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October 15, 2008

Economyths
by Bob Hoye

"When you look at the mistakes of the 1920s and 1930s, they were clearly amateurish. It is hard to imagine that happening again -- we understand the business cycle much better."

- Greg Mankiw, Harvard economist and textbook author,
Wall Street Journal, February 1, 2000

Every nationalistic bailout this year has been accompanied by global stock exchanges and debt markets plunging to new lows. More specifically, the biggest rescue in history saw the biggest Monday to Friday plunge in the Dow since 1914, which exhausted the latest panic. The conflict between ambitious policymakers and implacable market forces has become immense. The former have been sophisticated in theories but naïve about financial manias and their consequent busts. Indeed, market history, itself, is a "due diligence" on every great financial scheme, whether it has been promoted by Wall Street or by financial adventurers in policymaking.

Promises from the latter have been imaginative and range from being able, through certain manipulations, to "keep the recovery going", or if that is not working other manipulations will "prevent a slowdown" and then, as desperately needed, certain other efforts will "end a panic". If one accepts the first two premises the last one is impossible. Considering the enormity of the crash it seems likely that FOMC deliberations about administered rates will eventually lose their cachet. Professional Fed watchers may have to find supplemental employment.

Previous post-bubble contractions have prompted chagrin as well as a rush of recriminatory legislation, but claims from today's interventionists that the crash is a result of not enough regulation are absurd. The SEC and Glass-Steagall were regulations designed to prevent another 1929 bubble that obviously weren't effective.

There have been financial crashes for as long as there have been markets. Moreover, since the 1500s documentation is rather good with the recurring theme that blossoms with a bust is some intellectual will provide personal revelations that the disaster need not have happened if only more credit was available, or if only interest rates had been kept from rising. From Missleden following the 1618 disaster to Keynes following the 1929 disaster the revelations have been adequately documented as same old, same old.

This time around, chronic application of intuitive theories has resulted in the biggest credit bubble in history, and, so far it is being followed by the biggest contraction in history, which is again prompting knee-jerk remedies.

Actually similarity goes beyond responses by officials. Financial manias and consequent contractions have been methodical. So methodical that it should be taught in basic economics.

Firstly, it should be understood that there is nothing that can be done to prevent a financial mania when the markets want to have one. In the past the most dangerous have encompassed both tangible and financial assets. There have been five examples from the South Sea Bubble in 1720 to the 1929 blowout. Also it should be understood that the contraction is consequent to the boom.

The next step is to correct intuitive conventional wisdom that rising interest rates are detrimental to a recovery. No - hundreds of years of data record that rates increase during a boom. This is so reliable that it is an indicator that all is well. Going the other way, interest rates decline during a contraction. This is also so reliable that it is an indicator of a contraction. Furthermore, the sharpest plunges in short rates have been associated with the worst bear markets. Treasury bill rates have declined to 0.0% with this calamity. Belief that an arbitrary attempt to lower rates will restore a boom seems to be derived out of thin air.

Another blunder of our times is the notion that rising commodities are detrimental. No - throughout all of recorded business history rising prices have been associated with prosperity. And for the same length of time, falling prices have been associated with hard times.

And as mentioned above, the other classic error is to imagine that adding credit to a contraction will prevent an existing credit contraction. Proponents of this kind of thinking must have PhDs in Tautology.

More recently, the problem is that at the top of the stock market the street was celebrating the return of "Goldilocks" which was the euphemism for the genius of policymakers. With the official guarantee of no risk the street aggressively employed margin, as central bankers provided "easy" money.

This contraction, as usual, is prompting many nostrums, none of which are new as well as a lot of scapegoating, which isn't new either. That after such recklessness the notion that a bust could have been prevented is a demonstration that financial markets are not bereft of irony.

