Lessons of History, Part II

"When the world is engulfed in a wave of speculation," says Marc Faber, "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…"

Investors should never forget the lessons of the South Sea Bubble and John Law’s experiment with paper money, discussed in yesterday’s Reckoning. The Mississippi Scheme in particular is relevant to the current situation in the U.S.; 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 realised 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 practised 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.

The Mississippi Scheme: Banque Royale

In my article, "The South Sea Bubble and Law’s Mississippi Scheme" we looked at how the excessive money supply creation by the Banque Royale led to soaring prices for commodities and real estate, as the French public realised 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, towards the end of a speculative stock market bubble, the smart investors and (especially in the case of the recent high-tech bubble) corporate insiders realise 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 December 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.

The Mississippi Scheme: The Only Game in Town

But 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 – kind of 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 1717 to 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 all over Europe and 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. (The conservative Swiss canton of Bern speculated in London with £200,000 of public funds and sold out at a profit of £2 million.)

In fact, 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 only really took off at that time. 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 about 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 therefore lead to a series of new bubbles somewhere else.

The Mississippi Scheme: A Commodity Bull Market

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, in the same way that the excessive liquidity created at the time of John Law’s Mississippi Scheme, and also in the late 1960s, led to a sharp rise in the price of commodities and real assets.

In particular, I want to emphasise 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, for example, 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 1290%.

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 US$0.2575 on February 16, 1931 and a marginal new low on December 29, 1932 at US$0.2425. From there, however, silver prices advanced to US$0.81 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 US$50, he would have realised a profit of close to 200 times, whereas by 1980 the Dow was up by less than three times above its 1929 peak. (Admittedly, the performance of the Dow was far better if dividends were included; also we have to take into account that the 1980 peak in silver prices was similar in nature to the March 2000 Nasdaq peak at over 5,000 – in other words, a once-in-a-generation bubble peak.)

I might add that gold shares performed superbly in the Depression years. From a low of US$65 in 1929, Homestake Mining rose to a high of US$544 in 1936. Also, from 1929 to 1936, Homestake paid a total of US$171 in dividends, which was more than twice the price of its stock in 1929. (Dome Mines rose from US$6 in 1929 to US$61 in 1936.)

The Mississippi Scheme: After 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 a brief period 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 U.S. don’t improve, it is likely that the U.S. dollar will weaken much 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 15, 2003

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 U.S. 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.

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report. Headquartered in Hong Kong for the past 20 years, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public.

Looking ahead to where the real growth opportunities of the next 30 years lie, Dr. Faber has distilled his analyses into the ground-breaking book, ‘Tomorrow’s Gold’ – a wake-up call to Western investors.

"Spending our way to disaster," begins a CNN story. "The consumer debt bubble in the United States could make the stock bubble seem like nothing," it continues, stealing not just our thunder, but our lightning and hailstones too.

"The American consumer has become deeply addicted to spending, running up ever-higher levels of debt in order to live in a fashion that is beyond his means. And the world has become equally addicted to the consumer continuing to burn through cash.

"It’s a dangerous situation – potentially a bubble that dwarfs even the U.S. asset bubble that burst in 2000 – and it will be a challenge for policy-makers to keep it from ending badly." It will be more than a challenge, we think. It will be impossible.

Back in the ’60s, Americans borrowed about $1 for every $3 of extra income they earned. By the ’80s, they were up to borrowing $1.50. But when the something-for-nothing mentality really took hold of the country in the late ’90s, when the ratio rose to the point where Americans were borrowing $4 for every $3 in new income. Then, in the last couple of years, Americans borrowed even more – about $4.50 for every 3 bucks of extra income. And most recently, according to Kurt Richebächer, for every $3 increase in income, debt was clocked running at nearly $9.

The consumer didn’t worry about it, because interest rates fell so much he was able to refinance his house…reschedule his debts…and buy a new car at zero- percent interest. "We’re a what’s-my-monthly-payment nation," says Northern Trust’s Paul Kasriel.

