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We Know His Enemy

February 5, 2001

The now typical extraordinary volatility continued this week, with significant divergences between groups. The Dow added 2% and the S&P500 increased 1%. The economically sensitive issues outperformed, with the Transports jumping 5% and the Morgan Stanley Cyclical index adding 3%. The Morgan Stanley Consumer index added 2%, and the Utilities increased 1%. The small cap Russell 2000 gained less than 1%, while the S&P400 Mid-Cap index was largely unchanged. The Technology rally came to an abrupt halt as the week came to an end. For the week, the NASDAQ100 dropped 6%, the Morgan Stanley High Tech index 4%, and the Semiconductors 1%. The Internet index lost 8%, decreasing its year-to-date gain to 19%. The NASDAQ Telecommunications index dropped 3%, as its year-2001 gain declined to 14%. Biotechs continue to trade poorly, dropping about 8% this week. The financial stocks were relatively quiet, with the S&P Bank and AMEX Broker/Dealer indices unchanged for the week. Gold stocks mustered a slight advance.

On the back of extraordinary Fed accommodation, credit market yields continue their sharp decline. For the week, 2-year Treasury yields dropped 13 basis points to 4.64%, while 5-year yields declined 7 basis points to 4.83%. The key 10-year Treasury Note saw its yield drop 11 basis points to 5.16%, while the long-bond enjoyed a sold performance with its yield dropping 13 basis points to 5.51%. Mortgage-backs and agencies continue to perform well, with the yield on the benchmark Fannie Mae mortgage-back security sinking 13 basis points and agency yields generally dropping 14 basis points. The benchmark 10-year dollar swap spread narrowed 1 basis point to 85. Dollar weakness returned this week, with the dollar index dropping 1%. Whiffs of inflation were in the air, with crude oil adding $1.50 to end the week above $31, a two-month high. Gold jumped $4

"The rapid rise in the stock of money during World War I, when the Federal Reserve System served as an engine for the inflationary financing of government expenditures, continued for some eighteen months after the end of the war, at first as a result of the almost inadvertent financing of private monetary expansion by the System. The monetary expansion was abruptly reversed in early 1920 by Federal Reserve action – the first major deliberate and independent act of monetary policy taken by the System and one for which it was severely criticized.

The rest of the twenties were in many ways the high tide of the Federal Reserve System. The stock of money grew at a highly regular rate, and economic activity showed a high degree of stability. Both were widely attributed to the beneficent actions of the System. Within the System, there was much sophisticate and penetrating research on the operation of the financial markets and the role of the System. The result was a deepened understanding of its own operations and tools. Outside the System, bankers and businessmen at home regarded its powers with awe, and foreign countries sought its assistance in mending their own monetary arrangements. Cooperation with the great central banks of Britain, France, and Germany was close; and the belief arose that, through such cooperation, the central bankers could assure not only domestic but also international economic stability.

That era came to an abrupt end in 1929 with the downturn which ushered in the Great Contraction. In its initial stages, the contraction was not unlike earlier ones in its monetary aspects, albeit the money stock did decline slightly. Severe contractions aside, the money stock rises on the average during contraction and expansion alike, though at a lower rate during contraction. The monetary character of the contraction changed drastically in late 1930, when several large bank failures led to the first of what were to prove a series of liquidity crises involving runs on banks and bank failures on a scale unprecedented in our history. Britain's departure from gold in 1931 and the Federal Reserve's reaction to that event sharply intensified the banking collapse, if indeed they did not nip a potential revival in the bud. By early 1933, when the monetary collapse terminated in a banking holiday, the stock of money had fallen by one-third – the largest and longest decline in the entire period covered by our series (1867 – 1960). The banking holiday was a panic of the genus that the founders of the Federal Reserve System had expected it to render impossible. It was, however, of a different species, being far more severe than any earlier panic. In addition, whereas in earlier panics, restriction of payments came before many banks had failed and served to reduce the number of subsequent failures, the 1933 banking holiday occurred only after an unprecendentedly large fraction of the banking system had already failed, and many banks open before the holiday never reopened after it. One-third of the banks had gone out of existence through failure or merger by 1933.

