SLOW, SLOW, SLOW, THEN GO, GO, GO

During my army days, I learned how to slow a race car into a curve while trying to come out of the curve with the maximum possible momentum. Understanding the concept and executing it correctly are two different things. One army buddy of mine could do it better than anyone else in the company. It was amazing that he did not have to be in the fastest car to win his race. He would make up the difference by maintaining maximum velocity in the curves and by hitting the gas hard a half a second before the next driver. His timing was so precise that he would be still be braking with one foot while applying gas with the other. Other drivers were fighting an "over-steering" problem that he solved by accelerating at just the right time. To me, his move was like the difference between a baseball bat swing and a golf club swing; the baseball bat swing is natural and instinctive whereas the proper golf swing must be learned. Hey, don't take me to task if my sports analogies are weak; the only individual championship I won in "sports" was shooting marbles in the 5th grade.

FAST MONEY!

I have written about the velocity of money before but not in the sense of knowing how to speed up after the economic turn. As we make this huge mid cycle turn, the velocity of money is a critical question. My confidence in Big Ben Bernanke continues to grow. It appears to me that he has hit the gas with a 50 basis point cut in the Fed Funds Rate at just the right time. Prior to doing so, he delayed moving too early by making the master stroke of cutting the Discount Window Rate. His work is not done. He will probably have to hit the accelerator at least one more time. Ben cannot decide his next move in advance because he must adjust to the national and international situation as the turn progresses.


MV = PQ

The good folk at GaveKal have written an excellent article about the above "Fisher" equation. This classical economic equation says that the money supplied times the velocity of that money must equal the quantity of goods times the price of those goods. All current yak, yak, yak we hear about inflation is coming from people who believe or who want to believe that Big Ben's move to boost the money supply will result in a sharp increase in the price of goods. These folk try to make the formula read, an increase in M = an increase in P. At the same time, the "poor" union folk, who have a firm hold on a number of members of congress, try to make the PQ increase by holding Q down while increase P; this is typically done by restricting where the Q can originate. Of course, all the citizens of the world are better off if they are free to buy goods from the low cost producer, no matter the location or nationality of the producer, but, as we expect, the unions try to "win" an extra slice of PQ for their members. In the same way, unionized businesses with contract negotiations pending, may be pleased to see a slow down in the product of PQ because a slow economy may help them keep their input costs low and thus increase their slice.

The formula has two inputs and two outputs and the emphasis on what the government can do to help our "free economy" achieve the most has changed over the years. In a press conference last week, President Bush stated that he is a "supply side president". Supply side economist believe that one of the best ways to keep the price of goods affordable is to make plenty of goods available. In other words, while Milton Friedman was absolutely correct that inflation is the monetary phenomenon of too much money chasing too few goods, one solution to inflation is to not change the amount of money but to change the quantity of goods. In the past, when inflation got out of control, the medicine of cutting the money supply was often bitter medicine. Had the goods available been increased, for example though free trade, the inflation problem could have been solved without causing the suffering inherent in an economic recession.

Of course, the FOMC does not control policy and can only work with the tools it has available. The good news for all consumers is that the union strangle hold reached a clearing price the day that Ronald Reagan fired the air traffic controllers. The unions have continued the fight but on balance workers have had to accept wages that are more and more in line with the value of the work done. Low and behold, GM workers just accepted this concept. GM workers will earn a contracted rate plus a bonus that is commensurate with the profits of the company. Such a plan is so powerful and right. It is absolutely a fair thing for workers to benefit if their productivity goes up and if they align their interest with the interest of the company.

The AMR contract is not up until May of 2008 but the company has proposed a similar plan. The pilots will get a raise by agreeing to fly more than 19 hours per week. Bonus money will be paid when appropriate.

"Sticky wages" have been "the big economic problem" for centuries. In the old days, when the sales of a company slowed, the only viable option was to lay off or fire workers. Laws designed to help workers, such as over time pay, resulted in the hiring of too many people in the good times and the firing of lots of people in the tough times. Schumpter helped us understand that we should not want or expect to go to work for one company and stay there all our lives. The old union plan that "locked" an employee into a job for life was viewed as a wonderful benefit but it often proved to be a curse. I personally am thankful to have worked in several different industries and to have done scores of different jobs during my life.

The point of the above discussion is that the system has changed. Today the formula MV = PQ is a much more dynamic formula than in the past and at the same time the product of PQ is much more stable than ever before. This is great news. Who wants live during times of uncertainty? Who wants to live in constant fear of an economic downturn? Who wants to fear losing their jobs?

Governments all over the world have come to realize that taxing the heck out of the producers of Q is the sure way to reduce the total supply of goods and to increase the price of those goods. Lower taxes have enabled consumers to purchase more goods and live better lives while avoiding many hassles created when governments try to provide services that should be provided by private enterprises. The recent irony has been that even control economies such as Russia and China have given more economic freedom to the people and the results have been substantial. Hundreds of millions of people are living better lives as a result of economic freedom. Russia has back tracked on the ownership of major businesses but their continues to be great strides toward economic freedom around the globe.

