Old Dogs, Old Tricks

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my previous report on Fred
Sheehan’s essay, “An Investor’s
,” I presented his basic thesis: all of the investment
fund managers’ fancy mathematical analyses are no guarantee
that the geniuses and their computer programs will keep a major
disaster from happening.

The various
investment bubbles created by Federal Reserve monetary policy
have not yet been liquidated, he argues. The size of the debt
load of American consumers is still very high.

I would
make this modification: the size of the debt load is high, but
the monthly debt repayment burden has not changed much. It never
does. Year after year, decade after decade, the ratio of debt
payments to disposable personal income fluctuates within a narrow
range of two percentage points: 12.5% to 14.5%.

This means
that as interest rates have fallen in response to (1) the recession
and the weak post-recession recovery, and (2) Federal Reserve
monetary inflation, the American consumer has loaded up on new
debt. Because he can now afford to finance more debt because
of lower interest rates, he has leveraged his income. He has
bought more consumer goods, especially housing, with the same
income because he has been able to borrow more money at lower

The problem
will come if (1) his income falls, or (2) interest rates rise.
Families that have re-financed with ARM’s — Adjustable Rate
Mortgages — will find themselves facing unexpectedly large
mortgage payments when long-term interest rates go back up in
response to price inflation, i.e., a depreciating dollar. The
ARM’s allow lenders to raise rates in response to rising rates
in the credit markets. Anyone who has an ARM is playing with
financial fire.


points to the overcapacity of production facilities that were
built because of the stimulation created by FED monetary inflation.
This is consistent with Ludwig von Mises’ theory of the business
cycle. Mises taught that central bank monetary inflation lowers
interest rates temporarily, thereby luring entrepreneurs into
projects that they would not have begun, had the interest rates
not been artificially reduced by an expansion of central bank
credit. This is the boom phase of the business cycle. When the
expansionist monetary policy ceases, rates go back up, and many
entrepreneurs suffer losses. This is the bust phase of the business
cycle. I have written a chapter on this process in my eBook,
Mises on Money.

What we
now see is worldwide manufacturing overcapacity because of prior
central bank monetary expansion. This is what the bubble has
been all about. This overcapacity has not yet been liquidated
by collapsing capital prices, although the performance of stock
markets from January, 2000 to March, 2003 surely was the beginning
of the liquidation process. But central banks, especially the
FED, have poured new money into the economy to lower rates and
keep the capital liquidation process from fully revealing the
true free market value of capital assets. This monetary inflation
extends the illusion that these goods are still more valuable
than the market would reveal. But when this phase of the inflation
ends, either by monetary stability, deflation, or the inflationary
destruction of the monetary unit, the true value of capital
will be revealed.

This overhang
of productive capacity is keeping consumer prices from escalating
to match the expansion of central bank credit. But it is also
keeping businesses from investing this new credit. There is
no confidence among entrepreneurs that new investments today
will produce profits later. So, consumers are borrowing and
spending, oblivious to the continuing bubble status of the capital


thinks that fund portfolio managers will not shift from equities
to money-market investments, especially foreign currencies,
that are safer than American equities for preserving not only
capital but purchasing power. The managers follow the same drummer.
They are a pack of old dogs.

He cites
Peter Bernstein, the author of a great book on the history of
the discovery of statistics and their applications to the external
world, especially the world of markets. The book’s title is

Against the Gods
. Bernstein has warned about investment
advisors who refuse to learn that their formulas will not perform
well in protecting portfolio value. We really are in a new economy,
i.e., the end of the boom phase. Writes Sheehan:

Let’s assume we’ve collected a few willing listeners; what do
we tell them? A good place to start is Peter Bernstein’s interview
in the February 28, 2003, issue of welling@weeden. A large number
of his clients are institutional managers and pension funds.
He is telling them that, “the traditional institutional approach,
‘I will structure my portfolio in this way and make variations
on the theme,’ won’t work. So what I’m suggesting is, throw
it away. You have to be much more unstructured, opportunistic
and ad hoc than you have been in the past.” Later in the interview,
“. . . in this looser, more opportunistic environment I foresee
the abandonment of the dreadful, depressing, defaulting process
of putting managers into cubbyholes — large-cap growth, small-cap
value and such foolishness — along with the stifling, stupid,
obsession with tracking error instead of absolute returns and
risks incurred.”

though this is addressed to an institutional audience, the
way of thinking is not dissimilar to the retail investor.
Replace “portfolio managers” and “investment boards” with
Uncle Bob and Aunt Millie. “. . . People forgot during the
20-year bull market . . . that investing is all about taking
risks to get rewards. You’ve got a whole generation of portfolio
managers and investment boards who’ve convinced themselves
that if they diversify, stick to a style, and hold on for
the long-term, they’re home free.” (p. 11)

then applies to today’s markets Bernstein’s warning against
assuming that tomorrow will be pretty much like today.

