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ISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED NOVEMBER 23, 2001
Long Live Deflationary Shocks, and Down with Central Bankers Who Want to Prevent Them!
In all the more advanced communities the great majority of things are worse done by intervention of government, than the individuals most interested in the matter would do them, or cause them to be done, if left to themselves.
John Stuart Mill (1806–1873), Principles of Political Economy he inherited an apartment building in the city for whose apartments he is collecting a rent of less than US$1 a month! This lack of any property development over the last 25 years, unlike elsewhere in Asia, is also interesting given that economic activity is shifting to the outskirts of the city and to other regions of the country, where India’s totally incompetent government is unable to hamper economic development to the extent that it has in Mumbai’s inner city. I can do no better, in describing the Indian bureaucracy, than quote the 11th-century Chinese poet Su Tung P’o, who wrote: Families when a child is born, Want it to be intelligent. I through intelligence Having wrecked my life Only hope the baby will prove Ignorant and stupid. Then he will crown a tranquil life By becoming a Cabinet Minister. Still, what is reassuring about India is that, despite its horrendous bureaucracy, entrepreneurs have thrived and India is now home to many very promising companies doing business in all kinds of sectors, but especially in the fields of pharmaceuticals and software. The good news, not only for India but for the entire global economy, is that entrepreneurs are like rats who manage to survive in just about any environment, no matter how difficult, and that they show an impressive ability to adapt to even the harshest commercial and legal infrastructures by developing a high degree of immunity to these unfavourable conditions. Moreover, entrepreneurs can mutate rather quickly in order to take advantage of opportunities in sectors such as software, for which there were no government impediments or regulations in India. Such is the power of free markets over bad governments and governments’ interventions in the economy. Yet it is discouraging to see Mumbai, the business capital of the world’s secondmost populated country, lacking a large foreign business community, such as we find in New York, London, Tokyo, Singapore, and Hong Kong, because of the government’s inability to provide an efficient infrastructure and a more conducive business environment. (Even more discouraging is the virtually nonexistent nightlife in India’s capital, Delhi!) The Indian tragedy is that, in the absence of its bureaucracy and with, to paraphrase Adam Smith, a tolerable administration of justice (an efficient legal system with straightforward commercial laws and property rights), the country could easily grow at around 8–10% per annum — admittedly from a low base — and boost per capita incomes significantly compared to the present environment, which allows the economy to grow at only around 5% per annum while per capita incomes hardly budge. Still, this may be an opportune time for investors to purchase Indian shares. The Indian stock market, which shouldn’t have a meaningful correlation to foreign markets since India’s economy doesn’t depend much on foreign trade and foreign portfolio
I have just returned from visiting Delhi, Mumbai, Singapore, Shanghai, and Dubai. Mumbai and Shanghai are both impressive cities from an economic development point of view. In the case of Mumbai’s inner city, the remarkable feature is that little has changed since my first visit to the metropolis in 1973, except that its buildings are now even more dilapidated. The reason for this lack of development of the infrastructure in the inner city is a maze of totally antiquated property laws that have prevented landlords increasing the rents on the premises they let out, with the result that they have no incentive to maintain their properties in good condition. Furthermore, tenants have the right to stay in their apartments for as long as they wish, and the children of tenants can even inherit the leases taken out by their parents, many of which date back to before the Second World War. A friend of mine told me that years ago
com) who manages the Indian Capital Fund.flows (exports amount to just 10% of GDP). such as the Jardine Fleming India Fund (JFI). (See his contribution entitled “The Best of Times. the MSDW India Investment Fund (IIF — see Figure 3). For an investment in a fund with a stronger bias towards a bottom-up approach to stock selection. I have been visiting Shanghai regularly since 1989. written about India for this report. 1994–2001 Volume Source: BigCharts. Boom & Doom Report Figure 1 India 12-Month Forward P/E. in my opinion. are now at an all-time high (see Figure 2). although it was achieved at a certain price in terms of human rights. and on each visit I am struck anew by its continuously changing skyline and the extent and speed of its modernisation. as an Indian minister pointed out to me. in the past. And this is the same city that. all sell at discounts of around 20% from net asset value and might be a suitable vehicle for investors wishing to participate in the Indian corporate sector. In fact. Jon Thorn has.) There could hardly be a stronger contrast than travelling to Shanghai after Mumbai: whereas inner-city Mumbai has stagnated in terms of infrastructure and real estate development. Furthermore. 1993–2001 Source: ABN-AMRO Figure 3 Morgan Stanley India Investment Fund (IIF). the rapid development of its physical and commercial infrastructure is unprecedented in history. In addition. 1993–2001 Source: ABN-AMRO Figure 2 Time Deposits as Percentage of India’s Total Market Capitalisation. and the India Fund (IFN). the success Shanghai has achieved in improving people’s standard of living and per capita incomes far outweighs those shortcomings. ten years ago when I first began to write about its impending emergence as Asia’s most important commercial and financial metropolis. The Worst of Times” in GBD report of July 20. time deposits as a percentage of total market capitalisation. The various listed India Funds. is at present extremely depressed and is. discounting to a large extent the country’s problems (see Figure 1). which has declined to just 21% of GDP. businessmen in Hong Kong dismissed as being far too 2 The Gloom. our readers might contact Jon Thorn (jon@indiacapfund. 2001. Shanghai has emerged as a modern and impressive city over the last decade.com November 2001 . of which I am the chairman.
