Regime Change for the Stock Market

The financial press likes to talk up those occasions when the Dow presses on above 10,000. Such talk lately has become desultory, since it seems every other week the Dow lurches below 10,000 and then manages to climb its way back up. The market has been in this funk since February of this year, when the Dow began its most recent push from below 10,000, all the way to a peak around 11,200, only to fall three times below the 10,000 level since and recover with less and less conviction.

Is the market creating a topping pattern, or is this merely a consolidation period to be followed by new highs for the year? This is the perennial question whenever the market trades sideways, allowing the bulls and bears to thrash out the economic arguments, and ultimately allowing real world conditions to resolve whether the market will break out on the upside or downside.

Investors don’t often appreciate that this situation has persisted for over a decade. The Dow first breached the 10,000 level in the 1990s, on its way to over 14,000 at the peak, but down last year to 6,600 at the low. In other words, the market has traded in a broad range for a very long period of time, and the same questions we are asking about the short term market apply. Is the stock market biding time until it takes off again, or is this some massive topping pattern which will eventually drag the market much lower than 6,600?

The optimists like to say that the history of the stock market in the US is on their side. Time and again during the past 100 years bear markets come to an end and new highs follow. There is actually a real argument at work here: given that the Federal Reserve debases the currency by allowing some amount of inflation every year, and given that the price level of most goods and services rises over time because of this, it is only natural that stock prices should rise with the rate of inflation as well.

The pessimists say that this time is different. The Fed is facing deflation, not inflation, and stocks are especially vulnerable in deflationary times. But if this is true ”“ and certainly there is considerable evidence of deflation in the global economy ”“ why are stock prices even as high as 10,000? What has been holding the stock market up?

The answer to this problem lies with the fact that the stock market is ultimately about pricing the equity of thousands of different companies, and that means that investors make estimates about all the potential profits down the road of a particular company, and price the potential growth or decline in a stock accordingly.

What this means is that investors hold their breath at the start of every quarter when companies announce their earnings for the previous quarter ”“ the very thing the market is undergoing right now. And since earnings have been very good for a very long time for the typical company, the stock market has been able to levitate itself despite the tech bubble collapse, the housing market catastrophe, the credit crisis, and the recent flash crash.

Corporate earnings trump everything in the stock market, and unless there is some sea change in the prospect for corporate earnings, the stock market can push upwards even in the face of a persistent economic recession, or even a depression, which is what many consumers are experiencing. What, then, is the sideways trading we have seen both short term and long term telling us about corporate earnings?

It is telling us that the real battle in the stock market is not with the bulls and the bears, but with the corporations and the consumer. Corporations since the Ronald Reagan presidency have taken a larger and larger slice of the economic growth in this country, to the point where the imbalance is seriously against the consumer. Wages and benefits have stagnated for over 20 years in the US, while corporate earnings have surged. An estimated 30 million people in the US are living below the poverty level, while the top 1% of the population, who are mostly corporate executives and their families, enjoy unprecedented wealth from their stock grants and options.

The sideways trading we are experiencing is expressing uncertainty as to whether the era of corporate dominance at the expense of the consumer is over. Corporations have held the trump cards for over 30 years, having shipped millions of jobs overseas, laid off tens of millions of Americans, held salaries and wages flat, cut benefits, eliminated overtime, increased the workload, and converted employees to contractor status to avoid paying any benefits at all. These initiatives, along with generous reductions in their tax bills, to the point where any number of large corporations pay no tax at all, have fed directly into corporate net income and executive compensation.

In order to maintain their lifestyle, consumers have taken on debt at levels that are beginning to cripple the middle class. The hope that home asset values would increase over time to pay back these debts has now proven a mirage given that home values in the US have fallen over 40% since 2007. With the housing collapse it is now evident that most consumers are heavily over-indebted and have no room for more debt, a sentiment the consumer shares with the banks that no longer see the consumer as a good credit risk.

