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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Storm Watch:
Parallel Times -- "Those
who cannot remember the past are condemned to repeat it."--George
Santayana
(Feb 8, 2002)
by James J. Puplava / Financial Sense Online
History has a habit of repeating itself. The same mistakes made in the past can often be viewed in the present. The background and the players may be different, but the parallels are there for all to see. So it should come as no surprise that the burst of the 1990's stock market bubble would be compared to similar events in 1929 and the 30's. There are many commonalities that appear vividly familiar. The technology boom of the 20's runs strikingly parallel to the tech boom of the 1990's. The infatuation of the public with the stock market, and the degree with which stocks became vehicles for speculation, resemble the broader sentiments of today's stock market investor. The 1920's stock market investor knew little about investing or the stocks that were bought or sold. Investors moved in herds in and out of stocks based on news events, hot tips or the actions of the ticker tape. Today's momentum investor and day trader follow similar tracks. News is what moves markets as does the action of the tape. In many ways, nothing has changed since the 1920's.
It can hardly be said that the
last five years of the last decade taught us anything new about
speculation. Theories were invented to justify the rise in stock
prices. The "New Era" theory and the miracle of technology
became the mantra and impetus for money that poured into the technology
sector. Wall Street willingly obliged investors who blindly paid
higher prices for overly inflated earnings by telling them it
was different this time. The parabolic rise in technology
stocks was further explained away by Wall Street spin telling
investors that investment yardsticks were no longer applicable.
In fact, the most troubling aspect about the last decade was the
use and application of the word investment. It became the
masquerade for speculation. Prior to the advent of the "New
Era," there were sound investment principles that guided
the selection of common stocks for investment. The concept of
buying stocks at reasonable prices and then holding them for long
periods of time until their value was recognized was completely
abandoned. The wise men of investing like Graham, Templeton, and
Buffett were no longer revered. They were replaced by hedge fund
managers or day traders who had become rich through speculation.
What Ever Happened to Honor, Integrity, Trustworthiness, and Soundness?
Wall Street aided and abetted this speculation by emphasizing earnings without examination or emphasis as to their quality. The leading investment houses before the bubble were able to resolve the conflicts of interest by guiding their clients while still making money for themselves. The firms' reputation and continued existence depended on the soundness of their advice and the quality of the products they sold. In many ways, they acted as fiduciaries in a relationship of trust for their customers. That relationship began to blur as the buy and sell side of the business began to merge. Investment banking fees became more important to a firm's bottom line. With the plethora of IPOs manufactured by the investment banking side of the business, analysts became nothing more than pitchmen for the firm's new offerings. Eerily, this resembles the late 1920's when investment houses relaxed standards of safety on many offerings of inferior grade. Back then, like today, many of the methods of analysis used to sell the new offering were clouded by questionable methods in presenting the facts. In today's investment era, we've seen clicks replace bricks and eyeballs and stickiness replace earnings and a sound balance sheet or business model.
We All Share in Complicity
None of what went on in the 20's, or for that
matter the 90's, would have been possible without the cooperation
of the investment public. The insatiable desire to get rich through
the stock market and especially in new IPOs produced a need for
new issues that Wall Street was only too willing to supply. The
fact that human emotion and public psychology lent itself toward
speculation set the stage for the bubble. In the early years of
the bull market, the rise in stock prices closely resembled the
improvement in the business cycle. During the later stages of
the bull market in both the 20's and the 90's, stocks rose disproportionately,
inflated by unbridled optimism and speculation.
One of the more remarkable aspects of the 90's bull market is the dearth in earnings to justify a parabolic rise in stock prices. Corporate earnings remained sub par throughout the decade. They were elevated by a drop in interest rates at the beginning and then by financial engineering in the later half of the decade. In fact, as Buffett pointed out in his 1999 Fortune interview, "The rise in equity values since 1981 beats anything you can find in history". Even though profits were below normal as a percentage of GDP, interest rates were abnormally high at the beginning of the bull market. The drop in interest rates and the change in public psychology became the fuel for the greatest bull market of the 20th century. As Buffett elaborated, "Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov's dog, these 'investors' learn that when the bell rings - in this case, the one that opens the New York Stock Exchange at 9:30 a.m.- they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich." 1
Right on One Issue,
Wrong on The Other
it
wasn't interest rates . . . it was the supply of money
The infatuation with wealth and the desire to get rich quickly helped to set the stage for the market's ultimate collapse. Contrary to popular fiction, the Fed's tightening of interest rates had very little to do with the market's demise. As this graph of money supply indicates, monetary aggregates continued to grow before and after the market's descent. The erroneous assumptions made during this period and the focus on immeasurable intangibles could no longer support and justify higher prices. During the 1920's, investors were told similar stories. Intangible factors such as goodwill, expected earnings power, and management were the main impetus for making an investment decision. The fact that these factors were difficult to quantify made it easier to sell inferior investments to the investment public. Fast forward to the late 90's and a similar parallel can been seen. Wall Street pedaled hundreds of dubious investments -- many of which had no possibility for profits or even a successful business model.
