Fed cuts dollar, Fire sales vs FIRE sales, Duh-flation, and Bezzle shrinks again - Eric Janszen
Fed cuts dollar, Fire sales and F.I.R.E. sales, Duh-flation, and the Bezzle is shrinking... again
US consumer swan song means cheap now, cheaper later, then expensive -- it’s all about supply; there's never just one financial fraud, so check your docs; Duh-flation: Monetary policy is political not mechanistic; Rate cut follies: the Fed cuts the dollar
March 30, 2000 we were the first to note that a chunk of the money supply that John Kenneth Galbraith referred to in his 1954 book “The Great Crash 1929” as the bezzle, derived from the word embezzlement, grows when money is free flowing during a boom and no one is motivated to ask why. The bezzle shrinks when, after a financial bust investors start counting up the money they have left only to discover that not only has Mr. Market taken away a good amount but another pile was stolen by crooks. For Bernard Madoff’s hapless investors, if allegations turn out to be true, the amount left over appears to be zero and the bezzle an astonishing $50 billion, a new record for a single incident.
To the economist, embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or even years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely, not in -- the country's businesses and banks. This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression this is all reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks. - John Kenneth Galbraith, 1954
With the collapse of Bernard Madoff’s world class self-described Ponzi scheme this week, the bezzle shrank by $50 billion. The news on the story today is that the scheme looks to be a garden variety racket that anyone could have discovered if they’d applied the simple rule that if the returns are too good to be true, then the investment is probably a scam. But human nature being what it is, too good to be true is what everyone wants, so scams go undiscovered for years. That is especially likely in the case of a scam that is big enough to pay off regulators.
Ten years after Galbraith’s 1954 book, the $50 billion just lost in a single instance of embezzlement represented the entire U.S. net capital inflow of foreign assets in the first quarter of the year 1964. In Q1 2008 that number grew 10 times larger, to $465 billion. However, in a stunning turn, in the following quarter that sum fell to $26B. But I digress.
As I pointed out back in March 2000 writing for Bankrate.com, revelations of fraud are a standard feature of all financial bubble periods. Also, financial frauds are like cockroaches, there’s never just one; you can bet millions of hedge fund investors are pouring over their investment docs this week.
In 1954 US GDP was just over $3 trillion versus $13 trillion in 2008 -- or is it $12 trillion, or $11 trillion? At the rate the US economy is collapsing, guessing at this year’s GDP is like trying to toss watermelon into getaway car chased by cops on truTV. Until the FIRE Economy finishes burning out, we won’t know how much of the US GDP was credit industry bezzle extracted from the Production/Consumption Economy, that is, how much economic growth measured as GDP came from actual production versus the portion “earned,” if that is the word, by financial firms by swapping inflated assets back and forth.
The latest data from ECRI indicate that the US economy on track to contract to near its pre-FIRE Economy level. Already automobile unit sales are back to 1983 volumes. A full retrace of the FIRE Economy puts US GDP around $6 trillion, less than half 2007 GDP. I don’t expect that to happen; a solid portion of the technology-driven New Economy is real, so a decline to 1995 levels, around $9 trillion, is more likely, near the scale of decline experienced during The Great Depression. That may sound dire, but then when I told readers three years ago that the housing bubble was going to collapse and send the financial system and economy into the worst crisis in 70 years, that sounded dire, too.
US consumer swan song: Cheap now, cheaper later, then expensive -- it’s all about supply
Early next year expect a Great American Consumer Fire Sale to follow on the heels of the Great American FIRE Economy fire sale of financial assets that began in 2006. While the FIRE Economy fire sale was in houses, stocks, and all bonds but US Treasury bonds, with particularly heavy depreciation in securitized debt, The Consumer Economy Fire Sale starting in Q1 2009 will be familiar to anyone who lived through the 1980 to 1983 recessions when the Volcker Fed slammed the economy in a three years of contraction with rate hikes that created double digit unemployment and brought inflation down from over 12% to under 0% -- yes, resulting in a brief episode of actual deflation. Ask any old-timer coin dealer that survived it. Armageddon for them, nirvana for the FIRE Economy.
The major difference between the 1980 to 1983 recessions and the one that started in Q4 2007 as iTulip alone forecast in Oct. 2006: the Fed created the 1980 to 1983 recessions on purpose. This one is running on its own, out of control, with no apparent obstructions – fresh sources of credit, cash, or income -- to brake the fall.
