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Deflating Europe, Housing Bubbles and Greenspan’s Amnesia

I am writing this week's e-letter early, as tomorrow I travel to speak at an investment conference in Florida. As I review the articles and reports of the last few weeks, I am struck by the number of very interesting topics which deserve their own letter. There is truly a lot happening, so like the billiards player trying to make a difficult four bank shot, we will go from one side of the table to another and hope we end up making the shot, or at least making a point or two.

The More Things Stay the Same, the More They Stay the Same

In the US, the above line actually starts with "the more thing change, ..." But in the case of Japan, I think it is quite properly stated as above.

I remember a few years ago when Prime Minister Koizumi was elected on a reform platform. He promised change. He was going to force change, and the economy was going to get better.

Since his election, I am struck by how much rhetoric about change has come from the government, and how little has actually changed. He had a major opportunity to encourage change recently, as he had the opportunity to appoint a new head of the Japanese central bank. You read about a series of potential candidates, all of whom would bring about needed (much-needed) reform.

Yet he actually chose a gentleman who is on record as opposing any real reform. The former deputy governor of the Bank of Japan, Toshihiko Fukui, was appointed last week to head the central bank.

"Fukui, 67, had worked for the Bank of Japan for over 40 years. At one time he was dubbed the "Prince of the Bank of Japan" and held the post of deputy governor from 1994 to 1998. He was expected to become governor until he resigned from his post when a colleague under his supervision was arrested for leaking information to financial institutions about the contents of sensitive economic surveys. Since 1998 Fukui has worked as the chairman of a private sector think tank, the Fujitsu Research Institute.

"Fukui, who will replace outgoing governor Masaru Hayami on March 19, is regarded as a conservative who, like his predecessor, will reject calls for the central bank to set inflation targets and undertake other measures to overcome the deflationary cycle which has gripped the Japanese economy." (

Japan's unemployment rate rose to match a record 5.5% in January and consumer prices extended a four-and-a-half year slide, as slowing sales forced retailers to slash jobs and offer discounts. "Japan's economy is still at a standstill," Heizo Takenaka, Economic and Fiscal Policy Minister told reporters today. "Employment conditions continue to be very severe." (Bloomberg)

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Dennis Gartman (The Gartman Letter) brings us yet another note about how things don't change: "Earlier this week, Japanese Finance Minister Masajuro Shiokawa took Japan's largest banks to task for wishing to increase their capital through third-party stock allocations. Mr. Shiokawa said that the banks in question need instead to look to the public to strengthen their balance sheets. He said that they must make a concerted effort to encourage the public to purchase their shares instead of selling shares to particular companies, including their business partners. Shiokawa has been openly opposed to the too-close business relationships between manufacturing companies and the nation's banks, know in Japanese as 'kieretsu,' and he has been right in opposing that policy. He sees this recent decision on the part of the banks to sell shares to companies as simply another manifestation of 'kieretsu,' and he is right."

Shiokawa is right, but he merely jawbones them, and the LDP refuses to pass legislation and the Finance Ministry does nothing other than talk. Japanese corporations and banks continue to resist changes which would cause them pain, and the government only makes changes on the margin.

Stephen Roach often refers to the US as the engine of growth for the world economy. Japan is the third largest economy in the world, and it is getting increasingly difficult for the US to pull the, dead in the water, Japanese economy. Japan needs to start providing some locomotive help, but there is nothing on the horizon which makes me think there is hope for such a thing to happen. I have often said that the Japanese government and central bank are the only management team that can make Xerox managers look competent. I now must apologize to Xerox. Comparing their actions to Japan is way too harsh.

The more things stay the same, the more they stay the same in Japan, and that does not bode well for the world economy.

Europe: How do you say Deflation in French (or German or...)

The Financial Times writes: "In difficult times, eurozone economic management has taken on some of the hallmarks of its counterpart in Japan. The central bank refuses to loosen monetary policy sufficiently and worries in public about lax fiscal policy. Meanwhile, the guardians of fiscal policy relax their controls, despairing at the lack of monetary stimulus.

"...France admitted it had last year exceeded the 3% budget deficit limit set by the European Union's stability and growth pact; but proposed to take no remedial action. The ECB took that as a sign of fiscal irresponsibility: Mr. Duisenberg said he was 'a little surprised, if not to say disappointed'; Otmar Issing, the ECB's chief economist, described attitudes similar to the French government's as 'dangerous'." (Financial Times)

"Germany's GDP was flat in the fourth quarter and up only 0.2% for all of 2002. Growth for the last seven quarters was virtually non-existent as weakness was pervasive. Consumer confidence is at the lowest point since 1995, and the government is trying to avoid violating the EU's budget deficit limit for the second straight year. Net exports are being hurt by weakness in the country's major export markets and strength in the Euro, which has risen 24% over the past year." (Comstock Partners)

The jobless rate in Germany rose to 10.5% from 10.3%, the Bundesbank said.

