Regime Change is Coming
Andrew Bailey is right. The world is not at all in the place it was before the 2008 crash. It is far worse this time around. Government finances and general indebtedness, post-Covid, are in demonstrably worse shape than they were at the time that Lehman Brothers failed. The yields on US government paper – the world’s “risk-free rate” – have soared, and very quickly, as the Federal Reserve has grimly continued to hike interest rates in a doomed attempt to moderate the inflation caused by its own money-printing policies. Several large banks have already failed, or been put down – notoriously, Credit Suisse, the 167-year-old Swiss banking giant that was forced into an eleventh hour shotgun wedding with domestic rival UBS (very 2008). In the words of Cormac McCarthy (No country for old men):
In keeping with the cowboy theme, the downfall of the Western financial system began during an episode of Bonanza. Speaking to the American nation on television on 15 August 1971, interrupting the popular western series in the process, President Nixon announced that the US dollar would “temporarily” no longer be convertible into gold. (The temporary prohibition lasts to this day.)
For nearly 30 years leading up to that announcement, a system known as Bretton Woods had fixed the value of foreign currencies to the US dollar, and pegged the US dollar itself to the price of gold, at an exchange rate of $35 per ounce. But by 1971, the US government was en route to bankruptcy, courtesy of a guns and butter economic policy initiated by the earlier President Lyndon Johnson, who had landed America with the costs not just of a Great Society welfare programme, but of the Vietnam War into the bargain. Foreign countries, not least the French, were queuing up to exchange their increasingly worthless dollars for gold. The run on the US’ gold reserves had begun.
By removing its last links with gold, and slamming shut the window where currency could be exchanged for gold, Nixon was effectively devaluing the dollar. But by removing any practical constraints to the printing of dollars, Nixon also ushered in a period for the unrestrained creation of credit. If the US government was unable to balance its budget through tax revenues, it could simply print dollars to its heart’s content to make up the shortfall. And the US government has been no slouch when it comes to money printing ever since. By closing the gold window, the US government consciously removed the brake restraining the Fed from money creation without limit. The Fed was given the very tools that, if abused, would bring down the system. In the aftermath of the so-called Nixon Shock, governments and central banks around the world, with their own currencies no longer pegged to the dollar, have enjoyed a similar privilege. 1971 marked the start of the world’s biggest orgy of debt. It was a starting gun for what is now playing out, in real time, as a race to the bottom. Within the last week, both CNN and Fox News have hosted editorial segments discussing the exodus from the US dollar.
Economists sometimes talk of something called a Minsky moment. Named after Dr. Hyman Minsky, the Minsky moment is the market correction that ensues after a long period of apparent stability and prosperity. The prosperity and the characteristics of an asset boom lead to heightened speculation using borrowed money. By way of example, consider the easy credit environment of the Roaring Twenties leading up to the Great Crash of 1929. As speculators amassed ever-larger debts to fuel their addiction to seemingly easy profits, they experienced ever-greater demands on their cash flows. As the debt monster demanded to be fed, it ultimately consumed everything – and still wanted more. Losses from speculators led to growing instances of forced selling, which in turn forced lenders to call in their loans – and fresh waves of involuntary selling began. The market started to eat itself, and collapsed from within. With nobody left to bid for distressed assets, prices started to gap down in an increasingly disorderly manner. Market liquidity evaporated, and everybody wanted cash.
An analogy with the US authorities’ handling of forest fires may be useful. In the 1960s and 1970s, Midwestern American states fell victim to scores of wildfires and the US Forest Service used to try to put out these forest fires whenever they arose. These constant interventions by the US Forest Service appeared to have little positive impact – if anything, the problems seemed to worsen.
Over time, foresters came to appreciate that fires were a normal and healthy element of the forest ecosystem. Naturally occurring fires are necessary to remove old forest cover, underbrush and debris. If they are suppressed, the inevitable conflagration to come has a far greater store of latent fuel at its disposal. By continually suppressing small fires, the US Forest Service was unwittingly creating the conditions for larger and less containable wildfires in the future. They had inadvertently allowed a gigantic build-up of latent fuel that ultimately meant that ‘the Big One’, when it finally came, would be super-destructive.
