End Game

It's not often these days that mistakes in Washington leave me speechless, but the Fed's decision to cut interest rates did it. It was a watershed moment with implications far beyond the economy or stock market. I couldn't believe the Fed would be so breathtakingly reckless as to deliver a big rate cut with the dollar at an all-time low, gold at a quarter-century high, oil at an all-time high, and the stock indices near multi-year and all-time highs. As long-time readers know, I've been mostly correct about monetary policy and its effects for the past few years. In this post from December 2005, I wrote:

The Fed can continue to monetize each and every bump in the economy and the stock market, in which case gold will likely head towards $750 and oil for $80 with a concurrent and possibly precipitous rise in geopolitical tensions.

When I wrote that almost two years ago, gold was trading at $521. It closed Monday at $747. Oil was at $60. It's now $80. And "geopolitical tensions"? You be the judge.

What was so stunning about the Fed's decision was how, in one brazen moment, it exposed so many months and indeed years of tough talk as a farce. The gig really is up, and there's no going back. I've never been a big Ben Bernanke fan. But before two weeks ago, I gave him a solid B for his performance. Because of the rate cut, he gets an F. If the Fed continues to cut, he should lose his ticket to the senior prom. Trading data shows that during the summer market decline, the largest players, essentially bulge-bracket Wall Street trading desks, were massively long. The Fed has now done a wonderful job of bailing them out. And since the foreign exchange markets are a brutal taskmaster -- everything comes out in the Forex washing machine, which isn't known for having a gentle "permanent (printing) press" cycle -- everyone else will pay for this at the gas pump and corner market. None of this is a surprise to any appropriately skeptical observer of the Federal Reserve. But it's clearer than ever that policymakers think the viability of our financial system depends on the government's ability to stem soft spots at will, both overtly and covertly. I wrote a long post about the geopolitical implications of this a couple of years ago, and it's as relevant as ever.

During the past few years, it's been hard to miss a subgenre of economic commentary that's best described as apocalyptic. The same thing happened during the 1970's, and a lot of it is overblown. We have a great financial system, in theory and usually in practice, and things generally work out okay. The key words are usually and generally. Since the mid-90's and especially since 2003, the Fed has made it clear it will monetize any air pockets in the economy or financial markets. Of course there are lots of problems with this. A basic one is that it strengthens our adversaries -- one reason why they're "adversaries" in the first place and eventually "enemies." The nanny state's liquidity flows into the financial markets, into bonds, into stocks, into oil, and ultimately into state coffers in Moscow, Caracas, and of course Tehran. That wouldn't be a problem if those countries were willing to play ball with us, as the Saudis were during the 1980's and 1990's. But they're not. They're each shunning the dollar and buying gold. Here's one article about this big no-no. Saddam got the same bright idea before 2003. Remember: statists hate consequences. And the constant media speculation about military action against Iran provides a wonderful cover for the effect of all that liquidity on the price of oil and gold.

A phrase that's become popular is "a clash of cultures" and variations of it. The description's appropriate. The first culture is one in which policymakers believe they've repealed the natural business cycle. This culture of moral hazard and push-button Fed liquidity makes it possible for 30-somethings to sit in front of computer screens in Manhattan and Connecticut and make millions from the flickering green dots, while that same liquidity debases the dollars held by wage earners, retirees, and prudent savers; it allows mediocre corporate executives to exercise stock options and become fabulously wealthy; it tells stock and real estate speculators that if things go south, someone sitting in an office in Washington will press the "print" button and make everything okay; it makes "bridges to nowhere" possible; and it allows a nation to launch a preventive war and decades-long occupation without a thought about how to pay for it. This culture depends on dollar hegemony.

The other culture is composed of a few countries, non-allies, that happen to occupy the ground above the natural resource most sensitive to Washington's print button. Since they have the gall to object to our insistence on exchanging ever-depreciating pieces of paper for their main (and finite) natural resource, they both complicate our attempt at reinflation and profit from it.

If a U.S. attack on Iran happens during this administration, it won't be an act of the White House, neocons, or Republican party. And if it doesn't happen before January '09 and something magically comes along after that to make it "necessary" it won't be an act of the Democrats. It'll be the culture, the establishment. I don't mean "establishment" in the pejorative sense. You don't get to the Oval Office, or even come close, without understanding what that word means. Democratic leaders, including of course Hillary Clinton, understand the underlying exigencies and global market dynamics just as well as the White House. Of course we'll get the obligatory gnashing of teeth about the use of force. But let's see how much real resistance there is. Do you think the Dems want operational responsibility for what they realize must come next? This is deeper than either partisan politics or a weapons program that might produce a nuke three or five or ten years from now. And the geopolitical end game, nudged along by the Fed's action two weeks ago, is unlikely to be pleasant.