Everybody knows you never go full retard.
– Kirk Lazarus, Tropic Thunder
Dear Diary,
It looked as though US stocks were about to correct last week. But the market steadied on Friday. Calm, complacency, confidence – almost every measure (save for valuations) tells us we have nothing to worry about.
Still, since we have nothing to worry about, we will worry about nothing. Or as Churchill might say, if we have nothing more to fear than fear itself… surely, we’re missing something.
But let us move on by turning our heads around and looking at the road that led us here. We have been greatly aided by reading David Stockman’s book The Great Deformation as well as his blog, Contra Corner.
Stockman had a big advantage. He was at the heart of the federal government, as Ronald Reagan’s first budget director, serving from 1981 until 1985. Then he was in the belly of the beast on Wall Street, as one of the original partners at private-equity firm The Blackstone Group.
In government and in finance Stockman was on the inside when the major decisions and developments of the past 40 years occurred.
The Road to Perdition
By the time Ronald Reagan was first elected president, the US was already headed down the road to perdition.
Over the preceding thousands of years, humans had learned three important lessons: (1) that they could not rely on authorities to manage a paper currency; it had to be backed by gold; (2) that governments must not run large and repeated deficits; and (3) that markets must be allowed to freely discover prices rather than have them imposed by authorities.
After so many episodes… over such a long time… causing so much misery… only a mental defective would now ignore these lessons.
Yet, that is exactly what the feds have done.
In the early 1980s, the most recent major test of these verities was still very much in front of us. The Soviet Union still existed. And it was busy proving that central planning doesn’t work.
It was collapsing under the weight of administered prices that had distorted its economy to the extent that it had become a value subtracting enterprise. For each rouble of investment in raw materials, energy or labor less than one rouble of finished product or service emerged.
We personally saw this in action. Flying from Moscow to Minsk in the late 1980s we sat beside a young woman who spoke English. We noticed she had a toilet seat in her lap.
This seemed a bit odd, so we asked what she was doing with it.
“Oh… you know… everything is screwed up here. But airline tickets are cheap. So, it’s cheaper for me to fly to Moscow to buy a toilet seat than it is to buy the seat in Minsk. Besides, there aren’t any toilet seats in Minsk.”
Without free discovery of prices, you never know whether you’re coming or going. Is something worth doing or not? You don’t know, because the prices don’t tell the truth.
In the Soviet Union, prices lied. And after six decades of financial mendacity, the economy was failing.
Spiking the Punchbowl
Instead of learning from this example – or from the other examples over 2,000 plus years of market history – the US was busy unlearning.
By 1971, it had severed the final link between gold and its money system. Over the next three decades, it would also run the biggest deficits in its history; and it would become bolder and bolder in its efforts to replace discovered prices with ones it imposed itself.
The price of credit is the most important price in an economy. It affects all other prices. If the price is too low, it leads to excess borrowing, which then finds its way into various sectors of the economy.
The tendency to fix the price of credit – rather than discover it – took a leap forward after 1987, when Alan Greenspan found it convenient to hold interest rates down for extended periods, forcing the economy into booms… and then bubbles.
In theory, the Fed could move rates lower to stimulate lending… and growth. When the economy “overheated” it was the job of the Fed, in the words of former Fed chairman William McChesney Martin, to “take away the punchbowl.”
In practice, the Fed rarely took the punchbowl away. And when it was removed it was only a matter of time before it came back… with stronger liqor than ever.
Businesses, investors and consumers gradually came to rely on it. And the Fed gradually became aware it couldn’t take away the punchbowl without putting everyone into a severe dry-out funk.
From 1983 to 2009, US interest rates drifted lower and lower… until they finally hit zero.
We have just completed 68 quarters of ZIRP. And Janet Yellen tells us that, even though QE will be fully wound down by the end of the year, ZIRP will continue.
The economy still needs free money, she says. She does not explain how the economy came to be dependent on this heavily-spiked punch in the first place. She does not take responsibility for making the economy “substance dependent.” Nor does she offer any real theory as to how the economy will be able to afford honest interest rates in the future.
Poor Ms. Yellen. She should know better. As Kirk Lazarus, Robert Downey Jr.’s character in the movie Tropic Thunder, made clear, you never go full retard.
More to come…
Regards,
Bill
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