Thoughts from the Frontline

The level of attention to the recent and mild inversion of the yield curve has bordered on hysteria in the media. Does it portend a recession? Or is, as Ethan Harris, the chief economist of Lehman Brothers suggests, the bond market simply on drugs? This week we pause in our series on trade deficits to look at the real meaning of the yield curve and what it does and, just as importantly, what it does not mean. I give you a basic primer on the yield curve, as well as links to more information than you ever wanted so you can read morefor yourself. But first, thanks to all those who purchased a copy of Just One Thing this year. My editor tells me sales are doing very well, and another publisher has picked up the Chinese and Korean language rights. Thanks to a lot of word of mouth, like this note from Paul Howard:

We are awash in debt, assert numerous authorities. And they point to the charts which show debt mounting seemingly to the sky. But not all debt is bad. Some of it is good. We should save more and spend less. But if we do, there are consequences that we may not like. What's good for an individual may be a problem for a global economy. We continue with our series on trade balance and debt, with the thought going through our minds "Be careful what you wish for." But before we get into that, let's look at something far more important.

"I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change." - Paul Volker How long can the United States continue with an ever rising trade deficit? How far can debt rise? Will it end, as Paul Volker, former Chairman of the Fed stated above, in a financial crisis? Will it end as a soft depression as Bill Bonner suggests or is it different this time as the team at GaveKal project.

"Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own." -- Joseph Schumpeter How do we interpret the words of Schumpeter? Is the Austrian School of Economics right? Should the Federal Reserve have allowed the US (and thus the world) to go into a deep recession in 2001-02? Did we just postpone a Day of Reckoning only to have one in the future which will be even worse? What about gold? We look at these questions and more as we continue looking at the "debate" between the gentleman from GaveKal and Bill Bonner and Addison Wiggin.

"The economy in its entirety must continue to decline so long as more is being consumed than produced, and some part of consumption therefore takes place at the expense of the existing capital stock." - Friedrich August von Hayek For the past few weeks we have looked at the argument for the case "This time it's different," made eloquently in a 130 page book called "Our Brave New World" by the very bright minds behind GaveKal Research. The trade deficit of the US does not matter, they aver. For the next few weeks we turn to look at the opposite view, made by Bill Bonner along with Addison Wiggin in their new 370 page book, Empire of Debt. Not only do they tell us that things are not different, but that the end result will be the same as it has always been. And for the curious, the end result is not a pleasant thing.

Is it different this time? Can it be that trade deficits do not matter? Or is our collective debt going to end in a period of financial crisis and tears? Is Alan Greenspan right when he says periods of low risk premiums end in woe for the participants? For readers in the middle of this conversation, we are in a series on the debate held at a London restaurant between Charles and Louis-Vincent Gave (father and son) and Bill Bonner. The Gaves openly declared that "This time it's different," much to Bill's amusement. We all know that it almost never, ever is. They make their argument in a book called "Our Brave New World." I did part one of a review two weeks ago and will finish reviewing that book today.

What type of returns can we expect from the stock market? Do I think we are still in a secular bear market, even as the market tries to make new highs? What causes long term market cycles? Is there a psychological component to them? (Answer: yes.) And can we make any predictions about the future of the stock market? All this and more in this week's letter. Last week we started a series on the debate between GaveKal and Bill Bonner on whether "It's different this time," centering on whether trade deficits matter. I said I was going to address this topic for the next few weeks. However, that was before major jet lag and time crunches caught up with me in London. If I wrote anything too detailed, I might have to disavow it on Monday. So, we will take up the debate next week, hopefully with a fresher and rested mind.

"For over ten years now, a wide majority of market strategists and economists from respected investment banks (Morgan Stanley, Dresdner...), a large number of upscale financial publications (The Economist, The Financial Times... ), highly respected consulting firms (Lombard Street Research, Grant's Interest Rate Observer, Gloom Boom Doom... ) have drawn on historical parallels to warn us that the expansion of the past decade in US consumption was both unsustainable and likely to end in tears. Real estate all over the Christian civilized world was bound to collapse, along with global equity markets. The world would then enter into an 'ice age'. So far, despite the strength of the above thought process, and the numerous historical parallels, the dreaded meltdown has completely failed to materialize. So what is the next step?" -GaveKal Research, from the introduction to "Our Brave New World."

How bad is the pension fund issue. Is it a crisis as the Pension Benefit Guaranty Corporation (PBGC) claims? Or is the American Benefits Council right when they say the problems are blown out of proportion? And depending on your assumptions, they could both be right. Examining this debate will provide a useful springboard as we examine retirement issues you may be facing. But first, last week I promised a special announcement. Ready to ship and in a bookstore near you is my new book called Just One Thing. Some of you may have received an email yesterday about the book, and a lot of you ordered, because it is now #4 on Amazon in less than 24 hours! Permit me to make a few personal observations about the book and the publishing process.

The King is going. Long live the King. We now know that Ben Bernanke will be the next Fed Chairman. His approval by the Senate is as close to a lock as you can get. This week we focus on Bernanke, and specifically his most famous, and what I think one of the most important speeches ever by a Fed governor. We will look at how policies might change, the risks involved. Bernanke faces some very real challenges. We should all wish him well. First, let's look at who Bernanke is: Dr. Ben Bernanke was the Chairman of the Department of Economics at Princeton. He was the Director of the Monetary Economics Program of the NBER (National Bureau of Economic Research) and the editor of the American Economic Review. He co-authored a widely used textbook on macroeconomics. He is obviously well-respected in economic circles. He was appointed to the Board of Governors for the Fed in 2002. He was appointed the Chairman of the President's Council of Economic Advisors in June of this year.

Exactly how do you measure inflation? Last week's letter showed how the Bureau of Labor Statistics uses "owners' equivalent rent" to measure the rise in housing costs rather than the actual price. The conclusion is that it certainly smoothes out the volatility of housing prices, and keeps the CPI (Consumer Price Inflation) from violent swings from quarter to quarter, it also yields periods where the CPI both understates and overstates inflation. Today, given the rapid rise in home prices, it understates the actual costs of inflation, especially if you are buying a new home. Today's letter will start off with some comments from me on the direction of Fed policy and inflation, and then will go to some comments and notes on inflation I got from several distinguished analysts, including Peter Bernstein, Hoisington Management, and Charles and Louis Gave. I offer their comments in full and unedited, and I think you will find them enlightening.

How can inflation be so low over the past few years if we see rising energy prices, ever-increasing medical costs and especially the cost of housing rising so dramatically? Today, for the first time we see inflation actually showing the results of rising energy costs, and the number is ugly. But it is not as ugly as it could be. This week we look at how the Consumer Price Index is calculated. Like the making of sausage and laws, it is not pretty. It will make for a fascinating read, I think. But first, I am compelled to make a comment on the Refco situation. Dennis Gartman has what he calls the cockroach theory. There is never one cockroach. If you see one, there are a lot of them in the walls. Observers have been seeing cockroaches at Refco for a long time. When the whole story comes out, it is not going to look good. How you can hide almost a half a billion in losses when going through a public offering is mind-boggling. Refco has had a long history of problems. Most never make the light of day, but there is one that you might recall.