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THE GLOOM, BOOM & DOOM REPORTISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED NOVEMBER 23, 2001

Long Live Deflationary Shocks,and Down with Central Bankers

Who Want to Prevent Them!

In all the more advanced

communities the great

majority of things are worse

done by intervention of

government, than the

individuals most interested

in the matter would do

them, or cause them to be

done, if left to themselves.

John Stuart Mill (18061873),Principles of Political Economy

INTRODUCTION

I have just returned from visitingDelhi, Mumbai, Singapore, Shanghai,and Dubai. Mumbai and Shanghai areboth impressive cities from aneconomic development point of view.In the case of Mumbais inner city, theremarkable feature is that little haschanged since my first visit to themetropolis in 1973, except that itsbuildings are now even moredilapidated. The reason for this lack ofdevelopment of the infrastructure inthe inner city is a maze of totallyantiquated property laws that haveprevented landlords increasing therents on the premises they let out,with the result that they have noincentive to maintain their propertiesin good condition. Furthermore,tenants have the right to stay in theirapartments for as long as they wish,and the children of tenants can eveninherit the leases taken out by theirparents, many of which date back tobefore the Second World War. Afriend of mine told me that years ago

he inherited an apartment building inthe city for whose apartments he iscollecting a rent of less than US$1 amonth! This lack of any property

development over the last 25 years,unlike elsewhere in Asia, is alsointeresting given that economicactivity is shifting to the outskirts ofthe city and to other regions of thecountry, where Indias totallyincompetent government is unable tohamper economic development to theextent that it has in Mumbais innercity. I can do no better, in describingthe Indian bureaucracy, than quotethe 11th-century Chinese poet Su

Tung Po, who wrote:

Families when a child is born,Want it to be intelligent.

I through intelligenceHaving wrecked my life

Only hope the baby will prove

Ignorant and stupid.

Then he will crown a tranquil life

By becoming a Cabinet Minister.

Still, what is reassuring about India

is that, despite its horrendousbureaucracy, entrepreneurs havethrived and India is now home tomany very promising companies doingbusiness in all kinds of sectors, butespecially in the fields ofpharmaceuticals and software. Thegood news, not only for India but forthe entire global economy, is thatentrepreneurs are like rats whomanage to survive in just about anyenvironment, no matter how difficult,

and that they show an impressiveability to adapt to even the harshestcommercial and legal infrastructuresby developing a high degree of

immunity to these unfavourableconditions. Moreover, entrepreneurscan mutate rather quickly in order totake advantage of opportunities in

sectors such as software, for whichthere were no governmentimpediments or regulations in India.Such is the power of free markets overbad governments and governmentsinterventions in the economy. Yet it isdiscouraging to see Mumbai, thebusiness capital of the worlds second-most populated country, lacking alarge foreign business community,such as we find in New York, London,Tokyo, Singapore, and Hong Kong,

because of the governments inabilityto provide an efficient infrastructureand a more conducive businessenvironment. (Even morediscouraging is the virtually non-existent nightlife in Indias capital,Delhi!)

The Indian tragedy is that, in theabsence of its bureaucracy and with, toparaphrase Adam Smith, a tolerableadministration of justice (an efficientlegal system with straightforward

commercial laws and property rights),the country could easily grow ataround 810% per annum admittedly from a low base andboost per capita incomes significantlycompared to the present environment,which allows the economy to grow atonly around 5% per annum while percapita incomes hardly budge. Still, thismay be an opportune time forinvestors to purchase Indian shares.The Indian stock market, which

shouldnt have a meaningfulcorrelation to foreign markets sinceIndias economy doesnt depend muchon foreign trade and foreign portfolio

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2 The Gloom, Boom & Doom Report November 2001

flows (exports amount to just 10% ofGDP), is at present extremelydepressed and is, in my opinion,discounting to a large extent thecountrys problems (see Figure 1). Inaddition, time deposits as a percentageof total market capitalisation, whichhas declined to just 21% of GDP, are

now at an all-time high (see Figure 2).The various listed India Funds, such asthe Jardine Fleming India Fund (JFI),the MSDW India Investment Fund(IIF see Figure 3), and the IndiaFund (IFN), all sell at discounts ofaround 20% from net asset value andmight be a suitable vehicle forinvestors wishing to participate in theIndian corporate sector. For aninvestment in a fund with a strongerbias towards a bottom-up approach to

stock selection, our readers mightcontact Jon Thorn([email protected]) whomanages the Indian Capital Fund, ofwhich I am the chairman. Jon Thornhas, in the past, written about Indiafor this report. (See his contributionentitled The Best of Times, TheWorst of Times in GBD report of

