I’ve been wandering through University towns in France. It’s summer, the south, and very few students meandering about. In Montpellier, at a Café Tabac, I met with an old friend who teaches humanities. He wanted to know why I like markets, trading and reading things like The Economist.
He thinks I’m sooo American—a kind of tolerable Gordon Gecko…
I told him the markets are not just about numbers and speculation. In fact, I said they’re more like a private course in history and psychology—and even a dab of philosophy.
He didn’t believe me.
So I’m publishing this Four Part Series for an old cynic—and hope it raises an eyebrow of interest for you as well.
It is often warned that those who do not learn history are doomed to repeat it. Looking back upon the patterns of public and private market dislocations since the crash of 29 and our current Titanic-like path toward grossly inflated equity, bond, and currency markets, this warning acquires a particular relevance.
Present circumstances and past lessons suggest history is more pertinent today than the math of algorithm writers, CTA temperaments or the theater of sell-side market spinners to make sense of where we are now and what lies ahead for tomorrow.
This unpopular truth is more straightforward than the market cheerleading which predominates in the street, CNBC or the brochures of banks X,Y or Z. Indeed, the numbers and events of yesterday reveal a pattern of precarious cause and effect; the only change through time has been the size of the effect as measured in real and nominal dollars: millions in the 1930’s, billions in the 1980’s, and now trillions in the 2000 era.
The past is in many ways prologue and the lessons from yesterday and themes for tomorrow are as plain as they are unpleasant: when easy money created by central banks fuels unchecked speculation, markets inflate, create a false euphoria, and then—markets pop.
The history of the US markets since the 1920’s is one of increasingly ineffective policies designed to manage free markets. These polices are premised upon a well-intended yet misguided belief that the Federal Reserve can improve GDP and perpetually sustain frothy markets by adjusting the dial of interest rates and money supply.
The current and historical evidence shows, however, that this is not only untrue, but also dangerous. The now well-worn pattern of replacing past bubbles with new bubbles confirms a definition of market madness, i.e. the notion that one can repeat the same behavior yet expect a different result.
The Federal Reserve’s growing status as Wall Street’s mistress has tempted the Central Bank into increasingly promiscuous lending and rate setting policies which, like all such seductions, leads repeatedly to bad behavior and unhappy endings.
Such bad behavior has taken many forms and offered numerous symptoms (as this series will show) but all stem from the same virus of easy money/credit in the backdrop of a currency that has no backing or standard other than faith in its reputation. This history of liberal monetary policies explains:
*volatile market rides (the roaring 20’s, the junk bond 80’s, the tech-boom 90’s, the sub-prime 2000’s);staggering leverage use (from 1927 “hot money” to the embedded toxins of the current derivatives trade);
*mispriced assets (from the dotcoms and LBO’s, M&A’s and stock buy-backs of the 90’s to the real estate valuations of 06 or the sub-prime storm of 08); and
*a growing menu of risky investment vehicles (CDO’s, CLO’s, levered currency exchanges, counter-party-booby-trapped derivatives and churn and burn hedge funds.)
The following four posts examine the history of this easy money virus and its market symptoms without recourse to hyperbole but with a sober view of cycles, balance sheets, GDP truth-telling and, alas, a blunt prognosis of what lies ahead. (A good doctor doesn’t mince words just because the diagnosis is unsettling.)
Much of this data and vernacular is too heavy, voluminous, boring or even disturbing for easy synthesis and lucid conclusions. Many of us simply do not have the time or resources to objectively understand how to make sense of the admittedly messy moving parts of our markets and their history.
Sound bites or sector reports spun out of any semblance of context are all that most of us receive on a daily basis. It is therefore my hope to condense decades (even centuries) of time and tomes of figures and market data into a set of posts that, if read curiously, can provide a more user-friendly and easily understood backdrop to consider the markets we come from and the ones we are stumbling toward.
The ultimate aim here is to prepare investors for severe shifts in the status quo. This is not a recommendation for buying rice, guns, and water in the face of looming catastrophe, but serves rather as an acknowledgement of what most market professionals already feel: the current environment is unsustainable and heading toward a storm.
Turing Points—Taking Away the Dollar’s Standard
In understanding how central bankers lost their way and brought our current economy within eyesight of the next (and biggest iceberg), a review of two broad turning points in the history of the American markets is helpful. The crash of 29 is an appropriate starting point.
George Washington famously observed that a nation has neither permanent friends nor enemies, merely permanent interests. This homage to Realpolitik took its early economic form in the American approach to the crash of 1929 and the dollar-debasing policies unleashed in its wake.
Contrary to Bernanke’s Princeton thesis that the Great Depression was caused by a failure to bail out US banks in the post-crash environment, the evidence confirms that commercial banking outside of Wall Street (then as in our 08 crisis ) was in fact intact.
Instead, the actual severity of the Great Depression was attributable to: i) massive amounts of pre-crash, “hot/easy money” speculation begun in 1927, and ii) a collapsed export market (post WWI Europe was smoldering and in no condition to absorb US productivity).
Rather than assist Europe to become stronger buyers and seek trade cooperation, the US under Hoover took the “me-first/me-only” (i.e. Realpolitik) approach and choked rather than supported an already war-tired continent in the form of a tariff wall—aka the Smoot Hawley Bill.
