Liquidity and Interest Rates

Attention, we think, is entirely misdirected when it comes to the crucial issue of interest rates versus liquidity. This issue is NOT the FED FUNDS RATE or the FED target for FED FUNDS. This may be of significance when the situation is normal, but it IS NOW NOT EVEN REMOTELY NORMAL.

There is ONE and ONLY ONE ISSUE NOW, AND THAT ISSUE IS LIQUIDITY. Specifically, it is the LIQUIDITY POSITION OF THE BANKING SYSTEM.

There is a gross and growing shortage of liquidity in the banking system. The FED, thus far, has sat on its hands. Its liquidity injections have been followed almost immediately by MOPPING UP operations. Consequently, the DURABLE INJECTION OF LIQUIDITY HAS BEEN UTTERLY INADEQUATE. The obsession with the Funds target is dangerous nonsense.

The FED needs to inject -- ON A DURABLE BASIS -- sufficient liquidity into the banking system to allow it to overcome the deepening credit crisis. We will get an appropriate signal from the FED FUNDS market when adequate liquidity has been injected. This signal will come in the form of a stabilization of the Funds rate FOLLOWING WHAT MUST INEVITABLY BE A SUBSTANTIAL FALL. The Funds rate will naturally decline to a bottom when the rate of equilibrium between the demand for reserves and the supply of reserves are in balance. The FED'S RESPONSIBILITY IS TO SUPPLY ADEQUATE LIQUIDITY REGARDLESS OF HOW LOW THE FUNDS RATE SINKS AND TO DO SO NOW. For the FED to continue targetting a specific rate is to DANGEROUSLY SHORTCHANGE THE BANKING SYSTEM IN ITS MOMENT OIF DESPERATE NEED. Targetting equates to DRAINING DESPERATELY NEEDED LIQUIDITY. If the Funds rate falls in the morning and rises in the afternoon back to the "target" it simply REFLECTS that day's open market operations by the FED trading desk in New York -- i.e., the FED liquidity injection in the morning is removed in the afternoon.

This does not constitute even a minimal amount of MONETARY SANITY in the existing conditons, WHICH CONTINUE TO DETERIORATE THANKS TO THE FED'S FAILURE TO PROVIDE DURABLE LIQUIDITY.

Humpty Dumpty: Banking System in Jeopardy?

The flood of verbiage since the onset of the "sub-prime" crisis has been concentrated on several narrow issues: attempted explanations of the sub-prime situation, reports of difficulties in the commercial paper market, human interest reporting on the fallout of the credit squeeze on individual familites, hedge fund losses, FEDSPEAK, the repetition of assurances that all is well and that the disease is curing itself. There have been plenty of reports of losses and problems of SPECIFIC financial institutions. Lots of stories on mortgage industry problems and failures. Tons of reportage and "analysis" of Federal Reserve policy and "actions." What has been widely ignored is an issue of VAST IMPORTANCE, COMPARED TO WHICH ALL OTHERS PALE INTO INSIGNIFICANCE.

This issue, quite simply, it the DEEPENING TROUBLE IN THE BANKING SYSTEM.

While we are still a fair distance from it, the possibility of a serious crisis within the system is coming closer. To grasp the profound reverberations such a crisis could produce, and to comprehend the URGENCY of taking preemptive action, we would recall the words of the famous nursery rhyme:
"Humpty Dumpt sat on a wall. Humpty Dumpty had a great fall. All the king's horses and all the king's men couldn't put Humpty Dumpty together again."

Is the banking system Humpty Dumpty?

We think so.

The essential vulnerability of the banking system derives from the LEVERAGE it regularly employs and the LONG/SHORT DILEMMA. Banks borrow money, and make loans many times the size of their net capital. Leaving aside the issue of sale of loans and resale (via securitization, primarily), bank profitability depends upon the "spread" between the cost of their money and the NET return on loans (after expenses). This is the bank's profit.

The profitability of banking -- and, ultimately, the SOLVENCY of banks -- depends upon certain preconditions, however:
(1)The SPREAD between what banks pay for their money and the return on the loans they make must be wide enough to cover expenses AND produce adequate profit;
(2)The market value and salability of loans the banks make and hold on their books must remain comfortably greater than bank liabilities (i.e., money owed to depositors and other creditors of the bank);
(3)Bank reserves and borrowing power must be sufficient to enable the bank to weather any shortage of funding which may develop.

