24 August 2008

What is the problem?

It seems like every time I read the financial press, there is at least one article on the front page speculating about the Federal Reserve.  What will it say at the next meeting, how long until the next rate move, and will the move be up or down?

The question I never see asked, but which screams out for on answer, is why the government fixes the price of credit in the first place.  Isn't our financial system supposed to be based on free markets, which allocate resources according to supply and demand through the mechanism of price?  If the government can fix the price of credit, what's to prevent it from setting that price based on political considerations rather than supply and demand?  What's to prevent it from setting the price of credit too low, thereby creating an excess of demand and a shortage of supply in the market for capital?  And in fact, that is precisely what has happened.

The reason we have a financial crisis is because the Fed has held interest rates below their natural equilibrium for far too long, thus leading to a major divergence between the financial economy and the real economy.

It's important to keep in mind that money is a medium of exchange, and has value only to the extent that it can be exchanged for real goods and services.  Philosophically, money can be thought of as a claim on real assets.  The act of saving consists of not exercising all of one's claims; instead, those claims are transferred through the financial system to businesses and entrepreneurs, who exercise the claims and and use the assets claimed to create new productive assets.  Those new capital assets then generate more resources, from which businesses return to the saver his original claim, plus interest or dividends to compensate for his deferment of consumption.  

In the financial economy, interest rate equilibrium occurs where dollars borrowed equal dollars lent.  Since the Fed has virtually unlimited lending powers, it has a powerful – but not unlimited – ability to set interest rates in the financial markets.  In the real economy, however, interest rate equilibrium occurs where total saving equals total investment.  When the Fed pushes interest rates below their natural equilibrium, it creates the illusion that saving has increased, which in turn leads to an increase in investment.  But this increase in investment has occurred without any corresponding increase in saving, so total consumption plus total investment now exceeds the total available goods and services in the economy.

Put another way, when the Fed pushes interest rates below equilibrium it discourages saving and encourages investment, and so we get less saving and more investment.  But a decrease in saving coupled with an increase in investment will push interest rates higher.  Thus, the more the Fed pushes interest rates below their equilibrium, the greater become the natural forces pushing interest rates higher.

Now consider economic players' reactions to this disequilibrium between the financial and real economies.  Real investment opportunities are always limited, so entrepreneurs facing a glut of capital begin to invest in less attractive endeavors, i.e. those with a higher risk to reward ratio.  In addition, while the rate of saving declines, those who do save are tempted to shift into riskier assets in an attempt to maintain their cash flows or achieve greater capital gains.  On either side of the ledger, both borrowers and lenders are taking on more risk.

At some point, the Fed decides rates are too low and begins to raise them; economic players suddenly realize they are taking too much risk and a collective scramble for safety ensues.  The economy begins to turn down.  But the equilibrium interest rate will have moved higher, depending on how low and how long the Fed held down rates.  If the Fed lets rates move all the way back up to the new equilibrium, then the divergence between the real and financial economies will have been eliminated, but at a cost.  Essentially, the illusion created by the Fed must be undone, and that means marking down financial and other assets to their real worth.  Usually, however, the pains of disillusionment prove too great to bear, and so the Fed begins once again to lower rates before achieving a new equilibrium or eliminating the divergences.

Monetary policy, as practiced by the Fed, is bounded by what I call the 'Boiling' and 'Tipping' points.  If interest rates are pushed down to the Boiling Point, economic activity becomes driven by speculation and irrational exuberance.  If rates are pushed up to the Tipping Point, economic activity falls off a cliff and the pain is so great that social turmoil results.  The problem is that no one really knows where these levels are, and the levels themselves are constantly shifting.

Let's first consider the Boiling Point.  This occurs because in the real economy, there are a limited number of investment opportunities.  Entrepreneurs will always invest first in those opportunities which promise the most attractive returns.  So any addition capital will be invested in less attractive opportunities, and eventually in the least attractive opportunities.  Since the additional credit created by the Fed first flows through the financial markets, there tends to be a boom in financial assets.  At the Boiling Point, it becomes more attractive to speculate on financial assets than to invest in actual wealth-producing enterprises.  People purchase assets because they expect prices to go higher, regardless of intrinsic value or economic fundamentals.

