Tuesday, February 08, 2005

Signs of the Economic Apocalypse 1-24-05

From Signs of the Times 1-24-05:

The dollar closed at .766 euros last week up a bit from the previous week’s close of .763. Conversely, the euro closed at 1.305 dollars, down less than a half percent from the previous week’s 1.3106. The Dow Jones Industrial Average closed at 10,392.99 down 165.01 or 1.56% from the previous week’s 10,558. The NASDAQ closed down 53.64 or 2.64% at 2034.27. All three weeks of 2005 has seen declines in the US stock market. The ten-year US Treasury Bond fell to 4.14% compared to the previous Friday’s close of 4.21%, for a 1.7% drop. Gold closed at 423.30 US dollars on Friday the 21st, up from 422.50 last week and 325.42 euros, up from 322.37 on the 14th. Oil closed at 48.53 US dollars a barrel or 37.17 euros. That is up from the previous week’s $48.38 and 36.91 euros. An ounce of gold would buy 8.72 barrels of oil down slightly from the previous week’s 8.73.

Again, there was no dramatic change from last week. Are we really headed for a collapse? What is frightening is that even if we ignore non-economic causes of a collapse, the purely economic factors are probably enough to cause one. According to Jeff Ferguson,

Two secular bear markets have occurred during the past 100 years of US history. 1929 saw the beginning of a 90% decline in equity [stock] values which transpired over the subsequent three year period. During the 1930's the US economy experienced the failure of thousands of banks and unemployment over 25% with grinding depression lasting until world war displaced depression as the overwhelming economic force. The Dow industrial index didn't regain its 1929 peak until 1954, 25 years later. The second secular bear growled its way through the 1970's, and it was truly secular in nature. Contrary to a common belief equities didn't simply move sideways through the 1970's before moving to new highs with the great bull market starting in 1982. This illusion is caused by the inflation which plagued the period. Deflating the S&P 500 with the CPI reveals that the market peaked in 1969, not 1973, before falling 64% over the subsequent 13 years, ultimately bottoming in 1982. Stock prices failed to exceed the 1969 peak until 1993, 24 years later, and didn't move convincingly through the 1969 level until 1995. At this point the weary, and
rather aged, investor still faced capital gains taxes on a phantom 300% gain wholly due to inflation. Covering this tax liability likely extended the true recovery period to within shouting distance of the bear market in stocks beginning in 2000, the most recent peak in equity markets.

Ferguson interprets Stephen Roach of Morgan Stanley’s term, “economic armageddon,” as referring to just such a “secular bear market.” I tend to think there is a good chance of something much worse and so would prefer to keep terms like “armageddon” for that. In any case, a great depression is bad enough and, according to Ferguson, we are due for one solely due to economic reasons. Can we see one coming in advance? Ferguson says yes. The boom-bust cycle occurs in short term and longer term cycles. We call the short-term bust a recession and the long-term one a depression. The fuel for the cycle is excessive optimism in the expansion phase and excessive pessimism in the contractive phase. Is there a third cycle, longer than the 50-year depression cycle? Rather than a “business cycle” we might call that a “civilization cycle.” We’ll get to that later. For now, let’s look at the business cycle. Ferguson sees the historically low interest rates of the last decade as being a type of price control on finance and argues that price controls usually end badly with shortages of what was kept cheap. So if the cost of money (capital) has been kept artificially low, then soon there won’t be any money.

The most profound damage would be caused by perpetual distortion of a price which affects all consumption and investment decisions in all markets. Does such a price exist? Certainly…the rate of interest! Every consumption decision involves, although perhaps not explicitly, the choice between consumption now or saving now and consuming more in the future. Depression of interest rates makes current consumption less expensive relative to future consumption with saving relatively less attractive since earnings on savings are lower.

Business investment decisions are also affected by interest rates. Every such decision, at least implicitly, involves a valuation of discounted cash flows. A lowering
of the interest rate reduces the discount making business investments look more
attractive than would otherwise be the case.

