Greenspan: 'The Devil Made Me Do It!'

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One
of my favorite Flip Wilson characters was Rev. Leroy, the pastor
of the Church of What’s Happening Now. I am not a fan of cross-dressing,
so I was not a fan of Wilson’s Geraldine. But Geraldine’s immortal
line — "The Devil made me do it!" — was always good for a
laugh. Combine Rev. Leroy and Geraldine, and you get Alan Greenspan.
I am tempted to call him Rev. Al, but Al Sharpton has a lock on
the title.

The
Federal Reserve System is surely the economy’s Church of What’s
Happening Now. What is happening now is not much. That’s what has
been happening for several months.

The
adjusted monetary base is
the one monetary component that the FED controls directly. When
it buys or sells Treasury debt, the statistic goes up or down, respectively.
This is high-powered money: the money that serves as the legal reserve
for the commercial banking system. These days, the AMB is barely
moving. In the most recent reported week, it was moving down.

This
is consistent with the FED’s announced policy of raising interest
rates, which means short-term rates. The American economy is expanding
today, while the money supply’s legal monetary base is flat. The
presumption is that interest rates — the price of borrowed money — will
rise: more demand, fixed supply.

The
other major monetary statistic that I watch closely is MZM:
money of zero maturity
. I think it is closest to true money:
no waiting. It has been flat — peak to peak — for eight
months, which is a considerable period of time in the world of the
FED.

What
about consumer prices? There is no agreement among forecasters and
economists as to which official consumer price index best reflects
the condition of Joe Average. I use the median CPI, which is published
monthly by the Federal Reserve Bank of Cleveland. The median CPI
is a weighted median of the CPI. As a price inflation predictor,
it does pretty well. November’s increase was 0.1%, or 1.1% annualized.
Year to year, the increase was 2.3%.

So,
from the point of view of statisticians, the FED is achieving its
stated goal of bringing down price inflation. It is also acting
consistently with its stated goal of raising short-term interest
rates.

But
. . . the fall in the rate of price inflation tends to reduce long-term
rates, meaning bond and mortgage rates. Why? Because a permanent
reduction in the expected rate of price inflation reduces the fear
of lenders that they must add a money depreciation factor into long-term
loans. Ludwig von Mises called this the inflation premium of the
free market’s interest rate.

If
lenders believe that today’s rate of price inflation — low — will be
maintained for the duration of the loan, they will be willing to
lend money at a lower rate of interest than they would if the rate
of price inflation were higher.

This
reduction in the long-term interest rate can be offset by a reduction
in the demand for long-term loans. If borrowers think they will
have to pay off their debts with money that is less likely to depreciate,
they may be less willing to take on new debt. Maybe they planned
to stick it to lenders good and hard by riding the wave of price
inflation and repaying the loans with funny money.

At
present, we are seeing rising short-term rates and stable long-term
rates. Mortgage rates fell slightly in the first week of January,
and are slightly lower than they were a year ago.

If
the FED sticks to its present policy of stable money, price inflation
will become a declining factor in the long-term credit markets.
Long-rates will not rise as fast as short rates will. This raises
the specter of recession.

THE
INVERTED YIELD CURVE

When
90-day T-bills pay more interest than 30-year T-bonds, we call this
an inverted yield curve. Why inverted? Because it’s abnormal. Why
abnormal? Because it is normally riskier to tie up your money for
30 years than 90 days. So, the interest rate on long-term money
is higher: a default-factor premium.

For
short-term rates to exceed long-term rates, there has to be an intense
demand for short-term loans. What would cause this? This: fear of
falling demand for goods and services — a fear so great that business
borrowers want to finish existing capital projects. They may be
facing falling revenue, or expect to, which pressures them to shut
down uncompleted projects. They resist shutting them down, for obvious
reasons: incomplete projects produce no income, yet existing debt
must be paid off, whether a project is shut down or not. So, they
want short-term money to tide them over. Demand for short-term loans
rises in relation to demand for long-term loans, which frighten
borrowers who think recession is coming.

The
inverted yield curve is the best predictor of recession I know of.
The Federal Reserve in 1996 published a paper that reached the same
conclusion. I used this indicator to forecast Bush Sr.’s 1990 recession
and Bush Jr.’s 2001 recession.

Today
in the United States, we do not face an inverted yield curve. Britain
does. Here are the observations
of John Mauldin
, author of Bulls
Eye Investing
(Wiley, 2004). He used to be the manager of
my newsletter, Remnant Review. I introduced him to the yield
curve 15 years ago. John is something of a quant. He loves rows
of numbers. He monitors numbers. Here is what he has discovered.

