05/03/2001 The Power of Money *

It was a now normal week of wild volatility and stunning moves in many individual stocks. The more speculative areas of the market significantly outperformed. For the week, The Street.com Internet index surged 11%, and the NASDAQ Telecommunications index jumped 7%. The NASDAQ100 added 6%, the Morgan Stanley High Tech index 3%, and the Biotechs 4%. The Semiconductor stocks were largely unchanged after their huge April. The broader market performed quite well, with the small-cap Russell 2000 and S&P400 Mid-Cap indices gaining 2%. Financial stocks were volatile, but finished the week on the upside. For the week, the S&P Bank index added 1% and the AMEX Securities Broker/Dealer index jumped 4%. The blue chips enjoyed modest gains, with Dow, S&P500, Morgan Stanley Cyclical and Morgan Stanley Consumer indices all increasing about 1%. The Transports gained a fraction, while the Utilities declined 2%. The HUI Gold index declined 1%.

A deteriorating labor market is creating expectations of more Federal Reserve interest-rate cuts, much to the delight of the bond market. For the week, 2-year Treasury yields declined 12 basis points, with a 9 basis point decline for the 5-year, 11 basis points for the 10-year, and 9 basis points for the long-bond. Mortgage-backs and agency securities outperformed, with benchmark Fannie Mae mortgage-back yields sinking 18 basis points and agency yields generally dropping 17 basis points. The benchmark 10-year dollar swap spread continues to narrow, declining 2 basis points this week to 79. The dollar declined on today's weak jobs report, with a loss for the week of less than 1%. Gold gained $2.20 this week.

If I had to make a single observation regarding the weak payroll report, it would be that today’s release is the best evidence yet that the current massive monetary expansions ("reliquefication") is having considerably less economic impact than a similar episode coming out of 1998. It is not good news that we have reached a point where extreme monetary expansion works only to sustain consumer spending in the midst of a bursting technology bubble and sinking consumer confidence. These are ominous portents, especially with the recognition that a major mortgage-refinancing boom will soon have largely run its course. Bubble economies are very sensitive to any deceleration, from the economic or financial spheres.

In my Bulletins, I will strive to address both economic and financial issues. With this in mind, I have once again dug into a bit of detail from the monthly auto sales reports. This major industry is in a way a microcosm for the underlying structural problems now confronting the U.S. economy. Sure, the Fed can reduce interest-rates and today stimulate spending, but more than ever before such efforts are not enticing U.S. consumers to purchase automobiles from General Motors when they have a preference for Toyotas.

April auto sales came in at a rate of about 16.7 million units. While the headlines labeled this as "below expectations" and a "weak" performance, it is worth noting that this level for the month of April was second only to last year’s record rate of 18 million units. For comparison, vehicles were sold at a rate of 16.3 million units during April 1999, 15.5 million during April 1998, and 14.3 million during April 1997. The real story continues to be the very poor relative performance of U.S. brands. Year over year sales at General Motors slumped 16%, with car sales down 15% and truck sales 16%. Ford saw total vehicle sales drop 15%, with year-to-date sales down about 12%. Year over year, Ford’s Mercury division saw sales sink 22% and Lincoln down 21%. Chrysler sales declined 18%, with auto sales a pathetic 33% below last year.

It’s a completely different world for foreign nameplates, with many never having had it so good. Toyota enjoyed its strongest April on record, this following its best ever first quarter. It was a record month for both autos and light-trucks, with popular new truck models leading an almost 17% year over year increase in light-truck sales. Total vehicle sales increased 5% from last year. Toyota’s luxury Lexus division experienced a record April as well, with sales up 19% from last year. It was a record April also for Nissan’s Acura division, with sales up 6% from last year (ytd. up 28%). Honda sales were down 3% from last year, although year-to-date sales have been running up about 4%. April was the second-best month ever for BMW, with sales up 30% from last year. Year over year, Porsche sales were up 15%, Volvo 5%, and Jaguar 3%. Volkswagen had its second-best April since 1977, although sales declined 4% year over year. It was the second-best April ever for Mercedes-Benz (sales down 8%). Looking at other Asian manufacturers, Mitsubishi sales were up 9% (best April on record) from last year, Subaru’s up 12% (best April since 1986), Mazda 3%, and Suzuki 18%. The Korean manufacturers continue to rapidly gain share, with Kia sales 29% above last year and record sales at Hyundai up 24%. Asian market share has jumped to 31%.