Banks DO NOT match the duration of their borrowings to the duration of the loans they make. This fact makes banks extremely vulnerable to any significant loss of short-term funding. Banks' depositors, and other creditors, MUST continually renew their loans to banks. If they do not, then banks must find the cash to pay off those creditors who refuse to roll over their loans to the bank. And herein lies the danger. For, apart from very limited reserves, banks only have two means of paying off creditors: sale of assets (i.e., loans the banks have made which remain on the books) or BORROWINGS FROM OTHER BANKS OR FROM THE CENTRAL BANK, which has the responsibility of serving as the lender of last resort.

If only a few banks are suffering from inadequate liquidity, there is no systemic problem. Such banks can be placed on central bank life support, and arrangements made for another bank to take it over on favorable terms. Altenatively, the bank may be allowed to go into liquidation. Its most important creditors -- depositors -- are paid off by the FDIC. The all-important CONFIDENCE of the generality of depositors in the safety of their bank deposits is maintained.

So, what's the problem? The problem is that if a number of MAJOR BANKS SIMULTANEOUSLY experience a significant decline in the value and salability of their assets, a notable dropoff in the ability to borrow, and/or are compelled to pay too much to those creditors who would otherwise decline to roll over their loans to the bank, a systemic crisis may impend. If this crisis is not resolved, the banking system WILL COLLAPSE and an economic Depression (NOT recession) may occur.

Let us return for a moment to the earlier issue. Why do banks NOT match the duration of their borrowing to the duration of their loans? Two reasons. First, many borrowers need loans for longer periods than lenders to banks are willing to provide funds. Second, it is MORE PROFITABLE to lend long and borrow short: the banks pay less for short-term money and get more for long-term loans. However, this situation obtains ONLY when the structure of the yield curve is NORMAL -- i.e., UPWARD-SLOPING.

This HAS NOT BEEN THE CASE FOR MANY MONTHS. For more than a year the yield curve has either been inverted -- with short-term interest rates EXCEEDING long-term rates -- or FLAT, with long rates no higher than short rates. This ABNORMAL condition is attributable fo a PROFOUND DIFFERENCE in the inflation fears of the Federal Reserve as compared to those risking their capital in the bond market. The FED has hiked the overnight rate, which it controls, and which influences other short rates, SEVENTEEN consecutive times over the past eighteen months. It has done this out of FEAR OF INFLATION. If its fears were well-grounded, then LONG RATES would have risen as short rates rose. This HAS NOT HAPPENED. Long rates have remained essentially stable; at times, they have even declined as the FED pushed short rates HIGHER AND HIGHER.

In every instance when a FED-engineered cycle of rising short rates HAS NOT produced the normal response at the long end ( a concurrent RISE in long rates) it has constituted an EXTREMELY RELIABLE WARNING that the FED is raising rates TOO HIGH, DRAINING TOO MUCH LIQUIDITY from the system, and producing conditions which will lead either to RECESSION or something like it. On EACH occasion, 12-18 months subsequent to the initial inversion, RECESSION or something close to it has developed.

THIS TIME IS NO DIFFERENT. Nor is the FED response in the period subsequent to the commencement of the inversion. On each occasion, the FED "explains" that -- yes, you guessed it -- "this time it's different." As those of you familiar with our blog well know, it is NEVER different. The consequences are the same, and the FED'S attempt to preempt political "interference" is the same.

The FED's excessive monetary tightening over the past eighteen months has seriously eroded the profitability of banks' normal lending. This has spurred banks to increase their high-risk lending, heightening the risk to the value and salability of a growing portion of their loan portfolio. (Of course, banks' own greed and wishful thinking, along with intense competitive pressures, have also played an important role in banks' decision to downgrade the quality of their loan portfolios in the quest for greater short-term profitability). Nor is this all. Since the FED tightening has raised short rates, it has simultaneously raised the cost of bank deposits. This in turn stimulated over-borrowing by banks in the commercial paper market. The "off-balance sheet" Structured Investment Vehicles (i.e., conduits) which banks set up to SPECULATE in the mortgage-backed market have been funded by naive/greedy lenders in the commercial paper market, increasing the volatility, and hence the security, of the banks' source of continuing credit. Depositors, after all, are much less likely to pull their money than purchasers of short-term commercial paper.