July 20, 2001.)There could hardly be a stronger

contrast than travelling to Shanghai

after Mumbai: whereas inner-cityMumbai has stagnated in terms ofinfrastructure and real estatedevelopment, Shanghai has emergedas a modern and impressive city overthe last decade. In fact, the rapiddevelopment of its physical andcommercial infrastructure isunprecedented in history.Furthermore, as an Indian ministerpointed out to me, although it wasachieved at a certain price in terms of

human rights, the success Shanghaihas achieved in improving peoplesstandard of living and per capitaincomes far outweighs thoseshortcomings. I have been visitingShanghai regularly since 1989, and oneach visit I am struck anew by itscontinuously changing skyline and theextent and speed of its modernisation.And this is the same city that, tenyears ago when I first began to writeabout its impending emergence asAsias most important commercial andfinancial metropolis, businessmen inHong Kong dismissed as being far too

Figure 1 India 12-Month Forward P/E, 19932001

Source:ABN-AMRO

Figure 2 Time Deposits as Percentage of Indias Total Market

Capitalisation, 19932001

Source:ABN-AMRO

Figure 3 Morgan Stanley India Investment Fund (IIF), 19942001

Source:BigCharts.com

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November 2001 The Gloom, Boom & Doom Report 3

bureaucratic and lacking the necessaryeducational infrastructure to develop!

I also visited Suzhou, a city Ihadnt visited for over three years. Atthat time, there were just twoindustrial parks under construction onthe outskirts of the city; now there arefactories everywhere, with trucks

continuously moving goods to andfrom Shanghais port along a newlybuilt highway. While I am fully awareof the problems that are endemic tothe Chinese economy, including thedifficulties facing foreign companieswanting to make money (due largelyto the tremendous overcapacities inall industrial sectors and the inevitablespeed-bumps the Chinese economywill periodically hit), the changes thathave occurred in China in the last few

years are simply extraordinary. (Andyou may recall that I am rather wellknown for my somewhat cautiousviews about the health of Chinassocial and financial system.) Whileseated comfortably, on my way back toHong Kong, in a business class seat onChina Eastern Airlines withsignificantly more legroom than inany first class seat of a US air carrier,not to mention the far friendlierservice, I mused how in the future

airlines such as China Eastern andChina Southern would dominate theskies, while the Swissairs of this world,with their high cost structures, wouldbecome extinct.

My visit to the United ArabEmirates also held some surprises. Asin the case of Shanghai, both AbuDhabi and Dubai have developedrapidly in the last few years and havenow become far more cosmopolitanthan in the past. In particular, Dubai

has emerged as an important tradingcentre, being the gateway to a largenumber of Middle Eastern, CentralAsian, and North African nations, aswell as an enjoyable entertainmentand tourist centre for well-to-dopeople from around the region.Whereas Shanghai is impressivebecause of its size and rising economicpower, Abu Dhabi and Dubai impressthe visitor because of the money theruling families have spent over the lastfew years on building extravagantgardens and parks, as well asmonumental hotels. In fact, Dubai is

worth visiting just to see the Burj AlArab Hotel, the worlds only seven-star hotel, whose stunningarchitectural structure rises to morethan 40 storeys from a man-madeisland in the Persian Gulf.Admittedly, one could argue that theMiddle Eastern economies are

artificial, since they depend largelyon the price of just one commodity oil. But what is the difference betweenthe Middle Eastern economic system,which depends on the price of oil, andthe Western industrialised nations,which over the last few years haveincreasingly become dependent on theprice of their stock markets foreconomic growth? And on whatwould you rather bet your future: oil,whose price is now rather depressed

(at least in real terms); or Westernstock markets, which by any valuationstandard still appear to be expensive?

The purpose of this briefdescription of my recent trip is not,however, to draw any conclusionsabout the relative investment meritsof emerging economies compared tothe Western industrialised nations.(For such an analysis, see GBD reportsof May 16, 2001, entitled EmergingMarkets: An Unpopular but Depressed

Asset Class, and of July 20, 2001,entitled If the Purchase of EmergingStock Markets is Financial Suicide,What Then is the Buying of USEquities?.) Rather, it is to note that,

despite the fact that the emergingmarkets have grossly underperformedthe Western developed markets since1990 (see Figure 4), impressiveeconomic progress has taken place inmost developing economies over thelast ten years. Who, ten years ago,had heard of Bangalore and of Indias

now famous software andpharmaceutical companies, or spoke atdinner parties about Shanghaisstunning development and Chinaslarge trade surplus with the UnitedStates? And who at that time wasaware of Emirates Airlines, an airlinethat is now certainly better managedthan Swissair or Sabena in recentyears, or of the Emirates Tower HotelGroup, which owns and managesseveral luxury properties in Dubai

(among them the Burj Al Arab Hotel)and now also runs the Carlton TowerHotel on Londons Cadogan Square?