While I am fully aware of the problems that are endemic to the Chinese economy. while the Swissairs of this world. now there are factories everywhere. What Then is the Buying of US Equities?”. whose stunning architectural structure rises to more than 40 storeys from a man-made island in the Persian Gulf. FC=standard) Source: Gaveco The Gloom. As in the case of Shanghai. the changes that have occurred in China in the last few years are simply extraordinary. with their high cost structures. In particular. which by any valuation standard still appear to be expensive? The purpose of this brief description of my recent trip is not. both Abu Dhabi and Dubai have developed rapidly in the last few years and have now become far more cosmopolitan than in the past. Central Asian. there were just two industrial parks under construction on the outskirts of the city. in a business class seat on China Eastern Airlines with significantly more legroom than in any first class seat of a US air carrier. one could argue that the Middle Eastern economies are “artificial”. In fact. whole regions that in the past were absent from our Western market economy and which shunned our capitalistic system as a result of their adherence to socialist ideologies and to the ideas of self-reliance and hostility towards foreign investments have ºnow been fairly well integrated into a “global economic system”. or spoke at dinner parties about Shanghai’s stunning development and China’s large trade surplus with the United States? And who at that time was aware of Emirates Airlines. an airline that is now certainly better managed than Swissair or Sabena in recent years. entitled “If the Purchase of Emerging Stock Markets is ‘Financial Suicide’. as well as an enjoyable entertainment and tourist centre for well-to-do people from around the region. to draw any conclusions about the relative investment merits of emerging economies compared to the Western industrialised nations. there is no doubt in my mind that over the same period. RT=Effective. 1991–2001 Asia ex Japan/US stock market index [index 1994. 2001. on my way back to Hong Kong. over the last ten years or so. a city I hadn’t visited for over three years. it would seem to me that.) While seated comfortably. despite the fact that the emerging markets have grossly underperformed the Western developed markets since 1990 (see Figure 4). including the difficulties facing foreign companies wanting to make money (due largely to the tremendous overcapacities in all industrial sectors and the inevitable “speed-bumps” the Chinese economy will periodically hit). and North African nations. or of the Emirates Tower Hotel Group. see GBD reports of May 16. an Figure 4 Performance of Asian and Japanese Markets Relative to the United States. My visit to the United Arab Emirates also held some surprises. ten years ago. since they depend largely on the price of just one commodity — oil. whose price is now rather depressed (at least in real terms). had heard of Bangalore and of India’s now famous software and pharmaceutical companies. At that time. Dubai is November 2001 worth visiting just to see the Burj Al Arab Hotel. MVM=Mean. But what is the difference between the Middle Eastern economic system. 2001. Who. it is to note that. entitled “Emerging Markets: An Unpopular but Depressed Asset Class”. RT=Effective. as well as monumental hotels. and of July 20. which owns and manages several luxury properties in Dubai (among them the Burj Al Arab Hotel) and now also runs the Carlton Tower Hotel on London’s Cadogan Square? While I am aware of all the shortcomings of globalisation. Whereas Shanghai is impressive because of its size and rising economic power. Admittedly.) Rather. I mused how in the future airlines such as China Eastern and China Southern would dominate the skies. FC=standard) Japanese index/US stock market index [index 1994. with trucks continuously moving goods to and from Shanghai’s port along a newly built highway. Dubai has emerged as an important trading centre. which over the last few years have increasingly become dependent on the price of their stock markets for economic growth? And on what would you rather bet your future: oil. (For such an analysis. Moreover. MVM=Mean. not to mention the far friendlier service. Abu Dhabi and Dubai impress the visitor because of the money the ruling families have spent over the last few years on building extravagant gardens and parks. the world’s only sevenstar hotel.bureaucratic and lacking the necessary educational infrastructure to develop! I also visited Suzhou. or Western stock markets. being the gateway to a large number of Middle Eastern. however. (And you may recall that I am rather well known for my somewhat cautious views about the health of China’s social and financial system. Boom & Doom Report 3 . impressive economic progress has taken place in most developing economies over the last ten years. would become extinct. which depends on the price of oil. and the Western industrialised nations.