This situation, ironically, gives the consumer the ”œleverage” to turn the tables against the corporations. Consumers have no choice but to cut back drastically on their spending, to default on their debt, or to do both. Both are now happening, though spending cuts far exceed defaults because banks are loath to accept the existential damage of writing off all the consumer loans that are already seriously delinquent. The result of this is that consumer spending has never really recovered in this depression, despite what retail sales numbers may say, because what growth in sales has occurred has been provided by initiatives like the Cash for Clunkers program, the $8,000 home buyers credit, or the freed up cash from homeowners in default on their mortgage who have not yet been forced out of their homes.

Wall Street analysts and financial media don’t want to believe that the era of cheap credit they have known all their lives is over. The banks and corporations can’t accept that a permanent shift has come to the US economy, which is operating on half of the credit that was available up to 2007 when the securitization process and the shadow banking system still functioned. Even the Fed does not want to accept that the support it has given to the mortgage securities market or to the commercial paper market represents a permanent role for the government. The Fed keeps trying to pass these duties back to the private sector, and persists in the illusion that the securitization market is going to pop back into life any day now.

These are further reasons why the Dow keeps holding its head above 10,000. Wall Street in particular wants desperately to believe that the good old days are going to return. It cannot see that a regime change has come to the markets, one in which corporations will be increasingly on the defensive, hounded by governments everywhere looking to raise tax revenue, and assaulted by a permanent buyers strike from consumers adjusting to their own drop in living standards.

As for the banking sector ”“ which is enormously profitable compared to most any other industry ”“ the long slow slide to mediocre profits as the norm has begun. Both banks and consumers are ripping up credit cards as fast as they can be paid off. Individual investors are fleeing the stock market and along the way pulling their money out of asset pools run by the banks. Trading is a lot more risky now that volatility has returned to the market. The equity extraction business called home equity lines of credit is shrinking quickly now that home equity is falling, not rising. Other equity extraction businesses, like High Frequency Trading, are bound to be outlawed the next time another flash crash occurs. Corporate mergers and acquisitions are withering on the vine because cheap financing is gone and buyers have to pony up cash instead of debt to buy another company. All in all, there isn’t any main line of the banking business that isn’t under assault, and the big banks in particular may be toast if consumer defaults accelerate, especially strategic defaults where the consumer walks away from a mortgage even though they can continue paying it.

Another reason corporations don’t want to accept the regime change that is staring them in the face is that the mad race to ever-higher returns on equity is finished. The days of 15%, 20% or even 30% ROEs are coming to a close, and eventually corporations will be bragging about their 5% ROEs. This is perhaps the most painful adjustment of all, because it hits corporate executives right in the pocketbook. Much smaller ROEs will lead inevitably to much smaller executive paydays.

All of these pressures on corporate performance will sooner rather than later push the Dow closer to 6,600 rather than 14,000. And when 6,600 is broken, what then? Between Dow 1,000 to Dow 6,600, there are no natural buyers of stocks, because the move up from 1,000 was a moon shot straight through the Reagan, Bush I, and Clinton years. There was no significant consolidation in the markets during this entire period, which says that the market is well overdue to revisit this area, and perhaps retrace the move all the way back to Dow 1,000.

Most people, especially professionals in the market, think it preposterous that the Dow could fall as low as 1,000. That level was last seen at the very start of the Reagan years. But think about it: the market has already begun to unravel the great credit boom that began under Reagan and continued all the way to 2007. The total level of credit available to the US economy is shrinking to what was normal in the 1980s, and corporate profits are shrinking accordingly. The standard of living for the average American is collapsing as well, especially for the baby boomers who have no money saved for retirement other than some worthless tech stocks and an overvalued home. Why shouldn’t the stock market adjust in a similar manner? The Dow has already lost about 8,000 points from its peak when it fell to 6,600, so what are 5,600 points more?

For the moment, the idea of the Dow at 1,000 seems fantastical and absurd, but if and when it happens (and the odds favor when, not if), everything will look perfectly sensible afterward. We will all wonder why the Dow could possibly ever have traded above 10,000, and why we didn’t sell our shares back then when we had a chance. But of course, who was going to sell their shares on an idea that back then was considered fantastical and absurd?

