The Wrong Kind of Bubbles
Keynes explicitly classified the two components in the money supply as "industrial circulation" versus "financial circulation." The distinction is important; it is like the difference between a woman and a female impersonator. They may be alike in almost every respect, except the essential ones. Bill Bonner explains…
"Don’t look, Edward."
The instruction came from Elizabeth, directed at her youngest son. We were driving through the Bois de Boulogne, a notorious hangout of extravagant prostitutes.
"Besides, they’re not what you think they are. They’re disgraceful. Sordid. Some of them are men dressed up as women."
Of course, Edward craned his neck to look even harder. And so do we crane our necks today…to take a better look at a counterfeit. That is also what makes financial history so entertaining, after all; it is like the Bois de Boulogne – full of jackasses and imposters. Alan Greenspan will go down in it, of that we are certain. He will be remembered as the greatest central banker since John Law. Mr. Law invented modern financial bubbles. Dr. Greenspan perfected them.
In the early 18th century, John Law was on the lam in France, after having killed Beau Wilson in a duel in England. France was broke, thanks to the grandiose spending of Louis 14th. A clever rake, Law proposed to solve the Regent’s financial problems with a novel monetary system, based on a new national bank – the Banque Generale – and a new currency backed by the future profits from Louisiana. Anyone who had set foot on the banks of the Mississippi at the time would have known that there was little easy money to be had in that savage place. But almost no one had seen it, so they could imagine all sorts of fantasies – even that they’d get rich panning for gold there.
At first, of course, Law’s project was a great sensation…by 1720 he was the richest man in the world…women threw themselves at him, and France even gave him a title – the Duc d’Arkansas. Here again, a little travel would have put the kibosh on the whole enterprise. Even today, you could be an Archduke of Arkansas; people would still laugh at you.
It didn’t take long before Law’s adventure blew up; his bank and his money sank into the bayou mud. Law was forced to flee angry mobs in Paris, and went to Venice, where he died, disgraced, nine years later.
Today’s news tells us that Alan Greenspan is still invited into polite society. His gives speeches. People clap and want their photographs taken with him. Still, Dr. Greenspan’s big, yellow moon seems to be waning.
But neither the Bois de Boulogne nor the former Fed Chairman is the subject of today’s pensée, just the point of departure. The period of low inflation and rising asset prices – known by economists as "The Great Moderation" – is over. Inflation rates are rising all over the world; people are rioting over food; truckers are blocking roads to protest high fuel prices; credit is harder to come by. Today, the subject of the following 400 words is: what next?
After you take out spending on the necessities, reported London’s Daily Mail, "families have less to spend on themselves than at any time for 17 years." Discretionary spending, that is, things you buy after you have paid for food, housing, heat and council tax, is at its lowest level since 1991. In America, too, staggering increases in personal, mortgage, and public debt have wiped out the accumulated savings of 6 generations. Prove it to yourself by simply dividing the U.S. government’s "financing gap" of $57 trillion by the number of households in the United States. You will get about $500,000 per family, far more than what the average family has in assets.
What was it about The Great Moderation that left such sour disappointment? The answer is simple: it was a counterfeit.
"There are principally two different kinds of spending…" wrote the late Kurt Richebacher. "One kind is on goods and services from current output, adding to the gross domestic product. The second kind is spending on existing property, land, buildings, plant and equipment, and all sorts of paper assets (such as stocks, bonds, mortgages, and so on)…"
Keynes explicitly classified the two components in the money supply as "industrial circulation" versus "financial circulation." The distinction is important; it is like the difference between a woman and a female impersonator. They may be alike in almost every respect, except the essential ones.
Many overseas markets – including China, India, Russia, and Brazil – have enjoyed real booms. They’ve built factories. They’ve built highways and airports. Wages have gone up. GDPs have risen. People are better off in those countries than they were 10 years ago. That’s why they have been such good investments; it’s also why we continue to recommend them. If they continue to grow, their citizens can expect not only to be as rich as Americans one day – but to be richer.
But the boom in the United States was not an economic boom; it was a financial bubble; and all bubbles explode. In the typical financial bubble – from Tulipmania of the 17th century to the Wildcat Bank Bubble of 1837 – asset prices blow up and speculators lose money. Then, speculators wipe the dust off their faces, poorer but wiser, and people get back to work. But the bubbles of recent years have had something that previous bubbles lacked – the support of the world’s largest, most powerful central bank…and a currency as faithless as its custodians. This was largely the contribution of Dr. Alan Greenspan and now, his protégé, Ben Bernanke. They made the world safe for bubbles.
