He's Forever Blowing Bubbles by Gary North
Until 2000, the investing public believed that Alan Greenspan could
do no wrong. He was untouchable. Now, however, doubts have begun to
be voiced in some quarters (1st quarter, 2nd quarter, etc.) –
doubts, as the Bible puts it, like clouds no bigger than a man's
hand.
He would prefer to go down in history as Benjamin Strong did. Strong
was Governor of the New York Federal Reserve Bank in the 1920's.
This bank set FED monetary policy in that era. He had the good sense
of timing to die in 1928, missing the inevitable result of his own
inflationary policies: the Great Depression. People said then, and
economic historians say now, "This never would have happened if
Benjamin Strong were alive." Yes, it would have. Had he never been
Governor, the economic disaster in the United States would have been
minimized. That is because somebody other than the "significant
other" of Montagu Norman, the head of the Bank of England, would
have run the FED in the 1920's. When Norman asked Strong to open up
the American money spigot in order to keep gold from flowing out of
England to America, Strong complied. A different FED Chairman would
have told Norman to take a hike . . . alone.
Then again, probably not. Irrespective of their personal ties that
did not legally bind, both men were in the hip pocket of the Morgan
Bank – and that tie surely did bind. In a review of a newly
published book on the history of American banking, articles written
by the late Murray Rothbard, Dr. David Gordon writes:
At Norman's behest, Strong inflated the U.S. monetary supply, in
order to enable Britain to maintain in operation the gold-exchange
standard. By doing so, Rothbard claims, Strong bears heavy
responsibility for the onset of the 1929 stock market crash and the
ensuing depression. "The United States inflated its money and credit
in order to prevent inflationary Britain from losing gold to the
United States, a loss which would endanger the new, jerry-
built 'gold standard' structure. The result, however, was eventual
collapse of money and credit in the U.S. and abroad, and a worldwide
depression. Benjamin Strong was the Morgan's architect of a
disastrous policy of inflationary boom that led inevitably to bust"
(p. 271).
Rothbard goes even further in his assault on Federal Reserve
inflationism. Contrary to Milton Friedman, the Federal Reserve did
not follow a contractionist policy once the depression began.
Rothbard assails "the spuriousness of the monetarist legend that the
Federal Reserve was responsible for the great contraction of money
from 1929 to 1933. On the contrary, the Fed and the administration
tried their best to inflate, efforts foiled by the good sense, and
by the increasing mistrust of the banking system, of the American
people" (p. 275).
Greenspan has faithfully followed Strong's inflationary policy, and
has upped the ante. Every time there is the threat of a major
crisis, such as the Asian meltdown in 1997 or the LTCM crisis in
1998 or the Y2K threat in 1999 or the 9-11 threat in 2001,
Greenspan's FED has cranked up the digital printing presses. These
crises are becoming more frequent as his term as Chairman grows
longer.
He began his career as Chairman with a crisis: the 508-point one-day
collapse of the Dow in October, 1987. The FED responded that
afternoon with the promise of liquidity, i.e., the printing press.
That tactic has now become FED strategy. As Franklin Sanders says,
the FED has only two tools at its disposal: fiat money and blarney.
Greenspan's blarney has been identified by James Grant as central
banker Esperanto. It doesn't impress Congressmen quite so much any
longer.
The question today is this: Will Greenspan die before the dollar
does? Right now, the odds are just about even.
FRED SHEEHAN'S MASTERPIECE
Once in a while, someone writes an article that is close to perfect.
I recently came across one. It puts in plain English the most likely
threats that the American economy is facing and will face until
there is a final blow-off (inflation) or breakdown (deflation), or a
sequence of these events: mild deflation, inflationary blow-off, and
a switch to a new currency.
The article appeared in the April issue of Dr. Marc Faber's Gloom,
Boom, and Doom newsletter, which I regard as one of the best. Dr.
Faber also writes a monthly column with the same title in Strategic
Investment. I usually read his article first. In the April issue,
Dr. Faber wrote an excellent essay on SARS and its potential for
doing harm. As background, he provided a history of the Black Death,
which hit the West in 1347. I have researched that event
sporadically for almost 40 years, and I regard his essay as a very
good introduction. It shows what a pandemic can do to an economy.
The world has not seen anything like it since, but now we have
biological warfare and ever-less expensive equipment. One of these
days, we may see something like the Black Death again. Ah, the
wonders of technology!
Sheehan's proposed scenario is much less of a long-shot. I regard it
as a sure thing, short of something far worse: what Greenspan called
cascading cross defaults, i.e., a bank payments gridlock. So,
Sheehan's scenario is not a worst-case scenario. But it's bad
enough, and the odds are far better that it will take place.
His thesis is that all of the fancy mathematical analyses are no
guarantee that the geniuses and their computer programs will keep a
major disaster from happening. The experience of Long Term Capital
Management is the classic example. Two Nobel Prize-winning
economists wrote the formulas, but LTCM's near-collapse in 1998
threatened to create one of Greenspan's cascading cross defaults.
