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Wednesday, February 14, 2007

I agree with Bernanke's testimony - mostly.

Stripping away all the fluff, what he said was that the outlook for inflation demands upon oil prices, and he is correct. Increases in crude prices are by far and away the biggest source of inflation, and decreases in crude prices are by far and away the biggest economic stimulators. And he said that the outlook for growth depends upon consumer spending, and he's correct about that.

Fourth quarter GDP is going to be revised downward, anyway. Problems in rural areas are escalating. But right now, the Fed knows nothing because the Fed can't predict crude prices, and the Fed can't predict what's going to happen in housing demand, because it depends on unknown factors.

This note ought to give everyone pause, though:
With fewer jobseekers entering the labor force, the rate of job creation associated with the maintenance of stable conditions in the labor market will decline.
What he means is that job creation is subpar and likely to remain so, but that retirements will prevent the unemployment rate from escalating proportionately. Now when larger companies feel strain, the first thing they do is restructure older workers out (higher wages, higher medical and benefit costs), so my guess is that we are going to see a net, unfavorable swap effect in 2007, in which high-income workers lose their jobs at disproportionately large rates, both in the blue-collar (construction, construction related) and in the professional segment. Any company which relies upon broad consumer sales is feeling pressure and will experience a disproportionate discount by the Street if its profitability lags, so there will be a broader restraint on employment this year, but the net is likely to be a disproportionate decline in consumer spending. However, there is some offset in the works related to departure/enforcement for illegals. This boosts wages at a time when we need higher wages. It also cuts public expenditures.

And this:
All told, consumer expenditures appear likely to expand solidly in coming quarters, albeit a little less rapidly than the growth in personal incomes..."
The debt stimulus is probably over, and consumer spending will become more dependent on actual earnings - this should give everyone pause. This statement matches well with state experience on sales tax proceeds (the debt effect seems to be waning). Income inequalities have now become a real issue for the health of our economy. The much-maligned Medicare drug coverage may be the single thing that boosts spendable income for most retirees and moderates the effects of economic irrationality, thus giving us some more margin for the rest of 2007.

FWIW, I think Bernanke will be an excellent chair. When Greenspan talked about virtuous cycles that cut the economic prospects and overall stability for over 50% of our workforce, I never could figure out whether it was senility or putting his best face forward. Lord knows the old man did his level best to get economic reality across to Congress, so it was probably the best face tactic. The Fed would be fools to try to talk this market down, but they are signaling that they won't bail out irrational behavior. Anyway, as you can see, the Street is in the mood to keep the party going. Positive expectations only last for so long, though.

The truth is that retail gas prices now control whether we experience a rural recession/mild financial expansion on deal-making or an unqualified recession. Regardless there will be a lot of pain this year. At no time since WWII have the 55 plus cohort had so little in combined savings/pensions, so much debt and such high insurance costs. The numbers are horrific. Furthermore, the local/state public pension problem is likely to overbalance in the next two years. Granted, NJ is the worst in the nation at this, but once these things tip they move rapidly. NJ is faced with a difficult problem. It cannot support its public debt without economic growth, and its economic growth is being destroyed by high taxation caused by public debt. The only way out for them is to flat tax and attract rich people from the tri-state area, but somehow I don't think one of the least functional state legislators in the nation is gonna tumble to that solution.

On the other hand, Joe Six-Pack has been beaten up for 20 years now, and for the most part Joe Six-Pack has become a canny survivor. There's a lot of initiative out there. But Joe Six-Pack on a low retirement income and high personal expenses has no option but to flee high taxes, so....

The reason I thought the Fed would have to cut rates by 50 basis points at the end of the third quarter is that this is the only margin they can extend to cushion those dire second liens, especially HELOCs. That's where the trouble is. They may have decided to let the chips fall and force massive reworks on those suckers instead, but if that is their decision, it is a very, very risky one that may well cause considerable problems.

On growth, Bernanke described a nice moderate growth scenario for the next two years, but then added this proviso:
To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006.
In other words, if it doesn't start improving it will spill over to the broader economy. On inflation:
Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers. After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices, which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services.
The reality is that an energy policy is the fix. Generating more energy domestically gives us a fix for the trade deficit, an increase in domestic investment, generates excellent paying jobs related to that fixed investment, and controls energy costs which boosts manufacturing even more. The joke's on us - it is only bad public policy which is causing a lot of our pain.

