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Financial Fantasies
By Bill Bonner | Published  03/3/2008 | Currency , Futures , Options , Stocks | Unrated
Financial Fantasies

The Dow got walloped hard on Friday, down 315 points. But it still remains well above the lows it hit in January. Analysts don’t know what to make of it. With so much bad news around, you’d think the Dow would react to the downside. Typically, the commentators reach the wrong conclusion: that the stock market is telling us not to worry; the economy will recover in the “second half.”

Dear Readers are encouraged to worry anyway. What the stock market is telling us, we think, is that there are conflicting forces acting upon it. Inflation on the one side...deflation on the other. Neither is good for stock prices. But inflation tends to hold up nominal prices...while real prices collapse. A share of Google (GOOG) may be worth $400 in 2010 for example. But so might an ice cream cone.

Stock prices in the ’70s, for example, tended to bear up or fall a little. In real terms, however, they fell a lot. We seem to be coming upon a similar situation now – popularly known as stagflation. The economy is sinking while inflation pushes up consumer prices.

Friday, for example, while the Dow fell 315 points, the price of gold shot up another $7.50 – to a new world record, $975. Oil stayed over $100. And the dollar gained a little bit on the euro (EUR), but it still takes more than $1.50 to buy one.

“Fed cuts not doing the trick,” says a headline in the LA Times. The trick Fed cuts are not doing is the old, familiar one – they’re not boosting the U.S. economy. As Paul Volcker put it, the Fed has lost control of the situation. It cuts rates...but its efforts to cause ‘growth’ in the economy only cause a growth in prices – commodities, gold and the consumers’ cost of living.

Our old friend, Rick Ackerman, comments:

“The Fed’s extraordinary steps thus far to reinflate the economy have been directed almost entirely at institutional lenders rather than individuals. (We ignore the $160 billion tax rebate, since it is just a drop in the bucket relative to total debt.) The result is that there has been little discernible economic stimulus, only a buildup of reserves on lenders’ books with no corresponding demand for loans. (Actually, loan demand has been shrinking, and fast.)

“So, what Helicopter Ben appears to have achieved using measures that even we would concede are hyperinflationary is: nothing. The banks might be able to pass themselves off as solvent, provided the auditors are in on the con. But merely making the lenders appear not to be bankrupt has done absolutely nothing to achieve what the Fed had set out to do – i.e., re-kindle the housing boom. In fact, even though mortgage rates have trended lower, the lenders have been under great pressure to tighten their standards. The result is that, on balance, demand from home buyers has continued to fall.”

Still, the Fed is not giving up without a fight. The smart money is betting that we’ll get another rate cut later this month – another 50 basis points, bringing the key rate down to 2.5%.

“The party’s over,” says Warren Buffett. He was talking about the party in the insurance business, where profit margins are shrinking. But he may also have been referring to a much bigger, wilder party. In his annual letter to shareholders, he says that Berkshire Hathaway as seen its best days. He regards it is too large to produce the kind of above-market performance the group has had in the past.

And he probably also had the state of the U.S. economy in mind. The lights have been turned off and the bottles put away at the party in the housing market, for example. Buffett says the revelers got carried away by “fantasies.” House buyers thought housing prices would go up forever. So did the people who lent them money. Since prices would rise forever, there was no need to worry too much about a borrower’s ability to repay the loan; it was as though he’d never have to.

Another subject for the Sage’s scorn were the self-serving fantasies promoted by pension funds, CEOs, and investment managers who imagine that they will be able to produce earnings far above what is really likely.

Of course, fantasies were behind the whole boom. For example, Americans lived beyond their means and thought they could do so indefinitely. This led to the curious situation in which fewer than 10% of the world’s people – in the U.S.A – were spending more than 80% of the entire world’s savings. The foreigners saved and lent their money back to the United States, usually in the form of Treasury or government agency bonds (such as those from Fannie Mae (FNM)). Americans took the money and spent it, again, on things coming from overseas. Gradually, the foreigners built huge piles of U.S. dollars, some of which they’ve put into Sovereign Wealth Funds.

Buffett had something to say about these funds too. The SWFs are coming under attack in the United States. But they’re not some underhanded way of stealing from Americans, he says. Instead, they’re the logical consequence of spending more than you earn. That was a fantasy to you can’t give foreigners pieces of green paper and expect them not to spend them.

Meanwhile, the weekend press brought more proof that Volcker is right; the Fed’s cuts are not working. The BBC reports that HSBC (HBC) is going to announce a writedown of $16 billion. And the hedge fund, Peloton, is sticking investors with $2 billion in losses.

In some areas of the United States, there are now more foreclosures than house sales.

Derivative trading predicts another 20% drop in housing prices, says former Treasury Secretary Larry Summers, which would put 10 million homeowners upside down, with more mortgage than house. If that happens, he says 2 million houses would be foreclosed over the next two years.

Summers goes on to propose a new law, which would prevent the lenders from foreclosing. Why not? Once you permit yourself to assign profits and losses according to your own desires...rather than let people get what they’ve got coming...well, the sky’s the limit.

*** Alan Greenspan was back in the news too. He told a group of Arabs that the Gulf oil states should cut their currencies loose from the dollar. Good advice for everyone. But it’s funny stuff from the mouth of the person who had more to do with the dollar’s decline than any other human in history.

*** Over the weekend came news that Boeing (NYSE:BA) has lost its lock on the US Air Force. EADS, the European defense company, won the bid for $35 billion worth of refueling tankers, a job that may be eventually worth $100 billion.

*** “The biggest baby boom in history,” the Financial Times calls it. No, this one is not in America...it’s in Africa...Uganda to be precise, where the population has doubled in the last 20 years. By 2030 the population is expected to double again to 60 million. Uganda is also the world’s youngest country with more than half the population under the age of 18.

We don’t think too much about population growth anymore, not in Europe or America. In places like Italy and Spain, the local population isn’t even replacing itself. The Russians’ birth rate is so low, they are practically disappearing. And the Japanese, too. But in other parts of the world, there are more and more mouths to feed – millions of them.

But while the world adds billions of new people...and billions (trillions!) of new paper money...it doesn’t add very much in the way of wheat fields. Or cattle ranches. No, dear reader, there are some things are easily reproduced and some things that are not. Back in the monetary Dark Ages, before the Enlightenment of 1971, people used to think you needed to bind a nation’s currency to something that was not easy to reproduce – specifically , gold. It was a way of assuring that the supply of money didn’t run wild. Now, we just have faith...we trust our financial authorities.

At least, some people do. Here at The Daily Reckoning, we have faith in our central bankers and financial policymakers. We have faith that they will act like men, not like gods. They will make mistakes...they will yield to temptation...they will screw up the nation’s paper money and its economy; count on it. All things being equal...you could expect to see prices of gold, food, oil, etc, explode to the upside.

But all things are not equal, Malthus was wrong at the beginning of the industrial revolution; food production expanded faster than population. Will he be wrong now? Populations are exploding...and key resources (including food) are apparently reaching peak production levels. There’s only so much land. And so much water. And so much oil. What next? We don’t know...

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.