We are living at the long end — if “end” it is — of gross
financial imbalances. Most people don’t understand this, or
won’t acknowledge it. This fog of extremity and perplexity is
a financial maelstrom that has been building for a generation.

the end of his essay, he summarizes our present dilemma: the
aging of the West’s institutional innovation.

If you look back at Peter Bernstein’s interview, his description
is of a tired, exhausted mind. In the past century, we have
grown and grown, but lacking originality, only compounding behemoth
structures in most every walk of life. Bernstein calls for a
renewal, a re-birth. He repeatedly emphasizes the convulsion
we face: “[W]e are going to have to learn to live without the
crutch of things like policy portfolios — because the conditions
that justified their existence for so long have been shattered.”
(p. 15)
The problem
is the welfare State. Everywhere, there are State-mandated safety
nets. Compulsory safety nets reward the losers at the expense
of the winners. The old dogs, being old, refuse to learn new tricks.
The system is too large, too geriatric, and too wealthy to change,
except through the pain of competitive pressures imposed by agile,
innovative, and youthful entrepreneurs outside the West.

Institutions as a whole have grown to a size at which they can
no longer act because of girth. They must follow a set of implicit
assumptions that stifle imagination. What, for instance, can
really be done to restructure Fannie Mae if its financial models
go awry? One can go on and on: public school systems, the airlines,
the auto companies, the multinational consumer goods companies
(Coke, McDonald’s), pension consultants and their benchmarks,
the central-bank created money flows, trillions of dollars a
day flowing between markets with little attention paid to economic
valuation, financial derivative contrivances, the IMF, professional
sports, the Olympics and stockholders of fractional interests
in the companies they own with little knowledge or ability to
act as an owner.

is not only a problem of advanced age; it is also of wealth.
We live comfortably; our houses are filled with material possessions.
To reform radically could endanger our cozy living rooms,
fervently encased with rolls of duct tape.

It is
not by coincidence that countries with the oldest demographics
find it harder to change their ways. Japan is Exhibit A; Europe
and the US are right behind. Older countries worry more about
things like car seats, tamper-proof bottles, smoking and bicycle
helmets; are up-to-speed on the latest FDA warnings; and cling
to the television set if a large storm threatens. With younger
demographics comes greater flexibility and dexterity. (p.


It took
the National Bureau of Economic Research until this month to
conclude that the recession that began in March, 2001, ended
in November,

So, the
U.S. has been in recovery mode since November, 2001. Question:
Why is unemployment still rising? What kind of economic recovery
loses millions of jobs? For two charts comparing today’s rising
unemployment figures with falling unemployment figures in previous
recessions, click

What is
also abnormal about this recovery is that unemployment is rising
in Europe, too. This is a Western problem, not just an American

A look at unemployment figures is worth considering, of Us and
Them. According to government numbers (which surely understate
any bad news), the US unemployment rate rose from 5.6% a year
ago to 5.8% today. The change over the same period in Belgium
was 10.8% to 11.7%, France 8.8% to 9.2%, Germany 9.6% to 10.6%,
Switzerland 2.6% to 3.9%, and Spain 11.1% to 11.9%. (p. 12).


with rising unemployment, we have seen the falling dollar. Sheehan
believes that the dollar has only begun to fall.

The dollar’s fall from grace might be enlightened by a look
at our debt obligations. What we owe is growing at a clip many
multiples in excess to the growth of the economy. During the
fourth quarter of 2002, total credit debt grew by US$2.3 trillion,
but the economy grew (measured by GDP numbers) US$363 billion.
The paper debt grew 6.3 times faster than the economy. To look
at a longer view, US total credit market debt was about US$7
trillion in 1985; it is over US$30 trillion today.

if Americans don’t want to buy all of this paper? Well, we
haven’t bought it for quite awhile, so we ship these IOUs
overseas. About 80% of the world’s savings was spent last
year investing in the US. How much more will the rest of the
world buy? (According to Steve Hanke, it is 100%.) Isn’t there
some farm equipment company at home with a decent shot at
success? (p. 12)

Why should
American investors expect the rest of the world’s investors
to continue to invest 80% of their savings in dollar-denominated
assets when the greatest economic growth is in Asia? Why should
the world invest here when American business owners are not
investing here?