Now one might argue that, on the contrary, the number of investment opportunities is infinite, and if only more capital were available then all these opportunities could be pursued.  But that is precisely the point; there is a limited amount of capital available for investment, and in a free market capital is allocated to those opportunities which promise the highest return with the lowest risk.  When the Fed pushes interest rates below their equilibrium and creates the illusion of additional capital available for investment, entrepreneurs will begin embarking on less  attractive investments because they do not immediately realize that the additional capital is an illusion.  The result is a competition between investors and consumers for scarce resources, and hence upward pressure on prices.  When interest rates eventually move higher and losses are realized on investments, this represents a real economic loss, as many of those losing investments will be under utilized or even abandoned.  Goods and services were squandered, real wealth was destroyed.

If the Fed does not allow interest rates to rise up to the new equilibrium before it begins pushing them down again, then the still-existing imbalances from the previous rate cycle will be compounded by the creation of a new illusion.  In the previous cycle, businesses invested more than they otherwise would have because of the illusion created by the Fed.  In many cases, the result was over-capacity.  So as the Fed lowers interest rates once again, businesses are less eager to invest and the Fed needs to be more aggressive with its rate cuts in order to get a similar level of stimulation.  

Over a number of cycles, if the Fed fails to restore equilibrium, businesses will become less and less eager to invest.  But the credit injected into the financial system by the Fed has to go somewhere, and what is not channelled into productive endeavors will inevitably be channelled into non-productive endeavors, i.e. speculation.

These two factors, lingering imbalances and reluctant entrepreneurs, suggest that from one cycle to the next, the Boiling Point is likely to rise.  In other words, the Fed's ability to drive increases in real investment will weaken over time.

Now let's consider the Tipping Point.  Remember that real saving can be thought of as a claim on assets that has not been exercised.  That claim is transferred to businesses who exercise the claim, and invest the claimed resources in new wealth producing assets.  The wealth generated by those newly-created assets is used to pay the saver his principal and interest.

When the Fed pushes down interest rates, it does so by buying government bonds in the open market, thus becoming the marginal buyer at the intersection of supply and demand.  Because it pays for the bonds by essentially writing a check on itself, the Fed is effectively injecting additional credit money into the debt markets.  But that additional credit does not represent a claim on any resources, it is simply created out of thin air.  Because there are no corresponding claims on real assets associated with the additional credit, there is no underlying foundation upon which to build new wealth-creating assets necessary for generating interest payments to the saver.

If debt cannot be serviced by the income from newly created productive capacity, then it must be serviced by capital gains; there is no other alternative.  When the Fed first pushes interest rates down to the Boiling Point, where speculation becomes the dominant investment theme, this is not a problem; the boom in financial and other assets is more than enough to service the illusion that the Fed has created.  But the longer the Fed holds rates below their equilibrium, the greater becomes the illusion of wealth and the greater become the debt servicing requirements of this illusory capital.

The Tipping Point is a reflection of an economy's sensitivity to interest rates.  When the ratio of debt to productive assets is low, the Tipping Point is very high; when the ratio of debt to productive assets is high, the Tipping Point is very low.  So as we go from one credit cycle to the next, without the Fed allowing interest rates to move up to an equilibrium where divergences between the real and financial economies can be eliminated, it stands to reason that relative level of debt will rise.  Also, as mentioned above, when the Fed pushes interest rates below their equilibrium, both borrowers and lenders tend to take on more risk.  This implies an ever-increasing sensitivity to interest rates, and thus a decline in the Tipping Point from one credit cycle to the next.

In conclusion, we have three key interest rates: the Equilibrium Rate, the Boiling Point and the Tipping Point.  We know that from one credit cycle to the next, as long as the Fed insists on holding interest rates below their equilibrium, the Equilibrium Rate will rise, the Boiling Point will rise and the Tipping Point will decline.  If carried on for long enough, a scenario for disaster unfolds:  the Equilibrium Rate moves above the Tipping Point, while the Boiling and Tipping Points converge on each other.

If we look at recent economic history, we see that somewhere in the 1950s or 60s (perhaps earlier), the Fed began to push interest rates below their equilibrium.  By the late 70s, the Equilibrium Rate had moved well above the Tipping Point; the situation was only resolved when the benchmark interest rate was allowed to rise to the previously unimaginable level of 20%.  At the time, it appeared that a true interest rate equilibrium had been achieved, and that the divergence between the real and financial economies had been eliminated.  Without a doubt, the Equilibrium Rate and Boiling Point fell dramatically, while the Tipping Point rose in equal measure.

Perhaps the excesses were never completely flushed from the system.  Or perhaps the Fed is simply incapable of resisting the urge to give the economy a little boost with its monetary powers.  In any case, not even three decades after the economy endured Volcker's harsh medicine, we're fighting the same fight once again.