The drastic decline in the stock of money and the occurrence of a banking panic of unprecedented severity did not reflect the absence of power on the part of the Reserve System to prevent them. Throughout the contraction, the System had ample powers to cut short the tragic process of monetary deflation and banking collapse. Had it used those powers effectively in late 1930 or even in early or mid-1931, the successive liquidity crises that in retrospect are the distinctive feature of the contraction could almost certainly have been prevented and the stock of money kept from declining or, indeed, increased to any desired extent. Such action would have eased the severity of the contraction and very likely would have brought it to an end at a much earlier date. Such measure were not taken, partly, we conjecture, because of the fortuitous shift of power within the System from New York to other Federal Reserve Banks, and the weakness of the Federal Reserve Board in Washington, partly because of the assignment – by the community at large as well as the Reserve System – of higher priority to external than to internal stability." Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960

"The failure of the Federal Reserve System to prevent the (monetary) collapse reflected not the impotence of monetary policy but rather the particular policies followed by the monetary authorities and, in smaller degree, the particular monetary arrangements in existence.

The contraction is in fact a tragic testimonial to the importance of monetary forces. True, as events unfolded, the decline in the stock of money and the near-collapse of the banking system can be regarded as a consequence of nonmonetary forces in the United States, and monetary and nonmonetary forces in the world. Everything depends on how much is taken as given. For it is true also, as we shall see, that different and feasible actions by the monetary authorities could have prevented the decline in the stock of money – indeed, could have produced almost any desired increase in the money stock. The same actions would also have eased the banking difficulties appreciable." Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960

The overriding goal for the Credit Bubble Bulletin is to educate and inform as I attempt to document as best I can this historic period in financial and economic history. I am also committing myself to years of endeavor striving to ensure that the true story of this fateful boom and unavoidable bust is documented completely and accurately, and that facts are not obfuscated as times passes by. Let there be absolutely no doubt, great efforts will be expended to paint all of this in a much more palatable light. One need not look far to see how fragile truth can be, with Saddam Hussein presented as responsible for the early 1990's US recession, crony capitalism the culprit for the SE Asian collapse, and a freak occurrence of "The Perfect Storm" doing in the hard-luck Long-Term Capital Management. Some may likely go so far as to explain the boom as some variance of "the nineteen-nineties were in many ways the high tide of the Federal Reserve System." I hope to fight this revisionist history every step of the way.

As such, I am compelled to comment on CNBC's Wednesday afternoon panel discussion of the Federal Reserve rate cut. Two of the great propagandists of this historic bubble, Louis Rukeyser and Larry Kudlow, made up half of the panel. Both sit firmly at the top of my list of individuals that I fully expect to demonstrate a propensity and raw talent for obfuscating the facts going forward. Not surprisingly, they are vocal leaders of the popular bandwagon chastising the Federal Reserve, blaming last year's rate increases for the sinking NASDAQ marketplace and the current economic downturn. Such analysis is a blatant distortion and a disservice to the public. The Federal Reserve's error was not that it increased rates last year, but that it failed to aggressively tighten policy much earlier. Speculative bubbles always go bust, it's only a matter of from what extremes and the resulting degree of financial and economic damage. Greenspan himself recognized dangerous speculative bubble dynamics at least as early as 1994 but, regrettably, never squashed these destructive impulses before they gained momentum and a very powerful constituency.

I will give the Fed the benefit of the doubt that it was appropriate to cut interest rates to 4.75% during the LTCM crisis in the Fall of 1998. However, a major policy blunder developed when these cuts were not fully reversed for almost one full year, despite a booming economy, heightened inflationary pressures, ballooning trade deficits, increasingly conspicuous financial and economic distortions, and a grossly speculative stock market. The Fed should have moved forcefully to tighten policy (and warned against speculation) to temper what were clearly unmistakable signs of an unhealthy financial and economic bubble. Moreover, the unprecedented accommodation going into Y2K was a bizarre and most unfortunate occurrence, sowing the seeds for a final historic speculative fiasco. The fact that the Fed attempted to rein in some of this extreme accommodation last year is certainly not the culprit of the inevitable collapse of this speculative bubble. To claim otherwise is obfuscation. Mr. Rukeyser and Mr. Kudlow spend a lot of time pontificating publicly about the stock market, but I don't remember many responsible comments warning viewers in the midst of the frenzy of the danger of wild speculative excess.

One of the most perplexing aspects of this boom cycle has been the complete disregard for its dangerous financial and economic consequences, both from the economics community and Washington policy makers. Clearly, there are some enormous flaws and shortcomings in contemporary economic curriculums in this country. There is surely a complete lack of understanding of money and credit. And, specifically, the fact that policy makers and academics are basically oblivious to the risks inherent in this fateful bubble has at its roots the analysis that ignored the causes of the 1920's bubble economy, while pinning the Great Depression on post-crash ineptness by the Federal Reserve.