While I am aware of all theshortcomings of globalisation, it wouldseem to me that, over the last tenyears or so, whole regions that in thepast were absent from our Westernmarket economy and which shunnedour capitalistic system as a result oftheir adherence to socialist ideologiesand to the ideas of self-reliance and

hostility towards foreign investmentshave now been fairly well integratedinto a global economic system.Moreover, there is no doubt in mymind that over the same period, an

Figure 4 Performance of Asian and Japanese Markets Relative to

the United States, 19912001

Source:Gaveco

Asia ex Japan/US stock market index

[index 1994, MVM=Mean, RT=Effective, FC=standard)

Japanese index/US stock market index

[index 1994, MVM=Mean, RT=Effective, FC=standard)

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unprecedented amount of knowledge,new ideas, technology, managementtechniques, and capital was transferredto these developing economies.However, such a major and rapidchange for the global economy theintegration of close to three billionpeople into the worlds economy

who, until the late 1980s, wereparticipating only on the periphery ofthe capitalistic market economy also brings about a state of lastingdisequilibrium. Following an initialboom that lasted from the mid-1980sto the mid-1990s, the emergingeconomies experienced severe crises inthe late 1990s. These crises wereaccompanied by significant currencydevaluations or, in the case of China,by a deflationary environment, which

in aggregate badly deflated the pricelevel of the emerging world. In turn,the emerging world is now exportingtheir deflated price level to theWestern world and contributing to astructural deflationary shock in theglobal economy, very much in thesame way the opening of the westernterritories in the US and the openingof Australia to the production of grainin the second half of the 19th centuryled to a deflationary period that lasted

from the mid-1860s to 1900 (seeFigure 5).

DEFLATIONARY SHOCKS

In a free market economy, prices willrise and fall depending on demandand supply. A deflationary shock isbrought about by supply rising muchfaster than demand, a condition thatis usually brought about by some majortechnological breakthrough. The

application of a new innovation leadsto greater efficiencies of production orto new sources of production, or to acombination of both. In the secondhalf of the 19th century, the earlierconstruction of canals and railroadsand the emergence of efficient trans-ocean steamships loweredtransportation costs by around 90%and allowed grain grown in thewestern territories of the US and inAustralia to reach Europe, leading todeclining agricultural pricesthroughout the world. Thus, we cansay that the application of new

inventions led to the opening of new

territories. The combination of thesetwo factors in turn increased thesupply of agricultural products, whichwere then the worlds most importantcommodities and largely drove thebusiness cycle. (Simply put,agricultural commodities were then tothe world what oil is today to theMiddle Eastern economies, with risingprices leading to periods of economicexpansion and falling prices torecessions or below trend-line

growth.)Compare this to the current

environment. The opening salvo tothe current deflationary shock wasfired as long ago as 1956, whenMalcolm McLean (the founder of Sea-Land) introduced the first containership. The container was one of thegreatest inventions ever, because itallowed for efficient and speedytransportation and avoided the costlyand time-consuming process of

stevedores loading and unloading, andstowing cargo from ships to trucks, andvice versa. It is difficult to imaginethat world trade could have expandedby as much as it has over the last 50years or so without containers. Thencame the Boeing 747, which loweredthe cost of air travel and air-freight;the fax machine in the early 1980s,which significantly boosted theefficiency of transmitting information;and later the PC and the Internet,which brought down the cost ofcommunication to almost zero. At thesame time, foreign exchange controls

were removed around the world and a

global capital market permitted theeasy and speedy transfer of funds intoregions that promised high returns.Thus, when the ideology of socialismcame to an end and numerouscountries such as China becameincreasingly integrated into themarket economy, several newtechnologies and a global financialmarket were in place to facilitate andspeed up the process ofindustrialisation, with the result that

the world is now faced with enormousnew sources of supplies ofmanufactured goods and tradableservices, in the same way that WesternEurope was inundated in the secondhalf of the 19th century by agriculturalproducts coming from the AmericanWest, which led to the fall in pricesreferred to above.

That deflation is being exported,in the case of manufactured goods andcommodities, from emerging

economies to the industrialisednations, including Japan, is evidentfrom declining import prices (seeFigure 6) and, in the case of services,from the growing trend to outsourceall kinds of accounting,communication, and informationfunctions to countries such as theCaribbean Islands, Mexico, and India.In fact, the current deflationary shockwould reach far greater proportions if,along with the free flow of goods andcapital, labour could move freely fromone region of the world to another.One could even argue that there was

Figure 5 Wholesale Prices in France, Germany, and the United

States, 18201896

Source:David Hackett Fischer, The Great Wave

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far more freedom of movement acentury ago than there is today,because of much tighter migrationpolicies now. But if there was acompletely free movement of labourin our times, we would see millions ofpeople from poor countries migratingto countries with high price levels andseeking employment at high wages in

countries such as Japan, the US, andWestern Europe, and temporarilydepressing wages in the manufacturingand service sectors of thoseeconomies. However, totally freemovement of people would notnecessarily damage these economies inthe long run, but rather would benefitthem. This is so because if currenttight migration laws are maintained,more and more businesses will simplymigrate to low-cost countries such as