Before we take a close look at some economic history to get a sense of these monetary cycles, let's consider just exactly what the nature of money is.  An economist would say that money performs three functions:  it is (1) a medium of exchange, (2) a measure of value, and (3) a store of value.  Medium of exchange simply means that we pay money for what we buy, and in turn are paid in money for our labor, etc.  Measure of value means that prices, salaries, etc. are quoted in monetary units.  And store of value means that money set aside today can be spent at some later date.

There's no doubt that the U.S. dollar performs the first two functions of money admirably. But with regard to the third function, the dollar's performance had been less than stellar.  The St Louis Fed puts the Consumer Price Index at 19.0 for the start of 1921 and at 219.964 for July of 2008.  That works out to an annualized rate of inflation of 2.84%, i.e. a doubling of prices every quarter century.  So in any study of economic history, using the dollar as a benchmark of constant value will provide a skewed perspective.  Gold, in terms of which the dollar was once defined, has by contrast increased in value from $20.67 to $800 during that same period, which represents an annualized rate of increase of 4.27%.

It's important to understand, however, that gold often acts like a canary in the coal mine of financial markets.  When confidence in the dollar is low, demand for gold is high; when confidence in the dollar is high, gold is scorned as an investment that pays no interest.  In 2001 gold traded as low as $255, while in 2008 it has been as high as $1035.  Based on those recent prices, gold's annual rate of increase would be 3.17% and 4.60%, respectively.  The question remains, however, whether gold is a reasonable benchmark of constant value, or if it has an inherent tendency to appreciate in value.

Finally, we must consider the accuracy of the CPI itself.  There have been serious allegations, notably by www.shadowstats.com, that the CPI substantially understates the rate of inflation.  Given that Social Security and other government obligations are tied to the CPI, it is certainly in the government's financial interest to understate the CPI.  But in the end, with regard to the study of economic history, one can choose either an inflation-adjusted dollar or gold as a benchmark for constant value.  Some put their faith in government statistics; I trust the market.

 Below is a chart of gold going back a century.  The prices are Comex gold futures, and monthly averages from the London fix (courtesy of Kitco.com) from before the futures were traded.  It's admittedly not the best, but hopefully sufficient for this essay.  Notice the big spikes up in the 1970s and the 21st century.  At a minimum, I think we can all agree that these spikes represent periods of low confidence in the dollar. 

Next we have a chart of the Dow Jones Industrial Average, in nominal dollars, on a log scale.  There were two bear markets of significance, which began in 1929 and somewhere in the 1960s.  In the first bear market, the DJIA declined by 89% (386 to 40) while gold appreciated 69% ($20.67 to $35).  In the second bear market, the DJIA went sideways while gold appreciated 1847% ($35 to $681).  That's using end-of-month prices, at its peak gold was up 2400%.  It remains to be seen how significant the bear market that began with the 21st will turn out to be.


Up to now I've been using the term 'cycle' rather loosely.  A MAJOR credit cycle runs for a third of a century or so, and ends only when interest rates touch the Equilibrium Rate, resulting in the elimination of divergences between the real and financial economies.  Within a major credit cycle are numerous MINOR credit cycles, which correspond to the traditional business cycle.  But with each minor cycle, as the Fed pushes rates down and then fails to raise them back to the new, higher Equilibrium Rate, the Boiling Point rises and the Tipping Point declines.

When a major credit cycle begins, the Boiling Point is very low and the Tipping Point is very high.  So the Fed's policy of holding interest rates below their equilibrium is very supportive of stocks, as the low interest rates push financial assets above their natural levels.  But beneath the surface, divergences between the financial and real economies are forming and gathering strength.  When we finally hit the Boiling Point, the Fed is reaching the limits of its illusive monetary powers.  The divergence between the financial and real economies has become so great that the natural forces pushing them back together can no longer be held in check.

In the illusive phase of the major credit cycle, some assets are driven to well above their intrinsic value.  But if some assets are priced above their intrinsic value, logic dictates that other assets must be priced below their intrinsic value.  Remember that money is a medium of exchange.  Behind the veil of money is a real economy where every good and service can be measured in terms of any other good or service.  For the value of anything to go up, something else must go down.  Suppose that today an orange is worth two apples, and tomorrow an orange is worth three apples.  That means the value of oranges in terms of apples has gone up, but it also means that the value of apples in terms of oranges has gone down.  Every value is relative to some other value.

One could imagine, of course, a situation where the government simply hands out money to everyone, and consequently all prices go up by exactly the same proportion.  In that case, the value of the dollar would drop, but the value of all goods and services relative to each other would remain constant.  That is not, however, what happens during a major credit cycle.  The reason that this topic generates so much interest is precisely because distortions and disequilibriums do in fact occur, and generally wreak havoc on the economy.  Additional money is not injected into the economy by the government handing it out to everyone in a fit of generosity, it is injected by the Fed purchasing financial assets and paying for those assets by writing a check on itself.

