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The Crumbling Pillars of
U.S. Dollar Policy
Goebbels concludes this lesson in existentialism with the deduction that the State inexorably engages in lies. What an interesting observation, probably because of its source - Joseph Goebbels was Hitler's right hand man, and propaganda machine for the Nazis. It may be the most honest comment we could expect from a man in his position.
But why is it that the most basic of truths often prove to be the truest? I bet that 20 years from now when historians are trying to put today's stock market mania into perspective, it'll come down to valuation. It'll probably be that simple. I know nobody wants to hear that today. But maybe that's because they don't care where stock prices will be in twenty years. They wanna' know where they will be by tomorrow.
As for the quote, perhaps it epitomizes a man's awakening to the fate of his position in power (albeit at an extreme point of Statist oppression) in the invariable conflict between individual and state. The realization itself may have been a doorway to evil, particularly if embrace of the reality became comfortable.
Wow, that's pretty deep "Ed," but what the heck does it have to do with anything?
Good question, I'm not sure. But the question which came to mind as I first read the quote, and which subsequently led me to innovative depths of useless thought, was how "awoken" are our leaders to the basic truths of their own positions in power?
At what stage of consciousness are they?
Judging by the nature of recent policymaking maneuvers, it disturbs me to consider that these people, who are supposed to be our leaders, are completely alert to their own mendacity and that they have comfortably embraced a Machiavellian fate.
How aware is the Treasury about the audacity of its late October claim (on Halloween to boot) that the government should suspend issuance of its long term obligations on account that the US economy will return a growing budget surplus soon enough, and that they are therefore obsolete? Does undersecretary Peter Fisher really believe his own words, which fly in the face of historical precedent, or was he simply engaged in a lie to dissuade fixed income investors from selling their Treasuries?
Or worse, are he and Mr. O'Neill cognizant that such an announcement could prompt investor's to perceive a scarcity of these securities so that the "free market" could then depress long term yields? Are they aware that there is a competition for investment demand between gold and Treasury bonds?
If they were, would we look at their activity differently?
One way that the Fed changes interest rate levels is through open market operations in short term Treasury securities. The 2 rates of interest they target are announced after each FOMC meeting. It doesn't have a mandate to target any other interest rate.
Should we conclude that our free market governments engage in market operations outside of these securities now? Did you know that the Fed has made the case that it should be allowed to buy and sell mortgage securities on account that the buy back program (of long term debt) will eventually reduce the quantity of securities it is now able to manipulate, er, I mean engage, on behalf of monetary policy.
Actually, ever since Larry Summers left the Treasury the talk about buying back long term debt has moved towards a month-to-month notice, announced coincident with Fisher's advice that the Treasury suspend issuance of its long term debt as if fading out one scheme in favor of a new one.
Does Greenspan really believe that the budget surplus will return, soon enough, or is he too engaged in a fib allowing the already largest central planning organization in the history of the world to extend its reach even further? Does he realize the truth of his own institution's reality, particularly in regards to its juxtaposition with free market capitalism? Maybe he does, and if so, maybe he is just setting up a safety net for when Fannie Mae and Freddie Mac can't print money as fast as they used to?
Recall the after the fact discovery made in the advent of Enron's bankruptcy that the Treasury department was contacted by Enron officials.
The stock crumbled before it was announced. Why couldn't the October 31st Treasury announcement have been intended to squeeze the short side of the long bond in order to push down on longer term interest rates in response to an increasing quantity of economic problems, if not specifically aimed at Enron's case?
While we perhaps can't prove that to be the case it's certainly more plausible a belief than it is that suddenly, out of the blue, when the economy has been faltering and as the likelihood is that the government will need to borrow more not less, the Treasury advises that lowering long term rates this way will make it cheaper to borrow in the medium term. They didn't really believe that did they? Aren't there any economists on staff that can tell them that the resulting stimulus combined with more borrowing at the shorter end of the yield curve might result in higher interest rates in the short to medium term? Aren't they aware that the budget surplus in recent years can be easily explained by the boom in capital gains receipts and other affects from the late nineties asset inflation? Where are these blue chip analysts Clinton raved about?
