Bernanke's Big Test

The Daily Reckoning PRESENTS: When Alan Greenspan took over the helm of the Federal Reserve in 1987; he certainly had his work cut out for him. Nearly twenty years later, Big Al passes the buck and Bill Bonner wonders: What lies ahead for Ben Bernanke?


Alan Greenspan had only been on the job a few days when he was put to his first test. The crash of 1987 came as a shock to world stock markets. It came as a shock to Alan Greenspan, too. The man had run an economic forecasting business – notoriously badly. If economic forecasting were driving an automobile, you would not have wanted to climb into the car with the maestro. He drove blind – into financial potholes, stock crashes, bubbles, busts and head-on into recessions.

Now, Ben Bernanke comes into the same job. He sits in the driver’s seat in the same office, in the same country as his predecessor. But, he has stepped into a different world.

On Monday, October 19th, 1987, the Dow fell 22.6%. A similar drop today would take off about 2,000 points, but back then, the drop began from a much lower level. The Dow was barely at 2500 on Black Monday, when the “crash” took the stuffing out of the market and reduced stockholder wealth by about half a trillion dollars in a single day.

A number of factors led to the big drop, as analysts were quick to point out – one of them in an especially colorful way. In the early 1980s, investors, still hurting from the bear market between 1966 and 1982 and wanting to protect themselves against future losses, turned to “program trading” methods that sold off automatically in a downturn, to preserve capital. Should the market continue to fall, it immediately laid on put options to recover the losses. “Portfolio insurance,” it was called, and it sounded marvelous on paper. But, the more protection was made universal, the more risk also became universal. An investor, after all, can only protect himself if he can find someone who will take the other side of the trade. When the whole market goes down suddenly, who will still sell put options at reasonable prices? And who will buy shares in a falling market?

Of course, the U.S. market was not an isolated disaster. Markets all over the world skidded, too – even those without program trading or portfolio insurance. Australia dropped 41%. Hong Kong went down 45%.

Even today, no one knows why stocks suddenly fell that day…or why they fell so much. Asked after the fact, investors often reported that they sold because they “saw everyone else selling.” Some people were completely unhinged by the crash; newspapers reported that at least one client came into his stockbroker’s office and started shooting. Several brokers were killed. Markets closed early and surviving brokers locked their doors.

Alan Greenspan reacted quickly, nipping a couple of basis points off the Fed Funds rate. In retrospect, it seems to have been unnecessary. When the crash was over and the dust had settled, investors quickly recovered their nerve. Within five weeks, stock prices were in a new bull market, one that would, once again, take them up past 2,500and then, push on to the 12,000 mark 12 years later.

Those were happy times; the nation was at peace, more or less. The nation was prosperous. George Bush, the elder, was in the White House (Note: this was the Bush whose biggest foreign policy blunder was throwing up on the Prime Minister of Japan.)

Most importantly, the wind was at Greenspan’s back. He did not know it, of course. He did not understand that the barometer was rising, inflation was moderating and lending rates were in a sunny, long-term downtrend. Instead, the new captain of the Fed put on his foul-weather gear, turned his jaw to the wind and sailed off in the wrong direction. When he took the Fed’s highest post, Alan Greenspan began tightening interest rates, a process that was only interrupted, briefly, by his reaction to the ’87 crash. The maestro took the Fed Funds rate from 6% at the beginning of ’87 to nearly 10% in 1989. Higher borrowing costs probably produced the recession of ’90; the elder Bush believed Alan Greenspan had cost him the election. Hilary Clinton seemed to think so, too. After the vote went to her husband, she chose to take a position next to Greenspan at the inauguration. Between the two of them, Bill Clinton, ruled the nation for the next eight years.

On almost the very same day he took office, the Tokyo stock market collapsed. Later, the trend toward lowering borrowing costs got a big boost from overseas. In the 1990s, the poor Japanese, desperate to get the magic back, tried everything, including giving away money at zero interest. That created the “carry trade” in which speculators borrowed from the Japanese at very low interest rates and placed the money where it would produce a higher return. In the ’90s, the cash was often placed in the U.S. stock market. Since 2000, emerging markets and property have been favorite investments. More recently, a speculator could borrow from Japan and place his money in U.S. Treasuries. It seemed like a no-brainer.

When Alan Greenspan came into the Fed, the Dow was under 2,000 and a conventional 30-year mortgage was over 11%. When we looked yesterday, the Dow was nearly 11,000 and mortgage rates had just hit a three-year high of 6.24%, after dipping down to a low near 6%. Where exactly the trend toward lower rates ended, we don’t know – probably in 2003 or 2004. Some people think it hasn’t ended yet, but even if rates fall further, it is unlikely they will do so for the same pleasant reasons, or with the same beneficent results that greeted Alan Greenspan.

The wind has changed. The investors who were worried and skittish in 1987 are complacent and confident 20 years later. Those who panicked when the Dow hit 2,500 are now serene with it at 11,000. The credit derivatives market barely existed in 1987; now it is worth $12 trillion. And homeowners who wondered how they were going to pay off their $50,000 mortgages in the ’80s now borrow $200,000 with no intention of ever paying it off.