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Numerian

Numerian is a devoted author and poster on The Agonist, specializing in business, finance, the global economy, and politics. In real life he goes by the non-nom de plume of Garrett Glass and hides out in Oak Park, IL, where he spends time writing novels on early Christianity (and an occasional tract on God and religion). You can follow his writing career on his website, jehoshuathebook.com.

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  • Most people, especially professionals in the market, think it preposterous that the Dow could fall as low as 1,000. That level was last seen at the very start of the Reagan years.

    Warning, Gloomy Story

    Let’s examine,in the condition at the start of the Reagan years. They seem to be misrepresented.

    In 1973, I was living in South Africa, and the string bikini was the fashion choice in the Summer. I’d just be hired by IBM, and its was at the top of its game, expecting a large growth spurt by taking million on enterprises on line (lead by the Banks, and by luck and circumstance I was an expert in telecommunications.

    We planned to go to Swaziland in early November, however we never made the trip. The Israelis and Arabs decided to have another hot sport in their continual war, and the Africans and Arabs decided to get the UN to condemn the Israelis fro their actions. The price of the African nation’s support was an Oil Embargo on South Africa.

    The South Africa Government reacted swiftly. Petrol (Gas) Stations were close from midday Friday until early Monday morning. The price of Petrol went for about R0.40 per Gallon to about R1.20 instantly.

    The immediate impact to me personally was slight. I had a job, no debt, and was sharing a house with a compatible group of people.

    The economic shock to the world, the first oil shock was huge. In South Africa by 1975, home building had stopped. Houses had fallen so much in price that 40% of homes were upside down, and people just walked away from their mortgages and rented. The US has lines of Cars at Gas stations. IBM South Africa hired few if any people, a break from the immediate past.

    The recession, in my view, did not end in ’74, as one reads in some of the history. In my view, and that of those of my age living and working at the time, this recession continued from 1974 until 1982, until after the vicious interest rate squeeze of the early ’80 to defeat inflation.

    The FTSE bottomed out at 139. The Dow in the 800s. The stockbroking industry in the UK shed thousands of people, my sister and her friends among them.

    One of my Uncle’s was laid of from Wiggins Teape, and came to South Africa to survive, and did well there. A colleague of my Sister, a stockbroker, came to South Africa to work as the finance manager for a large used car dealership.

    There was no massive rescue of the Financial Industry. There were no million dollar bonuses. There were rich people, but not so visible. The excess and greed extant today were either non-existent or invisible, I believe non-existent.

    Is it the ready information provided by the internet? It’s hard to tell, because the supply of information is so much more plentiful for me now, internet now vs newspapers and no TV in the late ’70s.

    Or has this civilization become so much more venal? For what I believe now, greed and corruption, while always there, are rampant and prominent.

  • Very nice piece numerian but suprisingly apocalyptic. What you say makes sense, but won’t Bailin’ Ben fight this with every device he has? Is he not more willing to induce serious inflation than see DOW 1000?

  • … about a week ago. I don’t have a lot of capital to play with but most of what I have I put on the sideline for now. Even reduced my gold holdings and slightly increased my small S&P500 short position.

    It helps that I can lock in some gains – makes it psychologically easier to sell.

    I won’t fret if I miss out on some upside. The down side risk is just too large for me to be comfortable in this market.

    For what it’s worth I think your analysis is spot on. The only wildcard is the Fed. If they start to monetize debt in earnest then the Dow will find some earlier support but I still expect it to fall hard.

  • to ever convince me of a forecast like you just made,other than it being an extreme attention grabbing number that satisfies a psychological satisfaction in collapse scenarios. As in, RUN FOR THE HILLS!!!

    Consider.

    The Dow is calculated on a multiple of earnings, and is composed of 30 companies. So what happens?? How does the Dow get from 10000 to 1000 (a decline of 90%) on the mix of companies currently listed, and what are the earnings that create this??

