The Sagacious Dr. Ron Paul

By: Doug Noland | Fri, Mar 2, 2001
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Implied Yield on 10-Year Agency Futures
Total Money Market Fund Assets
Broad Money Supply (M3)
US Savings Rate

Perhaps it is subtle, but wild volatility appears to be giving way to even greater instability. For example, from yesterday’s low to today’s midday highs, the Semiconductor index surged 19%, only to reverse sharply into this afternoon close. Amazingly, the Dow ended the week largely unchanged, while the S&P500 declined about 1%. The Morgan Stanley Cyclical index actually added 4% and the Morgan Stanley Consumer index increased 1%. The Utilities and Biotechs both increased 2%. The broader market moved around a lot but ended little changed, as the small cap Russell 2000 and the S&P400 mid-cap indices ended largely flat for the week. Generally, the selling remains isolated largely in the technology sector. For the week, the NASDAQ100 declined 8%, the Morgan Stanley Technology index 7%, and the Semiconductors 4%. The Street.com Internet index dropped 8% and the NASDAQ Telecommunications index sank 6%. The financial stocks were mixed, with the S&P Bank index gaining 1% and the Securities Broker/Dealer index declining 1%. The HUI gold index ended the week sporting a 5% gain.

The U.S. credit market was particularly unsettled this week, as a significant rally for most of the week surrendered to selling today. For the week, the yield on 2-year Treasuries declined 7 basis points, the 5-year yield dropped 12 basis points, and the key 10-year Treasury bond sank 15 basis points. Mortgage and agency securities have been especially volatile, although they ended the week with yields 14 and 16 basis points lower for the week, respectively. The implied yield on the June agency futures contract dropped 12 basis points Tuesday, only to shoot 10 basis points higher today. We expect current market unstable conditions to continue, mindful of what we believe are enormous speculative trades that dominate the marketplace. The dollar came under selling pressure this week, with the dollar index declining about 1% despite a faltering yen. With the ramifications of Japanese stocks at 15-year lows an inarguable negative for the Japanese banking system, there is clear risk of unpleasant market surprises going forward. The Japanese own a tremendous amount of American securities.

Broad money supply increased another $19 billion last week, making it $358 billion (almost 17% annualized) during the past 16 weeks. We see an historic mortgage-refinancing boom as continuing to play a major role in this period of extraordinary monetary excess. Bloomberg reported yesterday that prepayments on Freddie Mac mortgage-back securities jumped to record levels during February. “Prepayments on the roughly $560 billion in outstanding 30-year Freddie Mac mortgage bonds more than doubled and in some cases tripled on the largest issues, the biggest monthly rise ever, analysts said.” The incredible real estate lending boom continues, with dire consequences for the soundness of the U.S. economy and financial system.

This week, The Office of Federal Housing Enterprise Oversight (OFHEO) released its Fourth Quarter 2000 House Price Index. The data confirms continued strong housing inflation throughout the country. Nationwide, prices increased 1.8% during the fourth quarter and have increased 8.1% during the past year. The data is broken down by eight regions: New England, Pacific, Middle Atlantic, Mountain, West North Central, South Atlantic, West South Central, East North Central, and East South Central. Interestingly, and indicative of systemic real estate lending excess, West South Central (Arkansas, Louisiana, Oklahoma, Texas) demonstrated the weakest pricing gains during the quarter, with prices still rising at better than 5% annualized. For the quarter, prices rose at a rate of 10% in New England, 9.2% in Pacific, 7.2% in Middle Atlantic, 6.8% Mountain and East South Central, 5.6% in both West North Central and East North Central. These gains, however, do not do justice to the degree of housing inflation experienced during this boom. According to OFHEO, 5-year price gains have been 42.3% in New England, 36.7% in Pacific, 24.9% in Middle Atlantic, 30.7% Mountain, 25.2% East South Central, 25.9% West North Central, and 31% East North Central. Is this not sufficient data to demonstrate an historic nationwide real estate bubble? The Fed, however, is trapped in policy that perpetuates historic lending excess.

