A Crisis in Democracy
The Price of Intervention
© Martin A. Armstrong
Arthur William Edgar O’Shaughnessy once wrote in his classic Ode back in the 19th century…
“We are the music-makers, And we are the dreamers of dreams, Wandering by lone sea breakers, And sitting by desolate streams; World-losers and world-forsakers, On whom the pale moon gleams: Yet we are the movers and shakers Of the world forever, it seems.”
Perhaps we have been merely dreamers of dreams and indeed in the end we may find our children’s children one day writing of a society of “world-losers” and “world-forsakers.”
Perhaps the dreams of lower interest rates have suddenly been shattered as the Ides of March brought in its shadow the first prime rate hike in many long months. Of course the words that poured forth from the mouths of our politicians all clearly foretell of this event as a mere glitch in the long journey to where full employment, no inflation and cheap money lies patiently just around the next bend. Either our fearless leaders are lying /through their dentures or they are so confused themselves that they believe in what they actually speak. They have taken the role of a father who sits on his child’s bed and reads stories of endless wonder; the stuff that dreams are made of which disappear in the mist of the night when the new born sun begins to rise.
Are we dealing with a glitch in a long-term journey to the fable land where the best of all extremes lies waiting to be plucked from a tree like a legendary golden fleece? Is it really possible that lower interest rates lie ahead, unemployment will be banished along with the trade deficit at the hand of a lower dollar and our politicians will suddenly see the light and balance our fiscal budgets with the sweep of the pen? Or are we at the beginning of the end of a dream which has overstayed its welcome? It is always nice to be the dreamer of dreams like a child who falls fast a sleep leaving behind in the world of reality only a tiny smile for all to see. But when we gave up our youth, we gave up that special right to dream of things which no mortal should dare. For when we wake, the harsh consciousness of reality becomes the master of our own fate. But strange as it may seem, the real power of the future lies within the grasp of us all, for indeed in the end, we are the movers and the shakers of the world forever, it seems.
The golden dreams of cheap money, full employment, no inflation and prosperity for all, has never graced the world simultaneously. Oh sure, one nation has experienced this phenomenon for a brief period in time at the expense of its neighbors; but it has never lasted. Such goals on a long-term basis are mere fables for children told to comfort them and their fears of the oncoming night. The long-term models which we have designed have foretold of events in a far different light than most. March, we warned, was the ideal turning point for interest rates, particularly on the short-term. This recent hike in the prime rate is not a freak, but a forewarning of what is yet to come. It came on the heels of our model so quickly, that this in itself is not a omen of stability, but a change in the winds of destiny.
At the 1985 Economic Conference held here in Princeton, I went over our long-term models on over 300 various economic indicators from 35 different nations. In each case, it was pointed out that the VOLATILITY was increasing with each turning point throughout this century. The fact that the model called for the turning point to be March of 1987 for the short-term rates is important. But of even greater importance is the fact that under normal conditions, a rate hike would take place within 3 months of reaching a major turning point. In this case, the first rate hike in years came precisely on the turning point. This is itself forewarning of even greater VOLATILITY than what was discussed at the 1985 Economic Conference.
This subtle glitch, as everyone is calling it, is more serious than we had expected. The mere fact that it has come so soon in conjunction with the major cyclical target, suggests that the upside potential in interest rates will be far greater than we have been talking about. We could easily see levels matching those of 1981 by January 1990 and this may be too conservative at that. The confirmation as to whether or not we are in fact in a new uptrend in interest rates over- all, will arrive when the Federal Reserve Discount Rate exceeds 6%. When that happens, then the possibility of this being a mere glitch, will forever be erased from our financial history.