Scratch My Back and I'll Scratch Yours
It was the absence of sound investment principles and the urge to forget them which contributed greatly to the excesses of both eras. Instead of investment stewards, Wall Street became the fox that fed on the lamb. The Street developed a symbiotic relationship with the press that became the conduit for the stream of hype that fed investor psychology. Wall Street needed an advertising source to drum up demand for its pipeline of new offerings. The media needed stories and ratings. The two fed on each other and the myth of the "New Era" was born. The media not only fed the growing level of speculation in the market, they also created some of its more prominent stars. The wise men were ignored and replaced by analysts and Wall Street pitchmen.
Financial Tinkering ~ Pick-a-Pocket or Two
Another similarity between the two eras was the lack of good financial information and the propensity for financial engineering. During the early part of the 20's, security analysis had advanced sufficiently enough to become a science. Analysts and investors paid careful attention to financial reports and statistical data on a company in order to make an intelligent investment decision. This caution was thrown out in the wind beginning in 1927 when the real mania began. From that point forward, the "New Era" mantra took over and any pretense of analysis was completely abandoned. Analysis and research was still being done, but for different reasons. It began to be used as props to support the hype of boiler room brokers. The facts and the figures were still there, but they were manipulated and twisted to support the popular delusions of the period. In fact, much of the financial information used to drive stock prices began to be manipulated for the benefit of insiders. Rightfully or wrongfully, brokerage firms began to make outlandish predictions about a stock's earning power. This became the basis for justifying a higher price for a security. The fact that the future is unknown -- much less predictable -- was ignored by the unquestionable belief in sound analysis.
Investment yardsticks that were
once considered to be prudent gave way to popular delusions. Before
1927, the common standard of measurement for a stock was considered
to be 10 times earnings. This usual method for valuing stocks
was superceded by a whole host of confusing data that valued stocks
in a much more liberal way. Stocks in different sectors were accorded
different valuations especially in the favored issues of the day
in radio, retailing and public utilities, all of which were considered
to be the premier growth stocks.
Fickle, False, and Downright Fraudulent
As the investment mania began to take root between 1927-1929, more and more of what was being reported in financial statements bordered on fraud. The deception was taking place not only on the financials, but also in stock offering memoranda. The result was that fraud and deceit became rampant. The number of bogus securities issued and false information presented to investors led to a complete breakdown in the system. It would not be too long after the stock market crash and the Dow's subsequent nadir in 1932, that Congress would eventually react with reform. In rapid succession, a series of laws were passed that would govern and regulate the securities industry. The SEC was established as an investor watchdog charged with policing the industry. Sadly, those laws came too late to protect the unfortunate masses that lost their life savings in the market crash and subsequent bear market of the 1930's. By then the Dow Industrials had lost 90% of its value. It would be 25 long years before the Dow would ever again approach the highs reached in September 1929.
Regulation Required for Those Who Can't or Won't Police Themselves
The main objective of those laws was to make sure that investors were required to receive financial and other significant information concerning securities offered for sale. The 1933 Act also prohibited deceit, misrepresentation, and other fraud in the sale of securities. The Act is often referred to as the "truth in securities" law. The Securities Exchange Act of 1934 created the SEC and also made requirements for companies with more than $10 million in assets and more than 500 owners to file annual and periodic reports with the SEC. These reports are available to the public through the SEC's data base at www.sec.gov/edgar/quickedgar.htm . Today, in light of the accounting scandals and the conflicts of interest, the government may find it necessary to set up a new watchdog agency to oversee the accounting profession.
