What Goes Up Must . . . Stay Up?

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In 1999, the
Federal Reserve System pumped in fiat money at a very rapid rate:
as high as 15%. Then it reversed course and began slowing this rate,
actually shrinking the monetary base briefly in early 2000. In response,
the stock market began to fall, beginning in March.

In May, 2000,
the FED reversed course again and began pumping in fiat money in
order to force down the federal funds rate, which was at 6.5%. This
is the rate at which commercial banks lend to each other overnight.
This rate-reduction policy was in preparation for a recession, which
arrived the following March. The FED continued its expansion of
money. Then came 9/11. The FED then forced even more fiat money
into the economy. The
chart of the adjusted monetary base reveals the erratic policy of
the FED.

The American
stock market peaked in March, 2000. It kept going down for the next
three years. So did the federal funds rate after May, 2000. The
FED fought the falling market, then fought the recession, then fought
the potential 9/11 aftermath with the only significant tool it possesses:
the monetary base. It kept buying U.S. government debt with newly
created digital money. This money was spent immediately by the government.
It multiplied through the fractional reserve banking system.

This is the
traditional policy of central banks: avoid the free market’s downward
readjustment of capital prices by flooding the economy with fiat
money. This policy subsidizes equity investors: stocks, real estate,
and commodities. The losers are those on fixed incomes, consumers
who pay higher prices, and (eventually) bond investors.

By June, 2003,
the federal funds rate was down to 1%. It stayed there for the next
year. Then, on June 30, 2004, the FED began announcing a series
of increases of 0.25 percentage points every six weeks for two years.
It adjusted its monetary policy to accommodate these announcements.

The federal
funds rate has not changed since June 29, 2006: 5.25% — over five
times higher than in May, 2004.

THE STOCK
MARKET

The movement
of Standard & Poor’s 500 stock index paralleled these changes.
You can see this in the
10-year chart
: down until mid-2003, when the FedFunds rate bottomed;
up since then. It is approaching the 1550 level it attained in March,
2000. It is still about 100 points away from that peak.

What does this
relationship tell us? In and of itself, it tells nothing that makes
investment sense. It shows that a falling FedFunds rate was accompanied
by a stock market decline, and a rising rate was accompanied by
a stock market increase. This is reminiscent of the observation:
"Low-fat cottage cheese must make people fat, because only
fat people eat the stuff."

Falling rates,
2000—2003, did not cause the market’s decline. Falling rates
were the FED’s response to this decline. Similarly, the rise in
rates after 2004 did not cause the recovery. It paralleled the recovery,
which had begun a year before. It was the FED’s attempt — so far
successful — to keep price inflation from raising long-term rates
and thereby tanking the bond market and mortgage markets.

Austrian economic
theory tells us that a central bank can undermine the capital markets’
reallocation of capital in response to a change in central bank
inflation. It does this by returning to monetary inflation. The
misallocation of capital continues.

Greenspan’s
FED adopted a monetary policy that accommodated a falling FedFunds
rate from early 2000 to mid-2003 in an attempt to slow and then
reverse the decline in the economy — a decline which was reflected
in falling stock prices. The economy slowly emerged from the recession
by November, 2001, but the stock market continued to decline. The
FED therefore continued to decrease the FedFunds rate. Not until
June, 2004, did the FED allow the rate to rise above 1%.

This was the
lowest FedFunds rate in a generation. Only after persuading stock
market investors that the FED was willing to keep this rate down
to an historic low until the economy revived enough to raise stock
prices did Greenspan & Co. decide to let the rate creep back
up.

This monetary
policy kept the housing market from following the stock market into
the tank in 2000 and beyond. It did more than this; it continued
to stimulate boom conditions in coastal regions. The post-1996 housing
boom did not falter. Easy money kept it alive.

Public economic
optimism did not falter, despite the 2001 recession and 9/11. This
is because most people assess their wealth by their job status and
the value of their homes. Most people don’t own stocks directly.
They may own stocks through their pension funds. So, the so-called
wealth effect — the willingness to borrow and spend to buy consumer
goods as personal net wealth rises — is more closely related to
the job market and the housing market than to the stock market.