The result was more and bigger bubbles than ever before.
"One bubble may be an accident," noted a columnist in the Financial Times, "but two in the space of a decade beings to look like carelessness."
After the bubble in tech shares blew up in 2000-2001, another bigger bubble – in residential property – took its place. It was aided and abetted by coincident bubbles in mortgage derivatives – notably in the sub-prime area – and in the financial industry, generally. The popping of those bubbles is what has dominated the financial headlines for the last year. It is also what has ended the "The Great Moderation."
But those bubbles were the result of neither accident nor carelessness. Fed governors have callouses on their hands to prove it. When one bubble popped, the Fed and other central banks pumped up another. Today, they are still pumping – with money supplies soaring all over the world (in the United States, the latest figure put money growth about 5 times the GDP growth rate)…and the Fed’s key lending rate at less than half of the rate of consumer price inflation. More bubbles are inevitable. And now the swelling goes where it is most unwelcome – into oil, commodities, gold and emerging markets.
The trick has turned against the tricksters. These new tide of liquidity doesn’t lift up the U.S. economy the way it did when it was going into stocks, housing and finance. Instead, this new tide pushes up consumer prices…while assets sink, entire families drown, and Dr. Greenspan’s reputation washes up like an empty, plastic bottle.
Until next week,
The Daily Reckoning
May 30, 2008 — London England
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.
Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available now.
The linchpin of today’s reckoning is this little headline in the Financial Times:
"Investors increase bets on US rate rise."
Anticipating a rise in rates, rather than another cut, investors sold gold, bonds, and oil. The black goo lost $4 a barrel. Gold got slammed for a $23 loss, while yields on 10-year Treasury Notes rose over 4% (yields rise as prices fall).
Why would the Fed put rates up? Ah…that’s our story for today. It’s a story of numbskullery, tomfoolery, and chicanery…of vigilantes and blazing saddles…of war and forgetting. In short…it’s a typical financial tale, where nothing goes as hoped for…and everything goes as it should.
Let us back up.
Last year, we were writing about a ‘battle’ between inflation and deflation. The markets were deflating…but the feds were inflating. Who was going to win?
Actually, it was a mixed-up, woebegone war…with casualties all over the place and the average American household caught in the crossfire. The poor lumpenconsumer has been taking incoming from both sides for more than a year. His house sustained a direct hit from deflation. Then, his income got whacked by shrapnel from the dollar’s blowup.
Meanwhile, inflation blasts him with higher costs for just about everything – notably the essentials, fuel and food. What can he do but keep his head down?
And pity the poor guy who was lured out to a distant, new suburb by a big, new house with a big subprime mortgage! Now, he’s got to pay $4 a gallon to drive to work, while his house payment goes up and his house value goes down.
Naturally, the feds rushed to help the guy. His real problem was that he had too much credit…but didn’t stop them; they tried to give him more.
Still, when a bubble pops, it is almost impossible to pump it up again.
Henry Kissinger explains why in today’s International Herald Tribune:
"…the role of speculative capital has magnified. For speculative capital, nimbleness is the essential attribute. Rushing in when it sees and opportunity and heading for the exit at the first sign of trouble…"
Speculative capital is what the Feds create when they lend money below the inflation rate. It does not go out and invest in long term projects like steel mills. Instead, it looks for the hot, rising market…the one that will give it a quick payoff. The guy with the big house and the subprime mortgage was not really buying a house…he never paid for it. He was just speculating.
And now his speculation has gone bad…and all the Fed’s hot air goes into a new bubble. When the tech stock bubble popped, for example, the next big thing was a bubble in housing and housing-related debt. When the housing and subprime bubbles popped we guessed that the authorities would pump hard to try to reflate them…but that the Fed’s inflation would go into new bubbles – in commodities, oil, and gold. So far, so good. Oil slid up past $135. Gold shot up over $1,000. And food? Food prices are so high they’ve set off riots all over the world. The OECD says high food prices are here to stay. And farmers in Argentina are setting up roadblocks, again, to try to starve the capital into submission.
Getting back to oil…British truckers clogged up London earlier this week, demanding relief from high fuel taxes; truckers in Marseille shoved against riot police…again, complaining about the high cost of diesel fuel, which is running about $9 a gallon in France. We’re pleased to report than no mobs are forming to demand cheaper gold…but surely some bubble in the yellow metal is bound to inflate sooner or later.
At the heart of the discontent is a very new, very disturbing, and very predictable fact: these new bubbles are not nearly as nice as the old ones.
