mauldins latest...a good read

A Historic Juncture - Part 1
Banking 101
Oh Canada

By John Mauldin
August 1, 2003

This week as I am in Nova Scotia, where my bride "suggests" I will be far
removed from any internet access, I am pleased that my friend Art Cashin
is allowing me to reproduce a series he has been writing about in his
privately circulated "Morning Comments" that I think you will thoroughly
enjoy. Art's thesis, and I agree, is that we may be at a very important
"tipping point" in the global economy. To help his readers understand why
that may be, he has written an essay explaining how banking, money,
central banking, interest rates and other factors "fit together." He has
done a very good job of explaining this complex subject in simple terms.
For those of you who already understand all these details, you will now
have some simple ways to explain them to your friends or give to your
kids. For the rest of us, it is nice to be able to see how the puzzle
pieces fit.

We will be doing this as a three part series over the next three weeks. I
will also have market comments next week, but as I write this at the
airport on Tuesday AM, I notice the bond market continues to fall out of
bed following Greenspan's last testimony. I continue to warn readers that
if this bond market does not stabilize soon, it puts at risk the mortgage
refinancing business, which will put at risk consumer spending growth,
which will result in the end of this period of the Muddle Through Economy.
The Fed action could result in a recession within a year if the bond
market does not stabilize, and soon.

More thoughts on these events next week from Halifax. As a way of
introduction for those few who do not know Art Cashin, he is Managing
Director at UBS Financial Services and head of floor trading (and is an
institution in and of himself) at the New York Stock Exchange. He was not
trading on the exchange when it was underneath the famous tree, but rumor
is that he came shortly thereafter. He is also a NYSE floor official. You
see him regularly on CNBC, especially late in the day on Tuesdays. Now
let's turn to Part 1 of Art's essay.

A Historic Juncture - Part 1

To understand why the global economy may be at a historic, even unique,
juncture; we need to examine how things worked through most of history.
Please also note that we said global economy in the singular. The
economies of nations are now so inextricably linked as to be considered as
one entity.

To keep this simple enough for even me to understand (and to avoid
footnotes) we'll talk in general terms.

Human history is riddled with stories of booms and busts. Great
civilizations and great cities arose, flourished and disappeared time and
again, often leaving few traces. The cause might be disease or lack of
water or farmed out land. But, in almost every case, the real cause was
success. The city or civilization became so successful that its
population grew to strain and eventually exhaust its resources. As we
have seen in recent bubbles there is nothing more dangerous than a lack of
restraint combined with the expectations of inevitable success.

From Biblical Times to the Middle Ages, economies saw booms and busts.
Trade associations, guilds and single purpose industries emerged,
dominated and then disappeared.

Toward the end of the Middle Ages when companies began to emerge in the
embryonic stage of capitalism the cycle of "creative destruction", to re-
coin a phrase, became a recurring economic reality.

Since capitalism is free enterprise, it presents a ready showcase for boom
and bust. And, the early economic thinkers felt that like a forest fire,
a "bust" was painful and frightening but a necessary purge to clear away
the dead wood and allow a rebirth of growth.

In capitalism whole economies, like the companies within them, experienced
booms and busts. Growing demand led new players to enter an industry, thus
adding new capacity. Older players were often forced to modernize in
order to compete. This, too, added to capacity. At some point the
process produced too much capacity or over-capacity.

If you could make too many shoes for your sales to justify, you then began
to cut prices (or add incentives) to steal your competitor's clients - or,
at least to hold your own.

This process also occurs in the service area. In the early 1950's when
the first bowling alley in town opened there was a two-hour wait for a
lane. When the second bowling alley opened, the wait at each was only 30
minutes. When the third bowling alley opened, there were open lanes and
discounts and promotions.

(On the manufacturing level, some folks think that China has opened a
fourth, fifth and sixth bowling alley in the global village. In the
service area, India is also thought to be adding alleys. We'll discuss
over-capacity in more depth later on.)