In this regard, Milton Friedman's analysis of the causes of the Great Depression has played a momentous role. I take strong exception to his work in this area. At the minimum, it grossly oversimplifies the issues that confronted the post-crash Fed. The bottom line is that the depression was not, as the consensus believes, caused by the Federal Reserves' failure to create bank reserves/liquidity (through the purchase of government securities) after the stock market crash. Instead, depressions are the unavoidable consequence of reckless boom-time money and credit excess, rampant speculation and the resulting severe structural and economic distortions. At some point, bank reserves and "liquidity" become virtually irrelevant to the greater issue of intractable economic imbalances and maladjustments, and the instability of debt structures. This was the case after the "Roaring 20s," and it is once again the case today. Sure, there were some post-crash policy errors, but a severe downturn and major financial dislocation were not to be avoided. Yet, under the chapter heading "Why Was Monetary Policy So Inept?" Mr. Friedman refers to the period 1929-1933. This is a convenient revision of history. The great policy blunders were made years before. I just don't buy the notion that all the sudden policy makers became inept in the U.S. in the 1930s or that they coincidently did the same decades later in Japan during the 1990s.

We have written extensively regarding the ominous parallels between the historic credit bubble in the 1920's and the much grander bubble that developed during the 1990's. It is today worth noting that we see the similar paths of these two respective bubbles having now parted. Greenspan is clearly determined not to repeat the "inept" policies of post-crash 1929 (and post bubble Japan for that matter). Indeed, he believes strongly that it is much better to strike hard and early to combat developing financial crisis. Greenspan "baby steps" are now reserved only for increasing rates. And, actually, Greenspan has in the past made it perfectly clear that he would aggressively add "liquidity" to dampen the economic impact of a pierced bubble. As stated repeatedly, he (erroneously) believes that it is impossible to recognize a bubble until after the fact, but he definitely has had plenty of time to adopt a strategy for dealing with the inevitable bursting. This exercise has now begun in full force. Greenspan's "Great Experiment" has gone to the next stage, not even waiting for a failure of a major financial institution or even significant economic weakness. He now leads us into dangerous and uncharted waters, apparently determined to avoid recession at almost all costs.

And while General Greenspan has for years planned, strategized and formulated a careful plan of attack, we have a strong hunch he is not all too clear in recognizing the enemy. It is tempting to see this confrontation in a similar light to Greenspan's previous battles, but this is anything but the case. For his first big embroilment after the 1987 stock market crash, the enemies were discernable and all grouped together on one front - low stock prices, financial system illiquidity, and broken confidence. In the early 1990's, it was an impaired banking system in desperate need of a recapitalization, as well as an economy requiring heightened credit growth to stimulate demand and inflate asset (real estate and stock) prices. It was certainly not the "Desert Storm-type" victory like '87, but with the spirited assistance from Wall Street and the hedge fund community the enemy was put down. In 1994, the enemy was Deleveraging, and to prevail in that battle required only a mechanism to allow the offloading of huge speculative trades in the credit market. This time the Fed allied with the rising government-sponsored enterprises for what in hindsight can be appreciated as a rather easy triumph that greatly enhanced the fortunes of the victors.

1988 had at the time all appearances of an intense multi-front conflict, but in the end the main domestic enemy proved to be (1994-style) financial system illiquidity. This warfare the General has mastered, and despite some close calls the enemy succumbed with the heroic efforts of the government-sponsored enterprises playing a decisive role. Importantly, but not appreciated, the General had a great advantage with his old nemesis Inflation getting hammered on another front (Inflation was being ravaged by powerful deflationary forces in Asia, Russia, and elsewhere). After 1998, the General successfully fended off some covert intrusions in the gold market, derivatives markets, and was on a full stage alert for the Y2K false alarm.

As we begin 2001, the General has orchestrated an aggressive Colin Powell-style attack – the plan is to go early and hit hard with overwhelming force. The powerful and ungovernable GSE's (always hankering to fight!) have for some time been out firing at anything that moves. And while the General is rather shadowy when it comes to identifying the enemy, interestingly, as the war begins this issue is of little concern. In fact, there is even this delusion that savage inflationary warfare can be waged with complete disregard for the possibility that the supposedly spent forces of Inflation regroup and play a decisive role. Besides, EVERYONE has been conditioned that when the General goes to war, good things always happen (I am reminded of my historical readings with respect to the jubilance that ushered in the first World War in Europe). But unbeknown to the cheering population, the General must carefully conceal his heightened self-doubt about this particular engagement, as he nervously falls back on his weathered old battle plan of fighting Illiquidity and Insufficient Demand. It has yet to be recognized that the General has succumbed to the age-old dilemma of "fighting the last war." Most importantly, the Old General doesn't even recognize that a powerful, sweeping and illusive new adversary has joined the fray. We Recognize His Enemy Clearly; We Know His Enemy. It goes by the name Financial Fragility.

