10/31/2003 Straight Talk from Consumate Central Banker Dr. Otmar Issing *

Over-liquefied markets came flying back this week. For the week, the Dow and S&P500 gained about 2%. The Utilities were unchanged, while the Morgan Stanley Consumer index added 2%. Not surprisingly, economically sensitive issues and sectors continue to outperform. For the week, the Morgan Stanley Cyclical index jumped 5%, increasing y-t-d gains to 36.5%. The Transports added 3% (up 26.0% y-t-d). This week also saw the S&P Homebuilding index add 4% (up 82% y-t-d), and the S&P Steel index surge 10% (up 34% y-t-d). The broader market performed well. The small cap Russell 2000 jumped 4% (up 38% y-t-d) and the S&P400 Mid-cap index added 3% (up 28% y-t-d). Technology stocks surged, with the NASDAQ100 advancing 3% (up 44% y-t-d) and the Morgan Stanley High Tech index increasing 4% (up 58% y-t-d). The Semiconductors jumped 8%, increasing y-t-d gains to 72%. The Street.com Internet index’s 3% rise increased 2003 gains to 70%. The Biotechs added 1% (up 38% y-t-d). The Broker/Dealers gained 5% (up 57% y-t-d) and the Banks 2% (up 26% y-t-d). With gold giving back $4.30 of last week’s big gain, the HUI gold index declined 1%. Treasury yields crept higher, but not much considering the environment. For the week, 2-year Treasury yields added 4 basis points to 1.77%. The five-year Treasury yield gained 9 basis points to 3.24%, and the 10-year added 6 basis points to 4.29%. The government long-bond yield added one basis point to 5.13%. Benchmark Fannie Mae mortgage-backed yields rose only 3 basis points. The spread on Fannie’s 4 3/8% 2013 note narrowed 1 to 39.5; Freddie’s 4 ½% 2013 note narrowed 0.5 to 39; and the FHLB 10-year was unchanged at 35. The 10-year dollar swap spread was unchanged at 42. The implied yield on December 2004 Eurodollars added 8.5 basis points to 2.50%. Bloomberg tallied a strong $14.7 billion of corporate issuance this week (two week total of $31.9 billion), versus the year’s average of $12.5 billion. Investment grade issuers included Daimlerchrysler $2.0 billion (up from $1.5 billion, with orders of $6 billion), Altria $1.5 billion (up from $1.0 billion), Intelsat $1.1 billion, American Honda $750 million, Nisource Finance $500 billion, Quebecor World $600 million, Mantis REEF $550 million, Host Marriot $725 million, CIT Group $500 million, PNC $600 million, Washington Mutual $1.4 billion, HCA $600 million, South Carolina E&G $250 million, Health Care REIT $250 million, Bank of New York $200 million, International Lease Finance $218 million, Silgan Holdings $200 million, Unitrin $200 million, Centerpoint Energy $160 million, and Zions Bancorp $150 million. Junk bond flows were about flat for the week, although there was plenty of liquidity for a slug of new issues. Issuers included Nalco $1.6 billion (three times oversubscribed!), United Rentals $525 million, Cincinnati Bell $400 million, Gaylord Entertainment $350 million (up from $250 million), Odyssey RE $150 million, Neighborcare $250 million, O’Charleys $125 million, and Telex Communications $125 million. Brazilian petrochemical company Braskem raised $200 million at 950 basis points over Treasuries. Converts issued: JDS Uniphase $475 million, Brilliance China $170 million, and United Rentals $125 million. A Merrill Lynch investment grade debt spread index declined to the narrowest level in four years. Bloomberg quoted a fixed income investment managing director: “This is a market that is defined by ebullience and optimism because the economy is clearly and definably on an accelerated path.” But bond investors are becoming increasingly edgy elsewhere. Australian government bond yields jumped 11 basis points to 5.76%, with yields up 117 basis points from June lows. UK 10-year government yields rose 3 basis points to 5.0%. From Bloomberg: “Yields on U.K. two-year gilts had their biggest monthly rise in more than 8 years on speculation the Bank of England will raise interest rates as soon as next week…” Implied yields on 2-year gilt futures have surged almost 60 basis points so far this month to 4.60%. Japanese government bond yields jumped 10 basis points this week to 1.46%. While emerging debt markets suffered a scare from the tumult in Russia, they generally made it through the week impressively. Russian government bonds and the ruble even made it through relatively unscathed. Emboldened emerging market players are sensing these markets are much less prone to external shocks than at times past. The bank of Japan sold about $25 billion worth of yen during the past month, bringing two-month currency operations to an unprecedented $65 billion. Ominously, huge dollar buying has only succeeded in keeping the greenback’s decline orderly. The dollar index added better than 1% this week. Curiously, commodity currencies outperformed again this week, with the Australian dollar (up 26% y-t-d), Chilean peso (up 15% y-t-d), South African rand (up 24% y-t-d), and New Zealand dollar (up 17% y-t-d) all adding about 1%. The Mexican peso enjoyed a gain of better than 1% against the dollar. On the back of surging copper prices, the Chile peso enjoyed its strongest month since 1992 (to a 28-month high). Commodity Watch: Copper rose 5% this week (strongest weekly gain in two years), to the highest price since October 1997 (up 36% for the year). The Journal of Commerce Industrial Metals index added another 2% this week to the highest level since early 2000 (up almost 20% y-t-d) October 29 – Bloomberg: “Soybean prices rose to $8 a bushel in Chicago for the first time in six years on signs of increased demand for the U.S. oilseed. China, the largest buyer of U.S. soybeans, has