The FED'S over-tightening has thus not only impacted NEGATIVELY upon the first of our 3 preconditions for bank profitability and solvency (i.e., narrowing the interest rate spread and reducing lending profitability) but has also negatively impacted condition #2: the value and salability of the banks' loans.

The most critical aspect of point #2 is that the central bank's over-tight monetary policy has catalyzed THE BEAR MARKET IN HOUSE PRICES. This has produced deepening financaial distress among mortgage borrowers, and a consequent and SPIRALLING RISE in non-performing mortgage loans. This in turn has reduced the market value of mortgage-backed securities and jeopardized the financial viability of all institutions which hold large quantities of same -- ESPECIALLY MAJOR AMERICAN AND EUROPEAN BANKS.

The totality of these developments has led to a serious undermining of precondition #3. Bank reserves have been seriously impaired. Now that banks are increasingly being forced to assume the liabilities of their SIVs, since the latter are increasingly UNABLE to roll over their own paper, their own liquidity, as well as their borrowing power re. other banks and re. the commercial paper market is shrinking further.

Bottom line: the ominous implications of this continuing and in many respects self-reinforcing downward spiral MUST BE HALTED by the only insitutions capable of doing so: the FED and the US Government. Above all, the root cause of the crisis in the banking system needs to be ADEQUATELY ADDRESSED, either directly or indirectly. This ROOT CAUSE IS THE BEAR MARKET IN RESIDENTIAL REAL ESTATE.

We are OPTIMISTIC that this will, in fact, be done. Despite vehement denials, baby steps in this direction, at both the FED and via the Administration, have already begun. Deepening distress in the credit market and, more importantly, within the banking system will ineluctably cause the destruction of the wishful thinking currently shackling the FED and the Administration, and will COMPEL THEM TO ACT, we believe. We expect not only a flood of liquidity and an attendant drop in short-term interest rates, but the assumption, one way or the other, of the mountain of bad loans on banks' books by the FED/US government. Bank liquidity must be restored, and solvency assured, by PROMPT action, if we are to avoid Japan's fate.

Britain: Bank Run

According to several press reports, the run on Northern Rock Plc, one of the largest mortgage lenders in Britain, continued on Saturday. On Friday, frightened depositors reportedly withdrew 1 billion pounds. Saturday's withdrawals are unknown, but long lines reportedly formed at quite a few of the bank's branches.

We have seen more than a few bank failures, both here and abroad, over the years. We do not, however, recollect having seen an actual run on a major bank. These sights were familiar in the early 1930s, BEFORE the advent of deposit insurance. Insofar as we know, they have never occurred in a developed country where deposits are protected by deposit insurance.

Deposit insurance has played a critically important role for the past 70 years. It has served as an indispensable firebreak between credit crises and bank failures, and between bank failures and a systemic collapse of the banking system. Consequently, it has been effective in performing its most important firebreak role: insulating the overall economy from the consequences of a financial panic. Since it is this connection which has historically constituted the chain leading to serious depressions, the positive role of deposit insurance has been of decisive importance.

The breakdown of this link in Britain -- a country known for its sobriety, prudence, and stiff upper lip disposition -- is disturbing. It is legitimate to pose some very troubling questions:
--Will further breakdowns occur?
--Will panic spread?
--How will governments and central banks respond?

What is painfully apparent is that CONFIDENCE has been DAMAGED. Since it is CONFIDENCE which stands as the crucial bulwark against panic and severe economic consequences, the Northern Rock panic is deeply worrisome. Clearly, the Bank of England has failed to maintain public confidence. The stout-hearted Governor, Mervyn King, has perhaps been a bit too stout-hearted. Bravado at a central bank, and the upholding of the Calvinist principle of "moral hazard" can have incalculable costs to a nation. This has been conveniently forgotten by central bankers everywhere, who, in mounting their high horses, have forgotten the 1930s and the lessons of history.

Let us hope that this serves as a wake-up call for our own Chairman Bernanke and his own obtuse colleagues.

Stocks and the Credit Market Crisis

Is the sub-prime meltdown bad for stock prices?

Is the spread of the sub-prime crisis to the commercial paper market bad for stock prices?

Moneysage, after analyzing these questions from every angle we can conceive of hereby offers his conclusions: the credit market crisis is VERY FAVORABLE FOR SELECTED STOCKS AND FOR THE OVERALL STOCK MARKET.

