Gold And Deflation

In July of 1927, Ogden Mills, the U.S. Secretary of the Treasury organized a remarkable meeting at his home on Long Island. He had invited the most powerful money men of his era – the central bankers of England, France, the U.S. and Germany.

Present were Benjamin Strong of the Fed, Montagu Norman of the Bank of England and Hjalmar Horace Greeley Schacht of the Reichsbank.

Emile Moreau, head of Bank of France, hated travel almost as much as he hated England’s central banker. So he sent a subordinate to represent him.

The problem before them was gold. More to the point, the problem was the run on England’s gold because of the mispricing of the pound sterling by Norman. Strong was a close personal friend of Norman’s. Schacht and Norman were friendly too. It was the French who were causing problems. France was threatening to redeem its credits with the Bank of England by drawing down England’s stock of gold.

Strong decided to help take the pressure off the pound by lowering U.S. interest rates and making U.S. gold available to the French. An economist at J.P. Morgan remarked shortly after: “Monty and Ben sowed the wind. I expect we shall have to reap the whirlwind…We are going to have a world credit crisis.”

A credit crisis did develop. But only after two years of ballooning debt. The stock market had already nearly doubled since the end of 1924. Then, following the Long Island conference, Wall Street shot up another 50% in the second half of ’28. Then, in the three months’ leading up to August of ’29 – it ran up another 25%.

New credit instruments were developed – such as installment purchase plans – so more and more people could participate in the prosperity. “Everybody Ought to be Rich” wrote John J. Raskob, director of General Motors and Chairman of the Democratic Party, in Ladies Home Journal magazine. Then, as now, it was widely believed that new technology – radio, telephone, automobiles, electrical appliances – were making possible a whole new era of wealth.

And yet, then as now…the New Era proved an illusion.

I can almost hear you groan, dear reader. “Oh no,” you must be saying to yourself… “not another letter about the New Era!”

But before you turn off your computer and begin looking for lost socks, let me reassure you. Today, I write about neither stocks nor technology – but about gold.

And what I want to show you is what happens when a New Era credit bubble collapses.

“Why would I want to buy gold?” asked a DR reader recently. “You said yourself that deflation is in the offing…not inflation. Won’t gold go down instead of up?”

Of course, I do not know what gold will do. But I will show you what happened on the last occasion of deflation in America.

In the last half of the `20s, the Fed began to become nervous by what it saw as excessive borrowing and `irrational exuberance’ in the stock market. In 1925, the Discount Rate charged to commercial banks for Fed funds was only 3%. In a series of increases, it rose to 5% in 1928. But the mania continued. Finally, in August of ’29, the rate was hiked to 6% and the bubble was pricked.

These rate increases are blamed for the bust that followed. But the real rate of return on borrowed funds was so high that it is doubtful that these rate increases had much effect. If you could earn 25% on your money in 3 months in the 2nd quarter of ’29, on Wall Street, a 1% increase in the cost of money would not be a serious deterrent. Then, as so recently, money from Europe rushed into the U.S. to take advantage of rising stock prices. An extra point of interest cost did little to tilt the balance away from U.S. investments.

Still, the balance did tilt…so much that investment slid from the positive to the negative side of the scales in a trice. Stocks crashed. Businesses failed. Prices fell. By 1931, wholesale prices were 24% below those of ’29 and would soon drop another 10%. 15% of the labor force was thrown out of work by 1931…two years later it would reach 25%. Over 10,000 banks failed.

Banks back then were like mutual funds…or stock portfolios… today. There was no deposit insurance. Losses were real. Final. The wealth simply disappeared.

But what happened to gold? Did it fall more than 30% along with other wholesale prices?

No. Quite the contrary, it rose. Fearful of banks, wary of stocks…people turned to gold to protect their wealth. Bank deposits fell. People preferred to keep their cash – or gold – in hand. This was a problem. Because the financial system depended on the health of the banks…and their willingness to lend. When people withdrew their money, the banks failed and depositors became even more fearful of the banking system.

