Mr. Kudlow's Article

I was asked to read the following article by Larry Kudlow called “The economy in the Fed’s hands?”

http://www.nationalreview.com/kudlow/kudlow200505110857.asp

What is my take on it the article. Well let’s break it apart one section at a time.

“Take, for example, the latest monetary data from the Federal Reserve Bank of St. Louis. The data show a marked slowdown in key money-supply measures. The adjusted monetary base, over the past six months, is growing at a meager 2.6 percent annually. A broader money measure known as M2 has slipped to a below-normal 3.5 percent
There may be two key reasons for this money slump. First, the Fed is injecting less and less new cash into the economy as it raises its short-term target rate. Second, the increase in short-term rates to 3 percent from 1 percent may be reducing future economic demand.”

When Kudlow talks about new cash he means monetizing the debt. This is when the Federal Reserve credits the US government with money, but doesn’t sell any debt. This action causes inflation. This is also called debasing currency.

Normally the US government needs money and wants to borrow to obtain it. The Federal Reserve then offers Treasury bills, bonds, and notes (The distinction is on the amount of time the debt is good for). This is called sovereign paper and the Federal Reserve is our Central Bank.

The Fed then sells the paper on the international market. The interest rate it receives, the yield, is determined by the marketplace. If the market is lax the interest rate goes up to attract buyers. If the market is tight and many institutions want to own US sovereign debt, then the interest rate goes down.

The short term rate Kudlow is talking about is the rate the Fed charges for very short time periods, like overnight. The fed has not set a bottom for the long term rate. The long term demand is the devil setting bond prices all over the board.

Why the slow down of the rate of increase in the money supply? It is hard to tell from Kudlow’s writing, but I will assume that the US government didn’t offer as much additional debt on a logarithmic scale. What does that mean?

Lets say you have a total money supply of 1,000,000 (I am using small numbers) and you increase it 10% per year. After 8 years the supply of money would be over 2,000,000. This is an exponential jump in the amount of money in your economy. So in each year how much money did you create?

Year 0 = 100,000
Year 1 = 110,000
Year 2 = 121,00
Year 3 = 133,100
Year 4 = 146,410
Year 5 = 161,051
Year 6 = 177,156
Year 7 = 194,871.

In each period, the amount of money supply increases exponentially. So to say that the money supply grew only 2.6% over 6 months just means the money supply didn’t grow as fast. It certainly didn’t decelerate. So if you on creating the same amount of money let say 146,000 per year after year 5, than it looks like in year 8 that the money supply is slowing. It is really just not going up at an exponential rate any longer.

Consider this, as per my last argument that mortgage rates are low due to foreign banks not finding enough debt to invest their US dollars. When these countries run out of US sovereign debt they just buy mortgage backed securities (MBS) and other US bonds. This would make the MBS very attractive and competition for them would be very high. This would explain the low mortgage rates you see.

By lowering the amount of government debt on the market, you make obtaining bonds, MBS, and other forms of US debt the only way of maintaining the value of the US dollar. Remember, if the US dollar falls, then these countries, which have a lot of US paper as their core asset go into a banking crisis if the paper devalues.

Kudlow writes “Every one of the monetary readings is now way below the 6 percent growth of current dollar GDP. While the fit between money and national income is a loose one, it is not irrelevant. It could be predicting a sub-par economy next year.”

He indicated that if the money supply does not expand than the economy shall slump. With a negative trade balance you have to create more money through borrowing or you go bankrupt. The real problem he is alluding to is the ability to obtain loans from other countries. If the US cannot borrow any more money, we have to pay our debts through monetizing the debt, and then the currency will inflate (hyper inflate).

“It seems apparent that Greenspan is not targeting market-price indicators. So what is he targeting? Maybe he has the so-called housing bubble in his sights, or the mortgage credit-expansion behind it. If he is watching housing, he’s looking the wrong way. The key reason behind the surge in housing investment is the shower of tax advantages that have fallen on this sector since the 1997 tax bill. On a tax basis, it’s much better to invest in homes than in stocks as home-sale profits are tax-free up to $500,000.”

Mr. Kudlow has omitted many historical facts and is ignoring the impact of lower lending standards in his argument about housing appreciation. How very political of him to blame a “shower of tax advantages”. He knows, from his former job at the Federal Reserve that the United States and the other G-8 countries suffered an enormous banking crisis in 1998 due to Russia defaulting on its loans.

During the 1998 Russian banking crisis, the US bond market crashed. This was due to the fact that all of the banks in the world went under their fractional reserve limit and could not lend any more money. Here are some quotes from the history books about this time.