Well, dear reader, we presume that your immediate response will be: Hey, Moneysage, are you nuts, or are you merely an idiot?

Neither, we hope.

Our assesssment is based upon the following elements:

(1)The credit contraction, and its all-too-predictable worsening in the face of FED paralysis (thinly disguised as sober "policy") will INEVITABLY produce a significant DECLINE IN INTEREST RATES. Indeed, this is already a very powerful trend well underway in the Treasury market. Yields on the benchmark 10-year Treasury note have already fallen 100 basis points (1 full point) from the June peak. This constitutes a nearly 20% DECLINE in market rates. Moreover, further declines are a near-certainty, as the credit crisis impacts ever-more powerfully and ever-more obviously on the real economy.

(2)The FEDERAL RESERVE is being dragged, kicking and screaming to be sure, to CUT the overnight rate. Their gross failure to correctly assess the seriousness of the crisis and to comprehend its uncontainability by mere central bank verbiage instead of decisive action insures that FED cuts will be deeper and last longer than anyone currently anticipates, as the lagged impact hits the economy with far greater force than would have been the case had they acted like a central bank instead of an ivory tower debating club.

(3)The relationship between falling interest rates and stock prices is crystal clear, having been demonstrated in cycle after cycle for as far back as there are records. Stock prices rise as rates fall; the valuation of stocks INCREASES faster than earnings DECREASE. Of course, there are profound differences among INDIVIDUAL STOCKS and DIFFERENT MARKET SECTORS. When a company goes broke, its stock goes down to zero. It is beyond rescue from lower interest rates. Companies which experience severe earnings declines or move from profitability to heavy loss (homebuilders, thrifts, mortgage companies, certain retailers, etc in the current cycle) will witness massive declines in the price of their stocks which no decline in interest rates can possibly offset.

(4)There are RARE occasions on which the down-cycle in interest rates will NOT produce a rise in the market, but may actually accompany a SEVERE BEAR MARKET IN EQUITIES. There are two types of situations in which this may occur:

(a)if a general economic DEPRESSION ("D" word, not "R" word) develops causing a total collapse of corporate earnings, massive unemployment, and significant price deflation;

(b)if stock prices are overvalued by ORDERS OF MAGNITUDE when the economic downturn begins.

(5)There are only two occasions, if memory serves, in which these conditions were present, and, consequently, where a severe BEAR MARKET in stocks took place DESPITE the onset of the downward rate cycle: 1929-1932, and 2000-20002. In the first case central bank policy errors produced the worst Depression in American economic history, generating massive losses for businesses virtually across the board (although motion picture stocks rose 1000% in price during the Depression, as profitability soared with the entire country frantic for escape). In the second case, the BEAR MARKET began when the major large capitalization stocks (the S&P 500) was selling at 45x forward earnings, THREE TIMES today's level.

(6)Our bullish expectations for stock prices this round DOES DEPEND UPON ONE VARIABLE, HOWEVER. We do assume that the FEDERAL RESERVE will drive the overnight rate down sharply and flood the banking system with liquidity, thereby precluding a general economic depression.

(7)For those who have been reading this blog regularly, our careful analysis of the FED is well-known. For new readers, we suggest that you review these analyses. Briefly, we do not believe that the current central bank policymakers have either the guts or the independent political base that would allow them to RESIST THE RAPIDLY MOUNTING MARKET AND POLITICAL PRESSURES TO EASE MONETARY POLICY ADEQUATELY.

(8)We cannot EMPHASIZE STRONGLY ENOUGH THE CRUCIAL IMPORTANCE OF PROPER INDIVIDUAL STOCK SELECTION in order to capitalize on the forthcoming bull move in stocks WITHOUT EXCESSIVE RISK.

Central Bank Psychosis: The Case of Japan

Americans have been inculcated with the belief that the Federal Reserve is the unchallengeable repository of financial wisdom and the source of our country's economic well-being. In the hagiography of America's saints, none stand higher than the leading lights of our central bank. Alan Greenspan was "the maestro," according to the mass media. Our recently retired high priest of moneydom orchestrated the evolution of the American economy into the Elysian Fields

of economic growth, low inflation, and an endless trickling down of material goodies to the great unwashed. Unfortunately, all great things must come to an end: Greenspan had perforce to retire after so many years of Herculean labor.