What's more, the government hasn't run a surplus for over fifty years prior to this. Do they really believe there is something inherently different about this economy? Maybe they do. But what if they don't? What if they're just telling us what we want to hear?
History is littered with abuses of power, but maybe true evil lies in dogmatic pursuit of wrongs despite, and perhaps coincident with, an increasing level of consciousness about them. How dangerous are these people that continue to pursue the discredited theories of price controls, for instance, under the guise of dollar, investment, monetary policy, or other excuse? As benign a policy as that may be it affects millions of people with varying degree, and it affects the economy. But it helps their cause(s), which is just more power. How basic is that truth, which most readers are likely to scoff at?
Just the plain observation of the effort by policymakers to disguise their policies (of yesteryear) differently should be enough to arouse our interest. Do they really think that the differences in form are anything other than deceitful? After all, maybe Mr. Fisher believes he knows something we don't. Certainly, there are many bureaucrats who believe they are still working for the people's benefit. But maybe that's due to their yet to be developed level of self-awareness about the truth of their positions in power.
Maybe the true battle between good and evil lies at each moment of enlightenment, where individuals must consciously choose their fate.
For whatever it's worth, however, maybe at some point the choice no longer exists. Maybe the choice no longer existed for Hitler and Goebbels at some point. Maybe it no longer exists for some of our leaders today.
The Four Pillars
There is overlap, but that's as simple as we can make it. We're going to diagnose this structure today, with special emphasis on the Fed's role. Indeed, although the US Treasury is typically in charge of currency policy, it was tempting to put the FRB at the top of the chart, above "economic policy," but then we thought it might offend the President. In all seriousness, however, the creativity, and actual contribution to dollar policy, of this institution in recent years overwhelmingly places it in charge of much more than just monetary policy. The FRB seems to have an active, and perhaps more credible voice, than the Treasury in all of the aforementioned categories.
We could even say that the Treasury department works for the Fed in many respects, or so it appeared when Lawrence Summers was the man.
We are going to argue that the protectionist shift in US trade policy exemplified by at least the recent decision to impose up to 30% tariffs on imported steel is bearish for the dollar because trade policy is the second to last of the 4 pillars to crumble, right before international legal tender laws are altered and the increasingly controversial IMF gets the boot. Mr. Greenspan and other central bankers object to protectionist trade policy, because of how it undermines the willingness of US' trading partners engaged in competitive devaluations, in order to enhance their trade with the United States, to accumulate dollar reserves. It is true that many nations use currency policy, as a tool of their trade policies, but it is also true that the United States does the opposite.
It uses its trade policy as a tool of currency policy, perhaps unbeknownst to the President, and maybe even the Treasury department.
But Greenspan certainly knows. He knows how important the US leadership position on freer trade is to the global monetary establishment. He knows that protectionist policies will undermine US productivity (both really and according to his model). And he also knows that whatever dollar demand this action displaces, the Fed is going to have to pick up the slack, which means higher interest rates. Already the Fed is faced with a potential inflation problem due to a break down in monetary/investment policy, as well as a declining "unified" budget surplus, but now it must also deal with dollar supply over and above that from the unwinding of an over inflated investment premium.
The pressures are building for a reversal in the Fed Funds rate, and this is precisely what bond yields are discounting, rather than an economic recovery.
Now there is something that we should mention, which US policymakers may or may not be cognizant of. We'll leave it up to you to decide. It is very possible that as a consequence of fresh US protectionism it may be more taxing for the countries under European Union to advance the free trade initiative amongst themselves. To the extent that the credibility of the euro depends on continuing deregulation and relaxation of trade barriers within the EU, any revival of European protectionism could undermine it.
So the question is whether the Fed is aware that its government is provoking a European currency collapse by igniting the fires of global trade.
