“DEFLATION” or MONETARY DROUGHT STUDIES
AMI is seeking additional sponsors in an ongoing study investigating whether a form of monetary “deflation” is now in progress. The quotation marks are used because the correct word for naming the process in mind, does not appear yet in the vocabulary of economists.
Alan Greenspan and the rest of the monetary “generals” are still fighting inflation; the way military Generals are always said to be fighting the last war.
This study seeks to eventually establish quantitative and qualitative criteria to measure and determine whether monetary expansion or contraction is in progress, and to gauge its degree. For various reasons absolute measurements of changes in money supply figures cannot do this effectively.
Sponsors receive an initial report which details nine such major macro monetary events of the 19th and 20th centuries, through which the concept in question can be fully understood. They also receive all previous reports, which discuss the evidence whether such an event is now in the making, and present the path the research is taking.
Three additional reports on this investigation are sent over a period of about a year as the research continues. Sponsors can become interactive with the study, posing questions or challenges to past reports or suggesting questions and directions for the future research to take. As sponsors are expected from among institutional investors, The studies devote an appropriate amount of attention to the investment conclusions of such monetary theory; especially to their medium and long term effect, particularly on the US Dollar, and US long bond rates.
Persons aware of researchers or university departments who have or are currently working in this area are invited to send the names of such studies and how AMI can obtain them.
UPDATE December 8, 1997:
The second report in the Deflation study, completed on September 19, 1997, discussed some startling developments in the money supply statistics, the importance of which have gone unrecognized. The unprecedented deterioration in M1 levels, since the statistics began to be published, doesn’t scare economists using a faulty concept of money, but is potentially of great relevance when viewed with more accurate concepts of money’s nature.
Both reports one and two explained why there is not now a monetary demand for gold, months before the Swiss Central Bank announced it would be selling much of its gold; and before the Europeans said that gold would not be playing an important role in the coming European Central Bank.
The report’s conclusions on the $ Index; the U.S. Long Bond; and gold, have been proving correct. We are still near the beginning of very major monetary changes. The reason for AMI’s success in these projections is our concept of the nature of money. This concept, properly understood, should continue to generate accurate conclusions, long into the future, whether used by AMI or others. We urgently warn that the Federal Reserve System, the commercial banks, most money managers, and the “goldbugs”; are all misevaluating the current monetary situation; and are perhaps placing too much confidence in their own sales pitches. This is not an investment service. The broad investment conclusions are presented below for free.
Sponsorship of the AMI DEFLATION STUDY requires a $10,000 donation.
Contact Stephen Zarlenga by email for details.
Copies of the individual reports are available for $100. per report, postpaid.
AMI, PO. Box 601, Valatie, NY, 12184
FOLLOWING ARE EXCERPTS FROM ABOUT 90 PAGES OF THE REPORTS:
REPORT # 1 AUGUST 8 1997
Are there obvious and dependable measurements of monetary expansion or contraction? The complexity arises because the number of dollars in absolute terms is not a sufficient measure. The question is always the amount of money in relation to the work it needs to do. Consider our earlier example from the American money drought in the late 1800′s, where deflation existed even though the money supply was raised 17% over a 12 year period. That “work” depends on population, business activity, and speed of turnover among other things. For example seasonal factors require substantial changes in the money supply, just to keep on an even basis.
One problem is that terminology and definitions can have political motivation behind them. The way the economy is defined has a direct effect on governmental actions and programs; on whether the Fed’s monetary policy will overly favor debtors, or creditors, producers or bond holders. To a greater extent than realized, this battle for power starts with control over these definitions – with control over the English language.