Not surprising considering incredible money and credit creation – especially in the consumer mortgage sector - February auto sales surprised analysts, coming in much stronger than expected. Total vehicle sales were at a solid 17.5 million rate during the month, an increase from January’s 17.2 million. The story continues to be the strong market share gains by the foreign nameplates. Compared to near record sales last February, GM units sold dropped 9.5%, Ford 10.8% and DaimlerChrysler 10.5%. Elsewhere, it was a much different story. Toyota sold vehicles at a rate slightly above last February. Lexus had its best-ever February, with sales almost 7% above last year. BMW enjoyed sales 14% above last year, an acceleration from strong sales in January. Honda posted its best-ever February with sales more than 9% above last year. Acura had a record February, with sales up almost 41%. Year-to-data, Acura sales are running 39% above year-2000. Audi also had a record February, as sales increased 5%. Kia sales were 10% above last February, and are up 22% year-to-date. Hyundai announced a record February, with sales up 34% from last year. Volkswagen had its second best February in 20 years. Mazda sales were up 18%, and are running up 25% year-to-date. Porsche had a record February, selling 13% more vehicles than it did one year ago. Year-over-year sales gains were experienced at Audi and Infinity. While year-to-date domestic vehicle sales have dropped more than 8%, imported vehicle sales are down less than 1%. Year-to-date, “Big Three sales have dropped 10%, while Japanese sales are slightly positive and Korean sales have surged 31%.

I highlight “more than you want to know” auto sales detail as I think it underscores the complexity of the current environment. There is a very fine line between doing well and struggling – a fine line between profits and losses, success and failure. It is certainly an acutely competitive environment, but there remains strong demand in some sectors of the economy. The bottom line is that U.S. auto manufactures are not competing well against foreign nameplates. And with auto and housing demand relatively robust, as well as running massive trade deficits, all the talk of recession is not only superficial, it misses the key point that this is anything but a garden-variety downturn. As the technology sector falls deep into an historic industry bust, consumer- spending demand remains generally solid, for now, with some signs even pointing to a recovery in the manufacturing sector. Clearly, heightened pricing pressures show little sign of abating. This week’s report on personal income (up 0.6%) and spending (0.7%) were both very strong, and indicative of a very atypical environment.

Despite inflationary pressures and strong income and spending growth, the Fed has chosen to respond forcefully to the faltering technology and manufacturing sector. The collapse of one bubble fuels the greater bubble. Lower rates create more demand for homes and more money for consumers to spend from housing equity extraction, but it’s not going to help the failing Internet companies. It will also not create more demand for routers, fiber optics, etc. That boom is bust. It is also, importantly, not creating much demand so far for technology stocks. This week, interestingly, had the feel of a major inflection point where the hitherto technology bust began to develop into a major financial event. If this proves not to have been such an inflection point, this only means it is postponed temporarily. The stocks of the Wall Street firms have been under heavy pressure and financial stocks generally are looking increasingly vulnerable. The marketplace is now signaling acute financial fragility.

If anything, we see this highly maladjusted and imbalanced economy as much the wild animal that will respond unpredictably to aggressive Fed accommodation. The key point to recognize today is that the Fed is dealing with a very unstable economy and financial system and has few tools and little flexibility. This is a particularly perilous circumstance for the equity market.

From the Q&A, Testimony of Chairman Alan Greenspan - Federal Reserve Board’s semiannual monetary policy report to the Congress Before the Committee on Financial Services, U.S. House of Representatives February 28, 2001

Alabama Representative Bob Riley: Thank you, Mr. Chairman. Welcome, Mr. Chairman. Mr. Chairman, when I left the office this morning, I picked this off of my desk from Congress Daily. “Trade deficit hits new high. The nation's trade deficit with the rest of the world climbed to an all-time high of $369 billion, 39.5 percent higher than the previous record of $265 (billion). China now has taken over Japan as our country with the largest imbalance of $83 billion. Japan, which was up 22 percent last year, Japan rose another 10 percent. But when we're having these type numbers, when we're having a 40 percent increase in the trade deficit -- I know you answered earlier that it is of a concern, but when does it become alarming?

