Can the World Be Saved?
Global Meltdown post July 20th
Hedge Funds – Fed
Social Threats of War
& Designing A New World Financial System
by Martin A. Armstrong
copyright October 3rd 1998
Princeton Economic Institute
There has been much turmoil in the past several weeks that has led to considerable outcry for everything from intervention, regulation, interest rate cuts, international insurance programs and bailouts. While many continue to try to paint a rosy picture that the worst is over, the meltdown we have been warning about is not only upon us, but it has only just begun. While we have initially received praise from some for our position that at times an economy may need to be closed during extreme circumstances, there has also been heated criticism from others who interpret this as turning our back on free markets. Economics is a subject unlike that of many others. It is never black and white and unlike some things in nature, it is possible to be a little bit pregnant when dealing with reality. The primary problem with economics has always been the “idealistic” philosophy of both the left and right with neither coming to terms with reality that often lies somewhere in the middle.
We have always stood for the principles of free markets and firmly hold with much distaste the idea of government intervention, manipulation and over-regulation. We must realize that capital was invested in emerging markets based upon the assumption that there was an underlying guarantee by the IMF and/or governments. Therefore, while the so called free markets got us into this mess, the truth is that such capital would NOT have been thrown so willingly into emerging markets had there been no implied guarantees by the IMF. It is clear from our direct discussions with fund managers prior to July 20th that they were indeed betting on the fact that the emerging markets were NOT a true free market and that the IMF stood behind their trades at the end of the day. Consequently, there was NO TRUE FREE MARKET with respect in particular to Russia. While the decision to invest was freely made, the FALSE incentives implied by the IMF played a major role in this investment decision.
We must also realize that there can be a significant consequence to the actions of the past 4 years in emerging market investments. One topic that is immediately rising to the surface is again the moral issue concerning the distribution of wealth. While we see that society has a moral obligation to insure that no one starves, government should not attempt to impose moral standards upon society through taxation or regulation in an effort to readjust those moral issues. This is not merely true in terms of a domestic economy, but it also applies in the context of bailouts for emerging economies as well on a global scale. The only economist to be canonized a saint was Saint Thomas Aquinas. Thomas stated that while the distribution of wealth may appear to be unfair, it is the concentration of capital that provides economic growth through job creation. Thomas also upheld that it was equally immoral to steal from the wealthy to give to the poor and economically dangerous to do so as well. In effect, Russia adopted such a system with communism. By taking the wealth from its people, it destroyed progress and guaranteed economic collapse. Only the self-interests of an individual who has the capital at hand creates jobs. Government job creation comes at the expense of taxation, which reduces economic growth.
Nonetheless, the moral issue concerning wealth within economics, both domestically as well as internationally, is far more than a mere philosophy for debate. When the wealth of a nation is squandered by its own government, or through external forces, there has been no single greater cause of war throughout history. When economies are devastated, people become angry. When people become angry, they go to war. Hence, Russia is a far greater threat today than at anytime during the cold war. Like a wounded animal, Russia will strike back when its people come close to rising up against their own leaders. It will be at that moment in time that Russia will seek and find an external enemy. It will not seek to send missiles hurling across the skies at NYC, London, Rome, Tokyo or Frankfurt. Such action would only lead to missiles being hurled right back at them. However, it will seek to first retake the empire it has lost and move through the course of least resistance, which is most likely due south in search of wealth – namely oil.
We do need to be concerned about the moral implications of a global meltdown. That is not to say we should bailout hedge funds or hand over billions to corrupt governments like in Indonesia, Malaysia and Russia. Nonetheless, we should be concerned about the turmoil of financial markets and their impact upon the average man on the street in some of these emerging markets. It is for this reason that emerging market funds should not be bailed out and we should also consider allowing debt restructuring as well as the closing of some markets. We must be careful that we do not advocate bailing out companies that are perhaps even more corrupt than governments. In the case of Indonesia, some well-known companies realized that if they failed to meet an interest payment then the holders of their debt sold their bonds at the market in a panic. This led to some Indonesian companies INTENTIONALLY withholding interest payments while covertly buying back their own bonds for pennies through the Hong Kong market. To a large extent, much of the emerging market boom was in fact a vast transfer of wealth from the industrial nations to the corrupt coffers of those in Russia and Indonesia in particular. Our concerns are not about supporting corrupt governments, but for the social chaos this debacle has caused in the aftermath. There is NO WAY to put this thing back. The best we can now do is minimize the fallout. However, we should NOT now seek funding for places like Indonesia or Russia with the intent upon rebuilding a free market. Instead, anything given to these nations should be in terms of humanitarian aid – food, medicine etc. in an effort to stem the tide of war.
The reality of the Russian collapse has set-off a tidal wave effect that is headed across the oceans of capital on a global scale. In the course of this debacle almost every sector has been feeling the impact. So far, however, these effects remain very much within the institutional markets. Eventually, we will see these effects spread into the economies of Europe and the United States causing a slow down as we move toward 2000. It will be the pessimistic attitudes that emerge over the next year that will cause the media to seek other bad news thus causing both distortions of the facts and confusion among investors.