Bernanke’s test is coming. He, too, will have his opportunity to blunder. Will the stock market crash? We don’t know, but if it does, it has a lot more room to fall than it did in 1987. Will the derivatives market melt down? Who can say? But if it does, there will be hell to pay. Is the dollar likely to buckle…or the bond market fall to its knees? Don’t ask us. We only notice that whatever risks and dangers Alan Greenspan faced in 1987 have been multiplied many times for Ben Bernanke. On his first day on the job, he had about $15 trillion more in debt to worry about, savings rates that had not been seen since 1933, mortgage rates from the Kennedy era and 200 fewer basis points to cut.

He does not seem to notice.

Above, the clouds are thickening and hurricane winds are whipping up all around. The Bank of Japan is raising rates. House prices are stabilizing or falling. Ben Bernanke might want to get out an umbrella.

Bill Bonner
The Daily Reckoning
London, England
March 10, 2006

Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:

“Now Perhaps Someone Will Listen!”

“Tokyo ends loose-money policy,” says a NY Times headline.

After 16 years of slump, deflation, bust and aimless chopping, Japan’s economy seems to be stirring. It seems to be coming back to life. So, central bankers are taking down the I.V. drips of cash and credit that have kept the failing banks alive and encouraged bad investments. The patient is recovering and no longer needs constant medication.

Henceforth, borrowers will have to pay for money in Japan just like they do everywhere else. And henceforth, speculators may not be as flush. For several years now, they have been able to borrow from Japan at practically zero interest and re-deploy the money elsewhere. The world took to this easy money like a panda to bamboo shoots. The credit goosed up emerging markets in the Mid East, built factories in Asia and even contributed to the boom in consumer spending in North America.

So much so, that the boomers – we mean, the consumer boomers – now seem to think they no longer need to save money. In January, the savings rate in the U.S. fell to negative 0.5%, for the first time in history. Yet, more Americans than ever before are preparing to retire. What will they retire on? We don’t know. They have houses. They have credit cards. There is always that ready money in Asia to draw on, just in case.

“Trade balance hits new record,” runs another headline.

In January, Americans spent $68.5 billion more from foreigners than they earned from them. At this rate, in a year’s time, the trade balance will reach negative $822 billion – not too far from $1 trillion. It’s close enough to the point where the entire scheme blows up in our faces, though how much closer we don’t know.

Americans have always been famous for parting with money rather than saving it, but these days, they are parting with so much that their own incomes aren’t enough for it. They need other people’s income to keep parting with cash at the same pace. When they buy a new Toyota, for example, they have to borrow the money from a finance company that also borrows – at the lowest rates it can get. So, the rate they pay to buy their car depends on the rate the finance company can get, which mostly depends on the low rates set by the Bank of Japan and the Bank of Bernanke. It is thanks to easy credit from these two worthies, that the American lumpenhouseholder is able to buy his car at all – or even his house – without any money of his own. The sale brings dollars and profits to the Japanese, which are then recycled back to the United States as debt so the American consumer can dig himself into an even roomier hole.

And here in Britain this morning, the press has this headline: “Courts swamped with bad debt cases.”

It could have been a headline from the United States. On both sides of the Atlantic, the proles are getting squeezed. In order to maintain his illusion of financial progress, the average working stiff has to borrow against his house or on his credit cards. Borrowing has become easy, thanks to the aforementioned central bankers. Paying back may not be so easy, because the same waves of globalized commerce that throw up glittering aisles full of tempting gadgets and gizmos in Long Beach and London – the same currents of trade that bring him automobiles from Asia and bananas from Latin America are lapping against his own earning power and washing chunks of it away. Wages in rich countries are slowly being eroded…reduced to sea-level…brought down to the lowest common denominator the world labor market can produce.

And meanwhile, the rich grow richer.

“World gains 102 more billionaires,” says the Houston Chronicle. There are now 793 of them and their wealth grew 18% last year. Currently, they have about $2.6 trillion, according to the Forbes estimate.

More news from Aussie Joel and The Rude Awakening…


Dan Denning, reporting from Melbourne, Australia:

“Soaring gold and oil prices will be accompanied by soaring interest rates and inflation. The convenient fantasy world where consumer prices don’t rise and the dollar doesn’t lose purchasing power will collapse.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.


Bill Bonner with more information from London…

*** An announcement from Addison:

“Okay, we admit, we try to have a good time…even in the face of uncertainty.

“Last year, on our way back from the Agora Wealth Symposium in Vancouver we got stuck in a security line at the airport. At one point, hundreds of us were stuck in a little room, packed in like cattle waiting to be loaded train headed for market.

“Naturally, we started mooing. We blame Greg Grillot and Bruce Robertson. They had been up rather late the evening before congratulating themselves for a successful conference. But it did seem like the appropriate political commentary on our situation.

“Kate Incontrera, who writes the Daily Reckoning Weekend Edition, was an unwilling witness to the event. For some reason, she didn’t think the mooing was funny. She asked us to stop. We didn’t.