In a clear indication of weak structural economic underpinnings, Bloomberg reported that, with 414 companies of the S&P500 reporting, first-quarter profits declined 4.8%, the worst performance since the third-quarter of 1991. Bloomberg quoted Charles Hill, research director at First Call: "The second-quarter warnings are coming in at a staggering rate" and added that "more companies have told investors that earnings will disappoint than at any time since First Call began to track earnings estimates in the early 1990s." While profits for manufacturers are in a tailspin, heightened inflation is benefiting some industries, with healthcare industry profits up 15% and energy sector profits surging 72%.

From Christine Richard of Dow Jones: "Moody's Says Employment Cost Rise Hampers Credit Quality - During periods of rising employment costs, such as the first quarter of 2001, corporate credit quality tends to suffer, according to Moody's Investors Service. As a result, more layoffs are likely as corporations struggle to restore their credit position and improve profitability. A rise in the private Employment Cost Index during the first quarter of 4.2% was historically high and may have been understated, Moody's said in a recent research report. That's because average hourly earnings of non-supervisory employees rose at a substantially faster clip than the overall rise, Moody's said. And rising employment costs weigh on corporate credit quality. When the ECI was gaining at an annual rate of only 3.1% - between 1993 to 1999- there were 1.19 corporate rating upgrades for every downgrade. But when ECI was running at 3.8% - between 1998 until the first quarter of 2001 - upgrades fell to 0.52 for every downgrade. Not surprisingly, corporate profits are also linked with moves in the ECI. When ECI accelerated 10 years ago, non-financial corporate pretax profit growth slowed to 3.7% compared with 6.3% between 1985 and 1989."

Monday, the Commerce Department reported March personal income and spending data. This is certainly a series to follow going forward. For March, personal income increased 0.5% and spending 0.3%. Despite a rapidly decelerating economy, both personal income and spending have been expanding at about a 5% rate during the past four months. And as is increasingly the case, data becomes much more interesting when one digs below the surface. While wages from manufacturing increased 0.1% (versus February’s 0.2% decline), service sector income rose at strong rate of 0.7% (0.8% in February). Rental income increased 1.1% and "transfer payments" 0.7%. During the past 12-months, total service sector income has increased $112 billion, or 6.5%, compared to $18.5 billion, or 2%, for the manufacturing sector. To better appreciate the current significance of the service sector, take a look at data going back three years. During the past 36 months, service sector income has expanded $358 billion, or 24%, to $1.8 trillion, while wages and income from manufacturing increased $71.5 billion, or 9.5%, to $823 billion. Yesterday’s weak National Purchasing Management’s report on non-manufacturing activity (index has dropped from 61 to 47 in four months) proved a harbinger for today’s weak nonfarm payrolls data.

Clearly, few appreciate the profound changes wrought on the U.S. economy and financial system over the past few years of excess. Since March of 1998, total annual income has increased 18% ($1.32 trillion) to about $8.6 trillion, while personal consumption expenditures have surged 22%. And while American households were saving at a positive annualized rate of $286 billion during the first quarter of 1998, unprecedented borrowing and over consumption have since left savings in historic collapse. During the first quarter, the household sector had a negative annualized savings rate of $74 billion. Little wonder credit excesses are having reduced economic impact. Interestingly, total annual consumption expenditures have increased almost $1.3 trillion during the past three years, with $716 billion explained by increased expenditures on "services." Over this same period, the level of imported goods has jumped better than 30%, having increased from an annualized rate of $900 billion back in March of 1998, to the present pace of almost $1.2 trillion.