OOPS! WHAT HAPPENED TO V?

A relatively small portion of US mortgage debts are in default. Today's mortgage market place is very different than the one prior to the recession of 1973. Thousands of savings and loans went out of business during this recession and many more followed during the recession of 1990. These businesses bore the brunt of the inevitable downturns in the housing market. In recent years, the risk of these loans was split up into small pieces. The most secure of these loans ended up being owned by the billions of people who have money invested in money market accounts. The risk of these accounts is extremely small but, as a result of mistakes by rating agencies and of aggressive purchases of the high risk pools of mortgages, at extreme levels of leverage, several large companies will lose hundreds of millions of dollars and a few will lose a billion or two or three. A relatively mild down turn in housing has caused a bit of a panic. Savers stood in line for days to withdraw money from a bank in England that was caught with too much invested in these mortgages.

The above review of what just happened in the mortgage market was written to explain that the velocity of money slowed violently in recent weeks. People around the world have "hunkered down" to various degrees. The first response to the "news hype" about the "financial crises" was naturally to hoard ones cash. To stop the panic, Big Ben and other central bankers have pressed the accelerator hard. Money is routinely created when it is lent, deposited and relent again and again. High powered money is created when the central bankers hit the gas. In this race around the track, the big curve was entered, the brakes were applied to avoid going through the curve too fast and gas is already being supplied to shoot us out onto the home stretch.

HOW MUCH GAS IS ENOUGH?

The 50 point cut in the Fed Funds Rate receive the reaction of jubilation! The markets reacted more strongly than all but a few days in the history of the US markets. Up to down volume was 30 to 1 while the Dow soared 300 points. History tells us to expect average market gains of 20% or better over the next year.

However, it was not just stocks that went up in price. Gold, oil and the Euro Dollar all jumped. As stated earlier, many are looking at the actions of the FOMC to pump in money with the expectation that prices of goods will soar. This is a misreading of the situation.

WHALE HUNTING!

For the past couple of years, Ben and his fellow central bankers have been hunting "whales". You probably know about the country boy that fished by dropping sticks of dynamite in the lake. Each time a stick exploded, he would wait to see what floated up before dropping another. He did not bother collecting the little fish but kept on dropping dynamite until a "big whale of a fish" floated up.

For a long time, Ben and company have been well aware that there is a limit to how long the world economy can grow very fast. At some point in time, if there is too much growth the PQ side of Fisher's formula goes out of whack. When the supply of goods is limited because there is no spare capacity, the price of goods must rise or the growth in the product of PQ must cease. In the summer of 2004, Ben joined the hunt; he and Mr. Greenspan dropped the dynamite of 17 quarter point increases in the Fed Funds Rate. No whales showed up but other central bankers continued to hunt. You see, there are always small or medium sized businesses suffering or dying. The way the bankers know that they have dropped enough dynamite is to "float a whale". Recently, the run on a bank in England (North Rock Bank is the name that comes to mind), was the whale that stopped the dynamite. Now, part of what Ben has to do is watch the other hunters. Should, for example, the Bank of England, lower rates, Ben may be able to hold off the next move. Again, he does not want to lose any more momentum while rounding this curve than he absolutely must.

SUPPLY RESTRAINTS

I have written much about the supply of oil because this has been the most obvious area where capacity restraints have held down Q and of course forced up P. The good news is that the worst is already behind us. GaveKal Research reports that in 2008 there will be 1.4 million barrels per day of new refining capacity on line. Of this, the new 700,000 barrel per day refinery in China will process the sulfur heavy fuel oil that is in abundant supply. In other words, the oil is available now but just needs a place to be processed. With the rest of the world refineries running at only 92% and with conversions being made to other refineries, the sulfur heavy fuel is the equivalent of making a major oil discovery. Speaking of major discoveries, billions of barrels have been discovered time and again over the past few years. The process of developing those fields is in various stages at the various locations. By 2010, there will be ten million additional barrels of refining capacity available.

In any event, inflation need not "get out of control". No doubt, China needs to take action to avoid problems but Ben holds a lot of power in his hands and, besides, much work has already been done. Should you plot the Fed Funds Rate, the price of commodities and an inflation index on the same page, you would see that the three series follow closely together, with the Fed Funds Rate taking the lead from time to time. The current situation tells us that it is wise to expect inflation rates to moderate in the months ahead and since we know that the best time to own stocks is during periods of low to moderate inflation, BUY, BUY, BUY, BUY!

Again, how do the people who are bidding up gold and oil know that M is growing too fast? Do they know how fast V is falling? Is it possible that Ben will do a great job and increase M by just about the same amount of decline in V?

By the way, I do not believe it is total coincidence that there has been much saber rattling by Iran and the USA right here at the turning point. I believe $10 to $15 of the current oil price is an "insurance purchase". An exciting time lies ahead!