Wouldn't that be unscrupulous? Certainly, and maybe it's not the case, but it is well within their capabilities. They would have to be confident that the dominoes would fall faster in Europe than in the United States. Furthermore, my sense of the activity in cyclicals is that they have been discounting a weak dollar for about a month now.
Nevertheless, please keep that thought in mind if you're trading the euro. Scrutiny of trade issues within the EU in coming months should perhaps be at the top of your list.
Fed Stimulates Perception, not Economy
There are basically two cogent explanations for the surge in stock market valuations over the past 12 months. The first is that the Fed was right and that the productivity miracle has permanently lowered the equity risk premium despite the unanticipated fall in earnings last year. Under this scenario this drop in earnings is the anomaly.
The second explanation, which we support, is that sky high valuations are a result of the misguided (or perhaps mendacious) Fed's inflation policy.
Duh, which one of these really made stock prices rise over the past 5 years??
Almost every valuation formula we know of, excluding the simple PE ratio, uses both earnings and the rate of interest as inputs. It goes without saying then that models excluding interest rates in their calculation will seem extreme at one end today while those weighed by monetary conditions will show that the market is cheap.
Some academics that have argued for a lower equity risk premium resulting from implied gains in productivity, specifically, its affect on earnings quality, visibility, and also predictability. All of these things are argued to have improved and thus justify a permanently lowered ERP (endnote). But the evidence heavily weighs against them.
In our view, the ERP is like a market price in the sense that it is what it is. Markets should determine it just like any other price. They may place a low risk premium on equities today, but that may change tomorrow.
Calculating this number is like trying to compute the correct market price of a good, service, or asset. The market determines it, not the teacher of finance or economics, and particularly not the instrument of acquisition (monetary policy).
It is a problem of subjective valuation not objective valuation. There is nothing permanent about today's market assessment of risk premiums.
At the moment, equity risk premiums are still very low by most yardsticks. How can we tell if the future is uncertain? We can't with any degree of certainty.
But that is just the point. Nobody can know for certain how quickly earnings will grow in the future, among other things. Though we can compare various forecasts for earnings to the risk free rate of return offered in a particular economy, and make a decision, which will ultimately affect the equity risk premium. At any rate, it is the uncertainty that gives the FRB the ammunition to argue that the low ERP is largely the result of a technological influence on the economy. An inability to know the future is what promoters depend on to capitalize. I wonder if the Fed is cognizant of the effect that a low "relative" equity risk premium has on the investment premium of a currency?
If it is then should we be surprised that it argues for the productivity miracle?
To the extent that investors are still uncertain about the future and trust their central bankers, the FRB is able to sustain excessive stock market valuations with traditional inflation policies. Or, as Goebbels said, they can sustain the lie as long as they can shield people from its consequences. But to the extent that inflation policies impact on overall profitability as the consequence of their impact on the nation's structure of capital, or even just commodity prices, their credibility will in all probability decline coincident with mounting investor certainty about the uncertain future.
I believe this is happening today, right before our eyes. With "monetary" inflation on a tear, commodity prices and yields rising, and earnings declining, rapidly, the Fed risks not just a breakdown in monetary policy, but also investment policy, two pillars of dollar policy besides trade. Of course, we argue that monetary policy has already broken down and point to the aforementioned symptoms as a direct consequence of that.
This is easier to grasp once you understand what inflation really is and how it affects the structure of an economy's capital, or factors of production. Not that anyone we know can predict with accuracy how, where, and when such earnings distortions will occur. The point is they do occur just like they do in the labor market when the government interferes with minimum wage or other employment schemes.
Our job it to spot them when they do occur.
Moreover, just as the Fed engenders moral hazard in corporate/individual investment strategies, particularly when it is an active player, it similarly encourages bad press. Indeed, it provokes both, bad investment policy and bad press. And in fact, both are the epitome of what we refer to as moral hazard.
John Maynard Keynes showed long ago that if the government worked to create full employment it could succeed. His revelation was not new. Government's have been engaged in employment creation since the days that the Pharaohs used slave labor to build the great pyramids of Egypt, and in fact, long before then too.