I certainly cannot state the case better than was articulated by White House Economic Advisor Lawrence Lindsey, who spoke Monday at the annual convention of the Society of American Business Editors and Writers. Quoting Dr. Lindsey:

"I do think it is important that we all keep this in mind: we have had 20 years of expansion – 18 actually, going on 19. And it has been an extraordinary period. But that does not mean that everything is AOK. And I think that it is important to keep in mind what I think are three imbalances. They actually all come up to one imbalance. And let me sum it up with these statistics. Last year the private sector spent $700 billion more than it earned after taxes. (repeating) The private sector spent $700 billion more than it earned after-tax. Now that is 7% of GDP. We have never been there before. We are making up that 7% essentially from two sources. The public sector ran a 3% of GDP, roughly, surplus. And we took in 4% of GDP by borrowing from abroad. But in terms of being overextended, we have never been that overextended before. There is a lot of confusion between the health of the government’s books and the health of America’s books – they are not the same thing. The public sector ran a healthy surplus…taking a record share from the private sector. The private sector is running a record deficit. We are in uncharted territory. We don’t know how this is going to work out. But it is unlikely that we could forever borrow 4% of GDP from the rest of the world. Or more precisely if you look at trends, we are borrowing increasing amounts from the rest of the world. Imagine going to your banker and saying "we thank you very much for the $280 (billion) you lent us in 1999, and the $400 (billion) you lent us in 2000, and it looks like this year it is going to come in about $520. We are going to need $650 in additional cash in ’02, probably $800 in ’03." Getting the picture? This is otherwise known as "evergreen" financing. And it won’t work. At some point, it is going to have to be adjusted. I remember stories from the ‘80s. Many of you are probably too young. But our personal savings rate - that we moaned as being far too low - averaged 9.1% of GDP. Last year we were in negative territory. The first quarter of this year was minus 1%, the lowest since 1933. Similarly, if you combine personal savings with gross private savings minus gross private spending, we were short last year 5.4% of GDP. That is also a record. Unprecedented. It has to be adjusted. Something has got to give here…"

I was reading a recent newsletter written by an individual having come to adeptly recognize that Fannie Mae and the GSEs are much behind the recent surge in money supply. However, the writer also proceeded to dive further into the analysis, making some quite interesting statements that I think go right to the heart of some critically important monetary issues, as well as the great confusion surrounding the current credit system. I don’t like to "beat a dead horse," but I think a sound understanding of current extraordinary monetary processes is vital. It is apparently his view that the key analytical issue today is recognizing the source of the monetary expansion. If it is the Federal Reserve adding liquidity, this is the creation of "high-powered money." As he explained, when the Fed purchases securities in the marketplace there is a critical balance sheet impact on the dealers in government debt, increasing system leverage and liquidity for the financial markets. I don’t really have a problem with this analysis. But his main point was to stress that it is Fannie Mae and not the Fed behind the new credit. As such, he makes a strong differentiation regarding Fannie Mae created credit, which "has no such financial market impact – it simply puts money into the homeowners’ pockets through refinancing" which supports the housing market with greater credit availability. I take strong exception with any analysis that minimizes the financial market or economic impact of the historic GSE credit expansion.