The laws had good intentions and were designed to protect the investor. But that was back then when the market crashed. Now, we have today's accounting scandals. As I have already discussed in previous Storm Watch Updates, Breakdown and A Penny Less and A Penny More, the system is breaking down. The parallels to the 1920's are uncanny in that once again we see many similarities. Like the late 20's, sound investment principles have been abandoned and common methods and yardsticks for evaluation have been thrown out the window. Where once a P/E multiple of 12 to 14 was considered reasonable for a common stock and a multiple of 20 for a superb growth company, we now have multiples of 28 for the Dow, 60 for the S&P 500, and a negative P/E for the Nasdaq. Blue chip growth stocks like Intel, Cisco, and Microsoft carry multiples of 61, 95, and 34. There was once a time where reason, analysis, and sound long-term principles ruled the market. They have now been replaced by the emotions of the crowd.
Daily
Headlines Cry, "Investor Beware"
Even more worrisome for investors is that not a day goes by without another accounting scandal, misstatement of earnings or some new accounting irregularity making front page headlines. The ability of companies to manipulate earnings, obfuscate and hide debt from their balance sheet has never been greater. Today we have off-balance sheet debt in the form of hidden partnerships, operating leases and now synthetic leases.
The average investor remains clueless as to what is or what isn't reported as earnings. Earnings come in many shapes and forms. Not even the investment profession can agree on what constitutes the true earnings of a company. What is even scarier is the amount and degree of leverage that is contained on and off balance sheets either openly or hidden through off balance-sheet debt or derivatives. Derivatives weren't as widely used back in the 20's. They are more an invention of the modern era. They have taken speculation to a new level. We've seen this with Barings, Orange County, LTCM, and now Enron and Allied Irish Bank. Firms considered healthy one day are bankrupt the next. Consider the fact that Enron was the seventh largest U.S. firm in sales in January of last year and it was bankrupt eleven months later. It sort of reminds me of the recent movie, "Gone in 60 Seconds."
Margin Debt, Leverage, and Now... Derivatives
Margin
debt and leverage were as much at fault for the investment carnage
and plunge in stock prices back in the 1920's as they are today.
But today, we have added a new factor -- derivatives. Whereas
margin debt may be considered to be a hand grenade in its power
to detonate markets, derivatives are the equivalent of a neutron
bomb. No other financial instrument offers as much ability to
leverage, control, manipulate and profit from the investment markets
as these complex instruments. Yet no other instrument has as much
power in its holder's hands to destroy companies, disrupt markets,
and bring the world's financial system to its knees. Just as off-balance
sheet debt and derivatives hide a company debt structure, the
situation is even worse for our top banks. Our nation's top three
banks JPMorgan Chase, Citigroup and Bank of America look and act
more like high risk hedge funds on steroids. They control approximately
90% of the nation's derivative market and nearly 50% of the total
notional value of derivatives worldwide. It may be one thing for
a hedge fund to gamble with a millionaire's money, it is entirely
different when the country's top banks begin to speculate with
grandpa and grandma's savings.
Risk, Buried Debt, and Hidden Exposure
In addition to derivatives, many of the nation's top banks have risky off-balance sheet liabilities that are buried in their financial reports. These risks take the form of loan commitments made to companies that aren't fully reflected in the bank's liabilities. These loan commitments obligate a bank to advance credit to a company for which they receive a small fee. An example of this risk was illustrated in the case of Enron and more recently Kmart. JPMorganChase, Citigroup and Bank America had to advance $3 billion in loans even though they didn't want to. They had been paid a fee for a line of credit that they were obligated to fulfill. In the case of Enron, the loan commitment fee was $3 million on $3 billion. Today the off-balance sheet exposure of these three banks is almost as great or equal to the banks' on-balance sheet exposure. JPMorganChase has $224 billion, Citigroup has $200 billion, and Bank of America has $228 billion. The banks have very little in the form of loan loss reserves to partially cover these potential liabilities. 2
Monetary Policy in Parallel
Another factor that runs parallel to the 1920's is the degree that monetary policy played in creating and deflating the stock market bubble. Prior to 1922, the Fed bought Treasury bonds for three purposes:
1) for
income to operate the system,
2) to pay for newly-issued Federal Reserve Notes which were replacing
silver certificates, and
3) to push down interest rates
