He's Forever Blowing Bubbles

Until 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:

At 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).

Rothbard 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).

Greenspan 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!

Sheehan’s 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 continues:

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?

Debt. 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.


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

I 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.

From the High-Tech Strategist:

The 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.

However, 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.


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

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.

July 18, 2003

Gary North is the author of Mises on Money. Visit http://www.freebooks.com. For a free subscription to Gary North’s newsletter on gold, click here.

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