    For the Dow to hit 1000 today, earnings would have to both fall in excess of 75% on a permanent basis, and investors would need to price those earnings at never before multiples.

    Lets use Pfizer. 10000 to 1000, or 90% of its market value. For that to happen Pfizer would need to lose 75% of its earnings, and the PE would have to fall to 2.3 as a possible combination. For that to happen, every one of its patents would need to expire and the company have absolutely no new drugs brought to market, and no prospect of any ever coming on line in the future. Now, how likely is that? And this in the healthcare sector with an aging population and Federal benefits for drugs. I mean, health care services would be ending in the United States, and if that’s the case then the price of the dow is the least of our worries. This is just a nutty scenario, albeit satisfying for the apocalyptic cravings of some.

    For the entire Dow we would be looking at a permanent decline in earnings of 65%, and an overall P/E of 5. Even in the Great Depression the P/E remained above 5, and earnings did not fall a full 65%, though it did fall 60%. Also, the P/E of the Dow has never been at 5.0, not ever.

    I’d also note that the world is actually currently awash in cash looking for places to invest, and I will tell you before a company like Caterpillar or Coca Cola would ever let public prices hit such absurdly low prices, they would all be bought private and taken out of the mix. No controlling owners would ever let the public prices reach such goofy, non-market levels. If any Dow stock hit 5, it would be bought private for the cash flows to fast.

    A Dow 1000 across the 30 companies would see IBM at $10 per share; and all of the listings Alcoa, Bank of America, General Electric and Pfizer would be trading under $2 (assuming the same ratio currently). Some of these companies would be trading at half their book value, no value attributed to the deep wells of patents, or the level of funding that many of the these companies receive from Sovereigns.

    So nice sound bite, but not very rational.

  • “It helps that I can lock in some gains – makes it psychologically easier to sell.”

    I’ve been shorting for some time now and I’m in the same boat mentally. Being up in a down market is great… nevermind the final destination.

    Regarding the 1000 number… I don’t think so myself, but only on a technicality. I figure that quantitative easing will kick in and “save the day”. The numbers will be down relative to their equivalent worth today to be sure… though objectively they might not fall all that much, and heck, they may even rise substantially.

  • I very much hope so. As Scotjen61 outlines further down it’ll be a savage environment if we get there and I certainly expect the Fed to be hell bend of making sure it won’t happen. A dip below 6600 on the other hand I find quite plausible.

    Numerian is right in observing that it will be hard to find any technical pointers to where this may bottom out.

    To state the obvious: If this scenario comes to pass calling the bottom correctly will be a tremendous investment opportunity. Alas bottom picking is never easy even under the best of circumstances.

  • A P/E of 5 or less is certainly plausible, especially if you use forward looking earnings so favored by the analysts. If they can get projections that are overstated on the upside, they can certainly do it on the downside.

    Nor is there anything goofy about Caterpillar or IBM in single digits. Look at Citicorp, the biggest in their sector at one time.

  • They’ve got $2 trillion of assets now, much of it mortgage backed securities that the banks didn’t want to write down. While they are busy writing it down themselves, they’ll be asking the Treasury for a succession of capital infusions. What will they buy next? Treasuries themselves seem like the best bet, in fulfillment of Bernanke’s pledge to push down long term yields. But what good is this going to do? Short term yields are already at zero and people still aren’t borrowing. All QE will do in the future is take away even more interest income from savers, preventing that capital from being put to use in anything other than cash.

    Bernanke is almost out of tools to help the situation, and I suspect he knows it. Fed officials are already alerting the public that there is little more they can do.

  • was the capture ratio. If I could capture 50-60% of an upside move then I considered myself very successful. But then again, I’ve always preferred singles and doubles to home runs.

    “Sí che dal fatto il dir non sia diverso.”

    -Dante

  • Banks got into serious trouble back then with lending to South America, but they were able over time to rebuild their capital, at least those that survived. There was no heavy speculative industry like hedge funds and leverage buyouts around. All of this activity came about as part of the debt binge that began in 1982, timed not coincidentally with the mature earnings years of the baby boomers. These trends are now played out, with greed and corruption revealed to be the result of nearly 30 years of “wealth building”.

