The potent directors fallacy

A brief look at history - the crash of 1929

September 1929 – the slide begins

After reaching its then all time high of 381,17 on September 3 , 1929, the Dow Jones Industrials Average began what was at first a fairly slow slide.
From the beginning of June to the first trading day of September, the average had gained 79 points – almost as much as in all of 1928, which was already a fairly spectacular year. Margin credit exploded during the summer of 1929 by an average of $400 million per month, then a huge sum.

There was heavy trading volume throughout the summer, with about 5 million shares changing hands daily at the NYSE, which represented about 60% of all trading volume in those days (the remainder of trading took place at the 'curb' and exchanges in other cities; curb traded shares avoided the NYSE's listing requirements).

Not surprisingly, after such a heady summer, which capped several years of steady gains, no-one thought the September pullback remarkable. After all, the market had suffered quite a few pullbacks in the course of the bull market, some of which had been a great deal more scary.
The progress during the summer months had been steady, with pullbacks mild and never lasting longer than two or three days in a row.

During September, the market's character underwent a subtle change. In the first half of the month, pullbacks still only lasted two days in a row at most, but that changed later in the month. A string of five down days in a row, then one small up day, followed by another three down days ended the month – the DJIA was suddenly back at its level of late July, having lost all the gains made in August.

An interesting feature of the summer months as well as September was the attention broker loans received. Due to the high interest rate these margin loans paid and the presumed safety of the collateral behind them, they attracted funds from all sorts of sources. Speculators in turn didn't worry about the high interest rate – a 9% annual rate could not deter someone seeing gains of 25% in a mere three months, as had happened during the summer (and of course those gains had been magnified due to the liberal use of margin).

Nevertheless, there were numerous critics expressing worries about the growth of margin lending, but the financial press tended to play their arguments down, even going as far as charging the critics with trying to undermine confidence for ulterior reasons (Barron's and the Wall Street Journal both published editorials to that effect).

Economics professors from Princeton to Yale also lent their optimistic voices in support. The main argument was naturally that stock prices were actually not overvalued; after all, prosperity was deemed certain to continue to increase. Thus the bearish argument that 'margin loans will become a problem if and when stock prices should fall' was not to be given credence, because there was no reason for stock prices to fall.

Alan Greenspan, when defending central bank inaction in the face of the 1990's bubble, was - perhaps unwittingly - going to repeat an argument first forwarded by Professor Lawrence of Princeton in 1929, in defense of the 1920's bubble.

Professor Lawrence had said:

'The consensus of judgment of the millions whose valuations function on that admirable market, the stock exchange, is that at present, stock are not overvalued. Where is that group of men with the all-embracing wisdom that will entitle them to veto the judgment of this intelligent multitude?'

Alan Grenspan's words were:

'For a central bank to identify a bubble involves pitting its own assessment of fundamentals against the combined judgment of millions of investors.'

(It is interesting to note in this context that neither Alan Greenspan nor any other central banker thinks it odd that the central bank should know better than this 'multitude of investors' at which level interest rates should be set.)

The skeptics were few, and in addition, the seemingly unstoppable upward march of stock prices served to discredit them. Banker Paul Warburg was one of the few financial professionals daring to voice doubt.
Alas, his stern warning came in March of 1929, when the market had just endured a temporary break, and the subsequent rally relegated him to the stable of 'obsolete bears'. The pessimists, it was often speculated, had financial motives for their pronouncements, such as being short the market.

It was in this spirit that the late September decline was greeted. Two days after the high print of September 3, there had been a memorable one day break of 2,6% , which later became known as the 'Babson Break'.
The multi-talented entrepreneur , business cycle theorist and investor Roger Babson, an early proponent of technical analysis, had held a speech at the Annual National Business Conference in which he boldly predicted that 'Sooner or later a crash is coming, and it will be terrific.' Not only that – he also predicted that a vicious cycle of liquidation and a serious business depression would ensue.

The financial press lost little time in denouncing him (a Barron's editorial pointed to his 'many inaccurate predictions in the past') , and Professor Irving Fisher of Yale declared a crash all but impossible.

The news backdrop deteriorated somewhat in late September of 1929. On September 20, the business empire of Charles Clarence Hatry in Britain collapsed, among allegations of fraud. It turned out Hatry had forged stock and bond certificates and cooked his company's books to boot.
His undoing was triggered by an unsuccessful attempt to merge a number of steel foundries into United Steel, which would then have emerged as one of the largest British steel producers.

The coup was too big for him, and he got caught trying to pass off GBP 1 million worth of forged municipal bonds in an effort to obtain the necessary funds. This invited scrutiny of his corporate accounts, and the Hatry Group promptly collapsed ($30 million were lost due to the collapse of Hatry shares alone).
British investors then began withdrawing fund from elsewhere, including Wall Street. This probably contributed to the 7,4% loss in the DJIA from September 20 to October 1.

Concurrently, the Federal Reserve reported a slightly worrisome deterioration in business conditions, specifically, a marked decline in industrial production.
Nevertheless, as a measure of the confidence that continued to reign during most of September, broker loans increased by a record $670 million during the month.

October 1929 – the appearance of 'organized support'

On October 3, the day the Kingdom of Yugoslavia was established by merging Croatia, Serbia and Slovenia, the market endured yet another big break. The DJIA took an near 15 point nosedive, equivalent to a decline of 4,23%. It closed at 329 points, a level last seen in late June of 1929.
No particular reason accounted for the sell-off – it simply appeared to be a continuation of the late September malaise.

No-one was worried yet however, and the market recovered in the following week to 352 points. Professor Irving Fisher achieved a dubious immortality by stating on the evening of October 15: 'Stocks prices have reached what looks like a permanently high plateau'.

October 16 was another weak day however, with the DJIA losing over 11 points. It regained about half of that loss the next day, but then came Friday October 18 and Saturday October 19.

In those days, the exchange was open on Saturdays for a shortened session. Ominously, a large price break occurred with volume the heaviest ever recorded in the short session – nearly 3,5 million shares.
The Dow lost a cumulative 18 points, or 5,26% in those two trading days – landing at 323,87 – a new low for the move.

Rumors that margin calls had gone out began circulating (the rumors were true), and the Sunday papers uneasily reported about the 'wave of selling' that had engulfed the market on Saturday.

A more reassuring note was however sounded insofar as the papers – specifically the financial press – almost all concurred that 'the worst is over'.
This was when the phrase 'organized support' first appeared. The idea was that the major banks and Wall Street houses, as well as the highly leveraged investment trusts, would not 'allow' the market to fall further.

Frequent mention was made of what we nowadays know as 'cash on the sidelines', as the investment trusts were (correctly) thought to hold large cash reserves.

Monday October 21 was an uneventful day in terms of price movement, with the Dow declining another 2,96 points to 320. However, it sported what was then the third-largest trading volume in history, 6,09 million shares.
Intra-day the market had been down a much larger 8,5 points, and due to the frantic trading volume, the ticker tape for the first time in the course of the decline failed to keep track of prices in a timely fashion.

In hindsight, this technological snag probably contributed greatly to what happened next. The problem for the many margined speculators was that they could not tell anymore where prices were at a given point in time, and had to fear the worst.
This created a 'sell before it's too late' mentality.

On Monday October 21, the tape was 1 hour and 40 minutes behind actual events. This had of course happened before, but only in a rising market, not a falling one.
The psychological difference between being late in finding out how much richer one has become as opposed to being late in finding out whether one has been ruined is considerable.

That Monday, Professor Fisher again declaimed his confidence, by stating that merely 'the lunatic fringe had been shaken out' of the market, and that stocks were now undervalued, because inter alia, they did not yet reflect the beneficent effects of prohibition, which had made 'American workers more productive'.

The chairman of National City Bank (known today as Citigroup), Charles E. Mitchell, a.k.a. 'Sunshine Charley', announced that 'the decline has gone too far' , and in a refrain familiar to the newly minted veterans of the 2008 market crash, declared that the country's 'business fundamentals are sound'.
Furthermore, the attention paid to margin lending volumes was entirely unwarranted in his opinion.

It appears that Citi has attracted 'late dancers' in major bubbles throughout history. Similar to today's version of the bank that financed massive speculation in mortgage backed securities through its SIVs ('structured investment vehicles') under the leadership of former CEO Chuck Prince (who once famously stated: 'When the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you’ve got to get up and dance. We’re still dancing.') , its predecessor organization in the 1920's financed a great deal of stock market speculation – with similarly ill-chosen timing – under Sunshine Charley Mitchell.

Tuesday October 22 brought a recovery in stock prices, with the Dow rising 5,6 points, or roughly 1,75%. Mitchell and Fisher had managed to restore a small modicum of confidence for one day.
Babson however seemed not to share their optimism. He let it be known that 'investors should sell stocks and buy gold' – prescient advice as it turned out.

It is strange in retrospect that Wednesday October 23 never got designated 'black Wednesday'. This was certainly the day when the first truly chaotic and indiscriminate wave of selling hit the market.
Apparently the public had begun to put more stock in Babson's predictions than those of his expert contemporaries wearing rose-colored glasses.

The market opened quietly that day, but shortly before noon, selling started in car supplier stocks, and from there began to spread through the entire tape.
The plunge became especially pronounced in the last hour of trading, with 2,6 million shares traded , at the time an unheard of amount for a single hour.
The DJIA ended the day a full 20,66 points lower, at 305,85 points, only two points above the day's low. Slightly less than the entire gain of the year 1929 had been erased (the DJIA began 1929 with an opening price of 300 and a closing price of 307 points on January 2).

Once again the ticker fell behind, with cross-country communications additionally hampered by a storm in the Mid-West. A large number of margin calls went out.

Organized support made its entrance the next trading day. Thursday October 24 is nowadays widely regarded as the real beginning of the crash, and it has in fact been designated a 'black' day. Similar to today's magical thinking about government agencies supporting the market at will, there was a strong faith at the time that a consortium of New York bankers could achieve the same.

This faith was nurtured by the famous 'market rescue' ascribed to J.P. Morgan in the panic of 1907. A little bit of skepticism about these claims would probably have been in order.

For one thing, Morgan's intervention could not stem the stock market crash, which happened in spite of his efforts to prop up banks suffering runs by depositors. The proximate cause of the 1907 crash was a mistimed attempt to corner short speculators in a copper stock, United Copper Company. The trust financing the corner – the Knickerbocker Trust Company – promptly went bankrupt alongside Augustus and Otto Heinze and Charles Morse, who had attempted the corner.
The action was mistimed as it happened while an economic contraction was underway, and the people attempting the corner in addition misread the market.
They forced United's stock up from about 30 to about 50 points, but short sellers were able to borrow sufficient stock to counter the corner, and the stock promptly collapsed all the way to $10.

A typical chain reaction set in, with the collapse of the Knickerbocker Trust causing bankers to restrain their lending, and depositors starting to fear for the health of the banking system. There were many moments in this crisis when things were deemed to be 'touch and go' – inter alia NY City itself was close to bankruptcy at one point, and got a loan commitment from Morgan to avert this calamity.
The point though is that while Morgan was definitely instrumental in knocking heads together and ultimately finding a private market solution to the banking crisis, he could not avert the stock market crash.

In 1929, the 'organized support' of the NY banks was thought to be able to do just that – and it actually worked, for exactly two and a half trading days – which is oddly reminiscent of the two trading days for which the SEC's short selling restrictions seemed to 'work' in mid September of 2008, when the DJIA was driven up by nearly 1,000 points just prior to the October crash.