After World War I, and the debt it created, Congress woke up to the fact that it could use the Federal Reserve to obtain revenue without taxes. From this point forward, deficit spending was born and it has never left us since. In June 1922, the Fed created the "Open Market Committee" and the money and credit began to flow. There were three significant periods of money creation -- 1921, 1924, and 1927. In 1921, the Fed flooded the system with money to stave off a recession. In 1924, it created $500 million in new money to help bring down interest rates. Finally in 1927, it brought down interest rates and flooded the markets with money to help England. The plan was to create inflation in the U.S. by making U.S. goods less competitive in world markets and thereby cause gold to move to the Bank of England. In his book, Money: Whence It Came, Where It Went, economist John Kenneth Galbraith wrote that the problem was "the persistently weak reserve position of the Bank of England. This, the bankers thought, could be helped if the Federal Reserve System would ease interest rates, encourage lending. Holders of gold would then seek the higher returns from keeping their metal in London. And, in time, higher prices in the United States would ease the competitive position of British industry and labor." 3
Source: www.sharelynx.net
Easy Money Drives Speculation
The problem was that the new money created went into speculation. As this graph shows, the stock market which had been going up, went into a boom period between the years of 1927-29. During the final phase of the bubble, the expansion of credit went entirely into the market creating a speculative boom. The ample availability of credit began to change human behavior, driving it to the most bizarre forms of speculation. Belief in the economic boom, the technology revolution, and the ease with which it became possible to make money, found the country caught up in a speculative mania the likes of which had never been seen before. Stocks began trading at unheard of levels of 20-50-100 times their earnings. Speculators began to dominate the market. The general philosophy of the market could be described as the "Greater Fool Theory" for it was only the fools that were buying stocks at those price levels. To make even more money, investors began to borrow money and buy stocks on margin. An investor during the 1920's could buy stocks for as little as 10% down. The commercial banks were the "middle man" in this game of speculation. The banks also began to gamble with depositor money by becoming players in the market. Between 1921 and 1929, bank loans increased from $24,121 million to $35,711 million. During those same years, loans on securities increased by close to $8 billion. It appeared that the majority of borrowing during this period went into speculative investments. 4 Between August 1921 and September 1929, the Dow Industrials rose from 63.9 to 381.17 -- a rise of 597%.
It seemed like the good times would never end. In the words of the prominent Yale economist, Irving Fisher, in the autumn of 1929, "Stock prices have reached what looks like a permanently high plateau". 5 The professor was right on one thing only, stock prices had reached a plateau. From September onward the market began to fumble until the October Crash. The arguments for the new era revaluation of stocks began to unravel as the Fed sought to undo the easy money creation of the 1920's by a series of interest hikes which began in the fall of 1928. The rest is history. Instead of a permanent plateau, the Dow lost 90% of its value during the next three years. Instead of economic prosperity, our nation went into the steepest depression in the country's history.
The Money Bubble of the Nineties
Looking forward to the 1990's boom, you will see many of the same characteristics described above. A series of economic crises beginning with the Gulf War and the 1991 recession, the peso crisis of 1994, Asia in 1997, LTCM and Russia in 1998, Y2K in 1999, the recession of 2001, and the terrorist attacks of September 11th, the Fed has continuously inflated the supply of money into the financial system. The money spigot was back on in 1991 and money has flowed freely ever since.
The result of the money pumping is that economic activity picked up beginning in 1995 and the stock market began its final boom phase. Like the 1920's, the chief beneficiary of this new money was the stock market. From January 1991 to March 2000 the Nasdaq gained 1123%, the Dow gained 315%, and the S&P 500 gained 353%. Similar to the 1920's, the rise in the stock market was stimulated by low interest rates. A loose monetary policy became the Fed's response to any crisis that arose. This became more pronounced during the Clinton administration as the above graph illustrates. We can see a direct correlation between the creation of money and a rise in stocks as the charts of the S & P 500 and DJIA demonstrate.
By the middle of the 1990's, the American public became hooked on stocks again and the "cult of equity" was reborn. The majority of the country was now invested in the market in one way or another either directly through ownership of stocks or indirectly through mutual funds owned personally or through their 401(k)s. In the same way that private investment was channeled into investment trusts during the 1920's, mutual funds became the chief beneficiary and mechanism for money entering the markets. The stock market became the topic de jour on the golf course, in the gym, in beauty salons, television shows (with two full-time stations devoted to covering the stock market) and at cocktail parties. Mutual fund investing even made the front cover of Playboy magazine.
