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October 26, 2008

How the Fed Creates Bull Markets and Bear Markets
by Clif Droke

I received an e-mail recently that is typical of the pop economic philosophy being heavily touted today in various financial forums. The e-mail contained a petition for the elimination of the Federal Reserves system. The gist of the e-mail was that the credit crisis was caused by the Fed's "loose money policy."

The e-mail explained that loose money is the bane and scourge of the financial system and always leads to financial collapse and economic stability. The author of this e-mail made it sound like a loose monetary policy all by itself will lead to inevitable doom just as surely as clouds lead to rain.

Right here is where I disagree. It wasn't the Fed's loose money policy earlier this decade that resulted in the late financial contagion. Rather it was the Fed's excessively tight money policy of 2004 and onward that was the catalyst for today's trouble.

I won't argue that Greenspan's Fed was excessively loose with money and credit in 2001-2004 and there's no denying that his ultra loose monetary policy led to the creation of the housing bubble. But the pin that pricked the bubble was Greenspan's abrupt slamming on of the money and credit brakes beginning in 2004. This is something that most people fail to grasp. Monetary policy is always a two-way street, not a one-sided affair as the tight money advocates would have us believe. Loose money alone doesn't make for a financial crash; it's tight money that creates crashes.

Here's another e-mail I received earlier this week that relates to the subject at hand: "I am so brainwashed that the crash is from sub-prime and derivatives. Either I haven't been paying attention to tight money policies of central banks or very few people have written about it." That pretty much hits it on the head. Most all of us have been something akin to being "brainwashed" by the financial literature out there, the vast majority of which conveniently ignores the Fed's tight money policies of recent years and puts the blame squarely on the shoulders of the loose credit years earlier this decade. The trouble with today's self-appointed Fed experts is that they mostly seem to view monetary policy as the one-way street mentioned above. I'd like to remind them that yes Virginia, there is such a thing as a tight money policy that leads to financial crisis.

In his book, The Money Men, H.W. Brands wrote of the first major test the Federal Reserve faced after its creation in 1913. In its role as arbiter of the nation's money supply the Fed made its first policy blunder in making cheap money overly plentiful in the early 1920s, which encouraged a speculative bubble in the stock market. By 1928, the Fed recognized its error and instead of gradually slowing down the money creation, did something that has been part of their modus operandi ever since. In true reactionary fashion the Fed slammed on the monetary brakes and started raising interest rates, paving the way for the great 1929 stock market crash.

Making matters worse and adding fuel to the fire, the Fed continued its tight money policy while the U.S. government actually raised taxes and thereby greatly exaggerated the Great Depression of the 1930s. Was this a case of ignorance born of inexperience or was a sinister motive at work here? One could almost excuse their mistakes of the late 1920s and early '30s due to the Fed's lack of experience. Yet such latitude can't be so easily granted them today with more than 90 years of experience behind them.

Benjamin Strong, who had been the head of the New York Federal Reserve Bank, was one of the architects of the loose money policy of the early 1920s and he also orchestrated the shift to tight money later that decade as stock prices soared. Concerning the Fed's role in containing financial crises, Strong wrote, "The very existence of the Federal Reserve System is a safeguard against anything like a calamity growing out of money rates. We have the power to deal with such an emergency instantly by flooding the Street with money."

Unfortunately for Strong, he never had a chance to test his theory as he died in 1928. As Brands observed in his book, "No one had the nerve to open the sluice gates" when once the crisis unfolded in 1929-30. "The Fed kept interest rates high, with the result that the American money supply contracted by a strangling one-third." Truly we see that history repeats as we have experienced this year: the Fed's tight money policy of the last few years catalyzed the late financial crisis and only when the maximum damage was inflicted did the slow-to-respond Bernanke Fed open the sluice gates and that only grudgingly.

Long-time Fed watcher Bert Dohmen of the Wellington Letter offers the following insight, "Who controls the liquidity necessary to buy stocks? It's the Federal Reserve through its monetary policy." Dohmen goes on to observe, "Invariably bear markets occur when the central bank tightens money. This sudden change in the availability of money causes investors to sell stocks in order to raise cash. Suddenly the buyers turn into sellers and the markets plunge....It's a shift in the demand-supply relationship."

One astute economist wrote in 1966 concerning the 1929 stock market crash, "The excess credit which the Fed pumped into the economy (in the late 1920's, in order to lower interest rates) spilled over into the stock market - triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late: By 1929 the speculative excesses had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed....The world economies plunged into the Great Depression of the 1930's."

This economist was none other than Alan Greenspan. In the above statement he admits that whenever the Fed sees speculative excess (as they certainly did in the 2003-2004 period) it will cause them to tighten money. It has been ever thus since the Fed's inception in 1913.