The Great Man has been succeeded by Bernanke as Keeper of the Flame and Guardian of the secret mysteries of high finance. Unfortunately, in his first confrontation with trouble, Bernanke has allowed the sacerdotal raiment to slip a tad, demonstrating weakness, uncertainty, and ineptitude. Still, the central bank, and the Chairman as well, remain revered figures in the secular Pantheon. (At least so long as no serious recession or major political difficulties eventuate under the newly-anointed Chairman's stewardship).

America, a technocratic, statistically-oriented, yet hero-seeking society has a profound psychological need for a high priesthood of money, in view of the disdain in which the political class is deservedly held.

In Japan, things are quite different. Indeed, the Japanese experience may be indicative of where our own central bank is headed, both substantively and symbolically.

Japan's contemporary economic history is dominated by two catastrophic "policy errors," each made by the Bank of Japan (BoJ). The first was the 1980s error of excessive money creation and a deliberately contrived ultra-low interest rate regime. In all fairness, we must note that this was not only the decision of the BoJ. Rather, it was the entire government and the long-ruling Liberal-Democratic Party which made the policy decision. The Japanese establishment was motivated by the perceived need to satisfy the United States. The Reagan Administration wanted lower American interest rates without causing a true collapse of the dollar and the attendant evils of panic and runaway inflation. Japan, the most powerful economy and financial powerhouse in the world after the U.S., was therefore prevailed upon to keep its own interest rates low and to prevent the yen from skyrocketing against the dollar.

The policy worked fine for us, but turned out badly for the Japanese. The flood of yen catalyzed an unprecedented real estate and stock mania, facilitated by imprudent lending by the major Japanese banks. (sound familiar?) The bubble -- one of the greatest in history -- did not collapse of itself. It was the BoJ, under the stewardship of Governor Sumita's successor, Yasushi Mieno, which deliberately punctured the bubble by raising interest rates and keeping them elevated until the inevitable occurred.

This second great policy error produced a nearly 20-year depression/deflation, which has still not ended. The great Japanese economy was severely hobbled by Japan's own central bank.

Throughout most of this period, the BoJ was unable/unwilling to bring the deflation/depression to an end. The central government engaged in astronomical deficit spending, in accordance with the Keynesian formula, to prevent the situation from degenerating into an uncontrollable downward spiral culminating in massive unemployment. These efforts, though roundly criticized, achieved sufficient success for Japan to avoid a classic economic collapse.

Finally, the BoJ, under the soon-to-retire Governor, Fukui, adopted a very aggressive accommodationist monetary policy several years ago. For the first time, the BoJ aggressively sought to force-feed money to the banking system and, with the government's cooperation, to relieve the banking system of its gargantuan bad loans. Fukui's policy of "quantitative easing" seemed to work. The Japanese economy began to recover. The stock market rallied substantially, nearly doubling from its trough. Even real estate prices -- at least in the desirable sections of Tokyo -- began to rise after nearly 20 years of decline. A sustained recovery was beginning!

And then what happened? Well folks, believe it or not, BoJ Governor Fukui decided that it was time -- you guessed it -- to start RAISING INTEREST RATES and TIGHTENING MONETARY POLICY. Fukui informed everyone -- the Cabinet, the Diet, the media -- that it was necessary to start "normalizing" interest rates. Japan had to prevent the emergence of -- you guessed it -- INFLATION! This, despite the fact that a 15-year DEFLATION in real estate prices, and a 10-year overall price DEFLATION had not yet ended! Yep, the BoJ was looking ahead!

The BoJ fought tooth and nail to implement its new policy. The prime minister objected repeatedly, warning publicly that the deflation was not over, that it was premature to raise interest rates and tighten policy. The Finance Minister reiterated these warnings. The Liberal Democratic leadership demanded that Fukui not implement his new plan. LDP leaders in the Diet threatened to pass legislation depriving the central bank of its authority to set short-term rates and determine monetary policy.

It was all to no avail. Fukui plowed ahead. The economy, the BoJ stated, was strong enough. The deflation had ended, or soon would. "Normalization" had to begin -- now!

The BoJ managed 2 interest rate hikes. The economy stalled, then started contracting. Prices -- which seemed to have stabilized momentarily -- resumed their decline. This is where Japan is today.