purchased 445,000 metric tons of beans in the last two days, according to the U.S. Department of Agriculture. Soybean orders are up 30 percent this marketing year from a year earlier, the USDA reported last week. ‘China is willing to buy all the beans they can at this price,’ said Tim Hannagan, a grain analyst with Alaron Trading Co. in Chicago…” Global Reflation Watch: October 29 – Bloomberg: “U.K. mortgage lending and home-loan approvals in September soared to the highest since records began a decade ago, raising the chances of an interest rate increase next week. Mortgage lending rose 8.8 billion pounds ($15 billion), up from August's gain of 7.7 billion pounds, the Bank of England said. Approved house-purchase loans increased to 136,000. The value of all home loans including re-mortgaging climbed to 30.9 billion pounds, also setting a record… ‘Over the past year, total outstanding household borrowing has risen by a punchy 13.9 percent, a cause for concern to several members’ of the bank’s rate-setting committee, said Philip Shaw, chief economist at Investec Bank U.K. Ltd.” October 27 – Bloomberg: “U.K. pay growth accelerated from July through September to a two-year high, boosted by wage agreements for public workers, a survey said. The median pay increase was 3.3 percent, revised from 3.2 percent and the highest since the third quarter of 2001, according to Incomes Data Services, a research organization. That compares with 3 percent in the second quarter.” October 31 – Bloomberg: “Irish mortgage lending accelerated at the fastest pace in almost three years in September, boosted by the lowest interest rates in more than half a century, Ireland’s central bank said. The value of outstanding mortgage loans rose 24.6 percent to 50.6 billion euros ($59 billion) from the same month a year earlier… It was the fastest annual pace since December 2000… Annual growth in private sector credit excluding mortgages was 9.8 percent in September from 9.6 percent in August…” October 31 – Bloomberg: “Consumer prices in Tokyo fell at the slowest pace in four years because of higher medical costs and tobacco taxes… Tokyo’s core consumer prices, which exclude fresh food, fell 0.1 percent in October from a year earlier, the government’s statistics bureau said. The drop is the smallest since September 1999, when prices were unchanged.” October 29 - Dow Jones (Sonja Ryst): “Emerging market debt players remain bullish on the prospects for the asset class the remainder of the year, though the recent flood of issuance has taken some of the luster off the high-flying market. Emerging market bond issuance has totaled $23.5 billion since early September, according to a recent report by J.P. Morgan. Debt rated below investment grade has accounted for $13.2 billion of the total during the two-month time period, which compares with average monthly junk grade issuance of $3.5 billion the past few years.” October 27 – Bloomberg: “Taiwan’s banks’ lending rose 2.1 percent in September, the biggest gain since March 2001, because U.S.-led global economic growth is encouraging more companies to borrow to expand… ‘Appetite for lending has been revived, especially from exporters in computer or electronics-related industries, benefiting from a U.S.-led global economic recovery,’ said Allen Peng, executive vice president of corporate banking at Cathay United Bank…” October 27 – Bloomberg: “Shanghai, the largest commercial city in China, may post economic growth of about 11 percent this year, Mayor Han Zheng said at a press conference in Hong Kong.” October 27 – Bloomberg: “Thailand’s exports rose 11 percent to a record in September, helped by increased sales of rubber and electrical products to China and other Asian countries, Commerce Minister Adisai Bodharamik said… Rising exports to Asia prompted the commerce ministry to raise its growth forecast for overseas sales to 12 percent from a previous estimate of 10.6 percent.” Thai September industrial production rose at a 10.5% rate. This was above expectations and almost double August’s gain. October 28 – Bloomberg: “Malaysia’s broadest measure of money supply rose in September at its fastest pace in more than 5 years, helped by higher bank lending to small businesses, the central bank said. M3, the most closely watched measure of money in circulation, rose 9.2 percent from a year earlier, Bank Negara Malaysia said in a statement in Kuala Lumpur. That’s the fastest growth rate since May 1998.” October 28 – Bloomberg: “South Korean economic growth will probably accelerate to 5 percent next year from about 3 percent in 2003, Finance and Economy Minister Kim Jin Pyo said… To spur growth, the central bank has cut key interest rates by 50 basis points to a record since May, and the government has cut some taxes and announced supplementary budgets totaling 7.5 trillion won ($6.3 billion). The government plans to cut the minimum tax rate for smaller companies to 10 percent from 12 percent…” October 30 - Bloomberg: “Thai rice exports, which make up about a fourth of the world’s rice trade, may slow because of a shortage of ships and rising freight costs, a Thai government official said. Most ships in the region have been hired to carry steel and other building materials to China… Rachane Potjanasuntorn, director general of the commerce ministry’s foreign trade department, told a press conference. ‘Exporters have to pay much higher freight rates to deliver their rice on time. Higher freight rates have increased exporters’ costs and reduced their competitiveness.’” October 30 - Dow Jones: “With the Chinese auto market expected to expand rapidly, Toyota Motor Corp. plans to offer auto loans in