'Black Thursday' initially continued where Wednesday had left off – prices just fell into a bid-less void. Trading volume exploded to 12,9 million shares, more than double the previous record.
After an uneventful open during which prices actually rose a tad, volume suddenly began to swell, and with it, prices began to sag. The rest of the morning hours was characterized by a blossoming panic.

Once again the ticker tape was far behind the action, but word of an enormous collapse in prices got out anyway. This was accomplished via the bond ticker, which contained sporadic updates on stock prices that were more up-to-date than the ticker tape's. Margined speculators contributed heavily to the selling frenzy, often involuntarily.
Shortly before noon the DJIA had plummeted to an intra-day low of 272 points, down a huge 33,5 points from Wednesday's close.

That was when the 'organized support' went to work. A meeting was convened at the Morgan offices , with the presidents and chairmen of the biggest NY banks present (Sunshine Charley of National City, Albert Wiggin of Chase, William Potter of the Guaranty Trust Co. , Seward Prosser of Bankers Trust, and Morgan senior partner Thomas Lamont).
After the meeting, Lamont met with reporters, stating that 'there has been a little bit of distress selling on the stock exchange' but that this was only 'due to technical conditions' , and of course, the 'fundamentals remained sound' and the situation was clearly prone to 'betterment'.
The agency about to procure the betterment was the consortium of NY banks.

Prices immediately began to firm when word of Lamont's interview reached the exchange. Shortly after noon, Richard Whitney, vice president of the NYSE and floor trade for Morgan, went to the post for US Steel and left a limit order for 200,000 shares.
He then proceeded to leave similar orders for other key stocks at their respective posts. It was clear that the banks had moved in to support the market, and prices shot upward for most of the remainder of the afternoon. The fear of losing everything had been replaced by the fear of missing the rally. A small selling wave appeared again shortly before the close, but all in all the operation was deemed a great success. The DJIA closed with a relatively tame loss of 6,38 points, just under 300 at 299,47.

The ticker tape was over 3 hours behind that day, and many margined speculators had been sold out at the lows, so the recovery meant nothing to them. In the evening, the press was informed by the cast of usual suspects that the situation was well in hand, the fundamentals sound, and the 'technical break' over.

A contemporary account of these events can be found in this article by Time Magazine, 'Bankers vs. Panic'.

On Friday October 25, prices actually rose a tad, with the DJIA closing up 1,75 points. They softened again slightly in Saturday's shortened session with the DJIA closing at 298,97.
In terms of price movement, these two days were quite uneventful. In terms of trading volume they were anything but. Over 6 million shares traded on Friday, and over 2 million in Saturday's short session.

The weekend following the bankers' market intervention is an interesting curiosity for students of market psychology. Apparently, the previously predominating feelings of fear had almost entirely evaporated. It was as if someone had thrown the 'maximum optimism' switch.

A veritable who's who of the banking and industrial elite sounded off on the 'sound fundamentals' and the fact that 'stocks were now cheap'. Even president Hoover chimed in, insisting that 'the fundamental business of the country' was on a 'sound and prosperous basis'.
The papers were full of stories about 'buying orders piling up at the brokers for Monday's open' and exuded strong conviction that speculation could be resumed forthwith.

A few articles spoke of divine retribution that had been visited upon speculators, a warning shot that had done its sad, but necessary work.
The CEO of Associated Gas and Electric, Howard Hopson, likewise sung from this hymn sheet, declaring that 'it is without a doubt beneficial to the business interests of the country to have the gambling type of speculator eliminated'.
Several brokers joined in a concerted advertising campaign in Monday's papers, urging people to buy. This, so they said, could now be done 'with the utmost confidence'.

The banking consortium seemed to have succeeded – faith in the stock market was restored.

Late October, the crash continues anyway

As it turned out, the weekend before October 28 was one of the biggest exhibitions of wishful thinking in market history.

On Monday October 28, stocks went into free-fall – losing more on that single day than in the entire week before. Volume was once again very heavy at 9,25 million shares, with 3 million traded in the last hour alone.
Once again the ticker tape was way behind the action, but it was clear to everyone that things had to be bad. Shortly after 1 p.m. , Sunshine Charley was observed entering the Morgan office, which the news ticker duly reported.

A brief recovery in prices ensued, but Richard Whitney didn't appear on the floor this time. The market finally closed about 4 points off its lows, but the DJIA had lost over 38 points at the end of the day, a decline of 12,8%.
Similar to what we have seen in modern day crashes, the decline of the big averages didn't tell the whole tale. The more speculative and illiquid issues were hit far harder. It was an unprecedented debacle.

The bankers met again for a pow-wow that evening. Afterwards, Lamont once again met with journalists, only this time, he had no firm assurances for them. The most he would commit to was that the 'situation retained hopeful features', but he wouldn't be drawn on what those were.
He did however state that the banks did not see it as their duty to support stock prices at a certain level or protect people from losing money.
Foreshadowing a phrase we often hear nowadays when the market plunges, he said they were merely concerned with maintaining an 'orderly market'.

This is of course a bit like when CNBC's Bob Pisani nowadays announces that 'yes, the Dow has plummeted by X hundred points, but the interesting thing is that the decline was very orderly'.
The translation for investors and speculators is: 'you're losing your shirt, but let's be glad it's happening in an orderly manner'. One supposes it would be worse if it happened in the form of a disorderly panic, although the profit and loss statement presumably doesn't care about the distinction.

Thus the 'potent directors' myth was shattered by Mr. Lamont on the evening of October 28 1929, only a few hours after it had still informed the hopes of thousands of traders and investors.
The market reacted with yet another plunge on Tuesday , October 29, and there could be no doubt this time it was as 'disorderly' as they come.

Volume swelled again, although some stocks went bid-less for hours. A number of stocks were actually down by 90% during the day's trading, a fact that could only later be ascertained by dint of some people putting in 'spoof orders' well below the market that ended up getting filled.
At the end of the day, volume was recorded at over 16,4 million shares, a new record high, and the DJIA had closed down 30,57 points at 230,07 – a loss of 11,73% on the day.
This close was actually well off the day's low, which was at about 212 points. The market had been helped by short covering late in the day.
Prices were now back at the level of August 1928, but the crash was still not over.

There was a large recovery over the next two trading days, with the DJIA snapping back to 273 points by the close of October 31, but between November 4 and November 13 a string of harrowing losses drove the average back down all the way to 198,69 points.

Thus the crash had erased roughly 180 Dow points from the high, and bankrupted the bulk of margined speculators. Between October 24 and October 30, broker loans fell by $1 billion.

Incidentally, the bankers who had provided the 'organized support' were by way of rumors suddenly suspected of organizing bear raids, and Thomas Lamont was forced to defend them against this allegation in statements to the press.
The presumed 'saviors' had turned into widely despised pariahs within a week's time.

Many of the people involved in the rescue effort were in later years hauled before congressional investigation panels and blamed for the crash and its aftermath. Several were convicted for fraud and/or tax evasion (inter alia Sunshine Charley and former NYSE vice president Whitney).


The potent directors fallacy in modern times

One thing I often hear is that 'the Fed will do this or that to support the market'. In fact, the Fed has already done quite a bit. Contrary to what commercial or investment banks can do, there is in theory no limit to the Fed's operations – it can print up money at will, although this will of course always be done in the context of the buying of securities, be they treasury bonds or, as has recently been the case, mortgage-backed bonds.

Similarly, the treasury department is thought of as possessing near unlimited power to run up debts in support of 'stimulus spending' and endless bail-outs.
And yet, in spite of this near limitless fount of 'organized support' , the stock market has crashed just as badly as in 1929.

In fact, lately , the stock market has done even worse. After the crash of '29 ended on November 13, the market managed a steady recovery into late April of 1930.
Recently, the market has by contrast experienced the 'worst January in all of history' as CNBC informed us last Friday.
There is of course still a very good chance that a recovery will arrive with a delay, and the market has not yet breached its crash lows of November 2008.

While the Fed or the treasury have never said that they are aiming to support the stock market directly, there can be little doubt that this is one of the hoped for outcomes of their interventions. There is no more obvious barometer of the financial and business mood than the stock market. The hope is that by directing support at the center of the financial troubles , namely the credit markets, the stock market can also be induced to shake off its funk.

So how come the 'potent directors' are once again failing? The reason becomes clear when one thinks things properly through.
The economy and its underlying production structure are what they are. There is nothing the government can possibly add to to the economy in terms or real resources.
By intervening on a grand scale in what appears to be a distinctly ad hoc manner, it merely introduces what is known as 'regime uncertainty'.

The main question investors are faced with these days is not 'is the economy sound' (it isn't) or 'will earnings improve' (some day they will). The main question is 'what will these bozos do next'.
And yet, there is this almost touching, widespread faith that government holds the solution to our problems.

People have to believe in something – the idea that the 'wealth increase' of the bubble years was entirely illusory is still not fully embraced. It is simply unacceptable – everybody, even many former bears, hopes that the downturn, while likely bad, will prove to be just another brief slump after which a return to 'business as usual' will surely follow.
This is to say, everybody secretly prays for the bubble to return.

There are now debates between economists in the pages of the Financial Times over whether the downturn deserves to be called a 'depression' or not.
Note that the person refusing to countenance the thought is Stephen Roach, who for many years has warned of the bubble's excesses. Apparently not even he can imagine that the downturn will be a mirror image of the boom.

News flash: industrial production and capacity utilization are in free-fall all over the world; trade is suffering its biggest contraction in decades; unemployment is increasing by leaps and bounds (according to shadowstats.com , the US unemployment rate would already be at roughly 17% if it were measured the same way as in the 1930's) ; even the former polyannas of the 'Goldilocks club' are forced to admit that the downturn already looks like the worst of the entire post WW2 era.



The annual economic summit in Davos was overshadowed by the gloomy reality, but at the same time brimming with incantations and assurances of government intervention being capable of saving the day (eventually).

The fact that financial markets are apparently in violent disagreement with this view is generally put down to their inbuilt tendency to act in an irrational manner.
Sure enough, financial markets are not entirely rational. Their movement is best explained by herding and the constant feedback loop between observers and participants. This is however not to say that there is no connection between the deteriorating fundamental underpinnings and the action of the markets. The common denominator is economic man, and his liquidity preferences.
As to the 'potent directors' – today's version of them is more 'potent' than anything we have had before – and yet, reality is limiting the efficacy of their actions.

The government's actions are predicated on the notion that malinvestment can be given a shot in the arm once again (although of course no government bureaucrat would ever put it that way).
This has after all worked before. There is a difference to 'before' though.
For one thing, securities prices can not rise without limit, and neither can the prices of other assets. The only way to induce a near limitless rise in asset prices is to utterly destroy the currency in which they are denominated, but then they would still decline in real, purchasing power terms (as measured by their price ratio to gold).

More importantly though, there was never a chance to properly correct the earlier excesses when the great boom was interrupted by financial and economic crises previously. Every time the central banks and governments of the world managed to restart bubble-type activities (activities that would not be profitable absent a credit boom) before a correction could proceed to properly repair the world's increasingly misaligned production structure.

In this manner, error was heaped upon error – an assessment that the nowadays insolvent banking giants would probably have to concur with, given that they were a focal point of this accumulation of economic errors.
This can only be done up to a point – the point at which real resources are not able to support the consumption and production patterns of the bubble anymore.
We seem to have passed this 'point of no return' in the sense that not even the most massive monetary pumping exercise in human history seems able to rekindle bubble activities.