FEDERAL RESERVE YARDSTICKS
Surely the Federal Reserve System has accurate or at least adequate measurements of expansion or contraction? Maybe not. Just as the Bank of England in 1810 had falsely insisted that its creation of money could not have caused price rises, (see Macro # 1 above) the Governors of the Federal Reserve System through most of the 20th Century insisted that inflation was not caused by their issuing money. They denied even the broad quantity aspect or theory of money …
The FED finally admitted their role in causing inflation, after Friedman won the Nobel Prize in economics, and the quantity aspect of money could no longer be ignored. The speeches of William J. McDonough, (McDonough’s Speeches on 1/11/96; 2/27/96; 3/21/96; 10/2/96; and 11/6/96; are available the FRBNY’s internet web site) President of the Federal Reserve Bank of New York, indicate that the Fed is placing far too much emphasis on their “inflation” statistic, in setting monetary policy. McDonough gives essentially the same speech to various groups so the terminology has been carefully worked on. His statement of the Fed’s focus, will serve as our reading of Fed policy into the foreseeable future:
FED’S PRIMARY OBJECTIVE – “PRICE STABILITY”
McDonough writes “There is no question in my mind that the primary long-term goal of monetary policy should be price stability which is best defined as a situation in which inflation is not a consideration in household and business decisions. For me personally this goal always has been the prism for making monetary policy choices.”
But inflation has not been a big concern in American households since the late eighties. Today the real terror in the typical American household is job security, losing ones health insurance, and joining the army of the unemployed/under-employed. McDonough gives the Fed’s real definition of price stability:
“Policy must continue to aim at … inflation trending lower and eventually giving way to price stability.” That seems to say zero inflation.
This is quite remarkable, because by law the Federal Reserve System’s first priority is supposed to be full employment. Thus in most speeches McDonough asks his audience to support a proposed new law by Senator Mack of Florida, which would legally make “price stability” the top priority.
GROWTH IS SECONDARY TO THE FED
Regarding the economic growth which Fed policy is by law supposed to be fostering in order to promote employment, McDonough twists it to his (and the Fed’s) inflation theme. First he asserts:
“What monetary policy cannot do…is produce economic growth. “Then he says: “Though statistical evidence has not yet established a causal relationship between inflation and (economic growth)…I am persuaded that lower inflation most certainly benefits long run economic growth, even if it is not possible to pin down the precise numerical relationship.”
He says that studies show that for each 1% decline in inflation, there is a .35% increase in labor productivity, which “suggests that the decline in… inflation since the early 1980′s may be responsible for most of the recent rise in productivity growth.”The fuzziness of this self serving thinking, in the President of a Major Federal Reserve Bank, is alarming, if he really believes it. How much of this productivity increase went to the labor sector? None.
With all his concern over inflation, nowhere does McDonough even bother to define inflation! McDonough admits that Fed policy has concentrated wealth in the hands of the wealthy: “Over the last twenty years or so, advances in growth and prosperity have not been widely shared… Since 1973 real incomes for households in the bottom fifth of the population have fallen about 15% while those of the top fifth have enjoyed real income gains of 25%.” But again he distorts this to fit his inflation theme: “Inflation has a serious social cost because it falls particularly hard on the less fortunate in our society…Such people do not have the economic clout to keep their income streams steady, or even buy necessities, when a bout of inflation leads to a boom-bust scenario for the economy. As a consequence, they suffer disproportionately when the bust comes.” Unfortunately under the Feds policy, the poor don’t have to wait for a “bust” in order to suffer; by McDonough’s own admission they are suffering even while the stock market is boomed to all time highs.
WILLIAM VICKREY’S VIEW OF INFLATION CHALLENGED FED POLICY
Vickrey received the Nobel Prize in economics in 1996. He defines inflation as “the overall result of individual prices being independently increased”. Vickrey’s examination of the cause of inflation (William Vickrey, BUDGET SMUDGET, Columbia University Economics Dept. Papers. (See review at our website) notes that:
“…Increasingly prices are set by sellers, …(able)… to raise their prices without a loss of sales sufficient to wipe out the gain.” This ability to raise prices he says stems from: “the increasing sophistication of goods and product differentiation, both inherent and contrived. At the retail level, consumers are increasingly bamboozled by specious advertising and frivolous variety so that comparison of the products of various sellers is increasingly difficult…” and the demand for the products is inelastic.
For these and other reasons Vickrey concluded that: “Monetary policy is inherently incapable of curbing this process (of inflation) except insofar as it goes to the extreme of idling resources” and causing unemployment. Vickrey points out that this is rarely faced honestly: “While they generally avoid speaking or even thinking of the policy in terms of increasing unemployment, the main channel through which restrictive monetary policy will act to restrain the raising of prices by price setters is by cutting back on the demand for resources and adding to unemployment.”
