Since then, it has been known as “The Friedman Effect.”

It’s important to understand the Friedman Effect because it can have dramatic impact on your investment decisions and your portfolio…

Milton Friedman & The Friedman Effect

Basically, Milton Friedman found that if the Fed switched from tight money to easy money, or vice versa, it would take about six months before you would see any change in the direction of the economy or Wall Street.

The Friedman Effect worked like clockwork during the financial crisis of 2008. In late 2007 and early 2008, the Fed decided to squeeze the money supply and impose a credit crunch on the financial markets to slow down the real estate boom. The Fed got more than it bargained for. Its tight-money policy had a dramatic impact – the real estate market crashed and took the financial markets with it.

The Fed panicked and in September, 2008, Ben Bernanke & Co. reversed course and injected billions of dollars into the marketplace. The Fed’s balance sheet (see chart below) doubled in a few months as the Fed acted aggressively. Among other bold efforts, the Fed bought Treasuries and mortgage-backed securities directly in an effort to stem the tide of a deflationary collapse.

As you can see from the above chart, the Fed’s bank account (Adjusted Monetary Base) doubled in short order in 2008-09.

The Friedman Effect – Pinpointing The First Signs of Recovery

According to the Friedman Effect, that means the first signs of a recovery and stock market rally would occur six months later. Sure enough, in March, 2009, Wall Street bottomed out and roared ahead in one of the strongest rallies in Wall Street history. The S&P 500 Index has climbed an incredible 34% from its lows of March 8.

Moreover, we’ve seen sure signs of stabilization in the financial markets and the economy. The Libor rate – the interest rate banks charge each other to borrow short term – has fallen sharply, an indicator that the financial crisis is ending.

Many economic indicators have also turned positive. On Thursday, the Labor Department announced that the total number of people filing for unemployment insurance fell by 148,000 to nearly 6.7 million in the week ending June 6. That was the largest drop in more than seven years, and snapped a streak of 19 straight record-highs.

The best overall indicator of a possible recovery is the U.S. Index of Leading Indicators published monthly by the Conference Board, a private research group based in New York. The Ten Leading Indicators are designed to forecast the economy in the next three to six months. Most of the indicators are business related, such as new orders for capital goods, building permits and unemployment claims – and, I might add, the stock market and real money supply growth. The Conference Board also surveys the leading economic indicators for 10 other countries around the world.

The Board reported that the U.S. Leading Indicators fell sharply over the past year, and finally bottomed out – in March of this year! The leading indicators have now risen two months in a row. And on Thursday, the index rose 1.2%, the biggest gain since March 2004.

• In short, the good news is that the U.S. economy is slowly but surely on the road to recovery.
• The bad news is that the Fed has apparently decided to step on the brakes again, reversing course in its monetary policy. The days of quantitative easing are apparently over. As the graph above indicates, the Fed has stopped adding to its balance sheet – the adjusted monetary base has stopped growing.

The broader-based money supply (M2) was growing at double-digit rates until a few months ago. Now’s it’s growing at only 2% or less.

This tight money policy could spell trouble down the road if it continues. The stock market will probably continue to push higher for now, due to the lag time in the Friedman Effect. The Dow might even reach 10,000 by the end of this year. But if the Fed maintains this new tight money policy, we could be in for another rough period and a return of the bear market.

Source: The Friedman Effect: Is Another Bear Market Around the Corner?

There’s a hold up in the Bronx,
Brooklyn’s broken out in fights.
There’s a traffic jam in Harlem
That’s backed up to Jackson Heights.
There’s a scout troop short a child,
Khruschev’s due at Idlewild
Car 54, Where Are You?

Yes, crises abound for this modern-day Toody and Muldoon of the finance world. But it’s their own fault; former academic Ben Bernanke and lifelong government apparatchik Timothy Geithner have opened up a Pandora’s Box with the Bear Stearns bailout.

Sen. Chris Dodd (D-Conn.) recently pushed for help to re-liquefy the student loan market, but according to Bloomberg, that’s just the beginning:

Former Fed officials andother Fed-watchers say that Bernanke’s actions in saving Bear Stearns will expose the central bank to continuing pressure touse its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd’s request today, expanding the swaps to include securities backed by student debt.

Former St. Louis Fed chief William Poole cites Fannie Mae as a likely next candidate. And traders are betting on still others back in the investment-banking sector:

The cost of default protection on Merrill Lynch & Co. debt fell to 1.4 percentage point by April 30 from 3.3 percentage points on March 14, CMA Datavision’s credit-default swaps prices show. The cost of protection on Lehman Brothers Holdings Inc. securities has fallen to 1.5 percentage points from 4.5 percentage points over the same period.

No wonder Anna Schwartz, Milton Friedman’s collaborator on “A Monetary History of the United States,” calls the Bear bailout a “rogue operation” that the Fed had no business conducting. But it’s too late now. The Fed is fueling expectations of more and bigger bailouts. It can’t end well.