*** The bubble in residential property made people feel good. They thought they were wealthy and thought they could ‘take out’ a little of that wealth and spend it. A bubble in oil is an entirely different matter. It makes people feel poorer every time they fill up their gas tank. And it forces them to cut back on spending rather than increase it.
Earlier this week we reported an historic downturn in Americans’ driving habits. For the first time since the ’40s, they’re seeing considerably less of the U.S.A. in their Chevrolets. This morning, comes this headline from Bloomberg:
"Sears posts net loss as consumers slow spending on clothing."
They’re spending less on imports too – bringing the U.S. trade deficit to a 5-year low.
Remarkably, despite these huge victories for the forces of deflation, the U.S. economy is still growing and the stock market is not falling apart. The latest numbers from Washington tell us that GDP grew 0.9% in the last quarter, rather than the 0.6% previously reported. Knowing how the Labor Department suborns its numbers, however, we would want a good cross-examination before we believe them.
After the Fed intervened to save Bear Stearns, it looked for a while as if they had done the trick – as if they had succeeded in re-inflating the bubble in the financial industry. After the panic, the bank index rallied 22%. But now it’s given up almost all that gain. Banks are about 40% down from their high…amid talk of more pain and suffering in the industry. Wall Street, for example, said it had more layoffs coming later in the year.
Instead of pumping up the bubble it wanted…the Fed pumped up a bubble with a chip on its shoulder. A higher oil price doesn’t have the same agreeable effects as a higher house price. As we explained yesterday, we now have a group of "crude oil vigilantes" who race to buy oil in response to the Fed’s loose money policies. Then, higher priced energy hits the economy like an exterminating devil…it drives up prices for everything, effectively preventing the Fed from further inflating.
That’s what that headline in the FT is about; investors are betting that the Fed is going to change course…that with the economy still growing, it is going over to the other side…that it is going to turn its guns on inflation, rather than deflation.
There are three "vicious cycles" that the U.S. economy must face, former treasury secretary Larry Summers told the Financial Times. The first is a liquidity cycle, a kind of wash cycle in which unreasonably high asset prices are laundered out of the system… People are forced to sell…thereby sending prices down further. The second is a "Keynesian cycle," in which a slump in the economy rinses out the habits of the bubble period. People begin to spend less…and save more. This, in turn, gives rise to the spin cycle – where, as we imagine it, people get dizzy and depressed because their incomes are going down; they can’t borrow; their costs are rising; and they’re getting poorer.
Where are we in these cycles? Probably only at the middle of the first cycle. Housing and finance have gone down. They probably have further to go. We have seen a foreshadowing of the second cycle too – people are not spending as freely as they did 18 months ago; consumer confidence is falling.
But wait…we’re not finished…
If the Fed really is going to reverse course and begin raising rates, we need to ask some questions:
Aren’t the bubbles in oil, commodities and gold going to pop?
Isn’t our Trade of the Decade (long gold, short stocks) going to go bad?
And how about the dollar? When Volcker came in and raised rates in the early ’80s, the dollar rose to a new high…while gold went into a 20-year bear market.
We remember those years.
"We have been a gold bug for the last 28 years," we told a fund manager recently. "Only the last 8 of those years have been happy ones."
Are we gold bugs doomed to another two decades of misery?
Anything is possible, of course. But we don’t see anything like the situation that greeted Paul Volcker in the late ’70s…and we don’t see anyone like Paul Volcker at the Fed either.
Be sure you are aware, dear reader, of what is headed our way. You can still protect yourself and your assets – while building your portfolio at the same time. The key is to invest wisely…in things that actually benefit from a market downturn. Strategic Investment has pinpointed those areas, and they are all available to you in the Strategic Financial Library.
*** And speaking of former Fed chiefs, we mentioned that Short Fuse and Addison met the Maestro himself this past Wednesday, to interview him for I.O.U.S.A.
"Is it fair to say that Fed policy has had a dramatic impact on the nation’s savings rate?" was one of the things they wanted to pick Greenspan’s brain about.
"We paraphrase the rest of his response from memory," says Addison. "In an era of low interest rates, the nation’s savings rate has been abnormally low, as well. Rather than save a portion of their incomes at low interest rates, Americans have opted to divert a portion of their income into their 401(k)s and homes. As capital gains from these two asset classes slow down, Dr. Greenspan expects the traditional ‘savings rate’ to tick back up…as a larger portion of incomes are diverted back into savings accounts.
"He added, in the face of the dire fiscal policy of the federal government, there’s only so much monetary policy can do to shore up the currency in which people are trying to save."
Short Fuse and Addison assure us there will be more to come from this interview. Stay tuned.