Much of the early commerce was conducted in gold or sometimes silver. As
commerce turned international this became inconvenient. If you shipped a
boatload of gold in payment, and the boat sank, not only were you out gold
- there was temporary deflation (less currency - gold - around).

So instead of shipping the gold, they shipped letters of credit. There
were pieces of paper or parchment which said that the gold was still
physically in Venice but had been credited to your account. (And if the
ship sank, they just issued a new letter.) Thus banking (if not sailors)
began to flourish, followed by central banking.

With the emergence of central banks, countries began to dream about
controlling or at least taming the business cycle. Infrequently, they did
so by trying to cool the booms. Much more frequently they tried to ease
or eliminate the resultant bust. Let's have the party but let's avoid the
hangover.

So we see that human history is riddled with examples of booms and busts
of all kinds. Humans, the only species thought capable of logic often
forego that capability to veer off to emotional extremes, resulting in
elation (booms) or depression (busts). Like many members of its
population, human society has had recurring bouts of bi-polarity. Like a
pharmaceutical firm seeking a pill to fix the patient, countries began to
experiment with the drug of central banking.

This would lead to attempts to control the business cycle. Since most
panics and depressions had been assumed to be caused by currency and
liquidity problems, the banks were thought to be the perfect preventative,
if not the actual cure themselves.

Throughout the 1800's for example the United States saw several cycles of
booms and panics. While each one was different in its own way, economists
of the day saw a common ingredient - a temporary shortage or miss-
allocation of money.

More than a few of these panics were seen to have some basis in the crop
cycle. Here's how that evolved.

As the nation grew so did its major cities. Farms moved further away.
This produced its own ebb and flow. Take cookies for an example. The
factory that made the cookies was probably in the city where immigrant
labor was plentiful and cheap. Conveniently, the people who ate the
cookies were also in the city maybe working in some other factory. The
wheat to make the cookies, however, was grown father away, near some small
farm town.

In the fall, the cookie-maker would send his agent (and a checkbook) to
the farm town to buy up tons of wheat to send back to the factory. The
farmers deposited the checks they received in their local town bank. That
bank would call for funds from the city bank upon whom the check was
drawn. Thus many city banks saw their deposits drop as they sent funds to
the farm banks. The result was less money in the city, temporarily. But
that was often enough to put some shaky enterprises out of
business......and start a panic.

In the spring, a kind of reverse process occurred as farmers borrowed to
buy seed, equipment and other planting needs. Again, the shift of funds
caused temporary strains and prompted some failures.

Seasonality remains.....Wall Street folklore maintains that the two most
likely periods of the year to see a bottom or a low would be in April/May
or September/October. (Ironically, even after World War II, when we had
more smokestacks than haystacks the cyclical market weakness hung on.
Some habits are hard to break.)

The Panic of 1907, perhaps the worst bank panic in American history had
some part of its root in the crop cycle.

The Panic of 1907 is the primary reason that we have a Federal Reserve
Bank today. Had not J.P. Morgan stepped in, things might have spun
completely out of control. Terrified, the Congress and the Treasury set
to work to build a true central bank for America. Six years later the
Federal Reserve Act became law.

Thus, the Fed has been charged from its birth with smoothing things out.
The training period has not been exactly easy. Somehow the old line comes
to mind, "The operation was a success, but the patient died anyway."

No sooner had the Fed set up shop than WWI broke out. It changed the
world economically as well as politically. Many critics claim that in its
first 20 years the Fed did more harm than good. (Your library may have a
copy of Paterson's "1921-1929, The Great Boom and Panic".)

The Fed is not the only central bank to have been accused of being more
cause than cure. John Law's "Mississippi Scheme" to reflate the French
economy in the 1700's caused disaster and maybe a revolution. The
Reichsbank's efforts to stimulate the German economy in the early 1920's
by reflating the currency resulted in, perhaps, the greatest runaway
inflation in history. Money was so loose that it was cheaper to burn
money than to buy the coal. It destroyed the German middle class and is
cited by some as a prime contributor to WWII.

