stock market rose sharply on the final day of February and the first
Monday in March. Here’s why:
(Note: charts from the St. Louis Fed are constantly being revised,
but their Web addresses remain constant. All charts for this essay
are dated before March 5, 2002.)
The Federal Reserve System is now pumping in new money at over 20%
per annum. The St. Louis FED tracks the adjusted monetary base (AMB),
which is the one monetary component that the FED’s Open Market Committee
can control. This is the statistic of the actual holdings of monetary
reserve assets by the FED. Milton Friedman calls this “high-powered
money” because it serves as the base for all of the other market-generated
Because this is the one monetary component that the FED can control
directly, this figure is the best indicator of what the FED’s monetary
policy is. The other monetary figures are the results of money-holders’
allocation of assets into or out of the banking system.
The St. Louis FED not only graphs the AMB figure, it provides the
numerical rate of growth in the box beneath the chart. Since December
26, the increase has been 20.3% on an annual basis. Since late February,
2001, it has been 9.7%. Since July 25 — before 9/11 —
it has been 13.3%
There is no doubt that the FED is in full-scale inflationary mode.
It is not just in double-digit mode, but 20%. I will be surprised
if it stays this high for very long, but it is clear that Greenspan
is willing to keep the rate above 10%.
I don’t think Greenspan has increased the money growth rate to 20%
in order to give a boost to the U.S. stock market. The stock market
was not falling sharply, although it was heading down. He is concerned
about the overall economy. He gets blamed for recession. We were
in a recession last year, contrary to the financial press at the
time. He has inflated us out of it. The manufacturing sector of
the economy is at last positive, as reported the National Association
of Purchasing Managers (now called ISM). But manufacturing employment
continued to fall.
of Orders Index indicates that order backlogs grew for the first
time after 21 months of decline. ISM’s Supplier Deliveries Index
reflects slower deliveries for the second consecutive month. Manufacturing
employment continued to decline in February as the index fell
below the breakeven point (an index of 50 percent) for the 17th
consecutive month. ISM’s Prices Index remained below 50 percent
as manufacturers experienced lower prices for the 12th consecutive
month. . . .
is 54.7 percent in February, an increase of 4.8 percentage points
from the 49.9 percent reported in January. ISM’s New Orders Index
rose from 55.3 percent in January to 62.8 percent in February.
ISM’s Production Index rose 9.2 percentage points from 52 percent
in January to 61.2 percent in February. The ISM Employment Index
is at 43.8 percent for February, an increase of 1.2 percentage
points when compared to the 42.6 percent reported in January.
. . .
picture shows growth in manufacturing activity during the month
of February,” added Ore. “The PMI hasn’t been above the 50 mark
since July 2000, so this is certainly welcome news. Manufacturing
has struggled and hopefully this signals the beginning of a strong
recovery. . . .”
RATES AND CORPORATE DEBT
By injecting new reserves into the economy by purchasing U.S. government
debt — mostly short-term T-bills — the FED has lowered
short-term interest rates. This has killed the return for bank passbook
savings account holders and money-market fund savers. In the following
chart, you can see the dramatic fall in the commercial paper rate,
which parallels the T-bill rate. Compare this to the highest-rated
Aaa corporate bond rate. A year ago January, when the FED began
to lower the short-term rate, the corporate bond rate was a hair
above 7%. It stayed in the range until early December, when it fell
to 6.5%, where it has stayed.
Corporations borrow short-term money to finance inventories and
to keep their doors open. They finish projects that were begun prior
to the recession. CD-rates are emergency money rates and day-to-day
operations rates. The FED’s expansion of money since last January
has stimulated this kind of business activity.
What matters most for businesses, long-term, is the long-term corporate
bond rate. The lower this is, the cheaper it is to borrow long-term
money for financing land acquisitions, buildings, equipment, and
other longer-term productive assets. The FED’s stimulus package
has had very little effect here. It has not succeeded in driving
down corporate bond rates low enough to persuade managers to begin
loading up on long-term corporate debt.
What about the response of business to cheaper short-term and mid-term
money? It has sagged remarkably. Commercial paper (CD’s) has fallen
from over $325 billion to about $200 billion.
These are short-term loans. What we are seeing is remarkable. The
law of economics is this: “At a lower price, more will be demanded
(other things being equal).” But the short-term money rate has fallen
from 6% to under 2%, yet the amount CD money demanded has plummeted.
