(Way, way too long. :) )
In normal times the Fed has to keep the economy balanced between
inflation and recession. This isn't particularly easy, and the result is
the business cycle. But the balance of trade adds another factor.
This is one too many factors to balance simultaneously. When
foreigners want US dollars, as has happened pretty much constantly
since Volker's (sp) policies strengthened the dollar, they are pretty
much going to suck those dollars out of our economy, and the Fed
can't stop them from doing it. Lowering rates causes a boom here,
and the citizens go on a Mercedes buying spree. Raising rates
causes the dollar to go up, and even the poor people can afford
Volkswagens. There really is no way to force foreigners to not
stash our cash, except to inflate it. When we start inflating it, they
are gonna give it back to us. This will show up as a balance of
trade surplus. We had those, once.
The last time we had the rest of the world sucking out our money
supply was under Nixon. Only then we had them convinced we
would back our green with gold, so they weren't worried about
the dollar losing value. Ha ha, we sure taught them a lesson.
The dollar dropped like a rock, oil went through the sky (the first
oil shock), inflation suddenly appeared, and, in order to convince
investors to take 30 year bonds, we had to give out 14%. (And
they weren't callable!) Of course that put a dent in our economy.
Remember the housing industry mailing pieces of 2x4s to J. Carter?
They didn't have anything better to do, as they were all unemployed.
All in all, this was a major disaster, and the Fed is trying its best to
avoid a repeat. The great depression is not what they are worried
about, its a repeat of the 70s.
Whatever they do, the Fed can't let the US dollar get tanked.
And if they allowed interest rates to go too low, that is exactly what
will happen. Every time you see the dollar drop overseas, you will
almost automatically see an increase in short term rates the next
day in the US. In other words, don't worry about inflation. Inflation
is only the final effect. By the time inflation shows up the dollar
will have already been in a long slide. Instead look at what I think
the Fed watches, yen/dollar, mark/dollar. The inflation of our money
supply (i.e. that 9.1% growth rate in M3 referenced above) will only
turn into inflation in our prices to the extent that the increase in the
money supply fails to be absorbed by our trade deficit.
And why should a Japanese investor keep US treauries around?
Only one reason. He has to get a higher interest rate than at home.
And because of the exchange rate risk, it has to be a much higher
rate. So we are stuck with high rates. If the Japanese economy
starts booming, and they have to raise their rates, we will have to
raise ours higher. The alternative will be to suffer a sudden increase
in the domestic money supply, and see price inflation.
Its possible to some extent for the Fed to make our currency
attractive to foreign investors. But if they decide to dump their
dollars, their isn't anything the Fed can do to stop those dollars from
coming back here. The Japanese have occasionally threatened
to do this, or at least boycott the Treasury auctions. If they fail to
dump their dollars, then someday, we will get tired of running around
with high interest rates, keeping our economy from expanding, and
we will lower our rates. Foreigners will then crowd into the exits, and
drive the dollar down. Not a pretty sight. And the longer we keep
running big trade deficits, the more dollars out there. (Though it is
possible that the value of those dollars is declining relative to the
GNP.) In any case, when foreign holders decide to get out of the
dollar there will be pretty much nothing the Fed can do to stop them,
and the Fed will have to absorb all that liquidity to avoid price
inflation. (If this seems complicated to you, just imagine that you
are standing in line at McDonalds, preparing to eat a big-cow
(i.e. mindless bull) hamburger, when suddenly some guy with an
accent comes in and buys it before you get to the front of the line.
The clerk says, "Sorry, I just sold your food to China. You will
have to eat cake." This costs you money, and its called inflation.)
Anytime this sort of thing happens, you can say goodbye to the
stock market, as well as the bond market.
But now the Fed has another little problem. While you would
think that the effect of all those trade deficits would be to raise
interest rates in the US (and they did). And you would expect that
the high (real) interest rates would slow down the economy (didn't
seem to much), you would never expect that the US would be
able to simultaneously run up the largest stock-bubble of all time.
It just requires such a massively high ratio of greed / fear.
When stock prices reach 5x book value for the SPX, you
expect corporations to start issuing stock. Instead they have been
buying it. This is incredibly bizarre behaviour, and is the sort of
positive feedback that can only happen when MBAs are totally
out of their minds. Or maybe not. I was at a publicly traded
company (RENX) that had employee incentive stock options.
The company was always losing money, (cash flow and earnings)
so I thought it bizarre that they allowed employees to receive stock
instead of having to exercise their options. That is, instead of giving
the company the strike price and receiving new shares, (which would
have provided cash to the company), you could instead trade your
vested options for a number of shares equal to the amount your
options were in the money. When I pointed this out as being
stupid to the CEO, he explained that under the EMH (efficient
market hypothesis) the two ways of exercising options were
equivalent. Needless to say, the company went bankrupt. Maybe
having the cash from a few option exercises would have helped.
Probably not. In any case, they would have gone TU either a little
later, or with a little more cash for the creditors.
So history doesn't repeat itself, but it rhymes? In my opinion, we
are facing a stock bubble worse than 1929, but a trade bubble
worse than 1973. Prognosis: Two things are out of kilter, and two
things have to return to norm. (1) Stocks are way too high. (2)
There is way too much dollar running around outside the border.
These two problems are positively linked. That is, if stocks start
to crater, the Fed will be widely expected to lower short rates (just
like in 1987), and the dollar will consequently crater. (Note that the
Nikkei (sp) has already popped, so the Japanese don't have to
worry about starting a stock-bubble popping depression. And their
example of what happens when you pop your stock bubble must
be heavy in the minds of the Fed governors.) On the other
hand, if the dollar goes down, inflation will be expected, thus
interest rates will rise, and the stock market will crater.
I think the amount the Feds could lower rates in the event of a
market crash will be small compared to what happens when the
dollar tumbles. Therefore I expect higher interest rates. But
in any case, bonds are going to be more volatile than people are
used to their being. And I expect stocks and the dollar to dive.
Note that bonds aren't that high, so they don't have nearly as far
to fall as stocks (even with respect to bonds smaller volatility).
I agree 100% that if the Japanese sell off US treasuries, it will
not be out of some perverse desire to watch us eat dirt. It will
instead be because they pretty much don't have a choice. They
will be joined by our own investors selling off stuff.
Most of my sophisticated stock market buddies believe that gold
is obsolete, and will never again be seen as a store of value. Of
course, their equivalent were running around Paris saying the same
thing in 1795. But without the US dollar as a store of value, the
major banks of the world will resort to something else. Maybe gold,
maybe a foreign (to us) currency. But they will choose some store
of value. If you are the national bank of Guatemala, you simply can't
use Guatemalan pesos as your store of value to keep up the price
of Guatemalan pesos. Instead you have to have something
you can't print. We can keep the US dollar as the
default reserve currency for foreign nations only by defending it
with high interest rates. Are we willing to suffer those rates in
the face of an economic slowdown at home? Not if that slowdown
reaches depressionary levels. Foreigners don't vote, and neither
do the citizens who will later have to suffer inflation (at least they
don't vote yet.) So my bet is that they defend the dollar with
high interest rates until unemployment starts to get nasty. Then
they lower rates, the dollar crashes, and inflation begins.
Well maybe my IC compilation is done now. Back to work.
-- Carl |
