Headline: Will U.S. emulate Japan’s long slide? The U.S. economy is staring down circumstances similar to those that plunged Japan into a decade of stagnation

Source: Wall Street Journal, 7 November 2001

ULRL: http://www.msnbc.com/news/653960.asp

The Federal Reserve’s decision to cut its benchmark interest rate to 2 percent, its 10th rate cut this year, moves the U.S. central bank closer to the day when it runs out of rate-cutting ammunition. And that raises an unsettling question: Could the U.S. be going down the same dismal economic path trod by Japan a decade ago?

With each passing week, the similarities increase. In the 1980s, Japan was considered the model capitalist economy; in the 1990s, the U.S. held that distinction. In both cases, the good times ended with the bursting of a stock-market bubble, pricked, at least in part, by a nervous central bank. In both cases, predictions of a quick turnaround proved to be wrong.

The excessive American investment in fiber-optic high-speed phone lines echoes Japan’s decade-earlier investment binge in memory-chip factories. The plight of one well-respected American company, Enron Corp. — which has lost two-thirds of its market value in just three weeks — is reminiscent of the previously invisible weakness Japan’s slump exposed at many of that country’s banks. Even the recent squabbling in the U.S. Congress that threatens to derail a package of economic-stimulus measures sounds eerily similar to the bureaucratic and political wrangling that stymied bold fixes in Japan.

And now, U.S. monetary policy, considered to be the most powerful tool for countering the nation’s downturns, is looking increasingly like Japan’s, as interest rates fall toward zero.

Japan has endured a decade of stagnation. Could that happen here?

Most analysts continue to answer with a resounding no. They point out that Japan burst not just a stock-market bubble, but also a real-estate bubble, which in turn laid low its banking system. The U.S. bubble appears to have been limited to stocks, and the American banking system remains strong.

U.S. policy makers also insist that they are wiser than their Japanese counterparts, in part because they have learned from Japan’s mistakes. And, they add, the U.S. economic and political system is more flexible than Japan’s and better able to make the necessary repairs. NOT AN ‘APT’ COMPARISON

“It’s easy to raise the suspicion that the Japanese and American economies have some similarities,” U.S. Treasury Secretary Paul O’Neill said in a recent interview. “I don’t think it’s apt to make a comparison.” Among other things, he says: “They’re not an open economy. One of the things that has really been beneficial to our economy is this openness and the challenge that we have permitted to come in here, from foreign suppliers from all over the world ... .”

Moreover, the U.S. central bank hasn’t yet exhausted its rate-cutting options. In announcing its half-point rate cut Tuesday, the Fed’s policy committee made clear that it remained poised to keep cutting rates down into the 1 percent range if deemed necessary. “For the foreseeable future,” it declared, “the risks are weighted mainly toward conditions that may generate economic weakness.”

U.S. markets have rallied in recent weeks on the assumption that the Fed still will be able to turn things around by next year. Indeed, after trading a bit lower Tuesday in the hours before the Fed’s 2:15 p.m. EST rate announcement, the Dow Jones Industrial Average soared 150.09 points, or 1.59 percent, to finish at 9591.12, just 14 points below its close the day before the Sept. 11 terrorist attacks on the U.S.

Fed Chairman Alan Greenspan continues to cling to his faith in the U.S. economy’s future. “The long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate,” the Fed said in its statement Tuesday.

Yet the Japanese were no less confident about their economy a decade ago, even as it slipped into prolonged crisis. “Our foundations are solid,” declared Bank of Japan Governor Yasushi Mieno, as he started cutting interest rates in 1991.

Japan’s Nikkei Stock Average peaked near 40000 in December 1989. But in 1991, when three leading economic institutes issued long-term forecasts for Japan through the next decade and beyond, each saw long-term economic growth continuing at between 3 percent and 5 percent a year. Instead, the country grew at an annual average of 1.1 percent between 1992 and 2000.

In April 1992, as the Nikkei appeared to be hitting bottom at 17000, a consensus of a dozen top forecasters still foresaw Japanese economic growth for the following year at between 2 percent and 3 percent. It ended up growing 0.4 percent. Today, the Nikkei hovers around 10000, and the Japanese economy is back in its fourth recession of the past decade. One reason for the unexpected length and depth of Japan’s decline is that its 1980s bubble created a myriad of destructive excesses, many of which became evident only after the bubble popped. For example, it wasn’t until 1991 that real-estate prices started falling — and many analysts thought that decline would be temporary. It wasn’t until the mid-1990s that economists saw how severely the fall in real-estate prices had hurt Japan’s big banks.