However, such a system of production is not capitalism. Real (sustainable) profits do not derive from the success of government programs, monetary or otherwise. They derive from the very market process that the government interferes with. The press doesn't know this yet because most journalists aren't analysts, and those who are have to consider whether one of the many businesses or banks that the Fed de facto employs will withdraw their advertising dollars, or other support.
It is possible that they have been lulled to sleep because they perceive the Federal Reserve System to be a safety net, rather than an active agent. They don't possess the acumen (I wish I could be humble about this, but it's precisely how I see it) to understand how that illusion alone holds the potential to shift risk assessments made by economic participants about securities and other investments, never mind other market effects produced as a by-product of the moral hazard accompanying active policies.
I don't make these criticisms lightly. They are true. Why do you think many market professionals have always jokingly referred to the media as a contrary indicator?
Perceptions of history change all the time. How many people in the seventies loved Disco but are afraid to admit it today? How many people still listen to Boy George (a phenomenon of the 1980's) today? How many people trust their government today?
Yes, that's right, we haven't always trusted our government. But we tend to when it is convenient, and it is convenient when it appears that employment, profits, and wealth rise as the result of something the government has been doing. In such instances we assume it is doing something correct, even if it isn't. Government programs can affect all of those factors positively at times, but sooner or later they break down. The reason is always the same. Governments tend to borrow from the future in order to allocate today, whereas markets tend to allocate according to what is available today.
Most people will concur with the notion that powerful people in government and in business aren't always trustworthy, but for some reason many people have come to believe that central bankers are their protectors from the vagaries of unscrupulous politicians, businessmen, and "volatile" markets, if you will. It is as if people believe that it is the affect these "actors" have on the economy that the Fed is designed to shield them from, or in other words, that the Fed's job is to stabilize mad outcomes.
Very few investors, however, can comprehend how the Fed destabilizes outcomes, engenders bad investment policies, encourages corruption, and taxes its citizens without their knowledge / consent. Very few indeed. And the chief reason for that is a component of investment policy we refer to as propaganda.
Yes, the Fed manages perception. That used to be confined to "inflation expectations," but today it is much more broad because the investment premium has become so important to currency policy. Thus, we are going to continue to do our best to undermine the credibility of these insidious government institutions that are wholly responsible for the accumulating negatives of today, tomorrow, and the next day.
A Con Going Bad
The issue is never whether there is too much money? Of course there is, the issue is (and has been) what to do about it? Some kinds of inflation can be sustained, while others can't. Inflation that manifests in the exchange rate of a currency is probably the result of the nation's trade policy (competitive devaluations are a tool employed by many of the G7 as well as less developed capitalist economies). Whereas such a policy clearly fails to prevent breakdowns in the confidence of monetary institutions, the nation whose policy it is to employ inflation in asset markets, on the other hand, and does successfully, has been shown to thrive on the opposite outcome.
While one policy invariably manifests as a confidence meltdown in the currency, the other one results in a confidence melt up, and consequently, a rising purchasing power, for as long as the confidence stays.
However, in the end, both arrive at the same destination as a consequence of moral hazard. Eventually, "too much money" manifests in a debasement of the money unit, only in one case it is more direct as the result of the transparent policy. In the other case, where the inflation is applied to asset markets through investment policy, the end result is predicted to be lower profitability, because the inflation distorts the decisions of economic participants, thus the structure of capital, and it misaligns the factors of production, which harms a free market system in several ways, many of which we're just discovering today, but most of which have been known for almost 200 years.
Nonetheless, at that point where it finally derails profitability, confidence in the policy breaks down. Until that point, the nation enjoys an increasing purchasing power because the value of its currency is on the rise, along with asset prices, which makes everything priced in that currency cheaper. This is how such a system can be sustained, particularly more so when the nation's allies have a vested interest in the same currency (the dollar for instance is the main international monetary reserve).
