|Old Bull Lee
A Voice From the Reality-based Community
Notes from a Study of Things Themselves
Two recent developments have brought the future into clearer focus.
The first was the Fed's response to the subprime mortgage crisis. The second is the emergence of Hillary Clinton as frontrunner for the 2008 Democrat presidential nomination.
The first development reveals the Fed's willingness to inflate the money supply to bail out banks holding bad debt. The second development insures that the current Bush/Cheney wars in the mideast will continue and expand to other countries--as part of a process I describe as "colonization"--regardless of the winner of the 2008 presidential election. Government borrowing to accommodate the Fed's bailout policy and the high cost of colonization will have profound inflationary effects in the economy.
In the paragraphs below I describe the inflationary nature of ongoing government policy. In Part II of this essay I venture some opinions as to how the inflationary environment will affect personal investment in bonds, stocks and real estate over the next ten years.
The Fed's Bailout of Wall Street Bankers
During the early and middle years of the George W. Bush administration, Fed chairman Alan Greenspan lowered the Federal Funds rate, the interest rate that banks charge other banks for overnight loans, from 5.25% to 1% and kept it at 1% for two years. His purpose was to stimulate the economy, which had been damaged by the collapse of the high-tech bubble in 2000 and 2001. At the same time the US trade deficit increased dramatically as a result of a flood of imported Chinese manufactured goods and increasingly expensive petroleum imports. The trade deficit put billions of dollars in the hands of foreigners, who, unable to find a better investment for them, bought US Treasury bills, notes and bonds, thereby driving up the prices of Treasury debt and further driving down both long- and short-term interest rates for American businesses and consumers.
The long period of low interest rates across the entire yield curve led to an explosion of credit and a corresponding increase in the money supply. Speculators borrowed dollars at a low rate of interest to buy foreign currencies paying higher interest rates. Low mortgage interest rates and relaxed qualifying terms led homebuyers to purchase residences they otherwise could not afford. Cheap mortgages drove up prices of existing homes, prompting homeowners to borrow money using their increased home value as collateral. Cheap credit also led to overbuilding as real estate developers saw their carrying cost of unsold houses reduced to almost zero.
It is now clear that the run-up in real estate prices caused by low interest rates was a classic financial bubble. So why didn't the Fed see it coming and do something about it? Well, the Fed is charged with regulating monetary policy such that our economy has stable prices and high employment. Since prices seemed stable and employment seemed high, the Fed didn't see a problem.
At the heart of the Fed's failure is the agency's reliance on rigged economic statistics. Examples of government statistics-rigging relating to inflation, GDP and unemployment abound. A significant example is the "core CPI," which the Fed uses to gauge its success in controlling inflation. The core CPI is computed monthly by the Bureau of Labor Statistics (BLS) and is defined as the Consumer Price Index with "volatile" food and fuel excluded. A core CPI value of 2% or less is considered benign and during the period of extremely low interest rates, the core CPI stayed in the benign range. Obviously, food and fuel increased rapidly during that period, but they are not part of the core CPI. And house prices increased rapidly, too, but house prices are not part of the core CPI, either! Instead, a heavily weighted term called "equivalent rent" is used to estimate housing cost. Equivalent rent consists mostly of the cost of mortgage interest, which is very low when interest rates are low. The result is that the Fed always sees benign inflation, even when the money supply is exploding and overall prices are increasing rapidly.
A brief economics lesson is in order here. The Fed has power to regulate the amount of money lent by banks and therefore the size of the overall money supply. When a bank makes a loan for any purpose, it creates money out of thin air and increases the money supply. The act of creating money in this way is sometimes called "printing money." If the money lent is exchanged for goods or services having value that can eventually be exchanged for money needed for repayment of the loan, then the creation of money will be noninflationary. If the loan is not used productively--for example, if it is gambled away in a poker game or spent in an unprofitable or corrupt business venture--the printing of money is inflationary. However, the inflation might not show up in consumer prices. Such was the case in 1929, when borrowed money drove stock prices to unprecedented levels, but consumer prices remained fairly stable.
Three related points should be stressed.