UK
unemployment is an amazing 2.7%. I am sure there are examples,
but I cannot recall a major economic country with such a low unemployment
rate. Inflation, although rising, is still under 2%. Wages rose
by 4.4% in the three months through October, the highest rise
in several years and more evidence of nascent inflation.

The
housing market is doing quite well, thank you. In what everyone
calls a bubble, housing in England still rose 12.5% year over
year in November, although only 0.2% in the last month. Could
it be slowing? UK household debt is 140%, which is above US levels.

The
Bank of England recently noted, "Any sustained fall in [house]
prices would reduce homeowners’ cushion of housing equity. This
might reduce their opportunity to re-mortgage to consolidate other
debts or to lower their monthly payments. Financing difficulties
would be exacerbated if any fall in house prices were accompanied
by a wider economic slowdown." (Marshall Auerbach at Prudent
Bear). . . .

The
Bank of England is in a hard spot. They have been steadily raising
rates to keep inflation in check and to rein in the white-hot
housing bubble. Since the housing market is still doing well,
and inflation is rising, one would think they should continue
to raise rates. But with an inverted yield curve and a very strong
pound, raising rates might not be wise, as that could push the
country into recession.

If
I lived in England, I would be getting my personal house in order.
No long only stock funds, switching to bonds and absolute return
type investments and funds. While the Fed study on yield curves
was based on US precedent, the rule generally applies everywhere.
Thus precaution is the order of the day. . . .

I
think England may be 6—9 months ahead of us in the softening
process.

Mauldin
calls the inverted yield curve in Britain the canary in the coal
mine. Miners used canaries to predict gas leaks. The canaries would
stop chirping, due to the inconvenience of just having died.

I
say, let the Brits perform this useful function.

THE
GOLD/DOLLAR/EURO RELATIONSHIP

Gold
has been rising against the dollar at about the same rate that the
dollar has declined against the euro. Gold has not risen in the
euro price. This indicates that the problem is the dollar, not a
shortage of gold internationally.

The
dollar has rallied against the euro in recent days. A number of
contrarians predicted this, including Dan Denning of Strategic
Investment and Marc Faber of the Gloom, Doom, and Boom Report.
Both remain bullish on gold long-term, but both were convinced that
the dollar had been oversold in relation to the euro. Faber’s
report is especially prescient, published on December 1.

Regular
readers of this column know that my view remains that the US economy
is in deep trouble and that the US dollar is a doomed currency,
which will over time lose all its value. However, even within
a downtrend there can be countertrend rallies the same way there
can be significant corrections within an uptrend. Right now the
situation we find in financial markets is as follows. The US stock
market and other stock markets around the world have risen from
their late October lows in typical post election rallies (see
November report entitled, "Conflicting Trends"). However,
it is quite common that these post election rallies fade out relatively
soon, as was the case when Richard Nixon was elected in November
1972. This was followed by further strength but the stock market
made its final high in January 1973 — slightly higher than
in December 1972 — before entering a devastating two years’
bear market.

Since,
at present, the US and also other stock markets around the world
have become significantly overbought (see relative strength indicator
in figure 2) amidst record bullish investors’ sentiment it is
very likely that either a top is already in place or about to
occur within days, which should be followed by a correction of
around 5% at the very least and lasting into mid December.

From
a mid December low we should then get a year-end rally into January,
whereby I am expecting that numerous technical indicators will
fail to better their current high readings. This should then lead
to a more pronounced downturn into February.

The
first week of January brought a downward move for the stock market.
There was a rally in December, but it ended in December. In this
light, it is useful to consider the other half of Faber’s prediction.

Above
I mentioned that the US stock market is now — in the near
term at least — in significant over-bought territory. The
opposite seems to be the case for the US dollar, which has now
reached an extremely over-sold position. . . . I am not so sure
that the dollar is now over-valued against the Euro. Quite on
the contrary, from a recent trip to Europe it is my impression
that at the current exchange rate the dollar is — purely
on its purchasing power compared to the Euro — somewhat undervalued.
As a result, I think that the most likely financial developments
in the next few weeks will be a setback in US equities and a rebound
in US dollars. In particular, I should mention that numerous large
currency and commodity funds have huge leveraged dollar bear positions
outstanding, which could rapidly unwind once the dollar begins
to rally. I suppose that if the US stock market could decline
within a long-term uptrend by 21% in one day — this happened
on October 19th 1987 — the US dollar could easily
rally by 5% to 10% within a short period of time. (http://snipurl.com/b6q4)

THE
DEVIL MADE THEM DO IT!

