Thursday, September 3, 2009

Inside a Bubble

Say an alcoholic goes to rehab, and after a few days on the wagon, develops serious withdrawal symptoms. These withdrawal effects are so severe the doctor decides to simply give him a beer to temporarily ameliorate his condition. Seeing "improvement", the doctor proceeds to give him more beer, and finally, just gives him the key to the liquor cabinet. The alcoholic immediately begins to show outward signs of “improvement” as he no longer shakes. His spirit improves, and, in the short run, all is well. Now, would you consider this man to be in a state of “recovery” or would you consider him to be only delaying the inevitable, and perhaps, making the inevitable worse when it does come? And, on a related matter, would you consider the doctor to be a "healer" or a quack?

Like beer flowing from an open tap atop the alcoholics keg, central bank generated liquidity is flooding the monetary system, and global banks find themselves awash in cash. China alone has created over 1 trillion dollars which has mostly found its way into stock and real estate markets and is engendering what Kirby Daley aptly called a "medicated high". According to this article:

...while investors expect the market — up more than 80 percent this year — to keep rising, Chinese leaders are alarmed. They worry that too much of the $1 trillion lending binge by state banks that paid for China's nascent revival was diverted into stocks and real estate, raising the danger of a boom and bust cycle and higher inflation less than two years after an earlier stock market bubble burst.

Another recent article notes:

The country's banks have lent nearly 7.4 trillion yuan (1.08 trillion U.S. dollars) in the first half of the year - far higher than the initial full-year target of 5 trillion yuan.

On the back of the unprecedented rise in credit, the Shanghai Composite Index has rallied about 80 percent this year and real estate prices have rebounded to record levels in some major cities.

Some economists say much of the country's massive 586-billion-dollar stimulus package and record lending in the first half may not have been spent on real economic activities and created asset bubbles.

And what does China's central planners intend to do about this?

The Chinese government will not change its stimulus policies because it could derail its hard-won economic recovery, though record bank lending in the first half of the year has raised fears over credit risks and asset bubbles.

"The central bank is still committed to a 'moderately loose monetary policy'," said Su Ning, deputy governor of the People's Bank of China (PBOC), at a press conference in Beijing on Friday.

"When we say 'dynamic fine-tuning', we do not mean the monetary policy but the monetary policy operations. We will sharpen the focus and intensify the pace of the policies," Su said.

Note what the Chinese government considers to be "hard-won economic recovery": not increasing productivity built upon a foundation of hard work and thrift, but the creation of paper money. (Incidentally, if they consider the creation of 1 trillion dollars to be "moderately loose", what would they consider to be "really loose"?)

In Hugh Hendry's recent investor letter, he draws an interesting parallel between today's U.S. - China relationship and the relationship of the U.S. and Great Britain before the Great Depression. Today, in the midst of a massive creation of dollars by the U.S. central bank, China is inflating its money supply in order to keep its own currency from appreciating relative to the dollar which it believes would reduce the competitiveness of its export based economy. The U.S. "benefits" since China lends it surplus of dollars back to the United States in the form of purchases of an ever increasing supply of treasury bonds which tends to keep interest rates relatively low. This symbiotic relationship is analogous to the relationship of Britain and the U.S. in the 1920's with the U.S. then in the same position as China now.

In the wake of World War I, Europe was in ruins and in debt. America had accumulated a vast portion of the world's gold reserves and had become a net creditor and a net exporter (like China today). American interest rates were relatively low and the U.S. Dollar had appreciated dramatically relative to European currencies, especially the British pound sterling. Generally, this should have led to an increase of imports to America but Britain wished to increase the sterling back to pre-war levels and the U.S., taking a page out of the mercantilist handbook, wished to maintain its export industries. In order to accomplish this, the nascent Federal Reserve created massive amounts of dollars to artificially cheapen the dollar (strengthen the pound). This massive "pool of liquidity" found its way into the stock market and when the bubble finally burst (coupled with more destructive statist intervention into the economy), it led to the Great Depression.

The condition discussed above should sound familiar. It is virtually identical to the situation that exists today as China inflates its own currency to maintain its value relative to the dollar. Like the drug addict's fix, this inflation of the money supply props up bad investments, induces malinvestment, and prevents the market from fully recovering upon a sound economic foundation. Perpetuating this illusion requires continual credit expansion to fuel investments made upon the basis of expectations of continually increasing prices. Consider this quote:

"The central government has to fulfill their promise of 8 percent economic growth," said Wu Jun, 62, a retired civil servant who invested part of his life savings of 50,000 yuan ($7,300) and lives on a 2,000 yuan-a-month ($290 a month) pension. "They'll come up with measures to keep the market in good shape."

And what happens when the government stops the liquidity spigot to avoid a Latin American style hyperinflation? Of course, the bust portion of the boom-bust cycle occurs which leads statists to support creating ever more money out of thin air to prop up the malinvestments resulting from the previous boom and so on. Except, there is an end to the "so on." Such cycles can not continue indefinitely without an eventual breakdown of the economic system as has been the case throughout history.

For a direct look inside this bubble, here is a video in which Hendry walks through the streets of a city in China and observes fantastic skyscrapers all recently constructed. The only problem - they have no occupants. Despite this fact, we see cranes everywhere on the horizon, building ever more capacity. "Who is going to pay the debt that this building rests upon", Hendry asks rhetorically?

If you want to know how a drunk can recover by consuming alcohol, I would not ask the alcoholic. Ask the doctor who assuaged the alcoholic with advice he learned from the most famous and the most destructive economist of the 20th century: “in the long run”, this economist said, “you’ll be dead.”

14 comments:

Wallis said...

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.


Margaret

http://grantfoundation.net

Kevin said...