Those bad investments continue to haunt Japanese banks. The banks didn’t lend so much directly to real-estate speculators; instead, much of the money went through intermediaries such as nonbank finance companies and construction companies. Today, many of those contractors are near insolvency, and the banks may have to take huge write-offs. “We recognized that it would take a long time to be fixed, but even so, we thought that would mean two or three years,” Yoshimasa Nishimura, a former head of the Japanese Finance Ministry’s banking bureau, says of the bubble. EXCESS CAPACITY

And it took manufacturers many years to recognize that the capacity they had built up during the bubble was never going to be used. Auto makers manufactured 13.5 million vehicles, including trucks and buses, in Japan in 1990. The number fell off gradually after that and now stands at about 10 million per year. For years, companies kept excess capacity and workers, betting that the falloff was temporary.

When Japan’s economy first slowed, there was widespread confidence that its government could easily manage the downturn. In the 1980s, the country’s fabled bureaucrats had a sterling reputation for economic management, much as Greenspan did in the U.S. during the 1990s. With short-term interest rates at 6 percent and a budget surplus of 8.8 trillion yen ($72.3 billion) — or 2 percent of gross domestic product — the Japanese central bank and parliament had plenty of room to cut rates, cut taxes and boost public spending.

The Bank of Japan did ultimately cut rates by almost all six percentage points. Politicians used the full surplus and even let the government run a primary budget deficit — or deficit excluding bond issuance and repayment — of 11 trillion yen, or 2 percent of GDP. But they acted too slowly and in the end failed to jump-start the economy.

American policy makers give themselves higher marks for speed of response. The Fed has cut interest rates by 4.5 percentage points in just 10 months. It took the Bank of Japan more than 4-1/2 years to do the same.

Moreover, the U.S. Congress has turned unprecedented budget surpluses into almost certain deficits with equal dispatch, passing a massive $1 trillion, 10-year tax cut earlier this year and rapidly approving $40 billion in stimulus measures and a $15 billion airline bailout in the wake of the Sept. 11 terrorist attacks. Members of Congress now are caught up in a stalemate over a plan for $75 billion to $100 billion in additional stimulus actions, but that, too, has a good chance of enactment before year’s end. The Japanese Diet, on the other hand, dallied for a year and a half before passing its first stimulus package.

Even more important than the speed of America’s policy makers, though, may be the flexibility of the American economy itself. Analysts say the U.S. economy has a more self-cleansing form of capitalism that discourages the many excesses that built up in Japan during the 1980s.

A decade ago, the Japanese boasted of having found the secret formula for smoothing out free-market business cycles. Companies had friendly shareholders as well as bankers who provided “patient capital” that allowed for long-term technological investments in spite of weak quarterly earnings. Lifetime employment guarantees gave workers a sense of income security, encouraging them to keep spending during downturns.

In retrospect, those same traits seem like weaknesses — factors that shielded Japanese companies from the free-market pressures that would have made them more efficient. The U.S. system, by contrast, is considered better equipped to shift resources from unproductive to productive uses.

Even today, after the decade-long slump, the Japanese company Matsushita Electric Industrial Co. refuses to lay off any of its 130,000 employees in Japan, despite losses that are expected to exceed $2 billion this year. That’s a far cry from U.S. companies, such as International Business Machines Corp. and AT&T Corp., which laid off workers even during the boom years, freeing up technology talent to go to newer, fast-growing rivals such as Dell Computer Corp. or Cisco Systems Inc.

In part, it is U.S. policy makers’ willingness to inflict short-term pain that allows for that flexibility. American officials argue that Japan would have come out of its crisis more quickly if it had handled its banking crisis the way the U.S. handled the American savings and loan crisis in the 1980s. Back then, U.S. government-ordered thrift shutdowns and foreclosures caused shareholders to lose their investments and borrowers to lose their properties. In Japan, failed banks were propped up, and their problems allowed to fester.

Still, American-style free markets are hardly immune from excesses, and more and more become apparent the longer the economy idles. Telecom companies spent tens of billions of dollars to lay tens of millions of miles of fiber-optic cables, an estimated 2.6 percent of which is now being used.

