The Kindleberger Trick

Thirteen rate cuts on, we ask: does the Fed have a trick up it’s sleeve? Darn right, comes the response from True Wealth’s Dr. Steve Sjuggerud…

"This is a neat trick: always come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all."

– Charles Kindleberger Manias, Panics, and Crashes

Nightmares about a looming deflationary crisis are what keep investors, banks, and even other countries up at night.

"The world can’t grow if people don’t buy stuff," is the common thought. The big concern is that the world is so deep in debt, we’re close to the point where people have to scale back – to stop buying stuff. And this is where we get into trouble…

If people stop buying stuff, then prices will fall as companies want to sell us their goods at any price. Then as we realize that prices are falling, we’ll start to delay our purchases, waiting for a lower price. Poof, a deflationary spiral.

Charles Kindleberger: Can Deflation Be Avoided?

Beyond the pile of debt, there are many other deflationary concerns – cheaper goods from China, cheaper services from India, efficiency gains (the Wal-Mart effect)…the list goes on. Can deflation even be avoided?

Interestingly enough, Charles Kindleberger suggested an answer back in 1978 – during the height of inflation. Kindleberger died a few weeks ago, at age 92. He devoted his life to figuring out how the world works…in particular, the world of finance.

In 1978, Kindleberger published his most famous book, "Manias, Panics, and Crashes – A History of Financial Crisis." Based on his exhaustive study of every investment mania and subsequent financial crisis in recorded history, Kindleberger came up with what he feels is the very best solution to avoiding deflation. Kindleberger determined that we do actually need someone like Alan Greenspan. But his argument is tricky…

"A lender of last resort should exist, but his presence should be doubted," Kindleberger concluded. Whether you agree with him or not, Kindleberger’s Trick is exactly the policy the folks at the Federal Reserve are operating under…

Smart investors know the Fed is operating according to Kindleberger’s Trick. The Fed will "always come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution in other speculators, banks, cities, and countries."

Charles Kindleberger: The Fed Under Kindleberger’s Trick

When you consider the investment possibilities looking through this lens, the investment potential (or lack thereof) is obvious. Let’s take a look at three key areas of the investment landscape of late: stocks, your home and gold.

Can we actually own stocks now? Well, let’s consider how the Fed will operate under Kindleberger’s Trick…

Following Kindleberger’s Trick, the Fed will keep interest rates extremely low for an extremely long time, all the while talking about growth in the economy that is just around the corner, and why they may need to raise rates soon.

This threat is designed to keep speculators guessing. If everyone believed interest rates would stay near 1% for years, then chances are, everyone would be speculating with their money.

Having cut interest rates to 1%, the Fed is directly responsible for the 50% increase in the Nasdaq since October of 2002. The simple reason is that the Fed has left investors with nowhere to go except to try their luck in the stock market. And the public has responded exactly as scripted, by buying stocks.

The rise in stock prices, of course, has pushed stock prices to extraordinarily overvalued levels. Which doesn’t mean there are no stocks worth holding right now…but does call for an extra dose of caution when selecting them.

Charles Kindleberger: Offsetting Deflationary Forces

Under Kindleberger’s Trick, the Fed is going to do two things: keep interest rates low, and increase the money supply. The increase in money supply is an attempt to create an inflationary force to offset the deflationary forces.

What will these two things do to the housing market?

The increase in the money supply should push home prices higher, as there are more dollars out there chasing the same supply of homes, creating an "inflation" in home prices. Additionally, half-century lows in interest rates will push home prices higher as well, as people can afford more house for the same mortgage payment under lower interest rates…

People don’t shop for homes based on the price of the home. They shop for homes based on the mortgage payment.