Thus. The Great Wave DEFLATIONARY SHOCKS In a free market economy. a condition that is usually brought about by some major technological breakthrough. in the same way that Western Europe was inundated in the second half of the 19th century by agricultural products coming from the American West. In the second half of the 19th century. and vice versa. in the case of China. new ideas. and later the PC and the Internet. with the result that the world is now faced with enormous new sources of supplies of manufactured goods and tradable services. we can say that the application of new 4 The Gloom. prices will rise and fall depending on demand and supply. leading to declining agricultural prices throughout the world. the emerging economies experienced severe crises in the late 1990s. which lowered the cost of air travel and air-freight. because it allowed for efficient and speedy transportation and avoided the costly and time-consuming process of stevedores loading and unloading. which were then the world’s most important commodities and largely drove the business cycle. The application of a new innovation leads to greater efficiencies of production or to new sources of production. by a deflationary environment. very much in the same way the opening of the western territories in the US and the opening of Australia to the production of grain in the second half of the 19th century led to a deflationary period that lasted from the mid-1860s to 1900 (see Figure 5). communication. The container was one of the greatest inventions ever. Boom & Doom Report inventions led to the opening of new territories. technology. is evident from declining import prices (see Figure 6) and. when Malcolm McLean (the founder of SeaLand) introduced the first container ship. However. labour could move freely from one region of the world to another. including Japan. until the late 1980s. along with the free flow of goods and capital. Figure 5 Wholesale Prices in France.) Compare this to the current environment. which brought down the cost of communication to almost zero. such a major and rapid change for the global economy — the integration of close to three billion people into the world’s economy who. foreign exchange controls were removed around the world and a global capital market permitted the easy and speedy transfer of funds into regions that promised high returns. the emerging world is now exporting their deflated price level to the Western world and contributing to a structural “deflationary shock” in the global economy. Thus. A deflationary shock is brought about by supply rising much faster than demand. Germany. and the United States. with rising prices leading to periods of economic expansion and falling prices to recessions or below trend-line growth. One could even argue that there was November 2001 . or to a combination of both. That deflation is being exported. from emerging economies to the industrialised nations. Then came the Boeing 747. which in aggregate badly deflated the price level of the emerging world. which led to the fall in prices referred to above. and capital was transferred to these developing economies. several new technologies and a global financial market were in place to facilitate and speed up the process of industrialisation. agricultural commodities were then to the world what oil is today to the Middle Eastern economies. and India. Following an initial boom that lasted from the mid-1980s to the mid-1990s. These crises were accompanied by significant currency devaluations or. in the case of manufactured goods and commodities. In fact. were participating only on the periphery of the capitalistic market economy — also brings about a state of lasting disequilibrium. in the case of services. the current deflationary shock would reach far greater proportions if. (Simply put. when the ideology of socialism came to an end and numerous countries such as China became increasingly integrated into the market economy. At the same time. which significantly boosted the efficiency of transmitting information. and stowing cargo from ships to trucks. and information functions to countries such as the Caribbean Islands. Mexico. from the growing trend to outsource all kinds of accounting. the earlier construction of canals and railroads and the emergence of efficient transocean steamships lowered transportation costs by around 90% and allowed grain grown in the western territories of the US and in Australia to reach Europe. the fax machine in the early 1980s. In turn. It is difficult to imagine that world trade could have expanded by as much as it has over the last 50 years or so without containers. 1820–1896 Source: David Hackett Fischer. management techniques. The combination of these two factors in turn increased the supply of agricultural products. The opening salvo to the current deflationary shock was fired as long ago as 1956.unprecedented amount of knowledge.