Blue-chip American Express Co. ended up writing off more than $1 billion in junk-bond investments that were considered relatively low risks until the economy went sour. “Subprime” lender Providian Financial Corp. sent its earnings and stock price soaring in the late 1990s by tapping the once largely ignored pool of consumers with checkered borrowing records. Providian insisted that it used sophisticated models to limit its risks. Nonetheless, it ended up announcing a surprising 71 percent drop in third-quarter earnings last month, and its stock fell by more than half.

More surprises are almost certainly in store. Many analysts argue that the U.S. stock market — even at more than 25 percent below its peak — remains a bubble waiting to deflate further. The Standard & Poor’s 500-stock index still is trading at a price-to-earnings ratio of between 21 and 28 times earnings, depending on the measurement, and would need to fall at least 30 percent to reach its historic average P/E ratio of 15, according to the Leuthold Group, a Minneapolis-based investment research firm. SURGE IN BORROWING

To some analysts, the large amount of consumer debt outstanding in the U.S. is the ticking time bomb that could rival the bad loans dragging down Japanese banks. American households borrowed freely and dipped deeply into savings during the 1990s. In good times, with wages and stock portfolios rising, the situation seemed manageable. But now, as income-growth slows and mutual funds shrink, the burden could spin out of control. The Fed estimates that the household debt-service burden — the ratio of debt payments to after-tax income — rose above 14 percent earlier this year for the first time since 1987. At about the same time, the number of Americans filing for personal bankruptcy hit a record 390,064.

One reason for the surge in American borrowing has been a sharp increase in the number of new home mortgages and a wave of mortgage refinancing to take advantage of falling interest rates and rising home values. Both home sales and consumer spending, backed by rising housing values, have been rare bright spots over the past year in an otherwise dismal economy.

But there are dangers as well. One concern: that the sharp rise in home prices over the past four years — nearly 20 percent nationally, when adjusted for inflation, and more than 60 percent in hot markets such as Silicon Valley, according to the Office of Federal Housing Enterprise Oversight in Washington — could turn into a miniature version of Japan’s real-estate bubble.

Another worry: that America’s housing market isn’t driven entirely by free-market forces. Rather, this theory goes, it is propped up by Japan-like government subsidies and easy loan terms made possible by widespread assumptions that the government would pick up the tab for any defaults.

The nation’s mortgage market is dominated by Fannie Mae and Freddie Mac, government-chartered companies that are shareholder-owned but still enjoy various implicit and explicit subsidies, such as tax breaks and an emergency line of credit from the U.S. Treasury. The two Washington-area companies don’t actually issue mortgages themselves. Instead, they buy mortgages from lenders and repackage them into tradable securities. In doing so, they play a major role in influencing the size and shape of the market by setting underwriting standards for the loans they purchase.

Some conservatives — including the Fed’s Greenspan — have expressed concern that Fannie and Freddie, by using government subsidies to expand the housing market, create distortions, drawing capital away from more productive uses. The Congressional Budget Office estimates that the two companies last year enjoyed subsidies totaling $10.6 billion — a number they say is exaggerated. Other critics say that the companies encourage more, and riskier, lending than a completely free market would allow — a pattern that may sustain housing demand in the near term but raises the risk of a bigger bust down the road. Japan’s woes have been exacerbated by formal and informal government backing for lenders. That includes a Government Housing Loan Corp. that gets a $3 billion annual subsidy and a separate state-run loan guarantee program that keeps many technically bankrupt small businesses afloat.

Fannie Mae Chairman Frank Raines rejects the notion of any similarity between his company and Japanese-style subsidies. “Their mortgage corporation has no private-market discipline — there is no private management, no private equity capital, no private debt capital.” Fannie, he says, has all three, as well as tight regulatory standards requiring the company to keep enough capital on hand to withstand a catastrophe. The company’s private shareholders, he adds, have every incentive to prevent overly risky lending, since they would lose their investments even if the government were to intervene to back the loans.

