The Gloom, Boom & Doom Report

THE GLOOM, BOOM & DOOM REPORT ISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED FEBRUARY 3, 2006

outclassed by the other participants that since hedge funds were largely The surest way to ruin a in the roundtable. To our right momentum players, when some man who doesn’t know how usually sit Art Samberg of Pequot earnings disappointment hit the to handle money is to give fame and Abby Cohen, who despite stock of a company, that stock would her fame has remained extremely drop far below fair value and provide him some. humble and kind. To our left are the contrarian investors with an investment legend John Neff and the opportunity to buy a bargain. Along George Bernard Shaw king of bonds, Bill Gross. with Citigroup, one of Neff’s In general this year, the mood at recommendations was to buy the roundtable was quite positive for Hunstman (HUN — see Figure 2). INTRODUCTION equities with the exception of Fred A further two observations that I Hickey, who presented a very thought to be relevant were made by I hope my readers had as fortuitous a thorough and dim view of the high- two successful hedge fund managers. holiday season as I had. Shortly tech sector and whose Art Samberg lamented that two of before Christmas I read Russell recommendations included shorting his stock picks for 2006, which he Napier’s new book, Anatomy of the SanDisk (SNDK) — an excellent had prepared at the end of 2005 and Bear — Learning from Wall Street’s idea, I thought (see Figure 1), as well which were both foreign stocks, had Four Great Bottoms (see below). I as myself and my friend Felix Zulauf, already appreciated since the end of stopped over in Bahrain and Dubai who expressed our concerns about 2005 by 30% and were therefore no while en route to Switzerland, where global imbalances. One remark longer very attractive. As the day I skied for ten days. On New Year’s caught my attention. If I remember drew to a close, Felix Zulauf remarked Eve, I purposefully avoided over- well, it was John Neff who argued that for the first time ever, several indulging, as the next day I wanted to be able to ski as well as Bode Miller — in my opinion, the greatest alpine skier since Jean-Claude Killy and Figure 1 SanDisk Corp. (SNDK), January 2005 – January 2006 skiing’s answer to courageous rap superstar Eminem (whose real name is Marshall Mathers III, and whose music even a non-rap fan like me can enjoy). After my skiing holiday I travelled to the US, where for the first time in many years I was greeted by a friendly US immigration officer. This put me in a good mood for the annual Barron’s roundtable, which is put together by the witty and scathing Alan Abelson and is always an interesting meeting of investment minds. The roundtable lasts for a full day and is quite demanding, in the sense that one has to try and avoid making a total fool of oneself. I am usually seated next to Fred Hickey, the wonderful editor of the High-Tech Strategist. And while I cannot speak Source: www.decisionpoint.com for Fred, I sense that he and I are on 30-year US Treasuries rose from Figure 2 Hunstman Corp. (HUN), January 2005 – January 2006 6% in 1970 to 15.84% in September 1981 and sent bond prices tumbling; the 1973–1974 Hong Kong stock bear market, which brought the Hang Seng Index down by 90% to its December 1974 low at 150; the great sugar bear market, which sent prices down from 70 cents per pound in 1973 to 2.5 cents in 1985; or the Japanese bear market post-1989, when the Nikkei dropped from 39,000 to less than 8,000 in April 2003. Moreover, major market lows are associated by investors with total despair and panic among market participants, depression in the asset class that was subjected to the bear market, bankruptcies in that sector, and overwhelming negative sentiment. But, as Russell Napier shows in Anatomy of the Bear, the key element Source: www.decisionpoint.com in undervaluation can also be a period of time “when the advance in stock prices has failed to keep pace members of the roundtable had ideas, but I shall list the stocks I was with the economic and earnings offered several foreign stock picks for prepared to recommend further below. growth” within the system. Napier 2006. (Rolls-Royce was mentioned Shortly before leaving New York shows, for instance, that at the twice.) But, as I have mentioned, the for Asia, I received from Robert market low in 1921 the Dow Jones overall mood was constructive; most Blumen (robert@RobertBlumen. Industrial Average was no higher participants felt that the US stock com), who has contributed to this than it had been in 1899 — 22 years market, having underperformed report in the past, an excellent, very earlier — while nominal GDP had foreign stock markets in 2005, would thorough, but rather frightening increased by 383% and real GDP by outperform in 2006 and therefore analysis of “Bernankeism”. (Robert’s 88%! Similarly, by August 1982, the they belonged in the “10% to 20% article is reprinted on pages 5–11 of Dow Jones Industrial Average was no upside stock market club” for 2006. I this report and is a must-read.) higher than it had been in April was intrigued that none of the other 1964, and was down by 70% in real participants mentioned geopolitical RUSSELL NAPIER’S or inflation-adjusted terms. issues, the threat of a bird flu ANATOMY OF BEAR According to Napier, August 1982 pandemic, Africa, or the fact that MARKETS represented the fourth-best buying India, a country of more than a opportunity for US equities in the billion people, now (according to Russell Napier’s Anatomy of the Bear last century, aside from 1921, 1932, Forbes) has 27 billionaires and that — Learning from Wall Street’s Four and 1949. the collective net worth of its 40 Great Bottoms is an excellent read The important message one richest people is quadruple that of and easy to digest. (The book is might take from Napier’s book is China’s 40 richest. According to available from Amazon.com or from that it usually takes a long time — Forbes’ data, the collective net worth CLSA directly. Contact victoria. about 14 years — for stocks to of India’s billionaires stood at [email protected].) travel from overvaluation to US$106 billion, compared with just Conventional wisdom has it that undervaluation, and that the US$26 billion for their Chinese great market bottoms, which offer nominal low in stock prices isn’t counterparts. (Leading the list of the once-in-a-lifetime buying always the best time to buy equities. richest Indians is steel tycoon opportunities, occur after a What is more important is the real Lakshmi Mittal with a net worth of devastating bear market. In this level of equity prices and various US$20 billion, followed by Wipro’s context, the following events usually valuation parameters that indicate Azim Premji with US$11 billion.) spring to investors’ minds: the 1929– deep undervaluation. Thus, while the Nowadays, Barron’s restricts the 1932 bear market in US equities; the Dow Jones bottomed out on recommendations the roundtable collapse in the US bond market December 9, 1974 at 570, and stood participants can make to about five between 1970 and 1981, when yields at 769 at its August 9, 1982 low, in