Financial Fragility poses an intractable problem for the Greenspan Fed. Ironically, things have finally come full circle, with Financial Fragility having materialized specifically through years of rampant money and credit excess ineptly accommodated by the central bank. Financial Fragility is structural and its endemic. And, importantly, the forces of Financial Fragility will only be strengthened and become even more stubbornly entrenched by the present policy course of perpetuating monetary excess. More credit is not an antidote but instead a potent stimulant for Financial Fragility. Financial Fragility is comprehensive and very complex, but emanates from the massive amounts of over borrowing by the household, corporate and financial sectors. Clearly, the massive accumulation of foreign liabilities is a source of great fragility, and Greenspan policy ensures its perpetuation. Financial Fragility is also the term I will use to describe the deep structural distortions to the U.S. economy, and corporate America in particular. The recent episode of collapsing junk bonds and the faltering corporate debt market were an unmistakable manifestation of the acute vulnerability that has developed to even the shallowest of economic downturns. This is an ominous parallel to the 1930's.

The California energy crisis is a great illustration of the interplay of powerful inflationary forces with Financial Fragility. Predictably, such circumstances have materialized from excessive demand, gross malinvestment and a breakdown in the market pricing mechanism. It is, at the same time, also an excellent example of the atypical and acutely volatile nature of the current environment. Truly, expect the unexpected. The unfolding energy crisis will certainly not be beaten by the Fed's blunt instrument of accommodating greater money and credit excess.

The current troubles in the manufacturing sector should also be seen under the umbrella of Financial Fragility. Years of overheated and unsustainable demand concomitant with distortions in the economy's investment process and over borrowing have left their indelible mark. Fed policy strives to sustain unsustainable demand. And with an overvalued dollar, rising costs, and stiff foreign competition, there is a real story here as U.S. industry rapidly loses its global competitiveness. Again, current policy is powerless.

The US automobile industry is a case in point. Looking at January industry data (that, by the way, was considerably stronger than expected), we see that weak sales by the Big Three were offset by continued strong demand for foreign nameplates. It was a record January for American Honda, up 11% from January 2000. PRNewswire quoted a Honda executive: "January turned out to be a pretty good month after all, despite the prediction of all the doomsayers. The industry as a whole may be off a little from last year, but let's not forget that January 2000 was great month." BMW reported its "best January on record," with sales about 10% above last year. Lexus posted a record January, with sales 13% above last year. Acura had it best ever January, with sales 38% above last year. Mercedes reported its second-best January (behind last year), after its all-time record month during December. Mitsubishi also had its second-best January, with sales 15% above year-2000, as did Audi. Mazda announced that January sales were up 33% year-over-year, while Suzuki sales were 31% above January 2000. Kia sales increased 53% from last year and January sales at Hyundai were 50% above last year. There is certainly much more ailing US manufacturers than flagging demand.

And we certainly don't see the technology industry quagmire ameliorated by more "easy money." Instead, the great and now punctured technology bubble will be a case study for decades to come as to the negative financial and economic consequences of reckless money, credit, and speculative excess. Amazingly, however, there is still barely recognition that things ran so terribly amok. There appears no appreciation as to the extent of damage inflicted by an unprecedented flood of speculative capital into this sector. If the lending and speculative juices do get flowing again and $100's of billion of additional dollars fall into the black hole of the "telecommunications arms race," the consequence will be only an extension of this historic period of gross resource misallocation and precarious Financial Fragility. Perpetuating this boom creates considerable potential for the destructive process of "throwing good money after bad." This is but one of the most obvious costs of what will be Greenspan's failed experiment to repeal the business cycle.

And right here I would like to make what I believe is an important point. A key aspect of Financial Fragility is the accumulation of debt obligations (by households, businesses, financial institutions, and the American economy as a whole) that are in no way supported by sufficient underlying economic wealth-creating capacity. While the $100's of billions of dollars that flooded into the Internet and Telecom bubble have been spent and great resources squandered with little economic value to show for it, the financial claims for the economy as a whole remain as if this money and credit melee went off swimmingly in a sound investment boom. Broad money supply ended last week at almost $7.2 trillion, about $1.75 trillion (32%) more than where it began 1998. What wealth producing assets are backing this monetary explosion? It appears a fatal characteristic of bubble economies that financial obligations grow exponentially at the same time that the true economic wealth creation collapses.