Fed Chairman Alan Greenspan: It doesn't becoming alarming in any sense. In other words, the way I put it previously, clearly it's a function of the extent to which there are perceived long-term rates of return on investment in the United States. And to a very large extent it's the technology acceleration, which I've discussed earlier, which is at the root in certain respects of this deficit, trade deficit, which we now have. Because --

Alabama Representative Bob Riley: Excuse me, but are you talking about the technology advances in other countries or in ours?

Fed Chairman Alan Greenspan: In ours. In the sense that, as I indicated before, if your exchange rate is rising, it's basically suggesting that there is greater demand for investment in your country than in other countries. And the result of that is that the only way to engender a very significant current account deficit, which is the other side of a capital account surplus of investment coming into the United States, is to have a trade deficit. In other words, I don't want to get into the technicalities of it, but to a large extent our trade deficit is being financed basically by the desire on the part of foreigners to invest in the United States. And the reason is quite apparently the extent of the technological advances which we have created and the very high rates of return on investment which we have relative to other countries. Now, that can't go on indefinitely. And at some point it's going to change. I --

Alabama Representative Bob Riley: But let me ask you this, sir: Could you compare where we are today with this record imbalance to where we were 10 years ago?

Fed Chairman Alan Greenspan: We are -- we are clearly far -- 10 years ago, as you may recall, we actually had a current accounts surplus -- it will be 10 years ago -- part of which was payments that we received as a result of our assistance in the Gulf War. But, in any event, it was -- were quite low, even adjusting for that. And there has been a major increase in the current account trade -- in the current account deficit and in the trade deficit, and in the extent of investment in the United States. Those trends, as best I can judge, cannot continue indefinitely.

Alabama Representative Bob Riley: Let me ask you one final question, if I can. What impact, if any, would a tax cut at this time -- what effect would it have on future trade deficits?

Fed Chairman Alan Greenspan: Well, the usual way that question is asked is: To what extent would a reduction in the unified budget surplus -- or more exactly government savings -- have on the savings we borrow from abroad? The presumption is that if we have less savings in government we have to borrow more from abroad. That's a static view of the way the world works, and I think a more dynamic view really gets to the question of whether or not say a tax cut enhances productivity in the economy, increases the rate of return and essentially induces an offset to the loss of savings from government. I don't want to get into the complexity of this or we will be here all morning --

New York Representative Carolyn B. Maloney: Thank you, Mr. Chairman. Mr. Greenspan, while I know you do not speak specifically about whether or not you plan to adjust interest rates, I am concerned about the impact that a reported rise in the money zero maturity money stock may have on some members of the FOMC.

As you know, other monetary aggregates have also recently risen at historically high rates, and I would hope that this information would not keep the FOMC from lowering rates. However, I was concerned by comments I read in the February 19th issue of Barrons, where it was reported that the annual rate of MZM increased by 16.9 percent annually from November to January. The same short articles quotes an economist at the St. Louis Fed saying that he would be concerned about this increase if it continues into the summer. I truly hope this data does not discourage you from easing monetary policy. Mr. Chairman, can you tell me whether you or members of the FOMC are concerned about the MZM and other monetary aggregates, and whether this would discourage you from easing monetary policy?

Fed Chairman Alan Greenspan: Well, congresswoman, the cause of that rise, which is as you point out a significant acceleration, results from two factors. One, a reduction in interest rates has increased the so-called opportunity costs to hold deposits and a lot of increase in M2 and M3, and indeed MZM, have resulted from that.

There has also been an apparent shift out of stocks and other financial assets into deposits as stock prices have fallen off. And so a substantial part of that rise is very -- is easily understood. The general view that we have all had over the years, as I've mentioned before to this committee in the past, is while money supply has been a major issue with respect to the American economy, and money obviously is a crucial issue of inflation -- indeed, it is almost by definition in the sense of the relationship between units of money and units of goods. But we have had extraordinary difficulty in trying to find the right proxy to measure money per se, and none of these various measures -- M2, M3, MZM -- as best we can judge, seems to have the characteristics necessary for moneyness that is at the base of concerns that a number of people have with the issue of money expansion and inflation. As a consequence, we no longer report to this committee on money supply targets. And the reason we do not is we have not found, at least for the time being, money supply useful. Having said that, we do obviously follow it like we follow all financial variables, because they are -- money supply changes do signal what's happening in the economy, and whether those signals are telling us one thing or another are quite relevant to our overall evaluation of what economic activity is likely to do.