2 The Gloom, Boom & Doom Report February 2006 real terms the Dow had lost another low of Japanese equities as a price of natural resources. 15% since the 1974 low. Moreover, generational low — the bull market There is another point I should Napier exposes another myth — that in Japanese equities could easily last like to add to Russell Napier’s stock market lows lead the economic until at least 2010 or even longer, excellent study, which I strongly recovery by six to nine months, and and in the process significantly recommend investors to read. In a that at major market lows the news is outperform US equities. world of rapid monetary and credit universally bearish — by showing Another lesson from Napier’s expansion, an undervaluation of the that, in 1982, an economic book could very well be that other Dow Jones might occur, with a Dow improvement and better news in the Asian equity markets, relative to Jones at 36,000, 40,000, or 100,000 media led the stock market recovery other assets, remain grossly or more — a stock price level that by a few months. undervalued despite their post-1998 was predicted by several analysts in I think Russell Napier has filled a recovery. After all, many Asian stock 1999. How so? At present, the Dow is void with Anatomy of the Bear, since, markets, whether in US dollar terms at around 11,000 and the price of to my knowledge, it is the first book or in real terms, are still down by gold is at $550. Let us assume that, as to trace, with many pertinent more than 50% from the highs a result of Mr. Bernanke’s more insights, the swings from reached between 1990 and 1994. efficient paper money printing undervaluation to overvaluation and Lastly, if, as Napier outlines, it machine (incidentally, a machine back to undervaluation, of US stock takes about 14 years for equities to that has been in operation since the prices over the past 100 years. The make the journey from overvaluation formation of the Federal Reserve book also provides much food for to undervaluation, the severity of the Board in 1913 and which accounts thought. If equity prices swing back commodities bear market from 1980 for the dollar’s 92% loss in purchasing and forth between overvaluation and to the turn of the millennium — power since then), the Dow Jones undervaluation, other asset markets about 20 years — is evident. Put into rises to 36,000 in the next few years. such as real estate, commodities, and the proper perspective, in real terms (It won’t take another 100 years for bonds will do the same. Thus, I (inflation-adjusted) commodity the US dollar to lose another 92% of suppose that, in the same way that prices were, in the 1998–2001 period, its purchasing power; more likely is US bonds were grossly overvalued in at the lowest level in the history of 10 to 20 years.) If this were the case, the 1940s, Japanese bonds were capitalism (see Figure 3). And, the price of gold could rise from $550 grossly overvalued in June 2003, although some industrial commodity to $3,600, which would bring down when the yield on JGBs had declined prices may suffer from a significant the Dow/gold ratio from currently to less than 0.50%. At the same time, phase of profit taking in 2006, given about 20 to 10; or, in an extreme the April 2003 low for the Nikkei the fact that commodity bull markets case, gold could rise to 36,000, which Index at less than 8,000 may have tend to last anywhere from 20 to 30 would bring down the Dow/gold ratio been the best buying opportunity in years, we may just be at the to only 1 (as was the case in 1932 and Japan of this generation. In fact, the beginning of an extended rise in the in 1980 — see Figure 4). 2003 lows in Japanese equity prices and interest rates have similarities to the 1940s’ lows in US equities and interest rates. After the 1940s, US Figure 3 Real Raw Industrials Prices, 1800–2004 stocks rallied into 1973, but bond prices collapsed into 1981. Similarly, the stock market rally in Japan, which began in 2003, could last for many years and be accompanied by a significant bear market in Japanese bonds, which would drive local institutions and Japanese households out of their overweight bond and cash positions, which benefited during the 1990s’ deflation, and into equities and real estate. Moreover, if, as Napier explains, 1921, 1932, 1949, and 1982 provided outstanding buying opportunities for achieving subsequent high returns that tended to last for a minimum of eight years (1921–1929), but usually for much longer (1982–2000), then I suppose Source: The Bank Credit Analyst that — taking the late April 2003

February 2006 The Gloom, Boom & Doom Report 3 100 in 1918 to 171 billion, while in Figure 4 Dow/Gold Ratio, 1900–2004 dollar terms the same index had dropped from 100 to 2.72! Needless to say, the 1918–1923 German hyperinflation was devastating for paper mark cash and bond holders. Now, I am not necessarily predicting that we shall soon experience hyperinflation rates in the US, but the following piece on “Bernankeism” by Robert Blumen strongly suggests an inflationary bias. After all, and as I have maintained in the past, should the Dow Jones and the US housing market decline by 10%, it is very likely that the money printing presses would be put into Source: www.sharelynx.com high gear in order to fight asset deflation. I may also add that, while US investors are euphoric about the strong rise of the stock market so far Thus, in nominal terms, the Dow rose sharply in paper mark terms but this year (the S&P 500 is up 3.15% as would have trebled from the present tumbled in dollar terms (then a at this writing), in foreign currency level, but lost significantly in real strong currency), because the rate of terms the performance is less superb. terms — a possibility that I regard as the paper mark depreciation against Thus, in Swiss Franc terms the S&P very likely. In this respect, we the US dollar exceeded the local 500 is up only by 0.13%, and it is shouldn’t forget that during the share appreciation. Thus, by October down in British Pound terms by German hyperinflation period 1922, an index of shares in local 0.23% and by 0.17% in Japanese Yen between 1919 and 1923, share prices paper mark terms had increased from terms.

4 The Gloom, Boom & Doom Report February 2006 Unconventional Measures: Bernankeism and the Destruction of the Dollar Robert Blumen, E-mail: [email protected].

This article was originally given as a talk at the Burton S. Blumert conference on Gold, Freedom, and Peace, a benefit for LewRockwell.com.

In 2002, then-Fed Governor advocate of this new agenda. His when prices fall, people become Benjamin Bernanke burst into our leadership merits the name increasingly reluctant to spend (and monetary consciousness with his “Bernankeism” for this policy businesses to invest) because they printing press speech. His fine work program. anticipate that prices will continue to earned him the honorary title Upon reading the source fall. People start to hoard cash, “helicopter commander”. While materials, three main tenets of planning to buy tomorrow when largely a background figure since Bernankeism emerge. I will describe things are cheaper. The less people then, his recent appointment to them and illustrate with examples in spend, the more prices fall, and the succeed Alan Greenspan as Fed chair the Fed’s own words. The three are: more that people hoard. In the grip of makes this an ideal time to review prevention is better than cure, learn cash hoarding, according to Dr. Bernanke’s views on monetary the lessons of history, and the Bernankeism, the entire economy policy, and to speculate about what possibility of “unconventional would spiral down, as all spending his chairmanship will bring. measures”. ground to a halt. Since the Fed emerged from its For an example of this view, I will near-death experience in the 1970s, PREVENTION IS BETTER cite the research paper titled it has largely — and misleadingly — THAN A CURE “Monetary Policy and Price Stability” been identified with the label The first principle of Bernankeism is (1999) (by Fed research staffers): “inflation fighting”. Against this that it is better to prevent deflation backdrop, it is notable that Dr. than to attempt a cure after the If economic activity is weak or Bernanke’s research and speaking disease has set in. contracting and interest rates hit have dealt predominantly with the The basis of the Bernanke school’s the zero bound, a dangerous subject of deflation. thinking on deflation is the standard dynamic can be set in motion. While his infamous address before (mainstream) macroeconomic view Falling inflation, or even the National Economists Club, titled that consumer spending (not saving) escalating deflation, would “Deflation: Making Sure ‘It’ Doesn’t drives economic activity, and that increase real rates of interest. As Happen Here” (2002), has been insufficient consumer spending is the this depresses aggregate demand endlessly reported and debated, more cause of recessions. According to this further, downward pressures on revealing and less well known are Dr. view, when recession strikes, prices would raise real interest Bernanke’s many speeches on inflation is called for. rates further: The economy would deflation between 1999 and 2004, Inflation works in three ways. One, potentially face a downward and a series of research papers on the by lowering real prices when nominal deflationary spiral. same subject produced by the then- prices are for some reason “stuck” at Fed governor and a number of his above-market-clearing levels; and two, Governor Bernanke and his colleagues. by threatening a continued erosion in accomplices are obsessed with I have identified 14 papers and the purchasing power of cash, something known as “the zero bound speeches dealing with deflation (see inflation motivates anti-social cash problem”. Eight of the 14 papers and the references section), seven by Dr. hoarders to spend, thus providing the speeches that I examined deal with Bernanke and seven by other Fed missing stimulant to economic this problem either as their main governors and staff economists. These activity. A third is through so-called point or in passing. materials are all available for public “wealth effects”: when asset prices The zero bound comes about as download on the Fed’s website. To inflate, people misperceive the follows. The Fed commissars concern steal a line from columnist Dave inflation as true wealth and then themselves largely with controlling a Barry, “I’m not making this up.” increase their spending. single rate of interest, the Fed Funds A review of the most important Deflation is so dangerous, rate. This rate can be lowered only to points from these sources outlines a according to Dr. Bernanke, because it near zero, but not to zero or below, consistent point of view on deflation. is a self-reinforcing process that is because no one would buy a bond While Governor Bernanke is not the very difficult to reverse once it has that had a zero or negative yield; they only member of the anti-deflation begun. They start from the true would hold cash instead. This poses a wing at the Fed, the chair-in-waiting observation that when people spend problem for the central banker has emerged as the most prominent less, prices fall. They then reason that determined to inflate: if the Fed