This in turn makes the faith in the potent directors a dubious proposition, regardless of their indubitably great powers. Imagine for a moment that the central banks and treasuries of the industrialized nations were to decide to go well beyond their current 'all in' posture, committing to prop up asset prices at all costs, as demanded by the Keynesians at Pimco.

In short, imagine the effort to keep markets from reaching clearing prices would be expanded to whatever extent deemed necessary.
Such an effort would likely be shipwrecked by the very markets it was designed to manipulate. The idea that governments are free to completely ignore market discipline is mistaken.
Either the currency or the bond markets or both would veto the attempt – these markets can only be strung along to the extent that they remain confident that governments will be able to acquire the resources necessary to pay back their debts via future taxation. Once this confidence wanes, the game is over.

Similarly, the central banks can not inflate willy-nilly.
At present, a strong private sector credit contraction is a countervailing force to the inflationary policies, and traditional channels of monetary expansion - specifically the expansion of credit money – are clogged by dint of an insolvent banking system.
However, central banks can always go the route of crediting the government for debt it issues to them, and they can expand such activities to the point where they overwhelm the private sector credit contraction.

An example for this is the situation in Zimbabwe. Naturally, the country was in a position that was prone to such an outcome to begin with – many years of crass economic mismanagement culminated in the government's de facto insolvency, and massive inflation was the regime's 'last resort' in order to be able to continue to pay those that kept it in power. It would be an error to necessarily draw the conclusion that this is the path we are on. Zimabwe merely serves as a very good example as to the limitations the 'potent directors' eventually must face, even if there is no legal limit to their ability to issue currency or debt.

In conclusion, we should be just as skeptical about the current government and central bank directed efforts at influencing market prices as investors in the late 20's and 30's should have been regarding the efforts of the potent directors of their time – first in the form of the banking consortium that vainly attempted to stop the crash, and later in the form of the government and the central bank, neither of which could stop the depression from playing out. Instead, their ministrations ended up making it worse.
Not coincidentally, the liquidation in the stock market took a long time to play out, and prices eventually reached levels no-one would have considered remotely possible when the contraction began.

This is why even now, one must resist the idea that an allegedly 'cheap market' is once again fit for long term investment. At the moment, it is a market for nimble traders at best, for as long as it takes for the contraction to play out.
Notwithstanding all the hopeful incantations at Davos , we can not rely on the bureaucrats to pull our chestnuts out of the fire.

note: much of the historical information was sourced from John Kenneth Galbraith's book 'The Great Crash of 1929'. While i'm no fan of him as an economist, this monograph is an excellent synopsis ot the events surrounding the crash.

The Stock Market - relative strength comparisons

1.Fundamental outlook

'Worse than expected'

There can be little doubt that current economic fundamentals are extraordinarily bad – the new stock phrase that accompanies almost every economic data release lately is 'worse than expected' – and this happens with expectations already lowered considerably. A good way of following the evolution of expectations are WS estimates for S&P 500 earnings in 2009. These have gone from $98,-/ share about a year ago to $42/share now. There have been numerous revisions along the way, and economists are similarly revising their guesses as to economic data about to be released.

It is generally agreed however, that knowledge of current economic fundamentals is not necessarily useful information with regards to what the stock market is about to do. The theory goes, not unreasonably, that the market tends to discount fundamentals ahead of their manifestation. However, as i have previously pointed out, this has generally not been true over the past decade or so. The stock market has most of the time acted as a coincident, and at times even lagging indicator, at least relative to official economic data.

Nevertheless, this does not change the fact that current fundamentals are a poor guide to market action over, say, the next four weeks for instance. There could be a rally in spite of a continuing deterioration in fundamentals, pinned on nothing but hope (the 'it's so bad it can only get better' thesis of investing), or pinned on a more reasoned approach that is based on the general idea that stocks are not merely a claim on earnings streams in the relatively near future – rather they are a claim on earnings streams into the far future.

Still, it would be good to have a crystal ball that informs us of future fundamentals. Can we make an educated guess? A large percentage of mainstream economists routinely disappoints in the economic forecasting department. One can certainly not rely on their timing, and neither can one rely on their general forecasting abilities. How many economists did in fact forecast the bust? Given that they have obviously a tendency to have too rosy an outlook even in the face of one of the worst contractions of the post WW2 era (thus the never-ending 'worse then expected' moments), why should one believe their estimates of when a bottom is likely?

A review of the known facts is in order.

1.we are in a secular bear market period, which will be marked by a secular contraction in p/e ratios, from the over-valuation seen in 2000 to an as-of-yet undetermined level of undervaluation.

2.Such a bear market is accompanied by recurring economic busts of increasing severity and duration – busts that are a mirror image of the preceding boom.

3.The current bust has a unique feature - the banking system appears on the brink of insolvency after having inflated credit willy-nilly for several decades (this is no exaggeration as the US total credit market debt / GDP ratio shows).

4.The authorities – fiscal and monetary, know only one recipe to counter the bust – inflate, inflate and inflate some more (in a combination of using the printing press and blatant Keynesian deficit spending; both methods have been thoroughly discredited throughout history in practice as well as theory, but are resorted to as a matter of course anyway).

If we only consider the above, it is clear that the current bust is of a different order of magnitude than its predecessors. While it was also precipitated by relatively tight (relative to the period preceding it) monetary policy for a short while (2004-2006) , its major feature is the sudden incapacitation of the banking system – the very system at the heart of the practical implementation of the inflationary policy of the modern day industrialized welfare/warfare democracies.

It is important to note that the final inflationary boom – the real estate mania, respectively mortgage credit bubble, already saw the stock market decline sharply in real terms, even during the cyclical, nominal bull market phase.
In other words, the only thing that drove the rally from the 2002/3 lows in stocks was the inflation of money and credit. This becomes evident indirectly by the expansion of margin credit and the enormous leverage taken on by hedge funds and investment banks during the period.

It was a levitation on hot air - based on the false confidence that everyone in the chain of credit that was extended during those years would be able to pay.
The plunging Dow/gold ratio indicated though that it was an entirely illusory boom.
Given how the authorities have reacted thus far to the bust – the central question then becomes 'will they be able to create another inflationary boom?' In other words, can reality be masked again by a new illusion of wealth based on the inflation of money and credit?

This seems a tall order – since there is a limiting factor in the real world that doesn't lend itself to eternal exploitation – the pool of real funding. It matters not how many pieces of paper or electronic chits the Fed prints up in its balance sheet expansion – the amount of real resources available to the economy can not be changed by that.

The reality of the banking sector's balance sheet implosion is currently partly camouflaged via the Fed's interventions, but it can likewise not be winked out of existence.
What the banks now lack is capital – as their existing capital has been eaten away by too many securities turning worthless, and too many debtors defaulting. The problem is that everybody else lacks capital too, or owns capital for which there is currently no use and that can not be profitably employed in its current incarnation (a number of car factories come to mind, for example).

We can conclude that the bust will be intense, and investment strategies will have to be adapted accordingly.

The time of 'buy and hold' has been over for ten years already, even though a surprising number of analysts still seems to cling to this mantra of the bull market. Perhaps they should have specified 'buy and hold t-bills', since those have outperformed the stock market by nearly a cumulative 40% over the past decade?
Likewise, it appears the 'money multiplier' has degraded into a 'money divider' as Bob Hoye has recently put it.

2. Technical conditions

In terms of the stock market's technical condition, it is surprisingly poor. Why 'surprisingly'? There are quite a few historical examples of a market crash in the fall, both in the 20th and 19th century. One common feature of all those crashes has been a subsequent rebound that went hand in hand with a lessening of credit concerns and as a rule managed to retrace at least 50% of the preceding crash wave. A notable exception to the rule was the 1987 crash that happened in the broader context of a long secular bull market – in this case, the rebound erased over 100% of the crash wave before running into temporary trouble.
The point is, it is unusual to see the market as weak as it has been so far in January right after an autumn crash.


The S&P 500 Index with Elliott wave labeling. Wave 4 is likely still in progress. click on chart for larger image

It is possible, even likely, that the expected rebound will still happen with a delay. However, given the unusual action up to this point, one must be prepared for the alternative as well – a further wave of selling. As previously discussed, the market lends itself to a relatively obvious Elliott wave count since the October 2007 high. The corrective action since the 'wave 3' low has been a bit more difficult to interpret, which is a common feature of corrective waves, as there are a great many variations possible.
From this standpoint, the main question is 'are we still in corrective wave 4' or 'has wave 5 down already begun'.

One of the arguments in favor of a rebound is the fact that a number of market participants are reportedly simply waiting for the current horrible earnings season to be over before committing new capital. The earnings season is regarded as being chock-full of the same event risk that is currently dogging economic data releases – the 'worse then expected' syndrome.

Ironically, an argument can be made that the market is actually not 'oversold' , as Carl Swenlin shows here in this 'chart spotlite' at decisionpoint.

From experience though it can be stated that the shorter term the time frame considered, the more difficult it is to forecast the likely outcome. If acting in favor of one outcome, one should always prepare a plan of action for the opposite outcome.

Assuming that the rebound will resume, the question of which sectors are most interesting comes to the fore. Below are a number of 'relative strength' charts. They show how different market sectors have performed relative to the S&P 500 over the past year – whereby their performance since the November low is what interests us here.


Airlines have outperformed the rest of the market since the peak in oil prices. Note however that this streak seems potentially endangered now, which may be a hint that energy prices are about to rebound. Option traders are optimistic on airlines. put/call open interest across the sector is the lowest in the past year, and short interest in the group's most prominent component stocks has declined sharply. click on chart for larger image


Banks have once again strongly underperformed the market of late. As can be seen here, the BKX-SPX ratio chart broke the neckline of a head-and-shoulders formation, but may already have met the target range, and is now deeply oversold. Near term, we would avoid this group from both the short and long side. There's no need to try to bottom fish given the industry's sorry state and the risk of a snap-back rally is too great to make it an enticing target for shorting. This sector is best left to those who want to play hero. Interestingly, the sector-wide p/c open interest ratio of 0,87 is actually very low compared to the readings over the past year.
Note: as the market cap weighting of financial stocks declines, their influence on the market-at-large declines commensurately. click on chart for larger image



The biotechnology index has outperformed the market since last spring. The sector-wide put/call open interest at 0,62 is fairly high compared to readings over the past year, which is to say, option traders are rather pessimistic on this group now. Good relative performance coupled with pessimism is a good omen for this sector. click on chart for larger image


The Broker Dealer Index has made no headway relative to the market since the November low, and remains in its longer term down-sloping channel. Short interest remains high, but option traders are curiously optimistic on the group. We see no reason to engage with any financial stocks, given that their outlook remains bleak. Financials should be watched for signs of getting overbought, at which point they will likely continue to provide shorting opportunities for nimble traders. click on chart for larger image


There's nothing remarkable about the performance of the Chemicals Index either, which is essentially also going nowhere relative to the S&P, following a streak of under-performance since the fall. As a cyclical sector it suffers from the sharp deterioration in the economy. click on chart for larger image




Due to containing a large weighting of Wal-Mart (WMT), the MS consumer index CMR has outperformed the broader market. The discretionary consumer ETF XLY may be the better gauge in this case – it has flat-lined relative to the broader market, which is to say, it has performed just as badly. In short, there are neither fundamental nor technical reasons at this time favoring this sector. click on charts for larger images