    I would say that the 70s recession, which did indeed last the whole decade, was quite bad but not anything like we are continuing to go through now. We might as well call the current calamity the Baby Boomer Depression, because it is timed at the end of their careers (again that is not a coincidence), and it will leave most retired people in poverty.

  • I don’t think he can. Neither the Fed nor the Treasury are omnipotent. As some people have pointed out, Numerian among them, monetary policy is actually quite limited outside of the normal preferred bounds of economic growth and inflation. Money is currently not printed into existence but rather borrowed. Any attempt to strongly inflate would be met by the bond market demanding significantly higher rates. This would defeat the state and crash the economy immediately, effectively hitting the full stop button, because everything is now dependent upon federal support by way of debt issuance. The gov’t has backstopped the economy by borrowing and must continue to do so, and as we know, is already riding the line of how far and fast it can go doing this before it kicks the legs out from under the nascent confidence in the US dollar as reserve currency and hiding place of last resort. An attempt to strongly inflate should likely immediately backlash and kill the economy by driving interest rates up precipitously at a time when any sharp raise in interest rates will utterly and swiftly destroy the current remainder of private AND public financing.

    Bernanke and Geithner, and to more or less the same extent, all western central banks and finance ministries, are between a rock and a hard place, and there is no getting out without massive pain to everyone. What’s going on now is delay, delay and hoping for some kind of miracle to come out of left field. But given other emerging limits on economic growth (resource limits, including peak oil, water shortages, climate change), I think they might be better suited hoping the heavens open up and manna pours down for all to taste.

  • is recovering very well and resisting weakness with real products, at $66. You are telling me they will be less than $2?

    Their BOOK value per share is $13. They are building a backlog right now that brings sales back to record levels by 2012, and lead analyst pricing is putting the stock back to $80 share at that time.

    As to IBM they have weathered this period with nothing but strength. Stock is near all time highs. Their product mix is probably the best ever, and their R&D is a fantastic mix taking advantage of the record server and services buying going on this year. The internet is expanding at its fastest pace ever, and the whole system is being reoriented to handle video. They benefit from Asia and India, Russia and Brazil. Revenues from these sources are rising at near 20% a year. I am at a loss. All the targets are at $180, from $126 now. You indicate it will be at SINGLE DIGITS???

    Keep in mind that IBM P/E is running about 10 right now, a fantastic P/E so the $126 sits on a mountain of cash.

    I’m lost on this one all by itself.

    Give me a date for this? It sounds like a Aztec movie than a financial analysis. When do the comets start hitting??

  • … are consumers being able to buy enough to support these companies and all of the others that keep the economy functioning as a very complex, interlocking machine.

    It doesn’t matter whether these companies have patents, or are putting out sellable products, or if a clutch of rich investors are “awash with cash” ready to dump it on something profitable. In the Depression, farmers and manufacturers had operating cash and were producing plenty of product, and were throwing it in the garbage. Dairy farmers poured massive amounts of milk down the drain while people just miles away were starving, because people did not have the access to credit in order to make daily purchases, nor access to adequate wage-earnings to do the same. The collapse of credit kills the consumer, which kills the economy that rests on top of him.

  • The bond market has already taxed Greece and the other PIIGS with penalty rates because of their deficits, and the UK has now followed suit. European austerity is not so much a choice but is forced on these governments which have exhausted all the monetary and fiscal stimulus possible.

    This is playing out differently in the US, with the right wing deficit scolds preventing Congress and the Fed from conducting any more significant stimulus programs. Just look at the trouble the White House has in getting unemployment benefits extended. I gather from some Fed governor comments that the Fed is reading the political tea leaves very carefully and will be much less hesitant to set up a round two of quantitative easing. Remember too that the 2008 programs by the Fed were in response to a market crash and collapse of credit. While there could be another stock market crash and some banks could again be in jeopardy, it will be much harder for the Fed to use the disaster threat again. It may even be forced to allow some big banks into liquidation rather than pulling out any further tricks.