New York Representative Carolyn B. Maloney: Well, thank you for your answer. And, again, I hope that increases in the aggregates would not discourage the FOMC from easing its monetary policy.

Texas Representative Ron Paul: Thank you. Welcome, Mr. Chairman (Greenspan). In the last few weeks you have received a fair amount of criticism and suggestions about what to do with interest rates and the economy. And I think that's going to continue, because I suspect that we are moving into what you call -- you do not call a recession, but a retrenchment. I guess that may be a new word. But anyway, there will be a lot of suggestions, and I do not want to presume that I want to make a suggestion what interest rates should be, but I would like to address more the system that you have been asked to manage, because in many ways I think it's an unmanageable system, and yet it's key to what's happening in our economy.

We have a system that you operate where you are asked to lower interest rates. And I would like to remind my colleagues and everybody else that when you're asked to lower interest rates, you're asked, really, to expand the money supply, because you have to go out and buy something. You buy debt. So every time somebody says “Lower the interest rates” they'll say, “Inflate the money.” And I think that's important. You had a little conversation before about the money supply, conceded it was important, but you don't even know what the good proxy is, so it's very difficult to talk about the money supply. I'm disappointed that we don't concentrate on that, talk about it more, even to the point now that we are -- you no longer make projections.

I think this is a mission almost of defeat. There's no requirement for you to say, “Well, we're going to expand the money supply at a precise rate.” So we're past that point of a tradition that has existed for a long time. But I think it's an unmanageable system, and it leads to bad ideas and bad consequences, because we concentrate on prices, which is a consequence of the inflation of the money supply. And therefore, if a PPI (producer price index) is satisfactory, we neglect the fact that the money supply is surging and that it's doing a lot of mischief. And therefore we talk about, “Well, maybe if we just slow up the economy, if we slow up the economy, it's going to take care of the inflation.” I think we're really missing the point.

But you did mention a couple of words in your testimony today that I thought were important, acknowledging that there are problems in the economy that we have to address. You talked about excesses and imbalances and the need for retrenchment. And I believe what is important is that we connect the excesses and the imbalances to the policy that you operate, because I think it is key. And instead of saying and being reassured that the PPI is okay, if we looked at the excesses, maybe there would have been an indication that there was a problem in the overspeculation in the stock market.

But here we have a monetary system that creates a speculation where NASDAQ goes to 5000 and then we have a lot of analysts telling us it's a good buy, and yet you're now citing the analysts that say, “Well, we can be reassured because these analysts are saying, you know, there's going to be a lot of growth.” So I'm not sure which analysts you're quoting, but I'm not sure that would be all that reassuring.

But I think we should really talk about the money supply and what we're doing. In 1996, you expressed a concern about irrational exuberance in the stock market, and I think that was very justified. But since that time, the money supply, measured by M-3, went up two and a quarter trillion dollars. And the stock market, of course, has soared. And I see those imbalances as a consequence of excessive credit.

And the system has defects in it. You're expected to know what the proper interest rate is. I don't think you can know it or the Federal Reserve. I think only the market can dictate the proper interest rate. I don't think you know what the proper money supply is. You admit you don't have a good proxy. And yet that is the job, and yet all we ever hear are the people coming and saying, “Now, Mr. Greenspan, if you want to avert a downturn, if you want to save us, just print more money.” And that's essentially what the system is doing.

When it appears that most of Washington is frenetically caught up in a mindless battle to divvy up illusionary future budget surpluses, “hats off” to The Beacon of Light, Congressman Ron Paul for his unrelenting but lonely struggle to focus attention on truly critical issues for our country and the world. He is absolutely correct that the current financial system has “defects” and very serious ones at that. Further, we could not agree more that Wall Street, Washington, and our central bank have neglected “the fact that the money supply is surging and that it's doing a lot of mischief.” How can Congressman Paul’s vision be so clear with virtually all other policymakers so blind? This truly is a very strange environment. Not only do we think Dr. Paul is “spot on” with his brilliant analysis, his understanding of the momentous role played by money and credit put Chairman Greenspan to shame - “You (Greenspan) had a little conversation before about the money supply, conceded it was important, but you don't even know what the good proxy is, so it's very difficult to talk about the money supply… I think this is a mission almost of defeat.”

