richard russell

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    July 31, 2003

    Is there anything ethically or philosophically wrong with the central bank system of money as it has evolved? My answer is yes. As gold was systematically removed from the system, the system became a "fantasy system." I say fantasy because the central banks are able to create money at will. with no discipline to stop them. This I believe -- is immoral, even evil. The current system allows a central bank to create money out of nothing -- whereas I and my fellow Americans have to work for that same money.

    Is it ethical, even logical, that I have to work my whole life to make say a million dollars when the Federal Reserve can, in a minute, create billions of the same fiat dollars that I work so hard for? The system defies logic and defies reality. It's a scam.

    But because there is no limit to the fantasy-dollars that the system has created, the system has simultaneously created a giant edifice of debt. Nobody is certain how much debt has been built into the US structure, but the accepted figure is around $38 trillion. If you figure that the average interest on this debt is 5%, then you are talking about $2 trillion a year needed to service that debt.

    Thus, the system now requires inflation to handle the debt. You see, inflation renders debt less onerous through time.

    This explains why the Fed is so terrified of deflation. In deflation, debt become increasingly difficult if not impossible to handle. In deflation dollars become scarcer and more potent, while the debt remains constant. This, is a nutshell, is why the Fed is so frantic to thwart the forces of deflation.

    The forces of deflation? What forces? During the '90s people, cities, states, the federal government, corporations -- they all borrowed heavily. A huge world of "prosperity" was created. But alas, the structure toppled over starting in late-1999. We refer to that as the "bursting of the bubble."

    Why did the structure topple over? It toppled because "no tree grows to the sky." It's as simple and yet as mysterious as that.

    But worse, at the same time, a number of deflationary forces came to the fore. They were --

    The Internet, which allowed people to find the cheapest item.

    China and Asia, which gave manufacturers and service providers a way of drastically cutting their costs.

    Wal-Mart, which now accounts for 1.3% of the GDP of the nation. WMT gave people an outlet for Chinese goods. WMT is now a giant, fast-growing chain that cuts prices mercilessly.

    The global economy, which allows every nation to compete for exports with every other nation. This resulted in what I call "the end of pricing power." Today nobody can raise their prices and no manufacturer can raise its wage scale.

    The US negative current account, which exports tens of billions of dollars to other nations, and which has allowed Asians to built up their manufacturing facilities and thus compete with US manufacturers.

    The relentless rise in unemployment, which is a fear factor for the US population -- and also a force for deflation.

    All the above represent the forces that now threaten the current system of fiat money. Above all they threaten the edifice of debt that was built up during the '90s.

    What is the Fed to do in the face of these forces of deflation, and the death of pricing power?

    The Fed's answer is that "We will absolutely not allow deflation to enter the picture. We'll preempt deflation. Since deflation is basically 'too many goods confronting too little money,' why we'll defeat deflation by creating so much money that deflation will be swamped. We'll drown the forces of inflation with a veritable ocean of liquidity."

    Can it work? Can the Fed defeat the natural forces of correction and contraction that is following the collapse of the greatest financial bubble in history?

    The Russell answer -- It can work for a while, and, in truth, it has worked for a while. But what has also happened is that in its inflationary frenzy, the Fed has injected even more debt into the system. As I see it, three major problems have been rendered even worse.

    First, a housing bubble has been built. Due to low mortgage rates, Americans have rushed into housing, driving home prices up to absurd prices. And with the housing boom, more debt has been built into the system.

    Second, the stock market bubble has been brought back. Is the stock market a bubble? With the S&P selling at 32 times trailing earnings and providing a yield of 1.70%, I say that the stock market is now most definitely in a bubble.

    Third, in driving short rates down, the Fed has created a bond market bubble. At the recent low, 10 year T-notes were yielding 3.1%, rates not seen in almost five decades. The bond bubble has now suddenly and totally burst, sending bond rates and mortgage rates higher. This morning the rate on 30-year fixed-rate mortgages rose to 5.71%.

    So what lies ahead? What I see is a continued battle on the part of the Fed to thwart the forces of deflation. The more persistent the forces of deflation, the greater will be the Fed's inflationary efforts. The Fed will use every resource, every "trick in the books," to thwart deflation. I call it a "death struggle." It's a battle the Fed has vowed not to lose.

    In the end, the Fed's all-out inflationary war will impact on the dollar. Too many dollars will be created (of course that's happened already), but as the dollar is systematically destroyed, bonds will become suspect, and the whole world of financials will come under suspicion.

    Richard Russell’s Dow Theory Letters
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