“The effects of such a level of unemployment are particularly harmful when it is concentrated on a small percentage of the labor force, with consequent increases in crime and delinquency and disruptions of family life, rather than expressing itself as, say, an extra three weeks vacation for everybody. In the short run, at least, inflation is far preferable to unemployment if the two are considered alternatives.” But inflation hurts the wealthy bondholders, whereas unemployment hurts mainly the lower income groups through work loss, and the middle class through lower earnings. Vickrey has had an impressive record of practical implementation of his economic ideas. He thought inflation might be controlled through the development of a new tool such as a penalty tax on excess markups, as a means of containing inflation: “Firms would be given initial entitlements to gross markup on the basis of past performance.”
These entitlements would be transferable and a market in them would be developed. The plan would operate “somewhat similar to an excess value added tax, comparable in some respects to the wartime excess profits tax except for the fact that the entitlements would be directly tradable.” In one of his papers Vickrey estimated that several trillion dollars could now be added to the US money supply, with good results. We’ll review that paper in the next report. (Vickrey, WE NEED A BIGGER DEFICIT, Columbia U. Econ. Dept. Papers)
FED’S MISTAKEN GUIDEPOSTS
So we see the Fed’s apparent only guidepost for determining its policy is simply the inflation rate, which is too narrowly defined as price rises; and which is not even based on cause and effect; and is therefore fundamentally flawed. These policy descriptions based on inflation are mainly for public consumption, and for the weaker minds on the various Federal Reserve Boards. They are perhaps being used by some as tools or weapons – “A means of decoy and confusion…” If the Fed were truly as obsessed with controlling inflation as it claims to be, they could implement the type of instrument Vickrey proposed, or devise a better tool. But it is impossible to even imagine the Fed making such a proposal, because it infringes their free market theology…
CAN THIS FED POLICY SLIDE INTO DEFLATION?
Is there a real chance that this policy of restriction of money growth, using inflation as both an excuse and a criteria, could go out of control and slip over into outright deflation without the Fed even knowing it? The Fed thinks so: McDonough says: “We know that as currently measured, a zero inflation rate is not the same thing as price stability. This is because of well- known errors in measuring inflation…economists and policy makers cannot agree (on) this measurement error (overstating inflation) estimated to range from ½ percent to 2 percent. If … the inflation goal is set too low, we run the risk of tipping the economy into a deflation in which the true price level is actually falling….Therefore I believe that an appropriate number for this (inflation) goal should be within the reasonable range of measurement error – but in the upper end of the range because of the dangers of deflation.” He is saying is that “price stability” means 2% annual “inflation” as currently measured.
What is important to note in McDonough’s statement is the uncertainty which exists on the matter. This has not been reduced to a science, or even an art, by the Fed. How do we know they haven’t already “tipped” into deflation? Further, are there conditions or events where such monetary strangulation could escalate into sharp, uncontrolled deflation? We’ll examine this in future reports.
CONCEPTUAL ERROR IN THE “INFLATION” MEASUREMENT?
There is another concern I’m examining on whether the Consumer and Producer Price Indexes are structured to reflect actual weighted costs, or theoretical unreal expenditures, for the following reason. The real cost of labor in America has been dropping from at least 1973.
Recently the minimum hourly wage was raised to $5.50 per hour. However adjusted for inflation, it would have to be around $10 to $12 per hour, just to be equal in value to the late 1960′s minimum wage. Better paid workers are also earning far less than their nominal incomes were worth in the late 1960′s, and early 1970′s. Since the cost of labor is usually the main expense that a business has, are we in a situation where businesses are experiencing net deflation in their primary expenditures? If so, wouldn’t that deflation be as important a monetary signal, as the small rises in the CPI the Fed seems so concerned about? We’ll discuss the derivation of those statistics in coming reports.
