http://www.dailyreckoning.com/Issues/2006/DRUS071006.html Ponzi Economy by The Mogambo Guru The Daily Reckoning St. Petersburg, Florida Monday, July 10, 2006 --------------------- * Bernanke is fighting a battle on two fronts...the dirty little secret of modern central banking... * One of the best places to catch some zzzz’s...all about timing... * In economics, everything happens at the margins...the delicate balance of our everyday lives...and more! --------------------- Poor Ben Bernanke. The man is running from pillar to post - from Stamford Bridge to Hastings, fighting Vikings first, and then Normans...inflation here, and deflation there. Yes, he is fighting on two fronts. Publicly, his big battle is with inflation. Rates went up another quarter of a point a week ago...for the 18th time in a row. And now, the papers are telling us that he’ll take another swing at inflation next month. And we believe it, but for completely perverse reasons, which we’ll explain. “By August, the Fed will be thinking about lowering rates,” says old-timer, Richard Russell. Russell is usually right. And we admit to a certain amount of confusion here at The Daily Reckoning. But what war is Bernanke really fighting - against inflation or against deflation? Which is the bigger threat? Looking carefully at a chart of bond yields, we come to the conclusion that the great bull market in bonds is over. It ended three years ago. What this means to us is that credit is becoming more expensive, not cheaper. And if we’re right, this trend cannot be stopped by pulling levers and turning knobs at the central bank. Too many people are too far in debt. They need to pay down their debt, write it off, and work it out. That’s what must happen before a new round of credit inflation can begin. But that process can take years. A whole generation of big spendthrifts has to learn an important lesson: that spending money won’t make you rich. It’s not a lesson that is learned the easy way, or overnight. In fact, it would be surprising if it didn’t take a decade or more. In the meantime, you can expect a lot of grumbling. Everybody likes a credit boom. They all believe they have more money. This is the dirty little secret of modern central banking. It only works by stealth and fraud - silently debauching the currency so that people make mistakes. The businessman believes there is more demand for his products than there really is. The consumer believes he has more purchasing power than he really has. The lender believes the borrower is a better risk than he really is. All these mistaken judgments lead to spending, investing and lending - which look at all the world like a bona-fide boom. But it is an ersatz boom, a public spectacle, founded on fraud, expanded into farce, and ending ultimately in disaster. Eventually, everyone gets too stretched out on credit. Then, the bubble finally finds a pin somewhere, and the air wheezes out. That’s the part that no one cares for, because, it is when people discover that they’ve made mistakes, that they’ve over-reached, and that they’ve been had. If, as we believe, we’re at the beginning of the disaster stage, the Fed’s real enemy is not inflation at all; it’s deflation. Typically, a credit contraction shrinks everything down with it. Earnings go down. Consumer spending is reduced. GDP growth falls...or even goes negative. And prices for most financial assets dive. Both Bernanke and Greenspan recognized the deflation enemy, and raised rates - not to fight inflation (although that is what they appeared to be doing), but to “reload the gun.” They had to hike rates in order to be able to cut them to fight deflation. Now, with 525 basis points from here to zero, at least the Fed has a new round of ammunition. But what will get them to pull the trigger? The most likely signal of deflation is a slowdown in consumer spending. Since consumer incomes are either flat or falling, consumer spending depends on the real estate market continuing fat and flourishing. And for that, the housing market must be propped up like a corpse at a viewing. The Fed must try to keep house prices from collapsing - at any cost! But, the housing market depends on long rates, not short rates. Mortgages are long-term debt. And long-term lending rates depend largely on lenders’ views on inflation. If they think they have a real inflation fighter at the Fed, they are most likely to lend at low rates. If, on the other hand, they see the Fed’s knees weakening, or its hands toiling over a white flag, they’re likely to want higher rates. This explains why the Fed is still raising rates, even though it sees deflation as the biggest threat. It explains why Ben Bernanke may raise rates again in August, even though it is deflation he really fears. He is merely trying to keep mortgage rates low so the real estate market won’t fall apart. Now we see the Bank of Bernanke’s strategy more clearly: it must crush inflationary expectations, while preparing to fight deflation as soon as it appears. When U.S. asset prices crack - that is, when stocks, bonds, and real estate begin to collapse - you will see another rush to cut rates. It worked so well last time, from 2001-2004, it surprised us. Too bad it’s not the sort of trick you can pull over and over. [Ed. Note: Don’t let 2006’s “insane economy” catch you off-guard. Join ten of Agora Financial’s finest investment minds for a midyear update on the American economy...and you don’t even have to leave the comfort of your own home. Find out how by clicking here: Your Chance to Fight Back More news from our currency counselor... -------------- Chuck Butler, reporting from the EverBank world-currency trading desk in St. Louis: “The euro and the yen have not taken a piece of news from Japan very well, and have backed off even more overnight. Japanese Prime Minister Koizumi announced that he is studying the legitimacy of striking bases in North Korea.” For the rest of this story, and for more insights into today’s currency markets see: The Daily Pfennig -------------- And more views: *** We’re spending the summer in France. We took the train back to France on Sunday. The Eurostar just came out of the tunnel when news came that France had scored a goal against Italy in the World Cup soccer championship. “Hooray,” the cheer went up. Then, about 15 minutes later the loudspeaker announced that Italy had scored. The game was tied, one to one, proclaimed the conductor. It was still tied when we arrived in Paris. The whole nation must have been watching, because the subway was empty. The streets were empty. Everything