Anyone for Armageddon?

By: Bob Hoye | Tue, Nov 30, 2004
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Of course, the shorter Oxford Dictionary defines "Armageddon" as "the site of the last decisive battle on the Day of Judgement; hence, a final contest on a grand scale". Of importance is the simple phrase "final contest" and, for those who are aware of risk, this seems to be focused on just how destructive the collapse of the dollar will be.

Instead, history suggests that the most severe financial problem will be when the party of inflating anything that will fly against deliberate dollar depreciation ends. The final contest, then, is the desperation of Western central planners to make their imposed, and still socialistic, theories work against implacable market forces. Regard for socialistic central planning in Eastern Europe began a lengthy loss of regard in the late 1980s.

Quite likely, the real Armageddon will be the equivalent loss of esteem and power to policymakers in the senior economies.

Last February, Paul McCulley, at Pimco, made a very striking comment on reckless employment of policymaking and leverage. "When the Fed is the bartender everybody drinks until they fall down."

With much more reserve on April 18, 1929, Benjamin Anderson wrote "If the rate of credit increase rises above the rate of business growth, we have a condition of inflation which manifests itself in rising prices ... over-confidence and excessive speculation.".

Anderson was at National City Bank, which is now Citicorp, during the Roaring Twenties and was one of the few economists who described the boom for what it was when it was on. Moreover, he was one of the rare economists who was capable of writing an appropriate account of the consequent contraction once it was over.

Stephen Roach is the Chief Economist at Morgan Stanley and two weeks ago, at a meeting with a select group of fund managers, shocked the audience with his observation that the U.S. had no better than a 10% chance of avoiding economic "Armageddon". This is based upon extrapolating the soaring trade deficit and associated weakening dollar, which will force Greenspan to raise interest rates "further and faster" apparently than "what he wants" (Quotations are those of reporter, Brett Arenda, who obtained a copy of the presentation.)

Of these warnings, McCulley's is the most realistic, with the players drinking until they fall down. In real terms, rather than metaphor, the point is when the key speculative items turn down in price.

Then, an in any examples of runaway speculations, the damage is done to the economy when so much debt has to be serviced or written down during the recession that follows every speculative excess. The point that we have been making over the past few months is that the street thinks that an absolute collapse of the dollar in foreign exchange markets will be the Armageddon. Not so - no matter how rapid the depreciation has been, there has always been a binge in soaring asset prices. Disaster starts when prices stop going up. The hangover is inevitable and the one following this party could rank about 8 on the open-ended Armageddon Scale.

Thus our general observation that "the world is long inflation and short U.S. dollars". Speculative booms and busts are nothing new, but what is rare is the dedication of today's policymakers in promoting speculation against the deliberately depreciated dollar. There hasn't been anything to this degree since England's South Sea Bubble or France's Mississippi Bubble in 1720. Yes, the tech bubble in 2000 was wild, but the street and policymakers had little doubt that the boom could be sustained. - No worries then.

Now, there is palpable desperation in this attempt to keep the depreciation and the boom in whatever-is-hot going. This becoming very intense, so intense that it is worth reviewing a recent example of "Armageddon" related to the financial markets.

As late as 1989, best-selling economics textbooks were still touting the wonders of the Soviet economy. The thinking was tautological as interventionist economists assumed that because the Communists were so dedicated to central planning, the results had to be good.

Then in the late 1980s, the public in Eastern Europe began to see through the promises of the control freaks and began a long process of diminishing, if not dismantling, all of the state-run monopolies. For the central planning clique that couldn't move over to the market economy, this must have been the equivalent of "Armageddon".

Despite such a loss of esteem in Eastern Europe, no such censure was suffered by Western central planners. Indeed, more recently, the Fed has been praised for the wonderfully astute move of lowering short rates to "emergency" levels and stimulating the boom.

There are two things that suggest that this is a contrived explanation. One is that, for whatever reasons, the public began an aggressive consumption of grand cars and the median home shortly after 9/11. This anticipated the biggest speculation in commodities since 1989, and was mainly due to public initiative rather than policy.

The other misunderstanding is the notion of an "emergency" Fed fund rate. As we have long recorded, one of the features of the 18 months following the climax of a great financial bubble has been an exceptional plunge in short-dated interest rates. As a matter of fact, these are the only times that such plunges have occurred in the senior economy.

  DISCOUNT RATE
BANK OF ENGLAND
1873
DISCOUNT RATE
FED
1929
DISCOUNT RATE
FED
2000
PEAK 9% 6% 6%
LOW 2% 1.5% 1.25%

Of critical interest is that the orthodox explanation of the 1930s' contraction is that Fed personnel made a mistake in raising rates from 5% to 6% in August, 1929 and then were not aggressive enough in lowering them afterward. Post-2000, the drop amounted to 475 basis points, which the establishment considers as an "emergency" decline, which is little different to the 450 bps post-1929.