"Increases in crude prices are by far and away the biggest source of inflation ...." HUH? Bailey
Thursday, February 08, 2007
Discuss global trends with Mish at The Market Traders.
Counterfeiting Money - Crime or Good Economics?
Did you ever think that a counterfeiting money could be good for the economy and that the counterfeiter could be considered an economic genius or even a national hero? I received an Email from Nic Corsetti, a friend of mine, describing exactly how that might happen. Here goes from Nic:

Let’s say that I invent a printing press that allows me to produce counterfeit money (let’s say US dollars) by the trillions – these dollars look EXACTLY like real ones, so no one can tell the difference, not even the government or the bank. So I start off the first year by counterfeiting $3 trillion dollars.

I use $1 trillion to buy stocks (jump starting the bull market)
I use $1 Trillion to buy U.S. Treasury bonds (thus driving bond prices higher and interest rates lower)
I use $1 Trillion to go around to every neighborhood in every major city of the U.S. and start buying houses for 10% higher than the listed price
Obviously, this is a lot of work, so I hire a whole network of employees and consultants to help me achieve those lofty goals in a reasonable time period. The apparent benefits would be huge.


This will create jobs, since lots of employees and consultants will be needed to spend $3 trillion.
The stock market indices will soar. Everyone's 401(k) and day-trading portfolios will increase in value.
Home prices will increase by 10% overnight.
Interest rates will fall which will make it even cheaper for everyone to borrow money to buy new cars, upgrade into a bigger homes, and buy new gas plasma TVs every year hoping against hope of getting to watch the CUBs someday play in the World Series.
The lifeblood of America, vastly underpaid Real Estate Agents, will get a much needed and well deserved infusion of cash.
The economy will be humming so fine that no one will care about the loss of jobs to India and China.
Cheap goods will continue to pour into the US and the CPI will show only a modest 2% rise in the price of goods.
Additional Printing Presses

This is such a good plan, I decide to let some of my best friends in on the action. So I pick twelve of my closest cronies and give them identical printing presses, and instruct each of them to buy stocks, bonds and real estate with their counterfeit money. I tell them to loan the money to anyone who asks. Now we are really getting somewhere.

The stock market will rise 30%-50% every couple years
By buying massive amounts of treasuries, interest rates will stay at historic lows
Everyone's net worth will double every few years if they just buy more real estate
There will be no reason to save money, because assets will just keep skyrocketing in value.
Wave after wave of immigration proves adequate enough to supply the homebuilding industry with enough manpower to get the job done.
So much money is made in the stock market that $50 billion in bonuses can be distributed.
Home prices start rising so fast that people start buying two or even three of them. It's a "can't lose" venture.

There is so much money floating around that credit standards drop and everyone who wants a home gets one.
So many homes are being bought that massive numbers of jobs are created in the mortgage industry, home builders, architects, real estate agents, title insurance, property insurance, home decoration, lumber, copper, cement, truck manufacturers, granite miners, brick layers, roofing, repairmen, industry analysts, home flippers, internet bloggers, internet site maintenance, newspaper ads, Wall Street specialists(to create RMBS, CDO, CDS, Index swaps), hedge fund employees (someone has to trade all these securities, and accountants and lawyers to keep track of all of the above.
There are additional profits to be made on Wall Street by investing in IPOs, private equity LBOs, M&A, trading, mutual funds, and hedge funds.
There is job growth in investment advisers, investment analysts, day-traders, media cheerleaders, SEC regulators, state regulators, New York D.A. office, and accountants and lawyers to keep track of everything.
Government jobs explode. State and local governments get all sorts of funding for projects of all types – big and small. This creates still more jobs.
Everyone needs a place to spend their money. Shopping malls, strip malls, big box stores, specialty stores, boutiques and nail salons spring up everywhere.
People are so busy shopping they do not have time to cook. This creates a need for more restaurants or coffee shops on every corner.