was quiet...except when France nearly missed a goal, whereupon a huge groan of agony seemed to rise up from the city. The match ended badly for France. The star of the French team was removed from the game after he head-butted an Italian player. And then, with him missing from the line-up, the French missed a decisive penalty kick. All night long, from our hotel window, we heard the French arguing and cursing in the bar across the street. *** Yesterday, we went to hear our favorite priest - Peter Mullen, chaplain of the London stock exchange. Elizabeth enjoys Mr. Mullen’s sermons as well. We both listened intently as he warmed to his subject, which was, what is expected of us as churchgoers. Now, Elizabeth has a marvelous talent - she can fall asleep readily, at any time, anywhere. In theatres, at movies, on trains, plains, automobiles. She nods off quickly, quietly. “It is not enough to come to church,” explained Reverend Mullen, raising his voice. “You have to pay attention and think about what is going on here. Sunday used to be a day unlike all the others. The shops were closed. The streets were quiet. There were no football games on the television and we even had special Sunday clothes. But now, Sunday is not much different from any other day - except for the time you spend here,” he declaimed, pounding the podium to make his point. “This is not like going to the cinema,” he wound up. “You can’t just sit there and doze off.” At that moment, we turned to see what Elizabeth’s expression might be. But instead of listening carefully, her head was already hanging down. She had gone asleep. We tapped her discreetly as we whispered, “Wake up.” “I wasn’t sleeping,” she replied, groggily. “I was praying.” *** A Dear Reader writes: “I was recently reading the Daily Reckoning of the 07/03/2006 in which the author introduced the concept of ‘change at the margin.’ I quote the relevant passage: ‘Readers will say we exaggerate. We don't deny it. There are plenty of Englishmen in London and plenty of foreigners in Paris. But everything happens at the margin, as economists say. At the margin, Paris is a French city; London is an international one. Paris is an attractive capital city. London is a great one.’ “I am writing this e-mail hoping that someone at The Daily Reckoning might be good enough to suggest a book or other resource that explains this concept.” We can’t think of any good explanation, so we offer one of our own. Reading through history, we often note how many close calls there are. It is amazing how many decisive events could have gone in the opposite direction, had it not been for one small thing: battle plans are used to wrap a cigar and discovered by the enemy...someone arrives too late or too early...it rains...it doesn’t rain...a crucial vote is swung by a single vote. At the Battle of the Bulge, the Germans were undone when one of them, pretending to be an American and speaking with a perfect accent, asked for “benzine” instead of gasoline. The Archduke Ferdinand was shot because his driver took a wrong turn. Hitler probably would have smashed the English air force had not a German pilot made a mistake and dropped a bomb on London. The English retaliated with a raid on Berlin, which prompted Hitler to switch to bombing civilian targets, giving the hard-pressed air-force crucial time to recover. Harolde might have prevailed at Hastings, but he had heard a prophecy and believed he was doomed. As a result, say some historians, he failed to control his men and lost the battle. Do you see? Things happen “at the margin.” Important things. But the expression ‘at the margin’ has a special meaning in economics; in economics it is at the margins that everything happens. There are millions of holders of a particular stock, for example, but the price of that stock is not determined by all of them, rather by the marginal few who are buying or selling. Markets are always in a state of dynamic equilibrium. They are tipped...by small, marginal actions. There may be millions of homeowners in America, for example. But all it would take would be a relatively few desperate sellers, and the value of all the real estate in America could be cut by trillions of dollars. Only one house in an entire subdivision may be sold, but the price of that house largely determines the value of all the other houses in the area. The margins tend to be under-appreciated, in our opinion. We noticed a woman on the train. She was a mature woman, and a very attractive one, with blonde hair gathered up on the back of her head. She was well dressed, and well put together. A young woman can be pretty, sexy...casual...like a cheerleader on a weekend trip. But an older woman must shoot for something different. She must aim for elegance, a kind of dignified formality that makes her attractive. But this woman was chewing gum. It was a small thing, but it undermined her. The margins are everything in all parts of life. Because those are the only things we have any control over. The woman was what she was. She could not change her age. She could not change who she was or what she was. She could only remedy the marginal things: the way she dressed, the way she spoke, the way the carried herself. She could be attractive...or not; it was a marginal thing. Likewise, a general is not likely to win a battle against a much superior army. There is not much he can do. But against an evenly matched enemy, the battle will be won or lost “at the margin.” So are elections. We noticed an article in the weekend press that described the election in Mexico as a “cliffhanger.” And as you may have remembered, there are a lot of election results that hang over a cliff. George W. Bush won his first term - if at all - by a tiny handful of voters. Why? Because political parties operate like market economies...competing for the marginal voter, right in the middle of the electorate, who will decide the issue. Parties do not operate on the basis of principles. They would be out of business if they did. Instead, they seek power, and they know they can only get it by getting the votes of those decisive marginal voters, the “swing voters” in the middle. Positioning and repositioning themselves for the competition, the two sides usually end up fairly evenly matched. And so, if the election is to be decided at all, it must be by the marginal voters who could go either way. Markets, politics - even personal lives - all rest in states of delicate balance, until something (often something small) comes along and tips them over. Everything happens at the margin.