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September 27, 2007

It's the Currency, Stupid
by Charles Zentay

"Don't worry," a friend told me this last week. "Bernanke is a very smart man. He's doing a good job. He's a much better economist than Greenspan. He's going to take care of us."

While my friend is one of the most respected oil analysts in the country, I could not bring myself to feel the same level of confidence as he does. As I lay in bed each night last week, I keep hearing over and over what Ronald Reagan claimed were the 9 most dangerous words in the English: "I'm from the government, and I'm here to help you."

I'm confident that forthcoming events will cause the public to lose faith in the Fed, but I'm perplexed as to why so many people are still hoping the Fed can save us from a situation they largely created.

What is the situation? Debt. Plain and simple. The U.S. is suffering from excessive debt. Don't believe me? Check out the statistics. Debt-to-GDP levels are at records, debt-to-output is at records, and debt-to-income is dangerously high [What I like about these measures are that they are relative to the size of the economy and therefore take into effect changes in inflation, population, and the like. In other words, with more people and more money, we can support more debt, but we cannot realistically support more debt relative to the size of our economy.] Government debt is reasonable relative to GDP and business balance sheets are strong, but consumer debt is simply too high. The z1 report from the Fed shows the consumer in good shape only because asset values have grown with debt, but if housing prices prove illusory, future z1 reports could reveal a much bleaker reality. The fact that the Fed cannot raise interest rates to 5.25% without slowing the economy indicates clearly that debt is a serious burden.

Furthermore, with all the fancy financial innovations, such as CDOs, CLOs, and derivatives - not to mention the rise of leveraged hedge funds and private equity firms - our economy might be even more leveraged than stastics show. No wonder the Fed panicked and lowered rates 50 bps - even though major banks reported solid earnings last week.

Why have our debt levels grow so much? While there are undoubtedly many reasons, the simple fact of the matter is that the Fed has kept interest relatively low for 20 years. With the introduction of hedonics and substitution into inflation calculations in the 90s, inflation rates began to come out lower than previous forms of measurement. Measured the same way as in the 1980s, inflation has been way above the Fed Funds rate for a long, long time. To me, that's a clear signal to consumers that it's much better to borrow than save.

If a centralized committee (the Fed) is going to keep short-term rates below inflation rates, it is much smarter financially to borrow and buy assets. Look at housing as one example. Housing prices have gone up over the last nearly two decades while the value of the associated mortgages has gone down. With low real interest rates, it's the savers who are suckers! As John Stewart, who gave one of the best interviews of Alan Greenspan I've ever seen, asked "When you lower the interest rate and drive money to the stocks, that lowers the return people get on savings in the bank. So they've [the FOMC] made a choice: we would like to favor those who invest in the stock market and not those who invest in a bank...It seems to me that we favor investment but we don't favor work...there's this whole other world of hedge funds, short betting - it seems like craps - and they keep saying 'Don't worry about it, it's free markets,"...but it really isn't. It's the Fed...It's about making people believe the system is sound...If the stock market is high, people are confident in spending, and if it lowers, they feel less confident." Amazing that a comedian came up with one of the better critiques of the Fed I've heard in a while.

"But if the economy slows because of the debt burden," a business associate recently asked, "then wouldn't the economic slowdown reduce aggregate demand and therefore inflation?" That's the theory, and a large basis of Fed policy, but it's misguided. Because it doesn't factor in the currency effect.

In short, the Fed can inject liquidity into the U.S. market and support the U.S. stock market and banks, but it only moves the crisis of confidence from the lower lying banking level to the currency level (as we've seen in the past several weeks with the dollar reaching new lows). Bernanke claims that the Fed caused the Great Depression by not flooding the system with liquidity, but few remember that the market was getting ready to make a run on the dollar and the Fed was trying to defend the dollar and faith in the U.S. Back in those days, if you abandoned your currency, there were major consequences. Today, are there no such consequences?