There is this most regrettable notion in this country that how money is spent is not relevant. Amazingly, even the Greenspan Fed shows scant concern for the quality of investment or our economy's habitual over consumption. Apparently, the belief is that the quality of spending is basically inconsequential because it's pretty darn simple to make more money at a whim. It seemingly was not appreciated in Mr. Friedman's analysis nor by current central bankers that this is very much just "running a tab." While the resources are wasted, particularly at the latter stages of booms, the financial obligations remain. Simply creating more financial obligations only delays and makes worse the unavoidable financial and economic adjustment. At some point there will be a call on these obligations. Financial Fragility lies in wait. A failure of current policy is that it nurtures those with a proclivity of "running a tab."

Most important to this process, our foreign obligations now grow by almost $40 billion monthly, a truly staggering sum. Borrowing huge sums for consumption – by individuals and households at the micro level, or the U.S. economy at the macro level – should be patently recognizable as part and parcel to Financial Fragility. This is unsustainable and very much a critical structural issue that must be resolved, although the current central bank policy only exacerbates this disaster and ensures a dollar crisis at some point.

While the severity of structural economic distortions are becoming more conspicuous by the week, the heart and soul of Financial Fragility lies imperceptibly within the U.S. financial sector. Here, unprecedented leveraging and unfathomable derivative positions has created the proverbial house of cards. We have in the past often stated that when the financial sector loses its ability to leverage, the game is over. The financial sector ended the third quarter with $8.15 trillion of borrowings, an increase of $2.7 trillion, or 50%, in less than three years. However, this is the key area where Greenspan has great influence and the ability to prolong the game, albeit with incredible costs. And while the historic GSE bubble grows to unimaginable proportions, only time will tell as to what extent the US household sector takes the bait and piles on another layer of mortgage debt. We are in the midst of a major refinancing boom with attractive interest rates and years of extraordinary housing inflation providing the fodder for potentially unprecedented borrowings. Back in 1998 the average household was said to have extracted $15,000 of equity during refinancing. Taking a very conservative view with 5 million households pulling $20,000 of equity, $100 billion of additional purchasing power is created. This number could easily go much higher. Not only is such credit creation potentially destabilizing and inflationary, it will no doubt prove a very difficult burden come the inevitable piercing of the real estate bubble. Federal Reserve rate cuts are a fire hose showering gasoline onto the real estate finance bonfire, greatly exacerbating Financial Fragility.

The bottom line is that for years the financial system and economy have fallen terribly off course. Endemic over borrowing, massive over consumption, reckless speculation and incredible malinvestment have brought us to today's critical juncture. The situation beckons for what would be a difficult but necessary business cycle downturn, the only means of beginning the process of getting back on a track of sound money and healthy economic expansion. Perpetuating the current destructive process is an unmitigated disaster. Fighting Financial Fragility with only more monetary excess is a war that cannot be won. In fact, the present course guarantees that things go terribly wrong.

In a world where analysis seems all too often to be "turned on its head," I'll admit that the most perplexing commentary I have seen recently comes from Pimco's Bill Gross:

"And the most recent economic news suggests that the slowdown is picking up speed. So much so that if we aren't already in a recession, we are very close. Confidence in the economy is crumbling. Business confidence has plunged, capital investment is slowing and production is contracting. Consumer confidence is clearly in a downtrend. This indicator is key as consumers account for as much as two-thirds of economic growth. Confidence needs to turn back up for the economy to recover. We think the Fed will ease as much as necessary to restore confidence. That means the Fed Funds rate, which stands at 5.5% today, could be pushed down to 4% or lower."

I know that if I were the largest investor in the world in the US bond market, I would look with great consternation at the inflationary course set by Greenspan. But, then again, the bond market vigilantes are a relic from days long past.

I will end with several additional quotes that I see as particularly timely in this most fascinating environment.

"If we are dealing with a closed system, so that there is only the condition of internal equilibrium to fulfill, an appropriate banking policy is always capable of preventing any serious disturbance to the status quo from developing at all…But when the condition of external equilibrium must also be fulfilled, then there will be no banking policy capable of avoiding disturbance to the internal system." John Maynard Keynes 812

"…We have seen that having a widely accepted medium of exchange is of critical importance for any functioning complex society. No money can serve that function unless its nominal quantity is limited." Milton Friedman, Money Mischief 1992 MM42

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." John Maynard Keynes, 1920 (MM 189)

"(Federal Reserve Bank of Dallas President Robert) McTeer concluded his speech by driving home the message that consumers do their part to keep the economic expansion going. He implored the audience: 'Go out and buy something.' Dow Jones News 2/2/01

"If we all join hands together and buy a new SUV, everything will be OK." Robert McTeer, Associated Press, 2/2/01

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