We get lots of predictions, but they aren't worth much. Example:
Conventionally minded analysts draw amazingly precise
interpretations from opaque data (say, the same-store sales report)
and will surely reverse their market prediction tomorrow if the next
(say, GDP figure) will help their latest (but easy to revise) market
prediction. According to Paul Krugman, two years ago, the
Congressional Budget Office (CBO) projected a US$5.6 trillion
federal budget surplus over the next ten years. Now, the CBO
predicts a US$1.8 trillion deficit through 2013. We could have fired
the entire Congressional Budget Office apparatus and obtained a far
more accurate prediction if a single person looked at the incredible
rise in capital gains tax receipts. The general trend of household
net worth from stock market gains rose from US$2.8 trillion in 1995,
to US$2.5 trillion in 1996, to US$3.8 trillion in 1997, to US$3.3
trillion in 1998, to US$4.75 trillion in 1999.
So armed, the average Denny's burger chef would have seen that the
surpluses were never to be. Or this: the US states' pension plans
have swung from a US$112 billion surplus in 2001 to a US$180 billion
deficit in 2002. Did many (still addressing the average Wall Street
Journal reader and believer) stop and ask how did this enormous
mountain of money grow so quickly? If they spent five minutes
hunting for an answer, doubts to the future would lie exposed.
But doubts of the future must not be exposed. The inevitable
statistical reality of Medicare and Social Security will not be
faced by anyone in authority, including free market economists who
have bet their reputations on this slogan: "Deficits don't matter."
But deficits do matter, and these aging economists had better have a
pile of assets other than a promised pension from their non-profit,
501(c) employer or their TIAA-CREF fund to get through their golden
years on a diet more appetizing than Alpo. Sheehan continues:
I think we are at a similar point today. During the (ongoing)
bubble, hotshot ideas attract massive inflows which, in time, become
outflows. First was the Internet, then telecom (which locked arms
with the disappearing corporate bond market), then all of
technology, then these avalanches of federal, state, and municipal
debt sprung up from nowhere (at least to those busy spending the
huge and unanticipated tax receipts), and next it will be us. Once
the housing market goes, the means of expansion is the
Collateralised Debt Obligations (CDOs) and Collateralised Bond
Obligations (CBOs) market. CDOs are a collection agency of every
debt owed by anyone that the lender is willing to sell. Investment
banks corral thousands of these debt claims and turn them into CDOs,
a bond. The CDOs are impossible to understand in detail, so they are
mathematically modelled to predict how they will behave in
aggregate. These jigsaw puzzles include such loans as houses, cars,
boats, motorcycles, and – facelifts. Yes, in Doug Noland's February
28 Credit Bubble Bulletin (free of charge on the Prudent Bear
website), we learned that facelifts are now being packaged into CDOs
and the receipts from those loans will pay the bond buyers. So, for
those asking whether this credit bubble can possibly go on, yes, at
least for a while. If face lifts, why not dental bills, barber
shops, the idyllic lemonade stand?
Debt. There is a growing mountain of debt, a Himalayan range of
debt. It is cobbled together in millions of contractual obligations.
Its complexity is beyond the power of men or computers to
understand. We are asked to trust the free market to bring order out
of the apparent chaos of hundreds of millions of contracts.
Unfortunately, the entire credit/debt system rests on central
banking, and there is nothing free market about these government-
created monopolies over money. The entire system now rests heavily
on Mr. Greenspan's ability, in the language of B-westerns in 1938,
to head the bad guys off at the pass.
MEEKER AND HICKEY
Sheehan compares the analyses of Mary Meeker, who wasn't meek, and
Fred Hickey, whose role surely matches his surname.
I will now quote from an analyst who writes about the real world.
When Mary Meeker was "Queen of the 'Net,'" holding daily TV
interviews and signing ball caps, Fred Hickey was checking the
shelves at Best Buy and Circuit City and asking the salesmen about
their Christmas bonuses. Long before the rest of the world caught
up, Fred told his readers that the stuff was sitting on shelves. The
retailers couldn't sell it, and Dell was not a stock to own.
I turn now to Hickey's February 20, 2003, High-Tech Strategist. In
the first paragraph, he explains the vacuity of thinking on Wall
Street. I'll only add: they still don't understand why the market
collapsed, so they won't understand what is required for a real
recovery. In the second paragraph, he writes what we will not read
in a general circulation periodical. As far as I know, Wall Street
research is equally ill-prepared for such a discussion. Hickey
plants a physical image in the mind of the reader. Of the here and
the now. Of why this bear market is different from any that most of
us have lived through. We are sinking under several trillion dollars
worth (as carried on the balance sheet) of capital equipment that
will never be used. The debt load is so great at every seam of the
economy that companies cannot keep up with their debt payments,
never mind investing in equipment that might find a new application.
From the High-Tech Strategist:
The stock bulls remaining in this market have never grasped how
enormous the bubble of the late-1990s was. They've never understood
just how great the imbalances were. They've never comprehended the
vast amount of tech overcapacity created during the bubble period.