Alan
Greenspan has been unwilling to do what his predecessor Paul Volcker
did, 1979—82: stabilize money, let interest rates rise, suffer
a recession (some would say two), and eliminate the inflation psychology
from the markets. Volcker faced a far worse situation in 1979 than
Greenspan faces today: roaring inflation, T-bill interest rates
over 20%, and mortgage money at 14%. He stuck by his guns until
Friday, August 13, 1982, when Mexico threatened to default. The
reinflation began in earnest the following Monday.

The
FED under Greenspan since 2000 has created extensive monetary inflation,
a downward unprecedented manipulation of short-term rates even before
the 2001 recession began, and a housing run-up in most regions and
a bubble on the two coasts. This followed the FED’s expansive policies,
1995—2000.

Now,
if we are to believe the figures, the FED has repented. The Open
Market Committee has gone forward at the altar call, pledging to
turn back from their wicked monetary ways. We shall see. If the
FED sticks to its guns the way that Volcker did for almost three
years, the inverted yield curve will return. There will be another
Bush recession. The housing bonanza will end. But the dollar may
stabilize.

How
likely is this scenario? Not very. The FED will not stick to its
guns for three years. Greenspan has shown again and again, from
the first month he was in office (October, 1987), that the FED stands
ready to supply liquidity.

Today,
the FED is following the traditional post-election policy of tightening
money. In fact, this policy began even before the election. This
policy of stable money after a period of expanding money traditionally
ends a stock market boom, as Faber has described: Nixon, 1973. This
is followed by a recession: Ford, 1975.

Central
bank policies of stop-and-go monetary inflation produce stop-and-go
recessions. In 1972, F. A. Hayek’s book, A
Tiger by the Tail
, appeared. It was a collection of essays
on the monetary policies of the West. He argued that monetary intervention
had created a tiger of debt and misallocated resources. By the time
of his death two decades later, this tiger had grown much larger.
The expansion of nominal debt had been subsidized by the expansion
of fiat money. The aggregates grow larger. The web of debt grows
more intricate.

How
do we get off the tiger? If we failed after 1972, why would anyone
believe that Greenspan is ready and willing to play Roy to Volcker’s
Siegfried?

CONCLUSION

I
am not worried about price inflation in the near term. The FED’s
monetary policies over the last six months — really, over the last
year — have already turned down the burner.

I
don’t think the flame will be kept at low simmer. But until the
FED’s policy-makers see the reappearance of the inverted yield curve,
they are unlikely to return to the monetary policies of 2001.

This
is why the stock market is still in trouble. To rescue the dollar
in relation to the euro, the FED has adopted a stable money policy.
The trade deficit will continue if the dollar stabilizes against
the yen, and if China continues to link the yuan with the dollar.

The
boom, such as it is, is doing more for export-driven manufacturers
in China and Asia than it is for Detroit. Stabilizing the dollar
will not alter this effect of FED policy . . . until a recession
hits. Not until consumers get scared — really scared — are they going
to turn down Asian offers to buy now, pay later.

Americans
seem to be addicted to easy money, low interest rates, and imported
goods. Greenspan has announced higher interest rates, which can
be attained only by tighter money. The FED is providing tighter
money. But there is no indication that the public is ready to cut
back on buying imported goods. There are too many yuan and yen flowing
into our capital markets.

When
that flow is reduced, then the party will come to an end. Until
this happens, American consumers seem determined to take advantage
of the largesse of Asian investors and central banks. Americans
are letting Asians buy future income streams generated by America-located
capital, and they are using the money to buy goodies.

We
are selling our seed corn. It’s easier to sell it than grow it.
It’s easier to buy on credit than to save. Asians are taking advantage
of our present-oriented time perspective. It is if they were structuring
their economies in terms of the book of Deuteronomy.

The
LORD shall open unto thee his good treasure, the heaven to give
the rain unto thy land in his season, and to bless all the work
of thine hand: and thou shalt lend unto many nations, and thou
shalt not borrow. And the LORD shall make thee the head, and not
the tail; and thou shalt be above only, and thou shalt not be
beneath; if that thou hearken unto the commandments of the LORD
thy God, which I command thee this day, to observe and to do them
(Deut 28:12—13).

January
8, 2005

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.freebooks.com.

Gary
North Archives

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