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Great Depressions Are So Methodical |
Address to the Spring Dinner Meeting of the
Committee for Monetary Research and Education (CMRE)
www.cmre.org
May 14, 2009
BOB HOYE
One of the features of a great boom is the
excitement of shared convictions about eternal prosperity. One of the
features of the consequent contraction is bewilderment about how suddenly
the bust arrived. Beyond those directly hit, the establishment becomes
perplexed by the loss of liquidity and wonders where the money went.
With the 1980s crash in oil and property deals, a
hearing run by offended politicians asked a particularly aggressive Oklahoma
banker about "just where did the money go?". And as the Wall Street Journal
faithfully reported "We spent it on wine, women and song the rest we just
pissed away."
As flippant as this may be, it is accurate and
could be suitable in any example in any century. Fortunately, for
consistency in any century, there is the classic definition of inflation
that it is an "inordinate expansion of credit". In the 1930s, Keynes in a
number of letters to the Fed twisted this around to mean that inflation was
simply rising prices that had very little to do with central bank
manipulations.
Fortunately, Keynes is not around to provide
official confusion to the description that deflation is an inordinate
contraction in credit. Relentless credit deflation started in 2007, and this
implacable force has been part of every long depression.
Clearly, the title of this address puts me firmly
in the bear camp. Just as clearly, the possibility of another great
depression is highly controversial, particularly when such magnificent
efforts are being made to restore the prosperity of a financial mania, which
have always been ephemeral.
Perhaps my credentials should be reviewed.
Everything I needed to know about the markets I learned on the old and
notorious Vancouver Stock Exchange. For example, in a world of extravagant
claims from big government, big academe and big Wall Street the old
definition of a promotion is useful: "In the beginning the promoter has the
vision and the public has the money. At the end of the promotion the public
has the vision and the promoter has the money."
In 2006 to 2007 the public had the vision that
policymakers could depreciate the dollar forever and were positioned
accordingly. And for a moment the promoters looked brilliant as everyone
thought they were wealthy. Moreover, as with any promotion the bigger it is
the bigger the crash.
There are two failures going on. The most obvious
is in the financial markets and the other is in interventionist economics.
The latter failure is in theory as well as in practice, and can be described
as the greatest intellectual failure since the Vatican insisted that the
solar system revolved around the earth, more particularly, Rome. Too many
still believe that the financial world revolves around the Federal Open
Market Committee.
Last year's disaster fit the pattern of the 1929
fall crash with remarkable fidelity. Such a crash was obvious and as the
train wreck in the credit markets continued through the summer of 2008 the
Fed continued its recklessness. But with some marketing skills, the
objective of "stimulus" changed from keeping the boom going to the absurd
notion that bailing out one insolvency, Bear Stearns, would revive the boom.
As usual with a bubble, it was not just one bank that had been imprudent
most had been.
The establishment missing this recurring event was
bad enough but there is another clanger and that is the hopeless notion of a
national economy. Even in ancient times, Cicero knew that the prosperity of
Rome was vulnerable to the credit conditions in the Middle East. In this
regard, Mother Nature has again been providing some harsh lessons, and
history suggests she and Mister Margin will ultimately be successful in
teaching markets 101 to many policymakers.
In the meantime, coming out of the classic fall
crash orthodox investments such as commodities, stocks and bonds were
expected to rebound out until April-May. Until this hooked up, the typical
GDP forecast was tentative in looking for the recovery to begin "by
mid-2010, but our "model" needed forecasts of the recovery starting much
sooner. Then, thanks to the "Green Shoots" that began to appear with the
rebound in March, confidence was gradually restored in high places such that
the miracle of recovery would happen sooner. The higher the stock market
gets the more popular this idea becomes.
And this gets us to another lesson from the old
Vancouver Stock Exchange. "So long as the price is going up the public can
believe the most absurd story." This has been the best explanation of why
Wall Street, the supposed bastion of capitalism, focused on every utterance
from central planners in a central bank. Then when the price breaks, the
vision disappears along with liquidity.
The next phase of the contraction has been
expected to start after mid-year.
For most participants, post-bubble bear markets
have been sudden and severe. The 1929 example ran for three years and the
post 1873 example lasted for five years. The latter has been the best guide
for our recent mania and its bust, but this will be expanded in a few
minutes as it is worth reviewing the excuses offered by many in not
anticipating that short-dated interest rates as well as gold would plunge in
a classic fall crash. This was the pattern with the 1929 and 1873 crashes
and knowledge of such a plunge in short rates should have ended conventional
wisdom that a Fed rate cut would have prevented crashes from 1929 to 2008.
