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August 01, 2003

An Open Mouth
by Kurt Richebächer

The people who expect a double dip or worse in the United States certainly represent a small minority. Among policymakers and economists in America, it is a virtual consensus view that the Great Depression of the 1930s as well as Japan's present, protracted economic quagmire have their decisive cause in one crucial policy mistake: both central banks were much too slow in lowering their interest rates when the economies began to weaken.

All this really boils down to one key question: When do central banks make their decisive mistake? Is it during the boom and the bubble? Or is it in their aftermath?

Convinced he had learned from history, Mr. Greenspan slashed the Fed's federal funds rate with unprecedented speed from 6.5% to just 1%. Establishing thereby a steeply sloped yield curve, his aggressive rate cuts had sweeping effects also on long-term rates, as investors and speculators stampeded into highly leveraged purchases of higher-yielding longer-term bonds.

In principle, central banks have but two instruments at their disposal to influence money and credit growth with the ultimate aim to curtail or to stimulate economic activity: adjustments in bank reserves through open market operations; and adjustments in its key short-term rate or rates.

Yet there is still a third, unconventional instrument of which central bankers have made very different or no use of at all. It has sometimes been called a central bank's open-mouth policy. Mr. Greenspan is definitely the world's one central banker who has practiced this extraordinary tool with unusual abundance and aggressiveness. He, apparently, regards it as perfectly legitimate for a central banker to bend expectations in the economy and the markets in a direction he wants.

During America's boom and bubble years, Greenspan was effectively the most prominent and also the most pronounced New Era Apostle. In various speeches, he developed arguments or "theories" plainly rationalizing and fanning the euphoria in the stock market.

In his famous Boca Raton, Fla., speech on Oct. 28, 1999, just a few months before the stock market's crash, he suggested that the unprecedented equity valuations seemed to be the appropriate response of investors to the economy's advanced information technology:

"The rise in the availability of real-time information has reduced the uncertainties and thereby lowered the variances that we employ to guide portfolio decisions. At least part of the observed fall in equity premiums in our economy and others over the past years does not appear to be the result of ephemeral changes in perceptions. It is presumably the result of a permanent technology-driven increase in information availability, which by definition reduces uncertainty and therefore risk premiums. The decline is most evident in equity risk premiums.

"But how long can we expect this remarkable period of innovation to continue? Many, if not most, of you will argue it is still in its early stages. Lou Gerstner (IBM) testified before Congress a few months ago that we are only five years into a thirty-year cycle of technological change. I have no reason to dispute that."

Having learned nothing from his past blunders, Mr. Greenspan is at it again. To quote Fed mandarin Vincent Reinhart: "The Federal Reserve has always appreciated the importance of correctly aligning market expectations." Putting it rather more bluntly, the Fed endeavors "to manipulate market expectations in the direction that the Fed desires."

During the late 1990s, Mr. Greenspan was keen to foster the stock market bubble by aggressively manipulating both market rates and market perceptions. After the equity crash of 2000, he has become keen to foster the three new bubbles he kindled in fighting the burst of the stock market bubble - the house price bubble, the mortgage refinancing bubble and the bond bubble.

Together, these bubbles are plainly indispensable for maintaining some zip in consumer spending.

But among the three bubbles, one is of crucial importance because it drives the other two. That is the (now hard-pressed) bond bubble. Refinancing activity tends to pick up significantly whenever mortgage rates drop below previous lows. Importantly, Treasury yields guide the movements of mortgage rates. In essence, it was the sharp drop of Treasury yields over the past two years that led the simultaneous, steep decline of mortgage rates. The recent, renewed sharp drop in Treasury yields gave mortgage refinancing another strong boost.

Within barely six weeks, 10-year Treasury yields plunged from close to 4% to close to 3%. In sympathy, mortgage rates fell to 5.21%, the lowest rate in more than four decades.

The astonishing thing about this sudden decline in market interest rates was that it happened at a time when the stock market was, on the contrary, being carried upward by spreading hopes for the economy's imminent recovery. What happened to make this new, sharp decline of longer-term interest rates possible?

In its May 29 editorial, The Wall Street Journal praised the Fed chairman for his wily gamesmanship. "Merely by talking about deflation, he's made the markets anticipate easier money; long-term interest rates have fallen accordingly, helping to keep housing prices afloat and to spur one more round of home mortgage-refinancing. This in turn feeds consumer confidence and helps keep the post-bubble economy growing. As a monetary gambit, uttering the word deflation has so far been a great tactical success. We suppose that's worth the price of scaring people about an economic threat that isn't very likely."

In short, being assured by Mr. Greenspan and other Fed members that there would be no interest rate hike as far as the eye can see, investors and speculators, desperately hungry for big profits, stampeded into heavily leveraged bond purchases, giving through the sliding yield a new strong boost to mortgage refinancing.

Closer to the truth: In the guise of worrying about the evil of deflation, Mr. Greenspan signaled to the marketplace his determination to accommodate unlimited leveraged bond purchases. Investors and speculators complied with enthusiasm, giving long-term rates another sharp downward tick. Implicitly, in a country with negative national savings, any decline in market interest rates can only come from financial leveraging.

In this way, the last bit of restraint on financial leverage and speculative excess in the markets was effectively removed. Endless liquidity is available for the taking by the speculating financial community. The obvious result is a credit and bond bubble that meanwhile has vastly outpaced the excesses of the equity bubble.

The fundamental dilemma today is that - by every method available - the Greenspan Fed and Wall Street are making desperate efforts to sustain unsustainable bubbles. Of these, the belabored bond bubble is now our greatest fear. Its influences have pervaded the whole economy and the whole financial system, and its bursting may have apocalyptic consequences.

P.S. Nobody questions the need for action. But it should be clear that easy money can only be the cure for tight money, not for any other causes depressing the economy. For us, the real and disturbing story about the U.S. economy is that with all its imbalances it has reached the stage where it requires permanent, massive monetary and fiscal stimulus to garner just a tepid economic response - and to prevent the various bubbles from deflating. All this is definitely not prone to create a healthy economy being capable of self-sustaining growth.

Dr. Kurt Richebächer
The Daily Reckoning

A version of this essay was first published in the free daily e-mail: The Daily Reckoning.

Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer's insightful analysis stems from the Austrian School of economics. France's Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."

Copyright © 2003-2007 Kurt Richebächer

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