It is also the source of the deflationary bias built into the infrastructure of economic policy. The rising foreign exchange value of the currency allows a central bank the luxury to pursue easy money policies enabling it to maximize the dollar's investment premium, and consequently, its purchasing power. It also enables it to fulfill its full employment mandate. But the term deflation is misleading because it implies not enough money; regardless that is not the true source of declining prices in such a system, which uses currency policy in order to sustain the inflation by introducing a "deflation like bias." So the question is not whether we will at all have inflation.
We've had that, continue to have that, and will continue to have it until we stop trying to cure this deliberated "deflation bias" with more inflation. Under such a system, should the stock of money stop growing the collapsing investment premium is likely to reverse foreign exchange relationships that have thrived on the successful inflation policy.
True deflation can only come about if the central bank actively pursues the policies of deflation - i.e. by raising interest rates enough to persuade a contraction in money supply - or if nations pursue a policy of fixed exchange rates, complete with capital controls, or once the inflation has run its long run course and ruins the currency to the point that sound money policies are forcefully employed, which means that we have to get to the point where we no longer yearn to resolve our problems with more inflation.
Beyond that the only deflation we'll ever have is a scare.
After all it's not like the US consumer saved all of his capital and bought cheap assets overseas with it for a rainy day. No, on the contrary, he, as did his foreign partners, parlayed their savings into increasingly expensive assets. What's more, they continue to do so despite declining earnings and share prices. And whenever the stock market crumbles, we cry out for more inflation because we're afraid of discipline.
Consequently, investors continue to make poor investment choices that lead to higher default rates and more business failures. It is this desperation that the Inflationists, Central Banks, Governments and Interventionists exploit. They employ policies to try and distribute the inflation fairly in order to sustain maximum complicity. But in the end, the dollar is only a medium of exchange, and its value depends on the efficacy of the inflation policy in sustaining an increasing purchasing power, which means sustaining an investment premium on the US dollar, or dollar denominated capital markets.
When profits stop growing, and the prospect for investment returns dries up, global monetary compliance is likely to weaken because confidence in monetary institutions will have begun to erode. I know you know we've arrived there, but the about face on trade policy by the current administration is likely to deal blow to this compliance. It is at that point where "too much money" will begin to manifest in the value of the coin (currency), in unpredictable and mysterious ways, that the dollar will or will not pass the mustard, as money. For investors that have faith in the United States economy because it is a system of capitalism, they are destined for the realization that the pillars of capitalism have been transferred away by the inflation policy of the Federal Reserve System.
For domestic investors that have not been able to see the inflation, to their delight the hidden tax is beginning to ripple throughout the (world) economy in the form of lower profits, increasing calls for deficit spending to sustain uneconomic enterprises, and outright blatant pleas for more money. Sooner or later, the taxpayer is going to see the effects of the current inflation policy as sure as he (or she) can add up his or her stock market losses. The efficacy of such policy depends on his ignorance, trust, and complicity. He will sooner or later be able to perceive the down trending lines on the charts that Wall Street keeps telling him are about to reverse like a rocket ship.
His falling confidence and declining willingness to participate in losing schemes will undermine investment policy all the more, and should worsen an inflation breakdown where foreigners finally decide to cash in their own chips.
Everything depends on preventing just such a breakdown in confidence, which will eventually result in the visible monetary debasement.
We argue that point is nearer by the day. The only deflation there has ever been in the post FDR US economy is by virtue of success of the inflation policy. The deflation bogeyman is part of a con that is quickly turning sour, and the realization that the system is just a big fat wealth transfer lies just around the corner.
It's really just that simple. Watch and see.
Liquidation versus Dollar Liquidation
No, it does not stop there.
The Treasury Secretary says that such a form of protectionism would be beneficial only to the few. What?!? And then a week later we see import tariffs slapped on the foreign steel industry? What's the big idea? Well, I guess there is a fresh allegiance to the "few." At any rate, Wall Street has taken to the idea that the US economy is at that point where inventories have finally been drawn down, presumably in the industries where there was a build up, at least according to Mr. Greenspan and his army of blue chip neo-analysts, which use this argument along with collapsing bond prices as evidence of an impending economic recovery.
