 INSTITUTIONAL
ADVISORS
Great Depressions Are So
Methodical
Bob Hoye
Institutional Advisors
May 16, 2009
My recent presentation to
the CMRE
Clearly, the title of this
address puts me firmly in the bear camp. Just as clearly, the
possibility of another great depression is highly controversial,
particularly when such magnificent efforts are being made to
restore the prosperity of a financial mania, which have always
been ephemeral.
Perhaps my credentials should
be reviewed. Everything I needed to know about the markets I
learned on the old and notorious Vancouver Stock Exchange. For
example, in a world of extravagant claims from big government,
big academe and big Wall Street the old definition of a promotion
is useful: "In the beginning the promoter has the vision
and the public has the money. At the end of the promotion the
public has the vision and the promoter has the money."
In 2006 to 2007 the public
had the vision that policymakers could depreciate the dollar
forever and were positioned accordingly. And for a moment the
promoters looked brilliant as everyone thought they were wealthy.
Moreover, as with any promotion the bigger it is--the bigger
the crash.
There are two failures going
on. The most obvious is in the financial markets and the other
is in interventionist economics. The latter failure is in theory
as well as in practice, and can be described as the greatest
intellectual failure since the Vatican insisted that the solar
system revolved around the earth, more particularly, Rome. Until
recently, too many believed that the financial world revolved
around the Federal Open Market Committee.
Last year's disaster fit the
pattern of the 1929 fall crash with remarkable fidelity. Such
a crash was obvious and as the train wreck in the credit markets
continued through the summer of 2008 the Fed continued its recklessness.
But with some marketing skills, the objective of "stimulus"
changed from keeping the boom going to the absurd notion that
bailing out one insolvency, Bear Stearns, would revive the boom.
As usual with a bubble, it was not just one bank that had been
imprudent--most had been.
The establishment missing this
recurring event was bad enough but there is another clanger and
that is the hopeless notion of a national economy. Even in ancient
times, Cicero knew that the prosperity of Rome was vulnerable
to the credit conditions in the Middle East. In this regard,
Mother Nature has again been providing some harsh lessons, and
history suggests she and Mister Margin will ultimately be successful
in teaching markets 101 to many policymakers.
In the meantime, coming out
of the classic fall crash orthodox investments such as commodities,
stocks and bonds were expected to rebound out until April-May.
Until this hooked up, the typical GDP forecast was tentative
in looking for the recovery to begin "by mid-2010",
but our "model" needed forecasts of the recovery starting
much sooner. Then, thanks to the "Green Shoots" that
began to appear with the rebound in March, confidence was gradually
restored in high places such that the miracle of recovery would
happen sooner. The higher the stock market gets the more popular
this idea becomes.
And this gets us to another
lesson from the old Vancouver Stock Exchange. "So long as
the price is going up--the public can believe the most absurd
story." This has been the best explanation of why Wall Street,
the supposed bastion of capitalism, focused on every utterance
from central planners in a central bank. Then when the price
breaks, the vision disappears along with liquidity.
The next phase of the contraction
has been expected to start after mid-year.
For participants, post-bubble
bear markets have been sudden and severe. The 1929 example ran
for three years and the post 1873 example lasted for five years.
The latter has been the best guide for our recent mania and its
bust, but this will be expanded in a few minutes as it is worth
reviewing the excuses offered by many in not anticipating that
short-dated interest rates as well as gold would plunge in a
classic fall crash. This was the pattern with the 1929 and 1873
crashes and knowledge of such a plunge in short rates should
have ended conventional wisdom that a Fed rate cut would have
prevented crashes from 1929 to 2008.
The quickest sign of a gold
bug forecast going wrong is "Conspiracy!". With their
latest disappointment Wall Street strategists described it as
a "Black Swan" event, and therefore unpredictable.
That has been a cheap out as each transition from boom to bust
has been methodical. Others called it a "Minsky Moment".
Minsky accurately described the mechanism of a crash, but being
a Keynesian he also wrote that "apt intervention" could
keep the economy on a successful path.
Actually, financial conditions
reached the perfect "Keynesian Moment". As we all know,
Keynes said "If you save five shillings you put a man out
of work for a day." As part of the greatest mania in history
the savings rate plunged to zero--Keynesian perfection had finally
been accomplished. Many in the street, but only a few economists,
knew this was dangerous. Econometric modelers, who still believe
in the powers of regression equations, have long had their out,
which has been "Exogeneinous", and in one memorable
paper of 1983 there was "Super-Exogeneity". This arrived
in May 2007 when the yield curve reversed from inverted to steepening.