Disk Drive stocks have begun to outperform since the November low. It remains to be seen if this can be kept up due to the fundamental challenges faced by this industry. Still, storage is perhaps one of the better sub-sectors in the tech hardware world. click on chart for larger image


There is always a lot of worry about the pipelines of the large pharmaceutical firms, and the sector has for a long time been a downside leader (it was one of the first groups to break below its 2002 lows). However, strong balance sheets, high dividend yields and an intriguing streak of outperformance in recent months make this sector interesting. click on chart for larger image


Computer Hardware shows strong relative performance since the November low, mostly due to component stocks like IBM and HPQ. It remains to be seen whether this can be kept up – option traders are optimistic, and there are a number of fundamental reasons to remain wary.
click on chart for larger image



Internet stocks are helped by GOOG's less than horrible recent earnings report. There is however nothing especially exciting here. click on chart for larger image




The upcoming period of seasonal strength in energy could help both the XOI and OSX. XOI currently looks better on a relative strength basis, but the OSX is traditionally lagging, and usually has a higher beta, so it could play catch-up. click on charts for larger images


RTH's relative strength is helped by Wal-Mart (WMT). For obvious reasons, retail stocks should probably be avoided. The best thing that can be said for them is that most are technically oversold by now. click on chart for larger image


Networking stocks have been going nowhere in particular relative strength-wise in a wide channel. click on chart for larger image


The Semiconductor sector has recently strengthened as well, but the group remains suspect for fundamental reasons. click on chart for larger image


The relative strength chart of the telecommunication group is intriguing, as it is attempting a break-out. click on chart for larger image

The point of this exercise is basically, 'if you have to be long something, choose whatever shows good relative strength' . Two of the biggest reasons why I personally have become a bit more constructive vis-a-vis the stock market in the near term can be found below (please note, i remain medium to long term bearish):


The US dollar index appears to have built a bearish flag – a decline in the dollar would likely go hand in hand with rising stock prices. click on chart for larger image


The safe haven buying that supported the huge rally in T-bonds has subsided. The initial correction target has been met, so a rebound is increasingly likely. However, the bearish influence the bond market had on stocks has clearly lessened (currently, lower interest rates on long term government bonds are a bearish, not a bullish sign for stocks). click on chart for larger image

3. Gold and gold stocks

I'm looking at gold and gold stocks in a separate section because the gold stocks are currently the one market sector with the best fundamental and technical outlook.

Here is why:


Gold weekly, 3 years. this chart looks constructive click on chart for larger image


On the daily chart we can see that a big test lies just ahead for gold - the resistance in the 920-930 area that has stopped the previous rally attempt. It seems likely that this won't be overcome on the first attempt. Breaching this resistance would be a a very positive sign. click on chart for larger image


Gold keeps streaking higher against the S&P index. At the moment it is attempting a new break-out in relative strength terms click on chart for larger image


Gold has risen enormously relative to crude oil. Energy is a major input cost for gold miners, so this is a boon for their profit margins. Interestingly, Wall Street analysts are generally very lukewarm toward gold stocks. click on chart for larger image


Since the low was put in, the HUI has risen sharply vs. the SPX, but the relative strength chart is now running into short term resistance.

To reiterate something I have mentioned before: the gold sector will probably be the only major market sector to deliver earnings growth in coming quarters. In spite of this, it is strangely unloved by many in the Wall Street analyst community.
Let me name a few examples.

Newmont Mining (NEM) for instance currently sports 4 'strong buy', one 'buy' and 8 'hold' ratings ('hold' is the Wall Street euphemism for 'you should have sold it yesterday'). Put/Call open interest on the stock has soared in the past few months, from roughly 0,60 to about 1 now.

Barrick Gold (ABX) has 6 'strong buy', 1 'buy' and 7 'hold' ratings; put/call OI on the stock has also soared lately.

Goldfields (GFI) has 1 'strong buy', 2 'hold', and 1 'sell' rating. Note in this context that the price of gold in South African Rand is at a new all time high (!) , while GFI trades about 65% below its former all time high. p/c OI on the stock has doubled of late.

Harmony Gold (HMY) has 1 'strong buy', 1 'hold' and 1 'strong sell' rating. I'm not sure who dispensed the 'strong sell', but the company's balance sheet is stronger than it has been in years, it has 5 growth projects in the pipeline, and the fattest margins in at least 5-6 years.

You get the drift – Wall Street isn't exactly brimming with love for gold stocks. This is of course excellent news for anyone holding them, as it increases the chance for future upgrades.


Gold in South African Rand. This is a nice, steady bull market progression. The profit margins of South Africa's gold mines are soaring along with it.

another housekeeping note

Unfortunately i have not yet found the time to reply to the many interesting and often thought-provoking comments and queries that have been made in recent weeks.

I will try to reply to as many as possible over the coming weekend.
So if you have been waiting for a reply to a comment, best check back on Monday , January 12, by which time my replies should be posted.

I will try to do my best to post replies in a more timely manner in the future, but can not guarantee that that will always happen - thank you for your patience and understanding.

Let me also take the opportunity to somewhat belatedly wish everyone a happy and prosperous new year.

pater tenebrarum

Krugman's interventionist crusade

The high priest of interventionist economics

From his perch at the New York Times, Professor Krugman has been dispensing economic and political advice for many years. Unfortunately, he is to economics somewhat similar as Ben ('you have to buy financials here') Stein is to investments, in short, he is potentially capable of doing a lot damage.

For this reason alone, his views must be challenged from time to time, even though we poor bloggers do certainly not have his reach. My fellow blogger and friend Mish has recently done so , in a blog entitled 'Krugman still wrong after all these years'.

He certainly is, and i want to take the opportunity to add a few complementary thoughts to Mish's ruminations on the topic.

First of all, i would recommend this paper(pdf) by Daniel Klein and Harika Bartlett, in which Krugman's editorials have been analyzed statistically and then interpreted by the authors.

The verdict is clear: Krugman is propounding a social-democratic ethos , even though he curiously never admits it outright.
On the contrary, he presents himself as somehow being 'above ideology', while at the same time managing to be one of the most vocal and well known advocates for statism and interventionist policies in the economics profession today.

As the paper notes, if one thoroughly looks at e.g. his concern for the poor, it turns out that this concern is trumped by his support for statist intervention – this is to say, when the choice is between a policy of liberalization that clearly helps the poor and a continuation of a regime of regulation harmful to their interests, he will always favor regulation (by simply remaining silent on the topic).

His record of favoring markets apparently consists of a single assertion in one of his editorials which he purports 'not to be against the market' – a statement that is then thoroughly contradicted in almost every paragraph of the hundreds of articles he has written.
He has come out in favor of liberalization in exactly two cases in his writings for the NYT from 1997 to 2008, which comprised 645 editorials as of January 2008.

Krugman's political ethos is also marked by the 'social compact' chimera – he strongly supports democracy, because the act of voting in his mind legitimizes state coercion.
After all, you have a choice, so this theory goes. If you're not happy with the status quo, vote against it.
We all know however that this is not how it works in reality. You can not opt out, or vote against the status quo, because that choice is simply not presented in elections.
In the US specifically, the two party system is akin to a one party system with only slight shades of difference in emphasis regarding the types of statist policies that are supported.
In this context read Albert Jay Nock's very interesting and entertaining essay 'What the American votes for', in which he explains why he decided to abstain from voting, respectively only voted for people that were already dead.

Criticism without basis

Occasionally, Krugman will criticize the Austrians (whom he doesn't name – he calls them the 'liquidationists' instead – presumably short hand for everyone who thinks the state should not intervene to stem the bust), who in turn frequently criticize right back.

Curiously, Krugman does his utmost to ignore the Austrian school's arguments – it is as if he is aware he's being criticized, and given that the views of the Austrian school are lately gaining a certain degree of credence with the public, finds it necessary to publish an occasional criticism, but at the same time is studiously avoiding to actually read what they have written.

In his recent article on what he calls the 'Hangover Theory' , which can by implication only refer to Austrian Business Cycle Theory (ABCT), he once again roundly ignores arguments that have been sent his way quite some time ago already.

This can only mean one of three things:
A) he doesn't grasp the arguments (unlikely), B) he didn't read any of them, nor any of the classical works (possible i guess) , or C) he has read them, but now makes as if they didn't exist, thereby misrepresenting them by omission.

As Robert Murphy shows here by means of a little economic anecdote, Krugman simply ignores the role of capital (a failing of Keynesianism in general), and its intertemporal structure.
Now, he has either read Murphy's piece or he hasn't, but he sure does ignore it completely. Most importantly he ignores the point that during the boom, resources will be misallocated, which in turn leads to consumption of capital.

I urge everyone to read Murphy's article, as it lucidly explains why the view of the economy as an agglomeration of 'aggregates' is wrong – and how in an artificial boom, misallocation of capital along the production structure leads to capital being consumed and falling into disrepair.
As Murphy correctly remarks, it is vital to understand this part of the ABCT if one wants to sensibly contribute to the debate. It is the process of capital consumption – respectively consumption of the pool of real funding, or put in other words, previously accumulated wealth - that creates the illusion of the boom.

The master builder

Ludwig von Mises had numerous little common sense quotes and anecdotes in which he tried to paint an easy to understand picture illustrating such concepts.
With regards to capital consumption, he referred to consumption without preceding production (which is a side effect of the fiat money system's 'money out of thin air' creation) as akin to 'burning the furniture to heat one's home.'

One can do that for a while, and the house will be nice and warm for some time, depending on the amount of furniture available to burn. One day though, one will perforce run out of heating material, and voila – the home will grow cold (as a metaphor for the inevitable bust resulting from capital consumption).

Another von Mises anecdote that illustrates scarcity and the importance of correct – i.e., market-based - information in guiding entrepreneurial decision making, is the one about the master builder.

Imagine the Pharao charges you with building him a palace. At the outset, you are informed how many pieces of wood, hows many bricks, nails, glass panes, shingles and other building materials will be at your disposal.
In short, you seemingly have perfect information about the resources available to you.

However, someone made a mistake – there are in fact 20% fewer bricks available than you were led to believe. Some of the crew discover the mistake, but given that building the palace means a good time for everyone – they all have jobs, they're building a nice palace, everybody, including the builder seems happy – they decide to keep you in the dark about it.

You will of course succeed in erecting the foundation, and perhaps in building up to say, the first floor.
However, the building you have planned on the basis of this incorrect information will forever remain unfinished – at some point, the bricks will run out prematurely.

It follows that the earlier in the process you learn of the error, the better the outcome will be.
If you learn of it while still drawing up your plans, you can plan anew, and only some of everybody's time will be lost. If you learn of it after having built the foundations, there may still be time to change plans for a somewhat smaller, but still doable palace. If you learn of it one day before the bricks actually run out, it will simply be too late – a monument to malinvestment will have been erected – an unfinished palace.

The resources that have been used up in erecting this unfinished building have been used up, and while everybody had a 'good time' (the boom) while doing that, they are now faced with the fact of an unsalvageable and uneconomic project standing before them.

Relevance to the economy at large

The problem presented by an artificial credit boom to the whole economy is akin to this master builder problem. In this case, the artificially low interest rate is what creates a fata morgana – i.e. a crucial piece of misinformation – that leads businessmen astray, namely the illusion that more savings are available than there really are.