It was during this era of ultra low interest rates that the subprime loan came into being. Such loans were offered to borrowers with poor credit for use in financing or refinancing up to 100% of a home's value. The loans had adjustable rates such that the rate for the first few years would be extremely low and payments might be interest-only. After a few years, payments would increase or decrease depending on prevailing rates at that time. The issuer of a loan would take fees and commissions out of the borrowed money and then sell the loan to Wall Street firms that would combine loans into bonds known as Collateralized Debt Obligations, or CDOs. The CDOs were sold to investors and speculators and traded like other securities. The original issuers of the mortgages had nothing more to do with the loans.
As interest rates rose and house prices leveled off in 2006 and 2007, the payments on subprime loans which made up the CDOs began to adjust upwards. Many borrowers of these loans, who were poor credit risks to start with, couldn't make their payments and defaulted. In mid 2007 the high rate of default of loans making up the CDOs reached a crisis state wherein the market for CDOs froze up. There were no buyers of CDOs and no way to establish a price. Subsequently, the existence of other obscure off-balance-sheet debt obligations known as "SIVs" and "conduits" came to light. The owners of these instruments--banks, hedge funds, mutual funds, money market funds--did not want to acknowledge their losses, which would show up in their financial statements. More importantly, the Wall Street bankers did not want to jeopardize their million dollar bonuses that are granted as a function of company profit.
The bankers appealed to the Fed for relief. For a while it was unclear how the Fed would respond. Would it tell bankers, "You made your bed, now lie in it." Or would it bail them out by printing the money they needed to finance their losses from their unwise investments in CDOs?
In mid-September Ben Bernanke, Fed Chairman, announced that the Fed would reduce the Fed funds rate from 5.25% to 4.75%. Furthermore, he announced that the Fed would open the discount window and lend to banks directly at a rate of 5.25%. On November 1 he further reduced the Fed funds rate to 4.5%. In other words, he told the bankers he would lend them however much money they needed to clean up their mess, and at a bargain interest rate.
World currency markets recognized the Fed action as a bailout. Traders dumped the dollar to buy currencies where they could get higher interest. The US dollar dropped to record lows versus the euro, the UK pound and the Canadian dollar. The price of gold reached a 28-year peak. A panic rush-to-safety ensued as investors converted dollar assets to ultra-safe US Treasury securities, driving down interest rates paid on those securities to the lowest levels seen in several years.
The Fed's message was clear. It will be the policy of the US government to inflate its currency--to print whatever money is needed--to protect the Wall Street bonuses at Goldman Sachs, Citigroup, Lehman Brothers, JP Morgan, Morgan Stanley, Merrill Lynch and many others. Ben Bernanke embraced the "moral hazard" that his predecessor had warned about. Now everyone in the world knows that he is more concerned about the profits of the Wall Street bankers and speculators than with the value of the US dollar.
The Prospects for Future Government Borrowing and Inflation
Bailing out Wall Street bankers will not be the only source of inflationary government borrowing in coming years. A bigger source will be financing the imperialist wars that are currently under way and show no signs of ending. Below I outline some important background material and suggest, based on domestic political considerations, how the wars will play out and what the inflationary consequences will be.
The Bush/Cheney administration has repeatedly dissembled about its true geopolitical policy. After the 9/11 attack, it declared its policy was a "war on terror" but it never defined what it meant by "terror." That gave it latitude to specify numerous resistance groups, many of which were not even hostile to the US, as terrorists and therefore enemies of the US. But observers found it odd that one of the first acts of the war on terror was to let the 9/11 perpetrator, Osama bin Laden, escape into Pakistan, where he resides today. Terrorism was subsequently used as pretext for attacking, invading and occupying Iraq, a country that had never threatened, attacked or terrorized the US. Then, as the pre-war lies and cooked intelligence were exposed to everyone who was paying attention, people began to doubt that terrorism had been the real reason for invading Iraq.
