by Gary North
Consider the effect of a practical joker who, late at night, switches a road sign that says "Detour" to one that says "70."
If the police caught him, he would be given a jail sentence.
Now consider the effect of Alan Greenspan's policy of monetary expansion — in 1987, in 1995, and 2001. In each case, the interest rate was sending a signal: "Detour." In each case, he switched signs. Then he provided the liquidity necessary to legitimize the sign.
The problem is, each time he did this, capital was redirected from "Caution: Washout Ahead" to "70 Miles per Hour." He kept the stock market from falling, but he filled the highway with care-free drivers who put the pedal to the metal and pushed the cruise-control button.
This is what the Federal Reserve has done every time there have been signs of a recession, from 1930 to the present.
This is official policy. Every time the FED follows the familiar scenario, the public learns a lesson: "There is a floor below which my investment portfolio will not fall." In recent years, this has become known as the "Greenspan put."
A put is a contract to supply a capital asset to a buyer at a fixed price over a specific time period. So, if the price falls below the contract price, the holder of the put makes money. He can sell the underlying asset for the higher price allowed by the contract.
For someone holding lots of stocks, a put lets him insure his position against a serious fall in the stock market. Most of what he loses in the stock market he will re-gain with his put.
A "Greenspan put" was the investment world's term for a way to keep investors from losing too much money in a market meltdown.
The problem with this puts-for-all policy is the means of securing it: monetary inflation. It produces a constant upward ratchet of consumer prices.
Recently, I gave a speech to a group of trainees in an inner-city job search program. I told them about my first job. It paid a dollar an hour.
To let them know what this income was worth in 1957, I went to the site of the government's Bureau of Labor Statistics. I used the site's Inflation Calculator to see what I would have to earn today to match $1. It turns out to be $7.25.
In 1957, my employer paid $30 a year to Social Security. I did, too. That was a total of $60, or today's equivalent of $435. Today, for a person working 40 hours a week for 50 weeks, that's 2,000 hours, times $7.25 = $14,500. (This year, I will pay $14,400 into Social Security.) The combined Social Security taxes on $14,500 is $1,798. On top of this will be a Medicare tax: two times 1.45%, or a total of $420.
I was a lot better off financially in 1957 than today's entry-level worker is today. That is an unstated cost of the Federal Reserve System's constant sign-switching.
PUTTING FAITH IN THE PUT
The business cycle is the product of this sign-switching. This has been known for over eight decades, but only to investors (few) and economists (fewer) who are aware of the Austrian School of economics' monetary theory of the trade cycle. Ludwig von Mises pioneered this explanation back in the early 1920s, in the second edition of his book, The Theory of Money and Credit.
Mises recognized that it is interest rate manipulation that is the heart, mind, and soul of central banking. Central banks lower the rate of interest so that businessmen will invest in job-creating capital. The businessmen are lured into a false belief, namely, that investors have saved money, thereby making this money available for investment by businesses. But the underlying reality is that investors are not the source of money available for capital investment. The central bank is.
The central bank, unlike investors, does not restrict consumption in order to make money available to businesses. So, businessmen are lured into a false assessment regarding the willingness of investors to postpone consumption for the sake of future returns. The injection of new funds adds to the demand of all goods, but initially, this demand is confined mainly to capital goods. Demand is from people who are willing to borrow money, either from commercial banks or the government.
More money is now chasing the existing supply of goods, especially capital goods. Business costs will soon begin to rise, thereby calling attention to the false signal in interest rates, when the central bank expanded the money supply.
During the boom phase of the monetary expansion, capital markets boom or, if they had been falling, reverse. Greenspan reversed the 22% one-day decline in October, 1987, by means of fiat money. He created the stock market boom of 1995—2000 with fiat money. He created the stock market reversal of 2000 with fiat money. He created the housing bubble, too.
The booms were accompanied by falling interest rates. Falling rates accompanied the capital boom. It did this because of switched signs and a fiat money policy to back them up.