Will the Fed's latest efforts at reflating the financial market succeed? If history is any guide then it should eventually stabilize the stock market and allow the newly formed 6-year up cycle along with the peaking 10-year cycle to work its magic in 2009 for one final cyclical bull market before the "hard down" phase of the Kress 40-year and 60-year cycles commences in 2010.

Is Bernanke a modern day Lycurgus?

Lycurgus was ancient Sparta's famous lawgiver who transformed his country's economy by minimizing luxuries and emphasizing simplicity. His economic reforms can best be described as communalistic and his name is synonymous with austerity.

According to the historian Plutarch, Lycurgus outlawed the "needless and superfluous arts" thereby channeling Sparta's economic energies from luxuries to staples and necessities. He also abolished gold and silver money, replacing it with iron money. The relative worthlessness and lack of portability of the iron money discouraged his subjects from greedy pursuits. It also kept foreign trade at a minimum and abolished the luxury trade altogether.

Plutarch reports that this monetary reform of Lycurgus forced the Spartans to focus on the necessary arts and eschew all luxuries as non essential. His reforms virtually eliminated the distinction between the poor and the rich and created an exceedingly simple, communal lifestyle among the Spartans.

Lycurgus died some 2,600 years ago. Yet in many ways Lycurgus live on through the monetary policies of current Fed Chairman Ben Bernanke. Bernanke has been committed to following along the road of a Lycurgian austerity and of bringing to America a truly Spartan existence.

It's not hard to imagine Bernanke consulting with Lycurgus on matters of economic policy in Socratic dialogue form. If you listen carefully you can even hear what they're saying:

Lycurgus: Well I see you've been up to your old tricks again.
Bernanke: Ah, you know me too well my curmudgeony friend!
Lycurgus: You've made them all poor with your refusal to bend.
Bernanke: I felt it too soon for the tight money to end.

Lycurgus: Well at least you finally admitted your wrong.
Bernanke: Never will I sing that lamentable song!
Lycurgus: You mean you persist in your stubbornness ere' long?
Bernanke: I'll continue my ways 'til the sound of the gong.

Lycurgus: And when it's all through, Ben, what will you do then?
Bernanke: First I'll tighten some more, then I'll tighten again.
Lycurgus: And then of the bears you'll make many friends.
Bernanke: And to Greenspan's follies I'll add many more sins.

Lycurgus: But what of the Boomers who are soon to retire?
Bernanke: It's too bad for them all, they must put out for hire.
Lycurgus: They're too old to work, Ben, of that they'll soon tire.
Bernanke: Then I'll hasten their date with the funeral pyre.

Lycurgus: But your legacy, Ben, what will they all say?
Bernanke: Oh, let them eat cake! I see no other way.
Lycurgus: Fair enough, I suppose, at least they have today.
Bernanke: At least for as long as their pensions hold sway.

Lycurgus: Now I must bid thee farewell, my tight money friend.
Bernanke: May austerity prevail 'til the bitter end!

Bernanke is often ridiculed as "Helicopter Ben" for his supposed adherence to Milton Friedman's helicopter money thesis for dealing with lack of liquidity. What these critics (most of whom are fans of austerity, or "tough love" as they call it) don't realize is that Bernanke is actually their best friend and comrade in arms. Far from being an advocate of loose money as he is charged with, or even an exponent of monetary equilibrium, Bernanke's actions in the first two-and-a-half years of his tenure as Fed chief betray him as a deflationist. Until the exigency of the credit crisis forced him to abandon his tight money stance he was content to favor contraction over economic growth. Before his tenure is through he'll undoubtedly acquire the nickname "Mr. Deflation."

This leads us to ask, "Is Bernanke possessed of a Lycurgan spirit?" Indeed he seems to be, for the Bernanke Fed has heretofore failed in its appointed task of properly regulating the nation's money supply. The events of this year make that obvious for all to see. In the almost three years of his tenure, Bernanke has shown himself to be a dullard without equal in responding to the monetary needs of commerce. Only when the nation's financial system was threatened with collapse was he finally inspired enough to loosen money. He should be held accountable for his failure to act in a timely manner, along with Greenspan.

Even if Bernanke's emergency actions procure favorable results we should not be quick to overlook the severity of his tight money transgressions. His stubborn refusal to listen to the demands of commerce for liquidity, to the bond market in 2006-2007 - nor even to the deflating real estate market - leave no room for excuse. Untold destruction has been inflicted on the pensions and retirement savings of millions of Americans. Thousands of small businesses were thrown into bankruptcy by the Fed's belated response to the needs of commerce. The consequences of Bernanke's stubbornness will be felt for years to come.

Clif Droke
ClifDroke.com

Clif Droke is the editor of the daily Gold & Silver Stock Report. Published daily since 2002, the report provides forecasts and analysis of the leading gold, silver, uranium and energy stocks from a short-term technical standpoint. He is also the author of numerous books, including'How to Read Chart Patterns for Greater Profits.' For more information visit www.clifdroke.com.