House prices – rising more or less in line with increases in the money supply – and low interest rates made it possible to keep the spending frenzy going. Consumers could ‘take out equity’ while actually reducing their monthly payments. CNN notes that Wells Fargo now offers NowLine Visa, which gives homeowners access to a home equity line that can be used "for everyday expenses like gas, groceries, clothes, etc."

Thus does ‘the world’s mouth’ gobble down its own houses, one brick at time. Would it surprise you, dear reader, if it developed a case of indigestion?

Just as you can’t get something for nothing, neither can you use nothing to pay back what you borrowed when you thought you had something.

Instead, creditors will want hard-earned cash.

Over to you, Addison…


Addison Wiggin with news on the markets…

– Here’s news: Powerful interests are said to be resisting change at the New York Stock Exchange. Ya don’t say.

– After Dick Grasso ceremoniously departed as head honcho of the exchange – following scrutiny over his $187 million deferred-compensation package – many of the nation’s wish- they-were-powerful windbags started calling for "major reforms." Yesterday, state pension fund managers met with new acting interim chairman, John Reed, and tried to strong arm him into exacting changes in the way the NYSE is governed. Their beef? Securities firms that are members of the exchange are charged by the SEC with the task of self- regulating.

– "…A lot of people wanted to see [Reed] come in and spray a little perfume around the place and leave," Iowa Treasurer, Michael Fitzgerald, told the Washington Post after meeting with him. "He’s not going to do that." According to the Post, Reed has proposed reducing the number of members on the board to seven – all from outside the securities business. Great…maybe they’ll assemble a strong panel of masons, tugboat captains and pastry chefs to govern the exchange. Anything would be better than letting the people who know the business run their own show, wouldn’t it?

– Investors sprayed a little perfume of their own yesterday…and took the market out for a dinner and a movie. The Dow Jones closed 48 points higher at 9,812 – its first time above 9800 since May 2002. The Nasdaq inched its way nearly 10 points closer to the 2000 mark, but fell short at 1,943. The S&P posted a 4-point gain to close at 1,049. All 25 earnings reports released yesterday morning were either at or above expectations. Financial stocks swooned at the deliciously sweet odor of ‘economic recovery.’

– But what’s this? A tussle in the lobby. "Business To Lenders: Drop Dead!" says an onlooker. "Despite low rates, companies spurn borrowing," a subhead on CNN.com provides a little detail, asking, "Could it mean the recovery will be weak?" Even though business lending rates are at their lowest level in 20 years, according to a Federal Reserve report, the dollar value of commercial and industrial loans dropped to its lowest level in five years. Intel, for example, beat their own earnings estimates by 20%. But what may seem like blissfully good news for tech investors was inhaled a bit more soberly by Intel execs. They reported yesterday, too, they do not intend to increase their capital spending budget for the year.

– "A rebound in confidence," explains the CNN piece, "has certainly encouraged businesses to replace warn-out equipment…but with pricing still weak, cost-cutting is still the order of the day. This could mean the next burst of business investment won’t come for some time. It also means hiring, which is often the companion of business expansion, will also remain stagnant, at least for a while."

– "The tap is turned on a little higher than before," says Anirvan Banerji of the Economic Cycle Research Institute, "so we may see a little more job growth than before. But that just means we will shift from a ‘job-loss’ recovery to a ‘jobless’ recovery."

– It’s not just jobs that are missing from this reflating market bubble. Gas and gold stocks got trounced yesterday, too. The HUI closed down slightly. Oil dipped to $31.82. Treasuries got roughed up a little; the yield on the 10-year rose to 4.35%, up 9 basis points from Monday’s close.

– Gold, however, bucked the trend and gained 50 cents to close above $376.

– In the Pao Mo column, word comes that China’s auto industry is overheating…Yahoo! News reports that production of motor vehicles rose nearly 47% through August of this year. The surge in production has help boost the profits of China’s top 14 auto companies (all state-run) by 76% year to date. "There is a new Asia to discover," writes Marc Faber in the introduction to his book, "Tomorrow’s Gold." "If I were 26 again, I would likely move to Shanghai, Ho Chi Minh, Yangon or Ulan Bator. I would learn the local language to perfection, live with seven concubines and start a business."