"The economy is in a dismal state," said Hans Erwin Bauer, chief executive officer at HeidelbergCement AG, Germany's largest cement company. "We've dismissed workers and closed factories year after year. An end to this recession is not in sight." Politicians talk recovery in Germany. Businessmen are far less upbeat.

Wim Duisenberg, the European Central Bank's president, said last week that he had abandoned his forecast for a rebound this year. Reports this week have shown Germany's economy stagnant, Italy expanding at the slowest pace in almost a decade and Spain's growth rate is less than half what economists had predicted.

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Consumer confidence is down almost everywhere throughout Europe, although most stories blame the poor showing from the public on the approaching Iraqi conflict. The European services industry, the largest part of the region's economy, shrank in February for the first time in five months.

Inflation is running about 2% in Euroland, and dropping. Since the ECB target is 2% or below. The IMF projects that Europe will grow by only 1.3%, with much of that hoped for growth coming in the second half. Because of this economic weakness and favorable climate, 2/3 of economists were predicting a rate cut of 50 basis points. The actual cut was a very conservative 25 basis points, which will no doubt disappoint many people.

There are numerous stories from a variety of courses about the difficulties the "Stability Pact" is creating for Europe. When the common currency regime was born, this pact was created to govern future government and central bank actions. It set guidelines for government deficits and inflation. These guidelines severely limit the ability of a government to respond to an economic slowdown in its own back yard.

Now that a recession is staring some of the individual governments in the face (like France and Germany), they simply ignore the agreement to which they insist other European partners adhere.

When you consider how rough the European economy currently is and the potential for a recession or very little growth this year, the fact that the euro hit $1.10 this morning is all the more amazing. It underscores how weak the dollar could become if Europe begins to recover.

I want to make two points about Europe. First, in 2001 and 2002, I wrote repeatedly about competitive currency devaluations which artificially hold down currencies in relation to the US dollar, and the deflationary impact that has on the US. The world, and especially Japan and China, was exporting their deflation to us.

That phenomenon is now going to visit Europe. As the euro strengthens almost every week against most currencies world-wide, deflationary pressures are going to begin to visit their shores.

It is entirely possible the current tight monetary policy in Europe will soon be a thing of the past, as the world-wide tide of deflation forces Europe to respond or sink into a Japanese Syndrome. But apparently the ECB wants to see the recession before they decide to fight it aggressively, evidence their small rate cut.

Secondly, as the second largest economy in the world, they are also not doing anything to pull the world global growth engine. As the Financial Times noted above, there is an eerie comparison between the policies and response of Japan to their recession which started a decade ago and the policies and squabbling of Europe today.

Europe is not Japan, however. I doubt very seriously the various governments in Europe will continue with a collective agreement that looks like it could breed a Japanese economy. The current agreement has that potential if the ECB continues its current path. I expect it to change, or the various governments are going to force it to change. As Paul McCulley of Pimco notes today, the US Federal Reserve is a politically granted monopoly, and for all its claims to independence, is still subject to political realities and expectations. That goes double for the ECB. There is already a lot of private infighting going on within the ECB. It will be interesting to watch the "fights" that are going to happen over how (not if) a new pact will be crafted.

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It is entirely possible the current tight monetary policy in Europe will soon be a thing of the past, as the world-wide tide of deflation forces Europe to respond or sink into Japanese Syndrome. The world hopes they respond sooner rather than later.

On the Homeland Front

To demonstrate I am an equal opportunity critic of central banks, let's look at the US. Paul McCulley of Pimco fame ( wrote a brilliant piece this week on how Greenspan is starting to get selective memories. Like some investment newsletter writers, he is only remembering the good trades. McCulley documents what could be a very real problem, because Greenspan is now giving very conflicted advice to Congress.

McCulley wrote his piece before the Tuesday speech by Greenspan where he says, "The frenetic pace of home equity extraction last year is likely to appreciably simmer down in 2003, possibly notably lessening support to household purchases of goods and services."

Not to worry, though, because Greenspan said that even as home price increase slowly, the housing market is still in great shape, adding that he is not overly worried about a dramatic or disruptive drop in housing prices.