O’Shaughnessy’s words them- selves express the overall role of us all in this battle between the free markets and the aspirations of our Napoleonic forms of financial govern- ments who seek to manipulate and con- trol our economic social interaction. For indeed we are perhaps a bunch of world-losers who really do not know what lies ahead, but the mystical aspect behind our power lies in our sheer numbers. Government intervention can never work for a variety of rea- sons. If the central banks wish to support the dollar, and the free market forces continue to add selling pressure, the only way the central banks can hold their ground in terms of supporting the dollar, will be to continually buy all that is offered. The outstanding supply of paper money in circulation vastly outnumbers the buying power of the central banks. Even collectively, their total influ- ence upon the money supply can at best reach 6-7% or roughly the amount of reserves it requires from its member banks. Thus, these scares which inflict the currencies sporadically, have been merely temporary. The forces of volatility are always influenced by psychological implications of the central banks rather than the real amount of currencies they buy or sell through their intervention practices.
The central bank’s influence upon the credit structure is perhaps greater than its influence over cash itself and to exercise that influence, it will require discount rate hikes! As long as capital continues to run away from the bond market and into equities and gold, the selling of the dollar will continue at least on a short-term basis. The prospects of a trade war with Japan, will only further weaken the dollar’s posture in the short- term. Interest rates will rise in an effort to attract capital away from the equity markets and the dreams of dreamers who foretell of the promise land of lower interest rates will have turned into a dark and frightening nightmare.
There is no doubt that we have listened to a lot of things politically these past two years. We have been told that our trade deficit could be reversed if we only force the dollar lower. Well nearly two years later and with a 40% lower dollar since 1985, the trade deficit has continued to worsen. These trade figures are now being used to embark on a tit-for-tat trade war with Japan, who has by and large justly deserved it to some degree. But those who now spout forth warnings that we /will slip into another world depression due to protectionism (as they cite the Smoot-Hawley Tariff Act for creating the world depression in 1931), not only do they have their historical facts a bit out of order, but their reliance upon these current trade figures is not on solid ground either.
Have our government officials been disrupting the foreign exchange markets and are they liable to disrupt the interest rate markets based upon solid trade data for a just cause? The answer is NO! The first thing you should know is that the trade deficit figures are NOT actual sales or capital flows which are being counted as is the case with the money supply figures, new housing starts, retail sales or the consumer price index. Most of these indexes we hear of are actual hard numbers which are seasonally adjusted. But the figures used in the balance of trade status are NOT! These figures are purely a census which means they are put together by doing a survey. The data collected is not only unreliable, it is grossly distorted.
Unless the trade balance census is broadened to redefine this change which has taken place in our economy, the trade deficit figures which are being reported will not get a heck of a lot better. This fooling around with the foreign exchange markets to help the manufacturing sector in some areas, hurts the bulk of the American population by inflicting upon them an abnormal increased level of volatility in not merely foreign exchange, but in the equity markets, bond markets as well as gold and interest rates. To throw more salt on the wound, it doesn’t matter how low you force the dollar, the consumer has no other choice but to buy foreign manufactured goods in many cases. Stereos, VCRs, televisions, appliances, and many other areas of manufactured goods have little or no American domestic produced counterpart who will benefit from a trade war or a lower dollar. It will only increase the price of those goods to the American consumer which will spark inflation and then the Fed will raise interest rates to combat the inflation. The consumer loses no matter what happens!
Another aspect of forcing the dollar lower comes to light when one looks at the influence it has had upon the markets here in the United States. The decline in the dollar has sparked a flood of foreign buying in all areas of U.S. assets. If we look at the follow- ing table we can see the difference between a U.S. investor’s perspective and that of a German or Swiss investor.
02/85 03/87 % Change
Dow Jones… 1300 2400 +184%
DMark……… 29c 56c +193%
Swiss…………. 34c 68c +200%
The above table clearly illustrates that the advance in the Dow Jones Industrials has not outpaced the decline in the dollar. Therefore, if you had invested in the stock market in 1985 and then cashed all your stocks in during March of ’87, you would say you did quite well. But if you flew to Switzerland to buy a house which you had priced 2 years ago, even if the local real estate market did not appreciate in Switzerland, the house will have cost you 16% more over and above the 184% in profits you made on the Dow in two years!