THE US DOLLAR
If the hypothesis is correct, it will mean a strong dollar in both absolute terms and relative to other currencies, well into the future. The West’s monetary expansion from the Bretton Woods period forward has been built upon creating US Dollar debts, both in the US and abroad. This is because the primary way new US Dollars have come into existence is through bank loans, or through the monetization of US Government debt. These loans and interest must be repaid in US Dollars, not other currencies. If the creation of new US dollars is being overly restricted, for example through balanced budget legislation, this will create an ever more difficult situation for the $ debtors. Contracting the US Dollar supply would place many of those private and corporate debtors in a desperate situation. Their need for US dollars, to meet their obligations is inelastic and would be expressed in a strengthening dollar, to some extent independent of US trade deficits. This strengthening would increase their real debt load, and raise their real interest costs.
Since so much of the world’s debts are in US Dollars, non Americans with $ debts will be forced to sell other currencies, buy dollars, and remit them to US institutions in payment. Restricting the dollar thus has a greater effect on relative currency values than restricting the Mark, Franc or Pound. It can create genuine worldwide distress. An independent EURO creates a highly interesting situation. Of potentially major importance is that it will allow Europe to escape a US economic contraction, should the ECB managers be convinced to take that course during a dollar contraction. Much as China which was on a silver standard, was not drawn into the Great Depression of the gold standard countries in the 1930′s. But while the ECB can create European liquidity, the ECB cannot create US Dollars. In that scenario, the $ strengthens against the Euro.
THE US LONG BOND
Our thesis calls for the US long bond (30 years) to trend higher into the foreseeable future, with normal but sharp corrections, as its interest rate falls. The real rate of return (the nominal rate minus the inflation rate) is presently historically high at about 5%, and even higher when you realize the inflation rate may be exaggerated.
A continued strengthening of the US Dollar in absolute terms ought to keep pushing the nominal interest rate on these bonds down, so that the real rate of return ends up somewhere around 2%. If there is no monetary inflation, but merely businessmen raising prices (see above) then it would not be surprising to see the US long bond rates eventually reaching 2-3%. They are currently at 6½ %. Further, the great safety of this bond would give it an additional major attraction during any sharp deflationary developments. Because the 10 year bond was recently paying rates close to the 30 year bond, some advisors have preferred them, rather than “tying up money” for 30 years. But according to our thesis, its the other way around. Holders of the long bond are capturing high interest rates for 30 years, rather than 10 years.
For the past decade the non-professional investment interest in gold in America has been concentrated in conservative or right wing fundamentalist Christian groups. It is clear that though gold has nothing to do with Christianity, it is more a part of their religious belief, than investment decision – not questionable by facts or events. Their advertisements ignore how poorly gold has performed and that a major bull market in stocks has run for 13 years and that the dollar is strengthening in relation to other currencies. These folks generally have modest financial resources, and they keep waiting for and betting on the great crisis (that will in fact someday come) and think that gold will shine, as it did during the 1930′s depression.
However they are missing the point that the reasons gold did well during the last depression was because it was money, and because its official value was raised from $20.67 to $35 by law in 1933, while all other prices had collapsed. Money becomes more valuable during a crash, but commodities decline. Today, without legislation re-establishing a monetary privilege and official support price for gold, in my view it is more likely to act like a commodity than like money, during a financial crash. That is it would fall, with copper, aluminum, and lead. Even for an inflation generated investment interest in gold to re-appear would likely require a lengthy poor performance in the general stock markets first, as had occurred in the early 1970′s.
Gold’s present official support price, by the US Government is around $44 per ounce. Some countries have put higher, closer to market prices on their gold hoards, such as Germany recently in its attempts to do window dressing on its deficit. But whether those countries stand ready to support gold in the markets at those prices is an entirely different matter. Recently the Australian central bank has reported it has been selling substantial amounts of gold. Some “gold bugs” believe that gold will do well in a hyperinflationary depression, which they think could come about through a collapse of the US banking system, with the Government rushing to print enough money to bail out the banks. But a good understanding of money makes that scenario more of a fantasy than a real possibility, as we will explain in the next report.
There have been good plans in existence since the Great Depression to bail out the banking system, without causing any inflation or deflation, by simply making the current monetary levels real, instead of leveraged. Its called the 100% reserve system and it ends the possibility of system wide bank runs. That leaves only two “hopes” for gold: that the political move in the US to re-institute a gold standard, gains strength; or that there is a nuclear confrontation with Russia, or eventually in the middle east, plunging the world backward a few hundred years.