It is ironic that many of the disastrous unintended consequences of
central bank efforts have come from their attempts to reflate. In a minute
we'll to get to deflation and inflation and why it is so tough to control
either one.

For millennia booms and bust were viewed as natural consequences just as
the act of being born assures that you will die - eventually. There have
been recessions since the Medes were trading with the Persians. Mankind
has always accepted the antithetical nature of growth - birth/death; the
seasons; crop cycles and on. Early on they were addressed theologically.
Whether by sacrifice or celebration, mankind hoped to avert or at least
postpone the negative end of a cycle. Eventually most societies opted
simply to measure and plan around them rather than assume they could be
easily amended.

Central banking gave governments and economists the hope that at least one
cycle - the business cycle - could be smoothed out. This could be done
because the central bank could manipulate the supply of money, interest
rates and such, along with influencing those antithetical components of
currency creation - inflation and deflation. But, to understand that
concept we have to take a look at how modern banking works - or is
supposed to work.

Banking 101

A bank is not just a storehouse for money. You could put your money in
your mattress and buy a big dog and do just as well. A bank is supposed
to put your money to work (safely) and get a return for both the banker
and you.

That "mobilization" of your money is at the very heart of modern
economics. Economic activity (or the lack thereof) is not about the level
of interest rates. Ask Japan. It is not about government spending and
deficits. Ask Japan. Economic activity is all about something called -
"the velocity of money."

We could now present a lot of formulae, technical banking jargon, and
examples of modern money mechanics. However, we promised to keep this
simple enough so that even I might understand it. So with apologies to
professors and purists, here is a layman's version.

Remember the scene in Frank Capra's classic "It's A Wonderful Life"?
George Bailey (Jimmy Stewart) has been detoured from his honeymoon to
prevent a run on the good old Bailey Building and Loan. Facing a crowd of
frightened depositors he sums up the concept of modern banking succinctly.

To paraphrase slightly, George says - You're thinking of this all wrong.
It's not like I've got the money back there in the safe. Your money's not
here - it's in Joe's house right next to yours - or in Mr. Kennedy's house
or Mrs. Mecklin's or a hundred others. (If he had added a couple of
businesses he would have summed up banking perfectly.)

That's what banking is about. The bank lends your money out. But only if
someone borrows - that's the velocity of money.

Let's use a simplistic example. Here, unfortunately, we have to deal with
some jargon. Let's start with "reserve requirements". This is the
percentage of its assets that the Fed suggests that a bank keep around
just in case someone might ask for their money back.

Okay! For ease of explanation lets assume reserve requirements are 15%.
That means the Fed suggests you have at least enough cash on hand in case
one out of seven depositors shows up one day for total withdrawal. It's
close to the real number and makes the math easy. Also, to keep things
easy, we'll assume this is a one-bank town. Trust me, it also works in
places like Frisco, Chicago or even New York City.

You deposit $1000. The bank reserves $150 (15%) but can still lend out
$850. Your cousin, Bob, borrows the $850 and buys an old, old truck.
Sam, who sold the truck deposits the $850 in the bank. The bank must
reserve $127.50 (15%) but can lend $722.50. Maria borrows that amount to
buy something from Alice, who then re-deposits the money. By this
process, your 1000 deposit could increase the money supply (and economic
activity) of your little town by nearly $7000 - that's if everyone has a
use for money and they borrow. That is the concept of the velocity of
money.

This now brings us to interest rates. Interest rates are basically the
"cost" of money. If you and I have just landed on Mars and you offer to
lend me money at less than a quarter of one percent, why would I borrow.
I can't buy a car or even a Coke. Conversely, if we are in a Klondike
gold camp and I think I might quintuple my money in a year, I might be
happy to pay you 100% interest.