February 2006 The Gloom, Boom & Doom Report 5 Funds rate hit zero (or near-zero, as it had the Fed inflated sufficiently. The … addressing the Fed’s Jackson did with Japan), inflation cannot be Friedmanites depict a Federal Reserve Hole, Wyo., conference in 1999, accelerated by cutting the Fed Funds System ideologically paralysed by the Mr. Bernanke and Mr. Gertler rate. In these circumstances, the Fed’s so-called liquidationists. said the Fed should raise rates if inflation program would be frustrated. A recent front-page story in The rising asset prices fuel inflation, For this reason, Bernankeism Wall Street Journal delved further into but not to prick a bubble. “A advises the central bank to avoid the the pending chairman’s views on the bubble, once pricked, can easily zero bound problem by creating a Depression. degenerate into a panic,” they constant state of pleasant and benign said. When the bubble eventually inflation of around 2–3%. This will For decades, many economists and collapses on its own, the Fed keep the economy a safe distance policy makers thought the should cut interest rates to limit away from the dangerous precipice Depression was the inevitable the damage to the financial beyond which lies deflation, and consequence of excess system and the broad economy. gives the Fed room to cut rates. investment, flawed corporate For an example of their thinking, governance and speculation in the and: I cite a speech titled “An Unwelcome 1920s, culminating in the 1929 Fall in Inflation” (2003). Dr. stock-market crash. That view The Depression, he contends, has Bernanke states: was reinforced by John Kenneth taught the importance of avoiding Galbraith’s 1955 book The Great both deflation — that is, generally I hope we can agree that a Crash, 1929. falling prices — and inflation. It substantial fall in inflation at this Milton Friedman and Anna has also shown the threat that stage has the potential to interfere Jacobson Schwartz upended that falling asset prices — such as, with the ongoing U.S. recovery, view in 1963. In A Monetary potentially, in housing — and and that in conceivable — History of the United States, 1867– weakened banks can pose. Most though remote — circumstances, 1960, they argued that the important, it shows the damage a serious deflation could do Depression was far from inevitable, the Fed can do when it follows significant economic harm. Thus, but brought about by an “inept” wrong-headed ideas. avoiding a further substantial fall Federal Reserve. First, they said, in inflation should be a priority of the Fed foolishly raised interest The failure of Japan’s central bank monetary policy. To my mind, the rates in 1928 to end speculation on to inflate its economy out of the mess central import of the May 6 Wall Street, causing a recession following the bursting of the 1980s’ statement is that the Fed stands the next year that precipitated the stock and real estate bubbles comes ready and able to resist further crash. Then, it let thousands of in a close second to the Depression in declines in inflation; and — if banks fail and the money supply the Bernanke manual for deflation inflation does fall further — to shrink. In part, it thought weak fighters. Four of the 14 Fed speeches ensure that the decline does not banks should be allowed to fail. It deal mostly or entirely with Japan’s impede the recovery in output also feared that lower interest rates attempt to inflate its way out of a and employment. might lead foreigners to dump series of recessions that followed their dollars, straining the currency’s bust. Despite successive Keynesian- LESSONS LEARNED FROM link to gold. stimulus public-works programs (that HISTORY have nearly paved the entire island of The second principle of Bernankeism Our next Fed chair, in a speech Japan into a parking lot), several is that central bankers must heed the given in honour of Milton Friedman years of a near-zero short-term lessons of history. According to the (2002), expressed contrition on interest rate, and a massive program papers and speeches, the Fed’s fear of behalf of central bankers everywhere of foreign exchange intervention that deflation is based on the two great in saying, “I would like to say to has left the BOJ holding hundreds of 20th-century failures of central banks Milton and Rose: Regarding the billions of dollars worth of US to inflate: America’s Great Great Depression. You’re right, we Treasuries, the BOJ has been unable Depression and the Case of Japan in [the Fed] did it [caused the to generate much inflation at all. the 1990s. Depression]. We’re very sorry. But To cite one of many examples, in Dr. Bernanke accepts Milton thanks to you [Friedman], we won’t a speech titled “Preventing Deflation: Friedman’s theory of the Great do it again.” The Fed has learned its Lessons from Japan’s Experience in Depression. In the Freidman view, a lesson. the 1990s” (2002) (a paper by four contraction of the money supply The Depression has also shown Fed staff economists) we read: brought about by loan defaults and that central banks should adopt an then bank failures turned what would “asymmetrical” attitude toward asset We conclude that Japan’s have been an ordinary recession into bubbles. Smile on the way up, and sustained deflationary slump was the Great Depression. This then, try to reinflate them on the way very much unanticipated by catastrophe could have been avoided down. From the same WSJ article. Japanese policymakers and

6 The Gloom, Boom & Doom Report February 2006 observers alike, and that this was ‘non-standard’ policy alternatives.” But in contrast to the limited type a key factor in the authorities’ What does he mean by “non- of securities the Federal Reserve failure to provide sufficient standard”? This is what passes for can purchase, it can accept as the stimulus to maintain growth and “thinking outside of the box” among security for a loan virtually any positive inflation. Once inflation central bankers. security that the Federal Reserve turned negative and short-term The reader of the Fed’s papers and Banks themselves deem interest rates approached the zero- speeches will find a series of acceptable. And in fact, the lower-bound, it became much increasingly exotic plans for the Federal Reserve accepts mortgages more difficult for monetary policy dollar. From beginning to end, these covering one- to four-family to reactivate the economy. methods range from the merely residences; state and local unsound to the bizarre and terrifying. government securities; and UNCONVENTIONAL The paper titled “Monetary Policy business, consumer, and other MEASURES? and Price Stability” (1999) notes. These notes can be open The term “conventional measures” introduces some of the more mild of market securities such as figures prominently in much of the the so-called alternatives. The first of corporate bonds and commercial Fed’s discussion. “Conventional these tools is to expand the menu of paper or can be commercial and measures” is a term from the central assets that the Fed could purchase industrial loans extended by banker’s dictionary. These measures through its open market operations. banks, for example. consist of essentially two things: The Fed’s current structure limits its controlling the short-term Fed Funds activities to the purchase of short- The measures described so far rely rate, and purchase and sale by the term US Treasury bonds. When the on loaning money into existence in Fed of government securities by its Fed can no longer lower short-term order to generate inflation. This so-called Open Market Committee. interest rates, long-term rates are the channel depends on the willingness The lesson of Japan, according to next obvious target. Among their of borrowers to borrow the cheap Bernankeism, is that when the options for lowering long bond yields money that the Fed prints. But what powers of a central bank are limited are: the purchase of long-term US if borrowers won’t borrow? Don’t to “conventional measures”, the Treasury bonds, writing interest rate worry, say the Bernankeists, we will central bank may not be able to option contracts, purchasing foreign print the money and distribute it. prevent deflation, nor to fight it once exchange reserves (in an attempt to From the paper titled “Monetary it has taken hold. In the Fed’s view, lower the exchange rate of the Policy When the Nominal Short- Japan tried conventional inflation dollar), and purchasing private-sector Term Interest Rate is Zero” (2005), in measures to their utmost. However, securities such as stocks and bonds. a section with the ludicrous title because the deflation caught them by The measures described in this paper “Wealth Creation”, we find: surprise or perhaps due to the would involve massive Fed inherent limitations of conventional intervention in US financial markets. In ordinary circumstances, measures, the BOJ’s efforts were too If the above methods were not monetary policy exerts its little, too late. sufficient to “stimulate aggregate stimulative impact in part through The third principle of demand”, the Fed could loan money increasing the financial wealth of Bernankeism is the necessity of into existence, accepting as collateral the public — such as producing “unconventional measures”. Inflation almost any private-sector asset capital gains in bond and equity is always the answer (according to whatever. In the paper titled markets. If, at the zero bound, the these thinkers), but they are afraid “Monetary Policy and Price Federal Reserve had already taken that it may be nearly impossible to Stability”, we find: what actions it could to raise bond bring it about when they most need it. and equity prices, it might look to Suppose that the Fed found itself A central bank can also attempt to other tools it has to increase the fighting a stubborn deflation. If spur private aggregate demand by public’s wealth. One tool conventional measures had been tried extending loans to depositories, commonly attributed to the and failed, and with the US on the other financial intermediaries, or Federal Reserve, at least in theory brink of following Japan down the firms and households. By making if not by the Federal Reserve Act, road to a long and painful deflationary the loan, the central bank turns an is that of conducting “money morass, what would be the alternative? asset that may be illiquid for the rains”. I quote Dr. Bernanke himself from lender into a liquid asset. This may Money rains are a clean way to a paper titled “Monetary Policy be particularly helpful in spurring study theoretically the effects of Alternatives at the Zero Bound: An aggregate demand should the increases in the supply of money. Empirical Assessment” (2004). When financial sector be under stress and In practice, it seems a bit difficult the economy is at the zero bound, “a in need of liquefying its assets. to envision how the Federal central bank can no longer stimulate In the United States, the Reserve could literally implement aggregate demand by further interest- Federal Reserve currently lends a money rain — that is, give rate reductions and must rely on only to depository institutions. money away either through