“Okay, people,” she announced to no one and everyone around us, “New York Times best-selling author here…number one on Amazon right now…mooing.” Apparently she thought we could feel shame. She was wrong. We brayed a little louder.

At that point, Kate earned her future nickname. “If you guys don’t stop mooing right now, I’m going to quit!” Her cheeks flared red.


“That’s it! Seriously. I quit.”

After we got through the gate, we ran into several colleagues who had also joined us at the conference. They had passed through the line a half an hour before us. “Boy, that was terrible, wasn’t it?”

“Yeah,” we agreed.

“The mooing was pretty funny though.”

From that day forward, we began calling Kate “Short Fuse”…because (granted, after several days of dealing with us) she lost it. Fuse didn’t talk to us for several hours, but thankfully she didn’t quit.

In fact, as a way of commemorating the event, we’ve decided to rename her column in the Weekend Edition: “Views From The Fuse.” Look for the premier issue tomorrow.

[Ed note: We’re in the process of finalizing this year’s roster for the Vancouver event. The theme? Investing In The Age of Empire… it’s going to be sizzling hot and no doubt our best event to date. Steve Forbes, Bill Bonner, Mark Skousen and a host of the industry’s finest minds are going to be weighing in on the Empire and how to live well in the face of its decline… or debating whether it’s in decline at all. You’ll hear from all sides. And if you’re up to it, you can do a little political prankstering of your own on the way out of the country.

Hope you can join us…

Investing In The Age Of Empire
Vancouver, BC, July 26-29
Early Bird Discounts Available
Call Agora Travel at 800.926.6575 or 561.243.6276 for all the details.

*** And this from an anonymous source:

“Yesterday, Bill, you wrote: ‘And as an institution degenerates, so do the attitudes and habits of the people who run it. The managers – who are rarely real capitalists or real entrepreneurs themselves – have the same attitude. They want to get as much as they can out of the business for themselves and then move on.’

“Observation: some of the big problems in our country and in our corporations stem from the fact that the managers (and the voters) aren’t owners. GE buying iVillage for $600 million, for example. I remember when that piece ‘o crap business IPO’d.

“Of course, it soared in price. But the folks who were dumb enough to buy it and bid it up to $100 a share – those were the same folks who got killed when it returned to its real market price. The GE managers who bought it, on the other hand, they’ve got nothing personally at risk if it fails. Like President Bush in Iraq. He’ll be out of office soon and he’s only got daughters. I doubt if the entire Bush family has a single son in the armed forces today. Quite a difference from WWII when Bush Senior got shot out of the sky, isn’t it? George Senior had the opportunity to experience the risks of world improving. George W.? He hid in the National Guard. Nobody on his senior staff – Rumsfeld, Cheney, etc. – served either. To them, soldiers being killed in foreign lands is only an abstract idea.

“They’re more irritated by someone being in their parking space at the Pentagon.”

*** “We should have bought when we first got there.”

Elizabeth was making what she considered a simple observation; her husband took it as a provocation. We did not buy an apartment in Paris five years ago because he didn’t want to buy one. Now, we are buying an apartment and find the prices substantially higher than they were when we first moved to the city. For reference, Elizabeth found an ordinary three-bedroom apartment in an ordinary building in an older section of the very ordinary 16th arrondissement. It’s the kind of apartment you find all over the city. The price: $2 million, about twice what we hoped to spend.

“We made the right decision five years ago,” he explained. “We didn’t want to buy then (he was speaking for himself but used the ‘we’ form for self protection) and we didn’t buy.”

“Wait,” send Henry. “How can you say you made the right decision? Now you’re going to have to spend twice as much money. You would have been a lot better off if you had bought when we first got there. So, the right decision was to buy, not to rent. You messed up…admit it.”

“We didn’t mess up,” his father protested. “We didn’t know prices were rising.”

“Oh yes we did,” Elizabeth interrupted.

“No one can know what will happen in markets…or in the future at all. That’s why you can’t base your decisions or your conduct on what you think will happen. You have to always make decisions based on what is the right thing to do, not based on your speculations about the future.”

“Hold on, Dad. When you’re crossing the road and a big bus comes at you…you jump out of the way, because you know what will happen if you don’t. You’re basing your decision on what you think will happen in the future.”

“That’s different; that’s a calculation of the future based on direct, personal experience and observation. You can’t do that with things like housing markets. You just don’t know.”

“So, you’re saying the right decision has nothing to do with the outcome?”

“Yes. You have to always try to do ‘good.’ Whether you do well or not is not up to you. It depends on how things work out, but you can’t control all the things that decide the future. You just do your best. You do ‘good.’ If you’re lucky, you’ll also do well.”

“Oh, Dad…why don’t you just admit that you messed up?”

Here at The Daily Reckoning, dear reader, we do not aim for financial success. Instead, we aim for the stars. That is to say, we don’t know if we will succeed or fail. We don’t worry about it. Nothing we can do will guarantee success; all we can do it is deserve it. We aim for heaven…and occasionally, shoot ourselves in the foot.

The Daily Reckoning