I think we all suffer from trying to analyze the highly complex contemporary financial world through concepts that were developed back when the banking system was basically the credit system, and bank deposit expansion was the key component of money supply growth. Things have changed profoundly. I have no problem with the concept of "high powered" money when Federal Reserve open-market operations (security purchases) create new bank reserves. Traditionally, these reserves would then hold the potential to be "multiplied" through bank lending, subject to reserve requirements (i.e. fractional reserve banking), capital ratios, and bankers’ self-imposed liquidity concerns. This multiplication process is very powerful, hence the terminology "high-powered money." Importantly, however, this concept of "high powered" money specifically revolves around the multiplication of bank deposits. For example, when the Fed purchases $1 billion worth of bonds from a bank, the Federal Reserve creates a new liability by journaling $1 billion of reserves to the bank’s account at the Fed (i.e. the expansion of Fed credit through the ballooning of its balance sheet – creating an additional $1 billion liability by crediting the account Reserves Owed to Bank, while increasing its assets $1 billion by debiting Securities Holdings). For the bank, its assets remain unchanged, although bond holdings are reduced (credited) by $1 billion, and Cash Reserves Held at the Fed are increased (debited) $1 billion. Here, it is worth noting that banking system (financial sector) assets remain unchanged until additional loans are made. With $1 billion of new reserves, the bank now has the capacity (with a reserve requirement of 10%) to increase lending (create new deposits) by $900 million. The proceeds from the initial loan would then eventually make its way to be deposited in another bank, where it could be lent to the tune of $810 million (90% of $900 million), that would be at some point deposited at the next bank, and so on and so on. When the banking system was responsible for the vast majority of lending, hence money and credit creation, the issue of "high-powered" money was a significant aspect of monetary expansion. That Was Then, This Is Now.

Today, the money and capital markets have come to dominate the money and credit creation process, with non-bank financial intermediaries at the heart of the U.S. Credit Bubble. Bank lending to business, the mainstay of credit growth in years past, plays today a very backseat role to the hot game in town: financing the asset markets. In so many ways, this just changes the whole analysis. No longer does "multiplication" work only to create additional bank deposits but, importantly, the entire process is opened up for an explosion of money and credit generally. Specifically, an historic monetary expansion ("multiplication") has created money market fund deposits in excess of $2 trillion. Here, of course, the government-sponsored enterprises and Wall Street firms have come to play a momentous role. As such, it should be recognized that a massive money market fund complex has moved resolutely to the epicenter of this credit creation process, becoming what I refer to as "The Fountainhead." Importantly, this type of monetary inflation involving the expansion of (nonbank) financial sector liabilities is not subject to reserve requirements; thus "deposits" can be lent in full, repeatedly, and instantaneously (especially to asset markets), creating what I refer to as the "Infinite Multiplier Effect" that leaves the old process of bank lending "high powered money" in the dust. And with the unparalleled financial and political might of the GSEs, monetary processes have developed directing credit to an incredibly vast real estate market. This confluence of factors has created the equivalent of Nuclear Credit Fission.

So, in my analysis, during a period of general credit expansion, money market fund deposits basically operate as "Hot Money." They can be borrowed and immediately lent, where they can then be deposited and lent again and again. As such, it should be recognized that GSE balance sheet expansion financed by money market deposits (either directly by GSE short-term borrowings or indirectly through leveraged players borrowing in the money market to finance the purchase of GSE bonds) holds great potential for providing powerful monetary and financial market effects. The most conspicuous consequence is the uncontrolled expansion of money fund deposits and the closely related unlimited availability of credit. If fact, GSE purchases are not at all dissimilar to the Federal Reserve creating "Hot Money" through its balance sheet expansion. GSE balance sheet expansions, and mortgage refinancing booms in particular, are extremely powerful financial market liquidity operations that, in truth, make Fed open market operations over the past few years look like "small potatoes." Not only do they allow homeowners to capture additional liquidity (buying power to sustain the consumption boom or the acquisition of financial assets) through the monetization of real estate inflation, there is also the acutely potent systemic "reliquefication" effect.

When Fannie Mae and Freddie Mac balloon their balance sheets – particularly during a period of significant refinancings - through purchases of financial assets (newly created mortgages and other credit instruments), additional liquidity (buying power) is immediately provided to the holders of the old mortgages: the hedge funds, Wall Street firms, banks, insurance companies, pension funds, individuals, etc. This liquidity/buying power, largely in the form of expanded money fund deposits, is at once available for the purchase of other financial instruments, including short and long-term corporate debt issues, convertibles, credit-card and other asset-backed securities, agency debt, or myriad other debt instruments. After all, how else does one explain the seemingly insatiable demand that has developed over the past few months in the corporate bond and securitization marketplace? It is certainly not from household savings! As we saw in 1998 and are witnessing again today, this has an extremely powerful effect on financial market liquidity, the credit creation process generally, and usually the real economy. Financial sector assets are increased immediately with GSE balance sheet expansion, in what I argue is a process every bit as powerful as Fed purchases, and, as we have witnessed, with much greater potential to go to dangerous extremes.