Our research expected it to occur around June. By July of that
fateful year, there was enough deterioration to conclude that
"This is the biggest train wreck in financial history".
It is not over.
Although crashes are grisly
events, they share a common response from the establishment.
No matter how shocking, bloody, expensive, ruinous or just plain
shattering a crash is--within a week, there is no one in the
street who didn't see it coming. As ironical as this is, there
is a critical link from the stock market to the economy.
On the usual business cycle,
the peak in stock speculation typically leads the peak in the
economy by about a year. On the previous example, stocks set
their high in March 2000, and the NBER set the start of that
recession in March 2001. Using their determination this has been
the case for most cycles back to 1854. But, at the conclusion
of each great bubble in financial and tangible assets things
become abnormal. The failure in the financial markets and the
economy beginning in 2007 have been virtually simultaneous.
As we all know, in 1929 the
Dow made its high in September and the recession started in August.
In 1873 the bear started in September, and the recession in October.
This time around, the stock market high was in October 2007 and
this recession started in December of 2007. Close enough to fit
the post-bubble model, with implications that financial history
is now in the early stages of another Great Depression.
This melancholy event is being
confirmed by the behaviour of politicians and policymakers. After
swanning around claiming credit for the boom politicians panic
and then find scapegoats. Remember the "Goldilocks"
celebration of perfect management of interest rates, money supply
and the economy. Well, all five great bubbles from the first
in 1720 to the infamous 1929 have been accompanied by such boasting,
followed by what can best be described as frenzies of recriminatory
regulation. If the political path continues--protectionism--
will follow.
One of the worst such examples
was called, in real time, the Tariff of Abominations. But, this
is enough of dismal events and it is time to turn to irony for
amusement and enlightenment. The clash between the establishment
and financial history is rich with irony. Beyond that, financial
history, itself, should be considered as an impartial "due
diligence" on every grand scheme promoted during a financial
mania by the private sector as well as by policymakers. Let's
use a good old fashioned term-- policymakers have been financial
adventurers.
One of the richest ironies
occurred with the 1873 mania and its collapse. With typical strains
developing in the credit markets during a speculative summer,
the leading New York newspaper editorialized:
"but while the Secretary
of the Treasury plays the role of banker for the entire United
States it is difficult to conceive of any condition of circumstances
which he cannot control. Power has been centralized in him to
an extent not enjoyed by the Governor of the Bank of England.
He can issue the paper representatives of gold, and count it
as much as the yellow metal itself. [He has] a greater influence
than is possessed by all the banking institutions of New York."
In so many words, because the
treasury secretary was outstanding and had the benefit of unlimited
issue of a fiat currency - nothing could go wrong. Which it did;
the initial bear market lasted for five years and the initial
recession ran a year longer. The pattern of severe recessions
and poor recoveries continued such that in 1884 leading economists
began to call it "The Great Depression," that endured
from the 1873 bubble until 1895.
An index of farm land value
in England fell almost every year from 1873 to 1895. Of course,
academic economists were fascinated and for a couple of decades
wondered how such a dislocation could have happened, or even
worse, discussed how it could have been prevented. Ironically,
this debate continued until as late as 1939 when another Great
Depression was belatedly discovered.
Naturally the long depression
was blamed upon the old and unstable Treasury System, and at
the height of the "Roaring Twenties" John Moody summed
it up with:
"The Federal Reserve
Law has demonstrated its thorough practicality, and thus secured
the general confidence of business interests. The old breeder
of financial panics, the National Banking Law, which had been
a menace to American progress for two decades, has now been replaced
by a modern scientific system which embodies an elastic currency
and an orderly control of the money markets."
"The Federal Reserve
Law has demonstrated its thorough practicality, and thus secured
the general confidence of the business interests. The [old] breader
of financial panics, the National Banking Law, which had been
a menace to American progress for two decades, has now been replaced
by a MODERN SCIENTIFIC SYSTEM WHICH EMBODIES AN ELASTIC CURRENCY
AND AN ORDERLY CONTROL OF THE MONEY MARKETS."
The probability of a depression
has been discussed in the media. It seems that both sides have
yet to provide adequate research, with the establishment's response
limited to a classic non sequitur. "This is nothing like
the Great Depression, where we had 25% unemployment". That
was just the most recent example and sound research would compare
unemployment numbers from the first year after the crash. In
1930 the number was around 8%, and in noting that there could
be some difference in methodology today's number is an 8 percenter.