The quickest sign of a gold bug forecast going
wrong is "Conspiracy!". With their latest disappointment Wall Street
strategists described it as a "Black Swan" event, and therefore
unpredictable. That has been a cheap out as each transition from boom to
bust has been methodical. Others called it a "Minsky Moment". Minsky
accurately described the mechanism of a crash, but being a Keynesian he also
wrote that "apt intervention" could keep the economy on a successful path.
Actually, financial conditions reached the perfect
"Keynesian Moment". As we all know, Keynes said "If you save five shillings
you put a man out of work for a day." As part of the greatest mania in
history the savings rate plunged to zero Keynesian perfection had finally
been accomplished. Many in the street, but only a few economists, knew this
was dangerous. Econometric modelers, who still believe in the powers of
regression equations, have long had their out, which has been "Exogenous",
and in one memorable paper of 1983 there was "Super-Exogenity". This arrived
in May 2007 when the yield curve reversed from inverted to steepening. Our
research expected it to occur around June. By July of that fateful year,
there was enough deterioration to conclude that "This is the biggest train
wreck in financial history". It is not over.
Although crashes are grisly events, they share a
common response from the establishment. No matter how shocking, bloody,
expensive, ruinous or just plain shattering a crash is within a week,
there is no one in the street who didn't see it coming. As ironical as this
is, there is a critical link from the stock market to the economy.
On the usual business cycle, the peak in stock
speculation typically leads the peak in the economy by about a year. On the
previous example, stocks set their high in March 2000, and the NBER set the
start of that recession in March 2001. Using their determination this has
been the case for most cycles back to 1854. But, at the conclusion of each
great bubble in financial and tangible assets things change from normal. The
failure in the financial markets and the economy beginning in 2007 have been
virtually simultaneous.
As we all know, in 1929 the Dow made its high in
September and the recession started in August. In 1873 the bear started in
September, and the recession in October. This time around, the stock market
high was in October 2007 and this recession started in December of 2007.
Close enough to fit the post-bubble model, with implications that financial
history is now in the early stages of another Great Depression.
This melancholy event is being confirmed by the
behaviour of politicians and policymakers. After swanning around claiming
credit for the boom politicians panic and then find scapegoats. Remember the
"Goldilocks" celebration of perfect management of interest rates, money
supply and the economy. Well, all five great bubbles from the first in 1720
to the infamous 1929 have been accompanied by such boasting, followed by
what can best be described as frenzies of recriminatory regulation. If the
political path continues protectionism will follow.
One of the worst such examples was called, in real
time, the Tariff of Abominations. But, this is enough of dismal events and
it is time to turn to irony for amusement and enlightenment. The clash
between the establishment and financial history is rich with irony. Beyond
that, financial history, itself, should be considered as an impartial "due
diligence" on every grand scheme promoted during a financial mania by the
private sector as well as by policymakers. Let's use a good old fashioned
term policymakers have been financial adventurers.
One of the richest ironies occurred with the 1873
mania and its collapse. With typical strains developing in the credit
markets during a speculative summer, the leading New York newspaper
editorialized:
but while the Secretary of the Treasury plays the
role of banker for the entire United States it is difficult to conceive of
any condition of circumstances which he cannot control. Power has been
centralized in him to an extent not enjoyed by the Governor of the Bank of
England. He can issue the paper representatives of gold, and count it as
much as the yellow metal itself. [He has] a greater influence than is
possessed by all the banking institutions of New York.
In so many words, because the treasury secretary
was outstanding and had the benefit of unlimited issue of a fiat currency
nothing could go wrong. But it did; the initial bear market lasted for five
years and the initial recession ran a year longer. The pattern of severe
recessions and poor recoveries continued such that in 1884 leading
economists began to call it "The Great Depression", that endured from the
1873 bubble until 1895.
An index of farm land value in England fell almost
every year from 1873 to 1895. Of course, academic economists were fascinated
and for a couple of decades wondered how such a dislocation could have
happened, or even worse, discussed how it could have been prevented.
Ironically, this debate continued until as late as 1939 when another Great
Depression was belatedly discovered.
Naturally the long depression was blamed upon the
old and unstable Treasury System, and at the height of the "Roaring
Twenties" John Moody summed it up with:
"The Federal Reserve Law has demonstrated its
thorough practicality, and thus secured the general confidence of the
business interests. The breeder of financial panics, the National Banking
Law, which had been a menace to American progress for two decades, has now
been replaced by a modern scientific system which embodies an elastic
currency and an orderly control of money markets."
