Is it 1999 again? Yes and no
Creeping up to the Precipice, and how dollars in the global financial system are like cigarettes in a prison
by Eric Janszen - December 7, 2006
As the latest cycle of the Bubble Cycle—the one that produced the housing, private equity and USIP (Unregulated Speculative Investment Pool vs "hedge fund") bubbles—comes to an end, another moment of truth approaches for the U.S. Federal Reserve and the Treasury, as well as for central banks and treasuries worldwide. The long debate over inflation and deflation among those whom our Jane Burns calls "the worried well"—those who probably are already hedged and are now looking for confirmation of the wisdom of their caution—may also be decided. I predict that within a year, two at the most, the jury will be in and the matter decided in the course of events.
As iTulip readers going back to 1998 know, I've long predicted inflation—experienced as a rise in the general level of prices of non-traded goods and financial assets—at the end of each bubble cycle as well as at the conclusion of the series of bubble cycles. The cycle is six stages:
Phase 1: The monetary inflation that follows Phase 6 feeds into higher non-traded goods and a new round of asset inflation. In the field of opinion, over the years this position has been largely unoccupied; I haven't had much company.
Monetary inflation–Rapid money supply growth due to reflation (reflation: central bank lowers interest rates and the federal government cuts taxes and increases deficit spending).
Asset inflation–Asset prices rise ahead of the all-goods price growth, such as measured as Consumer Price Index (CPI) inflation.
Asset bubble growth–Period of extreme price increases divorced from market fundamentals, such as NASDAQ 1996 to 2000 and housing 2002 to 2005.
Random exogenous event–An event that triggers a bubble to collapse, such as tax loss selling in April 2000.
Asset bubble collapse–Period of asset price decline, such as NASDAQ 2000 - 2001 and housing 2005 to 2015.
Monetary disinflation–Money supply contraction, as occurred in 2001.
CPI Inflation: Traded versus Non-Traded Goods 1978 - 2006
(Message to U.S. Democratic Congress: Sure you want a weaker yuan and controls on Chinese imports?)
Fall 2001: It’s three years since I started iTulip to urge people to sell their investments in the “New Economy” stock bubble. The events of spring 2001 have borne out the prediction. I'm buried deep in a thick, velvet stuffed chair in an alcove in my friend's house on Martha's Vineyard. The house is on a 100-foot cliff overlooking the Atlantic. On a clear day, you can look out and imagine seeing Cardigan Bay in Wales. I hand my friend a gold coin, which I’ve brought for demonstration purposes—with the end of the stock bubble, I’m now foreseeing that the government will step in to reflate the economy with interest rate cuts, tax cuts and deficit spending, leading to non-traded goods and asset inflation. So I’ve done my research and placed my bet that gold was to rise first in dollars and then in all currencies. My friend takes the coin in hand, hefts it and chuckles. "Goldfiiiiiiinger!" he sings.
Asset Bubbles: Technology Stocks 1996 – 2000
August 2002: Ross Kerber of the Boston Globe writes a story on my 1998 prediction of the end of the technology stock bubble. He gives me kudos for that call, but suggests I might now be wrong: "However, he also predicts inflation and there is little sign of that," Kerber concludes the article. I’ve also weighed in early in the fact of a housing bubble, in August 2002.
April 2003: I'm in my office at Bluesocket. I have just raised $10 million, the third of three rounds of financing for the company, $28 million in total. The funding is announced in the press. It's a big deal because, in the depths of the IT depression, hardly anyone is raising money. Bluesocket is one of few companies growing rapidly in its market—wireless LANS for enterprise—which I’m convinced has great promise. As CEO, I am fortunate to have a fantastic management team, and some 50 very smart, hard working employees (access to talent and low operating costs are your key weapons to fend off failure in such times). As usual, after a round is closed and announced by Patrick Rafter (the public relations guru, not the tennis player), I am inundated with calls from investment bank money managers. They are hoping to manage the money they are sure I'm going to make when the company is eventually sold or goes public.