February 2006 The Gloom, Boom & Doom Report 7 directly disbursing currency to the stands ready to play its final card: the system” including “state and local public or by disbursing it through direct monetisation of goods and debt, real estate and gold mines the banking system. The political services. From the same paper, under — any asset”. difficulties that are likely to arise the heading “The Goods and from the Federal Reserve Services Solution”, we read: These “unconventional measures” determining the distribution of this all have two things in common: one, new wealth would be daunting. Why not have the Fed just that they are more inflationary than conduct an open market purchase the conventional central bank The above plan aims to decrease of real goods and services? Even policies; two, that they are among the the value of each dollar by increasing more so than exchange rate most absurd, bizarre, and preposterous the quantity in circulation. But what intervention, this strategy would monetary crank schemes ever if the Fed prints but people are represent a direct stimulus to proposed by anyone calling unwilling to spend? The next weapon aggregate demand. themselves an economist. Not to in their arsenal is to make money pay As posed, though, the strategy mention that some of these plans are a negative rate of interest. While that has a major drawback: it violates illegal (according to existing Fed sounds difficult, in the paper titled the Federal Reserve Act. The Fed regulations), though who doubts that, “Monetary Policy in a Zero-Interest- isn’t authorized to purchase goods in a crisis, this would be ignored? Rate Economy” (2003), two Fed and services, apart from those economists explain how: needed for the operation of the BERNANKEISM: FRAUD OR Federal Reserve System. MENACE? No one would be willing to hold The strategy can be Setting aside the legal and technical any asset that pays a negative implemented, however, by issues, another question remains: Do nominal rate, as long as zero- coordination with fiscal policy- they really mean it? Or is this just a interest money is available as a makers. The Federal government, lot of musings by academic store of value. The strategy for for example, could purchase goods economists with time on their hands? eliminating the zero bound, and services and finance the Too many boys with toys? Is therefore, is to make money pay a purchase with new debt, which Bernankeism a serious plan? Or is it negative nominal interest rate, by the Fed in turn would buy — in an orchestrated propaganda imposing some type of “carry tax” technical terminology, the Fed campaign? on currency and deposits. would “monetize” the resulting In attempting to answer that It’s easy to envision such a debt. question, we must not forget that system with regard to deposits at By coordinating with fiscal everything the Fed says must be the Federal Reserve or policy, the Fed could even looked at as propaganda. In the realm transactions deposits at banks; for implement what is essentially the of media relations there is surely the most part, the technology to classic textbook policy of nobody on the planet whose implement such a system is dropping freshly printed money utterances are more scrutinised than already in place. A tax or fee on from a helicopter. the Fed. The mere possibility of the Reserve deposits of 1 percent per removal of the word “measured” from month, for example, would mean The Financial Times of March 25, the statements accompanying recent that those deposits, in effect, pay a 2002 ran an article titled “Fed rate increases has spawned an entire nominal interest rate of roughly Considered Emergency Measures to body of analysis and commentary. A minus 12 percent. Save Economy”. The paper reported: Google search on “removal of the The technological difficulty word measured” yields over 500 hits. lies mainly in imposing such a tax The US Federal Reserve in The Fed is well aware of this and on currency. In the 1930s, Irving January considered a variety of it can only be assumed that Fisher of Yale University, one of “unconventional” emergency calculation plays a large part in their the greatest [sic] American measures to be taken if cutting artifice. Every statement by a Fed economists, proposed such a short-term interest rates failed to governor is without doubt carefully system, in which currency had to arrest a US recession and prevent crafted and vetted as a part of its be periodically “stamped”, for a Japanese-style deflation. One of overall message. The Fed’s fee, in order to retain its status as those steps may have been a plan management of the media, dubbed by legal tender. The stamp fee could to buy US stocks. some the “Open-Mouth Committee”, be calibrated to generate any is a key part of the manipulation of negative nominal interest rate According to the reporter, an public opinion that preserves the Fed that the central bank desired. unnamed source was quoted as mystique. follows: Even the Fed itself is not secretive If “aggregate demand” has not about their use of opinion been sufficiently stimulated by the the Fed “could theoretically buy management. One of Bernanke’s above measures, the Bernanke Fed anything to pump money into the papers, “Monetary Policy

8 The Gloom, Boom & Doom Report February 2006 Alternatives at the Zero Bound: An likely is it that the United States will Bernanke and Greenspan. While Empirical Assessment” enumerates see a long cash-building deflation, academic macroeconomists and “using communications policies to slowly falling consumer prices, and central bank researchers conduct a shape public expectations about the nominal interest rates near zero? Not heated debate about whether the future course of interest rates” as one very! central banks should prick bubbles or of the three main types of non- A few Austrian School just let them run out of steam on standard policies. And in “Central economists and assorted contrary their own, the question of their origin Bank Talk and Monetary Policy”, we thinkers (no doubt many readers of is politely ignored or passed off to a read: this publication among them) pathology of investor behaviour. recognise that the Greenspan reign The inconvenient fact is that Although effective has been one of rampant inflation. bubbles do not “just happen”, nor are communication by the central That this has escaped notice is only they an outgrowth of “irrational bank is always important, it because the Greenspan-era inflation exuberance”. In a market for credit becomes especially important has produced asset bubbles, rather that reflects the true scarcity of real when the rates are near zero. than rising consumer prices. funding, an investment boom that Indeed, when the proximity of the As we reach the end game of the increased demand for credit — in zero bound prevents further rate Greenspan era, it has become reality, a demand for scarce real cuts to stimulate the economy, difficult to find an asset that is not resources — would drive up interest talking about future policy actions over-priced. Even at the time of the rates. It is only because the central may be one of the few tools at the 2002 deflation scare, the housing banks maintain a supply of credit at a central bank’s disposal by which bubble was well under way. A recent fixed interest rate that the market’s to influence conditions in five-part series in the Wall Street mechanism for stopping asset price financial markets. Journal titled “Awash in Cash: Cheap bubbles before they start is defeated. Money, Growing Risks” documents Without the natural rise in Austrian economist Professor the inflation of nearly all asset classes interest rates due to the scarcity of Joseph Salerno has identified modern around the world, from the erosion of savings, increasing demand for credit macroeconomics as a “fiat risk premiums in stocks and bonds to can be accommodated while interest profession”, a manufactured the explosion in price of timberland. rates remain low, as long as the credit discipline whose purpose is to Dr. Faber wrote at the beginning of is channelled into asset markets. legitimise inflation among academics, last year that, for the period 2003– Asset bubbles are inflation by and whose development has been 2004, “the reflationary policies of Mr. another name. Ignoring the inflation funded by the centralised national Greenspan have managed to boost all that created the preconditions for states that wish to use inflation as a asset classes, including stocks, bonds, deflation is a rationalisation for a means of funding their profligate real estate, the art market, and permanent state of inflation. spending. Seventy years after Keynes, commodities”, a trend that continued Assets are only of value to the macroeconomic inflationism has throughout most of 2005. extent that they facilitate the become so entrenched in the Value managers are finding that production of final goods. From an economics profession that it has there are no values to be found. In Austrian School perspective, the formed the basis for the education of two recent Barron’s articles profiling economic problem resulting from two all university-trained economists. renowned value managers, Charles de decades of asset price inflation is that When false ideologies have been Vaulx (heir to Jean-Marie Eveillard the relative prices of financial assets, sufficiently entrenched, propaganda at First Eagle) and Irving Kahn compared to final goods, are far out of no longer depends on deliberate lies. respectively called attention to the line with the real cost of capital. Sincerely held beliefs by properly lack of real value in US markets. The real cost of capital must be trained experts are sufficient. Dr. Quoting de Vaulx: seen not in terms of bond yields, but Bernanke is most probably a true in terms of the scarcity of the means believer. Unlike Alan Greenspan, Five years ago, the beauty was we of funding investment projects via who got his start as a forecaster and had a bifurcated, two-tier market the sacrifice of possible consumption consultant before becoming a with very expensive growth stocks opportunities. In the absence of the government employee, Dr. Bernanke and tech stocks on the one hand interest rate price fixing practised by is a leading figure in the fiat macro and quite a few cheap small and central bankers, in a fully privatised profession, and his eminence in this mid-cap value stocks on the other. banking system this cost would be academic field pre-dates his That gap has disappeared, so accurately reflected by interest rates. appointment to the Fed. everything looks quite expensive Credit expansion can, for a time, I have no doubt that the authors in the U.S. create the illusion that there is more of the Fed studies would like to real funding available for investment implement their plans, if the Worldwide overpriced assets is the projects than actually exists, and a conditions played out the way that result of the asymmetric policies corresponding overvaluation of their theories describe. But how towards asset bubbles espoused by capital assets.

