• 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.
    For a free subscription to Gary North’s newsletter on gold, click

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