The housing boom really got underway in 2000. The stock market boom was ending, and people were looking for something to do with their money. I live in Florida. If you look at a chart of Florida real estate, you’ll see that housing prices here barely kept up with inflation until after 2000. People who bought in 2000 really got lucky…

In 2000, mortgage rates were about 8%, while today they’re closer to 5.5%. Back in 2000, the average Joe looking to spend $1,000 a month on his mortgage could buy a $130,000 house. Today at 5.5%, the average Joe looking to spend $1,000 a month on his mortgage payment can buy a $175,000 house. To say it another way, a $170,000 house today is more affordable to the average Joe than a $135,000 house was in 2000.

Said yet another way, yes I know that housing prices have risen a lot in the last three years. But to the average Joe, the average house isn’t more expensive than it was in terms of the monthly mortgage payment. The mortgage payment might even be cheaper to him even at today’s prices.

Charles Kindleberger: Comfortably Affording the Median Home

When you consider how much mortgage payment people can afford at their current level of income, you’ll find that more people can comfortably afford the median home in America than at any time since the early 1970s. When houses became this affordable back then, home prices nationwide doubled in six years.

While home prices have risen, I do believe that, between the affordability of mortgage payments and the Fed’s commitment to Kindleberger’s Trick, it is possible for home prices to double from here over the next six years.

This is, of course, going to come as a surprise to most readers of the Daily Reckoning. But when housing has been this affordable in the past, people have been big buyers. Since it is very affordable now in most areas (based on mortgage payment in relation to income), people are out buying. In many parts of the country, people are now paying over the asking price to get the home they want. It is a bull market in real estate. The demand for homes is obvious, and the supply of homes out there is low.

And what about gold? Well, it’s a no-brainer. When you consider Kindleberger’s Trick, you realize that the Fed’s goal is to secretly prevent deflation. How does the Fed do that? By printing money.

The goal here from the Fed is more dollars in the system – more bucks for you to spend. Meanwhile, the supply of gold is like a bump on a log – it doesn’t really expand or contract. So, like home prices, it’s Economics 101 – when the supply of dollars increases, and the supply of gold doesn’t change, it will cost more dollars to buy gold. The price of gold will go up. That’s it.

And the Fed really is going to be printing money…according to The Economist magazine, the word deflation hasn’t appeared in the press this frequently since the 1930s. To offset this major fear, it’s going to take a major money-printing operation.


Steve Sjuggerud,
for The Daily Reckoning

August 07, 2003

P.S. As I said Gold, is the no-brainer in the Kindleberger Trick. Own it, either in the stock market or through coins.

On the flip-side, the dollar is likely to continue to weaken. While in Canada earlier this month, I applied the Economist magazine’s "Big Mac Test": I checked the price of a McDonald’s Big Mac on both sides of the border at Niagara Falls (actually in Fort Erie on the Canada side). At the time (two weeks ago) a Big Mac cost $2.19 in the U.S., and $2.21 in Canada – not a big difference.

Spending a few days in Canada, I’d say your U.S. dollar goes a long way, but not as far as it used to. The purchasing power of the U.S. and Canadian dollars aren’t far off.

According to the Kindleberger Trick, however, this doesn’t matter – the dollar is what is sacrificed. As the Fed creates money, that money becomes worth less, and can buy less stuff. So in theory, just sitting on dollars (in the bank) and holding other U.S. paper assets (like stocks and bonds) is a not a good idea.

A smarter plan under the Kindleberger Trick is to hold money in real assets (like gold and real estate), and hold some money in assets outside of the dollar. That way, when you cash in on any of these assets, you’ll get many more dollars back than you originally invested.

Dr. Steve Sjuggerud has worked in the investment world as a stockbroker, the vice president of a $50 million global mutual fund, an international hedge fund manager, and the director of several research departments. An international currency expert, he is also a member of the Oxford Club advisory panel.

Yesterday, we wondered where we were. Today, we return to our dead reckoning. We look around and wonder…where is the recovery?

We know not where we are, but at least we know where we are not. We are not where most investors think: we are not in an ordinary cyclical recovery.