Indonesia. emerging economies are in a position to export deflation. ownership of land amounts to selling out their precious nation to evil and barbaric foreign intruders. Majorca. The same is occurring in the shipping and cruise line industry. totally free movement of people would not necessarily damage these economies in the long run.Figure 6 US Import Price Index (yearly percent change). Similarly. It should be evident that while European airlines with their high wage costs and poor management will fail. Then there is the retirement and health-care industry. and accounting industries. more and more people from the industrialised countries will retire in developing countries where the costs of living are just a fraction of what they are at home. foreigners would be unlikely ever to own more than 1%. A borderless world. the service sector isn’t immune from this trend. frequently. call-centre. (The retirement industry will only really take off in emerging economies if foreigners have the right to own landed property. but even so. an annual spending of The Gloom. leading to above trend-line growth in these countries and below trend-line growth in the industrialised nations. but rather would benefit them. This is. given the current recessionary environment. In the manufacturing sector this trend is already well under way and will accelerate. more and more businesses will simply migrate to low-cost countries such as China. a thorny issue in most developing countries. The entire international transportation service industry could be taken over by emerging economies with their low wages. or Malaysia. bridges. but also of labour. harbours. However. and temporarily depressing wages in the manufacturing and service sectors of those economies. However. very conservatively. we would see millions of people from poor countries migrating to countries with high price levels and seeking employment at high wages in countries such as Japan. and India (for services). this trend would accelerate significantly if government officials in the developing countries had the sense to refrain from their continuous anti-foreign rhetoric and allowed foreigners to own property. Mexican drivers with their lower wages will increasingly ship cargo between Mexico and the US at the expense of their American counterparts. as a percentage of their total property market. In the same way that there was a huge migration of well-heeled elderly northern Europeans to lower-cost and climatically more appealing places such as the Canary Islands. in the trucking industry.com far more freedom of movement a century ago than there is today. Assuming. the absence of property rights can put infrastructure. in time. however. airports. countries such as China will in future further increase their competitive manufacturing advantage over the developed countries. as we have seen in the case of India’s software. their nationalistic bias makes them think that the foreign. Naturally. Thailand. where most crew members originate nowadays from developing countries. Just imagine the effect of free migration on Japan’s economy! The unfavourable demographic trends would be reversed and. and given their almost unlimited reservoir of cheap labour. This is so because if current tight migration laws are maintained. which has contributed to these regions’ economic growth in the last 20 years. when in fact. the US. and Ibiza. as. power plants. because of much tighter migration policies now. would almost certainly increase the world’s GDP significantly — at least in real November 2001 terms — and benefit people living in poorer countries. Boom & Doom Report 5 . And since emerging economies with their low wages and. But if there was a completely free movement of labour in our times. the current strict migration policies in industrialised nations are unlikely to change (especially given the events of September 11). even worse. which would consist not only of the free movement of goods and capital.) But just think how the money spent by 100. and Western Europe. Asian airlines with their low labour costs will take over their business. where even those people who didn’t migrate would have a better chance of finding employment. and along the entire Spanish coast. and so on in place at a far lower cost than the industrialised countries. I can see that.000 retirees would boost the economy of a country such as the Philippines. tunnels. with pressure on wages. such as roads. because their false sense of patriotism or. Mexico. the country’s competitive position would improve. companies in high-cost countries (the developed countries) will shift far more production to emerging economies in order to cut costs. 1990–2001 Source: yardeni. Unfortunately.
Conversely. at least in Hong Kong. New Zealand. Hong Kong is host to a large flow of migrants from China. the Philippines. (If the US government was a profitdriven corporation. will be far more likely to adopt new homes in foreign countries than their parents who grew up. US$2 billion (or US$3 billion) would flow to these countries’ bottom line right away. say. and Nevada). who have.) The other service sector that is increasingly becoming tradable is health care. functions from expensive downtown areas to cheaper locations 6 The Gloom. Just have a look at how prices have moved up in southern Spain. not to mention the know-how and skills these retirees would bring with them. In countries such as India. Arizona. on long weekends Hong Kong almost empties itself. retiring expatriates are leaving Hong Kong for lessexpensive places offering a higher quality of life. and in the Balearic and Canary Islands. with far more people from poor countries moving to rich countries than vice versa. or China? Moreover. the Philippines. a structural deflationary shock from the opening of China is clearly evident and this deflationary trend will. Still.) While it is true that there are far more migrants from less-developed countries into the developed countries than the other way around. In general. kept wages from rising and are therefore a thorn in the side of the local labour unions. Even services are increasingly moving across the border. but also for some functions in the financial sector. Moreover. In the meantime. of course. But consider the following. it should be understood that there are businesses in the service industry that create wealth. say. There are a growing number of people who travel from Europe to Singapore for dental care (much cheaper) and to Bangkok for all kinds of bizarre operations. they would be correct in pointing out that at present the migration flows still favour the developed countries. while this migration trend is well under way within Europe (from north to south) and in the US (from everywhere to Florida. as people from Hong Kong find it cheaper and more pleasant to go to Thailand. (This trend will also be reinforced by the rising number of multiracial families. there will be no problem for most services. lunch. as people simply wouldn’t travel from a high-cost country to.000). and the estates their soft hearts would leave behind to their new-found communities! Yet. it still represents only a trickle towards developing countries. of spending hours each day driving