On this day I'm taking a meeting with a bright and attractive woman from one of the major banks, maybe Morgan Stanley, Goldman Sachs or Lehman Brothers, I can't recall which. She's telling me about a "costless collar" (a way of hedging illiquid private company stock) for my Bluesocket stock and asset allocation. Also she is recommending getting out of U.S. stocks (unwisely as it turns out). I ask her what U.S. stock allocation she was recommending to her clients in 1999. She shifts in her chair and answers, "Eighty percent." "I was selling U.S. stocks in 1999 and early 2000,” I reply. “If I'd listened to you then, I'd have lost a lot of money.” She asks what I'm buying now. "Gold and silver, mining company stocks and physical," I say. She looks at her watch, and the meeting is over in five minutes. I learn that mentioning precious metals (PMs) is a sure-fire way to end such a meeting in 2003. The PMs market—still only whackos invited.
In April 2003, gold was trading at $320, only 20 percent above its 20 year low of $250 in 2001. It had been as high as $380 at the beginning of the year, following the usual seesaw path of an asset in a rising or falling market. At the time, every dip was interpreted by most as proof that gold was headed back toward $200. Today, some 44 months later, gold is trading at $620 but has been as high as $720. If it corrects to, say, $500, over the next year or so as the current asset bubbles come to an end and before the next global central bank reflation program begins, I expect to hear the usual pronouncements that gold is headed back to $200. Or maybe not; possibly enough market participants have gotten wise to the post-bubble global central banking bubble cycle and the correction in gold may be minor.
Asset Bubbles: Private Equity and USIPs 2002 - ?
The idea that the U.S. Federal Reserve Bank and later global central banks were destined to reflate the economy by printing press was so deeply lodged in my skull since 1999, before the event, that I never considered the possibility that the Fed might not print away and that the world's central banks would sit by idle and watch the dollar collapse in a heap. In 1999, the deflation versus inflation was the hot topic among Internet economics and finance obsessives—the worried well—as it is today.
As I considered matters then, deflation did not compute. Clearly the Fed has the ability to create money. And the rest of the world needed to support the U.S. economy and the dollar as a matter of central bank policy—a collapse of the U.S. economy and its currency could only mean certain pain for their economies in turn. The question was not a matter of what the central banks wanted to do. It was this: What limits are there to what they can do to accomplish reflation?
In 1999, that was not a difficult question to answer. My take was that the central banks were going to take all necessary steps within the framework of the international monetary system to prevent a major liquidation of financial assets.
This is also true today, but we are in a different place than in 1999. Oil is three times more expensive. We are engaged in a war that has cost $346 billion to date (versus $640 billion total on Vietnam) and we’re still in Afghanistan and Iraq. The United States and several other nations including the United Kingdom, Australia and Spain have gone through housing bubbles that started collapsing in mid-2005. Housing bubbles deflate slowly, making the data on the resulting effects on the economy more difficult for the Fed to read and react to versus after a rapidly collapsing stock market. The negative wealth impact on the economy is more gradual but more profound, because three times as much household net worth is invested in homes than in stocks. Economic and financial system fallout from the collapse of the private equity and USIP bubbles is more difficult to gauge. The impact could be sudden or gradual. This is a very complex stew.
That the world's central banks will eventually fail to maintain the system is as good as fact, for reasons that are not hard to understand. The transition costs to a new international monetary system are too high for the world's central banks to allow them to enter into a process of major change willfully. The change will come by crisis. But financial crises of a international monetary nature, due to geopolitical influences, are famously unpredictable; how and when an international monetary system will fail is unknowable.
Thankfully, an accurate prediction down to the year or quarter is not necessary. In 1999 as now, PMs seem to me as close to a can't-lose long term bet as any I know. If the world's central banks are willing and able to act as I expect, PMs are due to rise again in price relative to all major currencies. If they fail, PMs are due to rise in dollars. Thus the most prudent approach now as then is to diversity into both PMs and euro- and yen- based stocks and bonds.