The Fed claims that if inflation rises, they will raise interest rates, thereby reducing aggregate demand, slowing the economy, and eliminating the excesses that are causing capacity constraints and inflation. If the economy slows, the Fed will lower rates, which will have the opposite effect. This Fed model, however, is flawed, because what happens if there is a crisis of confidence, and people start moving money away from the dollar?

If the U.S. experiences a falling currency, the effect can slow the economy AND cause inflation. Just ask anyone who has lived in Argentina, Zimbabwe, or numerous other countries whose governments created more and more money supply to try to rescue their economies. If a country acquires too much debt, other nations (as well as the country's own citizens) can begin to lose faith in the strength of the currency. As the currency begins to sell off, the economy begins to slow. In an attempt to rescue the economy, the government prints more money, but that only causes a further fall in the currency, slower economic growth, and more inflation. While not Argentina, the U.S. is showing similar characteristics, which should - if the inflation of the 1970s is any lesson - be addressed immediately, even if that means a deep but temporary recession.

The risk the Fed is running is that if the world begins to lose faith in the dollar then the Fed is useless. The dollar, and their ability to print more dollars, is the source of the Fed's power. Without that, they will just be a bunch of useless academics. The great market thinker Peter Schiff was on CNBC this weak and he suggested that the Fed should have raised interest rates not lowered them. He made a similar argument as I'm making. He was literally laughed at - by his fellow panelists and by the interviewers. We'll see who laughs last.

"But no one really knows the cause of inflation from the 1970s," said my business contact, "There were many psychological components." My oil analyst friend said something similar: "There is a psychological risk of panic. The Fed was right to lower 50 bps." While it would be foolish to deny a psychological element to movements in markets, these "moods" are temporary in nature and are only caused by underlying fundamentals. The crash of 1929 could not have occurred without massive debt growth throughout the 1920s. Was it the panic that caused the Great Depression, or the euphoria that led to the excessive debt build up that caused the panic? By 1929, the fundamentals in the economy were weak and prone to collapse. Conversely, with nearly $1 trillion in currency reserves, China is looking very strong. I can't imagine a run on the Chinese currency for "psychological reasons!" It's almost preposterous to say that. Sure, there could be a run on the dollar for psychological reasons, because people around the world could wake up and see the fundamentals for what they are! So we should focus not on trying to prevent the "psychological panic," but we should focus on the root sources of weakness in our economy, what caused them, and how we can fix them.

A final point I'd like to make is what I'm calling the debt productivity theory. The theory is quite simple, but if proven to be true, it would have tremendous consequences in terms of how the Fed conducts its monetary policy. The theory surmises that low interest rates are highly beneficial in the short run. They encourage the acquisition of low-cost debt, which provides extra growth and seemingly increases productivity, because more low-cost debt actually reduces a company's or a consumer's costs. However, when debt levels become too high, and rates must be raised to continue to attract capital, the opposite effect is true. Debt costs go up, and productivity goes down. The implication is that lowering rates might help the economy in the short-term, but it has a strong hangover effect, especially when debt levels are allowed to get too high relative to GDP, output and input.

So when inflation comes, don't buy the "surprise" that officials express. There have been many people warning of the consequences of higher debt for years. It's like the CEO of Countrywide, who claimed the market for housing was great, great, great. He did so for years. Finally when the bubble went pop, he expressed total and utter surprise. Surprise?

I received this in my inbox back in early 2004. I guess CEOs are different than average Americans and don't have their friends sending them funny pictures:

Surprise? According to the New York Times, "In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. 'There is room,' he wrote, 'for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.' As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst. Now the question is what can replace the housing bubble."¹

¹ http://www.nytimes.com/2005/05/27/opinion/27krugman.html?_r=1&oref=slogin

Charles Zentay
thinkinvest.blogspot.com

Charles Zentay is an independent business person who monitors the financial markets very closely.  Visit his blog at thinkinvest.blogspot.com.

Copyright © 2007 Charles Zentay

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