your children to daycare centres. who basically run Hong Kong. in my November 2001 .) In addition to the increasing numbers of Hong Kong Chinese who are living in or retiring to China.000 per foreigner (but more likely US$30. argue that while some deflationary pressures do exist in the manufacturing sector. Boom & Doom Report in the suburbs or even the countryside. Thus. And while Hong Kong people don’t travel to China for a haircut. as well as those that have stepped in to perform the work formerly performed by housewives who are now working women supporting their families. Manufacturing has already almost entirely left Hong Kong for locations across the border in China. If so many large companies have already found it advantageous to move their back-office. it would outsource the entire social security administration and the IRS to India. many women have come to believe that staying at home and raising their children is a demeaning job. not only for the export/ import-related service sector. Moreover. fear that a totally open border would depress real estate prices in Hong Kong even further. Sceptics of this deflationary shock scenario will. Moreover. Russia. how great a step is it in a highly costconscious world to move at least some processing functions to places such as India. I believe that services that add significant value to an economy. they can even depress them — as a large flow of migrants increases the supply of labour. a quick look at the Hong Kong economy might shed some light on the subject of the phenomenon of a deflationary shock. in recent years. I can see the positive contribution to economic growth that service sector companies such as temporary work agencies and courier services like DHL and Federal Express are making. or China for a couple of days than to stay at home in expensive Hong Kong. as compared to those which simply serve as substitutes for the old “household” economy. Thus. In this respect. the border closes at 11 pm and reopens at 5 am. lived.US$20. younger people. Less clear is the benefit to the economy of having to eat breakfast. over the last ten to 20 years. who by the time they retire will have travelled widely and perhaps lived in several different countries. Burundi for a cheap haircut. the flow of migrants from rich countries to countries with a low price level tends to raise prices in those countries that receive these more affluent migrants. (At present. and worked in the same city all their lives and travelled abroad only infrequently. and of having a cleaner come daily to your house because your wife works at a McDonald’s outlet and earns less than the value added if she had stayed home and looked after the household! But under the influence of vocal feminists. can be more easily outsourced to other countries. the incoming migrants have the tendency to keep wages in the industrialised countries from rising much — in some cases. and occasionally their front-office. or Southeast Asia. because the parasitic Hong Kong property developers. and dinner in a coffee shop. the Philippines. Australia. they do go there for shopping and for entertainment. and Thailand there are excellent health-care facilities that cost a fraction of what they cost in Western countries. while earning a salary for one’s work — even if it is associated with high transportation costs in addition to income taxes — is personally far more rewarding and glamorous. increasing numbers of Hong Kong people are moving their homes to nearby places in China because of the huge accommodation cost savings — a trend that would certainly accelerate if the Hong Kong government decided to open the border to adjacent Shenzhen 24 hours a day. such as can be found in Europe. Thailand just for a comparatively inexpensive meal or to.
Boom & Doom Report 7 . real wages rose practically everywhere more rapidly than in the first three-quarters of the 19th century (see Figure 7). But on the other hand. including shares and real estate. as a result of meaningful productivity improvements in agriculture and manufacturing. and brought about large economies of scale. with political consequences that included the Populist movement in the US. landowners aside. The 1873–1900 period was also highly beneficial to holders of fixed interest securities who reaped large gains from deflation. because of the accelerating process of urbanisation. fell.07% in 1899. It is true that the period between 1873 and 1900 wasn’t a golden era of prosperity. the European landowning class lost out. real estate in cities rose again after the 1873–1878 crisis. Deflation was obviously not particularly favourable for corporate profits.49% in 1861 to 3. Thus. created an integrated global market for commodities. Argentine beef. and in the US the yield on higher-grade railroad bonds declined from 6. while owners of agricultural land in Europe performed poorly. 1800–1896 Source: David Hackett Fischer. This was particularly true of the US. while real estate may not be particularly attractive in the present deflationary period (certainly not in financial centres). continue to depress the territory’s asset prices. THE ECONOMIC CONSEQUENCES OF A DEFLATIONARY SHOCK American economists such as Paul Krugman and economic policy decision makers such as we find in the US Treasury and the Fed would do anything to avoid a deflationary shock. and bonds therefore outperformed equities after 1876 (see Figure 8). Figure 7 The Rise of Real Wages. Thus.41% in 1866 to a low of 2. boosted world trade. The questions we have now to address regarding this deflationary shock scenario are whether such a condition is something to be concerned about. The yield on British Consols fell from a high of 3. and Canadian timber. as they not only faced declining rents and agricultural prices but also rising real wages. Grain farmers. selected real estate markets such as in Shanghai and Beijing could perform well after the more than 50% capital value decline they have experienced since the end of 1995. But let’s look at the evidence.opinion. both in terms of real estate prices and rents. were in deep trouble. 1857–1899 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 Source: The International Institute for Economic Research The Gloom. resembled far more a deflationary boom than a shock! Moreover. Australian wheat. New Zealand mutton. and which permitted November 2001 the exploitation of the American continent and other new regions and catapulted America into the role of the world’s leading industrial power. Returns on agricultural land. particularly in Europe. combined with declining transportation costs (the Suez Canal opened in 1869). the “revolt of the field” in Britain. and rural unrest in Europe and Russia.21% in 1897. and whether monetary policies can reverse this deflationary trend. The Great Wave Figure 8 Relative Strength of US Stock Prices vs Railroad Bond Prices. where real estate in southern California soared in the years preceding 1886. we should not forget that the economic development of many new regions which led to exports of Mississippi cotton. the deflationary shock that had been brought about by new technologies and inventions. fearing that deflation means depression. African ore. However. Thus.