The focus on inventories comes about by perceiving the economic world through aggregates. The idea is that if there was too much production of goods or services relative to aggregate consumption, the system will go through a period of liquidation where consumption continues to absorb excess inventories until production rates have to increase in order to sustain the aggregate demand. Now that's how you run a credit cycle all right. This kind of economic system all but requires the lender of last resort model because otherwise there would be bank runs. Yes, it's that simple.
But even in the aggregate, the logic is hedonistic. For one, isn't there a relationship between consumption, purchasing power, and stock, or asset prices? I mean, if the Fed could fuel consumption directly, great, but it doesn't. Stock prices, Real Estate prices and debt refinancing initiatives are some of its tools, as you know. So, the question a student of the aggregates ought to ask is what happens if stock prices crush consumption? To which Abby Cohen might suggest not to worry since the business people she talks to each day say they've been cutting away their rotten shell in order to become more profitable, which will sustain stock prices, because profits drive stocks.
Dear Abby, profits certainly should drive asset prices.
However, inflation is what has been driving stock prices, predominantly. Not only that, but if inflation has rotted the core, they may just be throwing the baby (the aggregate conomy) out with the bathwater. For as we know, too much money is neither a neutral variable nor does it end at the distortion of market prices. Recall that the entire concept of malinvestment is of monetary origin in the first place, as is economic justice, liberty, and perhaps even to a degree, morality, by way of any shift in economic justice.
With a sound system of money, economic malinvestments/volatility should not be as exaggerated as they seem today. Historians squabble about the historical record.
Some assert that volatility has always existed, even before the Fed; others say that sound money is a system of fixed exchange rates, as if fixity were the cure, and yet others say that volatility is the way of capitalistic life. It has reached a point where people are protesting against "unfettered capitalism" due to its inherent instability, as Mr. Soros likes to say. But a market system simply does not require long adjustment periods like the ones inferred today through a process of inventory liquidation.
An efficient market means that there is never excess or shortage. Only prices fluctuate, signaling the factors of production to shift around in order to produce what society needs. Theoretically, the free market should be less volatile because it is more predictable than an intervened-with market.
The point being that policies have unpredictable consequences except that in the end they create problems in the market; either they create shortages or surpluses.
A system of production based on maximizing consumption and supported by a lender of last resort can end many ways, but if the full employment agenda is taken to the extreme profits will eventually have to decline if the system is producing too much of the wrong stuff. Unfortunately, there is no way to know how much of the right or wrong stuff has been produced other than through hindsight.
For all we know, maybe this economy has produced too many dollars.
If by some strange chance that is correct, today's inventory liquidation could simply be the predecessor to tomorrow's dollar liquidation.
Certainly, there will be no shallow schmoozing broadcast on the boob tube about the proficiency (or lack thereof) of any recent Treasury inspired swindles in the bond market or anywhere else, because the rising price of gold is a barometer of the government's declining credibility, particularly in matters of money and capitalism.
Yes, you can take that prediction to the bank, and make another note: there are few instances in history where government economists have proven "generally" right. In addition, there are many instances in history where governments have manipulated, or targeted, prices, wages, and entire industries. Furthermore, they have never ever succeeded at increasing the welfare for anyone other than the few, in this manner.
How bearish is the rising tide of protectionism for the dollar? That depends on how it affects dollar demand, interest rates, the investment premium, consumption, business investment, productivity, and the resolute global monetary unity that has until now been able to repress dissent and maintain the State's lie, if you will.
I have to give Mr. Greenspan a pat on the back. I'm not sure he realizes that in discussing fallacious economics he invites science to systematically prove wrong all it has ignored before the age of the Internet. His learned background invites the rage of free market libertarians frustrated with his manipulative commentary. Whether he is conscious of it or not, he is calling out to science so it records this era properly. If only Mises were alive today! Or, perhaps Greenspan plans to bring him back to life.