Elsewhere on the business front, the vaunted flexibility of the American economy — while perhaps raising efficiency in the long run — could also serve to intensify a downturn. American corporations’ readiness to resort to layoffs at the first sign of weakness risks battering consumer confidence. In the past three months alone, the unemployment rate has soared by nearly a full percentage point — to 5.4 percent in October from 4.5 percent in August, and the U.S. jobless rate once again exceeds Japan’s, which after a decade of stagnation still is 5.3 percent. FRAGILE SAFETY NET

Even workers supposedly protected by union contracts have a fragile safety net. In the wake of the terrorist attacks, major airlines, such as AMR Corp’s American Airlines and Delta Air Lines invoked force majeure clauses in their labor contracts, allowing them to skirt many negotiated protections and dump workers without advance notice. Partly as a result, the Conference Board’s index of consumer confidence plunged to 85.5 in October from 114 in August, one of the swiftest declines on record.

While Japan’s unique circumstances may account for some of its problems, they also may demonstrate a broader and more disturbing point: that policy may at times be relatively powerless to contain the destructive forces of a bursting bubble.

As companies are saddled with excess capacity, they have little incentive to borrow to expand, no matter how low interest rates fall. Even after the sharp drop in capital spending over the past year, the percentage of industrial capacity in use in the U.S. in September was just 75.5 percent — the lowest level since 1983 and hardly an inducement for companies to build new factories. Layoff-spooked consumers also may be unwilling to spend tax rebates enacted to encourage shopping. A recent University of Michigan survey concluded that just over one in five households have spent the rebate checks mailed out this summer, with the rest tucking the money into savings or using it to pay debt.

At the extreme, the supply overhang from a collapsing bubble can touch off a dangerous cycle of deflation, or falling prices. In a deflationary environment, consumers curb spending, waiting for goods to become still cheaper in the future. Borrowers get crushed by debt burdens as their loans become more expensive in relative terms. Companies, forced to keep cutting prices, cut back on workers and purchases of supplies, spreading pain throughout the economy.

In Japan, deflation got under way in earnest in 1998 after the collapse of a major bank and securities company. In both 1998 and 1999 wholesale prices fell 1.5 percent, and after a flat year in 2000, they are falling again in 2001. The U.S. isn’t there yet. But commodity prices have fallen sharply since 1998, while U.S. consumer prices, by some measures, appear to be slipping. The Commerce Department reported last week that its favored measure of inflation — the price index for gross domestic purchases, or prices paid by U.S. residents — fell by 0.3 percent in the third quarter, a sharp reversal from the 1.3 percent increase in the second quarter and the first quarterly decline in nearly 40 years. (Analysts say the number was artificially depressed by one-time factors relating to Sept. 11 — insurance benefit payouts that, for measurement purposes, lower insurance prices.)

In a deflationary world, the central bank’s powers to respond are diminished because monetary policy works most effectively if interest rates can fall below the rate of inflation. But rates can’t do that if inflation falls below zero.

-- Andre Weltman (aweltman@state.pa.us), November 07, 2001

Answers

Response to U.S.: Will U.S. emulate JapanÂ’s long slide? (Wall St. J.)

DOING THE INTEREST RATE LIMBO

THE DAILY RECKONING

BALTIMORE, MARYLAND

WEDNESDAY, 7 NOVEMBER 2001

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*** Fed continues its march to zero...

*** Could the U.S. be following the Japanese? Uh...

*** Stock buyers are still bullish...commodities drift lower...Nicaragua spared...and Edward turns 8.

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"I don't know," writes a Daily Reckoning reader, "but it seems to me that if the Federal Reserve and Federal Government try hard enough, they can create inflation. And they are certainly trying very hard at the moment."

Yes, they are. The Fed cut rates again yesterday...the 10th time this year.

You'll recall the confidence that followed the first rate cut last January. Even if it failed to work, commented Ed Yardeni, "there are still 600 basis points from here to zero."

Well, now there are only 200 basis points left. And there is no sign of any recovery. "A grim economy gets grimmer," reports a Detroit Free Press headline. "More apartments standing empty," notes the Rocky Mountain News.

"Could the U.S. be going down the same dismal economic path trod by Japan a decade ago?" asks the Wall Street Journal.

When the Japanese market cracked in January of 1990, explains the WSJ, "there was widespread confidence that the government could easily manage the downturn." "Our foundations are solid," said Yasuchi Mieno, the Alan Greenspan of Japan at the time.

What did the Japanese do? They cut rates...from 600 basis points down to zero. But their foundations proved to be made of jello. Twelve years later, and the news just keeps getting worse and worse. Last month, Japan saw its biggest monthly rise in unemployment and its sharpest drop in industrial production in 20 years.