Also. since almost-zero interest rates. the opening of the American West to agriculture and the subsequent glut of agricultural commodities on the world’s markets that led to their price declines would not have occurred? In my opinion. there is. Moreover. the world had cut interest rates as rapidly. when. which were truly a deflationary bust. London. but Japan today would be in a far healthier financial and economic position. shut down excess capacity. Irving Fisher made the “over-indebtedness” responsible for the Depression. overindebtedness is brought about by “new opportunities to invest at a big profit … such as through new inventions. In fact. Easy money is the greatest cause of over-borrowing” (Irving Fisher. the Depression was only a consequence of the previous speculative credit-driven boom that led to the excesses of the 1920s. One point ought to be obvious: lower interest rates and easier monetary policies would in no way have reduced the production of agricultural commodities or retarded the process of industrialisation. there is a serious risk of a deflationary bust. from 1929 to 1941. as in the latter years of the 19th century. coal. would seem to depend very much on the level of debt in the economic system prior to the deflation. and the Asian crisis after 1997. This observation seems to have been confirmed by the deflation in Latin America in the 1980s following the petrodollar boom (in nominal terms there was inflation. Do you really think that. we should not forget that the deflationary boom of the 1873– 1900 period led to a huge geopolitical change. easy monetary policies combined with large fiscal deficits brought about the worst of all possible worlds: hyperinflation and depression. Therefore. given the current high level of consumer and corporate debts in the US. However. investors should not forget that in the period from 1873 to 1900 and. whether deflation leads to a deflationary boom. in the case of Latin America post-1981. in terms of investment strategy. with economists such as Milton Friedman arguing that economic policy mistakes post-1929 were the cause of the Depression. with Britain being a relative loser while the US became the world’s leading industrialised and political power. as was recently done in the US. under such conditions. I could make the case that easy monetary policies have had the effect of badly retarding the necessary reforms and of leaving the debt overhang problems largely November 2001 . 1933). THE EFFECTIVENESS OF MONETARY POLICIES IN A DEFLATIONARY ENVIRONMENT Assume that. instead of analysing the various causes of the bust following 1929. the Japanese government let the post-1989 crisis run its course and not intervened. in principle. Therefore. opening of new lands or new markets. they might have implemented economic policies during the 1990s that could have reduced the risk of a similar occurrence in the years to come. even if a deflationary bust can be avoided and some kind of deflationary boom were to occur in the years to come. and so on. I would argue that Japan’s problem is that it didn’t have enough deflation. while the Austrian school of economists maintains that the crisis was brought about by easy monetary policies prior to 1929. but because of the currency collapse there was deflation in real 8 The Gloom. which with its productivity improvements led to a fall in prices for steel. And in the case of Asia post the 1997 crisis. and eased monetary conditions by as much. in the manufacturing sector at least. combined with large fiscal deficits. I would argue that while the entire 19th century was characterised by a deflationary trend (commodity prices and interest rates in 1900 were half those of 1800). nothing to fear from deflation. which led to over-investments and “over-indebtedness”.In sum. they focus on the devastation the deflationary bust brought about. since even more railroads would have been built and the American continent would have been opened at an even faster rate. In his book Booms and Depressions. the Japanese deflation following 1989. new industries. Therefore. are too big relative to other economic factors”. and bankrupted weak companies. allowed the debt levels in Japan to grow in the 1990s to unprecedented levels for an industrialised nation. The Debt Deflation Theory of the Great Depression. bonds significantly outperformed equities. would Japan be worse off today had interest rates not been reduced to almost zero? It’s unlikely. published in 1932. in the years following the boom of 1866–1873. Whether in the years to come China will challenge the economic hegemony of the US remains to be seen. Also. it is possible that. the reason so many economists fear deflationary periods is that they only look back at the Depression years of the 1930s. development of new resources. which would have brought its price level more in line with those of other Asian countries. or to a bust. Had these economists studied the 1920s’ speculative boom more carefully. Boom & Doom Report terms or adjusted for the US dollar exchange rate). in fact. According to Fisher. as well as to speculative excesses in the stock market. Also. instead. it was a century during which enormous economic progress took place accompanied by strong population growth. China could overtake the US within the next ten to 20 years (with the proviso that there is social stability). even more so. which are now going — or will eventually go — out of business anyway. which in turn brought about the subsequent deflationary slump. However. but with a much larger debt burden than would have been the case five or eight years ago! As to whether the 1930s’ Depression could have been avoided with easier monetary policies is a much-debated subject. more pain would have been incurred in 1992. as after 1929. Had. such monetary policies would actually have accelerated this process. transportation. meaning “that debts are out-of-line with. but having witnessed with my own eyes what China has achieved in the last ten years.
