Saturday, January 08, 2005

Greenspan: 'The Devil Made Me Do It!'

by Gary North

by Gary North

One of my favorite Flip Wilson characters was Rev. Leroy, the pastor of the Church of What’s Happening Now. I am not a fan of cross-dressing, so I was not a fan of Wilson’s Geraldine. But Geraldine’s immortal line – "The Devil made me do it!" – was always good for a laugh. Combine Rev. Leroy and Geraldine, and you get Alan Greenspan. I am tempted to call him Rev. Al, but Al Sharpton has a lock on the title.

The Federal Reserve System is surely the economy’s Church of What’s Happening Now. What is happening now is not much. That’s what has been happening for several months.

The adjusted monetary base is the one monetary component that the FED controls directly. When it buys or sells Treasury debt, the statistic goes up or down, respectively. This is high-powered money: the money that serves as the legal reserve for the commercial banking system. These days, the AMB is barely moving. In the most recent reported week, it was moving down.

This is consistent with the FED’s announced policy of raising interest rates, which means short-term rates. The American economy is expanding today, while the money supply’s legal monetary base is flat. The presumption is that interest rates – the price of borrowed money – will rise: more demand, fixed supply.

The other major monetary statistic that I watch closely is MZM: money of zero maturity. I think it is closest to true money: no waiting. It has been flat – peak to peak – for eight months, which is a considerable period of time in the world of the FED.

What about consumer prices? There is no agreement among forecasters and economists as to which official consumer price index best reflects the condition of Joe Average. I use the median CPI, which is published monthly by the Federal Reserve Bank of Cleveland. The median CPI is a weighted median of the CPI. As a price inflation predictor, it does pretty well. November’s increase was 0.1%, or 1.1% annualized. Year to year, the increase was 2.3%.

So, from the point of view of statisticians, the FED is achieving its stated goal of bringing down price inflation. It is also acting consistently with its stated goal of raising short-term interest rates.

But . . . the fall in the rate of price inflation tends to reduce long-term rates, meaning bond and mortgage rates. Why? Because a permanent reduction in the expected rate of price inflation reduces the fear of lenders that they must add a money depreciation factor into long-term loans. Ludwig von Mises called this the inflation premium of the free market’s interest rate.

If lenders believe that today’s rate of price inflation – low – will be maintained for the duration of the loan, they will be willing to lend money at a lower rate of interest than they would if the rate of price inflation were higher.

This reduction in the long-term interest rate can be offset by a reduction in the demand for long-term loans. If borrowers think they will have to pay off their debts with money that is less likely to depreciate, they may be less willing to take on new debt. Maybe they planned to stick it to lenders good and hard by riding the wave of price inflation and repaying the loans with funny money.

At present, we are seeing rising short-term rates and stable long-term rates. Mortgage rates fell slightly in the first week of January, and are slightly lower than they were a year ago.

If the FED sticks to its present policy of stable money, price inflation will become a declining factor in the long-term credit markets. Long-rates will not rise as fast as short rates will. This raises the specter of recession.


When 90-day T-bills pay more interest than 30-year T-bonds, we call this an inverted yield curve. Why inverted? Because it’s abnormal. Why abnormal? Because it is normally riskier to tie up your money for 30 years than 90 days. So, the interest rate on long-term money is higher: a default-factor premium.

For short-term rates to exceed long-term rates, there has to be an intense demand for short-term loans. What would cause this? This: fear of falling demand for goods and services – a fear so great that business borrowers want to finish existing capital projects. They may be facing falling revenue, or expect to, which pressures them to shut down uncompleted projects. They resist shutting them down, for obvious reasons: incomplete projects produce no income, yet existing debt must be paid off, whether a project is shut down or not. So, they want short-term money to tide them over. Demand for short-term loans rises in relation to demand for long-term loans, which frighten borrowers who think recession is coming.

The inverted yield curve is the best predictor of recession I know of. The Federal Reserve in 1996 published a paper that reached the same conclusion. I used this indicator to forecast Bush Sr.’s 1990 recession and Bush Jr.’s 2001 recession.

