What Goes Up Must . . . Stay Up?

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 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.


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.


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!


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.

February21, 2007

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

Copyright © 2007