The obsessive fixation of the BoJ on an imaginary "inflation" even in the face of an actual and continuing deflation attests to the compelling power of this psychosis among central bankers. When a central bank is allowed to implement its wishes the results are what we have witnessed in Japan for the past 15 years.
Our own Federal Reserve of course is afflicted with the same inflation fixation. It is consequently imperative that intense pressure from politicians and lawmakers be exerted -- or legislated if necessary -- if we are to avoid Japan's sorry fate.
The problem with central bankers is that they do not know when to stop.

The Financial Markets: Credibility Versus Credulity

The airwaves, TV screens, and newspapers are awash with pleas from the most senior of our political leaders for "confidence" and "patience." These notables, who have reinforced the faltering legions of FED "policymakers" in pleading for "time" and "confidence" coincidentally overlook their own role in undermining the very confidence for which they now plead.

Abraham Lincoln's famous formulation about fooling all of the people some of the time, some of the people all of the time, but not being able to fool all of the people all of the time DOES NOT APPLY to financial markets. While it is certainly true that markets can go a long, long way beyond the injunctions of rationality, valuation, and prudence IT IS MOST ASSUREDLY NOT TRUE THAT THEY CAN DO SO WITHOUT THAT MAGIC INGREDIENT -- CONFIDENCE.

CONFIDENCE in the financial markets is based upon CREDIBILITY, NOT CREDULITY. During periods of stress, confidence can be a fragile thing. Once broken it is hard -- and costly -- to repair.

Nothing destroys confidence like the repetition of grossly erroneous prognostications by central bank policymakers and senior political officeholders AS THE INCORRECTNESS OF THESE REPEATED PROGNOSTICATIONS becomes increasingly clear. Markets have no respect for such officials, and place less and less credence in their assurances, which are increasingly perceived as akin to magical incantations which have no basis in reality. The credit markets vote, and they vote by allocating and pricing credit. Their judgments can be astoundingly clear.

In the current crisis, the bedrock reality is that the credit market has CONTINUED TO DETERIORATE. Credit is both scarce and dear, except where confidence continues to exist -- viz., in the Treasury market. The commercial paper market continues to shrink. That the rate of contraction has diminished is hardly justification for the incipient hosannas we are hearing. It is getting WORSE, in both absolute and relative terms. Ditto the mortgage-backed market, and the overall market for low quality (ie, junk) bonds.

We read daily of "private" bailouts -- banks taking onto their own their balance sheets the assets and liabilities of their SIVs (Structured Investment Vehicles -- ie, off-balance sheet units which hold staggering quantities of dubious paper, which continues to erode in value and is in many cases unsalable), banks taking up the slack in the commercial paper market, central banks injecting hundreds of billions of liquidity for brief periods into the money market. These are serious matters indeed, posing as they do the potential for a classic financial collapse, followed by a serious recession, or even a traditional depression. (Yes, the "D" word is much scarier than the "R" word -- that is why no one dares use it).

Having allowed the situation in the credit market to reach this dangerous pass, the Federal Reserve will now have to lower interest rates MUCH MORE than would have been the case had they acted in a more timely manner. The forthcoming flood of central bank manufactured liquidity will be much greater than it need have been, and the inflationary consequences down the road will be greater. Bottom line: substantially lower growth in coming years than would otherwise have been the case.

If the wages of sin are death, then the wages of inept central bank policymaking based upon lagging indicators and failure to implement their regulatory duties are long-term economic underperformance punctuated by periods of intense economic misery for the most vulnerable in our society.

Stock Market: Test of Correction Lows

We continue to believe that the equity market has seen its lows. Throughout the month of August and during September (through today) the market (DJIA) has traded in the narrow 13,000-13,500 range. The intra-day correction low of 12,500 was hit in mid-August, and has not been challenged since. The low close remains above 12,800. There have been several tests of this low: in each instance, support has held.

While we cannot rule out a test of the 12,500 area, we are inclined to doubt that this will occur. There has been a significant change in the MACRO-CLIMATE affecting stock prices.

The change: DE FACTO FED CAPITULATION. While we have not yet had a formal surrender, we doubt that the FED will be able to evade the inevitable much longer. The TONE and SUBSTANCE of public pronunciamentos from various FED "policymakers" has changed decisively. Even the anti-inflation diehards among them now acknowledge publicly that the risk of recession has risen appreciably. No FED "policymaker" who wishes to hang onto his job without risk could oppose a FED FUNDS cut in light of the recent dramatic change in FEDSPEAK.

