The Perils of Success
Last month, Alan Greenspan spoke to the N.Y. Economic Club and sounded, for a while, like his old self.
“Although the gold standard could hardly be portrayed as having produced a period of price tranquility,” he conceded, “it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.”
Mr. Greenspan was setting the stage. He might have added that no central banker in all of history had ever succeeded in proving the contrary. Every fiat currency the world had ever seen had shown itself ‘subject to excess’ and then subject to destruction.
Against this epic background, the new Mr. Greenspan strutted out, front and center.
Managed Currencies: The Moral Hazard of Banking
Today’s essay is not about Mr. Greenspan, per se, but rather about his trade. Each métier comes with its own hazards. The baker burns fingers…the psychiatrist soon needs to have his own head examined. The moral hazard of banking is well documented. Given the power to create money out of thin air, the central banker almost always goes too far. And if one resists, his successor will almost certainly succumb.
There are some things, dear reader, for which success is more dangerous than failure. Running a central bank – like robbing one – is an example. The more successful the central banker, that is, the more people come to believe in the stability of his paper money, the more hazardous the situation becomes.
Warren Buffett’s father, a congressman from Nebraska, warned in a 1948 speech:
“The paper money disease has been a pleasant habit thus far and will not be dropped voluntarily, any more than a dope user will without a struggle give up narcotics…I find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands….”
In all other lands, in all other times…the story was the same. Paper money had not worked; the moral hazard was too great. Central bankers could not resist; when it suited them, they overdid it, increasing the money supply far faster than the growth in goods and services that the money could buy.
Asked to produce a list of the world’s defunct paper money, Addison was soon overwhelmed.
“I don’t think you want all these,” he replied, “looking at his screen. They’re in alphabetical order. But there are 318 of them and I’m still in the B’s. And every one of them worthless.”
Against this sorry record of managed currencies is the exemplary one of gold itself. No matter whose face adorns the coin…nor what inscription it bears…nor when it was minted…an unmanaged gold coin today is still worth at least the value of its gold content, and will generally buy as much in goods and services today as it did the day it was struck. Gold is found on earth in only very limited amounts – only 3.5 parts per billion. Had God been less niggardly with the stuff, gold might be more ubiquitous and less expensive. But it is precisely the fact that the earth yields up its gold so grudgingly that makes it valuable. Paper money, on the other hand, can be produced in almost infinite quantities. When the limits of modern printing technology are reached, the designers have only to add a zero…and they’ve increased the speed at which they inflate by a factor of 10. In today’s electronic world, a man no longer measures his wealth in stacks of paper money. It is now just ‘information.’ A central banker doesn’t even have to turn the crank on the printing press; electronically registered zeros can be added at the speed of light.
Managed Currencies: Like the Promised Land
Given the ease with which new ‘paper’ money is created, is it any wonder the old paper money loses its value?
But for a while, Mr. Greenspan seemed to have a light shining on him. Standing there, center stage of the world economy like Moses in front of the Red Sea, he believed he had found the promised land of managed currencies – for his paper dollars rose in value against gold for two decades, when they ought to have gone down.
Mr. Greenspan explains how this Exodus came about:
“But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption. By 1979, the need for drastic measures had become painfully evident in the United States. The Federal Reserve, under the leadership of Paul Volcker and with the support of both the Carter and the Reagan Administrations, dramatically slowed the growth of money. Initially, the economy fell into recession and inflation receded.
“However, most important, when activity staged a vigorous recovery, the progress made in reducing inflation was largely preserved. By the end of the 1980s, the inflation climate was being altered dramatically.
“The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation.”
Until recently, Mr. Greenspan’s genius was universally acclaimed. Central banking looked, at long last, like a great success. But then the bubble burst. People began to wonder what kind of central bank would do such a dumb thing.
Managed Currencies: The Greatest Mistake a Central Bank can Make
“Evidence of history suggests that allowing an asset bubble to develop is the greatest mistake that a central bank can make,” wrote Andrew Smithers and Stephen Wright in “Valuing Wall Street,” in 2000. “Over the past five years or so the Federal Reserve has knowingly permitted the development of the greatest asset bubble of the 20th century.”
When the stock market collapsed, Mr. Greenspan’s policies began to look less prudent. During his tour of duty at the Fed, the monetary base tripled, at a time when the GDP rose only 50%. More new money came into being than under all previous Fed chairmen – $6,250 for every new ounce of gold.
All this new money created by the Greenspan Fed had the defect of all excess paper money; it had no resources behind it. Though taken up by shopkeepers and dog-groomers as if it were the real thing, it represented no increase in actual wealth. The retailer and the dogwasher thought they had more ‘money’, but there was really nothing of real value to back it up.
The new money was issued, light on value but heavy on consequences. It helped lure the lumpeninvestoriat into their own moral hazard; they no longer needed to save – because the Greenspan Fed always seemed to make money available, at more and more attractive rates. And it misled suppliers into believing there was more demand than there really was. Consumers were buying; there was no doubt about that. But how long could they continue to spend more than they actually earned?
