Hitler's Blackberry

Poor old Ben Bernanke has a deflation phobia. He sees it everywhere the way the kid in The Sixth Sense saw dead people. And Bernanke is equally terrified of falling stock prices (and their effect on consumer confidence).

Falling stock prices are what some people call deflation, or asset price deflation. Bernanke, the governor of the US Federal Reserve, believes the Fed made the Depression a Great Depression by raising interest rates too soon during the US recovery. He won’t make that mistake again! He will simply not allow stocks to fall.

The Fed chairman’s recent speech to the National Association for Business Economics lit a fire under US stock prices. All the US indexes charged ahead. And even gold got off the mat to close higher. Stocks are addicted to lower interest rates and yesterday they got a nice satisfying hit.

Bernanke is on the record for saying he’ll keep US rates low until 2014. Yesterday he repeated his willingness to keep rates low, saying, “Further significant improvements in the unemployment rate will likely require a more-rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies.”

It’s a bizarre world. The Fed chairman thinks lower rates are needed to produce more economic growth. Growth will produce jobs. Jobs will lead to spending. Only then can interest rates — the price of Fed money — be raised.

It’s a shame he can’t understand that the US rate policy is unsound. And since the rest of the world more or less keys off from US interest rates, an unsound US monetary policy leads to an unsound global monetary policy. By “unsound” we mean a policy that keeps interest rates too low, leads to asset price inflation, and a giant boom in debt.

This is all well-worn territory to long-time Daily Reckoning readers. If there’s anything comforting about the tenacity of Bernanke’s stupidity it’s that you have time to narrow down your stock holdings in a rising market. It’s much better to exit the market when stocks are floating along on a sea of liquidity than when they are crashing down.

But then that’s the issue now, isn’t it? As scared as Bernanke is of the 1930s, he and his central banking colleagues around the world are even more scared of another Lehman Brothers. This was a point we made at our Sydney conference. The lesson of Lehman is that central bankers will simply not allow another major financial institution to fail. They can’t afford to.

The financial system is still so leveraged and interconnected (mostly through the derivatives market) that regular infusions of credit and the monetization of government debt are required to keep it at a steady level. In some ways, the deflation you’d normally expect at the end of a credit bubble is actually happening right now — it’s just disguised by the huge growth in central bank balance sheets.

In other words, stock markets have become a giant charade. The indexes don’t communicate useful or accurate information. Prices have become more influenced by the supply of credit in the system than the underlying earnings of the businesses on listed exchanges. The whole thing looks suspiciously like a racket designed only to benefit the banks, the brokers, and the bureaucrats who nominally regulate them.

It’s kind of refreshing to say that, although we concede we could be wrong. It’s refreshing because once you acknowledge that the game you’re being asked to play is rigged, you can choose not to play the game. This makes your asset allocation decisions a lot easier. For instance, we bought more gold bullion this morning.

Not everyone agrees with our view that these periodic rallies are great times to liquidate portions of your portfolio. For example, Goldman Sachs released a report last week making the case for stocks. The report had a lot of big words and complicated arguments. But the basic argument was that stocks will do better than bonds, especially if the Fed keeps rates low.

People seem to forget that businesses exist to provide cash flow to their owners by providing services to their customers. Instead of an investment strategy that depends on the Fed’s monetary policy, why not invest in businesses that grow their earnings without using leverage? That seems like a better long-term bet.

In any event, the Fed’s willingness to keep pumping credit into the financial system gives you time, or at least the illusion of time. Time is a valuable commodity. It’s so valuable you can’t even buy it or sell it. You can only maximize it by using it to your best advantage. These rallies should be sold.

This brings us back to the code breakers of Bletchley Park. These men were brilliant. But they would never have become important if it hadn’t been for the hubris and paranoia of Nazi Germany. Allow us to quickly explain.

You may be familiar with the story of Alan Turing. He was one of the heroes of Bletchley Park. He’s credited with breaking the code used on Germany’s Enigma machines. Those machines were found especially in German U-boats, but were used throughout the German war machine.

Turing, by the way, later became famous for being a sort of God-father of information theory. His work led to the development of the first real computers (Turing machines). The video we linked to yesterday was so interesting because it showed that the Colossus machine built by Tommy Flowers, and based on the mathematics of Bill Tutte, was actually the world’s first electronic and digital computer.

But the Enigma machines were not used by Hitler or the German High Command for their most private and secret communications. Those conversations were conducted via encrypted messages sent by a Lorenz machine, or Hitler’s Blackberry, as one historian has called it. The German word for this machine is Geheimschreiber, or secret writer.

The British called the code generated by the Lorenz machines “Tunny”. Bill Tutte cracked Tunny in 1941. It was an amazing achievement, but it wouldn’t have been possible without a mistake. On August 30th, 1941, the German high command sent the same message twice from Athens to Vienna.