So the Bush/Cheney administration changed its story and announced its policy was actually to bring democracy to the hostile Muslims who populate the Middle East. As a few more years passed, this policy, too, was revealed to be a sham. It was noted that the Bush administration was not pushing Saudi Arabia and Egypt, two of the most tyrannical regimes in the world, to adopt western democratic practices. The US declared the democratically elected Hamas government to be a terrorist organization and actively worked with Israel to subvert Hamas authority in the West Bank. And the administration has never wavered in its support of Pakistan's Pervez Musharraf, a military dictator who has recently fired members of his country's supreme court and declared martial law.
Meanwhile, in the US, the Bush administration nullified constitutional civil liberties essential for democratic government: habeas corpus, due process, attorney-client privilege and open trials. He has declared that he has the authority to pick and choose which congressionally approved laws he can obey. The president of the United States can now literally order the chief justice of the supreme court kidnapped and transferred to the Guantanamo prison camp for torture. Is this democracy?
Lately a new rationale has been floated for continuing and expanding the war: the supposed spread of Islamofascism, a bizarre ideology that exists only in the mind of neocon godfather and Islamophobe Norman Podheretz. He "prays" that the US will initiate a war against Islamofascism by attacking Iran. This idea might be passed off as the harmless raving of a lunatic, but Podheretz is the chief foreign policy advisor to Rudolph Giuliani. Also, Podheretz's son-in-law, neocon Eliot Abrams, is the Bush administration's Deputy National Security Advisor for Global Democracy Strategy.
But I argue that that neither terror, nor democracy nor Isalmofascism is the real reason for the ongoing wars in Afghanistan and Iraq. Instead, I suggest that the real policy of the US in that region is to colonize the hostile Arab and Persian regimes, to bring them under American and Israeli political control and to benefit thereby from ongoing access to their natural resources at the same time we deny those resources to our international competitors in Russia, China and India.
Building the infrastructure for colonization has been underway for four years with the construction of massive, permanent military facilities in Afghanistan and Iraq. (Already one of our air bases is said to be as busy as Heathrow.) Their purpose is to project military power, not only in the country where they are located, but also to Iran, Syria and Lebanon. The fortified 104-acre embassy in Baghdad is being prepared as the nerve center for exercise of US/Israeli political control throughout the region. The colonization process now has considerable momentum. Politicians in the future will find it difficult, if not impossible, to reverse the process.
On November 26 the US government published its "Declaration of Principles for a Long-Term Relationship of Cooperation and Friendship Between the Republic of Iraq and the United States of America." This agreement between George W. Bush and Prime Minister Nouri Kamel Al-Maliki of Iraq outlines the terms under which the US will exercise colonial power over Iraq. Note, for example, item #2 in the third section. It states that the US will be
"Supporting the Republic of Iraq in its efforts to combat all terrorist groups, at the forefront of which is Al-Qaeda, Saddamists, and all other outlaw groups regardless of affiliation, and destroy their logistical networks and their sources of finance, and defeat and uproot them from Iraq."
This gives the US the option of using Iraq as a base from which to attack (and colonize) Iran, whose revolutionary guard has already been declared a "terrorist group." Likewise, Hezbollah in Lebanon has been declared a terrorist group and it can be attacked (and Lebanon colonized) using bases in Iraq. Of course the US is always in charge of determining who the terrorist groups are. See further comment by Justin Raimondo.
My purpose here is not to condemn or defend the policy of colonization. Rather it is to try to grasp the economic consequences of the policy and the effects it will have on the value of investment assets. I will argue that the enormous cost of colonizing hostile countries can only be financed by massive borrowing from foreign countries and that borrowing will be inflationary. Before I get into that, however, let me point out why I believe the colonization policy will continue into the next presidential administration and probably for decades into the future.
US foreign policy is not determined by popular opinion. The masses of Americans are far too ignorant of geography, foreign cultures and geopolitical issues to have an opinion, and, if they do have an opinion, it is generally based on falsehoods, propaganda and prejudice. And the US government now has the power to use its propaganda outlets, such as Fox News, to spread whatever falsehoods are necessary to sway public opinion one way or another.
Alas, foreign policy is determined by interest groups who have the power and money to influence politicians and bureaucrats. Politicians are influenced almost entirely by money that helps them get elected, and many interest groups are willing to supply that money. Interest groups that are pushing the war of colonization fall into three major categories.