Result: countries declared economic war, more trade barriers were raised and more economic decline ensued for one and all. By the time FDR took office, he was faced with the problem of how to create enough demand to re-ignite our broken economy and manage the outstanding debt incurred during the roaring, pre-crash spending spree.
Economic historians agree that FDR was not up to the task. In fact, like many elected officials, he was largely inexperienced in free markets, free trade and currency matters. As a result, a series of poor and trend-setting decisions followed, most notably in the form of devaluing the dollar.
As in any ponzi scheme that runs out of money, the immediate aim is to find more. When you run a country or central bank rather than a fraud-shop, this is legally achieved by: a) taking your currency off any collateralized controls (i.e. a gold standard) and b) printing more of it (if Madeoff had a printer, he certainly would have used it).
In 1933, Roosevelt did precisely that. First, he confiscated gold in the US and then embraced the Thomas Amendment, which in the stroke of a pen devalued the gold content of the dollar and betrayed global market participants who relied on a currency standard. This lead to exchange rate instability among an already unstable universe of ailing nations who needed open rather than nationalistic trade.
By removing the dollar from the gold exchange, FDR, like other unwise actors to come (and who will be discussed in the later posts of this series), focused on manipulating the US currency rather than addressing productivity—the veritable “P” in GDP.
Like nearly all politicians since, his was a shortsighted decision with long-term consequences. FDR’s knee-jerk macro policies interfered with the hard but informative lesson of free markets, namely: deep recession always follows deep debt. There’s just no such thing as a free ride…
Policy makers, however, like to sell free-rides to get or stay elected (as we’ll see with Nixon in Part II). The “elites” should have therefore acted with accountability and led the nation through restraint, short-term discomfort and a long-term rebuilding of a dollar standard, national balance sheet, open trade, and industrial productivity. But as I’ve said before, it’s not always wise to trust the elites…
Instead, FDR spent a lot of money, debased the dollar, and thwarted free trade. He goes down in history for his “New Deal” salvation policies, “bank holidays,” and dollar-debasing/money-printing reflation that in fact did nothing to bring the US out of the Depression.
Much like China’s 2004-2012 investment cycles of empty cities and bridges to nowhere (or even Stalin’s top-down “five year plans”), the New Deal programs, laudable in their intent but mathematically ineffective in stimulating consumer demand (which only works from the bottom-up), simply created unsustainable levels of outputs.
What actually pulled the US out of the Depression were not FDR’s inflationary policies, but the winds of a brewing world war and the slow emergence of the US (and its Treasury bonds) as a perceived safe-haven for investment and gold—whose reserves doubled from overseas before the first bomb hit Pearl Harbor.
Lesson/Pattern from Great Depression-to FDR
The broad themes and lessons of this seminal market crash deserve foundational attention in this Part I post because they reveal the first patterns seen over and over and over…in subsequent market cycles. In particular, a pattern where policy makers consistently made the fatal error of: i) devaluing the dollar, 2) providing easy credit/money as the perceived solution to economic growth, and 3) confusing stock market prosperity with national prosperity.
As we will see in Part II-IV, booming (inflated) stock markets do not translate into booming economies. In fact, with each cycle of easy money bubbles and the recessionary pops that followed (from 1929 to 2008), the spread between Wall Street euphoria and Main Street malaise only increases.
Another common thread woven throughout US market history is the misguided faith placed on elites who simply got it wrong without accepting the same and thus changing course.
A well-known example of the FDR period was Professor Irving Fisher, the Yale economics professor who just 10 days prior to the crash of 29, declared that efficiencies had made the stock market bullet proof. Years later, it was this same scholar who gave FDR the equally inaccurate notion that the best way to beat deflation (here wrongly defined as low prices) was to print money.
In more recent history, a similarly misguided professor, Princeton’s Ben Bernanke, assumed this easy-money baton of trying to solve deflated economies via inflationary policies. Such thinking misunderstands cause and effect. In fact, history tells a different tale, namely: The price and money supply declines which follow market crashes are not the cause of market deformations but the result of earlier easy money policies and the subsequent liquidations of bad debt, which takes time, not new money, to cure.
In 1927, the NY Fed opened its easy money spigots (ostensibly to help the UK adhere to their gold standard obligations on which the US later welched), but the net result was speculators taking the easy and short-term “hot money” and inflating market bubbles and margin debt levels which popped in 29 (just as they popped in 1987, 2000 and 2008 after similar and yet much wider money supply spigots opened).
Taking a quick and historical peek overseas, we saw an identical pattern when the Nikkei crashed in 89, namely easy money (cheap credit) booms followed inevitably by a mega busts (and then lots of money printing—continuing to the present). The bust which hit Japan has not been healed. The country remains an economic zombie. Yet despite such examples, investors ignore at their peril the history of spigots, easy money bubbles and subsequent collapses.
The Laws of Free Markets—Just as Real as the Laws of Gravity
Such cycles are the laws of free markets, who have repeatedly tried to teach lenders and borrowers these basic lessons: 1) too much easy money/credit leads to too much debt; 2) too much debt leads to inflated asset bubbles; 3) all asset bubbles pop; and 4) when a bubble bursts, policy makers should put a reign on providing easy money stimuli rather than create new bubbles.
In Part II of this series, we’ll look at how this same pattern of debt-driven boom and bust cycles (Nixon et al) continued well beyond the Great Crash of 29, straight up to the present.
August 14 2017