Bail-Out Mentality
December 2000
The Dangerous Bail-Out Mentality
The Federal Reserve Bank of the United States and its chairman and leader, Alan Greenspan, have earned a reputation that is approaching godliness. The Fed, as it is fondly called, bailed out the U.S. banking system in the early 1990s. It bailed out Mexico in the “Tequila Crisis” of 1994-95. It played a role in stabilizing the world financial system following the widespread currency meltdown that struck nearly all of the countries in the Far East in 1997. It bailed out the U.S. bond market in the Long-term Capital Management/Russian currency crisis of 1998.
In addition to repeatedly saving the day when financial crises strike, the Fed is receiving praise for properly managing our country’s extended period of uninterrupted economic growth while at the same time controlling price inflation. The Fed is also receiving credit for having encouraged our federal government to balance its budget and greatly slow the growth of total government debt. All these good works and public adulation work hand in hand to build confidence. That confidence has resulted in a soaring stock market and an acceptance of unprecedented wealth as commonplace and permanent. Another offshoot is the respect the dollar has earned in the foreign currency markets.
All of this has led folks to conclude that finally, because of the Fed, man has been able to get a handle on the business cycle. It’s not that folks believe business conditions won’t cycle somewhat, but they are fairly convinced that since the Fed doesn’t allow excesses on the upside, it won’t allow excesses on the downside. Therefore, the prospects of a stock market debacle like 1929-32 or another Great Depression are considered obsolete.
Settling in for the Long Term
It’s interesting the number of folks who tell me that as long as they invest with long-term goals, they don’t have to worry about the market. These same believers frequently mention the Fed and the government as stabilizing forces that will certainly come to the market’s or the economy’s rescue if they were to drop or slow too much. And that is why they insist that if investors just set long-term goals they will most certainly succeed.
There are three additional factors modern investors will invariably point to as reasons their patience will pay off handsomely in the years to come: professional management, the unrelenting flow of funds into retirement accounts invested in the stock market, and improved communications.
I was in the breakfast room of a roadside motel the other day having one of those “free” breakfasts. A gentleman was sitting at the table next to me. We struck up a conversation about the presidential race. He seemed like a well-informed individual, so I decided to press his button on the stock market. I mentioned that I believed the stock market was heading lower over the next 10 years and it wouldn’t make any difference who was president of the United States. He firmly disagreed with me and starting ticking off the reasons why. He pointed to professional management, the unrelenting flow of funds into retirement accounts invested in the stock market, improved communications, and that high tech always grows. Then he mentioned that the Fed and the government wouldn’t let the stock market decline for an extended period of time, because it wasn’t good for the country.
This fellow’s picture of our modern age mirrored that of the masses.
Naturally, all of us would like to live in a bed of roses. It’s an age-old dream. But that doesn’t jive with history. Generally speaking, man has gotten more sophisticated over time, but he’s never gotten any wiser. Folks were quite smart in the 1920s, and the Fed was there. Folks were quite smart in the 1960s, and the Fed was there. In both eras the economy ended up getting in trouble. In both eras the dollar fell apart. In both eras the stock market lost most of its value. (As measured in constant dollars the DJIA fell 85.7% from 1929 to 1932 and 74.8% from 1966 to 1982.)
Fed’s Main Tool Is Easy Credit
The primary factor behind most economic slumps is a credit contraction. Credit expands, reaches an unsustainable level, and then contracts. That negatively impacts the economy and the markets. That is what used to happen before the creation of the Fed. And that’s why folks wanted to create a Fed. They wanted a banker’s bank, a central bank, that could eliminate or smooth out the negative impact of credit contractions. What they didn’t factor into their equation is that the only weapons the Fed has in its arsenal to manage economic growth is more credit and fluctuating interest rates. Therefore, the only long-term consequence of a central bank’s effort to manage an economy is continuous and seemingly never-ending credit expansion.
What happened during the 1930s and the 1970s was that credit in the private sector contracted. In the former case the private sector credit system unwound and the currency’s purchasing power took a mild hit. In the latter case the overall credit system still expanded (with many private sectors imploding) compliments of massive government expenditures, and the currency’s purchasing power took a mighty hit. The hit in the 1930s was the Fed’s first real experience with a contraction. Afterwards, politicians and leaders said they’d never let that happen again. So when the contraction hit in the 1970s, the Fed and the federal government fought the tape and the consequences differed from the 1929-32 debacle.