Many retailers, especially discount chains, have already cut prices to cost. Shopping with the wife at a nearby Mall this past weekend we spotted tumbleweeds rolling down the isles of full price, brand name retailers while discounters offered goods Made in China, Indonesia and other lands at absurdly low prices.
The shoppers marveled. They felt rich, no doubt, as they snapped up the well crafted goods using cash and credit earned at an exchange rate value they may not see again for many years, unaware of the ephemeral quality of the precious purchasing power they wield this holiday shopping season in the final act of a 35 year consumption fantasy financed by other peoples' savings.
The spectacle evoked images of ill fated vacationers picking fish up off the exposed sea floor at Bali resort beaches before the tsunami waters rolled back in to drown them, and the story of the young girl who happened to learn about tsunamis in school the week before and, recognizing the danger, talked her family into running for higher ground. I could not help thinking that a year from now many shoppers, blissfully unaware of the economic calamity that awaits them, will wish they’d understood the perversely low prices as a warning of economic trouble ahead and saved their money for later.
The holiday retailer strategy: those left with the least inventory after Christmas live to fight another day. Then the first half of 2009 goes like this.
After Christmas sale 20% to 50% off
Liquidation sale 50% to 80% off
30% to 40% of retailers go out of business
Advice to readers: take advantage of the early 2009 Great American Fire Sale and go out and buy all the generators, chain saws, washing machines, fine linens, and other durable goods you’re going to need for the next few years because by the end of 2009 most of the inventory may be sold through, many retailers will be shut down, and replenishment of stocks of the survivors will likely be meager; our models say that the goods import supply will decline more precipitously than the supply of money available to pay for them. That spells severe stagflation.
Leading us to the latest installment of the inflation versus deflation debate.
Duh-flation: Monetary policy is political not mechanistic
It's about time to give up debating inflation and deflation with anyone who does not distinguish between asset prices in the FIRE Economy and commodities, goods, services, and wages prices in the Production/Consumption Economy. It’s a waste of time, like arguing with your dog. He doesn’t speak human, so everything you say to him sounds just as incomprehensible as everything he says to you, the human equivalent of woof, woof, woof. Simple ideas do get through, however, like holding the door open and barking “out!” to indicate it’s time to go pee.
In that spirit, we offer up a video located by eagle eye iTuliper LargoWinch created in 1933 to -- get this -- sell the American public on the benefits of inflation. In so doing we can demonstrate a principle even the most diehard deflation spiral believer can comprehend: government can create inflation if it wants to. It's just a matter of whose ox gets gored.
Before we show it to you, we'll first watch the opposite sales pitch from 1980 that is more familiar to readers, at least to those of us who grew up in the Reagan era when inflation overspread the land. It’s a movie starring Milton Friedman selling the public on disinflation, that is, a falling rate of inflation. (Stay with me, here -- it’s not that complicated. Inflation, whether in assets or commodities, is a positive rate of inflation such as 1% or 10%. Disinflation is a falling rate of inflation such as from 5% to 2%. Deflation is a negative rate of inflation such as -10%.)
Why, you ask, did the public have to be sold on the idea of lowering inflation? Wasn’t the torment of inflation obvious? Not to the man on the street. During a high inflation but below hyperinflation nominal wages go up, prices go up, interest rates on CDs go up, home prices go up. Everyone feels richer because inflation creates the illusion of increased value, at least if wages keep up -- except financial firms. They get their ass kicked as the purchasing power of income generated by capital gains on interest bearing contracts disappears. Wage and price contracts within the Production/Consumption Economy, however, can adjust to much higher rates to inflation without incident, up to a point – up to a 40% annual inflation, provided the inflation does not spiral out of control. Low inflation rates benefit the FIRE Economy far more than the Production/Consumption Economy.
What the Fed had in mind in 1980 that had to be sold to the public was tough medicine: high interest rates and three grueling years of recession. The government had to make the case that the pain was worth it.
5 minutes and 45 seconds
Sold! Let’s turn off the printing presses and kill the bad inflation! Thanks, Dr. Friedman, for selling a central tenet of the FIRE Economy – low inflation -- to the masses. (No hate mail from the Friedman fans out there, please. I'm a fan, too. But that does not change the fact that the FIRE Economy ran under the banner of Free Markets, with Friedman as the lead academic. Today it runs under the banner of Change.)