"It is, of course, possible for home prices to fall as they did in a couple of quarters of 1990," Greenspan acknowledged. "But any analogy to stock market pricing behavior and bubbles is a rather large stretch. In the housing market, local conditions dominate, strongly influencing home prices and to a lesser extent home mortgage rates. Thus, any bubbles that might emerge would tend to be local, not national, in scope."

Greenspan said last month that money consumers saved from refinancing helped counter the effect of this year's 19 percent decline in the Standard & Poor's 500 Index. "That has assisted an economy struggling to escape last year's recession."

Homeowners will take out $751 billion in home loans next year to repay older, costlier debt, often taking cash out of equity in their homes, the Mortgage Bankers Association estimated. That would be just over half the projected record of $1.4 trillion this year and down from $1.2 trillion in 2001.

The net effect of less refinancing next year is less stimulus for the economy. Consumer confidence is down because consumers remain worried about their jobs. There is a one to one connection between comfort about your job and consumer confidence. U.S. employers last month said they would cut 157,508 positions. This growth in job cuts is just from large employers, and does not count small employers. Some of the biggest areas where jobs are disappearing are from government job cuts.

Further, Goldman, Sachs & Co. estimated that home-equity withdrawals, or "cash-outs," accounted for half the rise in household spending since 2000. The boom fueled a 22 percent increase this year in the stock value of Countrywide Financial Corp., the largest mortgage lender.

"A dollar of equity extracted from housing has a more powerful effect on consumer spending than does a dollar change in the value of common stocks," Greenspan said in congressional testimony last Nov. 13.

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The pool of those willing or able to refinance also has dwindled as homeowners raced to lock in low rates. Refinancings accounted for a record 70 percent of all mortgage applications in the fourth quarter of 2001, according to the Mortgage Bankers Association. By the end of 2003, such applications will decline to 25 percent, the group said.

Less cash means consumer spending may fade after accounting for three-fourths of the economy's expansion in the third quarter. Companies cited diminished consumption when downgrading their economic growth forecasts for the next six months, the National Association for Business Economics said last week.

Borrowing Time

"A cocktail of surging home prices and falling interest rates propped up consumer spending, but consumers are living on borrowed time," said Jan Hatzius, senior economist at Goldman Sachs & Co. "That will drag the economy." (Some of the above came from a story in the Fort Meyers area News Press written by Dick Hogan)

Let me quote directly from the Federal Reserve "Beige Book" which came out this week. "Reports from the twelve Federal Reserve Districts generally suggested that growth in economic activity remained subdued in January and February.... Business spending was very soft, with little change in capital spending or hiring plans....Most Districts still described manufacturing activity as weak or lackluster, although half of the reports noted at least some degree of improvement.... Refinancing activity continued to drive growth in household loans, while business loan demand remained weak. Overall consumer spending remained weak during January and February."

So, when everyone including the economist acknowledges that consumer spending, the housing industry and business spending are the three main pillars of the economy, and if all three are "soft" or heading that way, then why in the wide, wide world of sports is Greenspan going to Congress and suggesting that they do not need to cut taxes or do anything to stimulate the economy?

You have just read the above rather stark forecasts. How can we square those reports, mostly from Fed sources, with the following direct quote Greenspan made to Congress?

"I'm one of the few people who still are not as yet convinced that stimulus is a desirable policy at this particular point. It depends very much on how one reads what is effectively going on under the whole structure of geopolitical and other risk. And unless and until we can make a judgment as to whether, in fact, there is underlying deterioration going on - and my own judgment is, I suspect not - then stimulus is actually premature.

Once again, dear reader, I am not making the argument that a government agency should or should not be making stimulus. Whether or not we need a Fed artificially messing around with the economy is an argument for another day. But the reality is that we do, and since they are clearly messing with the economy, what they do impacts our pocket books.

If the goal is to forestall recession, then why does Greenspan counsel waiting to see if we are actually in one before something is done? In one speech to Congress he says "I see no deterioration" in the economy and then a week later he says housing is weakening and home borrowing is waning. His own Beige Book staff reports a clearly slowing economy.

Which is it, Mr. Chairman?

Perhaps he is in the camp that thinks everything will boom once the Iraqi crisis is over, and thus we need to do nothing. But if that is the case, he needs to clearly tell us so.

