History Repeating

For those of you that spent history class with your head on your desk, fast asleep, this is a must-read. In Part 2 of this classique essay, Marc Faber illustrates the importance of drawing from the past to prepare for the future…

Investors should never forget the lessons of the South Sea Bubble and John Law’s experiment with paper money, as discussed in Friday’s Reckoning. The Mississippi Scheme in particular is relevant to the current situation in the United States; in fact, there are several lessons contemporary investors can learn from John Law’s rise and ultimate demise.

It is true that Law’s policies were initially a great success, boosting the French economy considerably. In fact, at his peak in 1719, Law was one of the most admired personalities in continental Europe. But the Mississippi Scheme failed, and Law fell from grace because the Banque Royale held for too long the firm belief that it could solve every problem simply by increasing the supply of paper money. When Law finally realized that the enemy was a loss in confidence in paper money and accelerating inflation, the damage had already been done.

There will surely be a time when the present "chain letter" type of fiat money operation practiced by the U.S. Federal Reserve Board will similarly no longer work and lead to a sharp depreciation of the U.S. dollar. The other possibility, of course, is that the dollar begins to depreciate, not compared to foreign currencies, but – as was also the case at the time of John Law – against commodities and real assets.

Stock Market Bubbles: The South Sea and John Law

In my article "The South Sea Bubble and Law’s Mississippi Scheme", we look at how the excessive money supply creation by the Banque Royale led to soaring prices for commodities and real estate as the French public realized that the banknotes were depreciating in value.

Concerning real estate, it is very common for prices to continue to rise for some time after a stock market bubble has burst, for two reasons. Once speculators realize that stocks have hit a peak, they shift their funds to another object of speculation. In other words, when the world is engulfed in a wave of speculation, the wave doesn’t end abruptly, but tends to carry on for a while and spreads to assets other than equities, such as real estate, commodities, art, etc.

Furthermore, toward the end of a speculative stock market bubble, the smart investors and (especially in the case of the recent high-tech bubble) corporate insiders realize that prices have shot up too much and bear little resemblance to the underlying fundamentals. Therefore, they shift and diversify part or all of their funds into assets that didn’t participate in the whirlwind of speculation and are consequently absolutely, or at least relatively, "cheap."

Thus, real estate prices continued to rise in Japan throughout 1990, for example, although the stock market had already topped out on Dec. 29, 1989. And in the case of Australia, real estate prices continued to rise for another two years after its stock market peaked out in the summer of 1987.

Stock Market Bubbles: The Only Game in Town

Although real estate prices can stay strong for some time after a bubble bursts, as money shifts from liquid assets into real assets, in due course, some kind of a bubble also occurs in real estate, because the property market becomes – in the absence of a strong stock market – the only game in town. As a result, real estate prices eventually also succumb to the forces of demand and supply and then follow the declining trend of equity prices.

The Mississippi Scheme and the South Sea Bubble are also interesting from another point of view. The wave of speculation in the period of 1717-1720 spread across the entire European continent, and the subsequent crisis was international in scope. The initial success of the Mississippi Company attracted investors from Britain to Paris, where they speculated in the company’s shares. At the same time, many investors from the continent also bought shares in the South Sea Company and other hot new issues in London.

In early 1720, a bizarre reallocation of assets seems to have taken place among international investors. As we have seen, the shares of the Mississippi Company began to collapse in January 1720, but in London, the shares of the South Sea Company had only begun to take off. In other words, British and international investors were in no way perturbed by the collapse of Law’s scheme. In fact, in London, the view was that the scheme had collapsed because of a political conspiracy against Law, since he was of Scottish origin.

However, in the summer of 1720, just as the South Sea stock peaked out, speculators moved funds from England to Holland and Hamburg in order to speculate on continental European insurance companies. I mention this because once excess liquidity has been created, money will flow from one sector or country to another very quickly and can lead to a series of new bubbles somewhere else.

For today’s investor, however, the most interesting effect of excess liquidity creation is perhaps found in commodity prices. In the future, just as during the Mississippi Scheme, a bull market in commodities is a distinct possibility and could exceed investors’ expectations. I have no doubt that the Federal Reserve Board will continue to flush the economy with liquidity, which at some point could spill over considerably into the commodities markets, as it did during the Mississippi Scheme, and also in the late 1960s, which led to a sharp rise in the price of commodities and real assets.

In particular, I want to emphasize that commodity prices can increase sharply under any economic scenario, provided that there is excessive money and credit creation and that investors’ confidence in financial assets is shaken. Take the early 1970s, when commodity prices soared, even as the global economy headed for the worst recession since the 1930s. Even more impressive than the rise in the CRB Index was the performance of agricultural commodity prices. From their lows in 1968-69 to their highs in 1973-74, wheat rose by 465%, soybean oil by 638%, cotton by 317%, corn by 295% and sugar by 1,290%.