To a lesser extent the support for colonization comes from the Wall Street investment banks, who stand to benefit from the globalization opportunities, and from the Big Oil lobby, which hopes to benefit (but hasn't benefitted so far) from US control of the mideast oil resources. All three of the listed groups have strong influence in the Republican party. In the Democrat party, groups #1 and #2 are somewhat weaker, but #3 is stronger because Jews tend to contribute more to Democrat candidates that to Republicans.Paul Craig Roberts sums up the 2008 presidential race as of November 27:
"Americans are unable to connect their dissatisfaction with the current political leadership with their choice of new leaders. All polls show that Hillary Clinton is far in the lead for the Democratic presidential nomination and Rudy Giuliani is far in the lead for the Republican nomination These are the only two candidates guaranteed to be worse than Bush/Cheney.
"Both Hillary and Rudy are committed to the war. Both refuse to rule out expanding the war to Iran and beyond. Both are totally in the pocket of the Israel Lobby. Indeed, practically every Giuliani advisor is a member of the Lobby. Both defend the police state measures that 'protect us from terrorism.'"
At this point it seems certain that Hillary will have all the money she wants from the Israel Lobby and money alone (and the TV time it buys) will probably be enough to win her the nomination. Also, she will be the beneficiary of all the credit her husband built up with the Israel Lobby. Remember that Bill Clinton pardoned billionaire tax evader Marc Rich, a big contributor to Israel, at the behest of Abe Foxman, head of the ADL. (Also aiding in Rich's pardon were his lawyer, neocon Lewis Libby, and his ex-wife, who contributed more than a million dollars to the Democrat party.) Paul Craig Roberts is right: Hillary's in the pocket of the Israel Lobby, and, if elected president, she will continue the colonization to pay off her political debt. Of course, it goes without saying that if any of the Republican candidates is elected, he will also continue the colonization.
How Much Will the Colonization Cost?
Colonization will be expensive. If the US follows the Israeli model of colonizing Palestine, we must assume the maintenance of Gaza-like concentration camps holding tens of millions of people. Many more millions must be confined to apartheid-like bantustans, similar to the West Bank, with thousands of checkpoints to regulate access. Security costs will be astronomical, and so will the bribes we pay to the puppet governments we install.
Colonization of Iraq has cost one trillion dollars (when costs of future liabilities are included) so far and we haven't gotten back a dime's worth of oil more than we would have gotten without the war. Maybe a half a trillion more will finish the job. The cost of colonizing Iran will be at least three times what Iraq cost because Iran is three times as big, more than twice as populous and it hasn't been crippled by ten years of no-fly-zone restrictions, as Iraq had when we invaded it. Add a trillion for Syria and another trillion for Lebanon. That comes to eight trillion of today's dollars. Spread over twenty years that is 400 billion a year, most of which will be borrowed from foreigners. The US Treasury's printing presses will run overtime to pay off this debt and the resulting monetary inflation will have significant effect on American consumers and investors.
Will Americans get compensating benefits for the costs of colonization? Yes, but the recipients of these benefits will be a narrow group of war contractors, bankers, flag rank military officers, politicians and maybe the oil companies. Israel will finally get its oil pipeline from Kirkuk to Haifa and will have the world's only superpower to protect it from sabotage. There will be no financial benefit to the American nation or its people as a whole.
In Part II I discuss a strategy for an American personal investor living in this inflationary environment and seeking preservation of capital.
 It is my opinion that the rigging of economic statistics is done intentionally to satisfy powerful political constituencies, such as Wall Street investment banks. As a practical matter, it is wise to be skeptical of all government announcements. I like Reagan's advice: "Trust, but verify." If a statement by a high government official can't be verified, it's likely to be a self-serving lie.Some References
Brandly, Mark, "Don't Believe Those Inflation Numbers", 1 Sep 2006
Stroupe, W. Joseph, "Caution - Inflation is higher than you think", 27 Jun 2006
"Why America's Currency is the World's Problem", Der Spiegel Online International, 30 Nov 2007