Today in the United States, we do not face an inverted yield curve. Britain does. Here are the observations of John Mauldin, author of Bulls Eye Investing (Wiley, 2004). He used to be the manager of my newsletter, Remnant Review. I introduced him to the yield curve 15 years ago. John is something of a quant. He loves rows of numbers. He monitors numbers. Here is what he has discovered.

UK unemployment is an amazing 2.7%. I am sure there are examples, but I cannot recall a major economic country with such a low unemployment rate. Inflation, although rising, is still under 2%. Wages rose by 4.4% in the three months through October, the highest rise in several years and more evidence of nascent inflation.

The housing market is doing quite well, thank you. In what everyone calls a bubble, housing in England still rose 12.5% year over year in November, although only 0.2% in the last month. Could it be slowing? UK household debt is 140%, which is above US levels.

The Bank of England recently noted, "Any sustained fall in [house] prices would reduce homeowners’ cushion of housing equity. This might reduce their opportunity to re-mortgage to consolidate other debts or to lower their monthly payments. Financing difficulties would be exacerbated if any fall in house prices were accompanied by a wider economic slowdown." (Marshall Auerbach at Prudent Bear). . . .

The Bank of England is in a hard spot. They have been steadily raising rates to keep inflation in check and to rein in the white-hot housing bubble. Since the housing market is still doing well, and inflation is rising, one would think they should continue to raise rates. But with an inverted yield curve and a very strong pound, raising rates might not be wise, as that could push the country into recession.

If I lived in England, I would be getting my personal house in order. No long only stock funds, switching to bonds and absolute return type investments and funds. While the Fed study on yield curves was based on US precedent, the rule generally applies everywhere. Thus precaution is the order of the day. . . .

I think England may be 6–9 months ahead of us in the softening process.

Mauldin calls the inverted yield curve in Britain the canary in the coal mine. Miners used canaries to predict gas leaks. The canaries would stop chirping, due to the inconvenience of just having died.

I say, let the Brits perform this useful function.


Gold has been rising against the dollar at about the same rate that the dollar has declined against the euro. Gold has not risen in the euro price. This indicates that the problem is the dollar, not a shortage of gold internationally.

The dollar has rallied against the euro in recent days. A number of contrarians predicted this, including Dan Denning of Strategic Investment and Marc Faber of the Gloom, Doom, and Boom Report. Both remain bullish on gold long-term, but both were convinced that the dollar had been oversold in relation to the euro. Faber’s report is especially prescient, published on December 1.

Regular readers of this column know that my view remains that the US economy is in deep trouble and that the US dollar is a doomed currency, which will over time lose all its value. However, even within a downtrend there can be countertrend rallies the same way there can be significant corrections within an uptrend. Right now the situation we find in financial markets is as follows. The US stock market and other stock markets around the world have risen from their late October lows in typical post election rallies (see November report entitled, "Conflicting Trends"). However, it is quite common that these post election rallies fade out relatively soon, as was the case when Richard Nixon was elected in November 1972. This was followed by further strength but the stock market made its final high in January 1973 – slightly higher than in December 1972 – before entering a devastating two years’ bear market.

Since, at present, the US and also other stock markets around the world have become significantly overbought (see relative strength indicator in figure 2) amidst record bullish investors’ sentiment it is very likely that either a top is already in place or about to occur within days, which should be followed by a correction of around 5% at the very least and lasting into mid December.

From a mid December low we should then get a year-end rally into January, whereby I am expecting that numerous technical indicators will fail to better their current high readings. This should then lead to a more pronounced downturn into February.

The first week of January brought a downward move for the stock market. There was a rally in December, but it ended in December. In this light, it is useful to consider the other half of Faber’s prediction.