Like their predecessors in the 1920's, the 1990's bull market investor shared similar traits with optimism leading the fervor. The "New Era" mantra resurfaced, margin debt exploded, sound investment principles were abandoned and replaced once again by the "Greater Fool Theory" of investing. Investors were urged to keep on buying from multiple media sources like the Internet, television, newspapers, and magazines. Direct mail had become such a science, that every day there was a new offering with a promise of great wealth in the mail. The 1990's made media stars out of analysts with Abby Joseph Cohen becoming the equivalent of the Irving Fisher of her day. President Clinton echoed the sentiments of Irving Fisher by saying that the concept of the business cycle may have been repealed. Our own President looked like a rogue with one scandal following another. But the general public loved him even more for he had given them prosperity.
Little by Little The Lies Grew Bigger
Unfortunately, it was a false prosperity. Like all bubbles, they eventually burst. Our bubble burst in March of 2000. There comes a point in time when the myth can no longer be propagated. There's a point when credit expansion reaches a limit in its ability to expand the bubble. Speculation comes to an end as there are no more fools standing in line waiting to pay more money for what the speculators are willing to sell. That is when the whole game ends. Then the harsh realities start to set in as the business cycle resurfaces with a vengeance and a bear market reappears. Events begin to reverse and rotate in the opposite direction. The degree with which the economy began to decelerate in 2000 and the speed with which profits disappeared took Wall Street and Washington by surprise. The initial response was one of denial. As the campaign heated up in 2000, the existing administration downplayed the slowdown and the media downplayed any negative economic or financial news. All the major powers in Washington, Wall Street and in the media denied its existence. Nobody acknowledged even the possibility of a recession or a bear market. Investors were left to find out the hard way with double digit losses in blue chips while technology investments imploded. The Nasdaq ended the year 2000 with a 40% loss. Many of its star companies suffered losses that were much greater.
Harsh Realities and Dramatic Moves
As we moved out of 2000 into 2001, it became
clear to everyone that things weren't going well. The Fed embarked
on the most aggressive easing stance in history cutting interest
rates 11 times and expanding the money supply by $1 trillion.
However, the Fed's monetary ease only served to reinforce the
denial. Wall Street still predicted a recovery in the second half
of the year and the financial media encouraged investors to keep
buying stocks. Nobody talked about a recession or mentioned the
words, "bear market." Such was the degree of belief
in the efficacy of Fed monetary policy that the degree of denial
was so widespread.
Denial Doesn't Make It Disappear
Then September 11 occurred which gave that denial an escape. Companies began to take large write-offs on their battered earnings. Analysts and economists found a convenient excuse to hide behind. The economy and the markets were really in the process of recovering, but were halted by the tragic events of 9-11. The economy was acknowledged to be in recession and the words, "bear market" were mentioned. The year 2001 ended up as another year of double digit losses for investors. However, no sooner was a recession acknowledged, that it was just as speedily pronounced over. The denial was still there. The response was that the attacks on 9-11 had merely postponed the economic recovery. As far as the stock market was concerned, its advance following the horrific terrorism of September were hailed as a new bull market and a sign of better things to come.
Talk It Up -- Prop It Up
The parallels to 1929 and the 1930's are similar.
The government and the public only grudgingly accepted the fact
that the general prosperity of the Coolidge and Hoover Administration
had come to an end. In 1930 the stock market had staged a partial
recovery. Julius Barnes, the head of Hoover's National Business
Survey Conference gave speeches of encouragement saying, "The
spring of 1930 marks the end of a period of grave concern American
business is steadily coming back to a normal level of prosperity."
6 Prominent political figures of the
day, from President Hoover to John D. Rockefeller, made statements
of their confidence in the markets and in the nation's economy.