China, Mexico, and India (forservices), leading to above trend-linegrowth in these countries and belowtrend-line growth in the industrialisednations. Just imagine the effect of freemigration on Japans economy! Theunfavourable demographic trendswould be reversed and, with pressureon wages, the countrys competitiveposition would improve. A borderlessworld, which would consist not onlyof the free movement of goods andcapital, but also of labour, wouldalmost certainly increase the worldsGDP significantly at least in real

terms and benefit people living inpoorer countries, where even thosepeople who didnt migrate would havea better chance of findingemployment. Unfortunately, thecurrent strict migration policies inindustrialised nations are unlikely tochange (especially given the events ofSeptember 11), but even so, emerging

economies are in a position to exportdeflation. In the manufacturing sectorthis trend is already well under wayand will accelerate, as, given thecurrent recessionary environment,companies in high-cost countries (thedeveloped countries) will shift farmore production to emergingeconomies in order to cut costs. Andsince emerging economies with theirlow wages and, frequently, the absenceof property rights can put

infrastructure, such as roads, bridges,tunnels, power plants, airports,harbours, and so on in place at a farlower cost than the industrialisedcountries, and given their almostunlimited reservoir of cheap labour,countries such as China will in futurefurther increase their competitivemanufacturing advantage over thedeveloped countries.

However, the service sector isntimmune from this trend, as we haveseen in the case of Indias software,call-centre, and accounting industries.The entire international

transportation service industry couldbe taken over by emerging economieswith their low wages. It should beevident that while European airlineswith their high wage costs and poormanagement will fail, Asian airlineswith their low labour costs will takeover their business. The same is

occurring in the shipping and cruiseline industry, where most crewmembers originate nowadays fromdeveloping countries. Similarly, in thetrucking industry, Mexican driverswith their lower wages willincreasingly ship cargo betweenMexico and the US at the expense oftheir American counterparts.

Then there is the retirement andhealth-care industry. In the same waythat there was a huge migration of

well-heeled elderly northernEuropeans to lower-cost andclimatically more appealing placessuch as the Canary Islands, Majorca,and Ibiza, and along the entireSpanish coast, which has contributedto these regions economic growth inthe last 20 years, I can see that, intime, more and more people from theindustrialised countries will retire indeveloping countries where the costsof living are just a fraction of what

they are at home. Naturally, this trendwould accelerate significantly ifgovernment officials in the developingcountries had the sense to refrain fromtheir continuous anti-foreign rhetoricand allowed foreigners to ownproperty. (The retirement industrywill only really take off in emergingeconomies if foreigners have the rightto own landed property. This is,however, a thorny issue in mostdeveloping countries, because their

false sense of patriotism or, evenworse, their nationalistic bias makesthem think that the foreign,ownership of land amounts to sellingout their precious nation to evil andbarbaric foreign intruders, when infact, as a percentage of their totalproperty market, foreigners would beunlikely ever to own more than 1%.)But just think how the money spentby 100,000 retirees would boost theeconomy of a country such as thePhilippines, Thailand, Indonesia, orMalaysia. Assuming, veryconservatively, an annual spending of

Figure 6 US Import Price Index (yearly percent change),

19902001

Source:yardeni.com

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US$20,000 per foreigner (but morelikely US$30,000), US$2 billion (orUS$3 billion) would flow to thesecountries bottom line right away, notto mention the know-how and skillsthese retirees would bring with them,and the estates their soft hearts wouldleave behind to their new-found

communities! Yet, while thismigration trend is well under waywithin Europe (from north to south)and in the US (from everywhere toFlorida, Arizona, and Nevada), it stillrepresents only a trickle towardsdeveloping countries. Still, youngerpeople, who by the time they retirewill have travelled widely and perhapslived in several different countries,will be far more likely to adopt newhomes in foreign countries than their

parents who grew up, lived, andworked in the same city all their livesand travelled abroad onlyinfrequently. (This trend will also bereinforced by the rising number ofmultiracial families.)

The other service sector that isincreasingly becoming tradable ishealth care. There are a growingnumber of people who travel fromEurope to Singapore for dental care(much cheaper) and to Bangkok for

all kinds of bizarre operations. Incountries such as India, thePhilippines, and Thailand there areexcellent health-care facilities thatcost a fraction of what they cost inWestern countries.

Sceptics of this deflationary shockscenario will, of course, argue thatwhile some deflationary pressures doexist in the manufacturing sector,there will be no problem for mostservices, as people simply wouldnt

travel from a high-cost country to, say,Thailand just for a comparativelyinexpensive meal or to, say, Burundifor a cheap haircut. Moreover, theywould be correct in pointing out thatat present the migration flows stillfavour the developed countries, withfar more people from poor countriesmoving to rich countries than viceversa. But consider the following. If somany large companies have alreadyfound it advantageous to move theirback-office, and occasionally theirfront-office, functions from expensivedowntown areas to cheaper locations

in the suburbs or even the countryside,how great a step is it in a highly cost-conscious world to move at least someprocessing functions to places such asIndia, the Philippines, Russia, orChina? Moreover, it should beunderstood that there are businesses inthe service industry that create

wealth, as well as those that havestepped in to perform the workformerly performed by housewiveswho are now working womensupporting their families. Thus, I cansee the positive contribution toeconomic growth that service sectorcompanies such as temporary workagencies and courier services like DHLand Federal Express are making. Lessclear is the benefit to the economy ofhaving to eat breakfast, lunch, and

dinner in a coffee shop, of spendinghours each day driving your childrento daycare centres, and of having acleaner come daily to your housebecause your wife works at aMcDonalds outlet and earns less thanthe value added if she had stayedhome and looked after the household!But under the influence of vocalfeminists, many women have come tobelieve that staying at home andraising their children is a demeaning

job, while earning a salary for oneswork even if it is associated withhigh transportation costs in additionto income taxes is personally farmore rewarding and glamorous. Ingeneral, I believe that services thatadd significant value to an economy,as compared to those which simplyserve as substitutes for the oldhousehold economy, can be moreeasily outsourced to other countries.(If the US government was a profit-

driven corporation, it would outsourcethe entire social securityadministration and the IRS to India.)

