Are we there yet?

I wrote my first commentary back in January about the pending decline in the fx value of the US dollar due to the large and growing macro-imbalances (current account and budget in the U.S.). Leon den Exter e-mailed me a very good (and in retrospect, right on target) question in response to my e-mail:

"Is it then conceivable that the Fed rate could be further (significantly) increased this coming year, despite what the current market expectations are based on the Fed comments? To further offset the trade deficit created by the import/export imbalance."


So my second commentary was my response to his question:

"You must have a lot of faith in Hellicopter (or Weimar) Ben Bernanke. As a side note, it will be interesting to see if our boy Benny is a serious public servant or yet another Bush administration crony. I am leaning towards the former, but only time will tell. At least they didn't try and stick us with Phil Gramm (former Republican senator who was a partisan hack) as Fed Chief.

The answer to the question is maybe. It would help the correct the imbalances in the U.S. economy. The problem is that if the Fed raises rates too high, it could bust the housing bubble. That would probably be a death blow to the U.S. economy.I actually think it would a positive, I think we need some pain (real pain) across the board in order to restore financial stability. In the long run, a short-term but severe recession could help avoid what I believe could be the next Great Depression.

I would say that there is a 75%/25% chance that once the economy slows from the Fed rate hikes, they will begin to cut rates (this seems to be what the bondmarket is forecasting). This will temporarily grease the economy and put us back towards the edge of calamity."


Are we there yet?

So now we are here: at the point mentioned in the question/answer above, or at least it is perceived that we are that point. The market seems to be impressed (even scared) by the manhood of Benny Bernanke, in his new role as an inflation-hawk. He has raised the Fed Funds rates twice to 5% since he took over from Easy Al Greenspan and is threatening (or promising) to raise them at least once more. In addition, central bankers around the world have done their part by raising rates, tightening the money supply, and talking tough on inflation. Please note that the actions of the Bank of Japan will also be a key driver of future events due to the potential for the unwinding of the yen carry trade - this is a huge and important topic in itself and I wouldn't do it justice in a one or two paragraphs. If you are interested in finding out more, send me an e-mail or comment on the blog site and I will point you to some readings).

In response, equity markets have tumbled, the yield curve has inverted and credit spreads have begun to tighten. Commodity prices have corrected back to two month lows (look at gold and silver over the past three weeks). By the way, I am still extremely bullish on metals as an inflation hedge as you will see at the end of this commentary.

My current view remains exactly the same as it did in January, this guy is not an inflation-hawk and probably would not even know what it would mean to be an inflation-hawk. As the convoluted, distorted, incomplete Core CPI rate has finally started to show the inflationary pressures from years of loose monetary policy (you see, the housing boom - and the commodity rally to a lesser extent - was really just an outgrowth of inflation but the CPI calculation does not use asset prices as an input) Bernanke has talked tough, his exact words were that these increases were "unwelcome" and "not consistant with a stable monetary environment".

So Wall Street is now worried that Bernanke is going to "go too far" in his fight against inflation and tip the economy into a recession (why did they not see this six months ago as everyone knows it takes somewhere between 6 - 12 months for a Fed tightening to make its way through the economy?). I think this has already happened as you can see the macro-environment weakening across the board from a collapsing housing market to a stalling job market (not unrelated to housing) to stagnant hourly wage increases. Inflation, at least Core CPI, is a lagging indicator - so by raising rates to combat the rise Core CPI, the Fed has probably already over tightened and will have to continue to raise rates at least one more time to maintain its credibility. So we won't see the impact of these latest rate hikes until late in 2006 when the economy will probably be in or near a recession.

So why do I say that this guy is not an inflation-hawk? Well, because I don't think it takes an inflation hawk to hike rates when the economy is still seen as strong (that is part of the problem of distorting growth and price statistics - look at the fake housing numbers - you get distorted decision-making). Everyone still talks about how strong the economy is and I'm sure that most of these people believe it, and this group includes Bernanke. So it is easy for him to stand up and talk tough on inflation - he thinks this is a free opportunity to establish his anti-inflation credentials.

However, the real test of an inflation-hawk (and this is where Greenspan failed) is their willingness to raise rates and tighten policy - or at least not loosen it - when the economy is slowing or even in recession. To inflate the money supply and increase credit everytime there is a blip in the economy makes you an inflationist. All these guys have been doing over the past eight years is postponing the inevitable and necessary economic corrections by printing money and pumping up asset prices (first equities, then bonds and real estate, and finally commodities).
However, while a severe recession would bring cleanse the system of waste and maladjustment, it would require a degree of pain and forbearance, a virtue in short supply in today's markets and society in general. Ben Bernanke, in particular, does not have the stomach or belief system for us to "take our medicine" and will lower rates and print money like there is no tomorrow when the economy turns the corner and heads down in a meaningful way.

Not sure if this will be in late 2006 or early 2007, but it will happen. This is what the bond market is telling us that much with its inverted yield curve. Market participants expect rates in the future to be lower than at the current time.