February 2006 The Gloom, Boom & Doom Report 9 However, while liquidity pumping in his book, What Does Alan of view, deflation is really more can push up asset prices, it does not Greenspan Really Think? Greenspan’s harmful than inflation. Indeed, create any more real savings. One knowledge is also proved by the there is a sense in which inflation way or another, the relative prices of release, after the five-year sliding wall, is infinitely more dangerous and assets representing claims on future of late 1990s’ Fed meeting minutes. needs to be more carefully production, expressed in terms of FOMC transcripts from the 1996 guarded against. Of the two errors, ratios to the prices of final goods, meetings show that, contrary to it is the one much more likely to must be realigned to reflect actual Greenspan’s statements at the time to be committed. The reason for this scarcities. That is, asset prices must the effect that a bubble cannot be is that moderate inflation is fall in relation to consumption goods. identified until it has burst, the generally pleasant while it There are two paths that will lead Greenspan Fed was aware that the proceeds, whereas deflation is to this result: one, a crash of stock market was in a bubble. immediately and acutely cascading debt defaults that would What is the rationale for the painful…. The difference between take down stocks, housing, and surely choice of hyperinflation over inflation and deflation is that, result in a systemic crisis for the US deflation? Does Bernanke believe with the former, the pleasant banking system; the other: an that he can engineer a soft landing? surprise comes first and the accelerating consumer price inflation Or do they truly believe that reaction later, while, with the (or even hyperinflation), in which deflation is more harmful than latter, the first effect on business the prices of end goods catch up with inflation? Some of the papers cited is depressing. There is little need the elevated prices of financial assets. above suggest that the Fed to take precautions against any Note that I do not include a “soft economists suffer from the belief that practice the bad effects of which landing” scenario, consisting of a rising asset prices represents the will be immediately and strongly gradual deflation of the asset bubbles creation of real wealth. felt; but there is need for with moderate inflation and From this false premise, the false precautions wherever action economic growth that over a period conclusion follows that asset which is immediately pleasant or of time will accomplish the needed deflation is wealth destruction. The relieves temporary difficulties realignment. Once bubbles stop idea that asset bubbles are beneficial involves much greater harm that inflating, they must lose air because a because the corresponding wealth will be felt only later…. It is bubble is a configuration of relative effects increase consumption implies particularly dangerous because the prices that is not consistent with real that collapsing bubbles are harmful harmful aftereffects of even small scarcities, and the tendency of because they drive the wealth effect doses of inflation can be staved off market forces is always to correct this in reverse. only by larger doses of inflation. type of discrepancy. Bubbles must Thinking as they do that asset Once it has continued for some inflate, or collapse. As the Austrian deflation is the problem and must be time, even the prevention of economist von Mises wrote: prevented at all costs, it is evident further acceleration will create a that when conventional measures no situation in which it will be very There is no means of avoiding the longer work, the central bank must difficult to avoid a spontaneous final collapse of a boom brought be ready to print money and buy the deflation…. Because inflation is about by credit expansion. The assets. This process may have already psychologically and politically so alternative is only whether the begun. There has already been much more difficult to prevent crisis should come sooner as the speculation that anomalously large than deflation and because it is, at result of a voluntary abandonment bond purchases from Caribbean the same time, technically so of further credit expansion, or sources that have shown up in this much more easily prevented, the later as a final and total year’s flow of funds data from the Fed economist should always stress the catastrophe of the currency system are a cover for Fed purchases of dangers of inflation. (Hayek, The involved. Treasury debt. Constitution of Liberty, pp. 330– From an Austrian point of view, a 333, cited by Joseph Salerno, While neither path is particularly deflationary correction is a healthy Quarterly Journal of Austrian appealing, the Bernankeists at the Fed process, bringing markets back in line Economics, vol 6, no. 4) are aware that they must inflate or die. with economic reality and enabling In spite of protests to the contrary, no production to proceed more in line Bernanke faces a precipice: he is one knows the score better than Alan with the actual scarcity of funding. worried about the aftermath of himself, who has staved off the Many economists of the Austrian multiple bubbles, but the relevant collapse several times during his School would side with economist comparison is to Argentina, not tenure by flooding the markets with Friedrich Hayek on this point, who Japan. He is worried about deflation, liquidity when the system threatened wrote: but the problem is multiple collapsing to unravel. Greenspan’s admission of asset bubbles, not slowly falling prices the possibility of a financial collapse It is, however, rather doubtful of goods and services. The Fed stands was first revealed by Lawrence Parks whether, from a long-term point ready to monetise anything and