To continue, during the illusive phase of the major credit cycle, assets are pushed away from their intrinsic values.  Generally, financial assets become overvalued and real assets become undervalued.  I use the word 'generally' because the definition of financial and real assets is not always clear.  Recently, we have seen houses, generally thought of as a real asset, turned into financial assets through the magic of securitization.  In the realistic phase of the cycle, assets move back toward their intrinsic values.  And yes, the process typically overshoots to a significant degree.

A stock traded on an exchange is the epitome of a financial asset.  By general agreement, it is worth the present value of all its future cash flows, which to a large degree are a function of the economy's performance extending out into the foreseeable future and well beyond.  The calculation of present value is highly dependent on the level of interest rates.  And since each shareholder's ownership interest is such a small part of the whole, there is no practical way to cash out his holding other than selling his shares back into the market.

Gold is the epitome of a real asset.  Its only value comes from the fact that is has always been valuable, in and of itself.  It depends on no one's promise or endorsement   There are almost no practical applications for it, and so virtually all the gold ever mined either sits in a vault or is worn as jewelry.  It is extremely compact, and large values can easily be carried on one's person.  It is virtually indestructible.

The two charts above displayed a century of history for both gold and stocks.  But to really see the history of major credit cycles, one needs to combine the two.  The chart below shows the DJIA in terms of gold, i.e. the end-of-month level of the DJIA divided by the end-of-month price of gold.  The solid blue horizontal line at the bottom is one ounce of gold per DJIA, and the dotted blue line just above it is five ounces.  The date of each peak is labeled in green, and of each trough in brown.  Two vertical orange dotted lines indicate the dates when the American public was defrauded by their government, and each line is labeled with the name of the despot who carried out the crime.  For the remainder of this essay, for the sake of brevity, each major credit cycle shall be referred to by the year in which it peaked, i.e. the cycle of 1929, 1966 or 1999.

The Federal Reserve began operations in 1913, and since then there have been two complete major credit cycles;  we are well into the third, and my back of envelope calculation estimates it will finish somewhere in the middle of the next decade.  Below is a summary of  key statistics for each major credit cycle; all prices are end of month.














DJIA / Gold

















DJIA / Gold

















DJIA / Gold




I should point out that my numbers for the  cycle of 1929 are somewhat arbitrary.  Until April of 1933, the dollar was legally defined in terms of gold at the rate of $20.67 per troy ounce of gold.  At that time, FDR decided to confiscate Americans' gold, and then devalued the dollar to the rate of $35 per ounce.  So the entire 89.5% plunge in the DJIA occurred while the dollar was still redeemable for a fixed amount of gold.  The appreciation in the price of gold occurred the following year, and was the result of legal dictate rather than a free market.  But the events are inextricably linked to each other, and I argue that without the devaluation of the dollar the DJIA would have bottomed at a lower level than it actually did, and probably much later.

While it remained illegal for Americans to possess gold until 1975, under the terms of the Bretton Woods agreement foreign central banks could redeem their dollars at the official rate of $35 per ounce, and there was an active market for dollar-denominated gold in London.  In the 1960s pressure began to mount on the dollar, and in August of 1971 Nixon surrendered to market forces with his  declaration that the dollar would no longer be redeemable for gold, thereby breaking his country's promise to the world.

In all my charts and statistics, the price of gold was $20.67 until 1933, when it jumped to $35.  There was effectively no free market for gold until 1971, although my price data does show that gold began to move in 1968.  I would love to incorporate historic daily prices from the London gold fix into my figures, but to this date have been unsuccessful at finding such data.  To conclude this brief history of gold, I am aware that my price assumptions are somewhat arbitrary, and that my price data is not of the highest quality.  Given the history and circumstances, however, I believe that my assumptions are reasonable and that the quality of my data is adequate.

As we examine the above chart of DJIA/gold, there are a few things that leap out at us.  The cycles of 1966 and 1999 each peaked at levels about 50% higher than their predecessor, but the troughs of both completed cycles were just above one ounce.  The amount of time between cycle peaks was 36 years and 5 months, and then 33 years and 7 months, which works out to an average of exactly 35 years.  Since the cycle of 1999 has yet to reach its trough, we only have one measure of the time between troughs, and the trough of the cycle of 1929 occurred remarkably soon after the peak.  Given the aforementioned history of gold and the length of the Great Depression,  I am going to take an extraordinary leap of faith and make the relatively unsubstantiated argument that the 'true' trough for the cycle of 1929 occurred in April of 1942 (brown arrow on chart).  That would make the time between troughs to be 37 years and 9 months, which when worked into the time between peaks comes to an average of 35 years and 11 months for the life of a major credit cycle.