Today, the
non-NASDAQ stock market is in its early 2000 range. (The NASDAQ
is still less than 50% of its 2000 high.) Net personal saving is
either negative or close to it. The
trade deficit
is approaching $750 billion if the monthly rate
is extended for a year from December, 2006. This is in line with
the $763 billion figure for 2006. In 2000, it was around $378 billion.

In 2000, the
gross domestic product was $9.8 trillion. In 2006, it was $13.2
trillion. That is a 35% increase in GDP, compared with a doubling
of the trade deficit. The trend is not good.

OPTIMISM
ABOUNDS

Despite the
abysmal performance of the S&P 500, 2000—7 — a
slight loss — and despite the far worse performance of the export
sector of the American economy — declining competitiveness — and
despite the disappearance of personal thrift, optimism abounds in
the Establishment financial media.

The stock market
bulls are as bullish today as they were in 2000, just before the
S&P 500 lost half its value.

The housing
market bulls are insistent that the bottom of the decline — a decline
they failed to foresee — has now been reached.

The economic
bulls are insistent that deficits don’t matter — not on-budget Federal
deficits, not off-budget Federal deficits, and not trade deficits.
We can eat, drink, and be merry, for tomorrow we will eat, drink,
and be even merrier. Nor will our health care expenditures bankrupt
Medicare, despite its present funding shortfall of $60 trillion,
which keeps rising.

This is the
optimism of the drug addict who is living off of the "generosity"
of the drug cartel, which has temporarily lowered its prices in
order to extend size of the market. Things seem rosy now. Instead
of mind-altering drugs, the most abused substance today is central
bank fiat money. Instead of a drug cartel, we face a central bank
cartel. Instead of poppies grown in secluded off-shore regions,
the off-shore export to the West is Asian money. But the strategy
is the same:

"The
first trillion dollars in below-market yuan are free, kid. Try
it. You’ll like it!"

Oh, baby, do
we Americans like it! "More! More! I want more!" Free
money always sells well. So do discount wide-screen TVs, 7.1 Dolby
receivers, and other trinkets for grown-ups.

As consumers,
the North American—European West is becoming dependent for
its lifestyle on low-cost imports from Asia. These imports are subsidized
by Asian fiat money, which keeps their currency exchange rates low,
thereby encouraging purchases of Asian goods.

This is the
economic equivalent of foreign aid to the West. It is an Asian version
of America’s Marshall Plan. It expands the market for exports, just
as the Marshall Plan did for American exporters. It therefore subsidizes
the domestic export sector by means of wealth extracted by the government
from its own citizens. It creates dependence on the part of the
recipients, just as Marshall Plan money did in the late 1940s.

Expressed another
way, this is the economic equivalent of a government-funded welfare
program. It hurts the suppliers of wealth (Asian workers, who have
fewer goods to buy) and benefits the recipients (Western consumers,
who have more goods to buy). But it creates lifestyle dependence
on the part of the recipients, just as every government-funded welfare
program does.

Americans have
become more dependent than Europeans have. We are the world’s "inner
city ghetto" society: more consumption than production. We
have the trade deficit to prove this. Our domestic personal savings
rate has fallen to zero. Our time frame has shortened. Instead of
investing, we are spending.

Asian central
banks are buying U.S. government debt with their fiat money. This
holds down America’s interest rates, thereby contributing to the
reduction of American thrift: a lower return on non-equity capital
(bonds, CDs). This is the classic effect of central bank-issued
fiat money: a boom economy stimulated by artificially low interest
rates.

This short-term
boom effect pleases Establishment economists. Keynesian economics
assumes that demand is everything for economic growth. Supply-side
economics assumes that supply is everything for economic growth.

In contrast,
Austrian economics assumes that freedom is everything for economic
growth — a freedom that denies the legitimacy of government-created
monopolies called central banks.

Keynesian economists
are therefore optimistic: Westerners are buying. Supply-side economists
are equally optimistic: Chinese workers continue to accept China’s
central bank policies that transfer a large share of the workers’
output to Western debtors.

In contrast,
Austrian economists — at least those who actually believe what Ludwig
von Mises wrote about the business cycle — are not optimistic, because
central bank monetary inflation (China’s and Japan’s) have created
an international economic boom, which must inevitably be followed
by an international economic bust.