It is the conceptual difference between money and real resources that trips up Krugman. He thinks if only someone – preferably, in his view, the state – were to spend money in the teeth of the bust, everything would be alright again. This ignores what has happened in the boom – scarce resources were misallocated due to false information on the true state of savings, and thus capital ended up being malinvested and consumed.

If we look at the policies enacted since the bust began, we see that they are all geared to keeping the disinformation that the boom was based on alive.

Once again, interest rates are being suppressed to an artificially low level. The state meanwhile is set to spend more money than at any time before in such a brief time span in peace time, on the idea that more spending is going to cure what too much spending has wrought.
However, the state can not add one iota to the pool of scarce economic resources that need to be optimally allocated if the economy is to recover.
We must always come back the the fact that the state does not have any economic resources of its own – it does not produce any. Instead, it must take them from those who do produce them.

Listening to Krugman, you'd think Austrians were a bunch of sourpusses begrudging everyone the good times of the boom, and then making things worse by being especially dour party-poopers with regards to the remedies thought to be necessary 'fix' the bust.
However, it is just realism and rigorous a priori reasoning that leads to their conclusions. Once the economy's pool of real funding has been damaged on account of an artificial credit boom, the priority must be to allow the production structure to readjust to reality, and that process, while painful, is also necessary.

The efforts of a coercive redistribution agency (the government) can not change that, and the printing of more fiat money can not either.
What the introduction of these factors does is to upset the market process.
They are deliberately used to induce booms (booms are politically popular until they go bust), in the hope that someone else will have to deal with the consequences (as is indeed the case; Bernanke gets to deal with Greenspan's legacy, and Obama with Bush's), and when those consequences inevitably arrive, they are used again in a futile attempt to keep those consequences at bay.

As long as the pool of real funding hasn't been damaged too excessively during a boom, a dose of monetary pumping can be expected to revive the illusionary boom – as has indeed happened several times in the past, most recently after the technology bubble flamed out.
The problem is that this only stores up even bigger problems for the future. We can all clearly see now that Greenspan's attempt to prevent the previous correction/bust from doing its work has led to an even bigger, more intractable bust in the present, but the interventionist caste still insists that we have to do the same thing all over again, only in larger dosage!

Once a boom turns to to bust, there are a number of facts that need to be faced:

1. there were not as many savings as thought, so capital was misallocated;
2. what the economy needs is as little interference as possible, since otherwise the danger is that even more capital will be misallocated.
3. the process of realigning the capital structure to reality is not painless, since it requires far fewer workers than are are needed when everything is humming.
4. the less interference there is, the faster it will be over.
5. to interfere means de facto to burden an already weakened economy even more – therefore, the more intervention, the less desirable the likely outcome (and it's not as if we didn't have any examples for that).

The pretence of knowledge

Lastly, look at how Krugman argues in favor of state intervention and spending to 'mitigate the bust'. His argument in favor of increased fiscal spending in Europe is summed up as follows:

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

Read the linked article for an explanation of the formula.

This is what Hayek referred to as the 'Pretence of Knowledge'.
Modern day economists seem to think that if it can't be put into a formula, then it can't be science. Economics is however a social science, not a natural one. It is about human beings, and the interactions of millions, nay billions, of human beings can not be pressed into neat little formulas.

This is not to say that one must completely abandon a formulaic approach to certain economic concepts (a graphic representation of a supply-demand curve surely has its place for instance), only that the 'ceteris paribus' type equilibrium which these formulas assume to be in place is not present in the real world.
The science of economics must proceed from sound a priori reasoning, otherwise it can not present the proper conclusions and provide policy recommendations.

It is this latter point that should worry us all. Krugman and other supporters of interventionist dogma are self-styled advisers to the political class, which in turn likes to hear nothing better than advice that prods it to intervene.
The courtier economists are thereby apt to doing a lot of damage, as mentioned in the opening paragraph.

Naturally, few economists would be prepared to admit that they actually don't know what to do. In this, the Austrian school is quite different. It essentially says: 'The entity that knows best what is to be done is the free market. Let it work'.
In other words, they have no 'policy recommendation' except - 'do nothing'.
When Ludwig von Mises was once asked what his first action would be if he were to be appointed 'minister of economics' he answered: 'Resign'.

It's not the type of advice one can easily make a living from. The interventionist courtier economist of Krugman's type on the other hand is asked to draw up plans, has the ear of the powers-that-be, gets to feel important , and gets paid nicely for his efforts.

Furthermore, as has been shown over and over again, the fact that intervention does not work is never seen as a reason to abandon it, but rather to come up with new, additional interventions purportedly designed to fix the unintended consequences of the old ones.
In this manner, the power of the state grows and grows – which is to the advantage of both the political class as well as its 'advisors' and everyone feeding at the state's trough (including many corporations; contrary to what one would think, most corporate entities are not in favor of a free market either – rather, they seek protection from competition in the form of anti-competitive regulations, respectively seek a slice of the tax payer pie that is doled out by the political class in its favors and vote buying activities).

What is to the advantage of the political class and its advisors and hangers-on is however as a rule to the disadvantage of everyone else.
If we want a sound economic policy, we must oppose Krugman's call for more intervention.

Off Topic – Serial Music

Another Austrian invention

there is another field pioneered by Austrians, one perhaps even better known than their contribution to economics – namely serial, or dodecaphonic music, a.k.a. 12-tone music.

The most famous composers of such music were Arnold Schoenberg, the inventor of the 12-tone technique, and his contemporaries Anton von Webern and Alban Berg. In modern times Karl-Heinz Stockhausen, Luigi Nono, Milton Babbitt et al. became well known proponents of this type of music.

Lesser known, but no less interesting, is Josef Matthias Hauer, who made his own contribution to serial music theory by introducing the so-called 'tropes' – a method for constructing chords in music without a specific key that allows for the composition of less 'dissonant sounding' 12-tone music. This method was developed independently of Schoenberg's theoretical work.

Take a look at this interview with classical pianist Mitsuko Uchida on Schoenberg and his piano concerto op. 42; she is one of the foremost interpreters of this work, which is extremely difficult to play (as she explains in the interview, this partly owes to Schoenberg not playing the piano very well, so he didn't consider the technical troubles a pianist would encounter when trying to play this composition, perhaps unwittingly making it a real tour-de-force for the interpreter).


Mitsuko Uchida on Schoenberg's piano concerto, opus 42

Note her mentions of the original 'tone row' (P0), the retrogrades, inversions, etc. - an explanation of these terms follows below.

A little bit of theory

Serial music favors a seemingly very 'mathematical' approach to composition, as it has certain specific rules, that govern the order in which different pitches can be used. At the core of the theory is Schoenberg's idea that 'no note should be accorded more importance than any other'; this is achieved by the rule that once a note of a '12-tone row' has been sounded, it may not be heard again until all other 11 notes of the row have been sounded. A tonal democracy so to speak, or rather, an atonal democracy.

Serial composers do not really think in terms of 'notes' – rather, they refer to them as 'pitch classes', that are typically numbered. For instance, if one were to write down a 12-tone row consisting simply of a chromatic scale beginning with 'C' , then the note 'C' would be termed pitch class 0, C# would be pitch class 1, D would be pitch class 2, etc.
Note also, in terms of notation, accidentals (#,b) are only valid for the pitch immediately following them, not for all subsequent appearances of the pitch, and enharmonic spellings of the same (well-tempered) pitch , like e.g. C# and Db are used indiscriminately.

At the beginning of every serial composition is the initial, or prime tone row, P0. This could for instance be:

D, G, F#(Gb), D#(Eb), C, B, A, E, G#(Ab), A#(Bb), F, C#(Db)

(this is the basic tone row that was used in the composition 'Matrix' that is available for free download at the bottom of this post).
If we were to write down this tone row in numbered pitch classes, it would look thusly:

0, 5, 4, 1, 10, 9, 7, 2, 6, 8, 3, 11


The above 12-tone row in normal musical notation - below the notes the respective pitch class numbers click on image to see larger version

Next one constructs from this original tone row P0 a number of additional tone rows, that are all derived from the original with a simple mathematical method. These basic transformations of the tone row are referred to as transposition, inversion, retrograde, and retrograde inversion. One thus arrives at 48 tone rows (P0 transposed 12 times, inverted 12 times, mirrored 12 times, and inverse-mirrored 12 times).

This can be done using a matrix. First one writes down the original tone row at the top, from left to right, then one constructs the inversion I0, writing it down in the first column to the left. The inversion is constructed by finding the complements to the pitch classes of P0, which are given by the number that when added to the pitch class number will equal 12.
Thus the inversion I0 of the above tone row P0 will be:

D, A, A#(Bb), C#(Db), E, F, G, C, G#(Ab), F#(Gb), B, D#(Eb) ,

or in pitch class numbers:

0, 7, 8, 11, 2, 3, 5, 10, 6, 4, 9, 1

from the pitch class numbers in the top row (P0) and left-most column (I0), all the other transformations are easily deduced. The numbers of the first row are at the same time the index numbers of the inversion columns, while the numbers of the first column give us the index numbers of the transposed rows. Thus the second row in this example will be P7, or P0 transposed by 7 half-tones, the third row P8, the forth row P11, and so forth. The second pitch class of P7 is determined by adding the second pitch class number of I0 to the second pitch class number of P0 modulus 12, the third by adding the second number of I0 to the third number of P0 mod 12, etc.
The rows when read from right to left give us the retrogrades (mirroring the intervals), the inversions when read from bottom to top give us the retrograde inversions (mirrored intervals of the inverted tone rows).

The entire matrix then looks like this:


The 12-tone matrix in numbers click on image to see larger version

or in terms of notes:


The 12-tone matrix in notes; P 0-11 are the original tone row plus its transpositions; I0-11 the inversions of the tone row and its transpositions, R0-11 the retrogrades and RI0-11 the retrograde inversions.
This matrix is the 'raw material' from which a 12-tone composition is made. click on image to see larger version

Josef M. Hauer , whom I mentioned earlier, developed methods that retained some of the features described above, while introducing new ones, especially w.r.t. construction of chords. Below a handwritten sheet of chords constructed with Hauer's method. (note: the letter 'H' is how the note 'B' is referred to in German). The main difference: it doesn't sound quite as 'dissonant'.


A picture of chords constructed with Hauer's method; the 12-tone rows (circled in red) are the only thing that changes – all other notes remain the same as one progresses; the notes are taken from the groups of 3 notes in the immediate vicinity of each other – whereby one starts with the ones next to the first note in the tone row. The 12-tone row moves like a snake through the chords. click on image to see larger version

This is only a very basic overview over the theory – if you wish to learn more, further introductory material can be found here: 12-tone composition

A labyrinth worth exploring

If one is not familiar with 12-tone music, it may seem a bit difficult to swallow at first, so to speak.
Milton Babbitt famously declared that he didn't care if anyone liked his music.
His argument went like this: most people don't understand it, but that is not an indicator of its worth. If a layman were to walk into a congress of nuclear physicists he wouldn't understand a word either – and so presumably would the majority of people, but that does not mean nuclear physics is not a worthy endeavor.

The infamous Babbitt essay 'Who cares if you listen?' is where these thoughts were formulated. Advanced music is for advanced listeners, so Babbitt. The rest have no basis by which to judge this type of music, just as a radio repairman has no basis to criticize the work of a nuclear physicist.
To some extent i'm sympathetic to this argument – as long as some people find enjoyment from dodecaphony, there is sufficient proof of its worth.