What will happen in the U.S.? We will see, dear reader, we will see. But one thing we don't see is anything to prevent the Fed from cutting rates all the way to zero, just like the Japanese. There is no sign of recovery...and no sign of inflation...

But let's check in with Eric and see what he sees...

*****

Eric Fry writing from New York...

- "Facing a choice between a small symbolic rate cut and a larger reduction likelier to please investors," writes Igor Greenwald of Smartmoney.com, "the Federal Reserve reached for the big axe, chopping its benchmark rate by half a percentage point to a new 40-year low. The year's 10th cut took the federal-funds rate to 2%, a token of the Fed's long - but so far unsuccessful - campaign to reverse the economy's slide into a recession."

- So what. The stock market loves it...and isn't that really all that matters? All the major stock averages soared to new post-Attack highs. The Dow gained a cool 150 points to 9,591, while the Nasdaq surged 2.3% to 1,835. And for the second day running, Internet stocks like "Chinadotcom" made a big splash - although not nearly as big a splash (or is that splat?) as they will make after this rally runs out of gas.

- Ironically, even as many stock market investors peer into the future and perceive the faint outline of an economic recovery ambling their way, commodity investors look into the very same shadowy future and see nothing but a black hole. The CRB Index of commodity prices is matching the S&P 500 Index downtick-for-uptick.

- Oil prices touched a fresh two-year low yesterday and most other commodities continue to drift lower as well. The CRB Index has fallen almost 20% so far this year. Demand seems to be the culprit - as in, there isn't any. Consumers may be spending a little bit here and there. But most American companies aren't.

- "Companies are consumers writ large," writes Barron's Alan Abelson. "When they earn more, they spend more...just as a more subdued mood begets retrenchment and job losses." Retrenchment is the order of the day.

- Furthermore, Moody's reports that corporate credit ratings are deteriorating significantly. Among the companies currently under its review, Moody's will likely downgrade five for every one that it upgrades.

- Net-net, says Abelson, "The destruction of corporate profits that we've been suffering through for many long months now shows few, if any, signs of letting up, and recovery is apt to be both tentative and slow. If corporate profits are the key to jobs and jobs are the key to consumer behavior and consumer behavior is the key to whether the economy declines or rises, and the outlook for neither profits nor jobs nor consumer behavior nor the economy is bullish, why in the world is the stock market selling at 25 or 35 times earnings?

- "That's a valuation more consonant with the tops of bull markets than the bottoms of bear markets," Abelson reminds us, "and, in fact, [it] is three to four times the multiple at which bear markets have typically bottomed out. Maybe [the market is] on to something. Or maybe it's just on something."

- Is the bear market truly over? Or is it just taking a breather? James Grant, editor of Grant's Interest Rate Observer, thinks the U.S. stock market has a little unfinished business: The bubble may have sprung a leak, but it still holds an air pocket or two.

- "When Osama bin Laden finally steps in front of a bus, the United States will be left with a more intractable foe, the legacy of its own boom," writes Grant. Citing the work of Goldman Sachs economist, John Youngdahl, Grant compares Japan's bubble in the late 1980s to America's experience a decade later. "In each case, stock prices soared by about 25% a year for the half- decade under the speculative spell, while business fixed-investment outlays climbed at a greater than 10% rate, nearly double the rate of growth in private demand. In the aftermath, too, parallels are striking: in both countries, stock prices plunged by about one- third in the year-and-a-half after the peak."

- Therefore, Grant wonders, "Will the U.S. follow Japan into a long stagnation? Unlikely, Youngdahl concludes: the Fed cut rates quickly and aggressively; the Bank of Japan dithered. U.S. fiscal policy turned easy fast, Japan's not for three years. There is one catch, however. Americans owned more high-priced stocks than the Japanese did." As of year-end 2000, stocks made up about 30% of America's household wealth - or about twice as much as Japanese households held when the Nikkei peaked in 1990.

- To judge from Greenspan's aggressive monetary response, the solution to the problem is elementary: reinflate the bubble.

*****

Back in Baltimore...

*** Good news from Nicaragua...

*** "After a peaceful & long electoral day," writes my friend Silvio Lacayo from Managua, "90% of the Nicaraguan voters elected Don Enrique Bolanos as the new President of Nicaragua. International accredited observers to the Nicaraguan elections give the new President an almost landslide victory over the Sandinista Party."