It cannot be an ordinary recovery because there was no ordinary slump to recover from. Unlike every previous cyclical downturn, consumers did not stop spending…and neither consumers nor businesses paid down debt. Instead, both kept buying things they didn’t need with money they didn’t have.

Why did people not do what they’re supposed to do in a downturn? Why didn’t they put off spending and reduce their debts?

For that we can thank Mr. Greenspan. While the bubble in stocks deflated, the Fed chairman did what the Japanese had done: he cut rates. Thus did he get the same results the Japanese had gotten; instead of a sharp bust, followed by a sharp recovery, lower interest rates held off the correction. Businesses refinanced debt on easier terms…and consumers refinanced their houses so they could continue spending.

"Ultra-low interest rates," explains Marc Faber in Barron’s, "lead to one bubble after another…"

Lower rates allowed marginal businesses and marginal consumers to dig deeper holes for themselves.

"What the capitalistic system then gets is not ‘survival of the fittest,’" Faber, a contributor to our own Strategic Investment, continues, "But ‘survival of the weakest,’ which has been the case in Japan since 1990…[where] low rates have prolonged the economic stagnation."

We look around us and see no line of people, with money in their pockets, ready to buy new autos and new houses; there are already millions of new houses, and a shiny new SUV in front of almost every one of them. Nor are businesses ready to hire people and expand their assembly plants. If they need more capacity, they can get it cheaper in China!

Interest rates eventually turn up, whether the Fed wants them to or not. In fact, the 20-year-long decline in interest rates may have come to an end on June 13th.

If so, Americans may soon find it harder to pay their mortgages and harder to hold onto their jobs.

The correction, long denied, might soon have its way.

Over to you, Eric…


Eric Fry, writing from New York…

– A disappointing earnings report from router-maker Cisco Systems routed the Nasdaq toward another losing session. The tech-heavy index slumped 1.2% to 1,652.68, its lowest close since July 1. The Dow eked out a 25-point gain to finish the day at 9,062.

– Cisco shares tumbled more than 6% after the company announced that its earnings merely matched – but failed to exceed – the consensus forecast. Equally disappointing to Cisco’s fans was the fact that the company said it expects only minor sales growth in the current quarter. Seems like the much-awaited IT-spending recovery will be a-waitin’ much longer still.

– The bond market rebounded a bit from yesterday’s shellacking. The 10-year Treasury note finished the session up nearly a full point, lowering its yield to 4.27% compared to 4.39% on Tuesday.

– Now that long-term interest rates are rising rapidly, why own the shares of a mortgage lender?…Especially a highly leveraged mortgage lender like Fannie Mae or Freddie Mac? At a minimum, growth is (almost) certain to fall and defaults are (almost) certain to rise. That doesn’t sound like a recipe for growth. But we’re just watching from the sidelines. Maybe the mortgage lenders look like a better investment when you’re down there on the playing field, standing shoulder to shoulder with them.

– The Wall Street Journal recently dubbed Freddie Mac a "fixer-upper." But maybe it’s really a "scraper" – that’s what the Silicon Valley crowd used to call an old, million- dollar house that would be scraped away to make room for a MULTI-million dollar house. The House of Freddie still stands, of course, but the floorboards may be rotting away in one or two places. How well will its financial structure withstand the stresses of rising rates? No one knows. Indeed, no one knows how well the entire economy will withstand the stresses of rising interest rates.

– Because Greenspan held short-term rates so low for so long, individual investors, hedge fund managers and corporate chieftains all came to understand that borrowing at low, short-term rates and investing at higher, long-term rates (even when the higher long-term rates weren’t that high) was a Fed-sanctioned, "government-guaranteed" trade. Every form of interest rate speculation known to man – and to computer – that relied upon "permanently" low interest rates was thought to be a "permanent" license to print money. And even all of the plain-vanilla financial activity that relies upon low interest rates flourished.