Popularity may count in pecuniary terms, but it is hardly the main criterion by which to judge art. Naturally, Babbitt put off a lot of people with his elitist essay, but he probably reckoned, so what? Those were the people who wouldn't listen to his music anyway! Here you find btw. an interesting early 80's article by Greg Sandow on the 'fine madness' of Milton Babbitt.

This elitist argument was carried even further by a German composer: Karl-Heinz Stockhausen. When asked by a student in the 1970's if the use of electronic instruments like synthesizer modules in his compositions would not risk losing a valuable and very important component of music as artistic expression , namely human emotion, he answered that he thought people were simply afraid.
Afraid of what? Afraid of not belonging to the newly evolving species of man that could relate to this type of music. He regarded modern music as accompanying the next step in human evolution - to truly grasp it, you had to have 'evolved' , or at least be in the process of evolving, to the next stage of human consciousness.

Oh well, what can one say to that. :) A recording of Stockhausen's 1972 lecture is below:


Stockhausen on human evolution and music, 1972

My experience is as follows: most people are rather taken aback when hearing serial music for the first time – chances are, after all, that they will hear a 'difficult' piece , since by their very nature, most pieces are difficult , and often dissonant.
In spite of its 'mathematical construction' aspect 12-tone music often gives the initial impression of being chaotic and disorganized - which of course it is not, but few people will realize it at first. It certainly is what one would call 'uncompromising' – it doesn't exactly cater to popular tastes.

You might ask, how does the composer actually introduce emotion when he works with tone rows that have been calculated beforehand? This is done by making use of all other aspects of musical expression. Rhythm, the way the various tone rows are interlaced, the timing of musical events, textures and tone colors, the type of instrumentation used – all can be and are used to create an individual artistic expression within the confines of the system. Naturally, great masters like Schoenberg and others occasionally would break their own rules. Once you know the rules well, you also know how to break them effectively after all.

It is generally unlikely that the untrained listener will immediately find his way to enjoying serial music. For one thing, it lacks the patterned, repetitive elements we are used to hearing in most tonal music; in addition, it frequently sounds dissonant, although as J.M. Hauer's work proves, this does not always have to be the case. Here is a rare recording of a Hauer piano piece as an example:


Josef Matthias Hauer's Klavierstuecke, opus 25

Nevertheless, it is a labyrinth well worth exploring – as Ms. Uchida remarks in her interview, there are a number of composers such as Debussy who did not use the 12-tone technique, but still left tonality largely behind in many of their compositions. Debussy is probably a good way of approaching atonal music 'painlessly' initially, before one takes the next step of exploring Schoenberg and the modern age composers.
I for one disagree with both Babbitt and Stockhausen – neither do I think it doesn't matter whether anyone listens to the music, nor do it think you need to climb the next step on the evolutionary ladder in order to find enjoyment from this type of music as opposed to being 'afraid' of it.
To be sure, it is not for everyone. If your idea of aural fulfillment is the next Britney Spears hit single, then forget it. Even if you like classical (a.k.a. 'serious') music it does not follow automatically that you will like 12-tone music. There's a pretty wide gulf between Mozart and Schoenberg after all.

A tip for getting acquainted with Schoenberg: his 'Variations for Orchestra', opus 31.

The Electronic Primitivism Project is a loose association of musicians that plays mostly my compositions. Below you find for free download a serial music composition for synthesizer and orchestra. It uses both Schoenberg's and Hauer's methodologies , as a result it sounds alternately tonal and atonal – furthermore, there is some rule-breaking trickery involved in several passages, whereby a 12 tone row was sent through sequencer combined with a so-called voltage quantizer; the quantizer takes incoming pitches and then picks the most nearby pitches conforming to a scale (in this case, minor scale) that has the incoming pitch as its tonic keynote. Thus, every time a new pitch class is received by the quantizer it will begin transposing to a new minor scale; in this way the 12-tone row is serialized in a new manner – as a series of different tonal scales.
It's probably best to download the mp3 file and listen to it over a system resp. headphones with good stereo imaging. By the way, the gentleman who unwittingly lent his hacked-to-pieces voice to the final vocoded part is Shimon Peres.

Please note: even though this is for free download, I retain the copyright – no commercial use without my consent (as unlikely as commercial use of this stuff is) and if reproduced for private use, the EPP must be identified as the author.

Matrix (P0: D, G, F#(Gb), D#(Eb), C, B, A, E, G#(Ab), A#(Bb), F, C#(Db)) - 58,6 mb

The war on savers and how it damages the capital structure

Boosting 'aggregate demand'

To no-one's surprise, the Federal Reserve's open market committee (FOMC) , slashed interest rates to near zero in December, while simultaneously announcing its intention to engage in even more interventions in the credit markets, that essentially amount to what is known as 'monetization of debt', whereby the Fed buys up debt securities in exchange for newly created 'money'.

The following statement accompanied the Fed's action:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 
Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco.  The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Take note of the sentence I have bolded in this statement from the money Kremlin:

„The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.“

Apparently, the Fed's central money price fixing committee holds that the way toward 'sustainable economic growth' is best fostered by making war on all of those who have refused to partake in the recently burst bubble – those that have been prudent and have accumulated savings.
It has just slashed their income by another ¾ – 1% to virtually zero, in the hope that this low rate of interest will induce them to spend their savings – in short, it intends to spur consumption by waging war on savers.

It is also hoped, judging from the statement, that consumption will be boosted by inducing the banking system to lend more money at favorable rates. The banks are large holders of the types of securities the Fed intends to 'monetize', and the Fed obviously wants to stuff them to the gills with 'new bank reserve assets' , to give them incentive to lend and get that darn money multiplier pointing up again.


A picture of monetary erectile dysfunction:
The famed 'money multiplier' – measured by dividing the money measure M1 through the monetary base. Since M1 measures inter alia the creation of new deposits (an indirect measure of the proliferation of fractionally reserved credit), the recent plunge in the multiplier indicates that the Fed's pumping up of base money has not had the desired effect. Click on chart for larger image.

The erroneous beliefs these actions are based on represent a sort of economic superstition. The idea that we have a 'deficiency of consumption' flies in the face of common sense, since common sense alone tells us that prior to the recent bust we had too much consumption – much of it financed with the same credit out of thin air that the Fed so desperately wants to get flowing again - and that this surfeit of credit based overconsumption is what has actually caused the bust in the first place.

So how come the money Kremlin believes more of the same will be a good thing?
Their error is in believing that the state of affairs prior to the bust was 'good', and thus should be recreated at all costs.
Was not the period now fondly remembered as the 'good times' – the boom – marked by lots of consumption? Yes, it was. Therefore, so they apparently hold, one should strive to once again put in place the set of conditions that seems to be the proper backdrop to 'good times'.

As I have mentioned previously, the people responsible for these decisions base them on a very simple circular flow model of the economy consisting of 'aggregates' that can be neatly pressed into equations. Drop some new fiat money into someone's lap, and presto, consumption will be revived, and with it 'sustainable growth', so their economic models tell them.
What they fail to consider is the economy's capital structure. To them, investment and capital are just another 'aggregate' , that sits somewhere in their circular flow model. 'Boost demand', so their thinking goes, 'and the rest will take care of itself'.

Unfortunately, it is a whole lot more complicated than that. If all it took to create 'sustainable economic growth' were the throwing of a few levers by a bunch of monetary bureaucrats, Zimbabwe under Dr. Gono's wise monetary leadership would be a utopia of riches. Surely no-one can possibly doubt his credentials as an accomplished inflationist. He has done a lot more to 'boost aggregate demand' than the FOMC has gotten around to so far, so it is only proper that we ask how his country ended up with an 80% unemployment rate. There has to be a fly in the ointment somewhere.

The structure of production, savings and interest rates

To the average mainstream economist, capital is merely an aggregate ; if that were actually the case, then the conclusion that lower consumption will necessarily lead to recession and unemployment would be correct.

However, there is in reality a trade-off between consumption and investment. Let us consider a world without interfering central planners.
In such a world, savings are simply that part of production that has not been consumed. Since investment is constrained by the amount of available savings, it follows that less consumption is the prerequisite for more investment.
Every year, a certain amount of capital needs to be replaced. The amount of savings in excess of this replacement need is what is available for additional, net new capital investment. Keep in mind that we are talking about real resources and capital, not 'money'.

Capital is however not an amorphous aggregate. It has a structure – what we will refer to as the 'structure of production'. This structure has a complex inter-temporal ordering; before a consumer good hits the shelves at Wal-Mart, it goes through number of processes , the stages of production.

Consider a relatively simple good like a toaster. It has metal and plastics parts, put together in such a way as to make the toasting of bread possible. In the early stages of production, the metal needs to be mined and smelted; the oil needs to be pumped and transformed into plastic. In the next stages the metal and plastic must be shaped into the various parts that will make up the toaster. In a still later stage, the parts need to be assembled. In the final stage, wholesalers and retailers hold an inventory of toasters and organize their distribution to consumers (this is a very simplified version of the whole process for the purpose of discussion – consider e.g. that the shaping of parts requires dies and molds, the production of which is quite a complex process as well).
If we consider the various stages of production involved in making this toaster, we can see that some of them must take place earlier in time than others, and that the earlier stages in which the higher order raw and intermediate goods are produced are likely to involve very long range planning and large capital investment.

So how will entrepreneurs know how much and in which stages of the production process to invest? Obviously this will depend on the amount of funds available for investment – i.e. the amount of available savings. The market signal that indicates whether a relatively large or small amount of savings is available is the prevailing interest rate.
We are all producers, consumers and savers in personal union; our propensity to collectively either consume more in the present, or consume less in the present in order to save for future consumption, is referred to as 'time preference'.

If our time preference is low, we will tend to save more of our production, which will increase the amount of savings available for investment – the interest rate in this case will fall. This allows the long range planning of consumers (saving for future consumption) to mesh with a corresponding long range planning of producers – as the larger amount of available savings as indicated by low interest rates makes very complex long range investment projects possible. Investment will then increasingly gravitate toward the earlier stages of the production structure, and these stages will then be able to outbid the later stages for labor and resources.
In addition, the production structure will tend to lengthen – a more complex and roundabout production process will evolve, adding new stages of production to the structure , improving overall productivity via increased specialization.

At the end of this process, over time, more consumption will be possible than would otherwise have been the case, i.e. if fewer savings had been available earlier. In short, by people deciding to consume less in the present and save more for future consumption, more investment is made possible, which in turn will enable more production and consequently make possible more consumption in the future.

This is what 'sustainable' growth actually is. There is no need to interfere with this process – it will spontaneously order itself in an optimal manner if left alone – by what Adam Smith called the 'invisible hand'. The sum of all individual decisions in the market economy – individual decisions that are all aiming for one's material betterment – will spontaneously create the order that makes such betterment actually possible.

By means of rising and falling interest rates, the market informs investors and entrepreneurs about the size of the subsistence fund available to finance capital investment projects, the preference for consumption relative to saving, and will thus guide the decision-making process regarding in which stages of the production structure to predominantly invest.

This also illuminates why Keynes' so-called 'paradox of thrift', which holds that a collective propensity to save more and consume less is a negative development for the economy, is wrong.
It fails to consider that only by saving can one invest – and that a propensity to save more will only affect investment in the later stages of production.
If the cycle of inventory build-up and liquidation and bidding for labor resources at retailers were the only measure of the economy's health, then we might agree with the 'paradox' – but not otherwise.

How the central bank distorts the market process

Consider now the populist policy of artificially holding interest rates as low as possible that is employed by the central bank. As noted in the introductory paragraph, low central bank interest rates are designed to artificially inflate credit and thereby stimulate consumption.

