He's Forever Blowing Bubbles

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2000, the investing public believed that Alan Greenspan could
do no wrong. He was untouchable. Now, however, doubts have begun
to be voiced in some quarters (1st quarter, 2nd quarter, etc.)
— doubts, as the Bible puts it, like clouds no bigger than
a man’s hand.

He would
prefer to go down in history as Benjamin Strong did. Strong
was Governor of the New York Federal Reserve Bank in the 1920’s.
This bank set FED monetary policy in that era. He had the good
sense of timing to die in 1928, missing the inevitable result
of his own inflationary policies: the Great Depression. People
said then, and economic historians say now, “This never would
have happened if Benjamin Strong were alive.” Yes, it would
have. Had he never been Governor, the economic disaster in the
United States would have been minimized. That is because somebody
other than the “significant other” of Montagu Norman, the head
of the Bank of England, would have run the FED in the 1920’s.
When Norman asked Strong to open up the American money spigot
in order to keep gold from flowing out of England to America,
Strong complied. A different FED Chairman would have told Norman
to take a hike . . . alone.

Then again,
probably not. Irrespective of their personal ties that did not
legally bind, both men were in the hip pocket of the Morgan
Bank — and that tie surely did bind. In a review of a newly
published book on the history of American banking, articles
written by the late Murray Rothbard, Dr. David Gordon writes:

Norman’s behest, Strong inflated the U.S. monetary supply, in
order to enable Britain to maintain in operation the gold-exchange
standard. By doing so, Rothbard claims, Strong bears heavy responsibility
for the onset of the 1929 stock market crash and the ensuing
depression. “The United States inflated its money and credit
in order to prevent inflationary Britain from losing gold to
the United States, a loss which would endanger the new, jerry-built
‘gold standard’ structure. The result, however, was eventual
collapse of money and credit in the U.S. and abroad, and a worldwide
depression. Benjamin Strong was the Morgan’s architect of a
disastrous policy of inflationary boom that led inevitably to
bust” (p. 271).

goes even further in his assault on Federal Reserve inflationism.
Contrary to Milton Friedman, the Federal Reserve did not follow
a contractionist policy once the depression began. Rothbard
assails “the spuriousness of the monetarist legend that the
Federal Reserve was responsible for the great contraction
of money from 1929 to 1933. On the contrary, the Fed and the
administration tried their best to inflate, efforts foiled
by the good sense, and by the increasing mistrust of the banking
system, of the American people” (p. 275).

has faithfully followed Strong’s inflationary policy, and has
upped the ante. Every time there is the threat of a major crisis,
such as the Asian meltdown in 1997 or the LTCM crisis in 1998
or the Y2K threat in 1999 or the 9-11 threat in 2001, Greenspan’s
FED has cranked up the digital printing presses. These crises
are becoming more frequent as his term as Chairman grows longer.

He began
his career as Chairman with a crisis: the 508-point one-day
collapse of the Dow in October, 1987. The FED responded that
afternoon with the promise of liquidity, i.e., the printing
press. That tactic has now become FED strategy. As Franklin
Sanders says, the FED has only two tools at its disposal: fiat
money and blarney. Greenspan’s blarney has been identified by
James Grant as central banker Esperanto. It doesn’t impress
Congressmen quite so much any longer.

The question
today is this: Will Greenspan die before the dollar does? Right
now, the odds are just about even.


Once in
a while, someone writes an article that is close to perfect.
I recently came across one. It puts in plain English the most
likely threats that the American economy is facing and will
face until there is a final blow-off (inflation) or breakdown
(deflation), or a sequence of these events: mild deflation,
inflationary blow-off, and a switch to a new currency.