– The problem with any permanent license is that it is never permanent. Now that rates are rising, some folks will be exchanging their money-printing licenses for money- losing licenses.

– The direct victims of rising interest rates will include all of the major investment banks, who have generated hundreds of millions if not billions in fees associated with securitizing mortgages. The aforementioned GSE’s Fannie Mae and Freddie Mac, could find themselves in trouble as their flimsy equity balances (ie. $17.9 billion for FNM and $24.6 billion for FRE) may prove inadequate to fully absorb a tidal wave of defaulted mortgages. But the carnage of a collapse will extend well beyond the obvious victims to include companies like Deere & Co., the tractor- maker, which saw its own sizable credit operations swell to produce ALL of the company’s net income in the first quarter.

– American households are also certain to suffer from rising rates. "In the past two years, mortgage debt has been rising at two to three times the rate of personal income," Bloomberg News reports. "Mortgage borrowing rose $723 billion (annualized) in the first quarter of 2003, according to the Fed’s Flow of Funds report. That compares with an increase of $667 billion in 2002 and $375 billion in the boom year of 1999. " Not surprisingly, the ratio of the market value of real estate to disposable personal income is at an all-time high. At 1.73, the ratio exceeds the previous high of 1.6, reached in 1989.

– All of this explosive debt growth might not be so bad, except for the fact that much of it ‘floats’ with rising rates – a phenomenon that will sink many households. "As interest rates have come down," Bridgewater Associates observes, "old and new homeowners have refinanced their mortgages, typically taking more than they owed and spending about half of it. In addition to using the mortgage borrowing to finance their current consumption, they tilted toward adjustable rate mortgages because these rates are lower, [while also] raising their vulnerability to rising rates…It wouldn’t take much of a rise in interest rates or fall in real incomes to cause major mortgage default problems."

– And we’re guessing it wouldn’t take much of a rise in interest rates to cause major problems for the U.S. economy and its richly valued stock market.


Bill Bonner, back in Paris…

*** And update from the pampas…

"You wrote in the Daily Reckoning today about the Argentina peso gaining ground, as if that were significant.

"In fact the peso’s value these days is controlled by the Central Bank. And more: if market forces were left to operate the peso would increase in value. The Central Bank doesn’t want this, as it would mean a return of the bad old days of the overvalued peso. So the Central Bank intervenes every day in the currency markets, buying dollars to keep the peso from gaining ground.

"The biggest reason for the dollar excess is that the Central Bank is NOT using dollars to pay the foreign debt. My Argentine friends figure this won’t last, that when the Central Bank starts repaying debt the peso will fall. I’m not so sure, but that’s beside the point.

"Finally, the government announced extra-officially last week that they want to see the peso go a little lower. So it’s gone from about 2.75 to about 2.95, directly as a result of Central Bank intervention. The smart money is betting that the government will keep the peso at around these values, provided the country doesn’t have another big hit of inflation."

*** The peso is not the only of Argentina’s assets making headlines. International Living’s Barbara Perriello sends word that Argentinian real estate is currently a steal…many dwellings are selling at half of last year’s prices.

In Buenos Aires, for example, you can pick up a 1,550- square-foot loft with a rooftop terrace in one of the city’s chicest neighborhoods for $63,000.

Compare that with the price of a renovated loft in our own corner of the world – the 16th district of Paris. For half the space of the Buenos Aires loft, one would have to shell out a whopping $697,000.

It is enough to make your editor weep.

*** The bankruptcy of Alstom dominates the business news in France. The huge company, among other things, builds trains and heavy equipment.

"No one mentions the executive responsible for derailing this company," writes our friend Michel, "who made off with 5 million euros."

The man in question had attended France’s elite administration school, ENA, and made a career in the top ranks of government.

"French capitalism," Michel concludes, "consists of enriching members of the ruling oligarchy while ruining businesses that are supposedly in the ‘private sector.’"

The Daily Reckoning