According to Professor Kindleberger.. whether there should be one. There are some more points to consider. 1995–2001 Source: The Stock Picture The Gloom. in 1998. “How much? To whom? On what terms? When? These constitute some of the dilemmas of the lender of last resort. Later. he emphasises the importance of the timing of the intervention. Enough at the right moment is better than either. and too late’ is one of the saddest phrases in the lexicon not only of central banking but of all activity. in the final months of 1999. who it should be. In particular. and Crashes (Basic Books. the effectiveness of drugs tends to diminish and occasionally disappears altogether as bacteria and viruses develop immunity. dosage and timing of the administration of drugs are of November 2001 particular importance. compare this to the present. as is well known in the medical field. In his highly recommended book. Liquidity has been pouring into the system.” Kindleberger then goes on to give examples of where interventions by the lender of last resort (usually the central bank) worked and occasions when they failed. today the stock market averages and its leading constituents such as Cisco (see Figure 10) still remain well below their year 2000 highs. 1997–2001 Source: BigChar ts. (Given the huge liquidity injection at the time. which “stands ready to halt a run out of real and illiquid financial assets into money. 1978).com Exchange provides no volume data Figure 10 Cisco Systems. monetary conditions were eased once again and within a few months the market made new highs (see Figure 9). Panics. That says nothing — and everything.) Now. and believes that it is impossible for restrictive measures to slow down the boom at the optimal rate without precipitating collapse. monetary conditions were massively eased once again because of the unfounded concerns about the problems associated with Y2K and the market again made new highs. it is an art. with the Fed fund rate having been cut by 450 basis points since the beginning of the year! But what was the result? The stock market has rallied recently. “‘Too little. All these issues derive from the basic dilemma that if the market knows it is to be supported by a lender of last resort. Manias. after it is determined. one admits the necessity for a lender of last resort after a speculative boom. the stock market soared in 1995 by more than 40% to new highs. Moreover. it will feel less (little? no?) responsibility for the effective functioning of money and capital markets during the next boom. but at the same time less effective in boosting or supporting the stock market and.” Therefore. the economy. the lender of last resort faces dilemmas of amount and timing … As for timing. then. too early’ is not an evident improvement. the rise was far less impressive than the 1995 or 1998 bull phases that followed the Fed’s easing on these occasions.unresolved. Charles Kindleberger devotes a chapter to “the lender of last resort”. but whereas in the past such massive easing moves produced new highs in the stock market within months. and second. if these monetary Figure 9 S&P 500. Then. along with it. Boom & Doom Report 9 . it is interesting to note that when the tightening cycle ended in the final months of 1994. Inc. it is by no means certain that current monetary policies in the US will be effective in reviving the economy. In particular. monetary interventions seem to have become larger in size. Thus. by making more money available”. following the LTCM debacle. The public good of the lender of last resort weakens the private responsibility of ‘sound’ banking. with increased frequency of usage. In other words. But how much is enough? When is the right time?” Kindleberger further states: “If. first. ‘Too much. In this respect.
In addition. 1997–2001 Source: ABN-AMRO couple of years. and especially China. especially against the Chinese renminbi. I also want to make the case here that if the world had had no central banks over the last 20 years and monetary growth had been kept constant at. Moreover. I would make the case that had the Fed not intervened aggressively in the money market and pushed down interest rates by 450 basis points since the beginning of the year. However. In fact. A mild form of deflation. CONCLUSION In the same way that the opening of the American continent in the 19th century led to a deflationary boom. which at present are hovering a tad below 4. equities could return less than ten-year Treasury bond yields. bond prices wouldn’t necessarily have to rally much. for the next 10 The Gloom. Once interest rates no longer decline. Thus. therefore. such as we had under the gold standard of the 19th century. it is possible that in order for bonds to outperform equities. is probably desirable. when long-term Treasury bond yields reached 15%?). sometime in the future. real rates (interest rates adjusted for inflation) remain high or even rise. A deflationary environment also forces November 2001 . while auto sales will collapse once the zero interest rate auto loans policy is discontinued (not to mention that zero interest rate loans will eat badly into the automakers’ profits). Without central banks. In time. interest rates could remain very high in real terms. “the great majority of things are worse done by intervention of government” than the market would do them if left alone. the rise of China and other emerging economies is spreading deflation around the world. easy monetary conditions will lead to further capacity expansion in Eastern Europe. and it wouldn’t surprise me if the Treasury’s decision to halt the sale of 30-year bonds has put a top in place for US government bonds and marked the low of interest rates. say. the expansionary monetary policies of the Fed are likely to weaken the US dollar. I explained earlier that. then against the Euro and. The injection of too much liquidity into the