Why they will "Print It"
An interesting article by Milhouse which argues that the US will inflate its way out of the coming crash. Great comparison with Japan.......
"IN REAL TERMS
Between its 1929 peak and its 1932 nadir, the US stock market (as measured by the Dow Jones Industrial Average) lost around 90% of its value in nominal dollar terms. In real terms the loss was much less because a 1932 Dollar had far greater purchasing power than its 1929 counterpart, thanks to a substantial contraction in the money supply (deflation). At the low point for the US stock market in 1982 the Dow traded almost 300 points below its 1966 peak for a nominal loss, over the 16 year period, of 25%. However, in real (inflation adjusted) terms, the loss was about 70%. In other words, when we account for the changes in the purchasing power of the Dollar we find that the 1966 E1982 equity bear market was just as severe as the 1929 E1932 stock market crash. This example demonstrates the inadequacy of using nominal dollars to measure investment performance and highlights a serious flaw in the 'buy and hold' investment mantra as applied to the overall stock market.
By the same token, the complete picture of the depth of the bear market in gold cannot be appreciated by looking at nominal price alone. From its peak of $875 in January 1980 until now, the US Dollar gold price has dropped by around 69%. However, simply considering the change in price does not take into account the fact that during this period the total supply of US Dollars increased at a much greater rate than the total above ground stock of gold. A more appropriate way of viewing the change in the relative valuations of US Dollars and gold over this period is to compare the value of the following ratio for January 1980 and May 1999:
Gold/Dollar Ratio = (Total Above Ground Gold Stock) x (US$ Gold Price)
(Total Supply of US Dollars)
What we find is that the Gold/Dollar ratio has declined by around 87% over the period in question. In other words, as improbable as it may seem, the bear market in gold since 1980 has been even worse than it appears on the surface. This is another argument against having blind faith in a 'buy and hold' strategy, even when it comes to gold.
In real terms, the stock market crash of 1929 E1932 was similar in scale to the sideways trading which occurred between 1966 and 1982. However, using nominal dollars to compare the two markets paints a completely false picture due to dramatic changes in the purchasing power of the Dollar. In real terms, gold's bear market has plumbed greater depths than either of these equity bear markets, providing anecdotal evidence that we are in the closing stages of the decline.
When we try to forecast the performance of the stock market indices, or any other asset prices for that matter, it is essential to firstly forecast the rate at which the currency will lose purchasing power. We cannot say that the Dow is going to fall by 90% during the next bear market simply because that is what happened the last time we reached a bubble top. Those who believe the US stock market will drop to a level of 2000 or lower on the Dow at some point during the coming equity bear market are still thinking in terms of the 'Fixed Rate Gold Convertible' monetary system that was in place during the 1929 E1932 crash. Our current 'Non-Convertible Free Floating IMF Bailout G7 Exchange Rate Jawboning' system imposes no limitations on the creation of money and, as such, will mask the real fall in equity values (and exaggerate the rise in the gold price).
At this point it is worth re-visiting a speech made by Alan Greenspan in January 1997, during which he made the following comments:
"Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency."
When he says that Central Banks can "discount loans and other assets" he means that they can purchase loans (which may be in default) and assets (such as real estate) with newly created money at a discount from book value.
The question is, when a debt crisis occurs in the US, will the Fed act to remove non-performing loans from the banking system by purchasing these loans with new money that the Fed creates? Such an action would, after all, result in a massive depreciation of the Dollar leading to increased inflation (of the CPI kind) and higher long-term interest rates. Fortunately (or unfortunately as the case may be), in 1998 we were given a preview of the way in which the US monetary authorities will respond to a crisis that threatens liquidity in the debt markets. Between October 98 and December 98 Fannie Mae and Freddie Mac, the two federal institutions that are responsible for ensuring a liquid mortgage market, expanded their assets at an annualised rate of 75%. Fannie and Freddie do not create credit directly, but they do create an environment that enables the banks to expand credit (for 'credit' read 'money'). Their remarkable efforts, in combination with the Fed's three interest rate cuts, were responsible for rejuvenating the world's greatest credit expansion and its offspring (the stock market bubble).
Based on the events of 1998, is there really any doubt that the Fed will provide whatever additional credit is needed to avoid a financial crisis? In actual fact, a crisis cannot be avoided, but it can be converted from the liquidity type to the currency depreciation type. The advantage of currency depreciation is that the painful side effects appear gradually over time and can generally be blamed on others (during the 1970s the Arabs were blamed).
It should be noted that the Japanese have chosen not to monetise away their debt problems. They have, instead, embarked on one fiscal stimulus programme after another in their attempts to revive the economy. In the process they have amassed an enormous government debt whilst non-performing loans continue to be a giant millstone around the neck of the banking system. Until the non-performing loan issue is resolved, the banks will be unable to lend money to support the country's businesses. However, taking a US style approach whereby the Bank of Japan simply purchases (discounts) all of these bad loans may not be a political option in Japan. The Japanese people are, after all, the world's greatest savers. Any government action that reduces the value of those savings is likely to be met with overwhelming resistance, particularly if the beneficiaries of such action are seen to be the banks. This dilemma does not exist in the US because the average US citizen does not have any savings. In the US the politically correct course of action is to do whatever it takes to maintain a liquid debt market and upward trending stock market.
The bull market in US stocks which began in 1982 and continues today (although in a seriously weakened state) ranks with the greatest manias of all time. The greatest booms are inevitably followed by the biggest busts, so the coming bear market will not be pleasant. In real terms (adjusting for inflation/deflation) the maximum loss this century from a bull market top to a bear market bottom has been around 70%, so it would not be unreasonable to expect the major US share market indices to lose 70% of their real value during the next 3 years. However, don't expect to see the Dow dropping by anything like the 7,000 points that such a decline may suggest at first glance. A large part of the fall will be shielded from public view by the depreciation of the Dollar.
Milhouse
Hong Kong
7 June 1999
The reader is invited to respond to Milhouse's wisdom via email: sas888@netvigator.com" |