Failing banks became such a problem that President Hoover tried persuasion to convince people to leave their money in the banks. He sent straight-talking Col. Frank Knox around the country on a campaign to discourage hoarding of currency or gold. Knox is better remembered as America’s Secretary of War in WWII. He is famous for his remark to T.V. Tsoong, the Chinese Ambassador. Putting his arm around the ambassador, Knox proclaimed his confidence in the American war against the Japanese: “Don’t worry, T.V.,” he assured the Chinaman, “we’ll lick those yellow bastards yet.”

As banks failed, the supply of money declined. Thus, the value of money increased (prices fell). The U.S. was still on the gold standard, so the value of gold increased accordingly. But soon, forward-thinking economists, led by Britain’s John Maynard Keynes, saw the need for more money…and more credit…to get the economy moving again. Gold seemed to bar the way.

Frightened that America might devalue the dollar (in terms of gold), investors began to move their capital abroad – or into gold itself. In February of ’33 there was a run on U.S. gold – $160 million left the treasury. Another $160 million was called away in the first four days of March. The commercial banks were losing gold too – over $80 million went out of their vaults in the last 10 days of February…and $200 million more in the first 4 days of March.

Arthur Dewing, professor at the Harvard Business School, was so alarmed that he went into the Harvard Trust Company on Harvard Square and took out his entire balance in the form of gold coins. “When the crowds inside the bank reported Dewing’s action to the people on the street,” writes Peter Bernstein in his book, Power of Gold, “a mob gathered on the Square, fighting to get into the bank to follow the example set by the distinguished professor.” Dewing was subsequently criticized for “unpatriotic behavior,” and left the faculty soon after.

Into this rush into gold came wheeled the next America’s next president, Franklin Roosevelt. On March 8, Roosevelt held his first press conference – assuring the nation that the gold standard would remain. On March 9, he pushed the Emergency Banking Act through Congress – giving him the power to regulate or prohibit gold ownership. And less than a month later, he replaced Hoover’s persuasion with outright force – the leader of the free world made it illegal to hold gold.

And two month’s later, Roosevelt even abrogated all contracts in which payment was stipulated in terms of gold – including obligations of the U.S. government.

Anything so popular that the government declares it illegal is bound to be a good investment. Gold rose in value – by market demand, confirmed by government edict – by 69% between Roosevelt’s inauguration in March ’33 and January ’34. In terms of purchasing power…gold had risen almost 100% during the biggest deflation in America’s history.

“This is the end of Western civilization,” declared Lewis Douglas, Director of the Budget. And, in a sense, it was….

More to come….

Bill Bonner Ouzilly, France December 29, 2000

*** The rally on Wall Street continued yesterday after a shaky start. Volume and breadth book looked good – with over 2 stocks rising for every one that fell on the NYSE and nearly that good a ratio on the Nasdaq. There were 383 stocks hitting new highs on the NYSE; only 53 hit new lows.

*** The Dow ended up 65 points. The Nasdaq managed a small gain – 18 points.

*** Intel and Micron both fell about 5%. Intel is trading almost down to $30. Other big techs – Sun Micro, Cisco and JDS Uniphase – were off about 4%.

*** But eBay has gained about 40% in the last 5 trading sessions. And Juniper has done nearly as well.

*** Insiders, it turns out, are value investors. They sold shares this year at a rate 55% higher than in ’99. And they bought 21% fewer shares. Among the biggest sellers were Bill Gates and Paul Allen – who together unloaded $10 billion in MSFT shares. Generally, the heaviest selling was in the tech area.

*** But insiders at value-laden Phillip Morris were buying – about $91 million worth. MO – which I suggested to you early in the year – turned out to be the best performing stock on the Dow…up 95% for the year.

*** Natural gas is up an almost unbelievable 300% since the beginning of the year. “Contrarians take note…” writes Dan Ferris, “The chemical sector is getting hammered by high natural gas prices. When people start saying that natural gas prices will be high for the next ten years, that’ll be a sell for natural gas, and a buy for chemicals…” Is it time to look at W.R. Grace?