Let me turn the perspective around for the American readers so you can clearly see what has really happened and why you have NOT made any money on this bull market whatsoever from a real honest international purchasing power perspective.
During 1985, the British pound fell sharply to US$1.03 sparking quite an uproar. From the local perspective, the price of housing in London was rising rapidly. In the fashionable sectors of London where the non-British residents normally lived, the pearly white town houses of Victoria and Kensington began to rise in price rapidly by 20 to 30% almost instantaneously. All the buying came from the non-British citizens. Suddenly it was like a one-day sale at Harrods. To the British, all they saw was real estate rising like crazy. To the non-Brit, the price had just been reduced drastically in terms of dollars, yen, dmarks and francs. The property values rose in DIRECT proportion to the decline in value of the pound as expressed in foreign exchange (from US$1.40 to the pound to US$1.03). From the British perspective, they saw massive inflation. From the international perspective, London property values rose back to where they had been prior to the fall in the pound from US$1.40 ro US$1.03.
What is happening here in the U.S. currently as the dollar has declined by 40% between 1985 and 1987 is exactly the same experience as that of the British between 1983 and 1985. All this foreign buying is coming into the US property markets on the part of foreign investors is being driven by the very same forces of asset inflation driven by sharp and swift foreign exchange fluctuations in value. But when this foreign buying comes into the U.S. markets, be it stocks, bonds, real estate, or gold, it is not considered to be part of the American balance or trade. Yet in reality, this influx of capital swells the local money supply and creates great booms, but in its wake lies cloaked in confusion, the seeds of inflation!
We are not benefiting at all from this lower dollar as a society on the whole for many reasons. If we sold our house and realized a sudden 40% gain in two years, we have merely kept up with the depreciation in the dollar. But the government then considers that we have just made a profit and we must pay our taxes. So if you made 40% and then paid a 20% tax, your net is 32%. You lose since the price of housing in overall terms has risen! Therefore, if you stayed in the same region, you will find that your net worth in international terms has just been reduced by the taxes paid to the state. Consequently, your standard of living is gradually reduced with every swing back and forth in the value of the dollar.
We have a hard time understanding what the real cost of government intervention into the foreign exchange markets may be in the bottom line. This taxing of so called profits, which are none other than adjustments to foreign exchange fluctuations, the higher cost of goods which have no counter part in American manufacture, the transfer of assets from domestic into foreign hands and the effect upon the volatility level in all markets from stocks and bonds to gold and real estate, combine to make our financial lives far from an easy road to follow. We are losing money and assets without ever knowing what is happening and such things can only be seen in a gradual decline in our standard of living in the years ahead. What young couple can afford a house today unless both work full time. That was not the case just 20 years ago. It is now for the majority. And at that, the new homes are of far less quality than before. This is how the standard of living declines.
Therefore, this new turn upward in interest rates is not a fluke. It is now the time when all this craziness filters over into the interest rates which will become yet another tool to defend a dollar which should never have been manipulated in the first place. Everything in life has its price. It is one giant chain reaction without end. Every short cut we take merely forces us to respond to another problem somewhere else along the way.
Nothing happens in a trend for no reason. Every move is a clue to the future. When gold peaked in January 1980 at $875 on Monday the 21st, by Friday of that same week gold had fallen to $630. It was under $500 by February. By March, everyone was talking about the decline being only temporary as gold rallied to $730. But that sharp decline between January and February was a warning in itself. Then too the words which spouted forth were joining together forming phrases which uttered wonderful dreams of how it was a temporary correction and that gold would rally beyond a $1,000 in the end. Nothing fundamentally had changed just yet. Russia was still in Afghanistan and inflation was still soaring. But that correction meant a great deal to the long-term. It was not a freak which should have been ignored, it was the sign of the beginning of deflation.