Now we go to the opposite case, back in 1933. A privative version of a FIRE Economy had a run in the US from 1925 to 1933. After it collapsed in 1929, asset price deflation spilled over into the Production/Consumption Economy in the 1930s. As unemployment increased to 25%, drastic anti-deflation policy was called for, the very opposite of what Friedman sold 47 years later in 1980. In 1933 Production/Consumption Economy leadership was elected in the person of FDR, and deflationary monetary policy followed by FIRE Economy leader President Hoover was about to change.
Runtime: 10min 32 sec.
This movie tells us two things. One, that FDR’s planned inflation program (see Ka-Poom Theory is a Rhyme not a Repeat of History) was, like the anti-inflation program of the 1980s under Reagan, not expected to go over well with the public, but for the opposite reason. The anti-inflation program was executed at the expense of wage earners in the Production/Consumption Economy for the benefit of FIRE Economy interests. Conversely, the anti-deflation program that started in 1933 was intended to accomplish the opposite, to kill off the remnants of the 1925 to 1930 FIRE Economy for the benefit of the Production/Consumption Economy. The movie was an attempt to inoculate the public from the onslaught of self-serving advice issued by the purveyors of the FIRE Economy, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate . . . purge the rottenness out of the system," not to mention the howling that issued from holders of bonds, soon to be wiped out, or gold, soon to be subject to confiscation. (Note to gold owners: a critique of the FIRE Economy is not an endorsement of pro-inflation policy. Here at iTulip we avoid "four legs good, two legs bad" over-oversimplification for readers who are interested in understanding what we refer to as The Inexorable Logic of the American Political Economy.)
This, readers, is why you see Treasury bonds at 0.00% and gold over $800 versus $400 where the deflation spiral believers earlier this year forecast the price to be by now. Treasury bond and gold prices reflect portions of a vast pool of money fleeing the collapsing FIRE Economy into the two assets that perfectly split the two political risks that now confront investors. One, that the new administration will persist with marginal and ineffective policies to fight asset price deflation which will thus continue to spill over into the Production/Consumption Economy and, two, that either the new administration will change course or another administration will execute drastic and effective anti-deflation policies once unemployment levels become politically untenable. My guess is that will happen no later than after unemployment surpasses 20% in 2010 but likely much sooner.
Keep an eye out for a YouTube video then lamenting the scourge of deflation and promoting an old idea re-tread and marched out as a modern monetary policy cure – new again as in 1933 – inflation, accomplished, as usual, via currency depreciation, but this time executed by unwitting US creditors selling dollar denominated assets versus deflating the dollar against gold.
Remember when you see that video that you heard it here first.
Also, look for the deflationists to begin changing their tune as they catch on to the deal. They will modify their old forecasts of a wage and commodity price deflation spiral to call for a period of deflation followed by inflation without acknowledging their shift to iTulip Ka-Poom Theory. Count on it.
Rate cut follies: Fed cuts the dollar
Back in February we expected the Fed to stop targeting price of money and instead the quantity after cutting rates to 2%.
The Bernanke Fed will use interest rate policy to stay in the low inflation/stable price zone until they see the high deflation zone approach at which point they will start to target monetary aggregates, not interest rates, much as Volcker Fed did to get out of a high inflation zone, but in reverse.
If that’s the case, the main trick for investors going forward is the figure out when to stop watching interest rates because the Fed is targeting money aggregates. Obviously this is made more difficult by the fact of the Fed no longer issuing official broad money aggregate (M3) data. My gut says the switchover occurs when the Fed funds rate drops below 2%, but perhaps the Fed has switched over already.
As the chart below shows, the Effective Fed Funds Rate today stands at 0.14%.
Despite appearances, a cut in the target rate is not merely symbolic. Rate cuts still have a reflation role: they cause the dollar to depreciate.
A quick review of this year's rate cuts so far and a forecast.
U.S. stocks were expected to plunge Tuesday after the Federal Reserve, responding to a growing financial market crisis, slashed interest rates 0.75 percentage point.
Dow Jones industrial futures, down more than 500 points, or more than 5 percent, before the Fed move, were fluctuating violently an hour before the start of trading, gave up much of their improvement and were down 427, or 3.53 percent, at 11,679 shortly before the opening.