The decline in demand has been even more dramatic with commercial
and industrial loans from banks, which are longer-term loans. They
have fallen from about $1.1 trillion to $520 trillion — a drop
of over 50%.
Conclusion: other things have not remained equal. Despite falling
short-term and commercial loan rates, businesses have left the debt
markets in droves. This means that they have stopped expanding.
They are operating on the basis od retained earnings.
This is rational in a market that is not expected to produce profits
in the near future. If your business is not producing profits, or
is even producing losses, you don’t want to increase your debt load
unless you think that a turnaround in your firm’s profit picture
is imminent. What the fall in commercial loan demand indicates is
that American business decision-makers do not expect a turnaround
The St. Louis FED also surveys rates of investment in several areas
of the economy. On one page, it lists six areas of the economy.
Hard hit in 2000 were real private fixed investment and real nonresidential
fixed investment. The biggest hit was in nondefense capital goods
orders: down to a negative 25% at the bottom: the end of third quarter.
It rebounded to a negative 18% in the fourth quarter. But equipment
and software investment continued downward into the negative 10%
Only one area of the economy stayed positive: housing starts/home
sales. Here is the heaviest debt load for consumers. Housing is
basically a long-term consumer good, heavily funded by mortgages.
So, consumers have remained optimistic, long-term, but their employers
have grown pessimistic at least with respect to the short term.
Consumers believe that the housing market will always rise. They
think, “buy now, pay later.” They think, “I can lock in low-interest
fixed mortgage money today, and I’ll pay it off with depreciated
dollars.” This strategy has worked ever since 1946.
The credit markets are supplying this money to borrowers. The mortgage
market is presumed to be secured by the U.S. government, so Fannie
Mae and Freddie Mac keeps making available mortgage money to borrowers.
These enterprises are called GSE’s or Government Sponsored Enterprises.
If mortgage holders think they can win at the expense of mortgage-issuers,
why do people continue to put their money into pools of long-term
mortgages? Because they think these pools of capital are government-guaranteed.
They are looking for high returns short-term. They figure they can
sell off their holdings later if rates climb. They think they can
protect themselves against both default (because of a supposed government
guarantee) and interest-rate risk (by selling to new buyers if rates
go up). They assume that their investment will be liquid forever.
There is a Web site devoted to warning the public about the risk
to taxpayers from these GSE’s: FM Watch. It has warned against the
massive increase in derivatives in the mortgage-based GSE’s. It
has also warned against recent equity losses. The looming risk is
gigantic: “the GSEs now guarantee more debt and mortgage-backed
securities (“MBS”) than all comparable U.S. Treasury debt.”
11, the nation has learned that risks once deemed improbable can
quickly become possible. With the nation in a recession, all financial
institutions risk being adversely affected but none more than
Fannie Mae and Freddie Mac, two Government Sponsored Enterprises
(“GSEs”). For years, the GSEs have been permitted to operate on
thin capital cushions built for best-of-times assumptions. The
last few months have underscored the riskiness of GSE excesses
o and permitted GSE abuses arising out of September 11. Recent
developments are dramatic:
In the third
quarter of 2001, the value of Fannie Mae’s shareholder equity
fell by $10.6 billion, a result of risky hedging in the derivatives
market. Fannie Mae’s debt/equity ratio is now 53:1, five times
more than the average for commercial banks. If Fannie Mae were
regulated like a commercial bank, it would face serious risk of
In the week
following September 11, the Federal Reserve extended credit of
$81 billion to ensure adequate liquidity in the markets. On September
14, Freddie Mac moved in an entirely opposite — and counterproductive
— direction, issuing $5 billion in two-year notes that took
cash out of the market. No other debt issuer did so because the
markets were loathe to buy private company debt during considerable
market instability. But Freddie Mac exploited its implied government
guarantee to raise cheap money from frightened investors at a
time of national emergency. . . .
years, the dramatic growth in GSE debt has significantly increased
the risk to U.S. taxpayers. Fannie Mae and Freddie Mac have increased
their debt six-fold since 1992, from $196 billion to $1.26 trillion
in the third quarter of 2001. In a decade when Treasury borrowing
dropped dramatically, uncontrolled GSE debt was moving in the
opposite direction. Almost unbelievably, the GSEs now guarantee
more debt and mortgage-backed securities (“MBS”) than all comparable
U.S. Treasury debt.
has been issued chiefly to fund a lucrative investment portfolio,
which was undertaken solely to grow profits for GSE shareholders.