Our nation’s economy and the entire world’s economy have been growing vigorously for the past 10 years. Consumptive credit has mushroomed. Businesses expanded to meet the accelerated demand, revenues soared, and accelerated cash flow pushed earnings higher, tax receipts up, and the government’s budget to a breakeven. Current times don’t look like they could be any better.
Even though this may be the best of times, debts aren’t like sales and earnings. Debts are permanent. Sales rise and fall and earnings are leveraged by the sales. When sales rise, earnings soar, and vice versa. Problems develop after there’s been an extended period of increasing sales when most of the increases in sales were financed with short-term consumptive debt and the debt totals increased versus incomes.
Short-term financings for inventories are totally different from short-term financings for consumption. Short-term debts secured with inventories can be paid off by liquidating the inventories. Short-term consumptive debts are usually met with excess cash flow, by drawing down savings, or the sale of highly liquid, unencumbered assets. Unfortunately, during economic slumps excess cash flow, savings, and markets for highly liquid, unencumbered assets are usually depressed.
We’ve Spent Ourselves Rich
The perpetual growth and prosperity that everyone hails as the Fed’s greatest achievement has been a product of the Fed’s skillful manipulation of credit. That manipulation literary stacked new debt on top of old debt just like you’d stack children’s wooden blocks. This stacking of debt has set the stage for two different cycle phenomena. One is a short-term cycle and the other is a long-term secular cycle. For 60 years now, total debt has grown virtually nonstop. But there has been many short-term cyclical “corrections” along the way. For a fact we will continue to have short-term cyclical corrections in this long-term debt cycle. These short-term pauses in the consumer’s desire to take on additional consumptive debt leads to recessions and financial dislocations. To counteract these consumer lapses, for the past 60 years the Fed and the federal government have adopted stimulative practices. As a nation we’ve literally spent ourselves rich.
Someday that tactic will fail. That’s when “just another” short-term cyclical contraction toggles a secular cyclical correction and the entire credit buildup dating back to 1932 unwinds. History indicates that such a scenario will eventually happen. When that secular contraction gets underway, Alan Greenspan and his Fed will be powerless in the face of what will be overwhelming market forces. How a future secular contraction unfolds is anyone’s guess. In our “modern” society, credit and currency are the same things. (Yeah, the caveman couldn’t have been that stupid.) Since they are the same, they will both play a debilitating role in a secular contraction. Most likely the currency will lose most of its remaining purchasing power. Total credit may or may not expand. Yet overextended sectors of the business and consumer communities will certainly fail. Most sectors will struggle. The government may spend mightily with borrowings financed by the Fed. But the falling currency may derail the stimulative effect of the newly issued credit and price inflation may mask many internal dislocations like it did in the 1970s. For sure, the economy will contract, unemployment and interest rates will soar, and the stock market will fall in value.
What’s really bad about the prospect of a recession/depression today is the mindset of most of the folks in our society. The people believe in the system. They believe in the Fed. They believe that by holding onto stocks they are doing the right thing for the country and for their own individual gains.
Bad Times Will Bring Ugly Truths
When the economy goes into a slump and the stock market falls, people will face some shocking truths. Unfortunately, they will not always draw the appropriate conclusions. Because they believed in the system, they will assume they were conned. If a recession becomes a depression, they may assume that George Bush didn’t do enough and that he is to blame. The seeds of discontent toward our government were sown by the fragmentary presidential race and hotly contested vote count. Since the Florida votes were never “hand counted,” that will continue to eat away at the psyche of many folks. And people like Jesse Jackson and his son will have a field day.
Shortly before Al Gore gave the speech of his life, a concession speech no less, Rep. Jesse Jackson Jr., D_Ill., urged Democrats to abide by the Supreme Court decision but said that “with every bone in my body and every ounce of moral strength in my soul” he disagreed with the high court. He called it “a willing tool of the Bush campaign” that “orchestrated a questionable ‘velvet legal coup.’” In his concession speech, Gore briefly echoed Jesse’s sentiments.
So our country is moving ahead with what many folks believe in their hearts is an illegitimate president and a politicized legal system. If those problems are eventually compounded with an economic depression, currency collapse, and stock market crash, we’ll have the makings for a revolution.
Yes, I’m concerned. The NASDAQ index has collapsed and is heading lower. The constant dollar DJIA and the S&P 500 indexes are on the verge of breaking their long-term uptrend lines. Talk of recession is commonplace in the media. Everyone is expecting certain individuals (namely, Alan Greenspan and George Bush) to make sure their dreams and expectations are met. Everyone is relying on the system. But it’s the system that brought us to this brink.
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