by Gary North
By now, you may have seen Jim "Mad Money" Cramer's tirade on Monday, August 6, against the Federal Reserve System's Open Market Committee (FOMC) for not lowering interest rates, meaning the Federal Funds rate, meaning the publicly announced target rate. Because of YouTube, Cramer's performance is all over the web.
I have never seen anything quite like it. Screaming, calling them idiots, saying that people he has been in the investment business with for 25 years are about to go bankrupt: this was unique. NBC's "Today" show ran the clip as its opening segment on Tuesday, the morning that the FOMC was scheduled to meet. I guess the "Today" people had never seen anything like it, either.
Cramer is almost always bullish on stocks. He tells millions of CNBC viewers that the stock market is going to keep moving up. I have never heard of an instance when he has said "sell your index funds now and wait," let alone "sell short." Yet on Monday, he got in front of the camera and started screaming.
Is he right? Are the people he has worked with for 25 years now facing financial Armageddon? Which sectors are they in? It sure would be helpful if Cramer would give his viewers a few hints at exactly which kinds of ventures are at risk of closing their doors.
WHAT'S THE PROBLEM?
Cramer seems unaware of the nature of the problem facing the Federal Reserve. Beginning in 1987, Greenspan's FED expanded money in order to overcome downward movement in the stock market. This began within days of his accession to the chairmanship, when the Dow fell over 500 points in one day over 20%, accompanied by comparable declines in stock markets around the world. His decision? To flood the economy with fiat money.
This was also his solution to the 1990 recession. For a decade thereafter, the FED expanded money. This created the upward move in stocks. It also led to the housing bubble. How? By keeping short-term interest rates low, the FED encouraged businesses to expand and consumers to borrow and spend. The consumers were employees. The economy grew. So, they moved up to nicer homes.
Beginning in mid-2000, the FED pushed the Federal Funds rate from 6.5% to 1% over a period of three years. Nothing like this had taken place since the Great Depression. To make overnight money available at 1% was like waving a red flag in front of a bull. The Dow still fell in 2001, and the Nasdaq collapsed. It took until 2003 for the reversal to take place.
Today, Bernanke's FED is keeping the monetary base growing at about 2% per annum, which is low. Month after month, the FED doesn't announce a lowering of the FedFunds target, which stays at 5.25% — lower than in 2000.
Short-term T-bills pay about 4.6% (5% when he launched his tantrum). With price inflation (Median CPI) at maybe 2.1% per annum, the real rate of return for T-bill investors is 2.5% per annum. On this, they will pay income taxes of maybe 30%. That's a real rate of return of 1.4% (1.75% when he threw his tantrum). Wow!
Yet Cramer wants the FED to lower the FedFunds target rate. That anyone should get a real rate of return of 1.75% a year by purchasing the debt of the United States government appalls him. He goes on national TV to scream that the FED's willingness to accept this proves that Bernanke is an academic moron.
THE CHINESE THREAT
Meanwhile, there is a move in Congress to hike tariffs against Chinese imports. In response, a Chinese official warned this week that China in retaliation would start selling T-bills, thereby driving up U.S. interest rates. In other words, China is threatening to adopt the strategy that works best in games requiring cooperation: tit for tat.
The stock market ignored this warning. It rose.
Think of Cramer's tantrum from the point of view of a central bank which holds hundreds of billions of dollars in U.S. Treasury debt. If the FED were to adopt Cramer's suggestion and lower the FedFunds rate, along with the T-bill rate, China will suffer a loss of income. It holds debt, not equity.
If the FED pushes down interest rates on debt in order to fire up an economic boom that we are assured by most Economists is doing just fine, this action tells central banks: "Your interests will be sacrificed to the interests of Jim Cramer's buddies of 25 years, who misforecast the market and are now in dire straits."
Investors think the Chinese are bluffing. Well, the Chinese may be bluffing. They have pursued a policy of modern mercantilism, exporting goods and buying Treasury debt with newly created yuan in order to hold down the value of the yuan and sell more goods abroad. But protectionists in Congress are upset with this policy. They want to pursue mercantilism, too. They want U.S. exporting firms to be subsidized by government policy. So, they threaten to impose tariffs on Chinese goods.