Or take the deflationary Depression years of the 1930s. At the time, the price of silver had been in a bear market since 1919, but made a first bottom at 25.75 cents on Feb. 16, 1931, and a marginal new low on Dec. 29, 1932, at 24.25 cents. From there, however, silver prices advanced to 81 cents in 1935, for a gain of more than three times their lows. In addition, if an investor bought silver in 1929 instead of the Dow Jones, which was then above 300, by 1980, when silver hit $50, he would have realized a profit of close to 200 times, whereas by 1980, the Dow was up by less than three times its 1929 peak.

Stock Market Bubbles: Extended Bear Markets

The most dramatic commodity bull markets all originated after extended bear markets, such as we have had since 1980 and which accelerated on the downside following the Asian crisis and again in 2001, when it became clear that the global economy was in trouble. At issue is the fact that off their lows – whenever these lows occurred – commodity prices experienced dramatic upward moves within brief periods of time.

If the global economy doesn’t improve dramatically, it is likely that commodity prices will be boosted, because of further liquidity injections by the monetary authorities as well as expansionary fiscal policies. Moreover, if the U.S. economy and the investment climate for financial assets in the United States don’t improve, it is likely that the U.S. dollar will weaken even more.

Now consider this: Investors have little faith in either the euro or the yen. Therefore, if in the future international investors lose confidence in U.S. dollar assets, where will they go with their liquidity?

Take as an example the Asian central banks whose assets are concentrated in U.S. dollars and who only hold about 3% of their reserves in gold (down from 30% in 1980). If the day should come when their faith in the U.S. dollar is shaken, will they pile into euros or the yen? Possibly, but it is also conceivable that, given the less-than-stellar fundamentals for these currencies – a diversification into gold will be considered.


Marc Faber
for The Daily Reckoning
October 19, 2004

P.S. As a holder of gold shares and physical gold myself,
I sincerely hope that there will be genuine deflation in the domestic price level in the United States. In this case, the economic mess will be complete, as the default rate among corporate borrowers will soar. At the same time, the confidence and blind faith of investors in the omnipotence of Mr. Greenspan will finally collapse and lead to a panic. That in such an environment gold prices could go through the roof isn’t difficult to envision.

With or without inflation, investors should therefore continue to accumulate gold and silver shares and a basket of commodity futures.

Correctus interruptus.

Yesterday, the dollar fell below $1.25 per euro. The euro came out at $1.12 and then dropped as low as 88 cents. American analysts yucked about how "old" Europe could never compete with the United States. Then, the dollar fell – losing almost half its value against the euro in a few months’ time. Everyone expected the dollar’s collapse to continue. (Readers will recall that we said we thought it would hit $1.50 per euro.) But the correction was interrupted…as all major corrections are…with a bounce. The dollar seemed to regain strength over the spring and summer. But now the autumn leaves are falling again…and so is the dollar, probably headed for $1.50 per euro.

The dollar is going down because more dollars go out of America than come in. The bank of Alan Greenspan, in its majestic wisdom, makes credit available to American borrowers at attractive rates. Borrowers use the money to buy things from overseas – where people sweat to make products for the "thinkers" in the United States. Thus, more U.S. dollars end up in foreign hands than foreign money in U.S. hands.

The imbalance has been corrected thanks to the generosity of the foreigners, who have been kind enough to lend it back to us. But lately, they seem to be finding other uses for their money – perhaps buying gold or oil. In August, foreigners returned less money to the United States than the month before…foreigners bought just $59 billion of U.S. financial assets, the least since last October.

For the last six months, nothing happened with the dollar. It traded between $1.17 per euro on the high side and $1.24 on the low. Now, stuff seems to be happening. The dollar’s long-awaited correction may be continuing.

A similar correctus interruptus took place in the Dow. After the opening of the bear market in January 2000, the Dow sunk below 8,000. Then, a countertrend rally took it back over 10,500 in February of this year. That bounce also seems to have topped out. The homebuilders are sinking. The insurance companies are dropping. The automakers, too.

"Do you really think the dollar will continue going down?" asked a friend last night. "Paris is getting very expensive. All my friends from the United States complain about it. What are we going to do?"

"You can’t know what the dollar will do. But for every penny to be made on the upside by betting on the dollar to go up…there must be at least 10 to be lost. We’d much rather hedge against the dollar going down than bet on it going up – even if we thought it would go up.

"It’s a little like the bond market…or even the stock market," we continued. "If the dollar collapses, U.S. bonds will collapse, too. But we have a hunch that bonds will go up before they go down. Because we expect a Japan-like slump – at least, for a while. On the other hand, there is so much money to be lost in bonds when the dollar goes down…and so little to be made…it’s probably better to be short…or out altogether.

"And stocks…how much upside could there be? Are consumers going to find money under the seat cushions? Are companies going to make a fortune by selling U.S.-made goods overseas? Stocks are already expensive. The dividend yield is below 2%. The transports are selling at a P/E of 90. The dividend yield on the transports is barely 1%. People are not buying them for the dividends, in other words. They buy them because they expect them to go up. The professional sentiment indicators tell us the same story – investors are overwhelmingly bullish, and have been for a long time. But when people buy stocks because they think they are going up, and not for the dividends, it invariably means that they won’t go up. It’s when they buy stocks for the dividends…and when they don’t believe they will go up…then stocks actually do go up.