The probability of a depression has been discussed
in the media. It seems that both sides have yet to provide adequate
research, with the establishment's response limited to a classic non
sequitur. "This is nothing like the Great Depression, where we had 25%
unemployment". That was just the most recent example and sound research
would compare unemployment numbers from the first year after the crash. In
1930 the number was around 8%, and in noting that there could be some
difference in methodology today's number is an 8 percenter.
Will it get to 25 percent? This remains to be
seen, but unemployment in the private sector will be the worst since the
last great depression.
By way of a wrap we will take it from the top. In
late 2007, Gregory Mankiw, boasted that the US had a "dream team" of
economists as advisors, and as with all claims at the top of six previous
bubbles "Nothing could go wrong". And even if things went only a little
wrong there were the "safety nets" that Krugman claimed would prevent
serious deterioration. Our view on Keynesian safety nets has always been
that in a bust they would be about as useless as a hardhat in a crowbar
storm.
In the post-1929 bust policymakers were realistic
enough to know that the boom caused the bust. The SEC was established to
prevent another hazardous 1929 mania. Also, one of the promoters of the SEC
boasted that the SEC would put a "Cop at the corner of Wall and Broad
Streets". Without much doubt the SEC has failed to live up to its billing.
The discovery of malfeasance always accompanies the discovery of
malinvestment.
Of course, the other act passed to prevent another
1929 mania was Glass-Steagal, which separated commercial banking from the
evils of Wall Street. This was taken off the books in 1999 as too many banks
were participating in the high-tech frenzy.
Has this happened before? I'm glad I asked the
question. With the financial violence of the South Sea Company in 1720, the
House of Commons passed the "Anti-Bubble" Act, which was taken off the books
in 1771 just in time for the full expression of the 1772 bubble. As with
the climax of the 1720 bubble the Great Depression ran for some twenty
years. This was also the case for the bubbles that blew out in 1825, 1873,
and 1929.
This ominous sequence of financial excess and
consequent disaster brings us to 2007, which will soon have the connotation
of "1929", as the world experiences the sixth Great Depression. Quite
likely, the only offsetting event could be the collapse of interventionist
policymaking, that would eventually be seen as a blessing.
The title of this address, "Great Depressions Are
So Methodical" is intended to be ironical, but some may be startled by the
audacity of the statement. Actually it is the conclusion that anyone would
make after a thorough review of market history. The real audacity is in the
claims of charismatic economists that their personal revelations can provide
one continuous throb of happy motoring. As Hayek said Keynes, as a young
scholar, was absolutely ignorant of financial or economic history. Only
someone who was ineffably ignorant of financial history would claim that it
can arbitrarily be altered.
The next Oscar in audacity goes to Paul Samuelson,
who, in the 1960s, boasted that the business recession had been eliminated.
Right!
Another such example was recently provided by
Gregory Mankiw when he condemned the old Fed with "When you look at the
mistakes of the 1920s and 1930s, they were clearly amateurish." Any
impartial review of market history would conclude that the "Roaring
Twenties" and the contraction was the way financial history works, after all
it was the fifth such example. It is worth recalling that at the height of
the 1929 mania John Moody had condemned the old Treasury System while
reciting that the new Fed was the perfect instrument of policy.
Mankiw then bragged "It is hard to imagine that
happening again we understand the business cycle better".
The Harvard professor topped this late in 2007
with: "The truth is that Fed governors, together with their crack staff of
Ph.D economists, are as close to an economic dream team as we are ever
likely to see."
Now it is time to get into the way Great
Depressions have worked. All six have started with soaring prices for
tangible and financial assets that, typically, run against an inverted yield
curve for some 12 to 16 months.
Then when the curve reverses to steepening it is
the most critical indicator that the credit contraction is starting. This
time around, the sixteen-month count ran to June 2007 and the curve reversed
by the end of May. Our presentations in that fateful month stated that the
greatest train wreck in the history of credit had begun. Deterioration
through July prompted the advice that most bank stocks were a nice "widows
and orphans" short.
Beyond the raw power of speculation, one of the
key features is each mania has been accompanied by a remarkable decline in
real long interest rates, sometimes to zero, and sometimes to minus. In our
case the decline was to around minus 1.5% in January and the increase so far
has been 5 percentage points. In five previous examples, the typical
increase has been twelve percentage points, which has been Mother Nature's
way of correcting untempered expansion of credit. And - in our times,
untempered policymaking.
Lower-grade corporate bonds, have already suffered
an increase of some 25 percentage points, which suggests that the 12 point
potential for treasuries is possible.