We believe that thanks are in order to Professor Martin Feldstein, who got the ball rolling with his realistic assessment of serious recession risk at the recent FED clambake at Jackson Hole. Dr. Feldstein, we would note, did not rely on computer models or reams of statistics but rather seemed to base his assessment on COMMON SENSE, a quality notable for its ABSENCE at the FED.

Sophisticated investors have duly taken note. With a flood of liquidity a'comin and stock valuations attractive, why fight the inevitable?

Dollar Bogeyman

The dollar is PLUNGING, TUMBLING, FALLING TO RECORD LOWS. Etc. etc. Ladies and gentlemen, please say hello to the DOLLAR BOGEYMAN.

The falling dollar is frequently highlighted in the media, we think, not because of its significance or the level of interest among readers and viewers, but because it makes such good copy. There is nothing like fear when it comes to selling. This topic is one over which writers and talking heads can whip up ever so much fear, thereby ramping up readership/viewership and thus selling more newspapers.

The dollar can be, and has been, blamed for everything save hemohrragic fever. It "caused" the stock market crash of 1987, according to some. It is responsible for the shift of wealthfrom the U.S. to Asia and the Middle East. It is sapping America's economic strength and world primacy. Take your pick!

Like all great misconceptions, the dollar hypothesis does contain a measure of truth. When skilfully -- or hysterically -- distorted, it does indeed become plausible. Plausible, but not correct.

The declining purchasing power of our currency vis-a-vis stronger currencies has important advantages for the American economy. By reducing the cost of US products to foreign buyers, it stimulates domestic production and bolsters our economy. It attracts foreign tourists. For these reasons, administration after administration has stealthily supported a weak dollar policy, vehement assertions to the contrary notwithstanding.

It is certainly true that the ever-weakening dollar ENABLES the debt-addled American consumer. This is distasteful from the perspective of Calvinist morality, to be sure. It is also reflective of a fundamental weakness in the economy. While these defects are lamentable, the realistic question is: given the current structure of the debt-fuelled consumer economy, where would we be with a strengthening dollar?

Answer: we would experience an economic recession/depression of painful magnitude. The standard of living of the average American would decline notably. Social and political tensions would increase.

There also exists the threat that a downward economic spiral without any discernible bottom could ensue. The debt bubble in this country has been ballooning for more than six decades. Without it, the average American family would not have a house, 2 cars in every garage, and a host of electronic gizmos.

The American economy is built on PEOPLE BUYING WHAT THEY DO NOT NEED WITH MONEY THAT THEY DO NOT HAVE. This may be "ultimately unsustainable" as central bankers and staid gurus (firmly ensconced in their multi-million dollar New York apartments) solemnly declaim. But we are living in the here and now, and both political and economic realities command the indefinite perpetuation of what is admittedly an unhealthy status quo.
Those in power in American society have contemptuously dismissed the cheap money demands of the have-nots. Cheap money is both theologically unacceptable and economically dangerous. The truth, however, is that while denouncing cheap money, they have in practice embraced and perpetuated it.

In what was probably the most famous speech in American history, William Jennings Bryan told the Democratic National Convention in 1896: "We will not be crucified on a cross of gold." Quite right. Each time we have deviated from cheap money, the result has been depression. This is the reality. Therefore, the determinative imperative of actual fiscal and monetary policy: feed the debt monster endlessly.

Of course, there are losers in this game. Obviously, the losers are the creditors. Much of the unending struggle between the proponents of tight money versus the advocates of cheap money has been cast in the light of the purportedly looming disaster of foreign creditors pulling the plug. They will sell their Treasuries, forcing interest rates sky high, and crushing our economy. This is the bogeyman trotted out whenever the conflict between cheap money and dear money heats up.

Well, will this happen? Is it better to take our lumps now, rather than delay and suffer more severe pain?

We think not. While foreign investors might possibly pull the rug out from under us, the PROBABILITY of this occurring is very low. Foreign investors who hold US Treasuries are primarily foreign central banks. These banks may be short-sighted, but they are not about to cut off their nose to spite their face. Pulling the plug on the US means pulling the plug on their own economies.

THE US ECONOMY IS TOO BIG TO FAIL. No amount of "moral hazard" or investment returns is worth a global depression. So sovereign foreign investors have reasoned, and so they will continue to reason, we believe.