The
Chinese stock market (Shanghai) is now becoming a bubble.
Chinese
government officials have admitted this publicly — something unheard
of in American political circles.

The Asian central
banks’ misallocation of capital is now international. Free trade
and government-managed trade have integrated the world’s markets,
including the capital markets. There is no King’s X from the business
cycle, other than in North Korea, which is always a bust.

As surely as
the drug cartel makes money by exporting reality-distorting substances,
so have Asian central banks made money for their nations’ export
industries through exporting a reality-distorting substance: fiat
money.

As surely as
it is unwise to turn over your automobile to a drug-abusing driver,
so is it unwise to turn over capital markets to drug-abusing commercial
bankers, who are protected by law from bank runs and other impediments
that are imposed by the free market. At least the stoned drivers
are not subsidized by the Federal government. The stoned commercial
bankers are.

RAISING
DOUBTS

Those few economists
who doubt the wisdom of central bank national cartels are also doubtful
about the sustainability of any economic boom, or any booming capital
market that is dependent on continuing subsidies from commercial
banks by way of central banks.

The biggest
doubt on today’s horizon is the housing market. The cloud no larger
than a man’s hand is the sub-prime lending market. High-risk home
buyers who thought they could become owners are discovering that
rising interest rates, rising property taxes, and standard maintenance
expenses are squeezing their after-tax income. They are not careful
budgeters. They are now trapped by loans made by a banking system
that thought it had passed risk on to quasi-government agencies
such as Fannie Mae and Freddy Mac.

There is a
great website called The Mortgage Lender Implode-O-Meter. It tracks
the number of bankruptcies of sub-prime lenders since December,
2006. The number keeps rising weekly. It is up to 23, as of February
14, but don’t expect this figure to peak at this level. This process
is just getting started. On this site are links to the latest articles
on the sub-prime real estate market. Track
this here.

If the Keynesian
optimists are correct — that the housing market has been the engine
of recovery in the American economy — then this site is like a dose
of ice water. But these optimists remain optimists even though the
basis of their optimism — the wealth effect of rising housing prices
— is no longer operating.

The
Economist
(Feb.
15) reported
:

Should loan
losses climb, investors in mortgage-backed securities will also
get burnt, especially those holding the riskier, higher-yielding
bonds. Financial engineers worked their mysterious magic with
these securities, turning the junkiest mortgages into high-grade,
sometimes AAA-rated, securities. They could do this only with
the blessing of credit-ratings agencies, which made a profitable
business out of rating these securities. But critics say the agencies
got complacent, and doubt the pooled loans were sufficiently diverse,
or sliced up with sufficient art truly to have dispersed risk.
One possible blind spot is that the dodgiest mortgages all behave
similarly in times of stress. Another is that it is hard to avoid
heavy exposure to mortgages from California, the biggest market
in America, where alternative products were popular.

Keynesian economists
are rightly worried about the reduced wealth effect of falling housing
prices: reduced consumer spending. Supply side economists are rightly
worried about the threat of rising interest rates on the domestic
home building market: reduced supply.

In contrast,
Austrian economists see this as the long-delayed response to an
overheated market. This is the free market reasserting itself. Now,
if the Federal Reserve will just keep its bureaucratic hands off
the digital money machine. . . .

That’ll be
the day!

CONCLUSION

When equity
markets fall, most economists and politicians call on the FED to
lower rates, meaning the FedFunds rate. Assumption: When equity
markets fall, short-term rates should be forced down to get equity
markets back up.

When equity
markets are rising, most economists and politicians do not call
on the FED to raise rates. They remain silent as short-term rates
rise. In fact, optimism becomes widespread. Rising rates are not
seen as a threat to rising equity markets. "Don’t worry; be
happy."

The optimists
never issue warnings to sell equities when rates rise. They issue
warnings to buy when rates fall.

In their world,
markets that have been falling — which optimists never predict —
have fallen as far as is likely. Markets are at the bottom. "It’s
time to buy." On the other hand, equity markets never rise
as far as is likely. "It’s time to buy."

When
is it time to sell? On the twelfth of never.

February
21, 2007

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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