For three consecutive years they've suffered compound double-digit
losses in their favorite Nasdaq tech stocks as they've hung on to
the notion that a rebound was imminent. There have always been
excuses to explain away their incorrect bullish forecasts. If not
for the 9/11 terror attack, the economy and the stock market would
have recovered in 2001. If not for the corporate scandals (Enron,
WorldCom, etc.) the economy and the stock market would have
recovered in mid-2002. If not for the Iraq worries, the economy and
the stock market would currently be booming.
However, when the war is over (hopefully quickly and successfully),
the bulls will learn that the excesses generated during the 90s boom
are still with us and will need further time to correct. There's
still years worth of fiber optic capacity in the ground.
Distribution channels (including EBay) are still littered with
excess networking equipment such as switches and routers and
gateways. A tiny fraction of the Internet hosting capacity that was
built is currently used. Thousands of unprofitable, cash draining,
start-up companies are still barely eking out an existence by living
off funding received during the boom. There are too many wireless
carriers with too much debt. Excess semiconductor foundry capacity
is enormous and is exceeded only by the capacity of semiconductor
equipment manufacturers themselves. There's so much DRAM
manufacturing capacity that prices fall every day, yet even more
capacity is being brought on line. . .
So much for Hickey's assessment, as of last February. Sheehan
explains what all this means.
That's it. That is our financial burden and will remain so for a
long, long time. When the analysts coo about the "productivity
miracle" (another sign of the times: miracles have been downgraded
faster than Ford Credit), they are talking about assets sitting in
the junkyard. High-Tech Strategist readers know that. There is no
sign that the media conduits (the intermediaries between Wall Street
and investors) have a clue. If they do, they aren't talking. If only
this were the extent of the problem. Far worse, the junk is still
sitting on the balance sheet, labelled an "asset". The left side of
the balance sheet is often rubbish. It doesn't help that the worst
of these companies borrowed far too much and are facing long odds to
pay back their debt. Nor does it help that corporations are making
less money every day.
He then quotes Dr. Kurt Richebacher, who has pointed out that
profits as a share of GDP have fallen from 6.7% in 1997 to 4.3% in
2000, to 3% today.
DERIVATIVES: $100+ TRILLION IN DEBT OBLIGATIONS
The derivatives market is an interconnected system of debts and
credits that are based mainly on expected earnings of assets of all
kinds. Sellers of expected earnings discount them in a highly
leveraged financial futures market. Winners and losers offset each
other in any transaction. It's a zero-sum game: for every loser,
there is a winner, assuming – the central assumption on which our
civilization rests – the loser pays off. If he doesn't, "the knee
bone's connected to the thigh bone; the thigh bone's connected to
the hip bone." It's cascading cross defaults time!
The experts are as baffled as you and I are regarding the
implications of all this. Sheehan comments on the knee-jerk reaction
of the salaried article writers, who own no investments other than
their mortgaged homes and their third-party–managed pension funds.
He contrasts their flippant optimism with the opinion of a man worth
about $25 billion, who made his money by investing.
In mid-March, Warren Buffett launched a Tomahawk missile against the
dangers of derivatives. The [Wall Street] Journal took exception in
an editorial, titled, "Derivative Thinking." In a compare and
contrast exercise: we start in the first column: "Derivatives are
one of the major innovations of the past three decades. These
instruments are little miracles [another downgrade] of financial
engineering, permitting investors to take a position, or make a bet,
without actually having to hold the physical asset. Rather, the
value of a derivative rests on the underlying security or a
particular reference. . . . " Now, from the second column: ". . . [F]
inancial accounting for derivatives is a mug's game. Valuing
derivatives on a mark to market basis can be an exercise in fantasy.
For many derivatives, the trading is so thin that valuation models
must be used and those models can contain a great deal of
unwarranted optimism. The result is inflated earnings." So, these
little miracles cannot be valued; can be highly illiquid; hold the
characteristics of non-continuous markets, which is a contradiction
of derivative models; the models can be rigged; and successfully so
since nobody knows how to value derivatives. It is from these voices
that many intelligent people form their knowledge of the markets.
CONCLUSION
I have summarized only a few of the insights of Sheehan's essay. But
His conclusions regarding your financial response to all this are
worth citing.
The top priority is to preserve your purchasing power. "Purchasing
power" is not "principal". Domestic money market assets will yield
limited protection in the US. They will not protect an investor from
the ravages of a collapsing dollar. It fell 70% against the Swiss
franc in the seventies. It fell 63% against the deutschemark between
1985 and 1995. It may very well do so again. There are funds that
invest in a combination of foreign money markets and gold. To look
at the securities held in one of their funds is to create a short
list of countries with strong balance of payments surpluses. Other
types of securities in these countries, such as common and preferred
stocks, are worthy of study.
A way to think about investing today is to stand in the opposite
corner of all that has reached untenable levels and proportions.
Start with US Treasury bonds. Second, do not feel any compulsion to
buy common stocks. However, the data from Lipper above shows where
the dumb money is overweighted and where it is underweighted.
Residential real estate is in for a real thumping. This is an
example of where liquidity can pay off in spades. In the early
1990s, banks auctioned foreclosed properties in the Boston area, and
people showed up with the cash to buy houses at deep discounts.
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