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The Third Crisis of American Capitalism

Just as all political careers are supposed to end in failure, all bubbles burst and the hangovers are usually far worse than the party that pre-ceded them. A few months ago in the wake of Enron and Argentina's collapse we asked who would be next. The answer has come weekly: Dynergy, Merrill Lynch, Global Crossing, Tyco, ImClone, Martha Stewart, WorldCom, Arthur Andersen and Xerox, it's been the bum of the week to be dragged off in handcuffs, arraigned before the authorities to personal and corporate disgrace.

No one should be surprised by these developments. The extent and the longevity of the bubble led to an all-round lowering of standards and conflicts of interest. Indeed, the system became conflicted from top to bottom, analysts, auditors, the press, the government and the regulatory authorities, and corporate executives all conspired, wittingly or unwittingly, to loot the system to the detriment of the shareholders. There is an almost historical inevitability to the process as excessive greed enveloped the system in a manner that had not occurred since the roaring twenties.

As the process continues its inexorable unwinding there will be an equally inevitable political reaction against the corporate greed as shareholders face reduced financial futures and constrained pensions. That was the case in the two previous financial excesses in the twentieth century. Both followed abnormally long expansionary periods.

The first followed the Civil War and the dis-inflationary impact of the opening of the prairies and the early industrialisation of the United States and the rise of the robber barons. After the crash of 1908, the same robber barons were roped in with anti-trust laws and the Federal Reserve System created.

The second was the expansion of the 1920s in the aftermath of World War I. Crazy speculation, driven by dreams that new technology would revolutionise society, coupled with an over-expansionary monetary policy led to the 1929 crash, The policy reaction to the resulting policy-induced economic depression was the creation of the panoply of regulatory agencies, including the Securities and Exchange Commission, that increasingly dominated the American economy from 1940-1980.

Regulation followed regulation until by the 1970s the US economy was strangulated into a low growth stagflationary morass that was only relieved by the deregulatory and tax cutting actions of the Reagan Administration that liberalised and re-energised the markets. Thus the long boom was created. For the first eight years the process was rationale and hugely beneficial. Normally, the expansion would have been self-correcting, but the end of the Cold War threw further fuel on the expansion by its impetus to globalisation, which sharply reduced defence expenditures.

Unfortunately, politics in the form of the Clinton Administration's monetary and electoral policies gave further boosts to the system after the Mexican, Russian, LTCM and Y2K bailouts, introduced moral hazard into the system - the Greenspan put - and fostered the dangerous illusion that 'this time it is really different'. The Clinton Administration, driven by the 1996 and 2000 elections, desperately wanted the party to continue long after it should have cooled off. They succeeded, leaving the Bush Administration to pick up the pieces.

The Bush Administration instead of preparing the public for the long haul ahead, and blaming its predecessor for the excesses, dithered. As a result, it is in danger of being blamed for the mess than continues to expose itself on a weekly basis. As we have stated before, the situation increasingly resembles that of Japan a decade before.

Disregarding interim rallies, the process has further to run, perhaps much further, both in time and distance. By traditional measures, the stock market is still over valued by 30-50 percent. George Soros says the dollar is overvalued by about 30 percent and the dollar this week reached virtual parity with the Euro for the first time in almost three years.

In addition, there is a huge property bubble that can be expected to burst sooner or later, most likely when interest rates begin to rise. If they do not rise soon - and the Fed may feel the need to continue holding them down - then they are stoking up even greater problems for the future.

There is one further less generally recognised danger: that of a derivative scandal. Given all the problems that bread and butter accounting have hidden, it seems only a matter of time before there are scandals in the esoteric, non-transparent and inadequately understood area of derivatives. Such a scandal would have more fundamental systemic dangers to the financial system compared to the mere overstatement of earnings of some third-rate industrial company.

The public seems to have been philosophical about all the financial shenanigans till now but, as the process continues, are likely to become increasingly discomfited and lash out in a populist upsurge at the political incumbents, regardless whether they are really to blame or not. The Democrats could well get control of both Houses of Congress in November. They, in turn, can be expected to reinforce the tendencies that have been in place since 11 September: a new regulatory upsurge - some undoubtedly justified but likely to go to excess - greater protectionist policies, following the recent of steel tariffs and new agricultural subsidies, and greater government spending. These are recipes for increased inflation, interest rates and ex-growth stock markets.

Whatever happens, the much vaunted and over-hyped American model seems likely to face its greatest stress in a couple of decades and perhaps its greatest test since the thirties. On the eve of the fifth anniversary of the Asian crisis, the much ridiculed crony capitalists there are grinning in their Johnny Walker Blue Label.

Investment implications
Our opinions remain unchanged. The fundamentals argue that the US market and the dollar remain substantially overvalued.

Whilst the markets may have reached a temporary point of exhaustion this week, confidence is fast leaking away from both the stock market and the dollar. As frequently expected here, the dollar index has broken important support at 110 and projects on the charts down to 95 and 80, the level from which its bull markets began in 1995. The Euro presently $0.99 projects to $1.10 and $ 1.20 and just possibly $ 1.40.

The US stock market, as measured by the S&P 500, projects on the charts to 350 should 950 be broken! Incredible as that may seem, that would indicate a multi-year decline comparable to the decline seen in Japan since 1990.

This promises to be a very difficult environment for investors. But the decline of the dollar may well induce fund flows into the Asian markets that have been through five years wringing their excesses out. A little money goes a long way there. The so-called Mango markets of Thailand, Indonesia and the Philippines, for instance, have a combined market capitalisation of less than USD 100 billion, a fraction of many fallen angels before their denouement. Commodities, including gold and silver, as we have mentioned many times before, have been starved of investment for twenty years and should also benefit.

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