I want to make a key point, and it relates to The Power of Money. Contemporary "money" is the consequence of lending and it is basically just credit. As such, it is easy to dismiss its importance. Yet, Money is a very very special type of credit of great significance. Importantly, money is today a financial asset where the holder perceives both liquidity and security. These are critical perceptions; that money is highly liquid, holds a fixed exchange value, and provides its owner security through its function as a store of value/wealth. And especially with the contemporary credit system providing easy access to borrowings to purchase anything from fast food to Fannie Mae bonds, the transaction aspect of money no longer plays the prominent role it has in the past. Much more momentous are money’s very special supply/demand characteristics, with an increase in the supply of money creating its own demand. This is a very powerful attribute.

As long as confidence holds, credit in the form of money has virtually unlimited potential for expansion. Stated differently, with the financial sector maintaining the capability of creating financial assets perceived to hold the characteristics of money, unlimited marketplace demand for these credit instruments provides the capacity to sustain systemic credit excesses. To illuminate the special nature of credit in the form of money, let’s compare it to telecommunications debt. Wall Street and the telecom industry may wish to expand credit through the issuance of more telecom debt, but that certainly doesn’t mean there will be marketplace demand to hold these instruments. As we have witnessed, the market pricing mechanism did (eventually) operate in the telecom debt market. Following natural credit cycle dynamics, seemingly insatiable demand permeating during the halcyon days of the bull market created excesses that later led to a problematic deterioration of liquidity, come the waning confidence of the bear.

Money, well, it is a completely different deal. As long as Wall Street expands credit through the issuance of new money market deposits, these instruments find continuous demand regardless of bull or bear, greed or fear. In fact, as we have witnessed repeatedly and unmistakably since 1998, periods of heightened financial stress and risk aversion create acute demand for instruments with the perceived liquidity and safety of "money." This has proved invaluable to the U.S. financial sector, creating insatiable demand for money fund deposits, as well as virtually limitless lending financed through this mechanism. Some think only credit matters, but I say the huge surge in money is at times a lubricant and, during key periods, powerful jet fuel. Money matters, and it matters tremendously. Let there be no doubt, it is this nature of unrelenting demand for money fund deposits that is at the heart of the perpetuation of the Great Credit Bubble. Historically, regular bouts of heightened risk aversion would be associated with the "hoarding" of gold and currency (liquidation of securities and bank deposits), wreaking severe havoc on a system of bank deposits "multiplied" from a base of cash and reserves. Although it was at times a painful process, the system was self-regulating with participants generally operating with an appreciation for the risks of lending and speculative excess. It was not that memories were longer back then, but that the cycles were much shorter.

Today’s system has thus far functioned with diametrical characteristics, as participants hold religiously to the faith that the Fed will ensure uninterrupted liquidity. Moreover, risk aversion today leads to "hoarding" of little more than money market fund deposits. An historic technology bubble collapse with major consequences for the financial system and economy; no problem. Just create $100s of billions of new money and "reliquefy." Don’t dismiss this issue of contemporary money as a key source behind this almost magical arrangement for Wall Street and the GSEs to perpetuate the bubble. And don’t think for a moment that there is not a great price to pay from such an exceedingly unstable system with a proclivity for wild excess. Basically, unlimited demand for financial assets (financial sector liabilities) allows for the perpetuation of extremely damaging credit and speculative excess; at least, so long as loan demand remains strong and this new credit can be packaged in the form of "money." It is no coincidence that the money market funds (largely operated by Wall Street) have come to provide the key and powerful intermediation function of this boom: the transformation, through the GSEs and Wall Street "structured finance," of increasingly risky loans into seemingly liquid, stable, and secure "money." It is too good to be true. Instead of any semblance of self-regulation, the current monetary regime is dangerously self-serving and self-reinforcing, while operating precariously and completely outside of market discipline.