10 The Gloom, Boom & Doom Report February 2006 everything, yet they cannot openly pubs/ifdp/2002/729/default.htm. Governor Ben S. Bernanke and Vincent state that they are playing this game 6. “On Milton Friedman’s Ninetieth R. Reinhart, presented at the without risking a run on the dollar Birthday”, remarks by Governor Ben S. International Center for Monetary and and a collapsing bond market. Bernanke at the Conference to Honor Banking Studies Lecture, Geneva, Bernankeism represents the final Milton Friedman, University of Switzerland, January 14, 2004. http:// Chicago, Chicago, Illinois, www.federalreserve.gov/boarddocs/ stand of central banking against the November 8, 2002. http://www. speeches/2004/200401033/default.htm. forces of economic reality. federalreserve.gov/boarddocs/speeches/ 12. “Money, Gold, and the Great 2002/20021108/default.htm. Depression”, remarks by Governor Ben References 7. “Deflation: Making Sure ‘It’ Doesn’t S. Bernanke at the H. Parker Willis 1. “Monetary Policy and Price Stability”, Happen Here”, remarks by Governor Lecture in Economic Policy, discussion paper by Karen Johnson, Ben S. Bernanke before the National Washington and Lee University, David Small, and Ralph Tryon, July Economists Club, Washington, D.C., Lexington, Virginia, March 2, 2004. 1999. http://www.federalreserve.gov/ November 21, 2002. http://www. http://www.federalreserve.gov/ pubs/ifdp/1999/641/default.htm. federalreserve.gov/boarddocs/speeches/ boarddocs/speeches/2004/200403022/ 2. “Monetary Policy When the Nominal 2002/20021121/default.htm. default.htm. Short-Term Interest Rate is Zero”, 8. “Monetary Policy in a Zero-Interest- 13. “Monetary Policy Alternatives at the James Clouse, Dale Henderson, Rate Economy”, Evan F. Koenig and Zero Bound: An Empirical Assessment”, Athanasios Orphanides, David Small, Jim Dolmas, Federal Reserve Bank of Ben S. Bernanke, Vincent R. Reinhart, and Peter Tinsley, November 2000. Dallas, May 2003. http://www.dallasfed. and Brian P. Sack, September 20, 2004. http://www.federalreserve.gov/pubs/feds/ org/research/indepth/2003/id0304.pdf. http://www.federalreserve.gov/pubs/feds/ 2000/200051/200051abs.html. 9. “Uncertain Times: Economic 2004/200448/200448abs.html. 3. “Fed Considered Emergency Measures Challenges Facing the United States 14. “Central Bank Talk and Monetary to Save Economy”, Financial Times, and Japan”, remarks by Vice Chairman Policy”, remarks by Governor Ben S. March 25 2002. (No URL, but article is Roger W. Ferguson, Jr. before the Japan Bernanke at the Japan Society available to paid subscribers of the FT Society, June 11, 2003. http://www. Corporate Luncheon, New York, on the Internet through archival federalreserve.gov/boarddocs/speeches/ October 7, 2004. http://www. search.) 2003/200306112/default.htm. federalreserve.gov/boarddocs/speeches/ 4. Minutes of the Federal Open Market 10. “An Unwelcome Fall in Inflation?”, 2004/200410072/default.htm. Committee, January 29–30, 2002. http:/ remarks by Governor Ben S. Bernanke 15. “Lessons of the ’30s: Long Study of /www.federalreserve.gov/FOMC/ before the Economics Roundtable, Great Depression Has Shaped minutes/20020130.htm. University of California, San Diego, La Bernanke’s Views (Fed Nominee 5. “Preventing Deflation: Lessons from Jolla, California, July 23, 2003. http:// Learned Perils of Deflation, Gold Japan’s Experience in the 1990s”, Alan www.federalreserve.gov/boarddocs/ Standard and Pricking of Bubbles)”, The Ahearne, Joseph Gagnon, Jane speeches/2003/20030723/default.htm. Wall Street Journal, December 7, 2005 Haltmaier, and Steve Kamin, June 11. “Conducting Monetary Policy at Very (p. 1). 2002. http://www.federalreserve.gov/ Low Short-Term Interest Rates”,

February 2006 The Gloom, Boom & Doom Report 11 BULLISH ABOUT Arabia, the United Arab Emirates, way or another, the relative prices EVERYTHING and Quatar point towards phase three of assets representing claims on I regard the current investment scene of my emerging stock market cycle future production, expressed in as most unusual, in the sense that theory, during which markets make a terms of ratios to the prices of everybody is very positive about one major top before a huge collapse final goods, must be realigned to or another asset class. Equity fund follows. But what will deflate the reflect actual scarcities. That is, managers around the world are booming economic and financial asset prices must fall in relation to positive about equities in both the conditions in the Middle East? A consumption goods. developed economies and in collapse in oil prices, or war? There are two paths that will emerging markets, while commodity What about the investment boom lead to this result: one, a crash of traders are positive about in China’s real estate markets and the cascading debt defaults that would commodities, gold bugs about continuous enormous industrial take down stocks, housing, and precious metals, property developers capacity expansion? Is a collapse of surely result in a systemic crisis for about real estate prices, art the Chinese economy imminent? the US banking system; the other: aficionados about art prices and In St. Moritz, where I spent my an accelerating consumer price collectibles, and bond investors about Christmas holidays, prices for luxury inflation (or even hyperinflation), bond yields declining further. This condominiums in the centre of the in which the prices of end goods universal bullishness about all asset village have skyrocketed. (Lakshmi catch up with the elevated prices classes is uncommon. If we look at Mittal, India’s richest man, bought a of financial assets. the 1970s, investors were, by and house about two years ago in a large, positive about the energy and prestigious location.) A few years ago, The deflationists, such as Robert mining sector, but cautious about nobody would have believed that Prechter and Gary Shilling — a equities, and negative about bonds prices for condominiums in the minority, I might add — certainly and the US dollar. Then, in the village centre would rise to between have a point in believing that “a 1980s, shortly before the 1987 crash, US$1,800 and US$3,000 per square crash of cascading debt defaults” will investors turned very positive about foot, and that a beer at the Palace “take down stocks, housing, and equities, but remained cautious about Hotel King’s Club would cost US$28! surely result in a systemic crisis for bonds and had given up on Latin As my friends at Gavekal Research the US banking system”, as Robert America. After the 1987 crash, the pointed out in their excellent book Blumen suggests as one possibility in investment community focused Our Brave New World (www.gavekal. order to bring down asset prices in largely on Japan and the Asian com), “being rich has never been so relation to consumption goods. In his emerging markets and remained very expensive and staying rich is going to Insight report of November 2005, cautious about the US, with the get more exorbitant by the day”. In Gary Shilling (www.agaryshilling. result that, by 1990, many financial New York, hotels are packed full and com) argues that institutions had more money invested room rates have risen sharply over in Asia than in the US. Then, in the the last two years as several hotels … history shows that the great late 1990s, investors loved the TMT have been converted to disconnect between the real world sector, while hardly anyone paid any condominiums. and financial markets will be attention to commodities. Asia, These boom conditions as closed sooner or later, and Russia, and “old economy” stocks and reflected in the “rich people’s” probably violently. Housing prices bonds were also shunned. economy are certainly not associated will no doubt fall substantially However, because of the fact that with great buying opportunities for nationwide, and that could since October 2002 all asset classes assets and, in fact, remind me of the destroy enough net worth to shift have appreciated in value, and also conditions I saw in Japan in the late the good deflation of excess because of the belief in the famous 1980s (before the asset crash of the supply we foresee to the bad “Greenspan put” as well as the 1990s) and in Asia before the 1997 deflation of insufficient demand. prospects of “Bernankeism”, crisis. In both cases, Japan and Asia, And meaningful cracks in house sentiment among investors is now when the boom came to an end, the prices will end U.S. consumers’ universally positive about all assets most leveraged players (mostly the quarter-century borrowing-and- appreciating further. So, as a sceptic rich, who had successfully capitalised spending binge and launch a and contrarian investor, I am deeply on rising asset prices during the boom saving spree…. A major global concerned about this “continuous with high gearing) were the hardest recession, or worse, could well asset inflation” consensus amidst a hit. result as Americans no longer buy benign “consumer price inflation” As Robert Blumen pointed out the world’s excess goods and scenario. For instance, as a casual above, services and export-led countries observer, I am stunned by the boom in Asia and Europe suffer. In these that is going on in the Middle East … while liquidity pumping can circumstances, stocks could and in the Middle Eastern stock push up asset prices, it does not probably fall well below the 2002 markets. All the symptoms in Saudi create any more real savings. One lows.