Surely, one might reasonably think, given our well developed understanding of the importance of prices in coordinating an economy and the consequences of
prices we wouldn't be foolish enough to manipulate the price capable of causing the most damage. Astonishingly we do so as a matter of policy! A primary function of the Federal Reserve involves the setting of short term interest rates. Furthermore institutional practices within our financial system distort the rate of interest to an even greater degree through fractional reserves at depository institutions; or most generally funding long assets with shorter term liabilities. Within modern day financial systems the rate of interest never develops through unfettered market action. All markets, financial and "real", are continually subject to distortion induced by the altered rate of interest. There is no opportunity for a market determined rate of interest to provide efficient, stabilizing coordination of resource allocation across time.

How could we fail to apply our understanding of the power of market prices to a price as important as the interest rate?

Perhaps, in part, the answer involves the abstract nature of the issue. Interest rates guide the allocation of resources across time, a particularly elusive concept. In the
immediate present, the frame of reference we all grasp most readily, destructive misallocations resulting from distortion of interest rates are not evident. In fact quite the contrary is true. Depression of the interest rate through expansion of money and credit seems to offer a miraculous opportunity to get something for nothing. As a consequence of credit ease we see higher levels of consumption, business investment, employment and financial asset values. How could any of that be bad? Periods of declining rates generally precede cyclic tops characterized by the best of conditions in the economy and financial markets.

Due to the amplifying effects of the financial system in reacting to low interest, rates, we end up with, “inherently unstable mass of credit supported by a relatively narrow base of money with each paper backed financial instrument serving both as an asset to one party and a liability to another.” What happens when interest rates start to rise after reaching historic lows at the peak of the boom?

To begin the exponential increase in values of long dated cash flows (earnings on stocks, interest payments on debt securities, etc.) which works such magic on the upside now shifts into reverse. The decline in values will be most evident in financial assets considered speculative, generally because they provide little or no cash flow in the present while holding the promise of large returns in distant periods. The value of these distant period returns are much more heavily impacted by rising rates than shorter term returns. However any long dated asset will suffer the irresistible force of higher rates of discount as interest rates climb, even those offering near term income. In short, equity and debt markets fall first and often fast. With long dated asset values falling sharply, short term liabilities remaining essentially unchanged and the cost of short term funding increasing investors quickly see profits dwindle while their net capital contracts or disappears entirely depending on their state of

It is important to note here that “long dated assets” doesn’t just mean financial instruments (like holding a bond, a mortgage note, or holding a share of the proceeds of millions of mortgages) but also, for those of us in the working class, the proceeds of our labor ten or twenty years down the line.

And by “working class” I don’t mean “blue collar.” I mean anyone whose main source of income is their paycheck. One of the brilliant maneuvers of late capitalism is the invention of a technical/managerial/professional class who were told that they were in the same position of the owner class. Unless those types can afford to quit their jobs, they are in the working class. However, psychologically and ideologically, they identify with the owners, that is, with a class that holds very different fundamental interests.

If we think that our future pay is going to fall for whatever reason, we will be less likely to borrow and spend.

Furthermore, early in the cycle short rates tend to climb faster than long rates. As the spread narrows the motivation to borrow short and lend long diminishes, curtailing creation of the new credit which might otherwise support the system. Eventually short rates may rise above long rates (inversion of the
yield curve) providing a powerful incentive for outright contraction of the financial structure. As the contraction progresses long dated asset values, which are now loss making to the leveraged financial player, often prove inadequate to cover stable value short term liabilities. Previously credulous investors turn pessimistic, rightfully enough, leading to expanding risk premiums, diminishing long dated values further still. Eventually savers rush for liquidity, seeking safety in very short dated, high quality securities or even currency.

The credit crunch characteristic of financial declines reaches full force.