China, the Kyodo News agency reported… The biggest Japanese automaker will shortly file with Chinese financial authorities for approval, hoping to launch the new service by the end of this year… Currently, only large Chinese banks are allowed to provide auto loans. But Chinese financial regulators will shortly establish a legal system to permit foreign concerns’ entry into the auto loan market…” Total lending in Brazil rose to its highest level in six months during September. Australian Home Lending was up 2.1% during September and 22.5% from one year ago. Building Approvals were up 7.5% from August and 12.5% one year earlier. South Korean Consumer Prices were up 3.7% y-o-y, the strongest increase in 7 months. Domestic Credit Inflation Watch: October 28 – Bloomberg: “Drew Matus, a senior economist at Lehman Brothers Inc. in New York, comments on Federal Reserve policy makers’ decision to leave the overnight bank lending rate at 1 percent, the lowest in 45 years. ‘The Fed had the chance to make an adjustment to their statement today -- the markets were expecting it. Instead, they choose to keep it almost identical’ to the previous statement. ‘That tells me they are truly looking at the output gap, they see no threat of inflation in the near term, and they can keep rates low for a very long time, we think for all of 2004.’” Goldman’s William Dudley doesn’t expect the Fed to raise rates until 2005: “What the Fed wants to see is sufficient job growth to actually drive down the unemployment rate, and I think that’s going to take awhile.” October 29 – Reuters: “Over $3 billion of asset-backeds were priced in a relatively busy session in the U.S. market Wednesday. Year-to-date asset-backed issuance now stands at over $335 billion, 19% more than last year’s (record) pace…” October 31 - Dow Jones (Tom Sullivan): “In the municipal bond market, the Golden State still glitters. But is it fool’s gold? Despite a huge structural budget imbalance, a grocery workers strike, raging wildfires, a generally weak economic environment, the worst credit ratings of any state in the country, two big bond issues tied up in court and a novice governor, California bonds sell. The state on Wednesday successfully sold $1.8 billion in fixed-rate general obligation bonds, which were increased from an originally planned $1.5 billion. The bonds were sold despite a down market with a true interest cost of 5.2%.” (A conspicuous sign of excess marketplace liquidity.) October 27 – Bloomberg: “Four courtside season tickets for basketball games at the University of North Carolina cost $1,800. Here’s the kicker: Newcomers first need to pay the university’s endowment fund $200,000. The tactic arises from a financial imperative in U.S. college sports, where athletic departments spend as much as $12 million a year for scholarships alone. The cost of fielding college teams and paying athletes’ expenses is rising so rapidly that endowments are now seen as the best guarantee for a sports program’s survival.” October 31 - Dow Jones (Dawn Kopecki): “Rep. Christopher Shays, R-Conn., said Thursday that he plans to ask for a federal investigation into the lobbying activities of Fannie Mae (FNM) and Freddie Mac (FRE), looking at ‘how they manipulate the system.’ ‘They buy up the market, they buy people to lobby and they pay people not to lobby, just so the best and the brightest aren’t available for the other side,’ Shays said in an interview with Dow Jones Newswires. Shays and Rep. Edward Markey, D-Mass., said accounting problems at both companies underscore the need for Congress to repeal their exemptions from securities disclosure laws. ‘How is it these corporations have been able to manipulate Congress and the White House for so many years so they don’t have to abide by the same rules that every other company in the U.S. has to abide by,’ Shays said. ‘Someone needs to look into this.’” Yesterday’s 7.2% third quarter GDP report has received thorough coverage, so I won’t add much. From a Credit Bubble analytical perspective, it is worth noting that the strength was uncharacteristically broad-based. Consumer spending expanded at a 6.6% pace, the strongest since 1997’s third quarter. Investment in technology equipment and software surged at a 15.4% rate, the strongest since Q1 2000’s technology mania climax. Government spending stabilized during the quarter and was largely immaterial to growth. CNBC this afternoon asked the question, “Blip or Boom?” My hunch today would be that this erratic Credit-induced boom has some room to run, but when it inevitably stumbles it won’t be getting up for sometime to come. Year-over-year, nominal GDP increased $532.2 billion, or 5.1%, to $11.04 Trillion. Personal Consumption increased $405.8 billion (5.5%), while Private Domestic Fixed Investment was up $113.3 billion (7.2%). Spending on Durables was up $49.2 billion (5.5%) and spending on Non-durables increased $148.5 billion (7.0%). Inflationary effects were conspicuous, as spending on Energy Goods surged $29.4 billion, or 16.5% and expenditures on Food increased $78.8 billion, or 7.7%. Consumption spending on Services increased $207.8 billion (4.8%), with Medical Care up $80.8 billion, or 7.0%. Breaking down Private Domestic Investment, spending on Residential Structures was up $73.3 billion, or 15.6%. Non-residential was up $40 billion, or 3.6%. Equipment and Software was up $42.3 billion, or 5.0%. Y-o-y spending declines included Non-residential Structures down $2.3 billion (0.9%), Transportation down $2.8 billion (2.0%), and Utilities down $9.3 billion (18.1%). Total Government Spending surged $123.4 billion, or 6.2%, with Federal spending up $86.7 billion, or 