08/30/2001 The 'Information Economy' *

It was an absolutely dismal week for global stock markets, with the equity bear gaining momentum around the globe. For the week, the Dow and S&P500 were hit for about 4%. Defensive issues outperformed, with the Transports and Utilities declining only about 1%. The Morgan Stanley Consumer and Morgan Stanley Cyclical indices both dropped about 3%. The broader market was under selling pressure as well, with the small cap Russell 2000 dropping 3% and the S&P400 Mid-Cap index declining 2%. Heavy selling hammered the technology sector, with the NASDAQ100 and Morgan Stanley High Tech index sinking almost 7%. The Semiconductors dropped about 5%, while the NASDAQ Telecommunications index was hit for 7% and The Street.com Internet index 9%. The Biotech group dropped about 3%. The financial stocks were weak also, with the S&P Banking index dropping 4% and the AMEX Securities Broker/Dealer index declining 3%. Although gold bullion gained $1.60, the HUI Gold index declined 3%.

Sinking stock markets and economic concerns continued to support bond prices. For the week, two-year yields dropped 17 basis points to 3.60%, 5-year yields declined 10 basis points to 4.38% and 10-year yields 9 basis points to 4.91%. Long-bond yields dipped 8 basis points to 5.37%. Mortgage-back and agency yields generally declined about 9 basis points. The benchmark 10-year dollar swap spread narrowed 3 to 82. The dollar was volatile but the dollar index ended the week unchanged, in what continues to be a rather unimpressive performance.

Moody’s reported this week that credit card delinquencies continue to rise, while "the charge-off rate rose to 6.47% from 5.16% in July last year. That 25% jump represents the steepest increase since July 1997…Personal bankruptcy filings, which typically contribute between 35% and 50% of the total reported charge-off rate, have been an especially big factor so far this year. In fact, a record number of consumer bankruptcy filings (746,927) were recorded for the first half of 2001." Bloomberg ran a story "Repossessions Bog Down U.S. Mobile-Home Industry." "The weak economy is reaching the mobile-home industry, as risky loans extended in the mid-1990’s come home to roost. Mortgage delinquencies for all housing rose to a nine-year high in 2000, while those related to mobile homes soared to their highest levels in at least 25 years…about 2% of all outstanding mobile-home loans are in repossession proceedings…"

The Mortgage Bankers Association application index surged this past week, with the index of mortgage refi’s jumping 16% to the highest level since April. Applications to refinance ran more than 400% above last year’s level. Total mortgage applications were the strongest since early June. With purchase applications about unchanged from last year, total applications are running 77% above year ago levels.

The market was not overjoyed with today’s Wall Street Journal headline, "Treasury Official ‘Skeptical’ of Fannie Mae’s Financial Role." While Treasury undersecretary Peter Fisher was obtuse, he did state that "things have changed" and that there is going to have to be "thinking about the right competitive structure" for the mortgage industry going forward. These comments reinforced the view that the Bush administration is uncomfortable with the current GSE arrangement. Interestingly, Dow Jones recently ran a story "Fannie and Freddie’s Derivatives See Huge Growth In Q2." According to this article, Freddie Mac increased its notional derivative positions by 20% to $692.7 billion, while Fannie Mae expanded derivatives almost 25% to $436 billion. This week the Treasury Department reported that net foreign purchases of agency securities jumped to almost $17 billion during June, while Treasury positions declined $3.5 billion. There have been $80 billion of net foreign purchases of agency securities during the past six months. This agency Bubble is to be watched very closely.

Interestingly, Alan Greenspan used his appearance before the annual central banker gathering in Jackson Hole, Wyoming to address the pertinent and controversial topic of the "wealth effects" from rising asset prices. He began his speech, "The rapid technological innovation that spurred the advancement of the ‘information economy’ had resulted in some dramatic capital gains and losses in equity markets in recent years. These remarkable developments have attracted considerable attention from economists and from macroeconomic policymakers. At the same time, movements in the prices of some other assets in the economy – changes in house prices, for example – have been steadier, less dramatic, but perhaps no less significant.

There can be little doubt that sizable swings in the market values of business and household assets have created important challenges for policymakers. After having been relatively stable for a number of decades, the aggregate ratio of household net worth to income rose steeply over the second half of the 1990s and reached an unprecedented level by early last year. That ratio has subsequently retraced some of its earlier gains.

But we must ask whether the aggregate ratio of net worth to income is a sufficient statistic for summarizing the effect of capital gains on economic behavior or, alternatively, whether the distribution of capital gains across assets and the manner in which those gains are realized also are significant determinants of spending. To answer these questions, we need far more information than we currently possess about the nature and the sources of capital gains and the interaction of these gains with credit markets and consumer behavior…

It is clear that the massive increase in capital values over the past five years had a profound impact on output and income. The influence of capital gains on economic behavior is likely to be of substantial consequence for the prospective performance of the economy."