In fact, in an early version of the Plunge Protection Committee,
bankers headed by staunch bull market defender Charles E. Mitchell
put together a consortium to prop up the market. Five men and
six major New York banks would ante up $40 million a piece, a
combined sum of $240 million -- an enormous sum in that day, to
prop up the market. "The object of the two-hundred-and-forty-million
dollar pool was not to hold prices at any given level, but simply
to make such purchases as were as were necessary to keep trading
on an orderly basis. Their first action, they decided, would be
to try to steady the prices of the leading securities which served
as bellwethers for the list as a whole." 7
Reality Breeds Change
The scheme failed miserably. By April 1930, the brief illusion of recovery withered away. Commodity prices kept falling, production declined, and the stock market began another series of declines. Confidence was lost and would not return to the market for decades. By 1931 the President's reputation had declined along with the markets and the economy. Democrats became gleeful with the prospects of recapturing the White House after a long reign of Republican presidents. Change was noticeable everywhere in the country from the breadlines to the hemlines of women's dresses. Everything changed from the infallible belief in science and Freud, to morals, agnosticism, and faith. Even in cultural matters, change was in the air. The Jazz Age had come to an abrupt end. In fashion bobbed hair lost favor and formal dress and attire returned in almost sharp contrast to the economic times. On Broadway, romance and a return to formality had replaced sex and modernism. A new mood of realism had taken over the country.
In another sign of the times, the once prominent investors of the bull market had fallen on hard times. Broadway's Eddie Cantor gave popular publicity to suicide legends of former speculators of the day. A common joke at that time was a story of hotel clerks asking new arrivals if they had come to sleep or to jump. William Crapo Durant declared bankruptcy in 1936 and was sold out by his brokers. The founder of GM ended up his days washing dishes in a New Jersey restaurant. The famous stock market speculator Jesse Livermore, after losing an estimated $32 million, declared bankruptcy in 1934, ending his life six years later by blowing his brains out in a New York hotel.
As the nation slipped deeper into recession, the apotheosis of business came to an end. Business was no longer deified. In fact, it became the target of the new Roosevelt administration. Taxes on the rich were raised to over 90%, bringing new investment virtually to an end. The Roosevelt administration enacted a series of measures to restrict market freedom. The Glass-Steagall Act was passed in 1933, separating investment and commercial banking. The Fed was given new power to restrict margin loans and the SEC was established to police the security markets.
Everyone Had and Has a Theory
The country's economic system was turned upside down. The system of free markets and a policy of laissez-faire in government came to an end. Roosevelt's New Deal moved against individual freedom and replaced it with government intervention in economic affairs. The free markets were replaced by welfare and work programs. Classical economics which could have explained the role that excess money and credit creation played in inflating the bubble and its likely cure was replaced by a new economic philosophy. In 1936 John Maynard Keynes published his book, The General Theory of Employment, Interest and Money. Keynes' theory attacked speculators and the markets for their ability to efficiently allocate capital resources. Ironically, Keynes himself had made a fortune speculating in the financial markets. Many prominent thinkers of the age had different views on the crash and the Great Depression. Milton Friedman blamed the Fed for following an overly restrictive monetary policy in his book Monetary History of the United States. Charles Kindleberger in Manias, Panics, and Crashes, took a much larger view seeing the Depression as a result of falling commodity prices. The prominent Austrian economist Murray Rothbard argued the stock market and the Depression would have sorted itself out if the process of credit cleansing had been allowed to occur. Had the market been allowed to fall until it found its own clearing level, the market would have recovered and along with it, the economy. Rothbard argued convincingly that had wages been allowed to fall with commodity and asset prices, market equilibrium would have been restored.
The debate over what led up to and prolonged the Great Depression carries on to this day. The problem with its analysis is that it is charged with political undertones. At the root of these arguments is whether the markets should be controlled by governments or left to remain free. What we do know from a study of history is that it was World War II and not the Keynesian policies of the New Deal that eventually revitalized the economy. The markets came under increasing control and would not be liberated for decades. Even today many of the freedoms that once existed in this country's economy no longer exist today. Just as central governments plan and direct the economy and markets in socialized countries, central bankers plan the economies of the West and especially the U.S. What the Fed thinks, says, and does moves the financial markets. In many ways it has been the actions of the Federal Reserve in lowering interest rates that originated and sustained the greatest bull market of the 20th century. However, it may also be said that these same policies were responsible for the creation of the biggest financial bubble in history.
Where Do We Stand Today?
Source: U.S. Census Bureau
Seventy
Years Older and Deeper in Debt
We now find ourselves, over 70 years later, under similar circumstances. The 90's were a period of unparallel credit creation as has been shown in the Money Supply (M3) charts above. Like the credit expansion of the 20's, the credit bubble of the 90's led to enormous speculation in the financial markets. The stock market bubble is now in the process of deflating and it has only just begun. We are now in a period similar to where we were between the years of 1930-1932 with one major difference: America is no longer the world's largest creditor nation. Our role has been reversed as the United States is now the world's largest debtor nation. Our country has been running trade deficits for decades, but during the 90's those deficits accelerated.