12.4%. State & Local spending was up $36.9 billion, or 2.9%. Today’s Chicago Purchasing Manager’s index increased 3.8 points to 55. The Production component jumped 6.2 points to 62, the strongest reading since February. New Orders jumped 6 points to 59.2, while Prices Paid surged 9.7 points to 61.5 (strongest since March). Broad money supply (M3) declined $15.4 billion during the week of October 20, with Money Funds and Large Denominated Deposits down a combined $30.8 billion. Demand and Checkable Deposits increased $11.4 billion. Savings Deposits dipped $4.6 billion and Small Denominated Deposits dipped $1.9 billion. Retail Money Fund deposits dropped $9.1 billion, the eighth straight week of decline ($41.7 billion). Institutional Money Fund deposits sank $8.0 billion, with a three-week decline of $42.4 billion. Large Denominated Deposits declined $13.7 billion. Repurchase Agreements gained $9.5 billion, while Eurodollar deposits were unchanged. Bank Total Assets declined $4.1 billion. Securities surged $34.0 billion, with Treasury, Agency up $30.6 billion. Loans & Leases declined $29.7 billion, with Real Estate loans down $21.8 billion (selling to the GSEs?). Commercial and Industrial loans dipped $4.6 billion. October 27 – National Association of Realtors (NAR): “The market for existing single-family homes rose again in September and set a third consecutive monthly record… Existing-home sales rose 3.6 percent to a seasonally adjusted annual rate of 6.69 million units in September from a pace of 6.46 million units in August. Last month’s sales activity was 20.8 percent above the 5.54-million unit pace in September 2002. David Lereah, NAR’s chief economist, said a strong performance was expected. ‘We knew the September pace for existing-home sales was going to be a big number, but after setting records in July and August we thought the pace might start to slow. This underscores the powerful fundamentals that are driving the housing market - household growth, low interest rates and an improving economy.’” With Existing unit Sales up 20.8% y-o-y and Average Prices (mean) up 7.1%, Calculated Annualized Transaction Value (CTV) was up a notable 29.3% y-o-y. CTV was up 56% over 2 years (sales up 34% and Prices 17%) and 108% over six years (Sales up 47% and Prices up 42%). Year-to-date sales are now running 8% ahead of last year’s record pace. New Homes were sold at an annualized pace of 1.145 million units, up 8.3% y-o-y. The average (mean) price jumped $18,000 during the month to $256,200, up 19% y-o-y. Strength was broad-based, with y-o-y sales up 12.5% in the Northeast, 6.7% in the Midwest, 7.9% in the South, and 23.8% in the West. September’s combined New and Existing Home Sales were at a 7.835 million seasonally-adjusted annualized rate. This record volume was up a noteworthy 18.8% y-o-y. Combined CTV was up almost $400 billion, or 29.2%, to $1.74 Trillion from one year ago. Combined CTV was up 58% from two years ago and 106% from Pre-Bubble September 1997. It is also worth mentioning that transaction value has risen sharply from the first four months of the year. Freddie Mac posted 30-year fixed mortgage rates declined 11 basis points to 5.94%, with 15-year rates down 13 basis points to 5.26%. One-year adjustable mortgage rates declined 2 basis points to 3.74%. Mortgage application volume was relatively weak again last week, with Purchase applications down 6% (dollar volume up 16% y-o-y). Laffer “Breaks Ground:” I thought it was spam, but it turned out to be an unsolicited email from Laffer Associates – “Supply-Side Investment Research.” Attached was giddy analysis written by Art Laffer and Andrew Coors. And since it goes directly to the essence of today’s flawed and dangerous conventional thinking, I believe it is worthy of comment. Excerpting from their report, “Borrowing Lessons from Economics.” “While it is commonly agreed that excessive and unaffordable debt held by consumers could have a detrimental impact on our economy (we cannot simply increase household debt loans ad infinitum), the level of debt does not matter as much as the cost of that debt. The fact that additional household debt in recent years is not leading to a rise in debt service payments – the estimated required payments on outstanding mortgage and consumer debt – is what should really be discussed. Because of lower interest rates, consumers are essentially making the same payments on a larger amount of debt… The panicked focus on household debt loans is misleading since it neglects to account for the lower interest rates. With this in mind, the increasing household debt is a manageable issue and one that does not deserve unmitigated worry.” The fundamental error people have made when suggesting that consumer debt has become unsustainable is that they are confusing stocks with flows. Debt levels are a stock, a fixed number. Debt service, the monthly minimum payment, is a flow, a recurring charge. If we were to compare debt to income, as do most who suggest debt levels are too high, we would be comparing a stock variable with a flow variable. It can’t be stressed enough: whenever comparing economic data, be sure that the variables are only of one type. If we want to get a more accurate picture of the economic landscape from the household debt perspective, we would be much better served by comparing income to debt service burden (two flows), or wealth to debt (two stocks). If consumers were piling on debt as a percent of their total assets in an increasing interest rate environment then it would be a good time to worry… While total household debt may be increasing, families are not overburdening themselves with debt payments