When Ben starts to loosen monetary policy and lower rates then the real fireworks will start. The dollar will fall (slowly at first), gold/silver will skyrocket and the stock market/housing prices will stabilize or even move to the upside. It will also put us firmly back on track for the 2008-2010 economic collapse which will finally wipe out the imbalances, distortions and malignancies in our economy and perhaps in society as a whole. This will be the topic of next week's commentary - the mass delusion of American consumers and whether an actual economic depression would actually be a good thing (in the long-run).

Weimar Ben (Bernanke) and his helicopters full of money

Despite the subject header for this week's commentary, I am not actually going to discuss the current chief of the Fed or the predicament that he finds himself in. I will only say this, he has stated that he would fight deflation with unusual methods (think dropping money from helicopters among others). Well, there is a consequence to this type of irresponsible policy-making. History has proven this over and over again.

A great example is the post World War I episode of hyperinflation in Germany. If only Weimar Germany had an Office of OMB which came up with an official calculation for Core Inflation that showed the cost of living to be increasing by 2% - they could have contained inflationary expectations and avoided the Hyperinflation that is discussed below. Just think, the cataclysmic rise of the Nazi Party and World War II could have been avoided by the Substitution Effect, Owner's Equivalent Rent and Hedonic Price Modeling.

Ok, I am being sarcastic - but based on the level of credibility given to phony CPI, PPI, and GDP-calculations (among other widespread inflation indices) by the mainstream media and financial community, it seems to me that the official numbers are all that anyone looks at. If you talked to the average American and asked them if their living expenses have only been going up by 2% per year over the past 3 years - I am pretty sure most people would laugh at you.

btw/ I did not come up with this absurdly disrespectful nickname for Ben Bernanke. I have to give credit where credit is due - Jim Willie CB, who is the editor of the “HAT TRICK LETTER” (http://news.silverseek.com/SilverSeek/1149079490.php)

Enjoy:

The 1923 Hyperinflation of the Weimar Republic (Germany) (Excerpt from Paper Money by "Adam Smith," (George J.W. Goodman), pp. 57-62.)

Before World War I Germany was a prosperous country, with a gold-backed currency, expanding industry, and world leadership in optics, chemicals, and machinery. The German Mark, the British shilling, the French franc, and the Italian lira all had about equal value, and all were exchanged four or five to the dollar. That was in 1914. In 1923, at the most fevered moment of the German hyperinflation, the exchange rate between the dollar and the Mark was one trillion Marks to one dollar, and a heelbarrow full of money would not even buy a newspaper. Most Germans were taken by surprise by the financial tornado.

"My father was a lawyer," says Walter Levy, an internationally known German-born oil consultant in New York, "and he had taken out an insurance policy in 1903, and every month he had made the payments faithfully. It was a 20-year policy, and when it came due, he cashed it in and bought a single loaf of bread." The Berlin publisher Leopold Ullstein wrote that an American visitor tipped their cook one dollar. The family convened, and it was decided that a trust fund should be set up in a Berlin bank with the cook as beneficiary, the bank to administer and invest the dollar.

In retrospect, you can trace the steps to hyperinflation, but some of the reasons remain cloudy. Germany abandoned the gold backing of its currency in 1914. The war was expected to be short, so it was financed by government borrowing, not by savings and taxation. In Germany prices doubled between 1914 and 1919.

After four disastrous years Germany had lost the war. Under the Treaty of Versailles it was forced to make a reparations payment in gold-backed Marks, and it was due to lose part of the production of the Ruhr and of the province of Upper Silesia. The Weimar Republic was politically fragile.

But the bourgeois habits were very strong. Ordinary citizens worked at their jobs, sent their children to school and worried about their grades, maneuvered for promotions and rejoiced when they got them, and generally expected things to get better. But the prices that had doubled from 1914 to 1919 doubled again during just five months in 1922. Milk went from 7 Marks per liter to 16; beer from 5.6 to 18. There were complaints about the high cost of living. Professors and civil servants complained of gettingsqueezed. Factory workers pressed for wage increases. An underground economy developed, aided by a desire to beat the tax collector.

On June 24, 1922, right-wing fanatics assassinated Walter Rathenau, the moderate, able foreign minister. Rathenau was a charismatic figure, and the idea that a popular, wealthy, and glamorous government minister could be shot in a law-abiding society shattered the faith of the Germans, who wanted to believe that things were going to be all right. Rathenau's state funeral was a national trauma. The nervous citizens of the Ruhr were already getting their money out of the currency and into real goods -- diamonds, works of art, safe real estate. Now ordinary Germans began to get out of Marks and into real goods.

Pianos, wrote the British historian Adam Fergusson, were bought even by unmusical families. Sellers held back because the Mark was worth less every day. As prices went up, the amounts of currency demanded were greater, and the German Central Bank responded to the demands. Yet the ruling authorities did not see anything wrong. A leading financial newspaper said that the amounts of money in circulation were not excessively high. Dr. Rudolf Havenstein, the president of the Reichsbank (equivalent to the Federal Reserve) told an economics professor that he needed a new suit but wasn't going to buy one until prices came down.