On the question of inflation versus deflation in the event of the end of the cycle of asset bubbles, as I argue in "No Deflation! First Disinflation, then Lots of Inflation," the Fed cannot possibly be more clear as to its intentions. The Fed will print money and use it to buy mortgage debt if necessary to prevent a collapse in the debt markets that support housing; not to support housing prices directly but to prevent the collapse of the U.S. banking system and economy. The question is, if the Fed does this, what will other central banks around the world do at the same time? What is likely to happen to the price of PMs and other currencies? I believe the question is answered by Gresham's Law as explained by John Kenneth Galbraith in chapter two of his 1975 book “galbraithmoney”:
"In the ancient and medieval world the coins of different jurisdictions converted at the major trading cities. If there were any disposition to accept coin on faith, it was inevitably the bad coins that were proffered, the good ones that were retained. Out of this precaution came, in 1558, the enduring observation of Sir Thomas Gresham, previously made by Oresme and Copernicus and reflected in the hoarding of the good Roman coin, that bad money always drives out good. It is perhaps the only economic law that has never been challenged, and for the reason that there has never been a serious exception. Human nature may be an infinitely variant thing. But it has constants. One is that, given a choice, people keep what is best for themselves, i.e., for those whom they love the most."On the question of inflation and deflation, Gresham’s Law tells us that it is important to understand that the value of an asset is not determined only by the quantity of money that is available to purchase it, but also by the value of the money used to purchase the asset relative to other kinds of money available at the time.
There is no magic to this. Anything can be money. In a prison or a city that is cut off from outside supplies, such as during war, cigarettes are money, functioning admirably as a store of value and means of exchange. All that is needed to monetize nearly anything is a limit of supply versus demand for that item relative to other forms of money. In the extreme case of hyperinflation, government money is in vast oversupply and thus shunned by everyone–and that goes for gold and silver, too, to a more limited extent. For example, when the Spanish government imported vast amounts by ship from mining operations in the New World in the 1600s, it created inflation in Spain and other parts of Europe.
In the case of fiat money, the monetization of common items can become sadly absurd. As there are always limits in the rate of mining versus printing, especially money created and stored as bits on hard drives, fiat money is always at greater risk of extremes of over-supply and under-value. At the height of the German hyperinflation in the 1930s, long after all of the gold coin and other rare items had been hoarded, and all of the brass doorknobs had been stolen from buildings and the copper pipes in them kept under armed guard, items that you might find at a yard sale, such molded glass figures, were used as a store of value and means of exchange, much like cigarettes in a prison. Note that neither gold nor fiat have much use as money in a prison or a city under siege.
A government can always print money to buy assets that the markets do not want. If in the future the Fed prints money to buy mortgage debt, it is doing so because that debt, as an asset on the balance sheets of lenders, has a negative net present value in the market. The money printed by the Fed to pay for it will also have less value in the market than money used to purchase items that the market values: "...people keep what is best for themselves, i.e., for those whom they love the most." The dollars thus printed to buy debt that the markets do not want will increase the quantity of dollars already in circulation, lowering the value of the currency on global markets, as happened between 2001 when I was sitting in my friend's home on Martha's Vineyard and the time of my visit with the investment bank money manager in 2003.
Global central banks are motivated to print their own currencies to purchase dollars and dollar-denominated assets. If they do not, the United States will experience a major increase in both inflation and interest rates, certainly sending the U.S. economy and possibly the world into economic depression. The world's central banks can be expected to print their own currency to purchase dollars, thus increasing the quantity of all money globally and causing PMs to rise in all currencies, as occurred between the time of the investment banker’s visit and now.
As we approach the moment of truth in 2007, the world of money is not unlike 1999. We stand at the precipice of a monetary deflation followed be a decline in the price of financial assets. The Fed will then print money to prevent the U.S. economy from falling into a depression and keep the U.S. banking system from seizing up. Global central banks will be compelled to follow suit both to support their own economies and keep the U.S. dollar and economy from falling into depression. It may collapse anyway in this cycle as described in Ka-Poom Theory. Currency markets further re-monetize gold and de-monetize dollars as gold develops more of the characteristics of cigarettes in a prison, which is what the out-of-date U.S. dollar centric, floating exchange rate international monetary system has become for global financial markets.
Ka-Poom Theory: The Last Bubble in the Bubble Cycle
If the bubble cycle does not end with the demise of the current set of asset bubbles, a new bubble cycle begins, typically centered on an financial asset that experienced growth in the previous bubble cycle but not bubble excesses. Securities related to energy are a likely candidate, as are PMs and to a certain extent euroes. In any case, even though PMs may correct short term during a disinflationary phase of the bubble cycle–perhaps especially when the private equity and USIP bubbles correct–they continue to look like a "heads I win, tails I win" bet long term. We have the observation of Sir Thomas Gresham from the 16th century to thank for explaining why this is so.
For macro-economic and geopolitical currency ETF advisory services see "Crooks on Currencies"
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