First, although we can no longer claim to be shocked by his line of reasoning, it is nonetheless amazing that Chairman Greenspan continues to posit "rapid technological innovation that spurred advancement of the ‘information economy’ as the cause behind the historic price volatility across a broad spectrum of asset prices. It just does not seem reasonable that he can remain so oblivious to the true cause and force behind this extraordinary period of monetary instability: credit excess. We certainly suggest that the Fed chairman spend more time with the Federal Reserve’s money and credit data to garner the unmistakable source of this historic asset and economic Bubble. All the same, CNBC today ran with the headline, "Fed desires better understanding of consumer spending," and apparently Mr. Greenspan has his researchers "in the process of developing balance-sheet disaggregations" to help the Fed "infer as to the propensities to spend out of capital gains across different classes of assets." Sometimes it seems like Mr. Greenspan and the Fed make the analysis more difficult than it needs to be.

Yet, surely Mr. Greenspan today increasingly appreciates that the over-borrowed U.S. consumer sector is long overdue for an unavoidable retrenchment after years of credit, speculative and spending excess. Our expectation that the severity of the downturn will be proportional to the excesses of the preceding boom leaves us fearful of a particularly deep and protracted adjustment period. A truly credit and consumption-based economy has developed, and with news this week of faltering consumer confidence only to be exacerbated by sinking stock prices, we suspect that the surprise over the coming three to nine months will be disappointing consumer spending. This, no doubt, holds significant ramifications for the vulnerable and highly unbalanced U.S. economy and financial system. Optimistic expectations for the typical Fed-induced rapid recovery in stock prices are dissipating quickly, and we would now expect a long and grinding period of faltering investor and consumer confidence.

And while the record boom in mortgage lending has thus far sustained the consumer sector in the face of a collapsing technology Bubble, the Fed and the marketplace have every reason to be increasingly apprehensive as to the implications for a very aged housing Bubble. We must admit that, in the aggregate, we find recent financial and economic developments particularly disconcerting. Most ominous is the relatively muted economic and financial impact from the enormous and protracted mortgage refi/lending boom. The future certainly holds a dramatic decline in new mortgage credit creation, with what will be potentially dire consequences to an economy addicted to heady consumer spending and a financial system addicted to extreme money and credit growth. We definitely sense the stock market is beginning to discount this most problematic development. With this in mind, it would be our view that efforts to study capital gains effects on consumer spending are generally missing the more important issue of the cause and consequences of an historic period of credit excess and monetary disorder. The key analysis going forward will be attuned to the dynamics of bursting financial and economic Bubbles.

Mr. Greenspan’s speech today repeated the prior assertion, "coventional regression analysis suggests that a permanent one-dollar increase in the level of household wealth raises the annual level of personal consumption expenditures approximately 3 to 5 cents…" The seeming insignificance of these numbers, apparently, provided the Fed justification for its general disregard for what became endemic asset inflation. This was, of course, a momentous policy blunder. We have repeatedly argued that the actual dollar increase in consumer spending spurred by the asset Bubbles, while significant, was of much less importance than the dangerous impact on the nature of spending and investment throughout the overall economy. It is the severe cumulative structural maladjustments that developed over years of monetary disorder that are of critical importance today. Rather than focus on capital gain impacts on consumer spending, it would today be much more valuable for the Federal Reserve to better understand both the causes and impact of rising asset prices in the contemporary environment to foster self-reinforcing money and credit expansion. We would like to see some recognition of the true forces and dangerous effects of monetary instability to both the real economy and financial system.

We suggest the Federal Reserve go back and read the astute writings of one of its eminent chairman, Marriner S. Eccles. Mr. Eccles successfully managed a bank holding company through the treacherous early years of the Depression, before being appointed Chairman of the Federal Reserve in 1935. He served at the Federal Reserve for a very distinguished 17 years. He certainly appreciated the institutional nature and dangerous consequences of monetary instability, and clearly would have warned sternly against the Fed’s focus on relatively stable consumer prices while ignoring extreme asset inflation.

From Economic Balance and A Balanced Budget – Public Papers of Marriner S. Eccles:

"Even if the amount of money did determine prices and even if the Federal Reserve System could determine the amount of money, experience shows that steady prices would not necessarily mean prosperity. It is true that violent changes in prices are harmful. A very rapid rise in prices results in speculation, in accumulation of inventories, and in unsound undertakings, which later result in a collapse with falling prices, failing business, and general distress.

But that does not mean that lasting prosperity is assured when prices are steady. We had fairly steady prices from 1921 to 1929; but during that period there was developing a speculative situation which led to the collapse in 1929. It was during this period that billions of unsound foreign loans were made; that expensive and unsoundly financed apartment housing and office buildings were erected far beyond the needs of the people; that stock prices rose to fantastic levels. It was during this period that the ground was prepared for the depression which began in 1929 and from which we have not yet completely emerged. An unchanged average of wholesale prices alone, therefore, does not assure the people of lasting prosperity. While prices are stable, destructive forces may be at work that lead to panic and disaster. To require the Board to be guided in its policies entirely or principally by changes in the level of prices would prevent it at time from doing its best to serve the public interest."

It is rather fascinating how Mr. Eccles can make so much sense, while Mr. Greenspan can appear so lost.

I apologize that this Bulletin in lacking in both information and insight. I traveled back to Dallas this week to spend a few days with David Tice and his associates. I had planned on devoting considerable more time to this commentary, but those plans fell by the wayside with the realization of how great it is to be among such good friends.