This was the best article I've read in some time. It sums up many of my concerns about our current economic situation, and the US-UK analogy is especially apropos. Keep up the good work.

Doug Reich said...

Margaret,

Thanks for the nice comment! I'm glad you are enjoying the blog and please comment away on whatever.

Kevin,

Thank you too for the kind comment and I'm glad you found it valuable. I have a bunch more to say but wanted to take this topic in stages otherwise it turns into one of my dreaded long posts...

Thanks again

Doug

Harold said...

Great video and post. "Margaret" is spam though.

Doug Reich said...

Harold,

LOL. Shows you how naive I am (or vain since I accepted the comment so eagerly). I will leave it though since it sounds nice.

Doug

Doug Reich said...

Harold,

Also, from now on I will now consider "Margaret" to be my biggest fan and most avid reader. Here's to you Margaret!

Harold said...

Harold,

LOL. Shows you how naive I am (or vain since I accepted the comment so eagerly). I will leave it though since it sounds nice.

Doug


Lol. I guess the question now is, what next? Get out of the dollar? That's what Schiff has been saying. I don't know enough about it to have an informed opinion.

Doug Reich said...

Harold,

Re "I guess the question now is, what next? Get out of the dollar?"

Knowing the economic fundamentals and forecasting how that will play out in the markets is two entirely different, albeit related, questions.

First question is the dollar relative to what? The Fed can inflate massively but if other countries are worse then the dollar may rally relative to those currencies. Also, there are "flight to quality" issues such that investors tend to buy dollars in a panic scenario.

I think Hendry's argument is that when the bubble bursts (again) there will be a tendency towards deflation and therefore should own dollar...If that's his position, I don't necessarily agree and it depends on the timing and all sorts of other factors.

Unless you are a trader, I think the best bet is always to own gold versus the dollar since gold will retain its value over the long run. Since the government's tendency is always to create money, since it is the path of least resistance for them, owning gold is your best protection. Even if gold goes down, it means prices overall are probably dropping so you won't lose much in real terms.

You won't "make" money in gold in the sense of actually gaining in real terms but it is unlikely you will lose either. It is just a way to protect your wealth. Staying in any paper currency is a bit of a gamble in my view.

That's my best advice.

Harold said...

Thanks for responding. It's something for me to think about.

Michael Labeit said...

Price deflation is certainly not a sure thing during recessions, not as long as central banks will expand the supply of credit and governments will keep wages synthetically high.

What's going on with "simply Capitalism?" Wouldn't want it to go the way of past Objectivist websites.

Stephen Bourque said...

Terrific post! Your analogy of the alcoholic is apt, and as usual, your development is clear and well-written.

I'm a little jealous that "Margaret" left such a glowing comment. I thought only my blog was special to her... :)

Doug Reich said...

Stephen,

Thanks so much for comment. Don't even think about trying to take Margaret away from me - she is special...

Doug

Peter Murphy said...

From your post -

"This massive 'pool of liquidity' found its way into the stock market and when the bubble finally burst (coupled with more destructive statist intervention into the economy), it led to the Great Depression."

This is the Austrian/monetarist view and it's completely false.

Excluding initial public offerings (the proceeds of which go to the issuer), for every buyer of a stock who is allegedly 'putting money into the market,' there is a seller of that same stock who's taking money out of the market. The stock market is an exchange, not a bubble which gets inflated then bursts.

The prosperity and resulting stock price growth of the Roaring Twenties was caused by growth in real productivity and profits. US currency remained on the gold coin standard, and although the Fed increased the money supply by 29%, that increase was far less than the increase in demand: the 109% real growth in industrial output. There was neither inflation nor deflation - just the kind of sustainable prosperity that men are able to create in a freer market.

Rational evaluations of the impending, draconian, Smoot-Hawley tariffs caused the crashes in October 1929 - not currency debasement.

See Richard Salsman's articles in The Intellectual Activist 2004-5.

Doug Reich said...

Peter,

"...for every buyer of a stock who is allegedly 'putting money into the market,' there is a seller of that same stock who's taking money out of the market. The stock market is an exchange, not a bubble which gets inflated then bursts."

If that argument were true, then there could never be price inflation or deflation.

Of course for every buyer there is a seller - but the question is at what price? Increases in aggregate demand brought about by the government's inflation of the money supply increased the prices of stocks more than otherwise (absent the inflation). There is overwhelming evidence of this empirically and logically demonstrated as you point out by Austrian economists.

It is also true that there were dramatic gains in productivity which had a positive effect on asset prices.

It is also true that the prospect of Smoot-Hawley (passed in 1930) had a dramatically bad effect on the market.

The fact that the U.S. was on a gold standard probably helped to retard the growth of the money supply but it did not stop the nascent Federal Reserve from creating dollars in an effort to keep the dollar from appreciating against the Pound Sterling (in a mercantilist effort to support America's export industries).

However, just a few years later, FDR would make private gold holding illegal and the dollar was revalued from $20/oz to $34 (if memory serves). This means that the $20/oz (which was a fixed rate) price was not the true market price during that time so I do not think you make the argument that "we were on a gold standard therefore no inflation..."

Inflation is an increase in the quantity of money above the increase in precious metals. Prices can decrease during an inflation in nominal terms if for example productivity gains are large. All that has to happen is prices drop less than otherwise.

We had inflation in the 1920's by definition since the Fed created more money than gold production. This had an inflationary effect although it was masked to some extent by the great productivty gains. But the effect still operates.

To say that this argument is "completely false" is not accurate. Nor would it be fair to say that the crash was only the result of an increase in the money supply. I pointed out in the post that statist intervention was one of the causes in addition to the money creation. I think it was both.