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Are the dollar rally and the gold plunge over?
Flash Bubbles
By Dan Denning
Wednesday, May 19, 2004
www.DailyReckoning.com
If you're like 99 percent of the world, you expect the
Fed to raise rates.
But somewhere along the way, in its perfect plan to
"reflate" the American economy and prevent a
Japan-style soft depression, the Fed made a fatal
miscalculation: It caused a simultaneous asset bubble
in stocks, bonds, commodities, housing, and real
estate. We stand on the edge of the great collapse
of the "reflation rally." Some assets will come through
relatively unscathed. Others will deflate. What the
Fed is about to reap is a lot different than what it
thought it was sowing.
The Fed thought it could make money cheap and keep
the stock market high (and households feeling wealthy).
It was right. It thought it could keep money cheap and
force savers to abandon money market funds and CDs.
It was right. It thought it could keep home prices rising
by keeping interest rates low (and mortgage rates low
in sympathy). It was right.
It also thought it could create so much money that
raw material prices would rise. It was right. The Fed's
cheap money caused a series of "flash bubbles" in the
commodities sector, especially in base materials, and
even in gold. It also thought it could keep money cheap
and force up producer prices. Producers have to buy
raw materials, after all. It was right.
And it thought that the whole chain of inflation -- or the
ladder, if you prefer -- would be completed in the form
of rising consumer prices. It thought it could prevent
deflation by first forcing up raw materials prices, then
producer prices, and finally consumer prices. If the
Fed couldn't make consumers borrow, it thought it
could make them spend by inflating. It was wrong.
This essay is not going to be a long explanation of
the failures of monetary and fiscal policy, though it
would be fitting if it were. Never before has an
American government been as irresponsible with its
citizens' money as the current administration. And
never before has the Federal Reserve done more to
undermine your standard of living than this Federal
Reserve has.
The government has borrowed beyond its means and
spent even more. It has made promises it can't keep
-- and probably never intended to. And the Fed has
encouraged the financialization of the American
economy. It's made borrowing money and using
leverage so cheap that there is virtually no sense of
risk in the market ... risk of taking on debt ... risk of
buying too high ... risk of the whole financial economy
falling apart.
To be fair, the irresponsibility of the American
government is perfectly in tune with the irresponsibility
of governments everywhere. We live in an age of
increased government action in the economy.
Economic policies (deficit spending, tariffs, currency
manipulation) are seen as the tools of economic
warfare. Nations wield them against one another to
gain relative advantages in a world marketplace thick
with competition from numerous low-cost producers.
The American government has made three unique
blunders. First, it has taken the good will of the rest
of the world for granted. America is a debtor nation.
It depends on the rest of the world investing in
America to keep the value of the dollar up. Take
away investment in American stocks, bonds, and
real estate, and the Great Inflation begins.
Second, our government has preached to you the
benefits of globalization, namely lower prices and
more choice. What they didn't mention is that true
globalization means a permanent change in the
structure of the American labor market. This is how
free markets work. Production moves to the
lowest-cost centers. This is not a cyclical
phenomenon, but a structural one: It means that
America is becoming a service economy. The wages
of excessive consumption are the loss of an
economy that produces new investment and wealth.
Third, however, and greatest of the policy blunders
is the assumption that monetary policy can cause
wage inflation. Because of this error, the Fed is
about to discover that its entire effort to reflate the
economy through low rates has failed. And it is
nearly out of interest rate bullets.
What do consumer wages have to do with monetary
policy? The Fed has succeeded in causing inflation
nearly everywhere in the economy EXCEPT in
consumer wages. But without rising wages,
consumers can't afford to pay rising prices. Think
about it. Gas prices are high and rising. Long-term
interest rates are rising, increasing the amount of
discretionary income the average consumer has to
pay on his adjustable rate mortgage or credit cards.
Now add to those two forces rising consumer
prices.
What is a consumer to do? If his wages aren't rising,
can he afford higher prices, along with already high
energy costs and debt service costs?
Greenspan knows that without rising wages, there
can be no real "reflation." In congressional testimony
that was overlooked in the press accounts, the
chairman said, "Remember that more than two-thirds
of the consolidated underlying domestic costs in the
United States are unit labor costs. ...And unit labor
costs, as best we can judge, are still going down."
In other words, everything is going up in price ... but
consumers can't afford to pay those prices. This,
ironically, is deflationary. As prices rise, consumers
cut back on spending. The more prices rise on the
margins, the less consumers consume. It is nothing
less than the end of the consumption-driven American
model -- the model the rest of the world has tolerated
because Americans have been buying on credit. The
credit crunch is coming.
If reflation were really going to show up in the economy,
you'd see big price markups across the board in all
sectors. But in a recent Financial Times article, only
three big U.S. companies reported success in passing
high raw materials prices on to the consumer. The
companies were Ford, Honeywell, and Hormel, the
company that makes SPAM. Not exactly a burst of
reflation in the economy.
It must be hard for the Fed to realize this. It's the
end of the line for the reflation model. The Fed can't
cause consumer price inflation because it doesn't
control the key element of the whole inflation ladder,
namely the labor market. In reality, labor market
changes are a function of globalization (aided and
abetted by the Fed's cheap money policy).
The Fed has thus made it possible for a huge spike
in prices, leading to the deflationary collapse of the
American consumer. The normal policy response to
skyrocketing inflation would be to raise rates (what
the market expects). But raising rates puts the
consumer in even worse shape than he is now and
threatens the main source of household
balance-sheet wealth: the house.
If it seems to you like the Fed doesn't have any
good choices left, I agree. It's backed itself into a
monetary corner from which there is no apparent
escape. It does have some options. But it will be
exercising them without any historical precedent
of success.
For example, the Fed may decide it wants to set
long-term interest rates too, either on the 30-year
bond (which would be reintroduced) or on the
10-year bond. Granted, this would be considerably
disruptive to the bond market. But in an era of
government intervention, it's just another form
of price control.
More likely is that the Fed will start to "monetize"
outstanding debt by buying U.S. bonds. There
would probably be a lot of sellers, if it got to that.
The Fed would be acting as a buyer of last resort,
trading newly printed cash for U.S. bonds, which
it would then own or retire. The whole goal would
be getting currency in circulation, getting the
consumer to spend. That, of course, is something
the Fed probably can't do, even it wanted to.
Spending is as much a psychological process as
a fiscal one. People spend now when they think
the future is getting better, with less risk. But
when people are cautious, they spend less, they
cut back, they downsize. They scale back
expectations. They think differently.
It's hard to predict what will happen to the
American economy when this happens. A dollar
selloff is coming. Standards of living are going to
fall. Land values will suffer, all because. ...
The American government was just another
government that couldn't pay its bills.
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