Pavlov was a Russian psychologist who conducted a famous experiment. He would ring a bell when he fed a group of dogs. They would salivate when the smelled the food. Then, after he trained them to associate food with the bell, he found that they would salivate when he rang the bell, even when he gave them no food.
For almost two decades, lower rates have meant "Greenspan put." Whenever he rang the bell by announcing a lower federal funds rate, investors bought stocks. This made them money because the FED supplied sufficient fiat money to force down other rates. In the supply and demand for money, more money lowered the market price of loans — temporarily.
This procedure got investors to salivate whenever the FedFunds rate was forced down by (say) half. When it was forced down from 6.5% (mid-2000) to 1%, (mid-2003), investors grew confident about buying stocks once again.
Home buyers never lost confidence. Prices soared after 1995.
So, when the FED ceased inflating heavily after 2002, and the FedFunds rate slowly but surely increased by .25 percentage point eight times a year, investors did not lose confidence in the boom. The boom had a floor. It had a Greenspan put.
Greenspan became chairman in 1987. He was thought to be a closet gold standard economist. His reputation as a man who was hostile to inflation preceded him. He never ceased delivering verbal warnings against price inflation. But the ratchet of fiat money never ceased.
THEN CAME BERNANKE
Bernanke arrived with the reputation of being committed to fiat money. His 2002 speech in which he playfully described the FED as a helicopter filled with paper money made him "helicopter Ben."
This was an indication that he stood ready at all times to extend the Greenspan put policy. Stock market investors breathed a sigh of relief when he was sworn in as Chairman of the Board of Governors in February.
Lo and behold, the FED immediately adopted a policy of stable money. The adjusted monetary base, which had been chugging along in an upward direction, went flat.
Then the FED stopped hiking the FedFunds rate. It peaked at 5.25%.
What investors and financial media commentators do not seem to understand is that the FED influences the FedFunds rate by monetary policy. It does not merely announce a rate; it announces a rate and then supplies money to establish it.
By the time the FedFunds rate peaked at 5.25% on June 29, the FED had stabilized the monetary base for over five months. Its subsequent announcements, the FED announced an unchanged rate.
Investors in stocks, like Pavlov's dogs, salivated. No more rate hikes! The FED would not threaten the capital markets with a tight-money policy. They started buying shares.
In the meantime, the price of silver and gold peaked on May 12, and were heading down by June 29. They continued down.
The precious metals are inflation indicators. These markets were saying, "the Bernanke put is a myth."
I had warned about this in mid-March. I had warned that the precious metals were close to a peak.
Investors refuse to look at the money supply statistics. These statistics are screaming "Tight money! Tight money!" They are screaming, "No more put." But investors refuse to grasp what is happening. The FED has reversed course, just as it did under Paul Volcker in October, 1979.
THE OTHER BELL
Bernanke is not ringing Greenspan's bell. He is ringing Young's bell.
Roy Young was Chairman from 1927 to 1930. After the 1928 death of Benjamin Strong, the leading FED figure as president of the New York FED, the FED moved toward tight money. Its decision-makers were convinced that the stock market had become a bubble. They wanted to cool the stock market. They did.
Interest rates in the Great Depression fell even below the 1% rate. T-bills were under .25% in 1932. Down, down, down went rates after 1930. Corporate profits, stocks, housing, and employment followed rates over the cliff. Only T-bonds went up.
Gold remained constant, since it was not a free market commodity. The Treasury bought it at $20/ounce. Then, in 1934, gold went up by 75%, when the government hiked its price from $20 to $35. Thus was born the myth of gold as a deflation hedge. It is not a deflation hedge when it is not a commodity with a government-guaranteed price floor.
The FED is not going to announce a FedFunds rate hike because the FedFunds rate is artificially high. T-bill rates are now lower than the FedFunds rate. The yield curve has inverted.
Falling rates are not signs of a Bernanke put. On the contrary, they are signs that the economy is slowing down and will continue to slow down. Corporate profits will follow.
The stock market bulls have been trained well by Greenspan. They hear the bell: "No more FedFunds rate hikes." They salivate. They buy.
