The Fuss About Interest Rates!

July 10, 2003

For most individuals involved in the financial world, risk determines the rate of interest charged. The lower the interest rate, the lower the perceived risk, and vice-versa. Now I would like to apply this age-old concept to the United States. Interest rates in the U.S. as determined by the Federal Reserve are now at 1% while the real interest rate (the interest rate minus the rate of inflation) is actually a negative 1.3%.

Therefore, if I take everything at face value, loaning money to the United States is as close to a sure thing as I'm likely to find. I normally wouldn't pay a lot of attention to this because I don't invest in the bond market and I don't want to refinance anything, but something that's gone up as much as bond's deserves a second look.

A quick review of current economic conditions in the U.S. is less than awe inspiring. A glance at the headlines of yesterday's paper produced the following:

* California is on the verge of bankruptcy.
* Total government obligations amount to $44 trillion.
* The U.S. trade deficit will probably reach $450 billion this year.
* Unemployment is at 6.4% and will continue to rise do to the fact that we export jobs.
* Record high housing foreclosures and credit card defaults.
* Real problems in Iraq.

I suppose I could go on but I think you get the point. The economic picture isn't so good in the U.S. but you wouldn't know it by reading the Wall Street Journal or listening to our politicians. For example, Elaine Chou, the Labor Secretary, came out on CNBC yesterday and said the poor employment numbers were do to the fact that many new workers are now back on the unemployment rolls because they expect a big economic recovery. What tripe!

This creates a real dilemma for anyone with even a small IQ. If you believe the statistics, the U.S. government seems to have very real and persistent economic problems. Yet on the other hand foreigners (especially Asians) are lining up to buy our debt like there's no tomorrow. The same debt which now pays a negative real return! And if the U.S. dollar continues its decline, real losses could reach as high as 30% for 2003. This begs the question "How can this be?" Why would the Japanese and Chinese line up to buy our paper if we are, in fact, such a bad risk? After considerable thought, I came to the only logical conclusion possible - they just don't have any other choice. Let me explain.

Asia has been supplying consumption goods to the U.S. consumer, in ever growing quantities, for more than two decades now. They assumed that the U.S. had an insatiable appetite for consumption goods and, as a result, they continually plowed profit back into new facilities in order to increase production capacity. These same facilities could produce good quality items at a much cheaper price than any comparable item coming out of the United States. It was a great arrangement for Asia: they sent us consumer goods and we sent them our jobs and dollars, the latter which we simply printed at no cost to ourselves. That brings us to the debt issue. We had to fund consumption one way or the other and since we couldn't produce anything that the Asians wanted other than dollars, we had to become very creative.

That's where Alan Greenspan and others of his ilk came to the rescue. In the mid-1990's, possibly as a result of the Mexican crisis, Sir Alan went about creating the stock market bubble. American consumers were going to "get rich quick" and, as a result, would be able to live well beyond their means for an indefinite period of time. After all, the NASDAQ was going to 10,000 so what was the problem. Alan, being a very intelligent man, didn't want to take any chances so he decided he needed an insurance policy. That insurance policy turned out to be the housing bubble.

Unfortunately, all good things come to an end. The equity bubble popped in March of 2000 and the dollar bubble followed about a year later. Not to worry said Alan, I'll lower interest rates! And he did, thirteen times to be exact. He initially lowed rates in an effort to keep the housing bubble alive long enough to turn the economy around. Well the economy has turned alright, but not in the right direction. It's now 2003 and the housing bubble is maxed out, so what can you do? Old Alan decides to "sing the bull to sleep" and creates the bond bubble. On top of that he lowers real interest rates into negative territory so that retirees, living on a fixed income, would be forced to liquidate their CD's. At the same time he props up the stock market just long enough for these same senior citizens to get the idea in their head that, just maybe, they should invest their retirement dollars in the good ol' NASDAQ. After all, reasons Alan, if it worked once it ought to work again.

Meanwhile the Asians are looking at all of this and praying like hell that Alan can pull off some sort of economic miracle. They are doing their part too. They continue to line up and buy U.S. debt and, at the same time, trying to devalue their currency in order to stay competitive among themselves. This "race to the bottom" is being instigated by China who has their Yuan pegged to the dollar. The US dollar has fallen 30% in value over the last year and a half, as has the Yuan, making Chinese goods 30% cheaper for the rest of the world. What hasn't gone unnoticed is that Asia is exporting deflation in a massive way, and that's the real crux of the problem. On the one hand, they give us money to keep us alive and consuming and this increases our debt load. On the other hand they send us deflation which makes our debt load unserviceable. They have to kill us in an attempt to keep us alive.

In closing, the bubblemania that has gripped the U.S. for more than ten years is coming to an end. The bond market has made a top and is heading down. The dollar is in the intensive care unit and probably won't make it in spite of our current rally. The stock market "mini-resurrection" will end sooner rather than later and the housing market really doesn't have any place to go but down. The fat lady has warmed up and she has now taken her place on center stage and there's not a damn thing in the world that Alan Greenspan, or any one else, can do about it. Deflation is in the wings and this will cause a debt implosion. The end result will be the greatest bubble of all - the gold bubble - as central banks, foreigners, and Americans scramble to salvage what little of their wealth they'll have left. My advice to one and all is to beat the rush and do it now.

Enrico Orlandini
Av. Pardo 224 Lima, Perú
Fax: 0051-1-435-0279
Website: lascoreport.com
E-mail: ebo@lascoreport.com

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