*** "We couldn't be more bullish about this place," adds International Living editor Kathleen Peddicord. "It offers the last great property deals of Central America. It is the quintessential sun-drenched tropical paradise. And now it has assured the world of its commitment to peace and prosperity. Nicaragua has been largely misunderstood and undiscovered. This will change now. Maybe quickly." (http://www.ranchosantana.com)

*** I hope it doesn't change too much. I'm building a house on the Pacific Coast, where I like the wild solitude and the low prices. But it can be lonely for a gringo.

*** The biggest news today is that my son Edward turns 8 years old. Happy birthday, Edward...

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The Daily Reckoning Presents: John Mauldin coming down with a rare case of bullishness. We hope it's not contagious...

DOING THE INTEREST RATE LIMBO by John Mauldin

I have a letter on the wall over my desk from John Wayne to my dad. The letter refers to some legendary WW II poker games. The Duke was gloating. He won. Dad lost. But Dad made it up from Wayne's scotch horde.

My less than sainted father was a games player. His dictum: "Tell me the rules and deal the cards. Just don't change the rules in the middle of the game."

Following the Treasury announcement to ditch the 30-year bond, I am tempted to ask, are the rules changing?

Upon serious reflection I've determined the answer is an unequivocal: Maybe.

In a concerted effort worthy of an Afghan relief mission, the Fed, the Treasury department and the U.S. Congress are trying everything thing they can think of - rate cuts, bond offerings, stimulus packages and more - to re-stimulate the economy. Not the least of which was the Treasury's announcement regarding the 30-year note.

It was a brilliant move. It almost makes me bullish.

But there is more to this than meets the eye, in my opinion. Let's go behind the scenes and see if we can find some clues as to who is really driving this move.

Clue #1: The Fed has cut short-term rates 10 times, and most observers now concede we will see two more cuts, as advertised here months ago.

But the problem the Fed has is that long rates have not come down very much and it is long rates that really make a difference in the economy. Long-term rates are what affect corporate bottom lines and spur recoveries. Greenspan could help a lot of companies get profitable again if he could somehow get long-term rates to come down.

Greenspan cannot be happy about the economy. The economy is in severe risk, not to mention his aura of financial wizardry, as it is beginning to look like he is pushing on a string.

Clue #2: Peter Fisher. Remember that name. He was a former executive vice president at the New York Federal Reserve. He was point man for coordinating currency moves among central banks, and was a key figure in the rescue/fixing of the Long-Term Capital debacle in 1998. At 44, he is on the fast track.

He is now undersecretary at the Treasury department. He was the one who coordinated and made the announcement about 30-year bonds no longer being sold.

Clue #3: Home values have declined for two straight months at a significant pace, somewhere in the neighborhood of 6%. This is significant. We learned this week consumer confidence is down to 85.

Now in the grand scheme of things, and given the circumstances, that is not all that bad. It is certainly no where near any long-term low. There have been times in recent memory when 85 sounded pretty good. It is just that we have come from such extreme highs that 85 looks bad.

The reality is that the consumer confidence number is not all that bleak. As a country, we are still pretty optimistic. But those who really study these things know that consumer confidence is related very closely to employment and home values. We all know unemployment is headed much higher. But home values have been holding up surprisingly well. Since homes values are our central source of personal wealth, we are not all that negative.

But if home values continue to drop for another few months, the mood could turn sour very quickly.

Mortgage rates are a key component of home values. Mortgage rates are closely linked to the rate of the 10- year Treasury. But the Fed can only affect short-term rates. What's a Fed chairman to do?

Clue #4: The country does need some economic stimulus. The $100 billion dollar stimulus package being shoved through Congress is peanuts in the grand scheme of things. We have just watched $5 TRILLION dollars disappear in stock market value. There are scores of companies who have watched their values drop by more than $100 Billion.

If mortgage rates drop by 1%, consumers save $1,000 per year on a $100,000 mortgage. Multiply that across the country, and that becomes huge. And it is every year, not a one time shot. And it doesn't run up the deficit.

Clue #5: Goodbye surplus. Hello deficits. The country is now going to need to raise money. Let's see. Short-term rates are really low and long-term rates are relatively high. If we borrow only short-term money, it will help the budget.