Total Fed Credit, the actual source of the fabled Money From Thin Air (MFTA), was surprisingly down by $8.7 billion last week, which is NOT the kind of thing you need if you are trying to buy your way out of the big stinking mess you have made. And you can believe me as a guy who has tried to buy his way out of a lot of embarrassing messes over the years!

First thing you do, usually, is carefully forge your wife’s signature on some stupid forms so that you can quietly draw down your savings or tap the kids’ college funds or something. Sure enough, the Fed’s own stash of government debt was suddenly down another $28 billion last week, about 5% of their total stash gone in one week, as those Fed weenies flail around in their hysterical panic at the mess that they have made with their ridiculous neo-Keynesian, econometric theory and laughable computer models.

Like, one of the supreme stupidities of the Federal Reserve is thinking that there is no upper limit on debt, and now they believe that growth in asset prices via additional money and debt is more important than controlling inflation in consumer prices, which is caused by the additional money and debt! Hahahaha! Theater of the Absurd at its best!

And it isn’t just the Greenspan and Bernanke weenies, but also Milton Friedman, the “father of the monetarist school of economics”, who never saw too much debt as a problem, and who only cautioned that the money supply should not grow too quickly. As Darryl Robert Schoon of drschoon.com writes, “Markets dependent on credit-based paper money produce increasing levels of debt until the amount of debt becomes unsustainable. This is where we are today. The growth, contraction and coming collapse of debt based credit markets is Friedman’s legacy, not free markets. Friedman’s theories gave bankers the intellectual cover they needed to indebt America beyond its ability to repay and indeed survive. Hailed as the champion of the free market, Milton Friedman was, instead, its leading assassin.”

As a result of all of this monetary madness in the past year alone, the dollar is down roughly 20% in comparative purchasing power against key currencies! In one year! What this means to you and me is that, on a stand-still basis for foreign exporters, we would have to pay prices that are 20% higher for our imports, just for them to break even when converting dollars back into their native currencies! Hahaha! We pay more for things! Welcome to the hell of a falling currency!

But there is so much panic that the Fed and the government are doing weird things, and sure enough, even a cursory glance at the repo market, as made handy at 321Gold.com, shows that absolutely astonishing sums of money are flying around through the banks, being lent on a short-term basis, to the tune of (hold onto your freaking hat!) $40 billion per DAY! And more! Per day!

And all of the money being pounded into the economy by the federal government and the Federal Reserve is finally making the prices of commodities rise in a general inflation. But with all this new money being created by the central banks looking for somewhere to go, the world is not producing any more commodities, as we learn from an interview of Jimmy Rogers, identified as a “private investor” in Barron’s this week, who says, “the commodities market started in early 1999. But nobody had brought on any new supply of anything in the last 25 or 30 years. The last gigantic oil field was discovered in the 1960s. The number of acres devoted to wheat farming has been declining for more than 30 years. Food inventories are the lowest they’ve been in 60 years.”

In short, be prepared for huge inflations in food prices, and generally all commodities, too, which will get so bad that it will “end in a bubble and hysteria”, which he figures will peak in 2018. Maybe.

Anyway, he summarizes that “the real problem is that our foreign debt is increasing at a rate of $1 trillion every 15 months.” Yikes! He’s right!

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Editor’s Note: Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter – an avocational exercise to heap disrespect on those who desperately deserve it.

According to a new book by Robert Auerich, Deception and Abuse at the Fed: Henry B. Gonzalez Battles Alan Greenspan’s Bank, nobody seems to be able to track down the Maestro’s dissertation, which led to Greenspan obtaining a doctorate in economics from NYU.

According to Barron’s:

For years, NYU told the public that, at Greenspan’s request, the thesis was locked away from public view in a vault at its Bobst Library. Auerbach himself was told this in January 2004 when he tried to obtain a copy.

Auerbach, who has a Ph.D. in economics from the University of Chicago (Nobel laureate Milton Friedman was his thesis adviser), kept requesting access to the papers until NYU’s provost, David McLaughlin, finally admitted in August 2005 that, “I can tell you that it was the practice of the business school, during the 1970s, not to deposit dissertations with the library. Thus, a copy of Greenspan’s dissertation is not in the Bobst Library. We suggest that you contact Greenspan directly in order to obtain a copy of his dissertation.

Barron’s did exactly that but was told by Greenspan’s spokeswoman that “his busy travel schedule precluded him from getting back to us in time for our deadline.” As for two inquires to the provost, they also went unanswered.

Such a story may not come as a surprise to those skeptical of the merits of centrally planned economics.

“We doubt that the science of as practiced by Bernanke, King and Trichet is really any more reliable than the science of modern portfolio management as practiced by the geniuses at Bear, Lehmann and all the others,” says Bill Bonner.

“We take as a given that central planners are as prone to error as a bear to honey. It also seems likely to us that it was a mistake for Alan Greenspan to cut rates so aggressively in ’02-’03 and leave them below the inflation rate for so long. The result was an orgy of spending and borrowing in the Anglo-Saxon economies…and an orgy of factory-building and capital formation in Asia. In both parts of the world, people missed their marks – overdoing it considerably.”