This has two simultaneous effects that conspire to create an artificial boom that must perforce give way to a bust at a later stage.
For one thing, it creates an incentive to consume rather than save – i.e. it raises time preferences. This raising of time preferences is not only due to the rising availability of credit and the lowering of returns on savings, but also due to the devaluation of money that the central bank's policies engender over time.

Normally, rising time preferences would tend to drive up the rate of interest, as fewer savings, and thus fewer funds for lending, are available. However, the rate of interest has been artificially fixed by the central bank, which then supplies as much money to the marketplace as is demanded at its prevailing administered rate. Contrary to real savings, this is however 'money out of thin air' – no production preceded its introduction to the marketplace.

At the same time, it won't fail to transmit the information to investors and entrepreneurs that there are plenty of savings available to invest.
In other words, the artificially low interest rate misleads investors into assuming that the pool of available savings (the pool of real funding) is much larger than it actually is. Large long lead investment projects in the earlier stages of production will be undertaken, just as consumers are actually saving less and consuming more due to the same artificial incentive.

For a time, the central bank can 'paper over' the fact that real resources are consumed instead of saved, but this process of 'papering over' actually accelerates the decline in the pool of real funding via overconsumption, while capital is concurrently misdirected and malinvested. This process of malinvestment can also be described as an intertemporal discoordination of the production structure, as too much capital flows toward the production of early stage higher order goods production.

This combination of overconsumption and malinvestment takes place until the point in time when the actual state of the pool of real funding is suddenly revealed.
Malinvestment implies that numerous investment projects were started that could not possibly be finished, respectively also that numerous economic activities were underway that would not be viable at all absent a credit boom.

Sometimes the artificial boom ends because the central bank belatedly decides to abort its artificial low interest rate due to the secondary lagged effect – rising prices – becoming 'visible in the data'. As an artificial boom-bust sequence progresses, it takes more and more credit inflation to engender the 'desired' economic effect of 'creating growth', which is really synonymous to creating economic activities that squander wealth. At the same time, it takes an ever smaller rise in the administered interest rate to actually starve the boom of the exponential credit creation it needs to survive.

The duration and amplitude of the boom-bust sequence meanwhile increases over time, as more and more of the pool of real funding is consumed. How can there be a 'boom' at all, when it consists mostly of overconsumption and malinvestment? Simply put, the artificial boom that credit and money out of thin air create draws upon the previously accumulated capital and consumes it, or part of it.

Note that there comes a point in time when no amount of additional credit out of thin air can restore the boom – this final stage is reached once the credit expansions of the past have consumed so much of the subsistence fund of real savings that it has stopped growing, respectively has actually begun to decline. The current 'credit crunch' episode is a strong sign that we may have reached that point.

How can we measure the increasing amplitude of the boom-bust sequence over time? This can be done by observing the ratio of the stock market to real money, i.e. gold.
Stephen Fairfax has written a brief article on the topic , entitled 'Out of Control: Recognizing Instability', which is a highly recommended take on the subject.

Although the pool of real funding is not directly measurable, a good indicator of its state is likely how the stock market reacts to monetary pumping. Normally the stock market is very sensitive to decreases in the Fed's rate of interest. When it fails to react to numerous rate cuts, we have a strong indication that something must have gone wrong on a very fundamental level – this fundamental level is the economy's production/capital structure and the pool of real funding.

Considering the fact that the the Dow Industrials Average has declined by almost 80% vs. gold and that the stock market has rarely – no, never – reacted so negatively to a major rate cut campaign (the stock market has never before experienced a one year decline as steep as in the one from its October 2007 high), we can conclude that a major failure of the 'money and credit out of thin air' experiment is in train.


The Dow-Gold ratio. Since the Federal Reserve was established, the oscillations in this ratio have become bigger and bigger. This is a good proxy for the boom-bust cycles engendered by fractionally reserved fiat money expansion. An additional note: should the stock market reach its putative target in real terms, there will have been no progress in real stock market value at all since the turn of the century; this contrasts with the time period prior to the establishment of the central bank, when the Dow-Gold ratio consistently rose in a relatively tight channel. This is to say, the stock market rose in real terms from 1790 to 1920 in said channel, until it broke out of it in the first artificial boom-bust sequence of the 1920's and 1930's. Ever since it has gyrated wildly. Click on chart for larger image.
chart via Fred's Intelligent Bear site.

The Bust – its function and why it should not be fought.

There is great incentive for the political class and the monetary authorities to be seen to 'do something' in the face of the developing bust. So they go forth and 'do something' – with nothing even remotely resembling a plan (although they are central planners, they do not even possess a plan – as evidenced by the ad hoc changes to various interventions to date and the continual piling on of new ones).
The public expects them to do something, in a mistaken assumption that they are actually able to avert or alleviate the bust. As I have said before, we should judge them by their results, which so far are sobering indeed.
As Bob Hoye has mentioned in this context, if it is true, as the interventionists contend, that their actions 'will only be felt with a one to two year lag', then one might well ask what they were planning for one or two years ago. A crash?

Let us consider for a moment in the light of the above excursion into capital theory what the root cause of the bust is – it is the preceding artificial boom. It felt like 'good times', but in reality it was an illusion. We certainly did not create a better economic production structure that will enable us to consume more in the future.
On the contrary, capital was malinvested on a truly momentous scale (as a look at current housing inventory easily demonstrates) , and quite apparently, this happened worldwide.

We did not save enough, as countless 'nay-sayers' warned - here, and here and here - while being ridiculed by the gaggle of courtier 'experts' and pundits, who to a man turned out to be wrong .
The bust is naturally painful – in fact, it's a good bet that the bust now underway will be very severe in terms of rising unemployment , falling industrial production, and other statistics describing the level of economic activity.

Think for a moment what a herculean task the economy now has to perform – the production structure must be considered to be severely out of whack, now that it has turned out that the pool of real savings is much smaller than previously thought.
Thus malinvested capital needs to be liquidated, and where possible redirected. Many investment projects in earlier, higher order goods production stages have been, or will still have to be, abandoned.
Savings need to be rebuilt, so the later stages of production are and will be exposed to a sharp decline in consumer demand.
The amount of labor needed to repair the capital structure will perforce be much lower than that likely to be employed when everything is running smoothly.

So there simply is no way this can be done painlessly. The mistakes of the boom can not be 'unmade' – the houses no-one needs, the shopping malls no-one needs, the factories producing cars that no-one wants, and the capacity in earlier production stages supplying them – it all has been built already. Creditors have lent money they will never get back.
The boom created both economic activities that were entirely artificial and consumed wealth (such as the surfeit of real estate agents in California, for instance) as well as misdirecting capital to the 'wrong' portions of the production structure , so we can also conclude that other, more worthy economic activities were deprived of capital – after all, the pool of real funding is finite. It will take time to redirect capital toward these activities, so one must allow for a period of sub-par economic performance until this process is completed.

The best we can hope for is that we get it over with as quickly as possible – but that is precisely what the interventions are unwittingly designed to prevent. We need more savings and less consumption for a time – which the Fed discourages by pushing rates to zero.
We need the private economy to have full access to the available resources at the right price. Instead we have the government 'crowding out' private borrowers by engaging in huge deficit spending. This spending must be financed from existing resources, but it can not possibly be a 'better' use of scarce capital - on the contrary, it will lead to more misdirection of resources.

In this context, note that the much higher interest rates that now e.g. prevail in the market for corporate bonds are a step in the right direction. Given that the risks of lending have risen and savings are scarce, the best way to draw new savings into the marketplace is by offering interest rates that compensate for these higher risks.

Meanwhile, the government and the central bank are trying to keep the 'something-for-nothing' scheme going that has led us to this juncture – the bust – in the first place. It will unnecessarily delay the economy's healing process, and this is no small matter, as one can easily ascertain when looking at Japan's two 'lost decades' or Hoover's and FDR's Great Depression.

In the whole world I have found precisely one mainstream politician in a position of political power (although he will find out that his position is a lonely one indeed, even in his own government's cabinet) who publicly speaks out against the folly – German minister of finance, Peer Steinbrück.
In reference to Gordon Brown's most recent economic insanities, Mr. Steinbrück remarked in a Newsweek interview:

“All this will do is raise Britain's debt to a level that will take a whole generation to work off.”...”The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn't this the same mistake everyone is suddenly making again, under all the public pressure?”
“It's the yearning for the Great Rescue Plan. It doesn't exist. It doesn't exist!”

Even if it is only a small consolation, there is at least one major political figure in a Western industrialized nation who does not seem to subscribe to interventionist voodoo economics. Funny enough, he's a member of the German Social Democratic Party. Paul Krugman doesn't like him, which counts as indirect confirmation that Steinbrück must be 100% correct.

Before anyone gets too excited, here is what Brown had to say by way of riposte:

“Mr Brown, who will head to Brussels later today, reiterated that "every country around the world" agreed with him.
He told LBC Radio in London: "Actually, the German Government is investing more. They have just announced a fiscal expansion so that they can invest in public works and helping their banks and doing these sorts of things. "I do not really want to get involved in what is clearly internal German politics here, because they have a coalition in Germany with different political parties. "The important thing is that almost every country around the world is doing what we have been doing." Not taking such actions would mean "failing in the role of Government", he said. (my emphasis).

Clearly there is little reason for hope, because what Brown says is true – virtually every government in the world has adopted the deficit spending and rate cutting malfeasance that has demonstrably failed every time it has been tried.

Ergo, get ready for a long, hard slog.


Interventionist Brown, crisis-stricken


Doubting Thomas: Peer Steinbrück


Interventionist Bernanke, pre-crisis


Interventionist Bernanke, crisis stricken

Some thoughts on the recent backwardation in gold

Definitions

Let me start with a definition of the term 'backwardation' for readers that are not familiar with it.
A commodity like e.g. crude oil that trades in a futures market, has many different contracts trading concurrently, for different delivery dates in the future. Normally, the contracts for later delivery will trade at higher price than those for earlier delivery. This 'normal' state of affairs is known as 'contango'.
The reason why contracts for later delivery are normally higher priced is that they must reflect two cost factors that are a function of time.
One is storage costs; obviously, it costs more to store 1000 barrels of crude oil (the size of one NYMEX light sweet crude contract) until January of 2010 than until January of 2009.

The other is opportunity cost; by tying up funds for the purchase of crude oil for future delivery, these funds are no longer available for other purposes – the simplest of which is earning a risk free interest rate.
Putting it differently, a futures market will normally reflect the 'cost of carry' – the cost one incurs by holding the underlying commodity from the current moment in time to the day of delivery.

However, the futures curve also reflects other considerations; the major one is the market's perception of the state of estimated current supply compared to expected future supply. For instance, at present, the futures curve in crude oil shows an unusually large contango – so large that people are scratching their heads over it, as it allows one to make very large arbitrage profits by simply storing oil and selling it forward.

Apparently the oil market currently has two major concerns:
1. current supplies are more than ample – the market is in fact oversupplied in view of a sharp fall-off in demand.
2. the low prices of today make a far less benign supply situation in the future more likely, as many oil production expansion plans are being shelved due to the recent price collapse.

Occasionally though, and at times for extended periods, oil has been trading in backwardation – meaning, that the futures curve looked opposite to its normal shape – spot oil and near delivery months traded at a (often large) premium over later delivery months.