Then there
is the expansion of American military power into Iraq. When
Sheehan wrote his report, Americans were not seeing news reports
every day about another American soldier killed. Americans are
now discovering that occupying a defeated nation where individual
citizens are armed is no picnic. The cost of occupying the world
looks higher than it did last March. The troops will not be
home by Christmas. In fact, there is serious talk about having
to increase the size of the occupying force. Taxpayers will
pay for this. We hear no more about the oil bonanza that will
pay for it all. There is only silence on the Iraqi oil front.
Being on top is risky, Sheehan says.

Being on top of the world is a precarious spot and it can end
in a flash: the Spanish Armada in 1588 and the Japanese at Midway
in 1942 are just two examples. In 1914, the US was a debtor
nation. It owed, mostly to the Europeans, US$3 billion. (That
really was a lot of money back then. It really was! Please trust
me.) By 1919, foreigners owed us US$10 billion and the US booked
a US$3 billion surplus. We were on top of the financial world
and sit there today. We displaced Britain in a very short period
of time. (A half-century later, Britain had spent itself so
thoroughly into the poor house that the IMF bailed out the pound
sterling.) By 1929, the national income of the US was greater
than that of Great Britain, Germany, France, Canada, Japan and
several other countries — combined. Jim Rogers tells us
that today we owe foreigners US$6.4 trillion and overseas interest
payments alone cost US$333 billion last year. (pp. 13—14)

Rumsfeld might talk of an old and new Europe, but the truth
is, we’re all old and bloated now. The United Nations is no
longer capable (if it ever was) of making a large decision.
It is too big and too entrenched in its ways. Politicians
fiddle around with microscopic changes to programs that will
bankrupt us all (Medicare, the NHS, welfare, etc.). They give
no thought to tossing them out the window and starting over
again. (p. 15)

Old dogs
grow tired. They do not learn new tricks. They are replaced
by younger dogs. But they yap as loudly as young dogs until
the very end.


As a child,
I saw the Disney cartoon of the grasshopper and the ant. I can
still remember the tune sung by the grasshopper in summer, “Oh,
The world owes me a living.” I was maybe seven years old, but
I got the message. By the wonder
of the Web
, I was able to refresh my memory. Disney released
that cartoon in 1934, long before I was born, during the Great
Depression. The lyrics were more pointed than I had remembered.

good book says the Lord provides
There’s food on every tree
I see no need to worry and work
No sir, not me.

Oh, the
world owes me a living.
Oh, the world owes me a living
Oh, the world owes me a living
You shouldn’t soil your Sunday pants
Like those other foolish ants
C’mon, let’s play and sing and dance.

Ant) You’ll change that tune when winter comes
And the ground is covered with snow.


wintertime’s a long way off
Ya dance? Let’s go!
Oh, the world owes me a living
Oh, the world owes me a living
You shouldn’t soil your Sunday pants
Like those other foolish ants
C’mon, let’s play and sing and dance.

of the West don’t want to believe that winter still follows
summer, but it does. We have had a long summer. We have done
a lot of dancing. We are a lot older. But we have not grown
wise with age.


warned a younger generation of Israelites who had gone through
forty years of wandering in the wilderness with their now-dead

And he humbled thee, and suffered thee to hunger, and fed thee
with manna, which thou knewest not, neither did thy fathers
know; that he might make thee know that man doth not live by
bread only, but by every word that proceedeth out of the mouth
of the LORD doth man live (Deuteronomy 8:3).

bankers have revised this ancient warning: “Man doth not live
by bread only, but by every fiat credit that proceedeth out
of the central bank doth man live.” It is time to go back to
the original text.

One other
thing: when the younger generation crossed into Canaan, the
daily supply of manna ceased (Joshua 5:12). For those addicted
to manna from heaven, the new challenge must have been fearful.
When an entire civilization looks at the central government
and sees “Department of Manna,” there will be a time of dieting

22, 2003

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