If we look at the time from peak to trough, we have 12 years and 8 months (using April 1942), and then 14 years, for an average of 13 years and 4 months.  Given a peak in August of 1999, that would put the next trough in December of 2012.  From the trough of the 1966 cycle (January 1980), if we go forward by the average length of a cycle (35 years, 11 months), we get the next trough in  December of 2015.  This suggests to me a reasonable likelihood that the trough of the present cycle will occur sometime between the end of 2012 and the end of 2015.

At the trough, DJIA/gold approaches one ounce.  Based on July's closing prices, we can throw around some ballpark figures.  If the DJIA remains unchanged, then gold should rise to almost $11,378.  If gold remains unchanged, then the DJIA should fall to almost 914.  If both gold and the DJIA were to move by the same factor, that factor would be 3.5285; the DJIA would drop 71.6% to 3225 and gold would rise by 253% to reach the same level. If the cycle of 1999 is anything like the cycle of 1966, when the DJIA in nominal terms was down 11% at the trough, that would put gold's peak near $9,600.

This essay began as a discussion about interest rates, and the inevitable consequences of holding them below their natural equilibrium.  So let's look at a history of interest rates.  Below is a chart of the long bond futures, traded at the CBOT.  This contract is based upon a nominal U.S. Treasury bond with a 6% coupon and a maturity of at least 15 years.  Originally, the contract was based on an 8% coupon, but changed in 1999 to the current 6%.  I exported all my old data to a spreadsheet, made the same percentage change to all prices, and then imported it back into my charting software.  For prices before 1977, when the futures started trading, I took historic interest rates for U.S. Treasuries and converted them into futures prices.  So once again, I must confess that my data is not absolutely pristine; nevertheless, I think it is reasonably accurate, at least for the purpose of this discussion.

The first thing I notice from this chart of bond prices is that nothing suggests the existence of  major credit cycles.  Not, at least, in anything like the form for which I made the case above.  It is worth noting that bonds made a major bottom in September of 1981, when yields were around 14%, which is 1 year and 8 months after the trough of the 1966 cycle.  Also, bonds made a major high in June of 2003, with yields just over 4%, which is 3 years and 10 months after the peak of the 1999 cycle.  These two items suggest that perhaps interest rates tend to hit their extreme some period of time after a cycle has turned.  Intuitively, this makes sense.  At the peak, the Fed continues to push rates down even after rate cuts have lost their potency.  At the trough, rates keep pushing higher until the demons of divergence have been totally vanquished.

Another thing to consider is that well into the cycle of 1966, we were still on a gold standard.  As long as the dollar was fixed to gold, inflation was not really a factor to consider when valuing a bond with virtually zero chance of default.  But with a free-floating dollar, inflation risk becomes a constant concern.  All in all, I think it's reasonable to argue that the nature of the bond market changed in 1971 when the link to gold was severed.  But to get a better picture, let's look at bonds in terms of gold.  The chart below is the same bond futures divided by the price of gold.  You can think of it as the number of ounces of gold it costs to buy an annuity of $6 per year for the next 15 years, with an extra payment of $100 at the end of 15 years.

The stair step pattern of this chart is certainly thought provoking.  I have drawn blue dotted horizontal lines at 6.0, 4.0 and 0.4 to indicate approximate levels of stability.  The amount of decline from one level of stability to the next is shown in red.  If bond prices in terms of gold can be considered as a proxy for the real cost of capital, then this chart suggests that a long period of stability is followed by a sharp rise in the cost of capital (drop in bond/gold price).  Why would that be?

Once again I refer to the major credit cycle.  By pushing interest rates below equilibrium, the Fed creates the ILLUSION of wealth.  When we hit the Boiling Point and the peak of the major credit cycle, the dimensions of the illusion have become so great that it can no longer be sustained, so the inevitable return to reality begins.  As the financial and real economies converge, those assets which were overvalued decline relative to those which were undervalued.  The overvalued assets, precisely because they experienced so much price appreciation, were the most likely to be used as collateral for loans.  