Even with all of that there is STILL NO INFLATION! Cheap imports keep prices from rising and the best part is that those foreigners keep taking this counterfeit money as if it was real money. No one can tell the difference anyway.

This goes on and on – we have really created a tremendous virtuous cycle where everything just gets better and better.

Everybody Wins

After a few years of counterfeiting I am quite certain that a "new era of goodwill and fortune" would be announced and that I, Nic Corsetti, would rightfully be hailed as the first Economic Grand Wizard to have permanently vanquished recessions.

But what’s the catch? Where’s the hole in this story? Is there a hole in this story? If counterfeiting is such a great idea, why isn't it legal? Actually it is legal.

Legal Counterfeiting

My name is not really Nic Corsetti, it is Alan Greenspan (Ben Bernanke if you prefer).
My twelve friends are the 12 member banks of the Federal Reserve
My employees and consultants are the financial services industry (Wall Street broker dealers, hedge funds, mutual funds, retail banks, and commercial banks)
Those printing presses are currently manned by me and my 12 friends

I (Ben Bernanke) hope these printing presses don't break down and that people keep accepting these counterfeit dollars or this economy might implode. This is my only fear right now.

Mish Note: Nic Corsetti is a real person. The above idea came in from Nic via email and was rewritten and reformatted by me. Still, Nic deserves full credit for the idea. Thanks Nic.

As "proof" of the ingeniousness of legal counterfeiting, Alan Greenspan has been hailed as an economic hero and knighted by the queen of england for "contribution to global economic stability". Printing presses do work (for a time) and Greenspan's timing was perfect as discussed in an Interview with Paul Kasriel.

Kasriel: Greenspan is a fascinating study. Some day I hope to write a book about him. Right now I willing to say he is the luckiest Fed chairman in history.
Mish: Greenspan is the luckiest Fed chair in history? How so?
Kasriel: He was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment the Fed could create large amounts of money and credit without causing inflation other than in asset prices.
Synthetic Money

By the way, so many others have acquired the magic printing presses that the Fed is now basically irrelevant when it comes to credit expansion and contraction. Synthetic money is now being created in massive amounts in numerous places. For example, GSEs are now running their own printing presses. Want a $500,000 mortgage? Boom, you got it. No one cares if you can pay it back either. It is foolproof as long as home prices only go up. Multiply that by the hundreds of thousands and it all adds up, and much of it done with 0% down, and most of it based on the belief that housing prices only go one way: up. The day of reckoning comes when home prices sink. A collapse is now underway, and it has hit the subprime market especially hard. Those credit problems are guaranteed to spread.

Some may object to the term "synthetic money", perhaps preferring something like creating money by "fiduciary media". The important thing is not what we label it, but rather the general idea of what is happening. And without a doubt enormous amounts of money (credit/debt) are being borrowed into existence with increasing leverage and risk.

Broker dealers (via junk bond offerings) have figured out how to create their own synthetic money backed by essentially nothing. As yields collapsed increasing leverage had to be used to generate the same returns. Such offerings have exploded along with mammoth growth in hedge funds all wanting a piece of the pie.

Some 20,000 hedge funds are now doing things with leverage because yields are too low. Various carry traders have created synthetic dollars of sorts by borrowing Yen and investing in US dollar denominated assets such as US treasuries. This has been building and building and building on itself so that no one even knows how many printing presses are actually running. The day of reckoning on carry trades will come when the Bank of Japan is forced by the market to raise rates at a rapid rate and there is a mad scramble to get out of dollars and back into Yen. Rest assured these events will be anything but orderly when they happen.

Initial sponsorship of "legal counterfeiting" came from the Fed and Central Bankers in general, but once Wall Street got a hold of the magic printing presses, things have gotten more than a little out of hand. This is what happens when you have money backed by nothing and borrowed into existence. This is also what gold lovers see when they recommend gold.

An Austrian Perspective

After reading the above some of you no doubt will be comparing this to hyperinflation and the Weimar Republic. Instead let's look at this (as best we can) from an Austrian perspective.
Money itself (however one defines it) is a claim on real savings (a placeholder for saved goods). For example, a baker makes bread, so what he actually saves is bread. The baker only transforms his savings into money (typically a monetary commodity that has a prior demand for other uses, such as gold) because that's far more convenient. The baker can not actually save bread, as it would get old.