The Fed's move was unsurprising, given that world stock markets were falling precipitously the past two days, and that U.S. stocks had tumbled last week amid growing fears of a recession in the United States. Still, the markets remain quite anxious, not sure that even interest rate cuts will lift an economy slammed by an ongoing housing and credit crisis.
The Fed's decision to cut its federal funds rate to 3.50 percent and the discount rate, the interest it charges to lend directly to banks, came a week before the central bank's regularly scheduled meeting, a sign that the Fed recognized the seriousness of the world financial situation.
A still-anxious Wall Street closed lower Wednesday, sacrificing the advance it made after the Federal Reserve cut interest rates half a percentage point. Investors collected profits after nearly three sessions of big gains, unwilling to leave money on the table amid ongoing economic uncertainty.
It wasn't surprising that the market pulled back, having suffered months of losses and having driven the Dow Jones industrials up more than 470 points so far this week ahead of the late-day downturn.
Wall Street stormed higher today as investors, optimistic following stronger-than-expected earnings from two big investment banks, were also galvanized by the Federal Reserve's decision to cut interest rates by three-quarters of a percentage point. The Dow Jones industrial average soared 420 points, its biggest one-day point gain in more than five years.
Many investors were expecting the Fed to cut rates a full point, but appeared to overcome their early disappointment, especially since a 0.75 point cut is still substantial. The central bank's benchmark fed funds rate is now at 2.25% � its lowest level since December 2004, and less than half what it was last summer. The Fed began lowering rates exactly six months ago, after the credit markets seized up due to soaring defaults in subprime mortgages.
Bernanke & Co. trimmed the Fed funds rate target to 2.0%, but lack of clarity about future moves caused confusion in the markets
The Federal Reserve delivered what Wall Street expected Wednesday afternoon by cutting the key interest rate by a quarter percentage point to 2.0%. But its murky statement dampened the enthusiasm and the early rally in stocks, leaving investors confused about what to expect next.
At the start of the session Wednesday, stocks were buoyed by a preliminary report showing that first-quarter U.S. gross domestic product rose by a better than expected 0.6%, and ADP's private employment index that showed a 10,000 rise in payrolls in April.
Then at 2:15 pm ET, the policy-setting Federal Open Market committee lowered its target on the federal funds rate by 25 basis points to 2.0%, as well as the discount rate by 25 basis points to 2.25%.
The lack of clarity in the Fed's statement about whether or not Bernanke and his crew plan to take a breather in their monetary easing campaign and a less fervent than expected stance toward inflation spurred confusion in the markets. Even more importantly, it sent a signal to currency traders that the firming of the dollar seen in recent weeks wasn't justified. The dollar promptly dropped, while bonds rallied on expectations that interest rates will remain depressed.
NEW YORK - Wall Street extended its huge decline today as an emergency interest rate cut failed to alleviate investors' fears that the paralysis in the credit markets will set off a global recession. The Dow Jones industrials, already down 875 points this week, fell another 150, and all the major indexes were down sharply.
Wall Street got the interest rate cut it wanted, but still turned in a baffling late-day performance, shooting higher and then skidding lower in the very last minutes of trading as some investors rushed to cash in profits after the market's big advance.
The Dow was up nearly 280 points after the Federal Reserve slashed a key interest rate by half a percentage point, but another bout of last-hour volatility wiped out the advance. Some analysts said hedge funds were cashing in their gains, while others said some investors were giving a bleak interpretation to the Federal Reserve's statement on the economy that accompanied its half-point rate cut.
The Dow closed 74 points down at the 8,890 level. The broader market indexes have ended the day mixed.
Finally, our forecast for Dec. 16, 2008.
Dec. 16, 2008: 1% to 0.5% Fed rate cut sinks dollar and stocks, boosts gold
The Federal Reserve reduced the Fed Funds interest rate to the lowest in history. The weak dollar sent oil and gold higher, while stock prices fell.
The rate cut was seen as largely symbolic as the Effective Funds Rate has not been higher than 0.5% since the rate cut to 1% on Oct. 29, 2008. As of Dec. 16, 2008, the effective rate was 0.14%, close to zero.
Rumors that the Fed is considering further unorthodox and radical monetary policy as interest rates approach zero sent the dollar down. Further weighing on the dollar was the revelation of the collapse of the $50 billion Bernard Madoff fund, run as, in Maddoff's words, a Ponzi scheme for many years under the noses of regulators.
Gold continues to outperform all other asset classes as it has since 1998.
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