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Open Letter to John Mauldin

Hi John,

Thanks to today's incredible communications, I have had the opportunity to read your discussions about the financial markets. Mainly these seem to focus upon what policymakers are doing or should be doing. At times of acute financial setbacks, the tone can become, "OMG, please do something".

Regrettably, there have been times when markets do not respond to central bank policies. Indeed, through the great bubbles since England's major banking reform of the 1840s, administered rate changes made by the senior central bank have been months behind the critical changes in market rates of interest.

Debating Fed policy now is likely to keep one behind market forces. Particularly, as margin clerks have always overwhelmed the abilities of central bankers to keep a bubble going. China's massive support during the initial panic in August updates the point.

Your letter of September 12th noted that Volker as Fed Chair had "stamped out" inflation in 1980 by raising rates. This note will review that no matter how popular the legend is, it is unsupportable. It will also place in perspective your call for an "inverse Volker".

Often the conclusions by the cottage industry that thrives upon discussing policy alternatives is that central banks will "muddle" through. At times, the orthodox regard for orthodox measures has little doubts. In the face of a decade or so financial violence the belief still remains that intervention is necessary and a future without intrusive central banking is unthinkable.

Sometimes specific policy measures are criticized, but the system of central banking, itself, is never criticized by the establishment.

Fortunately, interventionist economics provides its own critique. Involuntarily, but the establishment seems not to notice. Case studies are used in teaching law and MBAs. Intervention assumes the efficient market theory and the random walk. There are no cases to study.

How naïve.

In the month that the economy peaked in December 2007, Harvard's Greg Mankiw boasted that nothing could go wrong. The reason was that the Fed had a "dream team" of economists. Then, less than two years later the boast was that without massive ease the panic would have lasted much longer.

What was deemed impossible was then ended solely by those who had deemed it impossible.

The blunder has two aspects. The first was the assumption that the Fed in cutting the administered rate would keep the expansion going. Throughout business history market rates of interest have increased during a boom and decreased during the bust. In so many words, rising rates confirm the expansion and falling rates indicate the contraction. Fed aficionados could break from theory and look at the history of interest rates and recessions.

The other aspect is the assumption that financial booms need not clear excesses. The one that cleared in October 2007 had many of the features of a classic bubble. It was followed by a classic contraction, called the Great Recession.

As in 1932, liquidation of unsupportable positions ended and a business recovery accompanied by raging inflation in financial assets has been on since 2009.

Prior to Keynes, inflation was an inordinate expansion of credit. And therein lies the confusion. John Maynard, himself, arbitrarily declared that inflation was rising consumer prices. Of course, this has nothing to do with central bank issuance. Soaring prices are solely due to an unfortunate outbreak of inflation expectations by the benighted consumer. It helps to have a degree in tautology.

However, the way that markets have worked over many centuries is that credit does expand inordinately against a speculative rise in prices. In one era it will be against tangible assets, such as in the 1970s and the 1910s. In another it will be against financial assets, such as in 2007 and in 1929.

It has been naïve to assume that markets are not self-correcting (up or down) and that unrelenting and arbitrary positive feedback from a government agency is necessary. In engineering, positive feedback mechanisms accelerate to destruction.

Lately, central bankers are extremely concerned about their notion of "inflation" falling below a rate of 2 percent but they seem unconcerned about highly-inflated financial assets.

How long has inflation in tangible assets been occurring?

Since governments learned to nationalize and depreciate currency.

How long has inflation in financial assets been happening?

In London in the 1660s there were enough public companies and enough traders to call it a market. The Bank of England was formed in 1697 to remedy a bankrupt government. The pitch was that with government sanction it would "infallibly" lower interest rates. Despite supernatural qualifications it defaulted a couple times.

An era of inflation in tangible assets blew out in 1711. The South Sea Company was a quasi-government company and the focus of the first huge mania in financial assets. Despite inspired attempts to keep the bubble going, it climaxed in June 1720. A lengthy credit contraction followed.

With the advent of modern financial markets and central banking, this became the "model". The basic pattern has repeated, making 1929 the fifth example of an era of inflation in tangible assets setting up an era of inflation in financial assets. The mania ending in 2007 was number six in the series.

Now how about the legend that Paul Volker personally ended "inflation".

If the rampant speculation in commodities that completed in 1980 was the only one in history, it is possible for the establishment to conclude that Volker and the Fed ended it. However, it was a global phenomenon as was the example in 1920. That one was huge and the collapse was massive. Both shocked the establishment such that the Fed was very easy during the 1920s. The policy was to prevent wholesale and retail prices from falling. The Fed did not understand that it was time for another era of inflation in financial assets.

This completed in 1929 with the usual warnings from the credit markets. But hey, nothing could go wrong. The John Moody boasted that the old and bad Treasury System had been replaced by the modern and "scientific" Federal Reserve System.

In 1920, financial leaders had enough commonsense not to conclude that Fed Chairman Harding personally ended that remarkable surge in inflation in tangible assets.

Huge speculations in commodities have always been a global event. So have been the busts. The one that peaked in 1980 became exceptionally overbought and crashed, on Volker's watch. Despite widespread acceptance, correlation is not causation. In taking a look at money supply figures through that bubble and crash, there was no setback. M2 continued to grow, largely because speculation was shifting to financial assets.

Market rates of interest increased with nominal long-dated Treasuries soaring to 15 percent. Long rates adjusted for inflation (real rates) plunged to an exceptional low. By this measure, the Fed did not tighten.

By the M2 measure, the Fed did not materially tighten, but those speculating in tangible assets suddenly found the world had tightened funds to them. As with any crash in commodity prices, forced liquidation dominated until the market cleared. For the CRB it was in 2001.

The historical pattern replicated once again. A long advance in tangible asset prices blew out and was followed by another era of inflation in financial assets. On the latest burst of global enthusiasm, the highlight speculation was in Shanghai. The old history of great bubbles suggested this one would climax in May or June. Advanced technical research noted that the excesses displayed in June were matching those last seen in 2007 and in 1929.

In so many words. In one era the rage is to hoard tangible assets, which burns out. Then the rage is to hoard mainly financial assets, which burns out. Then the focus shifts to hoarding cash and/or near-cash instruments. The latter in the senior currency.

Volker's legend was confected by the Street, it is doubtful that it can conjure a reverse legend.


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