Therefore money, as such, is a claim on real goods. Credit by contrast, is a claim on money itself, which in turn is a claim on real goods. In our present system, credit claims on money to be paid back in the future masquerade as actual money and can thus be termed "synthetic money". In addition there is a "multiplier" effect. Someone gets a loan and spends it on goods. That money is deposited and is treated as money regardless of whether or not it is backed by real goods. Via sweeps and still more lending (see Money Supply and Recessions), the same money is lent out time and time again (the multiplier effect). This is the failure of the central bank administered fiat system: monetary claims proliferate beyond actual production of goods to back them up. In a honest system, only actual savings would be transferred from savers to borrowers (with banks acting as middlemen).

This "credit inflation" is thus fundamentally different from the "Weimarian printing press inflation". The Weimar situation brings about hyperinflation as the monetary unit itself is inflated in its physical form, as banknotes. By contrast, a credit inflation that creates claims that masquerade as money is prone to deflation because the money needed to pay back the credit is in a shortage (relatively speaking) compared to the outstanding credit claims.

This does not entirely preclude an inflationary outcome. After all, the Fed could in theory decide to monetize just about anything. It could monetize defaulted bonds and loans, it could even go and buy up foreclosed houses if it is prepared to go the Weimar route in order to avert what it would deem a deflationary calamity. As we have discussed in the past, this is unlikely to happen for a variety of reasons (see An Interview with Paul Kasriel and Q&A on the Psychology of Deflation). In addition to the ideas expressed in those articles there is bureaucratic inertia to the fear of losing wealth and power. One key point in this regard is the fact that the Federal Reserve system is made up of creditors. Those creditors will not like the Weimar solution because it would debase their credit claims.

This I believe is the message Trichet, Poole, and Weber were attempting to convey in Central Bankers Cry Wolf.

Weber: European Central Bank council member Axel Weber said investors shouldn't expect central banks to bail them out in the event of an "abrupt" drop in financial markets. "If you misprice risk, don't come looking to us for liquidity assistance," Weber said in an interview in Davos, Switzerland at the annual meeting of the World Economic Forum. "The longer this goes on and the more risky positions are built up over time, the more luck you need."

Trichet: Current conditions in global financial markets look potentially "unstable", suggesting that investors need to prepare themselves for a significant "repricing" of some assets, Jean-Claude Trichet, president of the European Central Bank. "We are currently seeing elements in global financial markets which are not necessarily stable," he said, pointing to the "low level of rates, spreads and risk premiums" as factors that could trigger a repricing.

Poole: "The Fed can provide liquidity support but not capital".

The most important facet of all of this is that monetary claims very likely exceed the pool of real funding by several orders of magnitude. When push comes to shove, this house of cards will eventually collapse in some way.

It is important to recognize that what is happening right now with stock buybacks, leveraged buyouts, and various carry trades for what it is: one giant Ponzi scheme. This will end the way all Ponzi schemes end: when the willingness or ability of consumers or or businesses to take on more debt stops and/or when the willingness to further speculate stops. When either of those happens there will be a mad rush for the exits and no more buyers for "overpriced tulips" will be found. Be prepared.

Note: This post originally appeared in Whiskey and Gunpowder. The section "An Austrian Perspective" was a last minute addition for this blog.
I just don't agree with Mish on this one. I'll try to explain why soon.
I understand, lately, I don't find myself agreeing with most people on most things. But, I enjoyed your post of the 6th & look fwd to reading your thoughts on this MOST important topic.
IMO oil doesn't come close to explaining inflation we've seen or are likely to see. But, to be fair, neither do any of our "accepted" measurements. My feeling is enacting the Boskin Commission recommendations coupled with the deregulation of our banking system (total repeal of Glass-Steagall) opened the money creation floodgates.
I see little resolution to the discussion until we first agree upon a minimal time period for measuring inflation & a reasonableness requirement that any measurement reflect the living standards of a representative population sampling. Bailey.
Bailey - On that, we DO agree. Inflation measurements are currently inadequate.
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