Whenever an industrial commodity is trading in backwardation, one can be sure of one thing: current supplies are very tight relative to demand. Backwardation discourages storage by making it very costly, and is the market's way of drawing as much of a commodity out of storage as is possible, as users need it in the here and now.
Thus the 'abnormal' situation of a backwardation in a futures market has an economically valuable function: it informs market participants of a supply shortage in the present, and by making storage a costly proposition and allowing for an arbitrage that makes it profitable to sell a commodity in the present and buy it in the future, it draws supplies out of hiding, which will eventually tend to alleviate the shortage.

A gold backwardation is different

Let us now proceed to looking at the recent backwardation in gold (in the meantime the market has reverted to a slight contango, but this seems poised to reverse again, as gold forward rates have resumed falling).
After reading the above paragraph on backwardation and contango, one might be tempted to conclude that a backwardation in gold is no different from one in say crude oil, or copper.
However, this is definitely not the case.

Many readers of this blog are probably familiar with Mike 'Mish' Shedlock's blog 'Global Economic Trend Analysis' and may have followed the recent back and forth between Dr. Antal Fekete and Mish on the topic of the recent brief gold futures market backwardation.

It began with Dr. Fekete's somewhat alarmist (but nevertheless quite interesting) article 'Red Alert: Gold Backwardation!!!', from whence it proceeded to one of Mish's frequent conspiracy-debunking blogs entitled 'Nonsense About Gold Backwardation, Ameros,Yuan Devaluations, etc.', which prompted Dr. Fekete to reply, a bit miffed, with 'There Is No Fever Like Gold Fever', followed by another rebuttal by Mish 'No Fever Like Gold Fever: Response'.

This latter article quoted me, following an e-mail exchange with Mish in which we discussed the situation. Since Dr. Fekete's article struck me as overly alarmist at the time, and I thought that the backwardation was probably mainly a short term anomaly, I was rather dismissive of the claims made therein.

For one thing, the gold forward curve is supposed to be quite flat at present – after all, official interest rates all over the world have been slashed to the bone, and this lowers gold's cost of carry commensurately – the opportunity cost of holding gold has declined sharply.

Secondly, we know that demand for small denomination physical gold has recently soared, which has surprised refineries that now have difficulties to deliver all the gold demanded in a reasonable time span.

Thirdly, it has been known for some time that gold lenders (mostly central banks) have become reluctant to lend out gold, due to rising concerns about counter-party risk.
This can be inferred from the gold lease rate, which has recently risen quite sharply. Since it is also a well known fact that forward selling on the part of gold miners has become very rare , a rising lease rate can only mean that the supply of gold for lending purposes has tightened (what little forward selling there is done is almost always tied to project development debt finance, but this is still easily overwhelmed by the ongoing covering of stale forward sales by large established producers like e.g. Anglogold, that has only fairly recently adopted a 'no more hedging' policy under its new CEO).


The LBMA's 3 month gold lease rate, courtesy of Lance Lewis. There has been a recent spike indicative of tightness in the gold lending market. click on chart for larger image

I did however mention that a backwardation had to be regarded as bullish, and I conceded that in the case of Zimbabwe, Dr. Fekete was perfectly right: it does not matter anymore how much money in terms of Zimbabwean government scrip one offers to a holder of gold in Zimbabwe - he simply won't sell. This, as I put it, is what happens once an inflationary conflagration of a fiat currency reaches the 'point of no return'.

Hyperinflations have several distinct stages that have been observed throughout history – in the course of the acceleration of inflation to ever higher rates of change, there always comes a certain threshold point – what I refer to as the 'point of no return'.
This is the point at which the public realizes that the inflation is a deliberate policy that is set to continue, for the simple reason that the government issuing the money in question is technically bankrupt.
What usually happens then is that the decline in the respective money's value begins an irreversible acceleration that stops only with the complete repudiation of the money concerned, even if the government stops printing more money, respectively prints far less than would be indicated by the acceleration in price increases.

We can actually observe this in Zimbabwe, where the government's bankruptcy has proceeded to the stage where it can not even afford the paper and ink anymore that it would need to print additional currency. Thus there is now hyperinflation (recently estimated at 500 billion percent annualized) concurrently with a deepening cash shortage.

In essence, the market has declared the government's scrip to have no value at all, and economic activity is increasingly reverting to barter.
Once the 'point of no return' threshold of an inflation is crossed, one can not hope to get any more gold in exchange for the government's scrip. One may be able to exchange other goods of value or foreign currency for gold, but not the fiat money in the throes of hyperinflation.
There may still be gold prices quoted in the inflating currency, but this is strictly a technicality, respectively illusion.

So why then did a slight backwardation in gold futures lead Dr. Fekete to exclaim that the irredeemable fiat dollar was about to meet with a similar fate? You may need some background on what makes gold different from industrial commodities – my brief article 'Misconceptions about Gold' posted under the nom-de-plume Trotsky at Mish's blog a while ago can be used as a primer.

The thing is, gold normally never goes into backwardation. One of the reasons why gold has been chosen as money by the free market is the fact that a large above ground supply exists – a supply so far in excess of the amount of newly mined gold added to it every year that it promises both to be stable and ample enough to successfully serve as money.

This large supply also ensures that normally, the gold futures curve will always be in contango – there can be no 'shortage' of gold similar to, say, a shortage of copper or oil.
The contango in gold futures meanwhile changes largely along with changes in the Fed's administered interest rates – expressing the either falling or rising opportunity cost of holding gold relative to the government's irredeemable scrip.

Copper and oil inventories can and are, usually measured in 'days or weeks of demand'. These are commodities that are used up in industrial applications, for which the annual primary supply/demand situation is quite important and determines the size of the inventory and consequently the shape of the futures curve.
There can be a shortage of copper, respectively a supply situation that is so extremely tight that a shortage seems imminent. When that happens, the copper curve will be in backwardation, often markedly so.

In light of the above, one must concede that Dr. Fekete has a point, even if he went overboard with his declaration of imminent monetary Armageddon.
If we look at the going-ons in the December GC contract specifically, it elicited a large demand for physical delivery, with about 12,000 contracts (equivalent to 1,2 m. oz.) standing for delivery in spite of a temporary backwardation that makes a 'sell now, take delivery later' arbitrage profitable.


The LBMA's 3 month gold forward rate (a.k.a. 'GOFO'), also courtesy of Lance – the only time this forward rate temporarily spiked into deep backwardation since 1990 was just prior to the announcement of the 'Washington Agreement' that limited central bank gold sales and gold lending activities; a huge short term surge in the gold price ensued. It is notable that GOFO usually tends to reach very low levels just prior to major bull moves in gold – this is only natural considering that a flattening of the forward curve is indicative of a falling opportunity cost of holding gold. click on chart for larger image

Concurrently we observe a fairly regular increase in the gold holdings of the gold ETF GLD; recently these holdings have reached a new record high of 670 tons. Over the past several months, the gold holdings of the ETF have either remained fairly stable or have risen regardless of the gyrations of the gold price itself.
This is a microcosm of sentiment among a certain – important - group of gold buyers.

These buyers represent exclusively monetary(or investment)demand, and they buy irrespective of short term price movements. Clearly, this group of buyers is very worried about the recent systemic crisis, and considers gold as an important form of insurance.

Exchanging promises for more promises

Anyone with assets to protect has probably given some thought to gold's ability to serve as a long term protector of wealth in light of recent large scale failures in the financial system.
If one has a large amount of money deposited with a bank, one has to confront the these days very real risk that the bank might go under; the bank's promise to produce one's money on demand looks a lot shakier than it once used to.
One possibility is to buy government bills, notes and bonds, something that countless big investors are in fact doing lately, inter alia because no other market is more capable of digesting very large sums without a hitch. The liquidity of the government debt markets is unparalleled.

However, one simply exchanges the bank's promise to pay for the government's promise to pay – and both the bank and the government only promise to pay in yet another promise to pay, namely the Federal Reserve's, in the form of the bank notes it issues.
Furthermore, here is where things become circular, lately with a twist. While the bank notes represent the central bank's liability, it normally has government debt on the asset side of its balance sheet – a promise to pay 'backed' by a promise to pay.

The 'twist' these days is that the asset side of the Fed's balance sheet increasingly consists of all sorts of garbage as a result of its countless special lending facilities, and fewer and fewer treasury bonds (the percentage of t-bonds has fallen from roughly 90% to a mere 22% of all assets held by the Fed).

As I have illustrated in this article that appeared at Mish's blog a while ago, this is a modern day update on the tally stick scheme.
The real 'backing' – the thing that ultimately stands behind all these promises – is the government's force monopoly, enforcing legal tender laws, the certainty that it will collect taxes in the form of this scrip and the fact that it accepts the scrip for payment of taxes (certainly no-one would accept irredeemable pieces of paper with ink slapped on them as 'money' in a true free market setting).

Investors have faith that the industrialized nation states will continue to be able to keep this scheme going, and that the possibility of government going bankrupt is remote – after all, there is a lot of accumulated wealth that can still be plundered, and also a reasonable expectation that in the long term, more wealth will be created (even though the process has met with a hitch for the moment, due to the bust that is now underway). This is certainly a reasonable expectation, based on historical experience.

However, this does certainly not mean that investors are completely discounting the possibility that the current monetary system itself could eventually fall into crisis. After all, what keeps it going is mainly confidence.
Should confidence in the system's viability evaporate, the only form of money still acceptable would be the one that is not a mere promise to pay – the money of last resort, gold.

A simmering crisis

I would in fact argue that signs of a simmering crisis of the fiat money system are increasingly in evidence. Take for instance the wild volatility of the fiat currencies relative to each other. It is as if capital were constantly fleeing from one corner of the burning building to the other (see the charts at the bottom).
Take the flight into government debt, that has taken on bubble-like characteristics. At one point last week t-bill discount rates briefly turned negative – investors were prepared to pay the treasury for the privilege of lending it money – of course, in reality they were paying the treasury for keeping their money 'safe'.

Consequently, Dr. Fekete does have a good point when he says that 'lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’. (emphasis mine).
The important point is 'lasting' – the recent backwardation looked more like a short term aberration, a technicality basically, but was perhaps also a first warning shot regarding what may lie in store in the future.

Conclusion:

One should keep a close eye on the gold forward curve. Should a backwardation eventually become deep and entrenched, it would be a strong signal that the financial crisis has progressed to the point where the monetary system itself becomes the center of attention.

Below a number of charts illustrating the 'simmering crisis' situation. click on charts for larger images

currencies:


Wild gyrations in the Swiss Franc. As both a 'safe haven' and former carry trade currency, it is especially prone to sudden explosive moves.


The Yen has gone ballistic – this is the highest level since the 1995 spike high.


The dollar index – from overbought to oversold within days – the recent correction looks more like a crash than a correction actually. The recent moves in currencies are not indicative of a healthy system. One should add that these moves are exacerbated by the actions of trend-chasing quant funds, most of which usually tend to end up sitting on the same side of the boat just before it capsizes.

government debt:


The US treasury long bond - can you say 'buying panic'?

central bank data:


The sudden death of monetary prudence – base money is now growing at a 360% annualized rate


A longer term view. One can see both the Y2K monetary pumping panic (which gave us the blow-off phase of the Nasdaq bubble) and the post 9/11 spike. Both spikes used to really stand out on this chart as historical aberrations. No longer.


A few more charts from the Fed highlighting the situation.

GLD:


Gold holdings of GLD via Lance – a new all time high.