Bankruptcies surge among entities which previously appeared sound as the failure to meet a liability on the part of one player leads to the loss of the offsetting asset held by another which, via chain reaction, leads to further failures. The force of leverage working in reverse overwhelms the system leading to a deflationary implosion of the inherently unstable, leveraged financial structure…unless the Fed can head the dive off with another round of money expansion. …

Reduced consumption and business investment along with contraction or collapse of the financial system leads to all the painful consequences we identify with arecession or depression; bankruptcies, high unemployment, diminished incomes,lower profits and lower financial asset values. Naturally such periods are also characterized by a general pessimism. Periods of general societal depression do develop following periods of mania but the conditions which foster such extremes of spirit are a direct consequence of the distortion of the rate of interest and misinformation conveyed by these distorted rates to individuals acting in an economy.

Every major financial crisis since the secular bear market of the 1970s was met with falling interest rates and the rapid expansion of credit. It is unlikely that this can be the response to any crisis happening now for the reason that rates cannot really go any lower and the Keynesian
response of governmental deficits to spur demand also is not an option, since the US deficit cannot go any higher. For this reason, according to Ferguson,
The Fed will soon face two dreadful options, either course likely initiating the secular decline; a persistent tightening which will cause the system to cascade into deflationary decline or an attempt to fuel the next boom while necessarily fomenting price inflation, driving real short rates deeper into negative territory. The deflationary scenario isn't likely due to political realities and institutions which have been put in place since the 1930's to circumvent deflation (e.g. FDIC). We can count on the Fed to use all means at its disposal in its role as lender of last resort when the time comes, as has been promised by members of the Fed. Hence we should anticipate a secular decline characterized by price inflation. Investors who take a defensive position today (investing in T-bills, TIPS, real assets including some precious metals and not currencies) will have moved out of harms way just in time within the secular timeframe whether the worst of the decline begins 6 months or 18
months from now.

Is what we are now facing another great depression or secular bear market, or could it be something worse? The threat of great shocks coming from non-economic spheres (natural or political catastrophes) would support the argument that that is the case. There are even internal economic factors that could support this as well. Marxists would argue that because of the falling rate of profit inherent in capitalism, the only way for the owners to counteract that is through either squeezing more out of the workers through less pay or greater automation, or by adding parasitic financial dealings on top of the system. With automation, the first is harder and harder, since wages account for less and less of the costs of production. Financial trickery, as we have seen above, can only go on for so long.

The financial industry would like us to think that they earn all their money by helping society to efficiently allocate savings to investment. But as Doug Henwood has shown in his 1997 book, Wall Street, this is not the case:

In a soundbite, the U.S. financial system performs dismally at its advertised task, that of efficiently directing society’s savings towards their optimal investment pursuits. The system is stupefyingly expensive, gives terrible signals for the allocation of capital, and has surprisingly little to do with real investment. Most money managers can barely match market averages – and there’s evidence that active trading reduces performance rather than improving it – yet they still haul in big fees, and their brokers, big commissions. Over the long haul, almost all corporate capital expenditures are internally financed, through profits and depreciation allowances. And, instead of promoting investment, the U.S. financial system seems to do quite the opposite; U.S. investment levels rank towards the bottom of the First World (OECD) countries, and are below what even quite orthodox economists – like
Darrel Cohen, Kevin Hassett, and Jim Kennedy of the Federal Reserve term “optimal” levels. Real investment, not buying shares in a mutual fund.

Take, for example, the stock market, which is probably the centerpiece of the whole
enterprise. What does it do? Both civilians and professional apologists would probably answer by saying that it raises capital for investment. In fact, it doesn’t. Between 1981 and 1997, U.S. nonfinancial corporations retired $813 billion more in stock than they issued, thanks to takeovers and buybacks. (Henwood, Doug, Wall Street, Verso Press, 1997, p. 3)

One thing the financial markets do very well, however, is concentrate wealth. Government debt, for example, can be thought of as a means for upward redistribution of income, from ordinary taxpayers to rich bondholders. Instead of taxing rich people, governments borrow from them, and pay them interest for the privilege. Consumer credit also enriches the rich; people suffering stagnant wages who use the VISA card to make ends meet only fatten the wallets of their creditors with each monthly payment. (Henwood, p. 4)

Could that be the plan all along, to concentrate all wealth in the hands of a small group of families? It may be that just as the financial boom and deregulation of the last two decades brought us closer to that point, a financial crash may complete the process.


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