As we have seen particularly over the past three years, the bottom line is that such a system leads to endemic and self-reinforcing credit excess. As I have described repeatedly, this process of the "infinite multiplier" and the implied taxpayer backing the marketplace affords the GSEs has created unlimited availability of mortgage credit and, not surprisingly, an historic real estate bubble. (From a recent Moody’s release where it assigned a top rating to a Conseco money market fund: "The Fund invests in securities rated Prime-1 or equivalent, including securities guaranteed by the U.S. government, its agencies or instrumentalities and other high-quality U.S. money market securities…" Is this wording appropriate?) Credit excess set in motion a process of self-feeding asset inflation and monetization that runs out of control to this day. It is certainly reasonable to see this in the context of the U.S. financial sector creating promises it simply cannot keep. It has brazenly created trillions of dollars of liabilities that are perceived by holders to possess the liquidity and store of value characteristics of "money." How long Wall Street can maintain this façade of liquidity and security for all this financial wealth created (with the ease of electronic journal entries) is today the $64,000 question. With this in mind, I will close with some excellent and quite pertinent analysis pulled from the article The Relative Liquidity of Money and Other Things, by Edward C. Simmons, American Economic Review, 1947:

"A brief consideration of the relative liquidity of money and other things may serve to throw light on some troublesome matters. If monetary management is to be relied upon, along with fiscal management, to control the level of activity in a free market economy, the quantity of money must have dimensions. If a dividing line between money and other things cannot be established both in theory and in practice, monetary policy discussions are meaningless. Should money be made more like other things? Should other things be made more like money? Should other things be made less like money? These three questions pose the issue. The position is taken here that the gap between money and other things should be made as wide as possible. The wider the gap the more effective can be monetary management…

"The phenomenon of liquidity appears in the economy as soon as mediation of exchange appears. Conceptually money can exist as a pure numeraire, but such a money seems unlikely to exist in fact in a free market economy…the inevitable result of exchange mediation is to create in the economy a special type of asset which by its nature serves as a store of value and a bearer of options… The store of value concept of money, although not yielding a satisfactory definition of money, does serve to bring out the liquidity problem…

We must now face squarely the question of the meaning of liquidity. There are no liquid assets aside from money, unless there is a central bank. In the discussions of liquid assets, it is significant that cash, bank deposits, and government securities are the only things ordinarily considered. Other securities and commodities are not added in when statistical estimates are made. Possibly this is a recognition of the painful truth learned in frequent panics under a national banking system that only a central bank can create liquidity. The shifting of assets among banks, firms, and private persons suffices in normal times, and in periods of boom everything seems to be salable and therefore liquid, but there can be no general movement from assets to money unless the money-creating power of the sovereign is brought into play. At this point, it might be remarked that the gilt-edge quality of government securities rests not only on the power of the sovereign to tax in order to service the debt but also to no small degree to the long established practice of having the central bank stand ready to lend on or purchase government debt instruments. The liquidity of things which may not be absorbed by the central bank is a fair-weather phenomenon. Nonetheless, this fair-weather liquidity is a matter of significance and requires consideration. To the extent that liquidity preference is satisfied in periods of calm by assets that prove to be illiquid in periods of stress, the system is rendered more unstable.

Probably no one would seriously defend the proposition that all things should be made liquid. A monetary policy which would endeavor to make the number of dollars equal to the dollar amount of gross national wealth is patently absurd. Monetary theory has advanced far enough to provide good grounds for holding that even the good bills doctrine is fallacious as a guide to monetary policy. Monetizing all wealth would result only in limitless inflation."