On the one hand, the Chinese central bank is subsidizing the U.S. Treasury, so that the Treasury can sell its debt at what would constitute below-market rates, were the Chinese central bank not a buyer. Congress loves the effect of these low rates: economic investment, rising consumer debt, and a rising stock market.
On the other hand, Congressional mercantilists now propose to penalize the Chinese export sector for the exchange rate effect of the central bank's policy of subsidizing the U.S. Treasury.
Then a Chinese official says, "You don't like our subsidy? OK, we will end it." Investors call this a bluff. Why do they think this is a bluff? Because the U.S. economy would contract, and U.S. consumers would buy fewer Chinese goods. This is an accurate assessment. But undergirding this assessment is an assumption: "The Chinese central bank is trapped by its own policy of mercantilism through monetary debasement. It dares not stop buying T-bills, no matter what Congress does to restrict Chinese imports."
In the short run, the Chinese central bank does have a huge problem. If it ceases buying U.S. Treasury debt, short-term U.S. interest rates will rise. But the People's Bank of China can then buy Chinese government debt instead. This will lower short-term interest rates in China. Chinese industries that export to America will suffer losses, but companies selling to Chinese consumers will be subsidized.
China's central bank does not have to subsidize the U.S. Treasury in order to stimulate economic expansion in China. It can subsidize the Chinese Treasury instead by purchasing its debt. A subsidy is a subsidy, no matter who gets it. The main economic problem is the subsidy itself, not who gets it.
The economic boom created by monetary expansion in China is artificial. It is the product of below-market interest rates. It will end either in the destruction of the yuan through mass inflation (the crack-up boom) or in a Chinese recession. But this is true whether the central bank buys U.S. Treasury debt or Chinese Treasury debt.
China's central bank has been willing to load up on Treasury debt that pays low interest rates. The Treasury can sell its debt at low rates precisely because of China's purchases. The quid pro quo is free trade. The Chinese central bank is subsidizing China's export sector by way of subsidizing the U.S. Treasury. If Congress changes the rules and blocks Chinese imports, then the Chinese can find a market which will not impose tariffs. That market is China's domestic market. "You Americans want to block our goods. Very well. We shall buy our own goods."
It is not the FOMC which is following idiotic policies. It is the protectionists in Congress. These people expect to block imports from China, yet they also expect the Chinese central bank to keep buying and holding U.S. Treasury debt which it purchased in order to stimulate Chinese exports to America. They think the U.S. holds all the cards in this high-stakes game. But it is the Chinese who are exporting wealth, not the United States. China is running the $200+ billion dollar annual trade surpluses with the U.S. The U.S. sells official promises to pay. China sells products.
In the long run, it is easier to sell products than it is to sell government promises to pay in a currency which the government's agent controls. It is also more expensive to manufacture goods than promises to pay. Manufacturers in the U.S. have found it too expensive to compete with the Chinese. These two facts point to a day of judgment. "We have decided to purchase no more T-bills."
Cramer will go ballistic, of course. He will lash out at the idiots who run the People's Bank of China, who are threatening the livelihood of his buddies. But the directors of China's central bank will not notice. They do not watch CNBC. They do not even watch "Today."
WHICH BUBBLE SHOULD THE FED POP?
Cramer thinks that the FED can and should lower the FedFunds target rate. The problem is, the FED cannot do this at zero cost. So, it's a question of who takes the hit: Cramer's buddies or the mortgage market.
If the FED lowers rates in a stimulative way, i.e., by creating more fiat money subsidies for the U.S. Treasury, then this will send a signal to investors: "Inflation ahead." Rational investors will then refuse to offer to invest in 30-year T-bonds at today's low rate, around 5%. They will ask themselves: "Why lend today's money in order to receive depreciated dollars for the next 30 years?" They will demand a higher rate of return. This will force up long-term interest rates.
The mortgage market will match every increase in the T-bond rate. So, what Cramer is calling for will have negative effects on the housing market.
The housing market has been a bubble. This bubble is ending nationally. We see this in the 40% to 50% decline in the share prices of home builders. In the midst of a crisis in the mortgage lending markets, rising mortgage rates would be another sledgehammer blow. Yet this is what Cramer's recommended policy would produce.
Can you see why the FOMC decided to leave the target FedFunds rate alone? It did not want to send a signal:
"Increased monetary inflation ahead. Raise those mortgage rates."