Why did the German government not act to halt the inflation? It was a shaky, fragile government, especially after the assassination. The vengeful French sent their army into the Ruhr to enforce their demands for reparations, and the Germans were powerless to resist. More than inflation, the Germans feared unemployment. In 1919 Communists had tried to take over, and severe unemployment might give the Communists another chance. The great German industrial combines -- Krupp, Thyssen, Farben, Stinnes -- condoned the inflation and survived it well. A cheaper Mark, they reasoned, would make German goods cheap and easy to export, and they needed the export earnings to buy raw materials abroad. Inflation kept everyone working.

So the printing presses ran, and once they began to run, they were hard to stop. The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. "If you want to save money," he was told, "and you want two cups of coffee, you should order them both at the same time."
The presses of the Reichsbank could not keep up though they ran through the night. Individual cities and states began to issue their own money. Dr. Havenstein, the president of the Reichsbank, did not get his new suit. A factory worker described payday, which was every day at 11:00 a.m.: "At 11:00 in the morning a siren sounded, and everybody gathered in the factory forecourt, where a five-ton lorry was drawn up loaded brimful with paper money. The chief cashier and his assistants climbed up on top. They read out names and just threw out bundles of notes. As soon as you had caught one you made a dash for the nearest shop and bought just anything that was going."

Teachers, paid at 10:00 a.m., brought their money to the playground, where relatives took the bundles and hurried off with them. Banks closed at 11:00 a.m.; the harried clerks went on strike.

The flight from currency that had begun with the buying of diamonds, gold, country houses, and antiques now extended to minor and almost useless items -- bric-a-brac, soap, hairpins. The law-abiding country crumbled into petty thievery. Copper pipes and brass armatures weren't safe. Gasoline was siphoned from cars. People bought things they didn't need and used them to barter -- a pair of shoes for a shirt, some crockery for coffee. Berlin had a "witches' Sabbath" atmosphere. Prostitutes of both sexes roamed the streets. Cocaine was the fashionable drug. In the cabarets the newly rich and their foreign friends could dance and spend money. Other reports notedthat not all the young people had a bad time. Their parents had taught them to work and save, and that was clearly wrong, so they could spend money, enjoy themselves, and flout the old.

The publisher Leopold Ullstein wrote: "People just didn't understand what was happening. All the economic theory they had been taught didn't provide for the phenomenon. There was a feeling of utter dependence on anonymous powers -- almost as a primitive people believed in magic -- that somebody must be in the know, and that this small group of 'somebodies' must be a conspiracy."

When the 1,000-billion Mark note came out, few bothered to collect the change when they spent it. By November 1923, with one dollar equal to one trillion Marks, the breakdown was complete. The currency had lost meaning.

What happened immediately afterward is as fascinating as the Great Inflation itself. The tornado of the Mark inflation was succeeded by the "miracle of the Rentenmark." A new president took over the Reichsbank, Horace Greeley Hjalmar Schacht, who came by his first two names because of his father's admiration for an editor of the New York Tribune. The Rentenmark was not Schacht's idea, but he executed it, and as the Reichsbank president, he got the credit for it. For decades afterward he was able to maintain a reputation for financial wizardry. He became the architect of the financial prosperity brought by the Nazi party.

Obviously, though the currency was worthless, Germany was still a rich country -- with mines, farms, factories, forests. The backing for the Rentenmark was mortgages on the land and bonds on the factories, but that backing was a fiction; the factories and land couldn't be turned into cash or used abroad. Nine zeros were struck from the currency; that is, one Rentenmark was equal to one billion old Marks. The Germans wanted desperately to believe in the Rentenmark, and so they did. "I remember,"said one Frau Barten of East Prussia, "the feeling of having just one Rentenmark to spend. I bought a small tin bread bin. Just to buy something that had a price tag for one Mark was so exciting."

All money is a matter of belief. Credit derives from Latin, credere, "to believe." Belief was there, the factories functioned, the farmers delivered their produce. The Central Bank kept the belief alive when it would not let even the government borrow further.

But although the country functioned again, the savings were never restored, nor were the values of hard work and decency that had accompanied the savings. There was a different temper in the country, a temper that Hitler would later exploit with diabolical talent. Thomas Mann wrote: "The market woman who without batting an eyelash demanded 100 million for an egg lost the capacity for surprise. And nothing that has happened since has been insane or cruel enough to surprise her."

With the currency went many of the lifetime plans of average citizens. It was the custom for the bride to bring some money to a marriage; many marriages were called off. Widows dependent on insurance found themselves destitute. People who had worked a lifetime found that their pensions would not buy one cup of coffee.

Pearl Buck, the American writer who became famous for her novels of China, was in Germany in 1923. She wrote later: "The cities were still there, the houses not yet bombed and in ruins, but the victims were millions of people. They had lost their fortunes, their savings; they were dazed and inflation-shocked and did not understand how it had happened to them and who the foe was who had defeated them. Yet they had lost their self-assurance, their feeling that they themselves could be the masters of their own lives if only they worked hard enough; and lost, too, were the old values of morals, of ethics, of decency."

The fledgling Nazi party, whose attempted coup had failed in 1923, won 32 seats legally in the next election. The right-wing Nationalist party won 106 seats, having promised 100 percent compensation to the victims of inflation and vengeance on the conspirators who had brought it.