Will it get to 25 percent?
This remains to be seen, but unemployment in the private sector
will be the worst since the last great depression.
By way of a wrap we will take
it from the top. In late 2007, Gregory Mankiw, boasted that the
US had a "dream team" of economists as advisors, and
as with all claims at the top of six previous bubbles "Nothing
could go wrong". And even if things went only a little wrong
there were the "safety nets" that Krugman claimed would
prevent serious deterioration. Our view on Keynesian safety nets
has always been that in a bust they would be about as useless
as a hardhat in a crowbar storm.
In the post-1929 bust policymakers
were realistic enough to know that the boom caused the bust.
The SEC was established to prevent another hazardous 1929 mania.
Also, one of the promoters of the SEC boasted that the SEC would
put a "Cop at the corner of Wall and Broad Streets".
Without much doubt the SEC has failed to live up to its billing.
The discovery of malfeasance always accompanies the discovery
of malinvestment.
Of course, the other Act passed
to prevent another 1929 mania was Glass-Steagal, which separated
commercial banking from the evils of Wall Street. This was taken
off the books in 1999 as too many banks were participating in
the high-tech frenzy.
Has this happened before? I'm
glad I asked the question. With the financial violence of the
South Sea Company in 1720, the House of Commons passed the "Anti-Bubble"
Act, which was taken off the books in 1771--just in time for
the full expression of the 1772 bubble. As with the climax of
the 1720 bubble the Great Depression ran for some twenty years.
This was also the case for the bubbles that blew out in 1825,
1873, and 1929.
This ominous sequence of financial
excess and consequent disaster brings us to 2007, which will
soon have the connotation of "1929", as the world experiences
the sixth Great Depression. Quite likely, the only offsetting
event could be the collapse of interventionist policymaking,
that would eventually be seen as a blessing.
The title of this address,
"Great Depressions Are So Methodical" is intended to
be ironical, but some may be startled by the audacity of the
statement. Actually it is the conclusion that anyone would make
after a thorough review of market history. The real audacity
is in the claims of charismatic economists that their personal
revelations can provide one continuous throb of happy motoring.
As Hayek said--Keynes, as a young scholar, was absolutely ignorant
of financial or economic history. Only someone who was ineffably
ignorant of financial history would claim that it can arbitrarily
be altered.
The next Oscar in audacity
goes to Paul Samuelson, who, in the 1960s, boasted that the business
recession had been eliminated. Right!
Another such example was recently
provided by Gregory Mankiw when he condemned the "old"
Fed with "When you look at the mistakes of the 1920s and
1930s, they were clearly amateurish." Any impartial review
of market history would conclude that the "Roaring Twenties"
and the contraction was the way financial history works, after
all it was the fifth such example. It is worth recalling that
at the height of the 1929 mania John Moody had condemned the
old Treasury System while reciting that the new Fed was the perfect
instrument of policy.
Mankiw then bragged "It
is hard to imagine that happening again--we understand the business
cycle better".
The Harvard professor topped
this late in 2007 with: "The truth is that Fed governors,
together with their crack staff of Ph.D economists, are as close
to an economic dream team as we are ever likely to see."
Now it is time to get into
the way Great Depressions have worked. All six have started with
soaring prices for tangible and financial assets that, typically,
run against an inverted yield curve for some 12 to 16 months.
Then when the curve reverses
to steepening it is the most critical indicator that the credit
contraction is starting. This time around, the sixteen-month
count ran to June 2007 and the curve reversed by the end of May.
Our presentations in that fateful month stated that the greatest
train wreck in the history of credit had begun. Deterioration
through July prompted the advice that most bank stocks were a
nice "widows and orphans" short.
Beyond the raw power of speculation,
one of the key features is each mania has been accompanied by
a remarkable decline in real long interest rates, sometimes to
zero, and sometimes to minus. In our case the decline was to
around minus 1.5% in January and the increase so far has been
5 percentage points. In five previous examples, the typical increase
has been twelve percentage points, which has been Mother Nature's
way of correcting untempered expansion of credit. And - in our
times, untempered policymaking.
Lower-grade corporate bonds,
have already suffered an increase of some 25 percentage points,
which suggests that the 12 point potential for treasuries is
possible.