"We don’t know what will happen, but it seems much more likely that they will resume the correction that began in January 2000…most likely it will go on for another 10 years."

More news, from Eric Fry in New York:


Eric Fry, reporting from Lower Manhattan…

"The consequences of a new bull market in taxation are profound and far-reaching. But one very simple question comes to mind: would it be better to pay taxes now, or defer them to some distant year when tax rates may be much higher?"

Interested?  Want to read more?  Check out

Bill Bonner with more views, from London:

*** The British tabloid press is full of the usual entertainment:

The Daily Mail includes a two-page centerfold spread of "Yummy Mummies," with before and after photos of women who recently gave birth. We are supposed to marvel at how good Liz Hurley looks two months after having a son. But why wouldn’t she? We must be missing something.

Page 3 has another pointless story. A rich man intends to "knock down a 1.9 million pound mansion," says the headline. We are given a photo of the house – supposedly a Victorian mansion – and a sketch of the house he wants to build in its place. As near as we can tell, he plans to level one ugly house and put up another ugly one. Why should we care? Again, we must be missing something.

Poor Richard Dreyfuss. He was supposed to open in a West End version of The Producers this Friday. According to the Daily Mail, the real producers sent him a text message yesterday telling him he was fired. "He just wasn’t funny," said a source.

*** The French papers are more like their American counterparts; they are dull and pretentious.

Today’s Liberation tells us that 300,000 taxpayers (including your editor) in France now pay the wealth tax – a tax not on your income, but on how much "wealth" you own. For instance, if you have a fortune of 20 million euros, Liberation explains, you pay 290,520 euros each year – even if you actually lose money during the year.

Liberation clearly thinks you should pay more.

*** Another Liberation story reveals that 18 American soldiers in Iraq have "mutinied." The story made its way into the International Herald Tribune too. Apparently, the soldiers decided it was just too dangerous to escort a convoy of tanker trucks; they refused.

Why weren’t the soldiers lined up and shot?

Wars should be taken up reluctantly and fought ferociously. A good country only goes to war when it has to, in other words, and then fights as though life were at stake – because it is. The Bush administration seems to have it backward: It rushed into a war in Iraq for reasons that it has yet to explain…and now fights as though it were a public works project. The soldiers are treated as though they were unionized employees; they may be subject to "disciplinary action," the Herald Tribune tells us.

Marshal Zhukov, arriving to take charge of the Russian defense of Stalingrad, lined up whole regiments of troops who had fought poorly. He had every 10th man shot – reviving the ancient practice of decimation, which had not been seen since the Roman era.

In their retreat from East Prussia, the Germans hung hundreds of their own soldiers from lampposts as a warning to the rest – the least malingering or hesitation would be severely punished.

Last night, we read a book of letters from French soldiers in World War I. One told how his outfit had been ordered to attack German trenches in 1915. First, the enemy was to be "softened up" with artillery. But when the cannons stopped and the poor French looked out, the barbed wire was still in place. Both officers and men knew it was suicide to attack. But they had their orders. So they wrote out their farewell letters, fixed their bayonets and went out.

"The officers led the way," wrote one of the few survivors. "They carried a revolver or a bayonet. Behind each officer was a group of six soldiers who carried big cutters to get through the barbed wire. And then, the rest of the infantry followed. We all yelled, ‘Onward. For France.’ and moved towards the enemy at a half run. Everything was quiet. Then the officers reached the barbed wire. Our lieutenant stood up to motion to the wire cutters to get to work. A bullet went through his head. All of a sudden, it was raining bullets. The other officers went down too. And then, the rest of the troops. In a few minutes, all were down. Most were dead. Some of us were merely wounded. But the German machine guns kept raking the ground so we were hit again and again. I managed to push a little dirt in front of my head…"

Good men like that are a nation’s treasure, says your editor; it is a shame to waste them.

We sympathize with the mutineers, too. There are some duties not worth doing. Unless a man wants to run for president, why take the risk?

*** A remarkable Daily Reckoning reader:

"You mention a family that lives on $30,000 per year and saves $500 a month. Well, my wife and I have NINE kids and we live on my salary of $49,700 per year, and we save between $500 and $600 per month. And we live in the Maryland suburbs of Washington, D.C. And no, we don’t have cable. And my kids are well fed and wear clean clothes."

*** And another:

"Cable TV a frivolous thing????? Nooooooooooooooooooo!! I don’t go to movies, plays, operas, concerts, skiing, boating, hunting, racing, sporting events, blah blah blah, etc. Because I have CABLE!!! Broadband Internet and cable with tons of books to read and music to play and records are all I need. No HBO? Give me HBO, or give me DEATH!

The only other hobby I have is buying silver and gold, gold and silver stocks (energy too).

*** And a comment:

"If these fellows on Place Pigalle were singing, ‘Sail
Bonny Boat,’ they were Scotsmen in English jerseys.
Irishmen would never be seen inebriated in a public place, not even in Place Pigalle."

The Daily Reckoning