Here’s how it works: the GSEs borrow funds cheaply because of
their implicit government guarantee, then invest them. The above-market
returns are highly profitable — but do nothing to increase
American homeownership. In 2000, both GSEs reported that this
arbitrage investing accounted for approximately 60 percent of
their net income. That’s like a local government issuing a revenue
bond to build a schoolhouse, then using part of the money to play
the stock market. If the GSEs bet right, their shareholders profit.
If they bet wrong, the U.S. taxpayer loses.
this debt growth, the GSEs are also leveraged far beyond what
would be permitted for other financial institutions. At year-end
2000, the GSEs’ debt-to-equity leverage for on-balance sheet liabilities
was 30:1 versus 11:1 for commercial banks. If the GSEs were to
meet the standards imposed on commercial banks, they would need
to hold $82 billion in capital — or double their current
amount. In their current condition, the Federal Reserve would
deem them “significantly under-capitalized” — and they would
face serious risk of closure. These institutions simply are woefully
undercapitalized — a situation that becomes more perilous
during a recession.
attempt to mitigate the risk associated with their debt through
extensive reliance on derivatives. From 1995 to 2000, the GSEs’
derivatives exposure increased over 400%. At the end of last year,
the GSEs had $749 billion in such exposure. This is a massive
amount of derivatives exposure.
above, recent events underscore the riskiness of a derivatives
strategy. In the third quarter of 2001, Fannie Mae reported a
startling write-down of $10.6 billion in shareholder equity, reducing
its equity by 29 percent from where it stood just three months
earlier. Fannie Mae took a big position in the derivatives market
and bet wrong. As a result, Fannie Mae’s debt/equity ratio shot
up to 53:1. This approaches a doubling of the GSEs’ year-end 2000
leverage ratio of 30:1.
THE HOUSING MARKET FALTERS. . . .
I don’t think that Greenspan is worrying much about the stock market.
If there is one area of the economy that must get his attention,
it is the mortgage market. The housing market kept the economy from
falling into even greater recession in 2001. This is because of
the existence of what is perceived as both safety and liquidity
in the mortgage industry’s GSE’s. Huge pools of capital have been
formed to keep home buyers happy. I receive a bulk e-mail (spam)
offer for cheap mortgage money every day. This has been going on
for at least a year. Investors perceive these markets as low-risk
yet paying an above-market rate of return. Borrowers perceive the
debt as profitable: use the home now, see it appreciate, and pay
off the mortgage with cheaper dollars.
It is perceived as a win-win deal because of the presence of an
assumed government guarantee. If this guarantee if ever perceived
by investors as an illusion that Congress cannot back up with money,
then the breakdown of the housing markets will be far worse than
the S&L crisis of the mid-1980’s. Liquidity will disappear.
I think the FED is providing liquidity mainly to keep this market
solvent. The problem is, the constant increase in credit money continues
to distort the capital markets. Eventually, monetary inflation will
produce price inflation. Long-term interest rates will then rise
to compensate lenders for the expected decline in the dollar’s future
purchasing power. Equity in mortgages already held by investors
will fall. There will be a derivatives-based, Enron-type event,
on a scale vastly larger than Enron.
Congress worries about another Enron, yet its own policies are creating
the biggest potential Enron-type event in history.
Housing got through the recession of 2001 unscathed. Any time an
investment market is perceived as low-risk, capital flows into it.
On the one hand, consumers are willing to borrow. On the other hand,
lenders are willing to lend long-term. Liquidity looks permanent.
The win-win nature of the arrangement is still widely perceived
as low-risk. This is the classic mark of a bubble.
My friend John Schaub, who has spent his career in real estate investing,
is convinced that we are close to a housing market peak. If he is
right, then the biggest bubble of all is looking not just toppy
We are still in a repressed
depression. The Federal Reserve System is still in inflationary
mode. The war against a free-market-based readjustment of capital
values according to supply and demand with monetary stability is
still being conducted by the FED. No one in power wants to know
what the conditions of supply and demand would be in a world without
monetary inflation. So, the inflation-produced distortions in the
capital markets are continuing, as usual. The dollar is still depreciating.
The annual increase in the median consumer price index jumped from
2% in December to 3.7% in January.
The war against the dollar’s purchasing power will continue. When
it comes to attaining a world governed by free market pricing instead
of monetary manipulation by a handful of central bank bureaucrats,
everybody wants to go to heaven, but nobody wants to die.