they cannot handle… We have seen that looking at debt without factoring in interest rates gives an incomplete picture, and that the composition of debt matters as well. In our current situation, consumers have maintained a stable debt service payment while increasing their real assets. Obviously, a more wealthy class of consumers, ceritus peribus, is good for the economy, so we now turn our attention to the last piece of our debt puzzle: a rising interest rate. A certain amount of lenience should be given to the press for economic ignorance, but nothing is more aggravating than those headlines that forecast economic disaster when interest rates rise. These ‘rising interest rate = economic doom’ statements are widespread but completely false. Of all the stupid things that are said, saying that rising interest rates are going to push the economy back into recession is the worst. It’s just dumb… The commonplace pessimistic argument points out that since low interest rates have been good for the economy, higher interest rates will be bad. Then, in terms of housing, as the argument goes, rising interest rates will cause the housing market to implode. Yikes! The fear is that a rising interest rate will decimate the previous levels of housing demand that were artificially maintained by incredible low rates. This sudden disappearance in demand will lead to a precipitous fall-off in housing prices, leaving homeowners with newly refinanced larger loans, and suddenly these loans will be worth more than the price of the home… Fortunately, applying even a modicum of economic insight shows the above scenario as dead wrong. Rising rates are not a bad thing per se… Although worries about interest rates and household debt run rampant, they are unfounded. Debt levels are healthy, housing prices are not going to fall off a cliff, rising interest rates are not going to suffocate the economy… This is just the way things are.” What's it they say, “A little knowledge is dangerous”? Well, the audacious Laffer folks should do some homework on Credit analysis before they Dig Themselves Too Deeply into an Analytical Hole. Certainly, one of the fascinating aspects of Money and Credit Analysis has always been the outward appearance of it all being rather obvious and straightforward. The wonderful complexity of the subject matter only emerges when one dives in deep. Plain and simple is camouflage, invariably setting traps for the eagerly misinformed. And throughout history, Credit boom euphoria - such as we are experiencing these days - entices otherwise intelligent people to say and do things they later regret. The fundamental flaw with Laffer Associates’ analysis is that it disregards the crucial financial “flow” – the flow of new Credit that is the fuel for both the economy and asset markets. Their focus is on relatively stable debt service payments (like eying the current cost of a tank of gas, while ignoring the ongoing rise in the flow of fuel required for a faltering engine). These somewhat steady debt payments, however, are the result of historically cheap borrowing costs held artificially low by the Fed, the expansive U.S. financial sector, and epochal leveraged speculation. Debt service has remained (seductively and deceptively) low specifically because we are in the midst of an historic Credit Bubble (low rates, unlimited liquidity, inflating asset prices and unmatched Credit availability). Debt service today appears ok, while the level of household debt to (inflating) household assets looks fine. Financial Bubbles thrive on gross excess that looks fine. The Mortgage Finance Bubble -- with its attendant unprecedented refi boom, record home equity borrowings, record home sales and unparalleled equity extraction -- has basically spurred the re-pricing of our household sector’s debt load, along with fueling a major inflation in asset prices. This unlimited supply of cheap mortgage finance has been the product of gross over-leveraging and speculating endemic to the now fragile U.S. financial system. The key to sound analysis is to appreciate that there are extraordinary Bubble dynamics in play with the GSEs, the leveraged speculating community, the U.S. financial sector generally, and global central banks. Dr. Laffer and others make the critical mistake of Extrapolating the Terminal Stage of Bubble Excess. As to the crucial “flow” of debt, sound analysis cannot ignore that Total Credit (Non-financial and Financial) expanded at an unprecedented annualized $2.82 Trillion (25% of GDP!) during the first half, a rate of 9.1%. For comparison, during the first eight years of the nineties, Total Credit Growth expanded by an average $1.011 Trillion. First half annualized Non-financial Credit growth of $1.88 Trillion compares to the $629.1 billion average during the first eight years of the nineties. It is also a pace almost 40% greater than the record $1.37 Trillion Non-financial Credit growth set last year (gone “parabolic”!). And looking specifically to the most important sector, Home Mortgage borrowings expanded at an $850.0 billion pace during the first half, a 13.2% rate. This compares to the average growth of $196.7 billion during the first eight years of the nineties. And we are to believe that it is irrelevant that Total Credit has expanded $11.7 Trillion, or 57%, to $32.4 Trillion over the past 22 quarters? The bottom line is that economic “output” is surging -- and Dr. Laffer can fearlessly claim that “debt levels are healthy” and that ballooning consumer balance sheets are “manageable” -- only because Credit Flows are running about three times the average level from not too many years ago (1990-1997). Bubbles are