In continuingly suppressing smaller outbreaks of financial instability or market volatility by means of drowning them with surplus liquidity, the monetary authorities inadvertently stored up a growing pile of combustible dry tinder. During the regime of the Greenspan put, numerous small fires in the market – including the 1987 Crash, the failure of Long-Term Capital Management, the non-event of the Y2K crisis, and the dotcom bust – were doused with easy money. Notwithstanding these interventions, equity market investors still endured two separate bear markets after the year 2000 that saw market valuations halve. Perhaps the mainstream policy response to any hint of likely economic hardship should not simply be to slash interest rates, in the same way that the best response to recalcitrant children should not simply be to smother them with sweets. The tirade will be all the stronger when the sugar wears off. As the philosopher Karl Popper said, “In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable.”
Central bank monetary planning is the glaring hole at the centre of modern economics. We accept (or should do) that the modern economic world is highly complex, with practically infinite interactions between countries, governments, exchange rates, interest rates, stock markets, corporations, households, entrepreneurs, and consumers. In most areas we also accept that free markets are perfectly capable of driving Adam Smith’s invisible hand to ensure that enlightened self-interest benefits the many as opposed to the few. Despite this, the idea that one institution – the central bank- is even capable of mastering such complexity and fine-tuning the workings of a highly complex economy through the brute mechanism of dictating the price of money has rarely been brought into question.
The 1810 Bullion Committee in Britain, however, acknowledged that economic central planning was impossible: “The most detailed knowledge of the actual trade of a country, combined with the profound Science in all the principles of Money and circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.”
The investor Charles Gave suggests that the role of economists, along with that of governments and central banks, should be to promote a stable monetary and legal framework for risk-takers (the likes of entrepreneurs and money managers) to make their decisions as rationally as they can.
“Unfortunately, this has not happened. Instead, in a new and improved declination of Friedrich Hayek’s ‘fatal conceit’, we seem to be moving away from ‘scientific socialism’ to ‘scientific capitalism’ – where the overconfident and overeducated control-engineers are no longer members of the avant-garde of the proletariat, but plain, boring and well-meaning economists working in the entrails of the world’s central banks. My intent is not to show why these economists will fail (bigger and brighter minds such as Hayek, Mises, Friedman, etc. have already done this) – but rather to review the impact that the misguided manipulation of the price of money (exchange and interest rates) is having on the notion of risk.”
As a direct consequence of the central bank manipulation of asset prices, today’s markets give the impression of risklessness, irrespective of price. Why not buy conspicuously overpriced bonds if you know there is a greater fool out there, in the form of a central banker willing to pay even more for those bonds than you did ? After all, the central bank can print money out of thin air to make those purchases. This must end badly: major financial accidents are typically born out of a misconception of risks, rather than returns. Building a rational portfolio, where risks can be appropriately hedged, is almost impossible when market signals have effectively disappeared. Our investment approach reflects these uncertainties. We seek a ‘margin of safety’ in relation to the ownership of listed businesses run by principled, shareholder-friendly management when the shares of those businesses (highly cash-generative, and with little or no debt) can be purchased at a meaningful discount to their inherent worth. We seek portfolio diversification and crisis insurance in the form of systematic trend-following funds uncorrelated to the stock and bond markets. And we seek further portfolio protection (and now meaningful capital growth in real terms) in real assets, notably investments associated with commodities and especially the monetary metals, gold and silver.
Anybody born after 1971 and the Nixon ‘gold shock’ could be forgiven for thinking that monetary and currency systems are durable. The reality is that they typically have a shelf life limited to roughly 30 years or so. And they always change. Fiat currencies unbacked by finite, tangible assets always fail, because politicians and their agent central bankers always end up printing money ex nihilo to the ultimate destruction of the entire system. But this time around, the West does not have all the cards. It may have the ‘big bazooka’ of the printing press and the ruthless willingness to use it, but after decades of squandering the exorbitant privilege of ‘maintaining’ the world’s primary reserve currency, the centre of global financial gravity has shifted: emerging so-called BRICS economies (including the likes of Russia, India and China) have less overall indebtedness, higher populations, superior economic growth prospects – and in many cases also have the backing of tremendous resources of real assets. A ‘great reset’ may well be coming, but it may not be like the one advocated by the likes of Klaus Schwab and the WEF. #GotGold ?
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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: [email protected]
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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