Above I mentioned that the US stock market is now – in the near term at least – in significant over-bought territory. The opposite seems to be the case for the US dollar, which has now reached an extremely over-sold position. . . . I am not so sure that the dollar is now over-valued against the Euro. Quite on the contrary, from a recent trip to Europe it is my impression that at the current exchange rate the dollar is – purely on its purchasing power compared to the Euro – somewhat undervalued. As a result, I think that the most likely financial developments in the next few weeks will be a setback in US equities and a rebound in US dollars. In particular, I should mention that numerous large currency and commodity funds have huge leveraged dollar bear positions outstanding, which could rapidly unwind once the dollar begins to rally. I suppose that if the US stock market could decline within a long-term uptrend by 21% in one day – this happened on October 19th 1987 – the US dollar could easily rally by 5% to 10% within a short period of time. (


Alan Greenspan has been unwilling to do what his predecessor Paul Volcker did, 1979–82: stabilize money, let interest rates rise, suffer a recession (some would say two), and eliminate the inflation psychology from the markets. Volcker faced a far worse situation in 1979 than Greenspan faces today: roaring inflation, T-bill interest rates over 20%, and mortgage money at 14%. He stuck by his guns until Friday, August 13, 1982, when Mexico threatened to default. The reinflation began in earnest the following Monday.

The FED under Greenspan since 2000 has created extensive monetary inflation, a downward unprecedented manipulation of short-term rates even before the 2001 recession began, and a housing run-up in most regions and a bubble on the two coasts. This followed the FED’s expansive policies, 1995–2000.

Now, if we are to believe the figures, the FED has repented. The Open Market Committee has gone forward at the altar call, pledging to turn back from their wicked monetary ways. We shall see. If the FED sticks to its guns the way that Volcker did for almost three years, the inverted yield curve will return. There will be another Bush recession. The housing bonanza will end. But the dollar may stabilize.

How likely is this scenario? Not very. The FED will not stick to its guns for three years. Greenspan has shown again and again, from the first month he was in office (October, 1987), that the FED stands ready to supply liquidity.

Today, the FED is following the traditional post-election policy of tightening money. In fact, this policy began even before the election. This policy of stable money after a period of expanding money traditionally ends a stock market boom, as Faber has described: Nixon, 1973. This is followed by a recession: Ford, 1975.

Central bank policies of stop-and-go monetary inflation produce stop-and-go recessions. In 1972, F. A. Hayek’s book, A Tiger by the Tail, appeared. It was a collection of essays on the monetary policies of the West. He argued that monetary intervention had created a tiger of debt and misallocated resources. By the time of his death two decades later, this tiger had grown much larger. The expansion of nominal debt had been subsidized by the expansion of fiat money. The aggregates grow larger. The web of debt grows more intricate.

How do we get off the tiger? If we failed after 1972, why would anyone believe that Greenspan is ready and willing to play Roy to Volcker’s Siegfried?


I am not worried about price inflation in the near term. The FED’s monetary policies over the last six months – really, over the last year – have already turned down the burner.

I don’t think the flame will be kept at low simmer. But until the FED’s policy-makers see the reappearance of the inverted yield curve, they are unlikely to return to the monetary policies of 2001.

This is why the stock market is still in trouble. To rescue the dollar in relation to the euro, the FED has adopted a stable money policy. The trade deficit will continue if the dollar stabilizes against the yen, and if China continues to link the yuan with the dollar.

The boom, such as it is, is doing more for export-driven manufacturers in China and Asia than it is for Detroit. Stabilizing the dollar will not alter this effect of FED policy . . . until a recession hits. Not until consumers get scared – really scared – are they going to turn down Asian offers to buy now, pay later.

Americans seem to be addicted to easy money, low interest rates, and imported goods. Greenspan has announced higher interest rates, which can be attained only by tighter money. The FED is providing tighter money. But there is no indication that the public is ready to cut back on buying imported goods. There are too many yuan and yen flowing into our capital markets.

When that flow is reduced, then the party will come to an end. Until this happens, American consumers seem determined to take advantage of the largesse of Asian investors and central banks. Americans are letting Asians buy future income streams generated by America-located capital, and they are using the money to buy goodies.

We are selling our seed corn. It’s easier to sell it than grow it. It’s easier to buy on credit than to save. Asians are taking advantage of our present-oriented time perspective. It is if they were structuring their economies in terms of the book of Deuteronomy.

The LORD shall open unto thee his good treasure, the heaven to give the rain unto thy land in his season, and to bless all the work of thine hand: and thou shalt lend unto many nations, and thou shalt not borrow. And the LORD shall make thee the head, and not the tail; and thou shalt be above only, and thou shalt not be beneath; if that thou hearken unto the commandments of the LORD thy God, which I command thee this day, to observe and to do them (Deut 28:12–13).