Have any of the mutual funds currently concentrating billions of dollars in gold and gold shares really done their homework on these matters?
EXCERPTS FROM REPORT # 2 September 19, 1997
RECAP OF FIRST REPORT
Our main hypothesis is that there is a real but unrecognized contraction or over restriction of the US monetary system …already underway… Our view is that this will eventually have a major negative impact on an over priced stock market. Because this viewpoint is out of the mainstream, our first report in this series concentrated on 9 macro historical examples where this process of engineered contraction had occurred. This served to both validate the possibility of the process happening again, and to help to define it, and the signs to watch out for. This report concentrates on the markets of the 1980′s, and the present situation. We also begin the process of defining and measuring whether a contraction is in progress, in our examination of what is happening to the M1 statistics.
THE FALL IN THE M1 MONEY STOCK…
The highest powered element in the money stock, M1, has been declining for three years! M1 is composed mainly of the amount of money in currency, checking accounts, and traveler’s checks. No one seems to have noticed that M1 topped out in July 1994 at 1150.9 billion dollars, and has declined to 1063.2 billion in June 1997; a drop of 87.9 billion, or 8.3%.
To place this drop into perspective, a look at the year end M1 statistics shows that there is no comparable drop in the M1 figures, either in percentage terms, or for so long a time period, going back to 1959, when my table of statistics starts. In fact there is no time during that period, when M1 dropped on a year to year basis. There are only a handful of cases where the M1 dropped from one month to the next. Here are the year end M1 figures in billions of dollars:
1959: 140. 1960: 140.7 1961: 145.2 1962: 147.8 1963: 153.3 1964: 160.3 1965: 167.9 1966: 172. 1967: 183.3 1968: 197.4 1969: 203.9 1970: 214.4 1971: 228.3 1972: 249.2 1973: 262.8 1974: 274.3 1975: 287.4 1976: 306.3 1977: 331.3 1978: 358.4 1979: 382.8 1980: 409.0 1981: 436.8 1982: 474.7 1983: 521.2 1984: 552.2 1985: 619.9 1986: 724.4 1987: 749.7 1988: 787.0 1989: 794.2 1990: 825.8 1991: 897.3 1992: 1025. 1993: 1129.8 1994: July: 1150.9; Dec: 1150.71995: Dec: 1129.0 1996: Dec: 1081.0 1997: June: 1063.2 July 1994 to June 1997: M1 falls 8.3%
This is a vitally important development which may be flashing an extreme danger signal. It must be watched closely, and further analyzed. I had not expected to find such an anomaly in these statistics. Milton Freidman has written that he considered another crash to be highly improbable, if for no other reason than that the money supply figures were being closely watched. He is correct in the sense that its not so easy to reduce the money supply as it used to be, and to get away with it! However, this may be happening before our eyes, under cover of a raging bull market.
FOREIGN CRISES MOUNTING
Instead of foreign crises being resolved one at a time, they are mounting up. The Middle East always hovers. The famine in North Korea threatens to re-ignite the Korean War, which was never brought to a final conclusion. 15% of the population is reported to be in the process of dying of starvation. There are reported to be about 1,000,000 North Korean troops on the border of the Korean de-militarized zone. (NBC News Report, September 17, 1997) The recent turmoil of the Asian Pacific Rim countries, after attacks on their currencies, has been credited with cutting back the stock prices of some major blue Chip companies in recent weeks. The problems of the Japanese economy continue as a threat to other economies. Not by accident a Japanese cabinet minister referred to selling off Japans holdings of US Bonds, roiling financial markets.
However the largest foreign problem and the most dangerous, not economically but politically, is the economic and monetary collapse of Russia. Probably Europeans have a better picture of this than we Americans do. The west has missed a great opportunity in Russia of really helping in a democratic transition in a manner appropriate to their history and situation, which would have been advantageous to all. Instead we sent them economists. We have pushed free market “reforms” on them, in a manner which seems to have mainly created a gangster class.