Earlier in this essay, I pointed out that credit injected by the Fed does not represent a claim on any resources, it is simply created out of thin air; it has value only to the extent that it dilutes the value of all existing claims on resources.  Because there are no corresponding claims on real assets associated with the additional credit, there is no underlying foundation upon which to build new wealth-creating assets necessary for generating interest payments to the saver.  During the illusive phase of the credit cycle, when overvalued assets are  becoming still more overvalued, there are enough capital gains to support interest payments on the illusory capital.  But after the peak of the cycle, those capital gains disappear.  Shrinking collateral, and no income stream to support the interest expense, sends loans into default and forces lenders to take losses.

In the cycle of 1929, there were actual runs on banks.  Soon thereafter, the government established insurance for bank accounts, so we don't have runs on banks anymore.  But that doesn't change the fact that at the peak of a major credit cycle, a huge amount of wealth in the economy is an illusion.  It doesn't really exist, it was a mirage created by the Fed.  Somebody has to accept a reduction in wealth, and that mere suggestion is enough to send all economic players fleeing for the exits.  In the old days we had runs on banks, but the government has taken on that risk, so now we have runs on the government.  More specifically, we have runs on the dollar. 

During the illusive phase of the major credit cycle, economic players are trying to maximize their gains; after the peak of the cycle, in the realistic phase, everyone wants to minimize his losses.  Every business wants to survive, but knows that many will fail.  Every business knows that the assets on its balance sheet are overvalued, and suspects that many others are in even worse shape.  Every business wants to sell depreciating assets before they decline still further, but no one wants to catch a falling knife.  Losing some portion of one's wealth is infinitely preferable to losing all of one's wealth.  In such an environment, it is no surprise that those still willing to lend demand an arm and a leg, which of course is reflected in a high cost of capital.   All of  which is simply another way of saying that the equilibrium rate of interest is very high.

In the cycle of 1929, the market was obviously blindsided by FDR's confiscation of gold and devaluation of the dollar.  That first stair step was almost a straight line down, with a bottom in January of 1934 (see chart above).  After that, there were about two decades of stability and then a decade of slow decline.  It's clear the market anticipated the end of Bretton Woods, because around the peak of the cycle of 1966 the decline accelerated.  The end of Bretton Woods triggered a sharp decline, there was a significant bounce in the mid-1970s, and then a slow decline to the bottom in September of 1980.  The sharp drops in the bond/gold price shortly after the peak of the major credit cycle supports the general thesis of this discussion.

The current period of stability is approaching three decades, the length of the previous period, which suggests that we may be close to the next stair step down.  The bottom in September of 1980 was 0.087; that was followed by a slow rise to 0.40 in March of 2001 and a decline to 0.12 in July of 2008.  There has been a small bounce since then.

There is no pattern, that I can discern, to suggest how far down the next stair step will be.   The average of the past two stair steps down was 2.8 ounces, but that would put us well into negative territory; at the extreme, the value of bonds can only fall to zero.  The average percentage drop was 61.5%, but any trend line with only two points is pretty weak, and this one strikes me as particularly so.

Earlier, I suggested that if the cycle of 1999 is anything like the cycle of 1966, when the DJIA in nominal terms was down 11% at the trough, and assuming that DJIA/gold approached one ounce, that would put gold's next peak near $9,600.  If bond yields hit 15%, around where yields peaked at the trough of the last cycle, that would put the bond price at about $50.  That gives us a bond/gold price of 0.005, which works out to a stair step down of almost 99% from the 0.4 level of stability.  The peaks of major credit cycles, as measured by DJIA/gold, have been higher and higher, so it sort of makes sense that the stair steps down for bonds/gold should be greater and greater.

These estimates of future increases in gold are an implicit prediction of sharply higher inflation.  There is currently a great debate between those who foresee hyper-inflation in the near future, and those who see only deflation down the road.  So once again I must emphasize that the key nature of the major credit cycle is the distortions caused by excessively low interest rates.  Some assets become extremely overvalued, but by the laws of nature that means other assets become undervalued.  The divergence between overvalued assets and undervalued assets, or as I have previously described it, between the financial and real economies, is the central element of the major credit cycle.

When the divergence reaches its natural limit, the process reverses itself, and continues until overvalued assets have fallen below, and undervalued assets risen above, their respective intrinsic values.  There is no fundamental requirement that this process be accompanied by a general rise in the price level.  However, the decline in overvalued assets inflicts severe pain on all those who participated in the speculation, notably banks and other lending or investing institutions.  This pain diffuses itself throughout the general economy, eventually resulting in a significant slowdown.

The only cure for this economic malaise is to allow nature to follow its course.  In time, the divergences will unwind themselves; losses will be written off,  resources will be redirected toward their optimal employment, savings will increase with higher interest rates, and the economy will reestablish itself on a much sounder footing.