  • Is an analysis of how much gasoline one dollar of Federal Reserve Notes would buy if the Federal Reserve Bank did not hold $2 Trillion + of junk securities.

    Also, where the Dow is and whether it’s valued fairly are moot points. The stock market is a racket again, as Al Capone famously observed; there are very few small investors involved any more. The volume is very thin, even with high volatility in share prices. The entire market is manipulated, and everybody knows it. Everybody. Dow 10,000? Who cares? It’s that because someone with a supercomputer five feet away from the NYSE servers says it is. Corn futures, FOJC, pork bellies, soybeans, all as irrelevant as the price of tea in China. Right now, as we speak, someone is cornering the cocoa market in Europe by hoarding nearly all the shipments from Africa. Who has the balls to corner a market any more? People who’ll never get caught, that’s who.

    Even the currencies we use to evaluate these things are now suspect, subject to squeezes and downgrades. What level is the FTSE 100, when it’s valued in a currency that may not exist three years from now? Would you prefer the yen or the renmimbi?

    As the old saw goes, some people know the price of everything and the value of nothing. How much will it cost us to have lost an orderly market? If you cannot find the value of anything, the price discovery, is the jig not already up? Economic instability leads to political instability. Trade wars into shooting wars. And when men can’t earn an honest living, they do so at the barrel of a gun.

  • Means nothing if there are not willing buyers for those assets at that price. $13/share is a depreciated value of assets. The assets could be worth more or less, if sold.

    Caterpillar, and IBM depend on their customer’s demand. If China stopped building, Caterpillar would nose dive. If 1930’s level of economic activity returned, IBM’s revenues would drop sharply.

  • a needed $2 per share, what it looks like and the condition of the companies that are somehow supposed to get there en mass.

    Sorry, but there is no rational argument yet put forward. Household income is rising, consumer consumption is up. Export sales are rising, I don’t see where ‘collapse’ can be found. Weakness yes, something along the lines of 1982 yes, but worse than the 30s? No.

    Even a disastrous rise in energy costs would bolster the energy sectors on the Dow. How do they go down under that scenario?

    I mean 6000 or something, this is laying out 1000. I am on record of 12000 by the end of 2010, and back to all time highs sometime in 2013-14. That I can back up with stimulative credit policies, strength in export demand, rising business investment, and a steady slow decline in unemployment: first in the Midwest, followed by the Northeast and moving south and west from there. A company by company look at the Dow and you see a wide variety of companies that are excellently positioned. I mean how on the planet does Wal Mart fall to $2. McDonalds at $2. They do BETTER in down economies.

    I agree by the way with the regime change message. It is true that consumers will have business by the short hairs for awhile, and this has been behind the enormous efficiency drives rippling through the business sector. We will have better, cheaper, better serviced products at the end of this period, and the ability of corporations to generate profits from revenues will be stronger than ever. The downside is the increasing need for an educated workforce for which our education infrastructure and culture is not ready for. America will need to abandon its celebration of stupidity.

  • … very prone to fretting about leaving money on the table. Nevertheless I also try to go by the 50% rule. Doubling of an investment over a time horizon of less than three years is usually a clear exit sign for me.

    But boy did I lose an opportunity once following that rule. Back when I was just about to wrap up my M.Sc. degree I had hardly any money to invest but I bought $1000 of Apple stocks when I heard that Steven Jobs returned to the company. I knew NextStep would make for a great Mac OS.

    Man do I kick myself for selling this after it only doubled. I pretty much bought it at the bottom in the nineties. My $1000 would have grown to about $50,000 now if only I would have hung on to it.

  • The people lose patience with being treated as the livestock of the rich. Massive nationalization of industry ensues. Executives and boards are lynched.

    Polluting corporations are found liable for environmental damages and the subsequent collapse of industries dependent on environmental quality.

    The giveaway of public natural resources is clawed back, with corrective payments (at market rates) demanded for resources already taken. The terms are “take it or leave it, but if you leave, don’t expect to escape with any assets.”