Encouraged by what seemed like almost unlimited buying from America, foreigners – notably, first in Japan in the ’80s, then in China in the ’90s – constructed new factories on a monumental scale. They sold their products to Americans…and then invested the proceeds, either in more capacity at home, or in more assets in the U.S. As mentioned above, by the end of 2002, U.S. manufacturing was in still in a 30-year slump…and foreigners owned nearly 20% of the U.S. stock market…42% of the treasury bonds market…and total dollar assets of as much as $9 trillion.
The effects of this moral hazard are just now being felt. The consumer is more heavily in debt than ever before – and seems to need increased credit just to stay in the same place. State and Federal governments have gone from modest surplus to flagrant deficit. Where was the money going to come from? Americans have very little in savings; it must be imported from abroad. But the current account is already in deficit by $450 billion annually. Stephen Roach estimates that the new capital demands will push the deficit to $600 billion – or $2.5 billion every working day.
Foreigners may be willing to finance the new U.S. spending binge. Then again, with the dollar already falling, they may not. We cannot know what will happen, but we can take a guess: they won’t be willing to do so at the same dollar price. The dollar ought to fall against gold…and against foreign currencies. It probably will.
January 13, 2003
Dollar down, gold up.
Two years ago, you could buy an ounce of gold for $255. Now it takes 355 dollars.
Of course, on the 30th of January, 2001, you could have bought a share of the newly combined AOL Time Warner for $54 and change. Now, it takes only $14 and change…and AOL Time Warner CEO Steve Case is resigning.
We guessed that selling stocks and buying gold would be the Trade of the Decade. So far, so good. So we’ll keep guessing.
Our guess is that this is a major trend, not a minor one. In the short term, gold has probably gotten ahead of itself. It will probably fall back and disappoint investors. But over the next few years, gold is likely to be a winner and the dollar a loser. Since Alan Greenspan has been Fed chief, $6,250 new dollars have been created for every new ounce of gold. People were perfectly happy with this as long as the new money was going into the stock market. Nobody complains about inflation on Wall Street.
But now there’s a problem. The boom on Wall Street is over. State governments are running huge deficits; New York says it will run short by $10 billion. California’s deficit equals $1,000 for every man, woman, and child in the state. And the Federal government is beginning a large spending program – $600 billion over the next 10 years.
Meanwhile, Americans continue to buy more from foreigners than they sell to them – about $1.5 billion per day.
Getting the money was easy when the going was good. But now the going isn’t so good…and the U.S. economy needs more money than ever. Government deficits have to be financed…as well as consumer spending.
Already, foreigners own 18% of all U.S. stocks and 42% of our treasury bonds. In total, they own as much as $9 trillion worth of U.S. dollar assets. Instead of adding to their U.S. dollar positions, a falling dollar suggests they’re lightening up. Trouble is, they might decide to lighten up a lot…and switch at least some of their money from the world’s most recent currency of first resort – the dollar – to man’s ancient currency of last resort – gold. More below…
But first, the latest news from our man on Wall Street, Eric Fry:
Eric Fry, reporting from New York…
– The stock market party train keeps chugging along, looking every bit like the little train that could. The farther it chugs uphill, the happier folks become…There’s just something about making money, rather than losing it, that brings smiles to investor’s faces. Last week, the Dow added 183 points to 8,785, while the Nasdaq raced ahead 4.3% to 1,448.
– After less than two weeks into 2003, the Dow has advanced 5%, while the Nasdaq has jumped an impressive 8.4%. This strong January performance puts the stock market well on its way to delivering the kinds of gains in 2003 that Wall Street strategists optimistically predict. But Mr. Market may not be so accommodating all year. Like a rebellious teenager, he often refuses to do what is expected of him. By December, Mr. Market may be sporting several tattoos and multiple body-piercings – behaving nothing like the sweet, investor-friendly lad he seems to be currently.
– Stocks may be rising, but life is not perfect in the “land of rising share prices.” Despite the strongly performing stock market – a factor that typically supports the dollar’s value – the beleaguered greenback is losing value faster than a Wall Street strategist loses credibility. The dollar dropped about one and a half percent against the euro last week to $1.0579.
– Bad news for the dollar, however, is good news for gold. Gold for February delivery advanced $3.40 to $355.00. But as noted recently in this column, the speculative bullish interest in the yellow metal has become quite substantial. Whenever bullish investors in any financial market become as numerous as sunglasses at the Grammy wards, a sell-off is often close at hand.
– According to the latest Commitment of Traders report from the Commodity Futures Trading Commission, the speculative traders in the gold market have amassed one of their largest long positions in many years. (I.e., they own a lot of the stuff). Meanwhile, the commercial traders in gold – considered the “smart money” – have amassed their largest short position in many years. In other words, whatever gold’s long-term virtues may be – and we here at the Daily Reckoning think gold’s virtues are considerable – the short-term sentiment indicators suggest the yellow metal is ripe for a sell-off.