12 The Gloom, Boom & Doom Report February 2006 As an aside, Gary Shilling’s moderate, in part due to very directions, the implications for November 2005 Insight report is modest growth in unit labor policy may differ. Because some recommended reading, as Gary deals costs…. Expectations of future asset prices may fall more abruptly there with “Greenspan’s Legacy”. inflation have fallen, and there than they rise, and because the Having personally known Alan appears to be confidence in effects of downward moves in Greenspan for 35 years, Gary offers an continued stable, low inflation. asset prices on demand may be excellent review of the Fed chairman’s Credit spreads and measures of larger due to the greater negative achievements. He concludes that, future volatility derived from impact of deflation on the net financial market data have fallen, worth of borrowers — witness the … declining inflation made his suggesting that investors and United States in the 1930s or tenure easy. He didn’t aggravate savers expect the greater realized Japan in the 1990s, the case for anyone by stopping speculation. stability in growth is likely to adjusting monetary policy in Indeed, by bailing out speculators, endure. Real interest rates at response to negative asset price creating confidence in his longer horizons have remained shocks is commonly considered leadership and trust that the Fed relatively low, reflecting at least more compelling than in the really is in control of financial in part that the global supply of alternative context. But this markets, he encouraged savings has increased relative to does not mean that monetary speculators to take even bigger demand for investment. policy should generally ignore risks…. Greenspan appears to be a the effects of increases and only flesh and blood human being who But after this requisite “party line respond to observed declines in was extremely lucky with timing crap”, Noble contends that Geithner asset prices. The test should be [due to the disinflationary forces, went on to announce the end of the the size and circumstances of the notably declining commodity “Greenspan Put”: asset price moves and their prices and the entry of China into impact on the forecast relative to the global economy, that That said, monetary policy still the central banks’ objectives, accompanied his tenure as Fed has to take into account the not the direction of the asset chairman — ed. note]. The impact of significant movements price move [emphasis added]…. prospective next Fed Chairman, in asset values on output and Consider the case in which it Ben Bernanke, is also a mere inflation. Financial asset prices, by seems prudent for the central mortal, but will not inherit such their nature, allocate resources bank to incorporate an fortunate circumstances. Indeed, between the present and the assumption for a significant move Greenspan’s legacy will no doubt future and thereby affect in the rate of change in future force him to deal with some very consumption, investment and asset prices into its forecasts for difficult problems. future growth. History provides us output and inflation. If the with numerous examples in which central bank’s assumption is that Our regular readers will know that significant movements in asset asset prices are likely to fall over I am leaning towards the view that prices have had sizable effects on the forecast horizon, perhaps in under “Bernankeism”, the US will the path of output relative to the wake of a sustained rise in attempt to inflate its way out of any potential and on price stability…. those prices, then it might in turn future problems that might arise from Of course central banks must forecast a softer path for aggregate declining asset prices. But this always be prepared to respond demand. These changes in the doesn’t mean that within a rising when factors threaten to push outlook might imply a lower long-term trend for asset prices, aggregate demand away from expected path for the target rate meaningful short-term setbacks aggregate supply and impact the than would have been implied by cannot occur. Grant Noble inflation outlook. Movements in a different assumed path for the ([email protected]) recently asset prices certainly have the behavior of asset prices. If it turns commented on a speech by Timothy potential to be one of those out that the anticipated fall in Geithner, president of the New York factors, and the implications of asset prices does not materialize, Fed, in which Geithner made some this approach apply in both the policy constructed under the unusual comments. (The speech is directions. In other words, central assumption of a decline will likely available at www.newyorkfed.org/ banks have to be prepared to have been too easy, and that newsevents/speeches/2006/ adjust policy when past asset price might itself contribute to further gei060111.html.) According to increases could be a significant rises in asset prices. Noble, Geithner first spouted “the factor putting upward pressure on usual lying pap” on low-core inflation aggregate demand, as well as when Grant Noble’s interpretation is and why long rates are so low: past declines threaten to reduce that Geithner is keen to defend the output relative to potential. bond market and is not concerned Inflation excluding food and Although the potential case for about the stock market. Grant energy, however, has been quite adjusting policy applies in both Noble:

February 2006 The Gloom, Boom & Doom Report 13 That means short rates are going of end goods catch up with the AN ATTEMPT TO DRAW higher whether you like it or not elevated prices of financial assets”. SOME INVESTMENT because the inflated stock market In this respect, it is interesting to CONCLUSIONS has helped spur inflation that will note that, as The Bank Credit If I look very simplistically at the eventually kill bonds and further Analyst showed in its November world, the following observations rev gold (the arch enemy of the 2005 issue, “the gap between spring to mind. paper currencies that we use to headline and core consumer price There are markets in the global manipulate the world). inflation” is at its widest (see economy that are glutted, while in Figure 5). The question is, of other markets relative shortages are My interpretation of Timothy course, whether headline inflation evident. There is plenty of sand in Geithner’s speech, however, is (which includes energy and food the desert and plenty of sea water in slightly different. Yes, the Fed will prices) will decline again towards the sea. There is also plenty of paper continue to increase short-term core inflation, or whether core money floating around, especially US interest rates in baby steps for as inflation will eventually rise dollars, and paper money’s supply is long as the housing market and the towards headline inflation. limitless. Conversely, there are stock market rise. But, in my Another question should be markets where relative shortages do opinion, should the Dow no longer whether the concept of core exist. There is a limited supply of rise or decline by 300 points, the Fed inflation shouldn’t be abandoned precious metals, oil, and other will stop raising rates. Moreover, altogether, because the typical commodities. There is also a limited should the housing and share market household’s cost of living increases supply of caviar, truffles, and Park decline by 5%, Fed fund rate cuts are not reflected by core inflation Avenue, Mayfair, and St. Moritz would almost inevitably follow. I am but headline inflation. (A pensioner properties. Therefore, over time, it therefore of the view that, under in the UK recently sent an angry would seem to be logical that markets Bernankeism, the adjustments letter to the Financial Times which are glutted and where the Robert Blumen talked about will complaining that the government’s supply can be increased at discretion occur as a result of “an accelerating inflation figures were bogus, and (paper money) will depreciate consumer price inflation (or even showing that his cost-of-living compared to markets where the hyperinflation), in which the prices expenses had risen by at least 10% supply is limited. over the past 12 months.) This isn’t to say that markets where we find relative scarcities cannot decline in price. New Figure 5 Headline and Core Consumer Price Inflation, 1994–2006 inventions, political events, and shifting tastes can change the demand or even increase supplies. Moreover, central banks could reduce the supply of money, in which case the price of money will tend to appreciate against other commodities. However, it should be evident that with asset prices being as elevated as they are at present, and with the debt level we have in the system, significant monetary tightening, as Paul Volcker undertook in 1979–1981, is simply out of the question — even if core inflation were to accelerate considerably. As Robert Blumen showed, Bernankeism will be very responsive to asset price declines. Moreover, extraordinary monetary measures in order to support asset markets are a distinct possibility. In addition, while Timothy Geithner, president of the New York Fed, could be considered a “hawk”, it is obvious that he views “the case for adjusting Source: The Bank Credit Analyst monetary policy in response to

14 The Gloom, Boom & Doom Report February 2006 negative asset price shocks” to be “more compelling than in the Figure 6 Gold Spot Price (dollars per ounce), 1976–2006 alternative context” (the alternative context being rising asset prices). Simply put, the Fed will only very timidly address soaring asset prices, but it will flood the market with money should asset prices decline meaningfully. In this respect, it is important to understand that there will be a time when additional money printing will fail to stimulate consumer demand (declining real personal incomes as a result of headline inflation significantly exceeding wage increases for an extended period of time). Heavy monetisation will then only lead to soaring asset prices in real terms whose supply is very limited. Maybe Sources: www.yardeni.com; www.oakassociates.com the recent strong rise in the price of gold is an omen of things to come. (Since Mr. Bernanke was appointed Fed chairman in November 2005, its Table 1 US GDP and Total Credit Market Debt (US$ billions) price has risen from US$470 to over US$550 — see Figure 6.) Increase in Total Dollars of Credit Market Debt Increase A reader of this report, Pierre Decade Credit Market Debt Growth for Each New Dollar of in GDP Vohl, kindly sent us two tables Outstanding GDP Growth compiled by the Contrary Investor 1950s $ 161.9 $ 286.5 $ 1.77 (www.ContraryInvestors.com) which 1960s 491.4 752.2 1.53 show that monetary policy is gradually losing its effectiveness in 1970s 1,655.9 2,791.4 1.69 terms of economic growth in the US 1980s 2,923.8 8,544.1 2.92 (see Tables 1 and 2). However (and 1990s 3,935.2 12,379.0 3.15 this is important for the outlook of 2000s 3,081.5 13,623.5 4.42 industrial commodity prices, which are economic sensitive), strong US Source: www.ContraryInvestor.com monetary and debt growth continues to stimulate demand in emerging economies, which could lead to still higher prices for oil and other Table 2 US GDP and M3 (US$ billions) industrial commodities whose supply is relatively limited. Growth in M3 for Every Dollar Decade M3 Growth Increase in GDP I shall add one observation of GDP Growth regarding the recent high total credit 1960s $ 316.3 $ 491.4 $ 0.64 market debt and M3 increases. In the 1970s 1,192.8 1,655.9 0.72 1960s it would have been 1980s 2,268.2 2,923.8 0.76 unthinkable that debt and money supply would ever increase at the 1990s 2,474.7 3,935.2 0.63 present rate. Therefore, we cannot 2000s 3,547.0 3,081.5 1.15 rule out that debt growth and money Source: www.ContraryInvestor.com supply growth will accelerate in the future by far more than we now think to be possible. So, given the above-outlined should a contrarian investor do? therefore, liquidate their stocks, monetary policy options and the Should investors bet that asset properties, commodities, and art current universal bullishness of prices will take a tumble in a bout of objects, and go into cash? investors about all asset prices “bad deflation”, as Gary Shilling and It is important here to focus on increasing further in value, what Robert Prechter suggest and, the most widely held of all beliefs —