It was a 4,000-character message that wasn’t received correctly the first time. When it was sent a second time, the operator in Athens didn’t change the key in which the message was encrypted. The result was two messages sent with the same encryption. This provided cryptographers with what they call “depth”. Depth allows for pattern detection, but obviously requires multiple messages with the same encryption.

There are many fascinating aspects of the story. For example, you’d think that if the Allies could read the messages between Hitler and his commanders as early as 1941, the whole war would have been shortened. And in fact, it probably was. But the Allies had to be careful about how they used the intelligence they gathered from Tunny.

If, for example, the Allies avoided every German ambush, were prepared for every German attack, and shot down every airplane carrying a German officer or general, it would have been obvious to the Germans that their communications weren’t secure and their code had been broken. The Allies had to use the intelligence gathered from Tunny in a way that looked random and improbable, not in a way that looked like they knew exactly what was coming.

Another interesting aspect is the use of pattern detection in code breaking. It would be nice if you could do the same with stock prices. You can’t, of course. But it is some consolation to know that there are patterns in economic and financial history you can study. They aren’t predictive. But they can give you a picture of what has happened in the past. Maybe this improves your probability of correctly preparing for the booms and busts ahead. Or maybe not.

By far the most interesting aspect of the whole affair is how trusting the Germans were in technology. This trust was born of a mistrust of people. The Nazis required machine-generated secrecy because the regime was paranoid. It never occurred to Hitler that his unbreakable machine had been broken. His penchant for secrecy became the proverbial Achilles heel.

We would attribute this failing not just to Hitler or to human psychology but to the entire idea of National Socialism, or top-down central planning. People who believe in their own ability (and moral right) to organize society (and economy) according to their ideals and prejudices are naturally arrogant and possibly psychopathic. That’s why you should never vote for anyone who believes themselves deserving of public office.

The Nazis’ paranoid self-belief cut them off from real thinking people capable of making sound judgments and put them at the mercy of, in this case, machines. It’s no coincidence that the people who support regimes like this are little more than Turing machines that follow orders as if they had no free will. The non-thinking and non-questioning people of the world are generally more compliant of tyranny. In fact, tyranny wouldn’t be possible with them.

By contrast, the British and American code-breaking effort was full of people that would have been excluded from the Nazi hierarchy, or exterminated in the death camps. Jews, gays, loners, and eccentrics all flourished in the Allied war effort, although Turing, who was gay, was later treated shamefully by the British government. These societies were not afraid of using every asset they had in order to defeat their enemies.

Systems that allow human ingenuity to flourish are far more likely to adapt and survive in a hostile environment and produce prosperity (or prolong life, in simpler terms). It’s probably a bit of a stretch to call Bletchley Park (or the Manhattan Project, for that matter) open systems. They were ultra-secret projects, of course. But they did draw on all the talents and strengths produced by American, British, and European society at the time. And those societies were all stronger because of their commitment to political and economic liberty.

We’re referring to the bedrock strengths of liberal democratic societies: the belief in open and honest scientific inquiry, basic political and religious liberty, and the rule of law committed to the protection of private rights and low taxes. Liberal systems must sometimes defend themselves from predatory ideologies and nation states. In this instance, the strengths of liberal society were put in the service of defending the system against the Axis powers.

When not mobilized for war, these strengths, at least for most of the last 300 years, have created innovation and prosperity for individuals in the free market. That should be encouraging. The intuitional DNA of the Western world is strong. If Aristotle is right that all men by nature desire what is good, then we will survive this current experiment in centralized government funded by unsound money and get back to a better, more resilient system.

Today’s system of the world can hardly be described as liberal or democratic or open or resilient. Institutions have been corrupted by unsound money, an intrusive State, and the myriad bad private decisions made by people and corporations under the influence of too much credit. Innovation and adaptation are stifled by a commitment to the debts incurred by corrupt politicians and lazy voters.

Our system, in other words, has become inflexible. This inflexibility makes it brittle and fragile, even as the stewards of the system remain supremely confident in both it and themselves. Hitler’s Blackberry and Bernanke’s printing press are both creations of hubris and vulnerable in the same way. Their overconfidence is their weakness.

But in a way, we’re thankful we’ve got Ben Bernanke on the job. Bernanke is like some misguided Spartan guarding the pass at Thermopylae (for his paymasters in the financial world). He’s giving them time to exit the system at a profit, passing the losses on to tax payers. But his commitment to the dollar-standard and low interest rates gives you time to prepare your portfolio for the world ahead…once the money printers are overrun by their own creation.


Dan Denning,
for The Daily Reckoning

The Daily Reckoning