Vigilant Investor

A true sign of hubris is often when the old rules don’t apply anymore… Here’s a bit of history mixed with current policy redux:

“When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves (e.g. printed money) into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain’s gold loss and avoid the political embarrassment of having to raise interest rates. The “Fed” succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process.

The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930’s.”

–Alan Greenspan, 1966

While our perhaps situation may not be so dire, this quote is worth placing in context with the vast amount of credit and money supply expansion that has taken place in the last fifteen years. Since 1970 alone (with the end of the gold-backed dollar requirement) the Fed has increased money supply by over 1000%. Folks often wonder how bubbles are created, and we believe they are made possible and bolstered with excessive expansion of credit and money supply. With that in mind, given recent policy reactions to the bubble burst of 2000, it should come as no surprise that bonds and real-estate reacted with echo bubbles.

Certainly investors should not have their head in the sands on such issues. What concerns me today is that few in the mainstream — either investment types or economists — seem to care. And, while the real estate bubble is hardly debated by all but the most stalwart supply side defenders, few can explain how it was made possible, or why the methods are dangerous in the first place.

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