What has happened to Russia has not been necessary, or the result of a law of nature. The weather has not changed. The population has not changed, nor have their skills. The land has not changed. I suspect when the full story is known, we will be able to identify false monetary theory foisted on the Russians from the west, as a central cause of the Russian collapse. When I find a source for that information I’ll report on it. We have helped to set the stage where a militarization of the Russian Regime appears now inevitable, and even desirable for most Russians. The German approach to Russia had seemed much more promising.
While this possibility is being discussed openly, it will still be a shock to Americans when /if it happens, because it goes counter to the American world view about the Russians and how to solve their problems. However even a military takeover may be too little too late to stop the slide of Russia into a decaying remnant of a civilized society, for the military itself may be too far gone. For example: ( Excerpted from NY Times article, July 28, 1997)
* the standard soldiers pay is $3 a month
* 500 Russian soldiers committed suicide last year, and so far this year’s figures are worse.
* Most military analysts say the Russian army could fully supply only one of its 78 divisions for battle.
* Giant ships from Murmansk to Vladivostok lie rotting in their berths…
* Army privates are allotted 5,000 rubles (about 70 cents) a day for food. By contrast, Russian prisoners, in conditions that are appalling, receive 7,750 rubles worth of food each day.
* with a military too poor even to train its soldiers for combat, 100,000 families of officers are homeless and only 10 percent of servicemen are issued boots, topcoats or full uniforms.
The real crux of the problem, and the danger for America and Europe is nuclear:
* Pavel Felgengauer, a leading military analyst said: ” There is going to be no army. Russia does not have the money to have a real army anymore …Russia can afford its nuclear forces and an honor guard to put around the Kremlin. And not much more.”
* Russian leaders have repeatedly asserted that Russia’s large nuclear forces must be maintained.
* The country’s last claim to might in the modern world is its stockpile of nuclear weapons.
*The recent ouster of Rodionov (Lebed’s protégé) by Yeltsin has potentially important significance for the Russian military planning. Yeltsin picked Gen. Igor Sergeyev, the head of the Strategic Rocket Forces, which controls’ Russia’s long-range nuclear arsenal, to serve as the acting defense minister.
* Sergeyev’s elevation is an indication of the increasing emphasis Moscow is giving to nuclear weapons to maintain its standing as a superpower. He is a strong supporter of building new strategic nuclear arms.
Throughout the 1970′s and 1980′s when concerned European friends would ask me whether there was a real danger of Russia rolling across Europe, I always told them no – that is an imaginary conflict between west and east (actually between west and west!) The apparent bi-polar conflict between the US and Russia did not represent an irreconcilable conflict of real interests, but was nurtured to provide the argument for running the US economy on the basis of what President Eisenhower warned us as the “military industrial complex”. This allowed for the continued organization of much of the economy for the production of unusable weapons systems.
This game was not questioned until it brought the world to the very brink of nuclear war in the 1962 Cuban missile crisis. Even that near miss at Armageddon didn’t really alter our policy. That only occurred after the astronomer Carl Sagan and other scientists made the convincing case that a “nuclear winter” would follow a nuclear war, and that there would be no survivors. Today I would answer the question of danger from Russia differently. While Russian armies are not going to roll into Europe in the near future, Europe and the west today are at greater risk of nuclear attack from Russia than anytime since 1962.
This attack could come by official act, by disaffected military or by something even more unconventional. Last Sunday General Lebed, the likely person to lead Russia out of the morass, reported that approximately 100 nuclear weapons were missing and unaccounted for. They are one kiloton weapons, which are constructed as suitcases, and are indistinguishable from traveler’s suitcases. He said that they were easy to detonate, without special skills, in 15 to 20 minutes. No doubt many of them are “safe” in the hands of Russian generals.
But some may already have been sold to those who would detonate them in European or American cities, in response to America’s role in the mid east or to the desert storm warfare and continuing embargo of Iraq. It is not a good thing when an organization controlling many thousands of nuclear weapons disintegrates into chaos. We have spent too much time gloating over Communism’s demise, and too little thinking of how to avoid the worst case scenario that could come from it.