seductive, seductive and more seductive. The key issue stated differently: The extreme level of debt (a “stock”) is sustainable only as long as extreme amounts of new Credit (a “flow”) are forthcoming. But what about sustainability? How long can our system expand Total Debt at an annual pace of 25% of GDP? And what are the consequences of this unprecedented Credit inflation – with respect to financial and economic stability (both domestically and internationally)? As students of Credit Bubble analysis, we are cognizant that current financial excess is a manifestation of exactly the accelerating Credit growth required to levitate inflated asset (real and financial) markets and sustain the impaired U.S. Bubble economy. We have also witnessed the incredible power of Bubble forces, and appreciate how the system rises to the challenge of sustaining precarious Bubbles. After all, when the NASDAQ Composite nearly doubled over twelve months from October 1998 lows, simple reason made it clear things were out of control. Prices then almost doubled again over six months in one of history’s great financial melees/fiascos. Similar to today, reasonable thinking and sound analysis were zealously pushed to the side. New Era views and propaganda took over as everyone played the final speculative blow-off. We know all too well how this works, and recognize today’s blow-off dynamics for what they are. The Laffer folks can ignore unprecedented leveraged speculation and unfathomable interest rate derivative positions; they can disregard GSE operations and the profound role these institutions play in supplying an enormous and expanding supply of mortgage Credit at very low (and, for years, declining) interest rates; they can remain oblivious to the instrumental impact $1 Trillion of total new mortgage Credit is playing this year in sustaining both the financial and economic Bubbles; they can pretend we did not get an indication of the potential for systemic interest rate/derivative disruption back in 1994 and with LTCM in October 1998; they can forget about last year’s near corporate debt collapse; and they can fail to appreciate the ramifications for a weak dollar in the face of unprecedented global central bank purchases. They can claim that our acutely fragile financial system and Bubble economy are not at keen risk to higher rates (the Fed clearly believes they are!). Yet their exercise of creating an appealing false reality will remain absolutely convincing to most as long as the Great Credit Bubble inflates. But Bubbles always burst, and this one should have been pierced several years ago. When Credit growth inevitably slows, or if interest rates spike significantly higher or the dollar dislocates on the downside, recession will be the least of our worries. A Warning from Dr. Issing: Fortunately, there is also exceptional analysis to share with readers this week. Below are extensive excerpts from a speech delivered by Dr. Otmar Issing, European Central Bank Chief Economist, Tuesday at the German British Forum in London. His comments offer somber Straight Talk from one of worlds’ most astute Central Bankers. Europe and the US: Partners and Competitors – New Paths for the Future http://www.ecb.int/index.html “It was just a few weeks after 11 September 2001, when the German British Forum met in London. On that occasion, I had already the privilege to participate in a panel on ‘a new framework for the US-European partnership.’ In my introduction, I stated that ‘... such traumatic events – hitting us as individuals, as nations and as a community of nations – have led us to rediscover a sense of purpose, reaffirm common values and act in solidarity. This brings people closer together in times of trial.’ Unfortunately, this sense of closer-than-ever ties across the Atlantic has not lasted long. Two years and two wars later, the relationship has proved rockier than expected… …I would like to briefly elaborate on the issue of global imbalances, which have attracted so much attention. While the notion of global imbalances may have different meanings to different people, the interpretation which will underlie my talk this evening concerns the international flow of goods, services and capital. Such imbalances manifest themselves in large trade and current account deficits in some countries, with corresponding surpluses in others. When one talks about global imbalances in this sense, one, of course, is immediately drawn to the persistent US current account deficit, which has existed more or less continually since the early 1980s and which currently runs at roughly 5% of GDP. As a consequence, the net liabilities of the US vis-à-vis the rest of the world increased to around 23% of GDP by end-2002 – compared with less than 5% in the early 1990s… There are three main reasons why a large current account deficit that goes beyond such medium-term equilibrium considerations may be a cause for concern… First, persistent current account deficits – and, in particular, trade deficits – may give rise to protectionist pressures in the deficit country. If the country is a major trading nation, this may pose a serious threat to the global trading system. Second, there is the risk of a disorderly adjustment. And third, world savings may not be allocated efficiently… Regarding the risk of a disorderly adjustment, it should be emphasised that any excessive current account deficit will need to adjust eventually. What cannot last, will not last. The crucial issue is whether the adjustment will be orderly or involve a large and disruptive change in key economic variables. Such a disorderly adjustment would affect not only the rest of the world