Bill Bonner, back in Paris…

*** "An unusual divergence has developed between stocks and the dollar," writes Carl Swenlin in his Decision Point Alert. "Stocks have bottomed and gotten stronger, while the dollar has weakened significantly. This is probably a manifestation of the Fed’s liquidity pump gone wild, reinflating the stock bubble and undermining the soundness of the dollar. My guess is that this is not a good thing."

*** Meanwhile, an article in Britain’s "Guardian" highlights the findings of economists Christina and David Romer. Analyzing data from previous cycles, the Romers discovered that the effects of interest rate cuts come faster than previously thought.

"Applying the Romers’ findings to the American economy," explains the Guardian, "suggests there could be bad news on its way. The Fed has already cut interest rates steeply – and if the Berkeley economists are right, the benefit of those cuts have already been passed through to industry. With base rates in the U.S. now at 1%, that means the Fed has very little gas left in the tank to get the U.S. economy running again."

*** "Stop picking on Rush," came a response to yesterday’s Daily Reckoning. "The poor man got hooked on painkillers after an operation. He’s admitted it. And he’s taken responsibility for it. Give the guy a break."

Ah, we love Rush like we love all sinners. But while we love honest sinners, we can’t help but ridicule humbugs. What we fault the man for is not his drugs, nor hiding the fact from his audience – it was none of their business anyway. It is the confession that we find pathetic and fraudulent. Rush says he does not consider himself a "victim." Yet, describing his drug taking as an "addiction" and asking for his listeners’ prayers makes it sound as if he had been struck by polio. If he were not in control of himself, why did he suddenly recognize it only after being outed by his housekeeper? Why does he not admit that he took drugs because he liked the sensation they gave him…and he’d still be taking them if he had not been exposed?

*** "There is an interesting point (among many!) in the following article," writes Daily Reckoning reader Byron King, "that the British occupation of Mesopotamia-Iraq in the early 1920’s was very expensive. (Well, duh. Taking over distant lands tends to be expensive, particularly if you cannot afford it, as Casey Stengel would say.) My take on it is…

"It was not just Britain’s World War I war debts, almost all of which were owed to the U.S., but the tipping-force of its Iraq war bills of the 1920’s, that caused a run on the Pound Sterling in the early-mid 1920’s.

"And then it was Britain’s ill-fated effort to support a falling Pound that caused U.S. Treasury Secretary Mellon to OK the ‘loan’ of U.S. gold reserves to London, followed by an increased use of the U.S. Dollar (then worth $20/oz of gold) as a world trade-settlement currency. More and more U.S. gold left the country (as in the expression ‘boatloads’), which prompted the Fed, which had only been around since 1913 and did not know what the hell it was doing, to increase the money supply (actually, it was the paper currency supply because the Fed has never operated a gold mine.) This additional Fed-created credit funded the ‘Bubble That Broke The World,’ as the great economic writer Garet Garrett called it, or ‘the Roaring ’20’s’ as it is affectionately known.

"This FED-induced credit bubble, coupled with massive corporate and Wall Street shenanigans that make Enron & Worldcom look tame by comparison, led to the 1929 Panic in FDR’s New York state. FDR’s Wall Street Panic spread across the land of President Hoover, who in turn raised taxes during a recession ‘to balance the budget,’ and funded ‘relief’ and public works projects to get people back to working. This led to the successful candidacy in 1932 of one FDR, who campaigned against Hoover deficits and tax increases and wasteful ‘make-work’ programs (hey, it doesn’t have to make sense…). And FDR’s November 1932 election precipitated a run on gold at America’s banks, such that over 4,000 banks failed between election day in 1932 and inauguration day in March of 1933. So that the first thing FDR did upon becoming President was to close the banks and, upon reopening them a week later, order all Americans to turn in their gold to the U.S. Govt. And some might argue that it has been downhill ever since.

"And now, we can connect the dots back to the British invading Iraq. The next time a member of the Iraqi Governing Council asks the U.S. to ‘leave,’ ought we to take him up on the offer? Hey, I’m not making policy. I’m just thinking out loud."

The Daily Reckoning