The article
appeared in the April issue of Dr. Marc Faber’s Gloom, Boom,
and Doom newsletter, which I regard as one of the best.
Dr. Faber also writes a monthly column with the same title in
Strategic Investment. I usually read his article first.
In the April issue, Dr. Faber wrote an excellent essay on SARS
and its potential for doing harm. As background, he provided
a history of the Black Death, which hit the West in 1347. I
have researched that event sporadically for almost 40 years,
and I regard his essay as a very good introduction. It shows
what a pandemic can do to an economy. The world has not seen
anything like it since, but now we have biological warfare and
ever-less expensive equipment. One of these days, we may see
something like the Black Death again. Ah, the wonders of technology!

proposed scenario is much less of a long-shot. I regard it
as a sure thing, short of something far worse: what Greenspan
called cascading cross defaults, i.e., a bank payments gridlock.
So, Sheehan’s scenario is not a worst-case scenario. But it’s
bad enough, and the odds are far better that it will take place.

His thesis
is that all of the fancy mathematical analyses are no guarantee
that the geniuses and their computer programs will keep a major
disaster from happening. The experience of Long Term Capital
Management is the classic example. Two Nobel Prize-winning economists
wrote the formulas, but LTCM’s near-collapse in 1998 threatened
to create one of Greenspan’s cascading cross defaults.

We get
lots of predictions, but they aren’t worth much. Example:

Conventionally minded analysts draw amazingly precise interpretations
from opaque data (say, the same-store sales report) and will
surely reverse their market prediction tomorrow if the next
(say, GDP figure) will help their latest (but easy to revise)
market prediction. According to Paul Krugman, two years ago,
the Congressional Budget Office (CBO) projected a US$5.6 trillion
federal budget surplus over the next ten years. Now, the CBO
predicts a US$1.8 trillion deficit through 2013. We could have
fired the entire Congressional Budget Office apparatus and obtained
a far more accurate prediction if a single person looked at
the incredible rise in capital gains tax receipts. The general
trend of household net worth from stock market gains rose from
US$2.8 trillion in 1995, to US$2.5 trillion in 1996, to US$3.8
trillion in 1997, to US$3.3 trillion in 1998, to US$4.75 trillion
in 1999.

So armed,
the average Denny’s burger chef would have seen that the surpluses
were never to be. Or this: the US states’ pension plans have
swung from a US$112 billion surplus in 2001 to a US$180 billion
deficit in 2002. Did many (still addressing the average Wall
Street Journal reader and believer) stop and ask how did
this enormous mountain of money grow so quickly? If they spent
five minutes hunting for an answer, doubts to the future would
lie exposed.

But doubts
of the future must not be exposed. The inevitable statistical
reality of Medicare and Social Security will not be faced by
anyone in authority, including free market economists who have
bet their reputations on this slogan: “Deficits don’t matter.”
But deficits do matter, and these aging economists had better
have a pile of assets other than a promised pension from their
non-profit, 501(c) employer or their TIAA-CREF fund to get through
their golden years on a diet more appetizing than Alpo. Sheehan

I think we are at a similar point today. During the (ongoing)
bubble, hotshot ideas attract massive inflows which, in time,
become outflows. First was the Internet, then telecom (which
locked arms with the disappearing corporate bond market), then
all of technology, then these avalanches of federal, state,
and municipal debt sprung up from nowhere (at least to those
busy spending the huge and unanticipated tax receipts), and
next it will be us. Once the housing market goes, the means
of expansion is the Collateralised Debt Obligations (CDOs) and
Collateralised Bond Obligations (CBOs) market. CDOs are a collection
agency of every debt owed by anyone that the lender is willing
to sell. Investment banks corral thousands of these debt claims
and turn them into CDOs, a bond. The CDOs are impossible to
understand in detail, so they are mathematically modelled to
predict how they will behave in aggregate. These jigsaw puzzles
include such loans as houses, cars, boats, motorcycles, and
— facelifts. Yes, in Doug Noland’s February 28 Credit
Bubble Bulletin (free of charge on the Prudent Bear website),
we learned that facelifts are now being packaged into CDOs and
the receipts from those loans will pay the bond buyers. So,
for those asking whether this credit bubble can possibly go
on, yes, at least for a while. If face lifts, why not dental
bills, barber shops, the idyllic lemonade stand?