The simple point is that growth is not about the level of rates. It is
about the expectation of gain from those rates. This is a matter of
frustration for central banks and economists. Japan brought rates to zero
and drew just a yawn. Fed Governor Bernanke's now famous "printing press"
speech implied that the Fed could make money so cheap and loose that only
a fool would not borrow. As noted earlier, the German Reichsbank in the
deflationary aftermath in WWI decided to reflate - full out. But, once
they started they found that taking away the "spiked" punchbowl was
politically and socially unacceptable. The result, as also previously
noted, was ugly - even historically ugly.

The Fed can increase or decrease the amount or cost of money available in
an attempt to smooth out the business cycle. The theory is that they want
to slow down if it is going too fast or speed things up if they are going
to slow. (Art's changes) They usually do this by bond transactions, which
we'll try to explain in a minute. They could do it by the more drastic
step of changing reserve requirements. They can even use their bond
activities to raise or lower interest rates. (Traditionally that's done
in short-term rates.)

Thus the Fed can make more money available at lower and lower rates. But,
like kids at a lemonade stand, they can find that low prices and lots of
supply don't guarantee better business. That is the reference you often
hear that in restarting an economy it sometimes looks like the Fed is
"pushing on a string".

We'll now begin to look at how the Fed operates to influence the cost of
money and the amount of available money. We'll explore the limits on
their power. And, hopefully we will begin to explore why the U.S.
economy, or, more correctly, U.S. governments and the Fed have favored
some inflation and are terrified of the possibility of deflation.

In our earlier discussion on the velocity of money we talked about a small
bank in a small town. Let's return to that bank.

You deposited $1000. This time, however, no one came to borrow. That
leaves the bank with a problem. If they don't earn any money on your
money, they can't pay you any interest and, worse for them, they can't pay
themselves, so they can't allow money to lie idle.

But, what do they do? They need to invest in something safe and liquid
(easy to turn over). They need to be ready in case you want some or all
of your money back.

To over-simplify, they have two choices. They can lend money overnight to
other banks who may be busier. This is the basis of the "Fed Funds"
market. They can also buy U.S. Treasury bills - which is what most of
them do.

So you deposited $1000. No one borrowed. To get some return, the bank
sets aside the 15% reserve and buys $850 worth of Tbills. The problem is
that the game stops there - there is no further velocity to the money.

Enter the Fed, or more correctly, the FOMC. In order to mobilize that
money again the FOMC may bid a premium for the Tbills. It's not much of a
premium but when you're talking billions and billions - little things mean
a lot.

The bank sells to the FOMC and is back with lendable cash. They look
around to see if anyone wants to borrow.

In very simple terms that's how the system works. The FOMC adds money to
the system by purchasing Treasuries from the banks and crediting their
account at the Fed. The bank then has money to lend. When the Fed wants
to tighten, it sells some Treasuries at an attractive price. When the
bank buys the Treasuries, it has less money to lend.

When the Fed "cuts rates", they announce that they have a target at which
they will buy Treasuries. Knowing the Fed will pay that price, no one
wants to sell below it and the market moves to that rate. Traditionally
the Fed or FOMC operates at the very short end or near term. That's where
they have cut rates the last thirteen times. That's what prompted all
that talk about the Fed "running out of room".

Longer rates guide off the short rate but they don't have the same kind of
assurance that the FOMC will pay a set rate for the five-year or 10-year.
That's what allows rates to fluctuate as people try to guess what the Fed
will do next.

(This is the end of part one)

Oh, Canada

I am at the Logan Airport in Boston waiting for my bride to arrive in a
few minutes and then we are off to Nova Scotia. Although she is Canadian
(one of their better exports), she (as well as I) has never been in Nova
Scotia. For the next week she has arranged for me to go cold turkey on the
internet and investments. Then we return to Halifax and I will set up shop
there, avoiding the Texas summer for at least a few weeks. Note to
clients: I will be available by phone, and also will be working on my
book.

Your looking forward to a cool time alone with my bride analyst,

John Mauldin
[email protected]

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