Cramer and his cronies are investors in the stock market. He is famous as a perma-bull regarding the stock market. He has staked his reputation on a rising stock market. Rising short-term rates threaten the stock market, given the bubble created by the Greenspan era's FED. But Greenspan's FED also stimulated the housing bubble by persuading buyers that the economy would boom forever. Buyers borrowed money to buy homes, based on their confidence that the economic boom was permanent.
Now the FED faces a dilemma.
- If it follows tight-money policies, it will pop both bubbles and the boom.
- If it inflates short term, it will stimulate the stock market bubble but threaten the housing bubble.
- If it inflates long term, it will undermine the purchasing power of the dollar.
We are in a transition phase. The FED has slowed down the expansion of the monetary base, and there has been no crash. The economy is still expanding. The stock market has not crashed — just dropped. The housing bubble has not popped in most markets, just slowed. So far, so good.
BUT IS CRAMER CORRECT?
Yes, he is. He has diagnosed the symptoms correctly. He just doesn't understand the solution.
It's not just his buddies who are threatened. It is the entire capital structure of the U.S. economy. The fiat money policies of the FED since the capitulation of Paul Volcker on August 13—15, 1982, reversed a tight-money policy that would have let the economy stabilize with much less monetary inflation. But the Mexican government 25 years ago launched a game of chicken. It threatened to default on its debt. It also threatened to nationalize all foreign banks in the country. Volcker blinked. So did all the other central bankers, who were meeting together in Canada that weekend. (Nice timing, Mexico.)
Greenspan followed in Volcker's post-1982 footsteps.
Bernanke is trying to call to a halt a 25-year policy of monetary expansion. This means that he is threatening the capital allocation decisions of a generation of investors who do not know what a good, old-fashioned recession is.
Cramer talks about his buddies of 25 years. Well, these guys grew up in an era of monetary expansion. They came to maturity in an era of inflation. Now Bernanke is trying to end this era. At some price, he can do this. Any central bank can. But the economic price is high. The politicians will not let the central bank force on the voting public the full costs of re-allocating decades of capital allocation, especially that supreme allocation: the investors' expectation of FED-subsidized interest rates.
Cramer's buddies are feeling the pain first. They have been hooked on fiat money all of their lives, as have we all. The FED has been the pusher. Now, unlike dealers in the past, Bernanke is trying to put his clientele on methadone. Cramer's buddies are suffering withdrawal symptoms. The methadone isn't working. The rush is gone. The pain is increasing.
Cramer's tirade had a resemblance to Frank Sinatra's performance in "The Man With the Golden Arm," when he stopped taking heroin. Withdrawal is no doubt an excruciating experience.
Cramer's buddies will not be alone in their pain if the FED sticks to its present program. The bust phase of the boom-bust cycle will induce a lot of pain. Investors who have assumed that the FED will always be a lender of last resort will find that their investment decisions are unraveling.
This is why, in the long run, Congress will start doing a passable imitation of Cramer's tirade. the FED will eventually knuckle under. But that will take time. It may take a year.
In the meantime, the withdrawal symptoms will spread.
Watching Cramer reminded me of a child's tantrum. "I want it, I want it, I want it!"
Some parents surrender early. Others hold out longer. But when it comes to central banks, they all eventually give in. "Yes, snookums, daddy will buy it for you. Please stop crying. Everything will be OK."
Snookums knows he will win the contest.
There is more than one kid in this family. They can gang up on the parents. When the tantrum spreads to all the siblings, the parents invariably capitulate.
The best we can hope for as investors is that we will not lose half our capital in the interim phase, when only a few of the kids are rolling on the floor and vowing to hold their breath until they turn blue. The parent is holding out for now.
There will be more pain. There will be more tantrums.
There will be more inflation.
The FED is hold out until Friday, August 10, when it injected $38 billion into the system. This may have been a one-shot reacition to Thursday's huge fall in the market. Officially, the FED is still fighting inflation. Its official position is this: "No, you can't have it. You must learn to control yourself. Bad behavior is not rewarded."
Yes, it is. Always. The dollar is down by 95% since 1913.
But, during the brief periods of parental authority, such as 1928—29 and 1980—82, those who expect the FED to capitulate may experience setbacks. Sometimes, the FED holds out longer than investors expect. Capital is then re-allocated. Snookums screams louder.
Cramer's tantrum is a foretaste of tantrums to come.
August 11, 2007
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