There is a growing mountain of debt, a Himalayan range of debt.
It is cobbled together in millions of contractual obligations.
Its complexity is beyond the power of men or computers to understand.
We are asked to trust the free market to bring order out of
the apparent chaos of hundreds of millions of contracts. Unfortunately,
the entire credit/debt system rests on central banking, and
there is nothing free market about these government-created
monopolies over money. The entire system now rests heavily on
Mr. Greenspan’s ability, in the language of B-westerns in 1938,
to head the bad guys off at the pass.


compares the analyses of Mary Meeker, who wasn’t meek, and Fred
Hickey, whose role surely matches his surname.

will now quote from an analyst who writes about the real world.
When Mary Meeker was “Queen of the ‘Net,'” holding daily TV
interviews and signing ball caps, Fred Hickey was checking the
shelves at Best Buy and Circuit City and asking the salesmen
about their Christmas bonuses. Long before the rest of the world
caught up, Fred told his readers that the stuff was sitting
on shelves. The retailers couldn’t sell it, and Dell was not
a stock to own.

I turn
now to Hickey’s February 20, 2003, High-Tech Strategist.
In the first paragraph, he explains the vacuity of thinking
on Wall Street. I’ll only add: they still don’t understand
why the market collapsed, so they won’t understand what is
required for a real recovery. In the second paragraph, he
writes what we will not read in a general circulation periodical.
As far as I know, Wall Street research is equally ill-prepared
for such a discussion. Hickey plants a physical image in the
mind of the reader. Of the here and the now. Of why this bear
market is different from any that most of us have lived through.
We are sinking under several trillion dollars worth (as carried
on the balance sheet) of capital equipment that will never
be used. The debt load is so great at every seam of the economy
that companies cannot keep up with their debt payments, never
mind investing in equipment that might find a new application.

the High-Tech Strategist:

stock bulls remaining in this market have never grasped
how enormous the bubble of the late-1990s was. They’ve never
understood just how great the imbalances were. They’ve never
comprehended the vast amount of tech overcapacity created
during the bubble period. For three consecutive years they’ve
suffered compound double-digit losses in their favorite
Nasdaq tech stocks as they’ve hung on to the notion that
a rebound was imminent. There have always been excuses to
explain away their incorrect bullish forecasts. If not for
the 9/11 terror attack, the economy and the stock market
would have recovered in 2001. If not for the corporate scandals
(Enron, WorldCom, etc.) the economy and the stock market
would have recovered in mid-2002. If not for the Iraq worries,
the economy and the stock market would currently be booming.

when the war is over (hopefully quickly and successfully),
the bulls will learn that the excesses generated during
the 90s boom are still with us and will need further time
to correct. There’s still years worth of fiber optic capacity
in the ground. Distribution channels (including EBay) are
still littered with excess networking equipment such as
switches and routers and gateways. A tiny fraction of the
Internet hosting capacity that was built is currently used.
Thousands of unprofitable, cash draining, start-up companies
are still barely eking out an existence by living off funding
received during the boom. There are too many wireless carriers
with too much debt. Excess semiconductor foundry capacity
is enormous and is exceeded only by the capacity of semiconductor
equipment manufacturers themselves. There’s so much DRAM
manufacturing capacity that prices fall every day, yet even
more capacity is being brought on line. . .

So much
for Hickey’s assessment, as of last February. Sheehan explains
what all this means.

That’s it. That is our financial burden and will remain so for
a long, long time. When the analysts coo about the “productivity
miracle” (another sign of the times: miracles have been downgraded
faster than Ford Credit), they are talking about assets sitting
in the junkyard. High-Tech Strategist readers know that.
There is no sign that the media conduits (the intermediaries
between Wall Street and investors) have a clue. If they do,
they aren’t talking. If only this were the extent of the problem.
Far worse, the junk is still sitting on the balance sheet, labelled
an “asset”. The left side of the balance sheet is often rubbish.
It doesn’t help that the worst of these companies borrowed far
too much and are facing long odds to pay back their debt. Nor
does it help that corporations are making less money every day.