“I feel your pain, and when elected I will solve this issue.”  That is what virtually every candidate for office says in this political season.  I can probably count on the fingers of one hand those politicians who advocate the course I prescribed in the previous paragraph.  It doesn't matter that there is nothing the government can do, every candidate promises to do something.

Actually, there is something the government can do to solve the problem, and that is to get out of the way.  But that is not what will happen.  Instead, the government will do everything it can to stop the divergence from unwinding.  Rules will be implemented to avoid the recognition of losses, in the vain hope that by waiting long enough overvalued assets will return to their prior unsustainable highs.  The government may even spend tax monies to purchase overvalued assets, thus guaranteeing deficits or higher taxes down the road, as the government joins the company of those speculator suffering losses.  But most importantly, the Fed will try to push rates lower in still another vain attempt to stem the tide of reality that is sweeping the markets.

Economic players and market participants are not stupid, and will soon realize that the tide has turned.  It will become obvious to anyone with half a brain that the trend has reversed, and that previously overvalued assets are declining while previously undervalued assets are rising.  So as official fiscal and monetary policy pumps money into the financial system, hoping against hope to stem the tide, that money inevitably flows into appreciating assets, which officialdom would prefer to suppress, rather than the depreciating assets it wants to support.  

As I've said before, during the illusive phase, financial assets tend to become overvalued while real assets tend to become undervalued.  But price indices are generally made up of real assets, so during the illusive phase the official price indices tend to be subdued.  In the realistic phase that ensues after the peak of the major credit cycle, that tendency reverses and price indices begin to rise.  The degree to which they rise will depend on the Fed, and how aggressively it attempts to fight the process of unwinding divergences.  The more the Fed attempts to support prices of inflated financial assets, the greater will be the rise in the price of real assets, and consequently the rise of price indices.

The above chart is an 80-year history of the Consumer Price Index, with the change from the previous year in blue and the change over seven years (annualized) in red.  That 7-year change is essentially a medium term average that eliminates noise and smoothes out the trend, so let's compare it to the peaks and troughs of major credit cycles.  The table below displays the key points.


Cycle Date











CPI 7-year average






CPI Date











The history of the CPI strongly supports the thesis of this essay.  And we can confirm it by simply looking at what has been happening in the markets.  Gold hit a low of  $255 in February 2001; earlier this year it traded over $1000.  Crude oil hit a low of $10.35 in December 1998;  it recently traded over $145.  Soy beans traded below $4.16 in January 2002; recently they were over $16, a historic high.  Copper traded below 61 cents in November 2001; in 2006 and again this year, it briefly surpassed the $4 mark.  Every market has its own dynamics, of course, and is subject to the vagaries of supply and demand which affect that particular asset.  But the long term trend is fairly clear, and that is for real assets to rise relative to financial assets.

When will it end?  The process will reverse course when, like a pendulum swinging back and forth, the dominant trend's waning energy is overcome by the waxing energy of the counter trend.  And like the pendulum, if left to its own devices, the economy will eventually come to rest at a point of equilibrium.

But as long as the Fed is trying to prop up inflated values by holding interest rates below their equilibrium, the process will gain momentum.  From a manic desire to own financial assets no matter how high the price, the process will, if driven long enough, eventually end in a panic to flee from financial assets no matter how great the loss.  The Boiling Point will have crossed above the Tipping Point.

As I study the economic history of the past century, I wonder whether the major credit cycle is a phenomenon that will endure forever, or is simply a phase leading to the next period of history.  Once the current major cycle – the third since the creation of the Federal Reserve System – reaches its trough, will we then begin the fourth cycle?  Or is this the third and final one?

The reason for these thoughts is that our current economic system may not be able to survive the coming trauma implied by my predictions.  Consider out federal government: the last time I looked its budget was about $3 trillion and its debt about $9 trillion.  Just for the sake of some back of envelope calculations, let's say the debt is three times the budget.  That means each one percent of interest expense is equal to about three percent of the budget.  At the trough of the last major cycle, in 1980, long term Treasury bonds yielded around 14% and short term bills close to 20%.  According to the chart of DJIA/gold, each major cycle is hitting new extremes, so it's certainly possible interest rates will hit new highs as we approach the next trough.  If average interest expense for debt hits 10%, that's 30% of the budget; an interest expense of 15% would be 45% of the budget; an expense of 20% would be 60% of the budget.  I think it's pretty obvious that somewhere in that scenario, there is a major crackup.  

