Fed's Folly Will Come Due in 2004 - TheStreet

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Led by the

Federal Reserve

, the world's central banks have spent five years pursuing some of the most reckless monetary policies ever seen in the developed world. Next year, though, their barmy bets will finally start to come undone.

The crackup won't start happening until the end of 2004 -- after George Bush, the market's favorite for president, has been safely re-elected -- but the coming deluge will usher in a period of global economic malaise and dire losses in financial markets.

The fast-declining dollar we see today is an early indicator of the reckoning that Fed Chairman Greenspan has long tried to forestall, using unsustainable measures. America will be the epicenter of the bust, because it is here that debt totals, as well as trade and fiscal deficits, have risen to historically delinquent levels.

Granted, it almost always pays to ignore most apocalyptic-sounding warnings -- and much money has been made over the years betting against the end of the world. Moreover, shrugging off such a dark-sounding forecast would seem to make a lot of sense after most of

this column's predictions for 2003 failed to materialize.

For example, Detox confidently expected equity markets would end 2003 lower than they started. But they have of course risen sharply, showing a 22% gain on the

S&P 500

index. Detox also said that stocks like

General Electric

(GE) - Get Report

and

Capital One

(COF) - Get Report

would crater, while

Tyco

(TYC)

would likely file for bankruptcy protection. None of those calls hit the mark, it is painful to report.

As foul as the freshly baked crow tastes right now, and as much damage as those predictions have done to this column's credibility, Detox is doubling up its bearish bet with its prediction of an economic and financial crunch starting toward the end of 2004. Why? Quite simple: America has no easy way out of the trap that the Fed has built for the country. No nation has splurged quite like this one without ultimately having to pay the piper. As exceptional as America is in so many ways, not even it can exempt itself from the laws of economics. And what's really scary for investors is that there is nowhere else in the developed world to flee.

Gutenberg

Morgan Stanley's chief economist Stephen Roach sums up this dilemma. "Central banks have made the riskiest bets in modern history -- policy rates of 'zero' in Japan, 1% in America and 2% in Europe. At the same time, fiscal authorities have upped the ante as never before, with government budget deficits of 7% in Japan, 4% in America and 3% in Europe. And the authorities have colluded in currency management in a period of unprecedented external imbalances."

But America is where things are at their worst. Resurgent equity markets in the U.S. say otherwise. But when governments are printing money like never before, a rise in stocks does not mean that a healthy economic recovery is under way. It just means that people, and their government, have more money to spend -- which is a very different thing.

Higher government and personal spending is what has kept the economy afloat over the past three years. But the logical question to ask is: How did these spenders get the extra dollars to blow? Well, they borrowed them, something that would've been impossible without the low interest rates engineered by the Fed. Debt may feel like wealth when it is being spent. And through the gunning of bank reserves, the Fed can inflate an economy by underwriting higher levels of debt.

But at some point the explosion in credit has to be paid back. The Fed's crazy bet is that the spending will lead to a recovery that will in turn increase personal incomes and taxes to the point where the extra debt taken on over the past five years becomes manageable. But the debt is too high to make this work.

In the second quarter, nonfinancial domestic debt was $21.6 trillion, or 199% of GDP. That's up $3.1 trillion from three years earlier, when the ratio was 181%. There has never been such a rapid rise in that ratio since the mid-80s, and we know what happened at the end of that decade. Some two-thirds of that increase -- over $2 trillion -- occurred among households or individuals. As a result, debt service ratios have climbed to historic highs for individuals, even with extremely low interest rates. It would take only small increases in rates to tip many people into real hardship or default.

Sulfa Drugs

The Fed believes it can win this gamble because it thinks it doesn't have to raise interest rates because inflation seems muted. There are two problems with that tack. First off, "real world" inflation does not show up in government statistics followed by the Fed and the markets. For example, the Bureau of Labor Statistics' most recent consumer price index data showed that growth in medical costs was slowing. There is absolutely no indication of that outside of the government numbers.

"There is something very wrong with these inflation numbers," says John Vail, a strategist for Mizuho Securities in New York.

Second, and much more important, anyone who thinks a central bank can splurge and underwrite towering levels of debt just because inflation is low has no understanding of how economies work over time. Excessive borrowing leads to the extensive distortion of prices and productive capacity.

Without the growth in debt and consumption fueled by Greenspan over the past three years, we would have had deflation. Why? The monetary excesses of the '90s had pushed up prices to excessive levels and the economy tried to adjust to bring prices down to affordable levels. The Fed did everything to prevent that, because deflation would've caused debt totals to grow in inflation-adjusted terms, creating a big credit crunch. Greenspan's solution? Create more debt in the hope it will cause another boom that will bail us all out.

"The Fed has tried to paper over the imbalances in the economy," says Paul Kasriel, economist at Northern Trust. "It has encouraged households to go deeper into debt."

Notably, central banks sitting outside of the Bank of Japan/European Central Bank/Fed axis have seen the danger of this approach. In press releases explaining why they have recently hiked rates, the Bank of England and the Reserve Bank of Australia both have alluded to credit growth.

Because of America's higher debt levels, the Fed doesn't have the luxury of practicing orthodox, sound central banking, and that is why Greenspan can say in the Fed's most recent communication on interest rates that "policy accommodation can be maintained for a considerable period."

Ball of Yarn

So how does the unraveling actually happen in 2004? The illusion of health will continue through most of the year. Bush will get his second term, elating markets for a short spell. Then the full size of the bills that must be paid will begin to really scare people.

But it's a job to know what will go wrong first when a patient is unhealthy in so many ways. It's clear that the breakdown will happen when interest rates go up. That will worsen debt burdens, causing forced sales in the housing market and a crash in that sector. Consumer spending will also get hit. Companies will not pick up the slack.

So what could cause a rise in rates? Perhaps a plunging dollar -- Detox expects $1.45 to the euro by year-end 2004 -- could force interest rates up. The government

budget deficit could come in way worse than expected, and the bond market could play a big role in pushing up market rates with such force that the Fed has to follow. There could be an unexpected rise in inflation, due to the amount of money pumped into the economy. It may even be a corporate scandal.

In 2004, the

problems at

Fannie Mae

(FNM)

, the government-sponsored company that is the backbone of the U.S. housing sector, finally could come to the fore.

It may be another terrorist strike within American borders. Indeed, through its monetary madness, the Fed has made the American economy all the more vulnerable, in the event of an attack.

So where will the indexes end up at the end of 2004? Well, equity markets will be very buoyant for most the year, and then dip only slightly. The S&P 500 will end the year up 15%, around 1,250. The

Nasdaq

will jump over 20% to around 2350. But enjoy the increases while you can, because those levels won't be seen again for several years.

And the probability that Greenspan gets us out of this mess unscathed? About 5%. The argument from the bulls is that America had similar economic imbalances in the 1980s and emerged healthier. Sorry, bad history. First, Bush isn't cutting taxes to the degree that Reagan did, nor is he pruning back nondefense public spending, as Reagan did.

The Cato Institute recently pointed out that discretionary nondefense spending slumped 13.5% in Reagan's first three years vs. a stunning 20.8% increase under the current president. The current account deficit was never this large in the '80s, so there could be a steeper decline in the dollar.

Detox,

gloomy from the start, has never been gloomier.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to

peter.eavis@thestreet.com.