The Best Known Civil Servant Since Pontius Pilate

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Today, on our way to work, we were stopped by a woman dressed as a banana. It reminded us of other odd people we have been privileged to know…about which, more below.

But such is the nature of our world that strange things happen from time to time. History records many episodes of aberration and many spasms of excess. We looked at one of those curious phenomena yesterday — the bubble in farmland in the otherwise monotonous western plains during the 1880s. So feverish were the borrowers and lenders back then, and so sure were they that land prices had nowhere to go but up, that there was soon one mortgage for every two adults. Per capita, debt levels in western Kansas rose over $347, or about four times as much as the nation as a whole.

And who could argue with the speculators? Everybody knew that the United States of America was filling up. And everybody knew that these new Yankee Doodles needed to be fed. Everybody also knew that the supply of farmland was not infinite. Out beyond Kansas, the land turned so dry that you could only graze cattle on it. This was the last big patch of earth on the whole continent that had not yet been put to the plow.

And yet, by the end of the decade the rains failed, the crops failed, the mortgages failed, the bubble failed, the New Era failed, and the farmers went back whence they came. One half the population of Western Kansas left the territory, says a source quoted by Grant’s Interest Rate Observer, “as they had entered it only a few months before, each with his family and his total worldly possessions in a single covered wagon, drawn by two gaunt ponies.”

But, of course, all of that happened before the invention of the Federal Reserve System.

Money grubbing is as old as pitching woo. Speculating predates spats. Bubbles have been around since the days of Bathsheba.

By contrast,
the phrase, "the Great Moderation," entered the history
books only recently.

It is meant to describe what has happened in the financial markets during the reign of the best-known civil servant since Pontius Pilate, Alan Greenspan. During his time in office, it is widely believed the Sturm und Drang (storm and stress) of the markets gave way to stability and predictability. It was as though a marching band had switched to playing E-Z listening elevator favorites, and the parade that normally followed — with clowns, acrobats, and soldiers in gaudy uniforms with weapons on their shoulders, and smelly crowds lining the sidewalks — had been replaced by accountants, economists, and investment quants armed with laptop computers and spreadsheets, in an air-conditioned room. The thrill went out of the whole thing, but so did the risk and surprise. With sophisticated modern financial instruments, and enlightened management, any risk can be hedged. There is no longer anyone to laugh at, they say, or anyone to feel sorry for. If a man goes broke today, it is his own damned fault.

That is the wonderful world in which we find ourselves today, or so we are told.

But that was also the world as it existed, more or less, in 1987. This was at the beginning of Alan Greenspan’s term. Then, as now, investment professionals had computers and the Black-Scholes option pricing theory. And then, as now, a lot of people were prepared to believe that investing was a science that could be modeled and controlled so as to eliminate risk. A few innovators had even come up with “portfolio insurance,” which offered investors a way to stay in the stock market without worrying about a decline in prices. Another new era had arrived for investors.

Dr. Bruce Jacobs
describes how it worked:

"An actual put on an underling stock portfolio protects the portfolio from stock price declines below a certain level while leaving the portfolio open to stock price advances. Using computerized rules and program trading (again, like today), portfolio insurance aimed to replicate the behavior of a put option by selling short stock index futures.”

Dr. Jacobs also put his finger on the fly in the ointment:

"Option replication requires trend-following behavior — selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends.”

One investor could hedge his exposure. All could not. Who would be on the other side of the trade? The more the idea of “portfolio insurance” took hold, the less insurance there was. In fact, the more people tried to protect themselves from falling prices all at once…the more they suffered losses. When “Black Monday” came, Dr. Jacobs describes what happened:

"Portfolio insurers sold futures equivalent to $530 million, $965 million, and $2.1 billion in stocks on the Wednesday, Thursday, and Friday preceding the crash (SEC 1988: 2.6, 3.9). The market fell 10 percent in this same period. A typical portfolio insurance strategy would have called for the sale of 20 percent of the equities in response to a 10 percent decline.”