February 2006 The Gloom, Boom & Doom Report 15 the mother of all consensuses, which however, financial assets such as financial assets have declined against is that consumer price inflation will equities, but especially cash and the price of gold (gold prices rising), remain low and that interest rates bonds, declined against gold — a there will be recognition that only won’t rise significantly. That this is trend I expect to continue under gold serves as a store of value followed “the consensus” is evident from the Bernankeism. by a universal rush to move out of low bond yields we find around the Moreover, measuring everything cash into bullion. (In 2005, gold prices world. in gold terms would also, at some rose in every currency.) But at what So, the contrarian investor should point, satisfy the deflationists who price will this universal rush into first sell bonds here or on any believe in a debt contraction. If the bullion occur? If every man, woman, rebound expecting consumer price gold price soared to where I think it and child in the world were to move inflation and interest rates to rise. On might go, in gold terms total credit some of his cash into one gram of gold first sight, a rise in interest rates market debt could indeed be reduced. every year, it would equate to an would not be favourable for asset And while Gary Shilling and Robert annual demand of 6,000 tons, which markets and could lead to some Prechter might be right in expecting would be two-and-a-half times the weakness. But under Bernankeism, stocks to sell off and take out the annual supply of about 2,500 tons. any weakness in asset prices would be October 2002 low, it should be noted Therefore, the new market-induced addressed by the Fed — and that in gold terms the Dow Jones has gold standard will lead to sharply presumably by other central banks already declined below its 2002 low higher prices — in particular, against around the world — with (see Figure 4). financial assets (see Figure 7). expansionary monetary policies. This In the end, investors anticipating Therefore, investors are advised to would most likely stabilise asset more asset inflation could be right, as accumulate gold and other precious markets and, in fact, would likely well as the contrarian who would now metals now or on any weakness. boost them further. But, under these liquidate all his assets and move into Based on the aforementioned, it circumstances, would asset markets cash. Under Bernankeism, all asset would appear that from a risk-reward rise in real terms? And what are “real prices — except bonds — could point of view, the US dollar and US terms” in the first place? Assuming continue to appreciate, but cash could bonds are the least attractive assets. the Dow Jones increases in a year by do even better. However, I don’t mean Investors should focus on assets that 10% while US inflation is 5%, the paper money cash, but cash in the are in relatively short supply, such as Dow would have risen in real terms world’s hardest currency — gold. In precious metals. In fact, I would by 5%. However, if in the same year fact, I believe we are moving back argue that a good long-term strategy the US dollar weakens against towards a gold standard. But not a that will never fail is to buy what another important currency by 20%, gold standard introduced by some central bankers are selling (gold by how much did the Dow appreciate central bankers; rather, a gold below US$300, and up to the in real terms? I suppose one could standard created by the market. When present day) and to sell what central argue that, in this instance, the Dow in every country the public realise that bankers are accumulating (US would have lost 10% in real terms. the value of cash deposits and other dollars and US dollar bonds). What I am driving at is that in a world of monetary and credit expansion, it’s not all that simple to measure real terms. Figure 7 Gold Cash Price Relative to S&P 500, 1976–2006 Possibly the best option would be to measure all price increases against the price of gold because of its relative scarcity. So, if the price of an asset increased at a faster rate than the price of gold, then we would have a “real” price increase; whereas if the price of an asset increased at a slower rate than the price of gold, we would have a decline in price in “real terms”. While not perfect, this methodology has several advantages. Measuring asset price movements against gold would show that between 1980 and 2000, financial assets performed superbly, as bond and equity prices rose rapidly while Source: Ed Yardeni, www.oakassociates.com the gold price declined. Thereafter,

16 FebruaryThe Gloom, 2006 Boom & Doom Report The Gloom, Boom &February Doom Report 2006 16 For investors who are required to volatility to increase far more under surest way to ruin a man who own financial assets, I continue to the new Fed chairman — especially doesn’t know how to handle money recommend a significant overweight given the universal bullishness we is to give him some.” I would like to position in Asian high-dividend- are encountering at present. add to those words the following: paying stocks. A huge wealth transfer Therefore, investors should look for “The surest way to ruin a currency from the US to Asia is under way as a opportunistic entry points in the VIX and a society is to have a central result of the US current account (see Figure 9). banker with the power to print deficit, which is largely offset by This report started with a quote money and to take extraordinary current account surpluses in Asia. from George Bernard Shaw: “The monetary measures.” Consequently, we should expect Asian asset price increases to outperform US asset prices. This Figure 8 Monthly Nearby Sugar #11 (NYBOT), 1971–2006 outperformance is likely to occur as a result of higher property and stock price increases in Asia than in the US, as well as through Asian currencies rising over time against the US dollar. A list of high-dividend-paying Asian stocks that (unlike bonds) would provide at least some hedge against a further depreciation of the purchasing power of paper money includes in Malaysia: Berjaya Sports Toto Berhad (BST MK), Fraser & Neave Berhad (FNH MK), SP Setia Berhad (SPSB MK), Malaysian Oxygen Berhad MOX MK), IOI Properties Berhad (IOIP MK); in Vietnam: Vinamilk; in Singapore: Singapore Press Holdings (SPH SP), SIA Engineering (SIE SP), Suntec REIT (SUN SP), Macquarie MEAG Prime REIT (MMP SP); and in Thailand: Rojana Industrial Park Source: www.mrci.com, Moore Research Center, Inc. (ROJANA TB), Ticon Industrial Connection (TICON TB), Thai Reinsurance (TRE TB). Due to the high yield of the Figure 9 Volatility Index – New Methodology ($VIX), Taiwanese and Malaysian stock January 2004 – January 2006 markets compared to local bonds, we continue to like Taiwanese and Malaysian equities (EWT and EWM). As mentioned in previous reports, I would maintain an overweight position in US pharmaceutical shares such as Pfizer (PFE), Merck (MRK), and Schering Plough (SGP). Two years ago, I became interested in sugar and actually recommended its purchase on numerous occasions. Sugar moves seldom, but when it moves the amplitude of the move can be huge (see Figure 8). Purchases are recommended with tight stops. Lastly, I have recommended the purchase of volatility on previous occasions. Last year the Volatility Index increased twice by more than 50% (see Figure 9). I expect Source: www.decisionpoint.com

17 FebruaryThe Gloom, 2006 Boom & Doom Report The Gloom, Boom &February Doom Report 2006 17 THE GLOOM, BOOM & DOOM REPORT © Marc Faber, 2006

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