Martin Mayer writes in The Fed “It turned out to be a weekend of pure terror”. “Lumping together the five nations devastated by the Asian financial crisis, the Deutsche Bank researchers concluded that “While it is difficult to argue that governments are insolvent … under most scenarios, the ability of the government to service its debt in the short run is questionable.” Turning attention to Russia, the German bank’s expert argue that “there is a very high risk that Russia will not be able or willing to repay its foreign debt.” – ever.”“

One of the last speakers at the Group of Thirty conference was William McDonough, president of the Federal Reserve Bank of New York… Everyone here, he said, is a banker or a bank supervisor. If you’re a banker, go out and lend – you don’t have to dot every I and cross every T. If you’re a bank supervisor, don’t criticize your banks for making loans even if they’re loans you might not have approved just a little while ago. Get the money out; the word needs the money.”

Then later that week at the Chicago Board of Trade Martin Mayer writes “And then the roar stopped, the men stopped waving their arms in the pit, and they all just stood, arms at their sides. At 11:45 in the morning, the price of the T-bond futures contract had dropped $3,000, which was the maximum move in a single day. The market has closed “lock limit down” for the first time since Saddam Hussein invaded Kuwait.”

“We returned to the Federal Reserve Bank of Chicago, and in the anteroom ran into Michael Moscow, president of the bank, a tolerant economist who does one thing at a time. We told him what we had seen across the street, and he nodded soberly. “Yes,” he said. “There are no bids for anything. There is no money.”

The Federal Reserve lowered the lending standard in order to inject currency back into the economic system. This action is what really lead to the housing bubble in the G-8 countries. In my opinion the tax advantage meant very little. The psychology of greed is what made people flip houses just like day traders bought and sold stock. Stocks had no such tax break, but that didn’t stop people from day trading did it.

“In the last economic cycle the Fed ignored falling inflation and instead aimed its guns at the Internet bubble. We soon were reminded that any time you deflate the money supply, the overall economy slumps badly. Stocks delivered their worst performance in over 40 years. As for signs of inflation today, the price of metals and overall spot commodities are dropping, gold is going nowhere, and long-term bond yields are at 45-year lows. These tried-and-true inflation indicators are saying: “No inflation.””

Kudlow is right on target here, any time your country depends upon debt to keep going, any small bump in the road will send your economy into a slump. However, we are still in the same economic cycle. How can that be, we never really recovered from the damage done to the banking system during the Russian banking crisis or the speculation of the dot.com crash. Instead of repairing the damage, we have “leveraged” our currency even more. This is not a recovery, this is a recipe for disaster when the lending stops.

Signs of inflation? The inflation numbers from the Federal Government have been manipulated for years. See Jim Puplava thesis called “The Core Rate” about how the government does this.

Stocks performed badly, of course, when massive speculation and bad investments hit bankruptcy, lending and investing institutions must liquidate in order to keep solvent and above their fractional reserve limit. This leads to the dumping of good stocks onto a market with few buyers, causing the stock prices to go lower.

Commodities prices are dropping, what planet is Kudlow on. I guess he never heard of rising food or energy prices. The two biggest expanses for people and let’s just ignore them. I guess that’s why the federal government took food and energy out of the inflation index.

Long term bond yields are at a 45 year low. Of course they are, when your currency is in every else’s banks, they have to buy your bonds or go into a banking crisis. This makes your bonds very important to them. The problem is when they decide that this has gone on for too long.

Under these conditions, if the US doesn’t offer as much as an increase in debt as expected, then the other countries will have to buy bonds with the money they would have used to buy US Treasuries. If they don’t buy US securities or assets, they dollar will devalue even faster and that could send them into a banking crisis.

“Milton Friedman taught us that inflation is a monetary problem caused by too much money chasing too few goods. However, as supply-side tax cuts expand the workforce, production, and investment, the increase in goods absorbs the existing money supply. Instead of prices rising, prices fall”

Friedman’s thesis is correct. The problem with our economy is that we have gutted our manufacturing base, so we don’t build that much stuff here anymore. “It's a deeply embedded structural problem," Warren Buffett said. "We're going down a path that's long being described as dangerous by some of the most intelligent people in this country."

“Former Federal Reserve governors Manley Johnson and Wayne Angell argue that financial and commodity-market indicators can inform the Fed whether money is too loose or too tight. Free-market prices, they’re saying, are smarter than central planners. Right now these market indicators, like the money-supply figures, are telling the Fed to stop tightening.”

I don’t agree tat the markets are good indicators here. If borrowed money dries up, than these businesses are in trouble. They need uncontrolled money expansion through borrowing or their companies will collapse. They think that the Fed has an impact on this. The lynchpin is really the health of the foreign banks.

“There’s a tug of war going on in the stock market today as the bulls and bears try to figure out which direction the future economy will go.”

The tug of war is really keeping this debt party going. The bears see it ending and the bulls are trying everything to keep it going. Tug of war, not really. It’s really a fight with our country forcing other countries lend us more money. Thank god we have a large military.

Mr. Kudlow has intentionally tried to steer focus away from the actual problems into a bunch of meaningless economic clichés. But what can you expect, he is a politician. Just check his resume.