Clue #6: Long-term bonds serve a real role in the economy. They are used by businesses and pension funds to control risk. International investors and banks love them. Without going into a lot of detail, long-term bonds can be used as a way to guarantee returns on other, more risky, offerings. There is a real demand for these investment instruments.

If you cut off the supply of new long-term bonds, the remaining bonds become more valuable. It is the law of supply and demand in action.

Yesterday, long-term bond rates dropped over 40 basis points in one day, as investors scrambled to get a "piece of the Rock". But did you notice that rates on 10-year bonds dropped to 4.25%?

Let's see if we can figure out what happened. Mind you, this is just my speculation. First, Greenspan can't get long-term rates to come down. He calls his buddy Fisher, now the senior guy at Treasury who actually understands where the levers are, and asks for help. Fisher goes to O'Neill and points out that if you stopped selling 30-year bonds you could:

1. Lower finance costs for the government for the growing deficit. 2. Push down the key rate to which mortgages are linked, thereby stimulating the economy. 3. Help prop up home values, thereby helping consumer confidence. 4. Lower the cost of corporate long-term borrowing, helping corporate profits. 5. You get to look brilliant and the only people who get hurt are bond traders and a few hedge funds, and who cares about those whiners?

It is a no-brainer. And who better to do it than Fisher, who has a history of making surprise economic moves? It is like declaring Jacks are wild after you deal the hand and notice you are holding a pair of them.

And because no one suspected or planned for it, it will have a big effect. When we look back 5 years from now, I predict that many economists will point to this Halloween Trick or Treat as a big reason for the economic rebound. That's right I said it...rebound.

Rate cuts do nothing to offset the deflationary winds sweeping the world economy. Deflation is going to push long-term rates even lower, which ultimately is bullish. Then things will change, and we will talk of inflation. But not for awhile.

Jamaican tourists invariably get prodded into a round of Limbo, seeing who can bend back the lowest to get under the bar. Interest rates are now doing the Limbo. How low can we go? Many of the interest rate gurus I follow think we will see 30-year long-term bond rates below 4% in this cycle. Some are talking closer to 3% than 4%. That means 10-year rates could approach 3%. That means mortgage rates could approach 5%. Already you can get 5.125% on a variable rate mortgage with a five year lock-up before adjustments.

I have been saying for years I think we will be able to borrow money at 5% for 30 years in this economic cycle. When that happens I will tell them to back up the truck. I might buy two homes just for the heck of it.

And if you are the government, here's the best part. Just as you changed the rules and said "no more 30-year bonds," you can change the rules again when rates drop close to 3%. Yes, you heard it here first. The government will sell 30-year bonds again. Hide and watch.

I am reminded of the Mel Brooks line in History of the World, Part Two, when he looked at the camera and dead- panned, "It's good to be King."

The guys up at Treasury must be thinking, "It's good to make the rules, especially after the hand is dealt."

John Mauldin, for The Daily Reckoning

John Mauldin is the founder of the Millenium Wave investment strategy: http://www.2000wave.com. He is a frequent contributor to the Fleet Street Letter. For investment ideas consistent with those expressed in this essay, please click here:

Better Than Buffett http://www.agora-inc.com/reports/FSUS/TheBuffetWay

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-- PHO (owennos@bigfoot.com), November 07, 2001.

Response to U.S.: Will U.S. emulate JapanÂ’s long slide? (Wall St. J.)

Not likely, since we are a nation of chronic non savers unlike the Japanese who refuse to spend money. Additionally the Japanese population is graying faster than ours.

-- Steve McClendon (ke6bjd@yahoo.com), November 07, 2001.

Response to U.S.: Will U.S. emulate JapanÂ’s long slide? (Wall St. J.)

Luckily, I was holding 100 December bond calls on Halloween. So, Treasury's Trick was, for me, a REAL Treat. I sold immediately, right into the rally that dropped the rate (temporarily--for only a few hours) below 4.70. First time in my life that I EVER caught a market at the VERY TOP. Thank you, Mr. Fisher.

And, I agree. This was a brilliant, strategic maneuver. This will force long-term rates down nicely over the next few years, long enough to launch recovery, then, lookie here, wonder of wonders, the 30-year bond is back.

-- JackW (jpayne@webtv.net), November 07, 2001.