    Historical trends of P/E ratios and such mean very little in situations where the people finally decide to fight what to date has been a unilateral class war.

    The bastards would not keep going on and on about socialism if they didn’t know that their abusive, exploitative and fraudulent ways of doing business have been dragging us in that direction. Sooner or later they’ll wish they had opted for the benign, social-safety-net kind of leftist backlash, after it is too late and what they are facing is the merciless fist of popular vengeance.

  • Mel Gibson could play the lead. Tie it to the Aztec calendar thing and I think you got a winner.

    Call it:

    And the People rise UP!! (from their Game Boys)

  • today’s perpetual debt servitude and tomorrow’s skipping meals? Between today’s family murder-suicides and tomorrow’s folks getting a little more strategic about acting out their grievances?

    There are lots of people in the world who have been bred to tolerate suffering and deprivation. Americans are not among them. The oligarchs will learn to share the spoils or they will pay the consequences. The time may not come soon, but it will come.

    The fat cats of Venezuela thought they had it all sewed up. All it took was the anomaly of the military aligning with the poor, and things went sour for them very quickly. And Chávez has not even been vindictive with the exploiters the way he could have been, the way a wrathful U.S. leftist leader might be.

    The American people must be furnished with a steady supply of creature comforts and distractions, or their allegiances will turn quickly. It is hard to see how that requirement can be consistent with the ever-growing greed of the rich and their allocating themselves an ever-larger portion of the economic pie.

  • In the seventies we had inflation because the government ran loose money policies to pay for everything from the Great Society and Vietnam, to higher oil prices. This then trickled down throughout the economy and more people had access to more money than there was production in the economy for people to spend it on.

    The story goes that Volcker cured this by raising interest rates and choking off the supply of new money. The problem is that inflation is an excess of money in the economy and higher rates hurt those willing to borrow and increase production, while rewarding those with more money than needed to spend on products, or increase their own productivity. This contradicts the logic of what Volcker is said to have done. How do you reduce an oversupply by hurting demand and rewarding supply? When he eased off rates in ’80, inflation came right back again. The question is why did it work when he eased off in ’82?

    Ronald Reagan was elected in 1980 on an economic platform of lower taxes and increased defense spending that his vice president, George Herbert Walker Bush, referred to as “Voodoo economics,” during the primary campaign. By 1982, the Federal deficit had reached 200 billion dollars, which was considered real money in those days.

    Question: What is the difference between the Federal Reserve selling debt it is holding, in order to reduce the money supply and the Treasury issuing new debt? The Fed simply retires the money it gets, while the Treasury’s money gets spent back into the economy in ways which have the effect of expanding the economy, both directly and through leveraging of the private sector, piggybacking on public initiatives. This increased the need for capital and brought the supply in line with demand. I think it safe to say that the Treasury was more responsible for curing inflation than the Fed was.

    There is a point of logic which the Fed’s methods serve to expose though. By reducing the money supply by selling bonds, what they are saying is that an excess of money in the economy is in the hands of those with an excess of wealth. Does anyone see why such an observation might not be popular with the powers that be?

    Of course, using taxpayer money to pay long term interest to these people only compounds the problem of large pools of surplus capital, until such time as this vast pool of wealth dominates the entire economy and everything revolves around it, like light around a black hole.

    They also learned not to let this excess money trickle down into the public economy, so that consumer inflation is kept low. Of course one of the main ways to invest their excess wealth beyond what the economy can actually absorb in useful investment, other than inflating asset prices, or gambling in the derivatives market, is to loan it back to these customers to buy what they cannot otherwise afford.

    Three hundred years ago, a debt based was a pretty smart idea, since there were few economic measures to determine the money supply and debt grows at roughly the same rate as productivity. The problem is that productivity must increase to pay off debt and debt must increase to finance productivity. Eventually you have that class of super-rentiers at the heart of this economic vortex and it must continue to grow or blow up. The financial apparatus has turned the entire economy into a debt production machine. This creates the illusion of wealth far exceeding the productive capacity of the economy and often subverts actual production in the process. It also becomes impossible to actually invest in productive enterprise, as opposed to simply speculating where those enormous amounts of liquidity will bubble up next.