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Contrary to much of the above, there is still reason to believe we can Muddle Through this year, but as I have repeatedly said, only if we get a federal government stimulus package. It is almost as if Greenspan wants any stimulus applied to the economy under his direct control. If Greenspan has killed the tax cut then we should call the next recession the Greenspan Dip.

(I know that if we have a tax cut the deficits will grow. But I can guarantee you that if we have a recession, they will grow faster. Like the old oil commercial, you can pay me now or pay me later.)

Where the Growth Is

There is growth in the world today. China and much of Asia is growing. India is growing. Australia is growing, except for its farm industry, which is in its worst drought in a century. Canada seems to be doing nicely, and the Central Bank there felt comfortable enough to actually raise interest rates yesterday.

The IMF said last month that a war in Iraq may cut by half the pace of global economic growth by reducing investment and consumer spending. Growth may fall to 1.5% from 3% in 2003. Without a war, global growth may accelerate to as much as 3.5% this year, the Washington-based lender predicts.

Asian economies, excluding Japan, may skip the slowdown, maintaining the 6% growth rate of last year as they cut interest rates to bring down business costs and stimulate consumer demand in the event of war.

Most economists believe that when global growth is less than 2%, the world is actually in recession. I don't have the space to explain why 2% growth is actually recession, but for now, let's take the assertion at face value.

We are dangerously close to what Stephen Roach calls "stall speed" on the global economy. The three largest economies are all in trouble or quite slow. If the US consumer retreats, then the growth predicted for Asia will also be less.

Will the Asian countries continue to support the US by taking our dollars at the very favorable rates (to us) in spite of our unbelievably high trade deficit?

The dollar will be under pressure this year. Currency maven Chuck Butler of Everbank writes "OK... Report card time... Best performing currency vs. the dollar in 2003 so far? Did you say... Aussie dollar? +9.93%... #2? South African rands +8.50%... #3? New Zealand +7.43%, and #4? Canadian dollar +6.80%" The euro is up 4.73% this year, and 26% in the last 12 months.

(Self-serving pat on the back: was it about this time last year I suggested buying euros at Everbank?)

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If you want to buy some foreign currency, Butler suggests waiting until after the Iraqi war. He writes a daily letter on currencies. Today he writes: "...should there be a quick and clean resolution to that war... The dollar will rebound, probably violently... We could very easily spend the start of baseball season with the euro trading around parity again... But... That will be temporary, and everyone and their brother needs to buy as many euros as they can get their hands on at that time because then everyone will look around and ask the question... What has changed? And very quickly, the euro rebounds, and ends the year at 1.12-1.15... It will be a slingshot move..."

Everbank is the one bank in the US (that I know) where you can get foreign denominated CDs (Certificates of Deposits) in a variety of currencies. I am not a currency expert like Butler, especially when attempting to forecast short term fluctuations. However, I still think the long term trend in the dollar will be to the down side before balancing out, and if Butler is right and the euro goes back to parity, it will be a buying opportunity. You can call him at Everbank at 314-984-0892, ext 102. (Disclosure: Everbank is a sponsor of my publisher's web site, but I am not required to, or even asked to, write about them. I am quite independent. I just happen to like foreign currencies and Everbank is a good source. If you know of any other sources for smaller accounts (anyone can open large accounts in Europe) let me know and I will mention them as well.)

Conclusion: the world economy is a balancing act which could tip either way. If the US economy tips into recession, it will drag the world with it. A recession will drag the stock market down, and for reasons I have written about in earlier letters, also delay any rise in interest rates. It was Patton who said a good decision applied with vigor now is better than a perfect solution applied ten minutes later. Someone needs to whisper in Greenspan's ear that waiting until the horse is out of the barn to close the doors is not good policy.

Off To Florida

I leave in a few minutes for Florida to speak at the Investment U conference, meet with some friends and clients and have some time to get into a little of my reading backlog. I will also continue to work on my book.

Again, for those interested in Fed policy, I suggest reading Paul McCulley's article at He is an acolyte in the Keynesian school, but his analysis of Greenspan is spot on. My only real gripe with McCulley is that he only writes once a month.

I must be having a good week. I got a notice that my email address has won (I am not making this up) $500,000 euros in the Hawaiian Lottery. There seems to be some mix-up, though, and could I call this guy and maybe even buy a few tickets in the next lottery to make sure I get my winnings? I wonder if the number is Nigerian.

Have a great week, and I leave you with this quote from C.S. Lewis: "Friendship is unnecessary, like philosophy, like art . . . it has no survival value; rather it is one of those things that give value to survival."

Your valuing his friends more and more each year analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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