THE 10,000 BARRIER IN THE DJIA
Report # 2 suggested that 10,000 in the DJIA would be a formidable psychological barrier, considering its historic overvaluation, and citing previous decimal barriers.
For example the 100 level held back the DJIA on 6 separate occasions for 17 years from 1906 to 1923:
YEAR % RETREAT FROM 100 LEVEL
Feb. 1906 to Nov. 1907……………… -46%…. (100 to 54)
Dec. 1909 to Sept. 1911…………….. -27%…. (100 to 73)
Oct. 1912 to Jul. 1914 ……………… -23%…. ( 94 to 72)
Oct. 1916 to Dec 1917………………. -38%…. (110 to 68)
Nov. 1919 to Aug. 1921……………. -23%…. ( 94 to 72)
Mar. 1823 to June 1924……………. -14%…. (105 to 90)
The 1,000 level held back the DJIA 4 times over a 14 year period:
YEAR———————– % RETREAT FROM 1,000 LEVEL
Feb. 1966 to Oct. 1966……………… -25%…. (1,000 to 750)
Dec. 1968 to May 1970…………….. -44%…. ( 975 to 550)
Jan. 1973 to Dec 1974……………… -46%…. (1050 to 570)
Apr. 1981 to Aug. 1982……………. -23%…. (1020 to 790)
By the end of the big drop in December 1974, it was not unusual for good small cap stocks to have fallen 75 to 85% in price, from their highs. Now that was a real bear!
EXCERPTS FROM DEFLATION REPORT # 3
“Why look for signs of monetary contraction or over -restriction?” (report # one, 1st week of August, 1997) Events over the past year, since report # 2 was issued (September 19, 1997) have continued to demonstrate that concern over deflation has been justified. Deflationary storms have swept through Southeast Asia, wrecking the economies of Thailand, Malaysia, South Korea, and Indonesia. Countries which economists until recently were calling Asian miracles. Hong Kong continues to be under the gun, and Japan’s ruling establishment continues its deflationary bias. The deflations have been a result of both market forces, and Federal Reserve System and other monetary authorities deliberate, but misguided policies. Policies which may soon be recognized to have been for several years highly irresponsible.
DETERIORATING CONFIDENCE IN THE MARKET
The revelation that one unregulated “hedge fund” the so called LONG TERM CAPITAL MANAGEMENT FUND, by itself was able to threaten the stability of western markets has served to shock the complacency of US investors. There are 4,000 such unregulated hedge funds in the US; not to be confused with normal mutual funds. So long as there are fewer than 100 investors in such a fund, it can remain unregulated.
There is a general suspicion that other hedge funds are also in trouble, which means the banks which lent them money will have problems. With $4 billion in assets, Long Term Capital Management undertook $1.25 Trillion in risk through derivatives, thanks to bank loans. These bank loans were recklessly made by the cream of the American banking establishment; without examining the impaired position of the borrower.
The Fed said that unwinding this fund’s derivatives positions could have created irreparable uncertainty, even in US agricultural prices, and it therefore organized a $3.5 Billion rescue package, from the banks involved with this hedge fund. But the damage to the complacency of U.S. investors has now been done, opening the way for some panicky markets. During the past year, of the $365 billion loaned out by US commercial banks in 1997, $125 billion of it were loans for securities transactions.
According to Barron’s magazine the American banks have already admitted to having lost $200 billion in Russia and in Asia; approximately 14% of their equity – an enormous loss. Barron’s considers it a conservative estimate.
DETERIORATING CONFIDENCE IN THE FEDERAL RESERVE
Just as serious is the growing loss of confidence in Alan Greenspan and the Federal Reserve System. On January 12, 1998 Greenspan was heckled off the stage in Los Angeles while addressing a community based forum on financing projects in poor neighborhoods. The audience disrupted his planned speech with shouts of “You should be ashamed of yourself!” and “Its a disgrace!”
Its easier for people not receiving benefits from the Fed to criticize the Fed’s activity. However, the criticism is now also coming from those who could be expected to support the Fed. We noted in report # 1 that in our view Greenspan and the Fed might have already slipped into deflation more than a year ago. This has finally dawned on the US financial press.