While it is true that there are farmore migrants from less-developedcountries into the developed countriesthan the other way around, theincoming migrants have the tendencyto keep wages in the industrialisedcountries from rising much in somecases, they can even depress them as a large flow of migrants increasesthe supply of labour. Conversely, theflow of migrants from rich countries tocountries with a low price level tends

to raise prices in those countries thatreceive these more affluent migrants.

Just have a look at how prices havemoved up in southern Spain, and inthe Balearic and Canary Islands, overthe last ten to 20 years. In this respect,a quick look at the Hong Kongeconomy might shed some light on

the subject of the phenomenon of adeflationary shock.

Manufacturing has already almostentirely left Hong Kong for locationsacross the border in China. Evenservices are increasingly moving acrossthe border, not only for the export/import-related service sector, but alsofor some functions in the financialsector. And while Hong Kong peopledont travel to China for a haircut,they do go there for shopping and for

entertainment. Moreover, on longweekends Hong Kong almost emptiesitself, as people from Hong Kong findit cheaper and more pleasant to go toThailand, the Philippines, or Chinafor a couple of days than to stay athome in expensive Hong Kong.Moreover, increasing numbers ofHong Kong people are moving theirhomes to nearby places in Chinabecause of the huge accommodationcost savings a trend that would

certainly accelerate if the Hong Konggovernment decided to open theborder to adjacent Shenzhen 24 hoursa day. (At present, the border closes at11 pm and reopens at 5 am, becausethe parasitic Hong Kong propertydevelopers, who basically run HongKong, fear that a totally open borderwould depress real estate prices inHong Kong even further.) In additionto the increasing numbers of HongKong Chinese who are living in or

retiring to China, retiring expatriatesare leaving Hong Kong for less-expensive places offering a higherquality of life, such as can be found inEurope, Australia, New Zealand, orSoutheast Asia. In the meantime,Hong Kong is host to a large flow ofmigrants from China, who have, inrecent years, kept wages from risingand are therefore a thorn in the side ofthe local labour unions. Thus, at leastin Hong Kong, a structuraldeflationary shock from the openingof China is clearly evident and thisdeflationary trend will, in my

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opinion, continue to depress theterritorys asset prices, includingshares and real estate.

The questions we have now toaddress regarding this deflationaryshock scenario are whether such acondition is something to beconcerned about, and whether

monetary policies can reverse thisdeflationary trend.

THE ECONOMICCONSEQUENCES OF ADEFLATIONARY SHOCK

American economists such as PaulKrugman and economic policydecision makers such as we find in theUS Treasury and the Fed would doanything to avoid a deflationary

shock, fearing that deflation meansdepression. But lets look at theevidence. It is true that the periodbetween 1873 and 1900 wasnt agolden era of prosperity. Grainfarmers, particularly in Europe, werein deep trouble. with politicalconsequences that included thePopulist movement in the US, therevolt of the field in Britain, andrural unrest in Europe and Russia.Returns on agricultural land, both in

terms of real estate prices and rents,fell. But on the other hand, real wagesrose practically everywhere morerapidly than in the first three-quartersof the 19th century (see Figure 7), as aresult of meaningful productivityimprovements in agriculture andmanufacturing. Thus, the Europeanlandowning class lost out, as they notonly faced declining rents andagricultural prices but also rising realwages. However, we should not forget

that the economic development ofmany new regions which led toexports of Mississippi cotton,Argentine beef, Australian wheat,

New Zealand mutton, African ore,and Canadian timber, combined withdeclining transportation costs (theSuez Canal opened in 1869), createdan integrated global market forcommodities, boosted world trade,and brought about large economies ofscale. Thus, landowners aside, thedeflationary shock that had beenbrought about by new technologiesand inventions, and which permitted

the exploitation of the Americancontinent and other new regions andcatapulted America into the role ofthe worlds leading industrial power,resembled far more a deflationaryboom than a shock! Moreover, whileowners of agricultural land in Europeperformed poorly, real estate in cities

rose again after the 18731878 crisis,because of the accelerating process ofurbanisation. This was particularlytrue of the US, where real estate insouthern California soared in the yearspreceding 1886. Thus, while realestate may not be particularlyattractive in the present deflationaryperiod (certainly not in financialcentres), selected real estate markets

such as in Shanghai and Beijing couldperform well after the more than 50%capital value decline they haveexperienced since the end of 1995.