    Since money is drawing rights to productivity, the question is how to formulate a viable and healthy production based currency system. Money serves as a store of value and a medium of exchange. As a store of value, it is private property, but as a medium of exchange, it is a public utility. As property, there is the desire to accumulate as much as possible, but as a medium of exchange, more money than productivity degrades the value of the money. As a public utility, it is similar to a road system. You own your car, house, business, etc. but not the roads connecting them and no one seriously cries socialism over that. Treating money only as form of public commons would make people very careful what value they would take from social relations and environmental resources to convert into currency in the first place. This would be healthy for society, the environment and the monetary system. Of course, it would create a slower, but more sustainable economy. We all like having roads, but there is little inclination to pave more than we need. If we applied the same principle to money, life would be in better shape.

    Money really is a public utility anyway. Just try printing some, if you think otherwise. It’s that banks, government and the wealthy like for us to think of it as private property, because this allows those controlling it to tax every aspect of exchange and enables the legal right to own most of this economic network, which is supported by the efforts of all.

    The function of the central bank is to make maintaining the value of the currency a public responsibility, while leaving private banks to profit from managing it. Political power starts as private enterprise, ie, warlords and eventually stabilizes into monarchy. When monarchs lost sight of the fact that their purpose was to guide their people, as opposed to simply exploiting them, they tended to be overthrown and eventually the whole system of hierarchal power was replaced by political power as a public trust. Democracy works by pushing power down to the level it is responsive. If we were to make banking a public function, it would also be bottom up. Local credit unions would use local deposits to loan to local enterprises and use the profits to fund local needs. They would then form regional banks for broader investments and managing the currency.

    We understand various civil institutions, such as the military, police and the courts, cannot be run as private, for profit enterprises. Eventually we will realize banking also falls in this category.

    Also, with a debt based currency, there is an overwhelming need to create debt. A good example is government spending. The current system is designed to overspend by buying enough votes to pass enormous bills that can only be vetoed in whole by the president. It is like negotiating with a kid over how many candy bars he gets for eating an apple.

    This serves to create debt in order to store capital, as government debt is the primary investment vehicle. In the spirit of actual budgeting, a possible solution would be to break the spending bills down to their constituent items and have every legislator assign a percentage value to each item and then re-assemble them in order of preference. The president would draw the line at what would be funded. This would divide responsibility, allowing the legislature to prioritize, while giving the president final authority over total spending. Since making the cut would be graded on a curve, there would be much less incentive to trade favors and the percentage system would allow legislators to fine tune their granting of favors to other legislators and lobbyists. As the beneficiaries of that narrow range of items in question would be much smaller than those paying for them, the political impulse to curry favor with pork barrel projects would be much reduced.

    Since this would likely reduce funding for local projects, a system of local public banks would fill this need. The overall result would be a far more moderated economic landscape, than the enormous mountains of wealth and broad deserts dividing them.

    It’s not like economics is impossible to understand. As my father used to put it; You can’t starve a profit. We all like to get out more than we put in though, so there is a market for casinos. It’s been fun, but the money is gone and it’s time to head for the door.

  • This sums it up clearly and with impeccable logic. Gaming the system can work quite well until it doesn’t. And we’re at the point where the games are over. The point about consumer leverage is supremely ironic. I suspect that it’s right on target. How did that happen – the massive “wealth” transfer to the big banks and other gamers. The outcome – the value of the pot is now vastly diminished.

    I can’t imaging what a 3,000 or less market looks like for retirees. Well, I can imagine that but don’t want to think about it right now.

    Excellent work! Thank you once again.

  • Breaking windows only shifts money that would have been spent elsewhere.

    You mean that the money would have been spent in the UK, but you didn’t think that far.


    — Thinking inside the box maximizes risk adjusted profits

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