We are now borrowing over $1 billion a day and are heavily dependent on foreign capital, especially Japanese capital, to support our way of living. Now Japan's economy is on the verge of collapse with ominous consequences for the rest of the world, and in particular the U.S. Japan owns $333 billion of our Treasury bonds, has bank loans in the U.S. that amount to $340 billion, and owns billions in U.S. equities. At home, Japan faces a debt implosion that could force its banks to call in its loans which could create an economic contraction that would sweep around the globe.
Like the 1930's, policy makers aren't sure what should be done. So far the Fed has liquefied the financial markets and stands ready to act as lender of last resort. This is a role it has played frequently and has grown accustomed to in the 1990's from bailing out S&L's and foreign governments to heavily leveraged hedge funds. Like the 1930's, the debate on whether the markets should be left free or should come under closer government regulation is once again under debate. The economic issues have been relegated to the back burner by the current War on Terror, but they remain below the surface. Similar to the early Depression years, there is still optimism, if not complete denial, in the land. Wall Street and Washington are talking about recovery and consumers remain hopeful. American business is less sanguine. The same issues regarding the market's integrity are front page news and there is talk of new legislation to regulate the securities and accounting industry. Like the 20's, we are dealing again with fraud, deceit, and the probity of the financial system. Despite various security laws enacted during the Great Depression to bring fairness and truthfulness to the financial system, they have proven to have broken down. You can't legislate integrity into the financial system. It is an issue of character -- not one of law.
Enron -- More Finances Than Energy
Resembling some of the scandals that would later surface after the 1929 Crash, we now have Enron. Enron has become the latest fascination and object of the media's attention. The issue is portrayed as an energy issue, when in fact, it is a financial one. Enron encapsulates many of the crises of the last decade surrounding derivatives and the greatest financial danger now posed to the world's financial system. There are the accounting failures, lack of disclosure, and issues of dishonesty and greed. However, the larger issue still remains derivatives and the amount of leverage they contain. In the words of Professor Frank Partnoy in his testimony before the Senate Committee on Governmental Affairs, "Enron makes Long-Term Capital Management look like a lemonade stand." This is what the media and Washington still don't understand. They do so at great peril to our own financial system.
Leadership Needed From The Top Down
The President understands the economic risks. He ran on those issues and made them part of the debate during the election. Lowering taxes to stimulate the economy, creating an energy policy to free this country from foreign dependency on energy, and strengthening the country's military became the platform of his campaign. Originally he was criticized for addressing those issues, especially on the economy. He has been proven right. The country was heading into a recession during the presidential campaign. Unfortunately, the President's tax bill got watered down. Instead of lower tax rates, we essentially got rebates. Lowering tax rates over 10 years does little to stimulate the present economy. Those lower rates are needed now, not later.
In his recent State of the Union Address, the President outlined three goals for his Administration: winning the war, increasing homeland defense, and pulling the economy out of recession. The major component of that plan was the President's stimulus package which contained all three objectives. I may not agree and others may not agree with the entire stimulus plan, but there are things about it that would be helpful in stimulating the economy. Spending on defense at a time of war would be a necessity. Increasing the security of the country has always been a proper role for government. Lowering taxes would go a long way in stimulating much needed investment and lowering the heavy tax burdens of most middle class workers. Like all plans, there are non-essential elements as a result of compromise or priorities of the Administration. The President's plan contains classical free market elements of lower taxes as well as Keynesian consumption stimulus and social welfare.
