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March 21, 2006

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Maestro's Performance
Name: Addison Wiggin

Company: Agora Financial

Learn More About Today's Author
Years Trading: 13

Favorite Movie: The Outlaw Josey Wales

Maestro's Performance

In February 2005, Alan Greenspan gave a speech in honor of the first modern economist—Adam Smith. The Fed chairman journeyed to Fife College, in Kirkcaldy, Fife, Scotland, where Smith was born in 1723. There, he commented on Smith’s work:

“Most of Smith’s free market paradigm remains applicable to this day,” said he.

In particular, the world seems to have discovered that independent buyers and sellers are better at delivering the goods than government planners.

This would have come as a shock to George Orwell. Writing at the beginning of World War II, Orwell expressed the belief of millions: “I began this book to the tune of German bombs. . . . What this war has demonstrated is that private capitalism—that is, an economic system in which land, factories, mines and transports are owned privately and operated solely for profit—does not work. It cannot deliver the goods.”

Orwell was wrong. Capitalism delivered the goods better than socialism, a fact that even nearsighted journalists and central bankers were eventually able to see. But even after the fall of the Berlin Wall, continued America’s most celebrated central banker, there was “no eulogy for central planning.”

Adam Smith had proposed a useful metaphor to help explain how a system of private, individual decision making—which must have looked chaotic to a top-down observer—actually functioned to the betterment of all. A rise in the price of pigs, for example, sends a signal to the hog raisers to produce more. Thus, the market is guided by an “invisible hand” to produce exactly as much of a thing as people really want and can really afford.

Quick-witted readers will already be gurgling with indignation. Markets work best without the heavy hand of regulation, Greenspan acknowledged. But he seemed to exempt, conveniently, the credit markets. The maestro’s speech hit a false note; rather like President Bush’s approach to evangelical democracy, it seemed to miss the point. Instead of letting lenders of credit and demanders of it be guided by an “invisible hand,” for years the Fed chief ’s boney paws have drawn them together. Mr. Greenspan’s “Open Market Committee,” not the open market, has largely determined the rate at which lenders will lend, short term, and at which borrowers will borrow.

Why is it that what is good for the goose of lumber markets, stock markets, grain markets, laptop computer markets, and almost every other market under Heaven is not good enough for the gander of the credit market? The answer is not one of logic, but of convenience. Most of the time, political leaders prefer easier credit terms than buyers and sellers would determine on their own. In setting its key rate, the Open Market Committee is likely to set a rate that is to the politicians’ liking.

New Yorker columnist James Surowiecki’s book, The Wisdom of Crowds, makes the point that two heads are better than one. Groups of people can be smarter than individuals. A market, theoretically, can do a better job of finding the right price for a thing. A market is supposed to aggregate the private opinions and independent judgments of thousands of individuals. Generally it succeeds. But on occasion, the market slips into crowd-like behavior—whipped to excess by the financial media or the financial industry.

And sometimes, the whole market is deceived by its own central planners. Rather than allow lenders and borrowers to decide for themselves what rates they would accept, the central planners at the U.S. Federal Reserve decided for them. How they can know exactly what lending rate such a large and infinitely complex economy needs has never been explained. But, historically, from the Fed’s lowest rate to its highest, there are about 1,200 basis points. On those odds alone, they have almost certainly chosen the wrong one. What’s more, Fed rates are not chosen on the basis of science or of logic, but of convenience. There are times—indeed most of the time—when political leaders prefer easier credit terms than buyers and sellers determine on their own. In setting its key rate, the Open Market Committee tends to set a rate much more to the politicians’ liking than the one offered by Mr. Market. A lower rate, that is. But as Schumpeter points out, any stimulus in excess of actual savings is a fraud.

This artificially low rate gives the illusion that there is more money available than there really is. Hardly anyone ever complains. Consumers feel they have more money to spend than they really have. Producers sense a demand that really isn’t there. Undeserving politicians get reelected. And conniving central bankers are reappointed.

The “information content” of the Fed’s low rate misleads everyone. They proceed happily on the long, slow process of ruining themselves, unaware that they are responding to an imposter. Only much later does the deception become a problem.

Friedrich Hayek explains:

“The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand, which must cease when the increase of money stops or slows down, together with the expectation of a continuing rise in prices, draws labor and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate—or perhaps even only so long as it continues to accelerate at a given rate . . . would rapidly lead to a disorganization of all economic activity.”

The way it works is simple: An economy is geared to produce for real demand.

Or it is misled by artificially low interest rates to produce for a level of demand that doesn’t exist. The deceit can go on for a long time. But, eventually, some form of adjustment must take place—usually a recession restores order by reducing both production and consumption. Generally, the correction is equal to the deception that preceded it.

But the Bank of Alan Greenspan thinks it can avoid these periodic bouts of sanity. Fed Governor Ben Bernanke proposed “global cooperation” in a November 21, 2002 speech. Then, in May 2003, he went to Japan urging concerted action. The Fed was prepared to sacrifice the solvency of American consumers, he told the Japanese. Tax cuts and low interest rates could still induce them to buy things they didn’t need with money they didn’t have. But Japan had to help hold down U.S. interest rates—by buying up dollars and dollar-denominated assets, notably U.S. Treasury bonds.

This is what happened next, according to Mr. Richard Duncan: “In 2003, and the first quarter of 2004, Japan carried out a remarkable experiment in monetary policy—remarkable in the impact it had on the global economy and equally remarkable in that it went almost entirely unnoticed in the financial press. Over those 15 months, monetary authorities in Japan created ¥35 trillion. To put that into perspective, ¥35 trillion is approximately 1 percent of the world’s annual economic output. It is roughly the size of Japan’s annual tax revenue base or nearly as large as the loan book of UFJ, one of Japan’s four largest banks. ¥35 trillion amounts to the equivalent of $2,500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime.”

Why did the Japanese create so much money? Because they needed to buy from their citizens the dollars they had accumulated by selling things to Americans. Had they not done so their currency would have gone up— making their products less competitive on the U.S. market. Had they not done so, the dollar would have fallen much further against other currencies. Had they not done so, the Japanese would not have had the dollars to buy U.S. Treasury bonds. And had they not bought so many of them, U.S. interest rates would have risen, consumers would have had less money to spend, and probably the whole world would have had an economic crisis.

“Intentionally or otherwise,” Duncan continues, “by creating and lending the equivalent of $320 billion to the United States, the Bank of Japan and the Japanese Ministry of Finance counteracted a private sector run on the dollar and, at the same time, financed the U.S. tax cuts that reflated the global economy, all this while holding U.S. long bond yields down near historically low levels.

“In 2004, the global economy grew at the fastest rate in 30 years. Money creation by the Bank of Japan on an unprecedented scale was perhaps the most important factor responsible for that growth. In fact, ¥35 trillion could have made the difference between global reflation and global deflation. How odd that it went unnoticed.”

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