He then
quotes Dr. Kurt Richebacher, who has pointed out that profits
as a share of GDP have fallen from 6.7% in 1997 to 4.3% in 2000,
to 3% today.


The derivatives
market is an interconnected system of debts and credits that
are based mainly on expected earnings of assets of all kinds.
Sellers of expected earnings discount them in a highly leveraged
financial futures market. Winners and losers offset each other
in any transaction. It’s a zero-sum game: for every loser, there
is a winner, assuming — the central assumption on which our
civilization rests — the loser pays off. If he doesn’t, “the
knee bone’s connected to the thigh bone; the thigh bone’s connected
to the hip bone.” It’s cascading cross defaults time!

The experts
are as baffled as you and I are regarding the implications of
all this. Sheehan comments on the knee-jerk reaction of the
salaried article writers, who own no investments other than
their mortgaged homes and their third-party—managed pension
funds. He contrasts their flippant optimism with the opinion
of a man worth about $25 billion, who made his money by investing.

In mid-March, Warren Buffett launched a Tomahawk missile against
the dangers of derivatives. The [Wall Street] Journal
took exception in an editorial, titled, “Derivative Thinking.”
In a compare and contrast exercise: we start in the first column:
“Derivatives are one of the major innovations of the past three
decades. These instruments are little miracles [another downgrade]
of financial engineering, permitting investors to take a position,
or make a bet, without actually having to hold the physical
asset. Rather, the value of a derivative rests on the underlying
security or a particular reference. . . . ” Now, from the second
column: “. . . [F]inancial accounting for derivatives is a mug’s
game. Valuing derivatives on a mark to market basis can be an
exercise in fantasy. For many derivatives, the trading is so
thin that valuation models must be used and those models can
contain a great deal of unwarranted optimism. The result is
inflated earnings.” So, these little miracles cannot be valued;
can be highly illiquid; hold the characteristics of non-continuous
markets, which is a contradiction of derivative models; the
models can be rigged; and successfully so since nobody knows
how to value derivatives. It is from these voices that many
intelligent people form their knowledge of the markets.


I have
summarized only a few of the insights of Sheehan’s essay. But
His conclusions regarding your financial response to all this
are worth citing.

The top priority is to preserve your purchasing power. “Purchasing
power” is not “principal”. Domestic money market assets will
yield limited protection in the US. They will not protect an
investor from the ravages of a collapsing dollar. It fell 70%
against the Swiss franc in the seventies. It fell 63% against
the deutschemark between 1985 and 1995. It may very well do
so again. There are funds that invest in a combination of foreign
money markets and gold. To look at the securities held in one
of their funds is to create a short list of countries with strong
balance of payments surpluses. Other types of securities in
these countries, such as common and preferred stocks, are worthy
of study.

A way
to think about investing today is to stand in the opposite
corner of all that has reached untenable levels and proportions.
Start with US Treasury bonds. Second, do not feel any compulsion
to buy common stocks. However, the data from Lipper above
shows where the dumb money is overweighted and where it is
underweighted. Residential real estate is in for a real thumping.
This is an example of where liquidity can pay off in spades.
In the early 1990s, banks auctioned foreclosed properties
in the Boston area, and people showed up with the cash to
buy houses at deep discounts.


through. Print out the entire issue. After work, sit down and
read it. There is more meat here than anything I have read in

It all
boils down to this: central banking has created the basis of
a nightmare scenario. The credit money-induced financial bubbles
have only begun to pop. The central banks have only just begun
to inflate. We now face a witch’s brew: enormous debt, enormous
confidence in fiat money, and six decades without a major financial
catastrophe have lulled people into complacency. I am not talking
about the common man, who has no understanding of such matters.
I mean (and Sheehan means) the sophisticated masters of the
universe: senior politicians, the entire financial brokerage
industry, and the debt-dismissing economists who serve as their
well-paid cheerleaders.

18, 2003

North is the author of Mises
on Money
. Visit http://www.freebooks.com.
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