Then, on Monday morning…

"From 9:30-9:40 a.m., program selling constituted 61 percent of NYSE volume. Between 11:40 a.m. and 2:00 p.m., portfolio insurers sold about $1.3 billion in futures, representing about 41 percent of public futures volume (Brady Comm. 1988:36). In addition, portfolio insurers sold approximately $900 million in NYSE stocks. In stocks and futures combined, portfolio insurers had contributed over $3.7 billion in selling pressure by early afternoon.

"From 1:10—1:20 p.m., program selling constituted 63.4 percent of NYSE volume and over 60 percent in two intervals from 1:30 to 2:00 p.m. In the last hour and a half of trading, insurers sold $660 million in futures. The DJIA sank almost 300 points in the last hour and a quarter of trading.”

Sophisticated investment tools did not make the situation better. They made it worse, but the bank of Alan Greenspan was ready. In this crisis, as in every crisis over the next 18 years, the Fed provided credit when credit was wanted. It encouraged speculators and homeowners to believe that credit would always be forthcoming, only more abundantly than before. After the crash of ’87, the LTCM collapse, the Russian bonds, the tech bubble, Argentine debt, and the recession of ’01—’02…after each crisis people let out a bigger sigh of relief. There seemed no crisis so big that the Fed could not handle, no risk so great that wasn’t hedged by the maestro himself, and no real danger to the economy or its speculators. The Great Moderation had arrived…this time, a new era for sure.

• "Ben Bernanke is going to have a challenge," said Joseph Stiglitz, a Nobel-prize winning economist at Columbia University in an interview yesterday. “He’s inheriting an economy that has some fragility going forward. The high level of debt, rising interest rates, problems of oil — all of this means he is going to have to manage the economy in a very difficult situation.”

Really. Good thing Bernanke is lily footing his way around the Senate then, huh? Yesterday he promised to “maintain continuity with the policies and policy strategies established during the Greenspan years.” Bravo. Can’t wait.

For our part in the circus, we sent — as we’ve been threatening to do — 537 copies of our new book Empire of Debt to all the Senators. And their cohorts across the rotunda. And the Commander-in-Chief down the street.

The cover letter we sent with the book suggested that continuing the policies of Alan Greenspan, while it might be what the country wants, is not likely to yield the desired result.

• A U.S. trade official says he expects the U.S. trade deficit with China to top $200 billion this year.

Meanwhile, foreigners may be getting tired of financing this deficit. Alan Greenspan said so himself: “At some point investors will balk at further financing.”

The Bank of International Settlement keeps track of cross-border capital flows. They note that more and more of them are being made in euros. In the first three months of this year, says BIS, 42.5% of foreign investments were in dollars, 39.3% in euros. The dollar portion was down 4%; the euro percentage was up 5%.

• The woman dressed as a banana reminded us of other eccentrics we’ve been happy to know. One acquaintance always wore his clothes backward. He had also learned to read and write upside down and back to front. He was a hobo who liked to hitch rides on freight trains.

None of this is particularly commendable. Like most extraordinary achievements, such as stuffing billiard balls in your mouth or learning the logarithmic tables by heart, it is probably not worth doing. Still, in a world dominated by people as grey and monotonous as a Senate hearing, a little lively color is a relief.

Another acquaintance would never say a word that began with the letter ‘F’. We wondered why. It was as if he had missed a day of school as a very young man and never caught on to ‘F’. All his life, he dodged the letter ‘F’. He never sat “on the fence,” for example. Instead, he sat on the enclosure or the wall or the barrier. Nor did he ever “have a little fun.” Instead, he enjoyed himself, or he amused himself. Or he merely had a good time. The poor man couldn’t even count properly. “One, two, three, quatro, cinco, six, ” he would say.

Finally, we asked him why he never said a word that began with ‘F’.

"My mother told me never to use the F-word," he replied. "I never have."

"Maybe she didn’t mean all words that began with ‘F’," we suggested. "Maybe she just had a single F-word in mind."

"I never thought of that…"

Bill Bonner [send him mail] is the author, with Addison Wiggin, of Financial Reckoning Day: Surviving the Soft Depression of The 21st Century and Empire of Debt: The Rise Of An Epic Financial Crisis.

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