– That said, we don’t try to tell the markets how to behave, they tell us. Furthermore, if the dollar keeps falling, the gold market won’t care what the “smart money” thinks; it will keep soaring higher anyway…
– A funny thing about the recent rally on Wall Street is that it completely ignored Friday’s grim unemployment report. In fact, the report wasn’t simply grim; it was disastrous. The unemployment rate remained at an eight-year high of 6%, as payrolls tumbled a whopping 101,000 jobs – that’s the biggest one-month drop in nearly a year.
– Meanwhile, the sickly U.S. economy continues to gut manufacturing jobs as if they were sea bass. The manufacturing sector slashed 65,000 in December, capping a forgettable year in which the manufacturing industry lost nearly 600,000 jobs.
– “All the portents suggest that even worse news on the job front is shaping up for the months ahead,” says Barron’s Alan Abelson. “Factories are limping along at 75% of capacity and, not unrelatedly, capital spending is plain punk…Peer as hard as we can, we just can’t see a plausible driver to employment. It’s also very tough, then, to envisage the economy doing more than straggling along.”
– Perhaps Abelson simply lacks imagination. An investor lacking imagination might find it baffling that the stock market would be rising, despite its still-rich valuation, despite an eroding dollar and despite a stubbornly rising unemployment rate.
– But IMAGINATIVE investors are not so constrained by empirical data and deductive analysis. At the moment, imagination is ascendant on Wall Street. Stocks will go up, the lumpinvestoriat believe, because the economy will improve. How and why the economy will improve, they cannot say. But they know it will happen just the same.
– The imaginative investor knows that nothing in the world ought to be cause for concern, as long as stocks go up. In fact, a rising stock market is proof that no serious financial problems exist in the economy.
– If President Bush, Alan Greenspan and Abby Joseph Cohen all promise higher share prices, what could go wrong?
Back in Paris…
*** Business lending is at a 3-year low, and inflation is at its lowest level in half a century…savings too…
*** Is this the bottom? At bottoms, stocks tend to sell for 1 times book. But U.S. stocks currently sell for 4.7 x book value. And current book values include a lot of ‘goodwill’ from the boom years, which will eventually be written off as worthless. In terms of ‘hard’ book value, price-to-book ratios are even higher.
*** Want a cheap stock? Try India. Stocks are selling for only about 10 times earnings. Mutual funds targeting Indian shares are closing down.
*** “The world economy needs help,” says an editorial by Jeffrey E. Garten, who has “held economic and foreign policy positions in the Nixon, Ford, Carter, and Clinton administrations.”
Here at the Daily Reckoning, we begin each day by reading the editorial page of the International Herald Tribune. The absurdity of it helps prepare us for the investment markets.
Don’t worry about the world economy; Garten knows just what the world needs now.
“The world economy is in trouble,” he explains. “Corporate investment and trade are slowing, factories are producing more than they can sell, and deflation is threatening many regions. Germany and Japan are stagnating. Big emerging markets, from Indonesia to Brazil, are in deep trouble.” What’s the solution?
Garten: “Washington must bring together its economic partners – the Group of Seven nations made up of Canada and Japan and four in the European Union – to get the global economy moving again.”
What a marvelous world Garten inhabits. Got a problem? Just get a group of policy hacks together. Garten thinks they can decide – among themselves – to alter the entire world economy.
The U.S. is already doing all it can, he says. Interest rates have been lowered. The nation is “already running huge budget deficits,” he notes with approval. But what about those Europeans? We’ve got to encourage them to lower rates too, and spend more too. And oh yes, we can also “push Japan to restructure its growth-strangling bank debts.”
Hey, that ought to do it. But wait, if you’re going to fix the globe’s economic problems, why stop there?
Remember, we will have to reconstruct Iraq, he says. That could cost $1.2 trillion, an amount “that does not include the costs of the administration’s vision of spreading democratic and free market institutions in the Gulf region.”
Wow. For $1.2 trillion, we would expect reconstruction worthy of a Hollywood tummytucker. That’s $49,896 per person in Iraq – or 20 times the average annual income. Well, that should go a long way to helping solve the world’s economy. And if it doesn’t, well…North Korea could use some reconstruction. And West Virginia… Where will the money come from? Here again, Mr. Garten is helpful: “The Bush administration needs to be working with Congress to incorporate the requirement [for the $$$] in planning – something which Mitchell E. Daniels Jr., director of the Office of Management and Budget, has been reluctant to do.” We never met Mr. Daniels, but we are glad to discover he is not as insane as Mr. Garten.
“We are entering a decade of political and military tension,” the latter continues, “and nation-building is going to be a major part of America’s response.” Why not? After fixing the world economy, the hacks ought to be able to build a nation or two without breaking a sweat.