*** The increase in fuel prices has hit California utilities especially hard. Losses by the two largest power companies in the state could reach $13 billion by the end of January. And if the companies’ credit ratings are downgraded, they will be unable to borrow the money they need – and may be forced into bankruptcy.

*** Isn’t it amazing how one event (a temporary shortage of natural gas) runs into another event (colder than expected temperatures) just as the moment when yet another event, apparently unrelated, (a credit squeeze) begins? When things go bad – they tend to go bad all at once.

*** A Wall Street economist quoted in a Bloomberg article: “This is a credit event. It’s not just simply an energy development.” The article by Noam Neusner continues: “A default by the two utilities could make previous credit crises negotiated by Greenspan and Treasury Secretary Lawrence Summers … look like a walk in the park. That’s because most major credit problems of the last decade have been overseas, and this one is at home – and its effect could be felt throughout the U.S. When hedge fund Long-Term Capital Management was on the verge of going under, it threatened its broker-dealer investors. By comparison, the two California utilities count among their creditors money funds used by millions of ordinary investors.”

*** Larry Summers and Alan Greenspan are two thirds of “The Committee to Save the World.” Are they up to the task?

*** The Financial Times includes an analysis of the mania and the lessons learned. One lesson was simply that technology doesn’t always work as well as it’s supposed to. Another: that most new business models are failures. But the third lesson from the FT is especially important: “Nothing destroys value like underpriced capital. The bubble will be studied not so much for its technical or entrepreneurial innovation, but as a capital market anomaly. In the closing years of a long bull market, the suppliers of capital – much richer on paper than a decade before and more willing to take a flyer – poured money into venture capital funds and then into the premature initial public offerings that validated those venture capital investments. This virtuous circle brought in more venture money and more successful IPOs, rewarding investment bankers, lawyers and other facilitators handsomely in the process.”

*** “This surge of money,” continues the FT article, “produced the biggest mispricing of capital since the Japanese equity warrant boom of the 1980s. When capital is nearly free, the need to discriminate between new ideas disappears. Clearly, the boom was a disaster. ”

*** Investors are becoming much more discriminating. They are trying to sort out the good models from the bad ones. While they have taken huge losses – they are still confident that they will discover stocks that go up at double-digit rates. The attitude among investors, so recently completely irrational, now seems reasonable: Find the good techs. Buy. Hold. Wait for better times.

*** Unfortunately, markets are not at all reasonable and cannot be reasoned with. They do what they want – which probably means purging all the techs – good and bad… bankrupting millions of businesses and investors…and hammering almost all stocks down to such low levels that people will no longer want to stoop to pick them up.

*** “Bankruptcy Lawyers Become Hot Products” says a headline in the International Herald Tribune.

*** Working from home is a pleasure – for a week or two. Then, after the novelty and convenience wears off – it is even more tedious than going to the office. The LA Times reports that the idea is losing favor in business management circles too. “Telecommuting doesn’t put anybody ahead,” said Larry Prusak, director of IBM’s Institute for Knowledge Management, a think tank in Boston that has researched telecommuting trends. “Workers lose because they aren’t in the office enough to be taken seriously for promotions,” he said. “Bosses lose because nobody’s around to keep ideas alive and work through projects.”

*** Well, no snow yet. But it has gotten colder…and the sky is cloudy. So, Edward goes to the window from time to time to see if the snow has begun. It rains often in this part of the world. But snow is fairly rare.

*** I’m learning a new trade. Something to fall back on if the Daily Reckoning doesn’t work out. I’m taking advantage of one of Mr. Deshais’s periodic attacks of sobriety to learn stonemasonry. We began yesterday to take down some of the stone walls – which looked as though they were going to fall down. I tend to underestimate these projects. Which is probably a good thing. Because if I realized how much work was involved I might never start.

*** We took down the leaning and bulging sections of the wall. But once these stones were off, the center could not hold. The walls are built of stone and mud…with just a lime/sand mixture called “chaud” on the outside. When you begin taking them apart…it’s hard to find a place to stop. We just kept taking off the stones and digging out the dirt until we had demolished a 100-ft wall about 3 feet high and two feet thick. Now we have to rebuild it.