THE HOUSING MARKET
Mike (Mish) Shedlock is a market bear. So am I. On October 15, he posted a report on real estate, "Kool Aid and Krispy Kremes." Here, Kool-Aid hearkens back to the mass suicide of "Rev." Jim Jones's cult in 1978. He had them drink poisoned Kool-Aid, which they did, knowing it was poisoned.
Much of this report is a reprint of a remarkable letter from a real estate specialist, Mike Morgan, who is well-known in financial media circles. Morgan writes:
Do you remember my analogy of housing to donuts? A year ago I said this was like the room of 1,000 donuts. Even if they are warm Krispy Kremes, how many can you eat? Three? Maybe four? And even if you come back the next day, and the donuts are now half price, how many can you eat? Same thing with housing. We only have so many people in the US. But builders built houses like donuts. They sold houses to non-users. They sold houses to the greedy masses that bought multiple houses to flip. Now we have the inventory, but there are not enough people to occupy these homes. Moreover, with interest rates rising and mortgages becoming tougher to obtain, we have less and less people that can buy these homes, even if they want to.
This is the supply/demand problem facing housing builders, who are described by Morgan as already having swallowed the Kool-Aid.
He published a piece on this in Barron's. He is getting calls from all over the country. The bubble is popping.
Townhome Developer — Asked me to resell 132 units that they had sold a year ago for an average of $400,000 a unit. All of their buyers have notified them that they will not close. Unfortunately, even a year ago in the heated market these units were only worth about $250,000. Now, the units will not command more than $175,000 . . . if they're lucky.
Real Estate Agent — She sold 10 of the 132 units I just mentioned to her friends, family, banker and co-workers. They're all going to walk away from their $40,000 deposits, so they don't lose $250,000. The developer will be stuck with 132 units that are not worth what it cost to build them.
Then he comes to a case that he thinks is a yellow flag to the housing market generally.
Homeowner — This one really hurts, and this is the next wave of the massive tidal wave hitting this industry. As surfers know, the third set is the biggest. This homeowner purchased her home for $390,000 plus $15,000 in closing costs. It is now worth maybe $300,000. Their interest-only ARM is scheduled for refinancing. The bank told them they need to come up with additional cash to cover the drop in equity. But they don't have the $75,000 the bank wants. And even if they sell for $300,000 and clear $280,000, they can't pay off their $390,000 mortgage balance. You see, their mortgage was 100% and it was interest only. They are going to walk away from the house and give it to the bank.
The bank, if they are lucky, will sell the house for $300,000 less commissions and expenses. Maybe they will net out at $280,000. The math is simple. The bank, at best, will lose at least $110,000 on a $390,000 mortgage. That's a 28% loss . . . IF they can sell at $300,000. Back to the donuts. Maybe they can sell a few of these homes at market prices, but as foreclosures mount, prices will drop further.
Morgan is really pessimistic about what is about to unfold. This is going to affect the entire economy, he says.
This massive tidal wave will affect all aspects of our economy. Some banks will fail. Other banks will suffer the worst liquidity crisis since the Depression. And there is no way to stop this wave.
I am not yet persuaded that the entire economy is this much at risk. That is because I think housing is less volatile than the stock market. People have to live somewhere.
The problem is liquidity. Every year, around 18% of Americans move. In a falling housing market, home owners will not be able to sell their homes at today's prices. They will not want to admit that they made a mistake by not selling in 2005, but when they are transferred, they will have to sell unless they can afford to buy a home and keep their old one, which I recommend as a buy/sell strategy.
The FED has switched signs for so long that investors now believe the signs, not the underlying roadways.
The sign that says "falling rates" has meant "economic boom" for so many decades that most investors have forgotten that "falling rates" can mean "collapsing economy," as it did, 1930—32.
Bernanke has rung the FedFunds bell: no more rate hikes. The salivating victims have rushed in to buy stocks. But the bell doesn't signify what it did under Greenspan.
I call them Greenspan's putzes.
October 19, 2006
Copyright © 2006 LewRockwell.com