but, in particular, the deficit country itself, turning this issue into a truly global one. There are a number of factors, which may increase the risk of a disorderly adjustment. For example, the longer the flow imbalances exist and the larger they – and the associated stock imbalances – are, the larger the required adjustment back to more reasonable levels would be. The risk of a disorderly adjustment is likely to increase with the magnitude of the needed adjustment. A further factor that may play a role in determining the orderliness of the adjustment process is the composition of the capital flows which finance the current account deficit. In particular, ‘hot’ portfolio flows may quickly reverse direction in a highly integrated global financial system characterised by close substitutability of different markets with respect to the diversification benefits they offer… At a minimum…it should be ensured that capital flows occur in an environment, in which timely and accurate information about investment projects is available, so that capital can flow to uses with the highest (risk-adjusted) rates of return. The importance of this condition is highlighted by the accounting irregularities at US companies, which resulted in an overstatement of actual profitability… Another reason why the efficiency of the allocation of global savings may be an issue is that, more recently, the external deficit of the United States reflects actions by public entities rather than private sector interactions. On the one hand, the US saving-investment gap is at present largely a public one, reflecting the increase in fiscal deficits. On the other hand, the financing of the current account deficit has shifted from private funds to public funds, as many central banks – in particular in Asia – are engaged in large purchases of US government securities. Given the historical track record of public entities with respect to the efficient use of funds, this shift towards the public sector – both on the financing and on the allocation side – may in itself provide some cause for concern. The current level of the US current account deficit is in the longer run unsustainable and an adjustment will eventually occur, whether actively supported by macroeconomic policies or not. The question is only whether it will happen in an orderly fashion. By supporting an adjustment sooner rather than later policy-makers could, in principle, help to ensure such a gradual and orderly adjustment, while at the same time possibly contributing to a more efficient use of global savings and safeguarding the global trading system by limiting protectionist pressures. This would be in the interest of all countries involved, including the United States. I sometimes have the impression that Europe and the United States are separated by two different schools of thought in that respect. In Europe the view seems to prevail that a problem with the US current account deficit indeed exists, while on the other side of the Atlantic many people do not consider this to be a problem, at least not for the US, but rather for Europe. Consequently, Europe should find a solution to it. Paraphrasing a statement, which former US Treasury Secretary Connolly made with respect to the US currency, one could summarise this view as ‘It may be our deficit, but it is your problem.’ It is, however, important to acknowledge that this is an issue of global relevance, as the smooth adjustment of a situation that is unsustainable is in the interest of countries on both sides of the Atlantic and also the rest of the world. Indeed, it appears that, despite the occasional rhetoric to the contrary, policy-makers in the US are well aware of the potential negative consequences of a disorderly adjustment on the US economy. But how can an adjustment be achieved? A slowdown in the deficit country’s growth rates relative to the rest of the world typically plays an important role in any such adjustment. This could, for example, mean an actual growth slowdown in the United States, thereby reducing the demand for imported goods and services, or a growth acceleration in the rest of the world, which increases the demand for US exports. If we had to decide on one or the other, the choice would not be difficult – it is higher growth everywhere else. This preference is also reflected in frequently heard demands from the other side of the Atlantic that Europe should generate faster growth to aid the adjustment process. In this respect it is extremely important to specify how this higher growth is to be achieved. Artificially stimulating the economy by large budget deficits and/or inflationary monetary policy is no viable option. In fact, history tells us that such policies can only provide temporary straw fires, with potentially damaging long-term consequences. To illustrate this point let me briefly take you back in time to the mid-1980s. At that time, the US-dollar had been appreciating rapidly over a number of years and the US current account stood at around 3% of GDP – at that point a post-war historical peak. Concerned about the potential side effects and risks involved in such an unsustainable situation, policy-makers from the main industrialised countries decided to tackle this problem in a coordinated fashion. In addition to agreeing to bring down the external value of the US dollar, they also decided that Europe and Japan should pursue policies aimed at stimulating domestic demand. They would thus become the ‘locomotives’, which would bring about the adjustment, while at the same time raising global growth. In the so-called Louvre Accord in 1987 the governments and central banks of the major industrialised countries, for example, agreed that Japan would ‘follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus.’ We all know what happened subsequently. The expansionary policies in Japan and, in particular, the monetary easing that was involved contributed to an asset market bubble, which burst and led to a decade of very sluggish growth and created structural imbalances which are still constraining growth in Japan to some extent today. Seen from this perspective, some of the problems of today's world economy date back to misguided policies triggered by efforts to solve global imbalances. Instead of short-term activism, which is likely to create imbalances in other areas and does not solve the underlying problem, sustainable policies are needed, with a view towards the medium and long-term… The ECB’s forward-looking policy with the objective of ensuring medium-term price stability together with necessary structural reforms is thus an indispensable condition for raising the potential growth rate of the euro area economies. In that context, one of the main reasons why such a policy is effective in providing a growth-enhancing environment is that it anchors and stabilises people’s expectations about future price developments. Therefore it is crucial to carefully guide those expectations, rather than try to manipulate them to obtain short-term benefits, while endangering the longer-run credibility of the overall monetary policy strategy… In that context, let me briefly address an argument that is sometimes made to justify the demand for a more aggressive expansionary policy in Europe. According to this argument, the United States have contributed to strong global growth in the second half of the 1990s, thereby ‘saving’ the rest of the world, and in particular Europe, from stagnation and recession. This implies, according to the proponents of this argument, that it would now be Europe’s turn to do likewise and to provide the needed growth impetus. This argument is not new and was used already extensively in the mid-1980s when the world economy, as I said earlier, found itself in a similar situation as today. But the argument is as wrong and dangerous today as it was then. The United States has not conducted macroeconomic policies with a view towards the world, thereby sacrificing domestic policy objectives in favour of global considerations. Both then and now, for good reasons the focus has been on the United States and the resulting policies happened to provide the rest of the world with some benefits – at least in the short run. This stance was succinctly summarised by Federal Reserve Chairman Greenspan in a 1999 Senate hearing: ‘We would never put ourselves in a position where we envisaged actions we would take to be of assistance to the rest of the world but to the detriment of the United States.’ As a consequence, the argument – which is sometimes elevated to the standard of a ‘moral obligation’ – that European policy-makers should forego important domestic policy goals is untenable. This is especially true if such goals were to be sacrificed in favour of short-term stimulus measures, which would not solve any of the underlying real problems, which give rise to the existing imbalances… Although faster growth in the rest of world may support the adjustment process, part of this adjustment will eventually have to come from an adjustment of the saving-investment gap in the United States… A considerably larger correction will be necessary for the public saving-investment balance, with the current fiscal stance certainly not being sustainable in the long run. Such a correction will in all likelihood imply lower growth for some time. The choice is, however, not between correction or no correction, but between a correction sooner rather than later. The current situation is not sustainable and an adjustment is inevitable. A timely one may in the end be less costly than a postponed but eventually more disruptive one… Regarding the current global imbalances, the euro area will play its part in trying to ensure that the adjustment will be as orderly as possible. However, it would be dangerous to believe that excessive expansionary measures would be a valuable contribution. They would be in the interest neither of the US nor of the euro area, as they would give rise to imbalances elsewhere which would have to be corrected at some point in the future as well. Even now, there is certainly no lack of liquidity in the world. Stability – also on the global level – begins at home and a narrow focus on the external side is certainly too short-sighted. In particular, the notion that higher growth – regardless of how it is achieved – is beneficial for the global economy, is fundamentally flawed. Rather than shifting imbalances between countries and regions, a more sensible approach would be for macro policy-makers to provide the framework within which sustainable growth can be achieved. For monetary policymakers, this means trying to achieve medium-term price stability… The orderly adjustment of existing global imbalances should always be considered as an issue of shared interest. We can only succeed in this respect, if we act as partners, rather than as antagonistic competitors. In the longer run, domestic and global stability, national and international interests, do not conflict, but go hand in hand.”  I will let Dr. Issing’s brilliant “central banking” speak for itself. It is both frustrating and disconcerting that there is no one in our country speaking his "language". I believe the ECB recognizes that the inevitable adjustment is long overdue and will likely commence in the not too distant future.