Barron’s Up and Down Wall Street column by Alan Abelson on July 27, 1998 commenting on Greenspan’s congressional testimony, called Alan Greenspan “the Great Waffler” because whereas earlier in January-February 1998, Greenspan had warned of deflation, in his July testimony to Congress, he warned of inflation. Abelson wrote: “Aside from placating the blind contingent at the Fed who still feign to see inflation looming large, Mr. Greenspan’s harping on the inflationary theme – in essence, he claimed inflation is our number 1 concern was a bit bizarre and more than a little bemusing. Or did he really mean – deflation?”
But the level of myopia among those in charge of the West’s monetary systems is truly frightening. In the IMF’s August 4th 1998 press release, the IMF announced that it wanted the Federal Reserve System to raise interest rates in order to hold off inflation! Remember this was after the Asian currencies had already fallen, taking their economies down with them.
FED POLICY CONTINUES TO RESTRICT M1
In report # 2 we pointed out that ” from July 1994 to June 1997 M1 fell 8.3%.” M1 has improved very slightly since the last report:1997: Jun… 1065.4 Jul… 1065.6 Aug… 1071.1 Sep… 1063.5 Oct… 1061.9 (the low up to now) Nov… 1069.2 Dec… 1076.0
Jan… 1073.7 Feb… 1076.5 Mar… 1081.1 Apr… 1080.8 May… 1078.0 Jun… 1074.8 Jul… 1071.6 Aug… 1068.4
This tiny improvement is better than a continued decline. The figures do not demonstrate a real policy change on the part of the Fed, away from its 4 year deflation of the M1 money supply. Remember, the absolute money supply must be increased each year to keep pace with population and commerce growth, for it to merely remain “unchanged” in the real sense. Therefore actual declines in these supply figures should be taken very seriously.
The importance of the M1 is that it is the least leveraged of the various M’s which the Fed measures. It is still leveraged, since bank credits in checking accounts are leveraged, but those accounts are almost all guaranteed by the FDIC (the government ultimately). As you proceed to M2, M3, and L, instruments which are more market dependent are included and those instruments are vulnerable to market decline. For example M2 includes money market mutual funds. M3 includes institutionally held money market mutual funds, and large time deposits, which are not full covered by the Federal Deposit Insurance Guarantee. L includes “other liquid assets”.
TOTAL BANK RESERVES ARE STILL DROPPING
In report number 2 we pointed out the deterioration in total US bank reserves: The updated figures (billions of $) below show continued deterioration:
1997: June… 46,871 July… 46,717 Aug… 46,939 Sep… 46,240
Oct… 45,958 Nov… 46,310 Dec… 46,669
1998: Jan… 46,501 Feb… 45,722 Mar… 46,047 Apr… 45,959
May… 45,591 Jun… 45,391 Jul… 44,814 Aug… 44,997
One must go back to late 1985 to find lower total US bank reserves. This means the cushion is small, for the huge bank losses already admitted.
MARKET DEFLATION ACCENTUATES FED’S MONETARY DEFLATION
Aside from the Fed’s deflation of the most high powered segment of the US money supply – M1 – collapsing markets themselves are huge engines of deflation. I received the following email from Thailand: “I’ve been residing in Thailand for the last nine years and watched the debt bubble inflate and then pop on July 2, 1997 when the Thai Baht was allowed to float… “What with the failure of numerous finance companies and banks within the region (Thailand’s bad debt load estimates range from 25-35%) and coincident plummet in stock prices (the Stock Exchange of Thailand [SET] Index is at an eleven year low) has resulted in a severe liquidity crunch. “Looks like US $ billions have evaporated over the past twelve months resulting in an effective contraction of the money supply (at least that part that used to circulate). Pretty powerful deflationary forces at work in these parts camouflaged in part by falling foreign exchange rates. Thought you might be interested in a view from East Asia.”
NOTE: AMI’s deflation studies were put on hold in 1999 in order to concentrate on getting our book into print:
The Lost Science of Money (Click here to see details, reviews, and an order form) The book is now available and since you have read this far, we strongly suggest that you read it.
However the deflation studies remain on the “back burner.” Some of the market observations above are obviously dated. Check our more recent interview with the Gold Newsletter.