“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.” –Warren Buffett
“There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.” — Ludwig von Mises
You might wonder what on earth these two quotes have to do with each other. Well, I will attempt to link them. Together I believe they describe how in some games, like world financial markets and politics, very few really have a good grip on what is going on. What are the incentives of the key players? Are they playing by the rules? Or are they bluffing? If you’re not sure, then, well, you’re …..
Let’s start with the game first. Alan Greenspan, in some sense, really is a Maestro, but the true monument of his success is shown in the chart below. Since Alan Greenspan took the helm in 1987 paper assets owned by central banks have exploded upwards by more than a factor of 5.
Paper money is the oil that greases a credit expansion in all its forms, from government deficits to uncontrolled debt expansion, to derivatives. Central bankers can only control the quantity of the money they create…or the quality. They cannot control both at the same time. Since they always tend to err on the side of quantity (who doesn’t like more of the green stuff?), quality suffers. Soon, there is more and more money around….until eventually, even investors notice and they begin to worry about it. They then want to exchange their money for things of unblemished quality – like gold. Gold doesn’t lose value for a good reason: its quantity is limited by nature. Rarely does the world’s supply of new gold exceed 2% or 3% per year…nicely – almost divinely – in line with GDP growth.
Alan Greenspan once knew this very well; he wrote essays about it in his early days…noting that gold backing for currency was necessary to
keep central bankers honest. Otherwise, they won’t be able to help themselves, he predicted; they will press down so hard on the money quantity pedal that money quality will go haywire.
No one pressed down harder than Alan Greenspan. He jumped on it with both feet. More money and credit was created during his time at the Fed than under all the U.S. Treasury secretaries and Fed chiefs put together. The value of the dollar – in terms of what it will buy – was reduced by half during Greenspan’s 18-and-a-half-year service. Over the past decade, consumer debts are up 121%, to $10.7 trillion, while real consumer income was either stagnant or falling. The newly created money fuels all asset prices so much that despite poor income levels and higher debt levels, most people think they are suddenly more wealthy. What they did to make themselves more wealthy they are not sure about, but somehow they come to believe that they can recklessly continue to increase debt and stop saving altogether. Swimming in endless supplies of money with rising asset prices makes most people giddy.
While everyone is having so much fun why should we worry? Well, the problem is that there is a Newtonian law of nature that for every action there is a reaction. The only comparable periods like this are the 1920s and 1930s in the US and the 1980s and 1990s in Japan. As the Bank of Japan put it, “The magnitude of damage caused by the bursting of the bubble is disproportionately larger than the gains obtained in the emergence of the bubble”.
From this perspective, the best thing to do is to avoid the bubble in the first place. How do we do this? Well, no less than the IMF did a study published in its “World Economic Outlook” in April 1993. This clearly pinpointed what creates a bubble – “a credit expansion in excess of the expansion of the real economy”. They went on to say “To the extent that asset price changes are related to excess liquidity or credit, monetary policy should view them as inflation and respond appropriately. There is nothing unique about asset prices that would suggest that asset prices can permanently absorb overly expansionary policies, without leading to costly real and financial adjustment.”
We have recapitulated Japan’s and America’s past disastrous bubble experiences in order to make three things poignantly clear: First, all asset bubbles are the product of credit inflation; second, the two worst bubble experiences in history have developed against the backdrop of virtual price stability; and third, both central banks made their obvious crucial mistake in focusing on low inflation rates and ignoring ongoing credit and asset inflation.
To this, we want finally to add a fourth point: America’s credit inflation since 2000 is the worst in history, as measured by credit growth relative to GDP growth. In essence, the Greenspan Fed replaced the prior bad equity bubble with a much bigger and much worse housing bubble.
The specific effects of credit inflation on the economy and the price system depend on the places where the credit deluge enters the economy. In Japan’s case, it grossly over expanded construction and business fixed investment. In the U.S. case of the 1920s, it over-expanded consumer spending. Today, the unsustainable excesses are concentrated in consumption and housing.
There is a widespread perception that the U.S. economy under the Greenspan Fed has gained unprecedented steadiness. In actual fact, U.S. economic activity has become dependent as never before on rising house prices facilitating unbridled consumer borrowing. This may temporarily create a semblance of economic stability and strength. The reality is an extremely vulnerable economy and financial system.
Now the responsibility for all monetary matters falls to the new Fed Chair Ben Bernanke and the problem here is that all his work on this issue has lead him to conclusions that could be dangerously wrong. Ben Bernanke is like a new weather forecaster who stands up and tells us that from now on there will be no more hurricanes.
Clearly, from his writings, he disagrees with the Bank of Japan and the IMF when he concludes that the US 1930s depression and the Japanese 1990s deflation were caused by an inadequate monetary response to
the fallout from the bubbles rather than the excessive credit that created the bubbles in the first place. In short not only was excessive credit, not the initial problem, it is, in fact, the solution. Ben Bernanke seems to take no issue with excessive credit growth at any time. Could he be Greenspan on steroids?
We have described the major money supply issues that will be played out over the next few years or decades. What investors have to do is to make sure they understand the game they are in. In such a distorted financial world, incentives and judgments can easily lead us in dangerous directions. Generating a good income and saving for the future is the key to long-term prosperity. However, in an environment of consistent excess credit expansion, it seems that saving is a waste of time and the optimal strategy is to leverage oneself as much as possible to rising asset prices. For a time it is, but in the end, it is not.
For now, the key to policy is to maintain high asset prices for as long as possible to keep the dream alive. However, asset prices are no longer as cheap as they used to be, and debt expansion produces a weaker kick to the economy than it once did. No doubt it can always be extended further and possibly for several more years, but unless your strategy is to die young you can no longer afford to believe in the never-ending dream. None of us will be served well to forget the basic principles of wealth creation and asset management. We all need a durable long-term income and savings plan and prudent and flexible asset management.
I realize this discussion has been somewhat unconventional and controversial in relation to financial fashions today, but very few people study history a great deal. We are simply reaching our conclusions from what has happened in the past. This may not be what you are usually told and it may not be what you want to believe. Perhaps this is why most people in the end lose money in the game. Make sure you’re not the Patsy.