system keeps inflationary expectations artificially high. It ensures the survival of the most efficient entrepreneurs and producers. interest rates on long-term bonds might very well be lower than they are now. market forces would have contained the speculative booms and the colossal busts that followed them far better than the central bankers have managed to do. it is likely that the wild swings we have experienced in the global economy since 1990 would have been avoided. undoubtedly. because any intervention in the free market leads to unintended consequences.4%. the refinancing boom will come to an abrupt end. and prevent excess capacities being shut down. while rapidly eliminating weak companies and inefficient market participants. In other words. which in such a deflationary scenario would continuously suffer from a deteriorating credit quality. coming largely from the rise of China’s manufacturing sector and new technologies. Finally. under this scenario. the refinancing boom in the housing market (see Figure 11) and zero interest rate auto loans. even under my deflationary shock scenario. One of these is. 3% per annum. then we may be in for some nasty surprises. As John Stuart Mill observed. not the “survival of the fittest”. I believe that the Fed’s intervention in the market will make matters worse in the long run. low interest rates will temporarily ensure the “survival of the weakest”. both of which simply borrow demand from the future. the answer may be found in the movement of the US dollar against foreign currencies. against the Chinese renminbi and commodity prices. Boom & Doom Report Figure 11 US Mortgage Refinancing Applications Index. And as to the deflationary scenario I have outlined above. and commodities. This would particularly be the case for corporate bonds. don’t I contradict myself? On the one hand I believe that the US Treasury bond market has reached or is close to a top. and on the other hand I believe that the deflationary forces will be exacerbated by easy monetary conditions.interventions are as timely as the US Treasury’s decision to halt the sale of 30-year Treasury bonds when yields are relatively low (why did the US Treasury not discontinue such sales in 1981. which may be reinforced by easy monetary policies and at the same time a relatively poor performance of bonds. bonds outperformed equities. Moreover. Russia. in previous periods of a deflationary shock. if not against the Yen. At the same time. thus reinforcing the over-capacity problem and the deflationary corporate profit environment. but could either remain just around the current level or decline less than equities. while interest rates do decline. But.
“Easy money is the greatest cause of over-borrowing. The process of deflation may be retarded.net. but in a deflationary environment for corporate profits a 4% return will be high compared to the returns I expect for US stocks. which is usually exacerbated by monetary policies and during which debts are out of line with and “are too big relative to other economic factors” (Irving Fisher). 2001 Author & Publisher DR MARC FABER Research Editor & Subscription LUCIE WANG Copyeditor ROBYN FLEMMING E-mail: rflemming@albury.” I very much doubt that current US monetary policies will be effective in combating deflation. should therefore be expected next year. I am afraid that investors will have to become accustomed to far lower returns in the next few years than they enjoyed during the 1982–2000 bull market for bonds and stocks. THE GLOOM. it would appear that the Fed has implemented larger and larger monetary interventions.net. In addition. as the real cost of money remains relatively high. Lastly. Moreover. The recent rally that began on September 21 is likely to fizzle out.au Subscriptions and enquiries MARC FABER LTD Suite 3308–3310. As Fisher pointed out. I believe that at very best the stock market will fluctuate (wildly) in a trading range of between 950 and 1. with stocks bottoming out at far lower levels. BOOM & DOOM REPORT © Marc Faber. in deflationary periods.gloomboomdoom.com Design/Layout/Production POLLY YU PRODUCTION LTD Tel: (852) 2526 0206 Fax: (852) 2526 0378 E-mail: firstname.lastname@example.org This publication is printed on recycled paper November 2001 The Gloom. as corporate profits will continue to disappoint. Boom & Doom Report 11 . Moreover. but that eventually a resolution on the downside is very likely. The Center 99 Queen’s Road Central Hong Kong Tel: (852) 2801 5410 / 2801 5411 Fax: (852) 2845 9192 E-mail: contrary@pacific. and more likely a break of these lows. As previously stated. the deflationary shock for the manufacturing sector brought about by the opening of China and other regions in the world cannot be avoided. but in the same way that agricultural commodity prices would have declined in the 19th century even under extremely loose monetary conditions. In terms of investment strategy.companies to continuously look for new methods of production in order to boost productivity and lower costs. and the now ongoing deflation for commercial properties (see enclosure on next page) will eventually also spread into the residential sector. real income gains by wage earners are usually higher than in inflationary periods. high-grade corporate bonds yielding above 6% are relatively attractive for taxexempt accounts.250 for the S&P 500.hk Website: www. The problem with deflation is not deflation. but the preceding inflation. deflation forces a more conservative approach towards borrowings and investments by the corporate sector. Long-term US government bonds are unlikely to rally much further. A test of the September lows. but successively with less and less impact on economic activity. I also doubt that real estate will perform well.
Source: Financial Times. October 8. 2001 Marc Faber Limited Enclosure 1 .
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