The 18731900 period was alsohighly beneficial to holders of fixedinterest securities who reaped largegains from deflation. The yield on

British Consols fell from a high of3.41% in 1866 to a low of 2.21% in1897, and in the US the yield onhigher-grade railroad bonds declinedfrom 6.49% in 1861 to 3.07% in1899. Deflation was obviously notparticularly favourable for corporateprofits, and bonds therefore out-performed equities after 1876 (seeFigure 8).

Figure 8 Relative Strength of US Stock Prices vs Railroad Bond

Prices, 18571899

Source:The International Institute for Economic Research

Figure 7 The Rise of Real Wages, 18001896

Source:David Hackett Fischer, The Great Wave

57 59 61 63 65 67 69 71 73 75 77 79 8 1 83 85 87 89 91 93 95 97 99

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In sum, I would argue that whilethe entire 19th century wascharacterised by a deflationary trend(commodity prices and interest ratesin 1900 were half those of 1800), itwas a century during which enormouseconomic progress took placeaccompanied by strong population

growth. Therefore, there is, inprinciple, nothing to fear fromdeflation. However, the reason somany economists fear deflationaryperiods is that they only look back atthe Depression years of the 1930s,which were truly a deflationary bust.However, instead of analysing thevarious causes of the bust following1929, they focus on the devastationthe deflationary bust brought about,when, in fact, the Depression was

only a consequence of the previousspeculative credit-driven boom thatled to the excesses of the 1920s. Hadthese economists studied the 1920sspeculative boom more carefully, theymight have implemented economicpolicies during the 1990s that couldhave reduced the risk of a similaroccurrence in the years to come. Inhis book Booms and Depressions,published in 1932, Irving Fisher madethe over-indebtedness responsible

for the Depression, meaning thatdebts are out-of-line with, are too bigrelative to other economic factors.According to Fisher, over-indebtedness is brought about bynew opportunities to invest at a bigprofit such as through newinventions, new industries,development of new resources,opening of new lands or new markets.Easy money is the greatest cause ofover-borrowing (Irving Fisher, The

Debt Deflation Theory of the GreatDepression, London, 1933).Therefore, whether deflation leads toa deflationary boom, as in the latteryears of the 19th century, or to abust, as after 1929, would seem todepend very much on the level ofdebt in the economic system prior tothe deflation. This observation seemsto have been confirmed by thedeflation in Latin America in the1980s following the petrodollar boom(in nominal terms there wasinflation, but because of the currencycollapse there was deflation in real

terms or adjusted for the US dollarexchange rate), the Japanesedeflation following 1989, and theAsian crisis after 1997. Therefore,given the current high level ofconsumer and corporate debts in theUS, there is a serious risk of adeflationary bust. Moreover, even if

a deflationary bust can be avoidedand some kind of deflationary boomwere to occur in the years to come,we should not forget that thedeflationary boom of the 18731900 period led to a hugegeopolitical change, with Britainbeing a relative loser while the USbecame the worlds leadingindustrialised and political power.Whether in the years to come Chinawill challenge the economic

hegemony of the US remains to beseen, but having witnessed with myown eyes what China has achieved inthe last ten years, it is possible that,in the manufacturing sector at least,China could overtake the US withinthe next ten to 20 years (with theproviso that there is social stability).Also, in terms of investment strategy,investors should not forget that inthe period from 1873 to 1900 and,even more so, from 1929 to 1941,

bonds significantly outperformedequities.

THE EFFECTIVENESS OFMONETARY POLICIES IN ADEFLATIONARYENVIRONMENT

Assume that, in the years followingthe boom of 18661873, the worldhad cut interest rates as rapidly, andeased monetary conditions by as

much, as was recently done in theUS. Do you really think that, undersuch conditions, the opening of theAmerican West to agriculture andthe subsequent glut of agriculturalcommodities on the worlds marketsthat led to their price declines wouldnot have occurred? In my opinion,such monetary policies wouldactually have accelerated this process,since even more railroads would havebeen built and the Americancontinent would have been opened atan even faster rate. One point oughtto be obvious: lower interest rates and

easier monetary policies would in noway have reduced the production ofagricultural commodities or retardedthe process of industrialisation, whichwith its productivity improvementsled to a fall in prices for steel, coal,transportation, and so on. Also,would Japan be worse off today had

interest rates not been reduced toalmost zero? Its unlikely, sincealmost-zero interest rates, combinedwith large fiscal deficits, allowed thedebt levels in Japan to grow in the1990s to unprecedented levels for anindustrialised nation. Had, instead,the Japanese government let thepost-1989 crisis run its course and notintervened, more pain would havebeen incurred in 1992, but Japantoday would be in a far healthier

financial and economic position. Infact, I would argue that Japansproblem is that it didnt have enoughdeflation, which would have broughtits price level more in line with thoseof other Asian countries, shut downexcess capacity, and bankrupted weakcompanies, which are now going or will eventually go out ofbusiness anyway, but with a muchlarger debt burden than would havebeen the case five or eight years ago!