While central bankers have claimed to have been in control, a review of previous great bubbles records that in a boom the street becomes supremely confident and gets leveraged - to the hilt. In their inevitable way prices start down, and although initially subtle, that marks the transfer of the baton of power to margin clerks and de-leveraging proportionate to the boom follows.

Of course, there is a difference in job descriptions. For margin clerks it has been to get the accounts in line. Considering a long run of serial bubble-blowing the job description of your basic central banker has been to get the accounts out of line. This year margin clerks have the power and policymakers and their politicians just don't get it.

Booms and busts will continue to recur, and there has been no need for massive and futile intervention. However, markets are poised for a natural, but brief rebound, which will be celebrated as a great result of policy. The May rescue was also considered a success: "The policy response to financial asset deflation was not only extremely fast, but extremely well coordinated. US policymakers deserve the Nobel Prize."

Doubtless that the central planning crowd has been shocked by the degree and relentlessness of the contraction. But, the establishment is still claiming that the collapse could have been prevented by even more intervention, so the shock hasn't been severe enough to initiate self-examination of the role of governments and their agencies in exaggerating financial volatility.

Fortunately history is providing perspective and as the saying goes in physics: "If you keep your data base short enough it will fit your theory." For scholars on contractions, such as Bernanke, the world starts in 1929 and ends in 1939. He, like so many researchers, concluded that the guys running the Fed in 1929 made a mistake. There is much more to history than one bubble.

Beyond being bracketed by exuberance and recrimination, financial manias have much in common. When speculation brews up the urge to borrow short and lend long will be taken to the limit. This drives short rates up faster than long rates and forces the yield curve to inversion. So long as the curve remains inverted the boom is on.

Politicians enjoy the prosperity and there is no hard evidence of government ever deliberately ending a mania. The notion that the Fed ended the Roaring Twenties by raising the discount rate from 5% to 6% in August 1929 has been an expedient to avoid criticizing the Fed's systemic inadequacies.

Short-dated market rates of interest began their decline in May, 1929 ominously signaling the advent of that infamous contraction.

It should be added that when the senior central bank has been permitted to aggressively change administered rates typically it has followed the key changes in market rates by 3 or 4 months. That is at the start of a boom, as well as at the end. In 1929 the Fed replicated what the Bank of England did at the climax of the previous bubble in 1873.

It is worth emphasizing that while the Fed can briefly push short rates down central bankers have no material influence on the curve. Fortunately, this allows the curve to remain a reliable indicator of market forces and when it reverses to steepening it has been the time when the wheels begin to fall off the most blatant speculations. In the spring of 2007 this writer's advisory service noted that a boom typically ran some 12 to 16 months against inversion and this made that fateful June the sixteenth month. The curve reversed in May marking the slide to contraction.

The other critical element in the reversal of fortune is the spread between different bonds or money market instruments. With all the confidence that goes with a boom investors reach for yield by buying riskier paper and this narrows credit quality spreads. This is also a part of the credit world that not just resists, but denies central bank influence and when it changes from narrowing to widening that is another indicator of the developing contraction. Many markets have seasonal tendencies and typically spreads narrow into May and then widen. When participants are euphoric and policymakers are basking in the glory of their fine works the change in spreads is the other warning device. This was also accomplished in that fateful June.

By July, 2007 changes in credit markets were sufficient to conclude that "The greatest train wreck in the history of credit." had started. Historically this could become severe enough to prompt popular condemnation of the systemic inadequacies of interventionist central banking.

In the 1830s and 1840s Samuel Loyd made a lot in finance and was regarded as the foremost authority on money and banking. He wisely observed: "No warning can save a people determined to grow suddenly rich."

In the 1600s when Amsterdam was the financial and commercial center of the world the Dutch term for easy credit markets was "easy". With elegant language use, the opposite condition was "diseased credit".

As with most impartial observations on markets, these are applicable now or in any century in the past or in the future.

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Here is an interesting interactive chart comparing past bear markets: http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html

Bob Hoye
Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

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