Collectively we are indeed the movers and the shakers. Ask yourself if you find interest rates reasonable enough to warrant buying now? Would you hold off waiting for 5% or 6% mortgage rates? The problem that we face is ourselves. Collectively we are satisfied with where rates have been and we are buying despite what everyone claims about a lower rate future. We all have collectively brought about this turn in interest rates and it is not a freak coincidence but a warning that the tide has quite possibly changed once again.
Figuring out exactly where we are on the long-term scale of things is never easy. Long-term trends are slow movers and they begin always with the subtle movements which make no sense and strike in the midst of the night when least expected. Only as time goes on, will additional fundamentals rise forth to the surface. 0nly then will we all gradually come to the same conclusion that rates are in fact headed for higher ground and not dreamland.
Back in April 1981, the Economic Confidence model turned pointing to a deflationary trend into July 1985. Everyone said it was crazy to forecast deflation. With deficits rising how could deflation emerge? Inflation was all around us; they said. Deflation was not merely impossible, it was INCONCEIVABLE!
Just prior to the 1985 Economic Conference, I was asked to appear on Financial News Network (National Cable TV). The commentator asked me what was going to be revealed at that conference concerning the long-term outlook. I replied that the deflation was at an end and that we would now begin a gradual shift back toward inflation with a rise in gold and the stock market simultaneously. He looked surprised and asked how could I possibly call for inflation when deflation was all around us? I responded, they asked me in 1981 when I forecasted deflation how could I possibly forecast such a thing when inflation was all around us? You never see the real truning point on a long- term model until you are normally 2 years away.
My opinions of what the future will be like have always been different than most. I am not a doomsday pessimist who foresees another world depression nor do I preach a return to the gold standard. In that department, we kissed those dreams good-bye a long time ago and returning to a hard money policy is too unrealistic for this day and age of instantaneous capital movement. Indeed the monetary system will collapse and be reborn. However, it will not be through a massive destructive wave of deflation as once plagued the world during the 1930s. The collapse that is forthcoming will be one of inflation inflicted by the paper money system. Government will move to replace our current world monetary system, not with gold, but with electronic banking.
The fuse which will ignite this change in events will be a world seriously burdened and overextended with debt. It will be the leverage effect of debt itself which will make the future more volatile and regretfully, inescapable!
As the deficits grow larger, and the need to raise taxes builds, the next popular move will be into the electronic banking system where money becomes accessed totally by your credit or debit card. Salaries will be automatically deposited and bills automatically deducted along with taxes. The excuse will be simple. We have heard it from Washington before. If the underground economy paid its fair share of taxes, they say, there would be no deficit, only surpluses. Therefore it will not be government’s fault, but the private sector’s fault for not paying its fair share! Such a new system will solved that problem.
This is the way of the future and it will not be that far off on the horizon. This circus game with jawboning the dollar up and down to influence trade balances, will soon backfire and the sheer increased volatility in foreign exchange will alone raise the voices of business who will demand exchange controls as a simple means to end the risk in conducting international trade.
The years ahead will be interesting indeed. However, they will not bring back old methods nor will old ideas suffice. We are on the verge of a new generation in economic experimentation and the sad part about it, is the sublime fact that there very well may be little other choice. For every action there is always the inevitable reaction, and for everything holy it is said there exists the unholy. In this case the robust and jubilant bull market in the equities is not a happening without its price. While the stock brokers cheer and the investors celebrate, further down the road lies a price waiting to be paid. That price of this current bull market is something again which few foresee. But in some respects, the footprints of the past show clearly all the wrong turns we have made which brought us to where we are today.
The most important parallel from the 1929 saga is not of bank collapses and shoe shine boys bearing market tips. The importance from a parallel standpoint is the interaction of capital flows from not merely one nation to another, but from one market to another. As discussed on numerous occasions before, the bonds collapsed as stocks soared between 1927 and 1929. It was the flight of capital from bonds and banks into equities which sparked greater problems in world debt. Those same influences are at work today and they will not simply go away. The price that we must eventually pay for this bull market in stocks world wide will be higher interest rates as governments and banks are forced to compete for capital against a buoyant stock market. When they clearly realize that they are losing that battle, then they will seek to write new laws to protect us from our foolish selves.