If we look at economic history going back six thousand years, there has never been a fiat money that did not eventually achieve its intrinsic value of zero.  Governments have a long history of stiffing their creditors, and that's exactly what both FDR and Nixon did when they devalued the dollar.  At a time when foreigners hold more U.S. debt than ever, and aging baby boomers threaten entitlement programs with a tidal wave of red ink, the government wants to step squarely in front of the locomotive bearing down on it by underwriting the obligations of privately owned financial institutions.  From my perspective, it's pretty obvious where this will end.

That's not to say that America is headed for the trash heap of history.  History shows that even great powers can take serious stumbles and still pick themselves up again, becoming even stronger and more powerful as a result of the trauma they survived.  Perhaps we'll see another revolution, this time in the form of a Constitutional Convention called by the states.  If so, and our financial system were to be rebuilt from scratch, what ought the future look like?

First of all, we have to recognize three underlying problems: a banking system based on fractional reserves, a Fed that exacerbates that problem, and a government unwilling to accept the workings of a free market.  That last problem I will leave for another day, but let's examine the first two.

A fractional reserve banking system is inherently unstable; no bank can pay back all its depositors, should they all want to withdraw their money at once.  As long as depositors have confidence in their bank, they prefer to leave their money where it is safe; but the moment there is the slightest doubt, everyone wants to withdraw his money and the bank suffers a run.

Banks deal in a fungible commodity, credit, and a loan from one bank is just as good as a loan from any other bank.  So borrowers shop around for the lowest rate, and competition forces banks to match the lowest rate.  Because of fractional reserves, banks acting collectively expand the amount of money in the system.  When times are good, banks are happy to lend and rates decline, until monetary expansion reaches its natural limit.  Then the cycle turns, and tough times force banks to raise their rates and call in loans.  This is the minor credit cycle, and the reason that the Federal Reserve System was established.

In theory, a central bank acting as lender of last resort can reduce risks to the financial system.  But in practice, this means the central bank is called to lend, i.e. inject additional money into the system, at exactly the moment when there is already too much money in the system.  Financial crisis occur when the expansion of money reaches its natural limit – that is when the good times turn into hard times.  Imagine, if you will, driving on a crowded expressway.  As traffic begins to move, everyone accelerates.  Then red lights flash ahead, and everyone hits their brakes.  Accidents don't happen when everyone is accelerating; they occur when everyone brakes, and someone is going too fast and following too close.

Now suppose a government bureaucrat is assigned to study the problem.  He soon observes that accidents occur when drivers slam on their brakes.  His imminently logical conclusion, therefore, is that government should pass a law outlawing brakes on cars.  This is the type of thinking that brought us the Federal Reserve System.  The free market solution, on the other hand, is simply to tell drivers to be careful and pay attention, because if you cause an accident then you are responsible for the damages.

The creation of the Fed has resulted in minor credit cycles that are less painful, but only because the Fed prevents those processes from playing themselves out.  We may have fewer accidents, but when we have one it's a massive pileup that shuts down the entire system.

I hypothesize that, had the Fed not been created, the banking system would have evolved beyond a system based on fractional reserves.  Commercial banks would provide services such as checking, money transfers, safe deposit boxes, payroll processing, etc.  But customer deposits would be invested in money market funds and similar cash equivalents.  Commercial banks could also offer trading accounts for customers who want to buy securities, similar to the way discount brokers now operate.

Exchanges would provide trading platforms for bank default futures, standardized contracts that pay a fixed amount if that particular bank defaults before the contract's maturity, or nothing in the absence of default.  (Notice that selling such a contract would be similar to buying a note issued by the bank.)  A default would consist of the bank being unable to pay any depositor his funds as promised.  Any commercial bank that defaulted would be immediately forced into bankruptcy and liquidated.  Savvy investors would closely scrutinize banks for any sign of risk-taking, and buy default futures at the first such sign.  Any rise in the default futures on a bank would be widely reported, and quickly trigger a run.

In such a system there might be a lot of bank runs and subsequent defaults; but if it happened early in the process, before a bank made too many bad investments, depositors would be likely to recover most of their money.  And for bankers, the knowledge that disaster is never more than a rumor away should be an excellent motivation.

And investment banks?  Well, they could invest.  There are always plenty of businesses that, although too small to issue their own securities, can put capital to good use.  Even larger businesses that can issue their own securities will still need the advice and counsel of finance professionals.

As for a central bank, I see absolutely no need.  Milton Friedman once suggested that monetary policy be run by a computer program, and that strikes me as a reasonable compromise.  Make it an open source model on which everyone can keep an eye, and let the free market work its magic.  It made America great once, and it can do so again.