By comparison, both were modest compared with the 700 bps plunge in the post-1873 experience. Of course, in the 1870s, financial reporting was sophisticated enough to understand that 9% represented an almost insatiable demand for money by speculators and eventually at 2% there was little demand for funds to speculate with. At the time, interest rates changed with the demand for funds as well as to maintain an adequate reserve behind the currency.

That was when London was the financial capital, but in New York, as it was then a junior financial market, anything was possible. At the height of the mania in 1873 and as signs of over-speculation were becoming evident to veteran traders, the leading newspaper editorialized that nothing could go wrong. It was argued and widely accepted that the Secretary of the Treasury had a greater ability to prevent a contraction than a mere central banker, who was limited by the gold standard. The theory was that the Treasury could buy enough treasuries out of the market to keep the boom going.

History has never long abided the policy theory that prevailed during a financial mania and this brings us to just what kind of an Armageddon is possible in a post-bubble world. The theories that financial bubbles can be sustained have had a short shelf life, as should those who insist that a contraction can be prevented by yet more issue of credit.

First, it is important to note that one of the most violent financial Armageddons was the Weimar inflation that was imposed upon Germany by their policymakers in the early 1920s. At the same time, Lenin intentionally employed the same method to destroy the middle class in Russia. Both were printing press inflations that can be argued as impossible to do in a credit-based economy such as the U.S. The paper examples resulted in Communism and National Socialism, which were labels for a horrendous political Armageddon inflicted upon society.

Using the history of England and America, it seems that the most violent abuses of the credit markets resulted in an equally violent loss of esteem by the prevailing theory during the financial mania.

In 1873, the Treasury System was touted as proof against contraction. With the occasional cyclical relief, the contraction lasted from 1873 to 1895 and was analyzed as "The Great Depression" until as late as 1940 when a more immediate one was discovered.

By 1900, the establishment had convinced itself that the "old" Treasury System was a breeder of booms and busts and that a modern central bank was needed. But as some memory remained of earlier condemnation of central banking, the term Federal Reserve System was used instead.

Then the higher the Dow went in the late 1920s, the more the abilities of the Fed were touted. A wonderfully ironic observation was made in 1931 by Alexander Dana Noyes, the venerable financial editor of the new York Times: "[The speculative 1901 bull market assumed] that we were living in a new era; that the old rules and principles and precedent of finance were obsolete; that things could safely be done today which had been dangerous or impossible in the past. The illusion seized on the public mind in 1901 quite as firmly as it did in 1929. It differed only in the fact that there were no college professors in 1901 who preached the popular illusion as their new political economy." (Noyes, as a young reporter, covered the 1884 panic.)

The irony continues with Alan Greenspan's essays in 1966 condemning the Fed's reckless ease in the 1920s in exacerbating that bubble, which exacerbated the consequent contraction.

Booms, busts, and lengthy contractions have been regular events and there has been no sound reason to propose that some policymakers or central bankers can materially alter financial history. This has been one of the blunders of those who thought that the prevailing agency could keep a financial mania going beyond its standard duration of 9 years.

Beyond the sudden loss of prosperity has been the "Armageddon" of the sudden loss of prestige that goes with a post-bubble contraction.

Celebrated as a financial genius during the Mississippi Bubble of 1720, John Law was fortunate to escape France with his life during the intense recrimination during consequent contraction. During the 1920s' financial mania, Andrew Mellon was celebrated as "the greatest Treasury Secretary since Alexander Hamilton". He has been condemned ever since as one who allowed the 1930s' contraction to happen.

Of course, during the late 1990s' mania, Treasury Secretary Robert Rubin was celebrated as the greatest since Alexander Hamilton. He wisely retired from the position before the top with his posterity intact. (With great futility, the Rubin-Summers Treasury was ostentatiously buying bonds in late 1999 - early 2000.)

However, whatever the reputation, Armageddon that could be visited upon the usual policymaker who overstays his role could be just a personal part of the much bigger picture - whether taxpayers like it or not, the full faith and credit of the U.S. (so to speak) has been employed to inflate any asset price that could be boosted.

Other than personal loss of prestige or a more widespread loss of prosperity, the worst Armageddon that can be considered is the typical collapse in esteem for the "genius" of the theories attendant to the speculative mania.

In the late 1980s, it was the collapse of socialist central planning in Eastern Europe. On the next contraction, Western central planners will likely suffer a massive loss of regard and, hopefully, arbitrary power.

Armageddon for them; eventually, financial blessings for the general public.


 

Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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