I would like to highlight an interesting paragraph from a speech given by Chairman Greenspan last fall:

“Even monetary policy rules that use recent economic outcomes or money supply growth rates presuppose that the underlying historical structure from which the rules are derived will remain unchanged in the future. But such a forecast is as uncertain as any. This uncertainty is particularly acute for rules based on money growth. To be sure, inflation is at root a monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of goods and services. But as technology continues to revolutionize our financial system, the identification of particular claims as money, near money, or a store of future value has become exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to output is the fundamental source of inflation, what specifically constitutes money is a notion that has, so far, eluded our analysis.” From Challenges for monetary policymakers, a speech given October 19, 2000 by Federal Reserve Chairman Alan Greenspan:

I used the previous Greenspan quote as the introduction to my application for a PhD thesis - “Endogenous Money, Wall Street Finance and the Great Millennium Credit Bubble.” Below is my first paragraph:

“I propose to undertake a comprehensive and heterodox study of money, credit and the historic financial and economic bubble that presently hangs in the balance in the U.S. In the spirit of Hyman Minsky, the analytical focus will be on the evolution of institutional and debt structures, as well as expanding on a theory of financial instability. In the spirit of Ludwig von Mises, the goal will be to present a contemporary ‘Theory of Money and Credit.’ My efforts will include an extensive review of previous literature regarding money and credit theory.”

It just doesn’t make any sense to me that the issues of money and credit are such great mystery, as they are today. I also believe the two reasons (opportunity cost and the equity downturn) given by Chairman Greenspan in response to Congresswoman Maloney’s inquiry on the recent explosion in money supply are inaccurate and indicative of an alarming lack of understanding of contemporary finance. Somewhere along the line, sound analysis has fallen by the wayside. Somehow, too many great thinkers with their brilliant analysis and writings have been lost or discarded along the way. Today, in the midst of an historic inflection point in financial history, it’s time to return to sound fundamental analysis of money and credit as a foundation for economic thinking generally. It’s not radical; it’s common sense. And I, like Congressman Paul, find the current system “unmanageable…and it leads to bad ideas and bad consequences, because we concentrate on prices, which is a consequence of the inflation” and it is “absolutely unacceptable that a central bank cannot constitute a definition of money.” These currently popular notions of “price rules” and other pop-monetary “analysis” - that hold that money and credit excess can run unfettered as long as consumer prices are stable - are as flawed as they are dangerous. I endeavor to contribute toward rectifying some truly flawed analysis in this area.

So, I will be boarding a flight for Sydney Australia tomorrow (Saturday). I am relocating to commence my formal study of economics, pursuing my PhD. This is a goal I have had for many years, and there has certainly been the recognition that “I’m not getting any younger.” I think the timing is pretty good. The environment could not be more fascinating, or the work more stimulating. I am quite excited to get started. I will be a PhD student during the day and investment professional during the evenings (nights!). I am most pleased that I have the opportunity to continue to work for David Tice, as well as publish my Credit Bubble Bulletins on Fridays. David could not be more supportive or accommodative.

I will be studying under the supervision of Dr. Steve Keen from the University of Western Sydney. Dr. Keen and I first made contact due to our mutual admiration for the work of the great Hyman Minsky. Dr. Keen is an authority on Minsky and debt structures, and I am very excited and fortunate to have the opportunity to pursue “Minskian” analysis with someone of Dr. Keen’s knowledge, expertise, and enthusiasm. Dr. Keen is not only very talented he is a determined iconoclast that is not afraid to state that there are some serious flaws in current economic thinking. He is an excellent writer and his soon to be released book “Debunking Economics” is a must read for all of us interested in sound and objective analysis. And, importantly, he is also a fine individual and a good friend (mate), very much the type of person I strive to work with.