Today Counts Toward Tomorrow
This Storm Watch Update does not attempt to debate the complete merits of the plan. However, it should be recognized that we now stand at the edge of a precipice. What we do today will determine whether we sink into the abyss or begin the long, long road towards recovery. This will not be an ordinary recession or bear market. The world and especially the U.S. could be heading towards the most serious economic crisis of the new century and the largest economic crisis since 1930. If we do nothing, that crisis will unfold in a way we will least be able to direct. In his book The Crash and Its Aftermath, Barrie Wigmore, a one time partner at Goldman Sachs, argued that Roosevelt's speeches during 1932 and his refusal to guarantee the gold standard encouraged the public's hoarding of money and brought on the banking crisis of early 1933. Wigmore argues that Roosevelt "as much as anyone, raised the Crash to its symbolic position as the cause of the Depression." 8 Roosevelt used the crisis as political capital to justify the policies of his new administration. It is with this idea in mind, that I view with suspicion Mr. Daschle's plans for holding up judicial appointments and over 50 bills in the Senate on energy, defense, and the economy. The Democratic leader of the Senate has invoked a rule that does not allow bills to the floor of the Senate unless there are 60 votes in favor of its passage. This parliamentary rule has kept the more conservative members of his party from working with Republicans and the President to get legislation passed. Can it be that Mr. Daschle's political ambitions for his party come before the needs of his country? This may be cynicism on my part, but it is a question worth asking.
There are a number of theories and proposals surfacing around the country on how to fix the economy. There is, however, very little discussion as to its root problem. Whenever a recessionary process is interrupted by credit and liquidity infusions from central banks, new distortions are created in the economy. The Asian, Russian, LTCM and Y2k problems were solved with Fed injections of liquidity into the financial system. Those injections solved a crisis, but created newer ones. The extra liquidity led to vast amounts of credit in the system which encouraged heavy borrowing by consumers and corporations. It further encouraged speculation in the financial markets. Austrian economists would argue that while macro economic activity appears to have increased as a result of fresh new money creation added to the system, it carries with it further consequences. At the micro level, those liquidity injections produce a more severe downturn or a more prolonged slump further down the road. In his article, "Financial Cycles, Business Activity, and The Stock Market," Anthony Mueller states that, "When monetary authorities repeatedly act to ward off economic downturns and continue to feed the markets with fresh liquidity, the belief in an eternal boom becomes more widespread each time, and economic activity becomes more intensive. Asset bubbles need a threefold basis: first, there must be a monetary policy that allows excess credit growth; second, monetary authorities and the government must induce moral hazard by signaling their readiness for bailouts; and third, investors must be exposed to a learning process where repeated verifications of bullish expectations lead to diminishing risk perception. It is not the outflow of monetary capital that produces distortions, but it is the massive inflow that makes malinvestments happen. These are brought to light once additional liquidity vanishes". 9 Isn't this how and where we are today?
On a final note, we are now at war and economic crises are erupting all around us. The international community carefully watches Latin America, Central Asia, and Japan. Global organizations are calling for a new global tax. There are also calls for new restrictions on the free flow of capital. In The Road to Serfdom, Austrian economist Friederich von Hayek wrote that state control of foreign exchange dealing was a decisive advance on the path to totalitarianism and the suppression of individual liberty. Edward Chancellor in his book Devil Take The Hindmost believed that Hayek had underestimated the power of speculators to liberate the markets. Another author, Gregory Millman, argues that the power of speculators was able to undermine the power and policies of central banks. Both authors have been right. In the words of Edward Chancellor, "The pendulum swings back and forth between economic liberty and constraint". 10 Let us hope that liberty prevails. Even so, I fear its Hayek's road upon which we are now traveling. ~ JP
References
1
Buffett,
Warren, "Mr. Buffett on the Stock Market," Fortune,
November 22, 1999.
2 Lenzner, Robert,
"Timebombs in the Vault," Forbes Magazine,
February 18, 2002.
3 Galbraith,
John Kenneth,
Money -- Whence It Came, and Where it Went, Houghton Mifflin Co.,
Boston, 1975, p. 174-175.
4 Griffin,
G. Edward, The Creature from Jekyll Island: A Second Look
at The Federal Reserve, American Media, 1998.
5 Allen,
Frederick Lewis, Only Yesterday, an Informal History of The 1920's, John Wiley & Sons,
1997, p. 245.
6 Ibid.,
p. 285.
7 Ibid.,
p. 250.
8 Wigmore,
Barrie, The Crash and Its Aftermath, Greenwood Publishing
Group, 1986, p. 337.
9 Mueller,
Anthony P., "Financial
Cycles, Business Activity, and the Stock Market", The
Quarterly Journal of Austrian Economics Vol. 4, No. 1
(Spring 2001): p.14.
10 Chancellor, Edward, Devil Take The Hindmost: A History of Speculation,
Farrar Straus & Giroux, 1999.
by James J. Puplava
February 8, 2002
Financial Sense (a Registered Trademark)
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