Vigilant Investor

The New York Times published a suggestion from Princeton economics professor, Alan B. Krueger, on how bubbles like the most recent one in Internet stocks that burst might be avoided in the future. Of course, like so many in the economics profession, he completely ignored a massive contributing factor — credit and money supply expansion.

The article is still a good read, even if Krueger’s conclusion (that more open-disclosure on who is holding how much of any stock would help improve “efficient markets”) is a bit shortsighted. It gives a little historic background noting the South Sea bubble. That’s a good reference because it was very much promoted by fraudulent means, and folks identify that with our most recent bubble.

Unfortunately, although fraud is popularly promoted as the near exclusive reason for the net bubble and the subsequent economic slide (the latter is also attributed to 9-11), such an explanation is grossly oversimplified even if it naturally supports Krueger’s conclusion. If only the truth were as simple as just mutual fund scandals, Enron, and Martha Stewart.

Otherwise, Krueger correctly points out that folks involved in bubbles get sucked into bubble-psychology, where safety in numbers and large profits cause people to check their brains at the door. Indeed, in the late 90’s many in the investment profession were caught up in it all, as well. Notes Krueger, “most financial economists believed that stock prices closely matched their fundamental economic value… a survey of 110 financial economists by Ivo Welch of Yale in 1997 found that fewer than one in 10 disagreed with the statement, “By and large, public securities market prices are efficient”.”

Krueger also points out one of our observations, that during bubbles participants voluntarily delude themselves that “this time things are different” because _______ [fill in the blank] has changed everything, and that the old rules no longer apply. We should always be reminded of the late 1990s phrase “it’s the New Economy”, which was used to justify ridiculously high PE ratios on anything with a .com in its name.

All said, while the South Sea example fits Krueger’s conclusion, he avoids less convenient bubble examples, like the John Law Mississippi Scheme that also occurred in the early 1800s, or the bubble leading to our crash in 1929. Of course, both had their fraud-related elements (excess always does), but missing — as always — was any mention of the greatest enabler of economic excess: The continuous expansion of credit and money supply.

That should be clear enough, since inflating currency takes control of wealth — out of the hands of more prudent types, pacing it in the hands of movers and shakers willing to circulate money right away where its hot.

While encouraging consumption is the immediate policy goal of such a policy, such stimulation merely gives economic participants the impression of booming growth and even “go-go” good times, which are both essential ingredients of any good bubble.

However, this inflation-induced consumption is not creating wealth as many presume. Instead, it merely reshuffles and dislocates existing, productive economic order. As such, this artificial stimulation does not have the self-sustaining qualities of organic savings based growth. That is because its core fuel comes from pilfering wealth that is confiscated via lost purchasing power from those who held the currency before the increase in money supply. This freshly-invented money and credit is backed not by savings, sacrifice, productivity, or effort — and as such is very different to dollars earned more legitimately through the exchange of value. It is no wonder it can so easily end up spent recklessly to fuel bubbles.

The more this sort of thing is done, the more economic activity we see, and especially in popular segments of the economy. And, in turn, the movers and shakers confidently turn increasingly to more irrationally-exuberant behavior — not because of the animal spirits many assert, but rather because the liquidity to do so is ready and available thanks to official policy. Meanwhile, the nation’s stores of savings and core capital funding are stealthily depleted as this inflation redistributes the wealth of those who were prudent enough to become its responsible stewards in the first place and into the hands of bubble participants from top to bottom.

That’s all benign enough to the social meddlers who can’t resist redistributionist policies to fund whatever objectives they might have ( many of whom also believe that those with the wealthy gained their riches only at the expense of others). Nor does it bother the interventionist-minded economist, who believes pushing the right policy buttons can suspend the laws of economic gravity simply because he says it can. And it certainly is a joy to the banking community and major investor types who get to play with all the nearly free cash and credit!

But, the culmination of such policy is inevitable even if many ways can be invented to stretch and delay it from coming to its own demise. The social-meddler has an insatiable appetite and cares not about the predicament it causes the policy-minded economist. The profiting Wall Street community simply gets the deals done that people are willing to do, making hay while the sun shines as they always do until something breaks badly. Just the same, that central planning-minded economist always believes things can be tweaked, and together such bedfellows grow overconfident believing that for most any situation there is an economic policy answer, never mind the insane heights a bubble may achieve, or dangerous high-wire balancing acts they might require to sustain it all.

All of this eventually comes tumbling down when the spigots associated with the creation of money (low interest rates, low reserve requirements, and the simple printing of currency) are turned back– which they must be in order to avoid the more obvious financial calamities associated with too much liquidity (as the Fed now is attempting). The consequence is that the liquidity-based fuel supporting certain popular asset classes is reduced and their upward momentum is subjected to economic gravity. Without the artificial support of inflationary policy, demand is cut back, and eventually a bubble is exposed as unsustainable as they always are. And, so, a bursting is set in motion, and soon enough the system’s vulnerabilities to human reactions are uncovered as the tide goes out and the naked are exposed.

I suspect that as the economy continues its current schizophrenic ways, giving both signs of boom and slowing, its likely that more folks will come to terms that the Kreuger’s of the world must be missing something since such band-aid recommendations never seem to truly solve the problem. Indeed, they are merely dallying with the symptoms of a far greater, although fundamentally very basic problem: Excesses, distortions, and dislocations caused by manipulation of credit and money supply.

Of course, Austrian School economists rooted-out this inevitability long ago – before the Great Depression, even. Their view of economies and business cycles provides the most reliable explanations not only for today’s situation, but also other problems encountered in history. From the South Sea and the Mississippi schemes, to the messes of the Great Depression and the 1970s, Austrian logic provides a clean and consistent explanation on how our nation’s present policy invariably distorts and distends economies.

Let’s just hope that when things hit the fan, people learn to finger the correct cause: The policies of both The Fed and the complicit gang of beneficiaries on Wall Street and in the spendthrift U.S. Congress.
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