The adverse effects will filter over into foreign exchange and it will be the combination of all these events which will carve the handwriting into the wall, not just on it. The solution to all such things will be as it has in the past. Government’s inability to control the free market forces will be blamed and their excuse will as always be the same. They need more power to do the job. We are indeed the movers and the shakers. Collectively we may know not what we are doing but in the end our response to the movement of the whole remains the true deciding factor in the end exactly as O’Shaughnessy once wrote.
You may think that this tale of the encroachment of government is a bit overdone on my part. But the course of history is in fact on my side. Govern- ment always evolves in this manner rising out of panic and turmoil with more power than it had before.
James Madison once wrote…
“I believe there are more instances of the abridgment of the freedom of the people by gradual and silent encroachments of those in power than by violent and sudden usurpations.”
Even Thomas Jefferson warned of the dangers which government offers…
“Sometimes it is said that man cannot be trusted with the government of himself. Can he, then, be trusted with the government of others? Or have we found angels in the forms of kings to govern him? Let history answer this question.!”
The future will spawn a crisis of a different sort indeed and its forthcoming can be read easily upon the chart patterns of bonds, stocks, gold and clearly in foreign exchange. The forthcoming crisis will be a Crisis in Democracy for to control our financial destiny in a more orderly fashion, we will give up much of our rights to privacy in our personal financial affairs. If this is correct, then gold has bottomed in terms of dollars in 1985 exactly in tune with the Economic Confidence Model, the interest rates will rise from 1987, stocks will explode beyond the wildest expectations of the majority perhaps exceeding 5,000 on the Dow by 1990, and the dollar will fall to new record lows under that of 1980 in the D-mark and Swiss franc. If all these things come to pass, the outcome will indeed bring forth a Crisis in Democracy such as we have never before witnessed in this century. Government will be unable to resist more controls in the face of volatility beyond our wildest imaginations.
The writings of Madison, Jefferson, Adams and others, all bear witness to this evolution process in government power. It was for these same reasons why the United States came into being. It is said that history repeats; perhaps it is not so much history which is on a repetitive cycle, but instead it may be man who fails to learn from his own mistakes and past misfortunes.
From an investment standpoint, enjoy the bull market in stocks. It should move through some fitful starts and stops here and there, but in the end, it will show us all the true meaning of a raging bull. Gold’s advances in terms of dollars is still just getting started. It has some testing to do on the downside and it will not advance upward in a greater proportion to the dollar’s decline. Nevertheless, long-term gold remains in a sound position. Weep for the poor soul who has not the courage to leave the safe and secure atmosphere of the bond market, for he will be the real loser in the years ahead. If there is anything we should have learned from the past 15 years, it’s definitely to go with the flow. No trend lasts forever; it’s just one of those times when the present must depart from the recent past.
The volatility which will besiege all markets will be the child of our past memories. When interest rates rallied steadily and gold soared to new highs in the late 1970s and early 1980s, the majority stood by in disbelief. With each new high in record territory, everyone remarked that it was the high and that it couldn’t possible move any higher. But both gold and interest rates eventually pressed beyond what everyone expected and only when those trends came near the end did the majority call for $1,000 gold and a 25% prime.
Today we are all aware that interest rates can return to 20% because they have been there before. We will not standby in disbelief as we did before, but instead we will all be much hastier to respond than we were the last time around. This natural tendency of us all will definitely spark a more rapid decline in bonds and a very rapid advance in gold when the key support and resistance levels are broken in the future. The balance of this decade will in fact bring with it record moves in all markets far greater than anyone is expecting at this stage in the game. Learn well from the past for it is our only guide to the future. What has happened before is always within the scope of possibility and each generation may believe that it has built a better mouse trap, but not one has yet escaped the turmoil of its consequences.