As to whether the 1930sDepression could have been avoidedwith easier monetary policies is amuch-debated subject, witheconomists such as Milton Friedmanarguing that economic policymistakes post-1929 were the cause ofthe Depression, while the Austrianschool of economists maintains thatthe crisis was brought about by easymonetary policies prior to 1929,which led to over-investments and

over-indebtedness, as well as tospeculative excesses in the stockmarket, which in turn brought aboutthe subsequent deflationary slump.Also, in the case of Latin Americapost-1981, easy monetary policiescombined with large fiscal deficitsbrought about the worst of allpossible worlds: hyperinflation anddepression. And in the case of Asiapost the 1997 crisis, I could make thecase that easy monetary policies havehad the effect of badly retarding thenecessary reforms and of leaving thedebt overhang problems largely

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unresolved. Thus, it is by no meanscertain that current monetarypolicies in the US will be effective inreviving the economy.

There are some more points toconsider. In his highly recommendedbook, Manias, Panics, and Crashes(Basic Books, 1978), Charles

Kindleberger devotes a chapter tothe lender of last resort, whichstands ready to halt a run out of realand illiquid financial assets intomoney, by making more moneyavailable. According to ProfessorKindleberger, How much? Towhom? On what terms? When? Theseconstitute some of the dilemmas ofthe lender of last resort, after it isdetermined, first, whether thereshould be one, and second, who it

should be. All these issues derivefrom the basic dilemma that if themarket knows it is to be supported bya lender of last resort, it will feel less(little? no?) responsibility for theeffective functioning of money andcapital markets during the nextboom. The public good of the lenderof last resort weakens the privateresponsibility of sound banking.Kindleberger then goes on to giveexamples of where interventions by

the lender of last resort (usually thecentral bank) worked and occasionswhen they failed. In particular, heemphasises the importance of thetiming of the intervention. Toolittle, and too late is one of thesaddest phrases in the lexicon notonly of central banking but of allactivity. Too much, too early is notan evident improvement. Enough atthe right moment is better thaneither. But how much is enough?

When is the right time?Kindleberger further states: If, then,one admits the necessity for a lenderof last resort after a speculative boom,and believes that it is impossible forrestrictive measures to slow down theboom at the optimal rate withoutprecipitating collapse, the lender oflast resort faces dilemmas of amountand timing As for timing, it is anart. That says nothing andeverything.

Therefore, as is well known in themedical field, dosage and timing ofthe administration of drugs are of

particular importance. In particular,with increased frequency of usage,the effectiveness of drugs tends todiminish and occasionally disappearsaltogether as bacteria and virusesdevelop immunity. In this respect, itis interesting to note that when thetightening cycle ended in the final

months of 1994, the stock marketsoared in 1995 by more than 40% tonew highs. Then, in 1998, followingthe LTCM debacle, monetaryconditions were eased once again andwithin a few months the marketmade new highs (see Figure 9). Later,in the final months of 1999,monetary conditions were massivelyeased once again because of theunfounded concerns about theproblems associated with Y2K and

the market again made new highs.(Given the huge liquidity injection atthe time, the rise was far less

impressive than the 1995 or 1998bull phases that followed the Fedseasing on these occasions.)

Now, compare this to the present.Liquidity has been pouring into thesystem, with the Fed fund rate havingbeen cut by 450 basis points since thebeginning of the year! But what was

the result? The stock market hasrallied recently, but whereas in thepast such massive easing movesproduced new highs in the stockmarket within months, today thestock market averages and its leadingconstituents such as Cisco (see Figure10) still remain well below their year2000 highs. In other words, monetaryinterventions seem to have becomelarger in size, but at the same timeless effective in boosting or

supporting the stock market and,along with it, the economy.Moreover, if these monetary

Figure 9 S&P 500, 19972001

Source:BigCharts.com Exchange provides no volume data

Figure 10

Cisco Systems, Inc.,

19952001

Source:The Stock Picture

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interventions are as timely as the USTreasurys decision to halt the sale of30-year Treasury bonds when yieldsare relatively low (why did the USTreasury not discontinue such sales in1981, when long-term Treasury bondyields reached 15%?), then we maybe in for some nasty surprises. In fact,

I believe that the Feds interventionin the market will make mattersworse in the long run, because anyintervention in the free marketleads to unintended consequences.

One of these is, undoubtedly, therefinancing boom in the housingmarket (see Figure 11) and zerointerest rate auto loans, both ofwhich simply borrow demand fromthe future. Once interest rates nolonger decline, and it wouldnt

surprise me if the Treasurys decisionto halt the sale of 30-year bonds hasput a top in place for US governmentbonds and marked the low of interestrates, the refinancing boom will cometo an abrupt end, while auto sales willcollapse once the zero interest rateauto loans policy is discontinued (notto mention that zero interest rateloans will eat badly into theautomakers profits). At the sametime, low interest rates will

temporarily ensure the survival ofthe weakest, not the survival of thefittest, and prevent excess capacitiesbeing shut down. In addition, easymonetary conditions will lead tofurther capacity expansion in EasternEurope, Russia, and especially China,thus reinforcing the over-capacityproblem and the deflationarycorporate profit environment.

