congress a few months
ago that we are only five years into a thirty-year cycle of technological
change. I have no reason to dispute that."
Having learned
nothing from his past blunders, Mr. Greenspan is at it again.
To quote Fed mandarin Vincent Reinhart: "The Federal Reserve
has always appreciated the importance of correctly aligning market
expectations." Putting it rather more bluntly, the Fed endeavors
"to manipulate market expectations in the direction that
the Fed desires."
During the
late 1990s, Mr. Greenspan was keen to foster the stock market
bubble by aggressively manipulating both market rates and market
perceptions. After the equity crash of 2000, he has become keen
to foster the three new bubbles he kindled in fighting the burst
of the stock market bubble - the house price bubble, the mortgage
refinancing bubble and the bond bubble.
Together, these
bubbles are plainly indispensable for maintaining some zip in
consumer spending.
But among the
three bubbles, one is of crucial importance because it drives
the other two. That is the (now hard-pressed) bond bubble. Refinancing
activity tends to pick up significantly whenever mortgage rates
drop below previous lows. Importantly, Treasury yields guide
the movements of mortgage rates. In essence, it was the sharp
drop of Treasury yields over the past two years that led the
simultaneous, steep decline of mortgage rates. The recent, renewed
sharp drop in Treasury yields gave mortgage refinancing another
strong boost.
Within barely
six weeks, 10-year Treasury yields plunged from close to 4% to
close to 3%. In sympathy, mortgage rates fell to 5.21%, the lowest
rate in more than four decades.
The astonishing
thing about this sudden decline in market interest rates was
that it happened at a time when the stock market was, on the
contrary, being carried upward by spreading hopes for the economy's
imminent recovery. What happened to make this new, sharp decline
of longer-term interest rates possible?
In its May
29 editorial, The Wall Street Journal praised the Fed chairman
for his wily gamesmanship. "Merely by talking about deflation,
he's made the markets anticipate easier money; long-term interest
rates have fallen accordingly, helping to keep housing prices
afloat and to spur one more round of home mortgage-refinancing.
This in turn feeds consumer confidence and helps keep the post-bubble
economy growing. As a monetary gambit, uttering the word deflation
has so far been a great tactical success. We suppose that's worth
the price of scaring people about an economic threat that isn't
very likely."
In short, being
assured by Mr. Greenspan and other Fed members that there would
be no interest rate hike as far as the eye can see, investors
and speculators, desperately hungry for big profits, stampeded
into heavily leveraged bond purchases, giving through the sliding
yield a new strong boost to mortgage refinancing.
Closer to the
truth: In the guise of worrying about the evil of deflation,
Mr. Greenspan signaled to the marketplace his determination to
accommodate unlimited leveraged bond purchases. Investors and
speculators complied with enthusiasm, giving long-term rates
another sharp downward tick. Implicitly, in a country with negative
national savings, any decline in market interest rates can only
come from financial leveraging.
In this way,
the last bit of restraint on financial leverage and speculative
excess in the markets was effectively removed. Endless liquidity
is available for the taking by the speculating financial community.
The obvious result is a credit and bond bubble that meanwhile
has vastly outpaced the excesses of the equity bubble.
The fundamental
dilemma today is that - by every method available - the Greenspan
Fed and Wall Street are making desperate efforts to sustain unsustainable
bubbles. Of these, the belabored bond bubble is now our greatest
fear. Its influences have pervaded the whole economy and the
whole financial system, and its bursting may have apocalyptic
consequences.
Regards,
Kurt
Richebächer
August 1,2003
for The
Daily Reckoning
P.S. Nobody
questions the need for action. But it should be clear that easy
money can only be the cure for tight money, not for any other
causes depressing the economy. For us, the real and disturbing
story about the U.S. economy is that with all its imbalances
it has reached the stage where it requires permanent, massive
monetary and fiscal stimulus to garner just a tepid economic
response - and to prevent the various bubbles from deflating.
All this is definitely not prone to create a healthy economy
being capable of self-sustaining growth.
Editor's Note: Dr. Kurt Richebächer's articles appear regularly
in The Wall Street Journal, Barron's, the US edition of
The Fleet Street Letter and other respected financial
publications. France's Le Figaro magazine did a feature
story on him as 'the man who predicted the Asian crisis.' Dr.
Richebächer is currently advising investors on how to profit
from Greenspan's mistakes. For more information, see:
Greenspan Is Robbing
You Blind
http://www.agora-inc.com/reports/RCH/OnTheMoney/
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