There is another important distinction. At the
peak of a great bubble, the stock market peaks virtually with the business
cycle. In 1873, the stock market blew out in September and the recession
started in that October. As noted above, a fiat currency with the potential
of unlimited issue was not proof against yet another Great Depression. In
1929 stocks peaked in September and the economy peaked in August. This time
around stocks set their high in October, 2007 and according to the NBER, the
recession started in that December.
Since 1937 the average length of recession has
been ten months, with six in the order of 8 months. This one has run for 17
months, which breaks a long-standing pattern. Following 1873, the initial
recession lasted 65 months, and following 1929, it ran for 43 months. NBER
data starts in 1854 and these were the longest recessions, with no others in
this league. This one has the potential of being a long one.
This is a lot of history, but what is happening in
the markets right now? Well, then the Green Shoots have finally encompassed
chairman Bernanke. On May 5, Bernanke observed that the "broad rally in
equity prices" is indicating that "economic activity will pick up later in
the year."
At the height of a similar rebound to April-May of
1930, Barron's wrote:
It is thus apparent that the public preference
for stock is not only as marked as ever, but also the will to speculate is
still a speculative factor not to be overlooked. The prompt return of huge
speculation and the liberal manner in which current earnings are again being
discounted indicate that it will be difficult to quench the fires of
stock-market enthusiasm for long.
Prompted by an animated stock rally, the Harvard
Economic Society, but with more gravitas, concluded that it "augured" a
recovery by late in the year. As we all know this did not last and what we
should understand is that it is the dynamics of a crash that sets up the
exciting rebound. Not policymakers.
Let's look at a classic fall crash, which we
expected. The pattern is interesting. The 1929 crash amounted to 48%. The
decline to the low in November 2008 was 47%, and within this the hit to
October 27 amounted to 42%. In 1929 the initial plunge amounted to 40% to
October 29.
The rebound was to November 4, in both examples,
with 2008 gaining 17% and 1929 gaining 12%. The final slump into each
November was 22% and 23%. Is it important to identify it as 1929 or 2008?
Our "historical" model expected the crash and the
rebound, as well as the nature of the establishment's utterances. Another
usual event is a frenzy of recriminatory regulation all supposedly new,
but delivered without knowing that their counterparts over the centuries
have made the same futile gestures.
Ironically, today's excitement in the markets and
convictions in policymaking circles are important steps on the path to a
great depression. As disconcerting as this may be, it is worth reviewing
another clichι of policymaking, which is the notion that lowering
administered rates will restore the momentum of a boom. Massive declines in
short rates, such as Treasury Bills have only occurred in a post-bubble
crash. In 1873 the senior bank rate plunged from 9% to 2.5%, as the stock
market crashed. In the 1929 example the fed discount rate plunged from 6% to
1.5%, as the stock market crashed.
This is getting a little heavy. Not so long ago,
but in another world, financially speaking, when an economist would change a
forecast on GDP from 3 % to 3.25% it was only done to display a sense of
humor. Now policy wonks seriously debate whether the Fed target rate should
be zero or a quarter of one percent (thats 0% to 0.25%). It is patently
absurd to debate what the rate should be or whether it would have any effect
on financial history.
It won't, because we are in a world of financial
violence that is not random, and not due to the Fed not making the
perfectly-timed rate cut. Instead it is due to a natural accumulation of
private speculation, as well as a chronic experiment in policy by financial
adventurers to accurately use a Victorian term.
There are some early terms to describe the sudden
loss of liquidity that marks the end of a bubble. In the 1561 crash Gresham
wrote the Credit cannot be obtained even on double collateral..
Another term goes back to the 1600s when Amsterdam
was the commercial and financial center of the world. The Dutch described
the good times as associated with "easy" credit and the consequence as
"diseased" credit. I'm sure that all in this room would agree with the
accuracy of the latter description. Diseased credit.
What can be done about it? Nothing since the
1500s the literature is complete with many comments that someone, or some
agency can set interest rates either high or low depending upon the
personal concerns of the writer.
Misselden in the 1618 to 1622 crash earnestly
believed that throwing credit at a credit contraction would make it go away.
Despite all this history, Keynes and his disciples cannot be accused of
plagiarism.
What's next?
Virtually, all of the "good stuff" likely to be
revived into May is being accomplished. This includes investments such as
commodities, junk-bonds and stocks, as well as positive statements from the
establishment. Both technical and sentiment measures on the stock market are
at "tilt" levels.
Because it is up at the right time, the conclusion
is that the down will come in on time as well. This would be the next step
on the path towards another Great Depression.
Of course, there is no guarantee that events will
continue on the path. But, then there is no guarantee that it won't. Best to
consider the odds.
E-MAIL
bobhoye@institutionaladvisors.com
WEBSITE:
www.institutionaladvisors.com |