But, dont I contradict myself? Onthe one hand I believe that the US

Treasury bond market has reached oris close to a top, and on the otherhand I believe that the deflationaryforces will be exacerbated by easymonetary conditions. Moreover, Iexplained earlier that, in previousperiods of a deflationary shock, bondsoutperformed equities. However, it ispossible that in order for bonds tooutperform equities, bond priceswouldnt necessarily have to rallymuch, but could either remain justaround the current level or declineless than equities. In other words,under this scenario, for the next

couple of years, equities could returnless than ten-year Treasury bondyields, which at present are hoveringa tad below 4.4%. And as to thedeflationary scenario I have outlinedabove, which may be reinforced byeasy monetary policies and at thesame time a relatively poorperformance of bonds, the answermay be found in the movement of theUS dollar against foreign currencies,especially against the Chinese

renminbi, and commodities. In time,the expansionary monetary policiesof the Fed are likely to weaken theUS dollar, if not against the Yen,then against the Euro and, sometimein the future, against the Chineserenminbi and commodity prices.

Moreover, I would make the casethat had the Fed not intervenedaggressively in the money market andpushed down interest rates by 450basis points since the beginning of

the year, interest rates on long-termbonds might very well be lower thanthey are now. The injection of toomuch liquidity into the system keepsinflationary expectations artificiallyhigh; therefore, while interest ratesdo decline, real rates (interest ratesadjusted for inflation) remain high oreven rise. Thus, even under mydeflationary shock scenario, cominglargely from the rise of Chinasmanufacturing sector and new

technologies, interest rates couldremain very high in real terms. Thiswould particularly be the case for

corporate bonds, which in such adeflationary scenario wouldcontinuously suffer from adeteriorating credit quality. Finally, Ialso want to make the case here thatif the world had had no central banksover the last 20 years and monetarygrowth had been kept constant at,say, 3% per annum, it is likely thatthe wild swings we have experiencedin the global economy since 1990would have been avoided. Without

central banks, market forces wouldhave contained the speculativebooms and the colossal busts thatfollowed them far better than thecentral bankers have managed to do.As John Stuart Mill observed, thegreat majority of things are worsedone by intervention of governmentthan the market would do them if leftalone.

CONCLUSION

In the same way that the opening ofthe American continent in the 19thcentury led to a deflationary boom,the rise of China and other emergingeconomies is spreading deflationaround the world. A mild form ofdeflation, such as we had under thegold standard of the 19th century, isprobably desirable. It ensures thesurvival of the most efficiententrepreneurs and producers, while

rapidly eliminating weak companiesand inefficient market participants. Adeflationary environment also forces

Figure 11 US Mortgage Refinancing Applications Index,

19972001

Source:ABN-AMRO

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companies to continuously look fornew methods of production in order toboost productivity and lower costs.Moreover, deflation forces a moreconservative approach towardsborrowings and investments by thecorporate sector, as the real cost ofmoney remains relatively high. Lastly,

in deflationary periods, real incomegains by wage earners are usuallyhigher than in inflationary periods.

The problem with deflation is notdeflation, but the preceding inflation,which is usually exacerbated bymonetary policies and during whichdebts are out of line with and are toobig relative to other economicfactors (Irving Fisher). As Fisherpointed out, Easy money is thegreatest cause of over-borrowing.

I very much doubt that currentUS monetary policies will beeffective in combating deflation. Theprocess of deflation may be retarded,

but in the same way that agriculturalcommodity prices would havedeclined in the 19th century evenunder extremely loose monetaryconditions, the deflationary shock forthe manufacturing sector broughtabout by the opening of China andother regions in the world cannot be

avoided. Moreover, it would appearthat the Fed has implemented largerand larger monetary interventions,but successively with less and lessimpact on economic activity.

In terms of investment strategy, Iam afraid that investors will have tobecome accustomed to far lowerreturns in the next few years thanthey enjoyed during the 19822000bull market for bonds and stocks.As previously stated, I believe that at

very best the stock market willfluctuate (wildly) in a trading rangeof between 950 and 1,250 for theS&P 500, but that eventually a

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resolution on the downside is verylikely, with stocks bottoming out atfar lower levels. I also doubt that realestate will perform well, and the nowongoing deflation for commercialproperties (see enclosure on nextpage) will eventually also spread intothe residential sector. Long-term US

government bonds are unlikely torally much further, but in adeflationary environment forcorporate profits a 4% return will behigh compared to the returns I expectfor US stocks. In addition, high-gradecorporate bonds yielding above 6%are relatively attractive for tax-exempt accounts.

The recent rally that began onSeptember 21 is likely to fizzle out, ascorporate profits will continue to

disappoint. A test of the Septemberlows, and more likely a break ofthese lows, should therefore beexpected next year.

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Source: Financial Times, October 8, 2001 Marc Faber Limited

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