There is another important
distinction. At the peak of a great bubble, the stock market
peaks virtually with the business cycle. In 1873, the stock market
blew out in September and the recession started in that October.
As noted above, a fiat currency with the potential of unlimited
issue was not proof against yet another Great Depression. In
1929 stocks peaked in September and the economy peaked in August.
This time around stocks set their high in October, 2007 and according
to the NBER, the recession started in that December.
Since 1937 the average length
of recession has been ten months, with six in the order of 8
months. This one has run for 17 months, which breaks a long-standing
pattern. Following 1873, the initial recession lasted 65 months,
and following 1929, it ran for 43 months. NBER data starts in
1854 and these were the longest recessions, with no others in
this league. This one has the potential of being a long one.
This is a lot of history, but
what is happening in the markets right now? Well, then the Green
Shoots have finally encompassed chairman Bernanke. On May 5,
Bernanke observed that the "broad rally in equity prices"
is indicating that "economic activity will pick up later
in the year."
At the height of a similar
rebound to April-May of 1930, Barron's wrote that the "will
to speculate was just as speculative as ever" and that it
would be "difficult to quench the fires of enthusiasm".
Prompted by an animated stock rally, the Harvard Economic Society,
but with more gravitas, concluded that it "augured"
a recovery by late in the year. As we all know this did not last
and what we should understand is that it is the dynamics of a
crash that sets up the exciting rebound. Not policymakers.
Let's look at a classic fall
crash, which we expected. The pattern is interesting. The 1929
crash amounted to 48%. The decline to the low in November 2008
was 47%, and within this the hit to October 27 amounted to 42%.
In 1929 the initial plunge amounted to 40% to October 29.
The rebound was to November
4, in both examples, with 2008 gaining 17% and 1929 gaining 12%.
The final slump into each November was 22% and 23%. Is it important
to identify it as 1929 or 2008?
Our "historical"
model expected the crash and the rebound, as well as the nature
of the establishment's utterances. Another usual event is a frenzy
of recriminatory regulation-- all supposedly new, but delivered
without knowing that their counterparts over the centuries have
made the same futile gestures.
Ironically, today's excitement
in the markets and convictions in policymaking circles are important
steps on the path to a great depression. As disconcerting as
this may be, it is worth reviewing another cliché of policymaking,
which is the notion that lowering administered rates will restore
the momentum of a boom. Massive declines in short rates, such
as Treasury Bills have only occurred in a post-bubble crash.
In 1873 the senior bank rate plunged from 9% to 2.5%, as the
stock market crashed. In the 1929 example the fed discount rate
plunged from 6% to 1.5%, as the stock market crashed.
This is getting a little heavy.
Not so long ago, but in another world, financially speaking,
when an economist would change a forecast on GDP from 3 % to
3.25% it was only done to display a sense of humor. Now policy
wonks seriously debate whether the Fed target rate should be
zero or a quarter of one percent. It is patently absurd to debate
what the rate should be or whether it would have any effect on
financial history.
It won't, because we are in
a world of financial violence that is not random, and not due
to the Fed not making the perfect rate cut. Instead it is a natural
accumulation of private speculation, as well as a chronic experiment
in policy by financial adventurers--to accurately use a Victorian
term.
Another term goes back to the
1600s when what is now called Holland was the commercial and
financial center of the world. The Dutch described the good times
as associated with "easy" credit and the consequence
as "diseased" credit. I'm sure that all in this room
would agree with the accuracy of the latter description. Diseased
credit.
What can be done about it?
Nothing--since the 1500s the literature is complete with many
comments that someone, or some agency can set interest rates--either
high or low depending upon the personal concerns of the writer.
Misselden in the 1618 to 1622
crash earnestly believed that throwing credit at a credit contraction
would make it go away. Despite all this history, Keynes and his
disciples cannot be accused of plagiarism.
What's next?
Virtually, all of the "good
stuff" likely to be revived into May has been accomplished.
This includes investments such as commodities, junk-bonds and
stocks, as well as positive statements from the establishment.
Both technical and sentiment measures on the stock market are
at "tilt" levels.
Because it is up at the right
time, the conclusion is that the down will come in on time as
well. This would be the next step on the path towards another
Great Depression.
Of course, there is no guarantee
that events will continue on the path. But, then there is no
guarantee that it won't. Best to consider the odds.
###
May 14, 2009
-Bob Hoye
Institutional Advisors
email: bobhoye@institutionaladvisors.com
website: www.institutionaladvisors.com
Hoye Archives
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