And while I will continue to write my Credit Bubble Bulletins from Sydney, I will nonetheless take this opportunity to thank some individuals that have been particularly helpful and supportive of my work. This is long overdue. First of all, I will be forever indebted to the unqualified support and encouragement I have received from David Tice. He is truly one of the finest individuals in the industry, and my decision to come down to Dallas and work for David was a fortunate and critical decision for my analysis. While in Sydney, I will certainly miss working in his office, as he has attracted a wonderful group on talented and dedicated individuals. I have been particularly impressed by David’s efforts and intense commitment to informing and educating. David, like Congressman Paul, is truly a “Beacon of Light.” I have been touched by his overwhelming support, and remain committed to working diligently on behalf of David, his firm and its investors. I find it very difficult not to have intense loyalty to someone of David’s character, commitment and sense of duty.

A special thanks also goes out to my good friend Bill Fleckenstein. Managing money during this extraordinary mania has been especially difficult for those most educated in history and company fundamentals. You really get a chance to see someone’s character when they are forced to deal with adversity. Bill not only is a “character,” he has a great deal of character, and I have come through this experience with great respect and admiration for Bill. He has mentioned my work many times and, more importantly, has been a great friend and supporter. Many thanks Bill! He is undertaking his new venture with Jim Grant (www.grantsinvestor.com) that is certain to be a great success. Jim has also highlighted my work in the past. Thanks Jim.

Also, a special thanks to Kate Welling. Wow, what a truly wonderful person and great talent. There have even been a couple of times when I have pondered how nice it would be to have a part-time job, so I could pick up the telephone and chat with Kate. What a treat. Kate, thank you very much for all you efforts! Thanks also to Don Hays, Jay Taylor, Michael Belkin, Bill Bonner, and John Rubino for mentioning my work. There is a long list of wonderful people that have supported my analysis. Quickly coming to mind are Jim Cook, Jim Deeds, Doug Gillespie, Tom Peterson, Jim Smith, Don McAlvany (www.mcalvany.com), Jim Puplava (www.financialsense.com), Mr. Moto (www.piraz.com), and Bill Murphy at (www.lemetropolecafe.com). These are “top-tier” individuals and I am honored that they would read my writings. Thanks also to the folks at Gold-Eagle. I also appreciate the efforts of several “mainstream” journalists, although I will not incriminate them (just kidding, sort of…) by mentioning them by name. Internally, a special thanks to Rob Peebles who creates the charts and adds considerable value in various capacities. I don’t want this to get out of hand (especially since I’m not receiving an award here!), so I will stop here with a very incomplete thank you list. Most of all, and however corny this sounds, I am sincerely and deeply appreciative for those that take the time to read my “Bulletins” (and the encouraging emails!). I have a long-term goal of becoming a very good analyst and writer. For those of you who are willing to deal with my “stuff” in the meantime, thank you very much. The best aspect of writing these pieces are the friends I am making along the way…

I am confident that I have only scratched the surface in the analysis of money and credit. I am determined to learn as much as possible in my studies, and I will strive to pass along as much knowledge and insight as I can, as we proceed into what will continue to be a most extraordinary environment. Interestingly, there is now more talk here at home about “bubbles,” and recognition that one had developed in NASDAQ. During a “bubble” discussion on CNBC last night, a money manager made the statement that “bubbles are as American as apple pie.” He also said that while the speculators at the end of the boom are losers, the country as a whole benefits and is much better off because of bubbles. There is a lot of work to do… If you asked those who lived through the Great Depression or those living in Japan today, they would clearly not share this sanguine view. As I head off for Sydney, I can’t help but to sense that “things” are now developing quickly. There is something major behind these highly unsettled markets at home and abroad. While current bubble talk centers on technology stocks, this has been only the most conspicuous part of an enormous bubble that has grown to encompass the entire U.S. credit system. The fact that the financial systems in Japan, Asia, Latin America and emerging markets, generally, are already acutely vulnerable from the bursting of past bubbles creates what is undeniably a precarious situation. There’s a lot of “rot” in financial institutions and systems throughout the world. It is now certainly appropriate to consider the ramifications for global financial crisis.


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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