RUSSIAN FINANCIAL FALLOUT
The collapse of Russia should have come as no surprise. Still, the foolishness of fund managers and bankers who have invested in these markets are right up there with some of the historical accounts of the greatest financial panics of the past. While their investments may have changed, they have indeed made the very same identical mistakes as those who were wiped out during previous panics. Therefore, it is not difficult to assess the damage and to extrapolate the future base upon how similar events filtered through the world economy. The one aspect about economics is that while economies change, the base human emotional response governing how capital moves remains very much the same. Consequently, even in today’s modern era, we are facing another financial panic for identical reasons as we saw back in 1931.
Bank stocks have been hit particularly hard due to the lack of transparency within the interbank market. If all transactions were placed through a clearing-house, such as the Chicago exchange, we would NOT be experiencing the chaos and uncertainty of the moment. Whatever the degree of uncertainty that now exists does so because we do not know which banks may have taken serious losses. Some have come forward to announce their exposures to Russia. Others are now starting to announce their exposure to Long Term Capital Management, such as UBS. Still, even we ourselves cannot determine whether we have a serious threat of a major banking crisis or if there is nothing to worry about. Without a central clearing-house, there is no one who stands in the middle, and as such, we lack the transparency necessary for sound judgement. It has ALWAYS been the LACK of information upon which panic historically thrives.
The first victim in this Russian debacle has been the interbank market itself. Liquidity has dried up as dealing desks at the banks lost tons of money on emerging markets either directly or through hedge funds. Those loses have caused them to even curtail market-making in dollar/yen, dollar/mark and other non-emerging markets. As market makers recoil from the day-to-day transactions, volatility rises due to the lack of liquidity. Hence, our computer model’s forecast for a bull market in volatility going into 2003 seems to be right on target. Only the forced merger of the interbank market with a central clearing-house type exchange will reverse this trend. Naturally, the banks would reject such a proposal and Rubin, coming from Goldman Sachs, would not be inclined to impose such a change on his own career.
The next victim in this Russian debacle has been the hedge funds. Besides the Fed intervention to stem the effects of the collapse of Long Term Capital Management, rumors have been abundant about several hedge funds that have lost more than 50% on this entire crisis. The cause of this appears to have been the drive to produce high quarterly returns that drove these fund managers into high risk, high yield trades. The problem that arises from his trading behavior is that many of these funds found themselves all on the same trade. As losses mounted and liquidity disappeared, volatility increased exponentially and positions moved into liquidation only mode.
The implications of this hedge fund disaster presents a new twist to the Panic of 1998 compared to previous debacles in history. Already we are seeing the collapse of Long Term Capital Management causing disruptions to the entire world economy far beyond what the Fed or anyone one else has publicly explained. The Fed has pushed the banks involved in derivative trading to come up with billions to hold the current positions at LTCM in order to facilitate the orderly liquidation of those positions. Several important facts about this issue must be understood.
- The Fed did NOT put up any public funds; it only put pressure on the banks to step up to the plate.
- LTCM positions were predominately within the interest rate markets worldwide.
- The amount of leverage used by LTCM was astronomical, giving it positions in excess of $1 trillion.
The impact that LTCM is having upon the entire world economy is significant. Mr. Greenspan did not testify as to why LTCM’s positions were important enough to warrant the Fed’s concern when no previous fund has ever risen to such importance. He did state that “hedge funds are beneficial” to the free market system and Mr. Rubin also stated that these funds were NOT responsible for the Asian currency crisis. The seriousness of LTCM’s positions goes beyond a mere threat to the marketplace; they have in effect usurped the power of all central banks by default! In other words, the one tool that any central bank has is the ability to establish the wholesale interest rates to the banking sector, thereby indirectly influencing the demand within the economy. However, by LTCM leveraging its capital base into $1 trillion and then playing within the interest rate markets in particular, they in reality are bigger than all the central banks combined, and the unwinding of such positions could in effect disrupt the interest rate policies of all nations.
It is also important to note that there is a serious misconception about the black-box model that LTCM was using. The first assumption that this has all been computer driven is ABSOLUTELY FALSE! The majority of LTCM’s trades have been FUNDAMENTAL views on the world, NOT COMPUTER DRIVEN MODELS. Any simple trend following system would have shown that the US bond market was in a bull market. Why was LTCM short US bonds? This was based solely on their view that the Fed was more likely to tighten than loosen due to the rise in the stock market and strength on the US economy. They were also long just about every debt market within Europe with a short position on Germany. Again, we do not see any model that defined this trade. The reason behind these “convergence” trades in Europe was the politically stated goals for the Euro that all nations will end up with their bonds becoming one bond – the Euro bond with interest rates that were equal. In reality, ALL of LTCM’s trades were based FIRST upon a fundamental view of the world and then a computer arbitrage model to extract minute differences between two instruments. While on the surface they may have appeared to be diversified, in fact, all their trades became one single giant bet on a fundamental assumption – European convergence along with higher interest rates in the US and Japan. All three assumptions have proven to be dead wrong to the tune of $1 trillion.
The single greatest threat that LTCM poses right now is by unwinding the European trades; they in effect cause the Euro to blow up or force a surprise readjustment before it begins. While the European politicians touted the brilliance of their policies and the success of European convergence ahead of the start date of January 1st, 1999, in reality it has been the hedge funds that accomplished that – NOT the politicians or central banks. This is why Greenspan referred to hedge funds as at times being “beneficial” to the free market system. The politicians set their goals and the hedge funds carried out the deed without the need for European central banks to put up public money to force that convergence within the marketplace. This is one reason why LTCM needed to be “managed” in the liquidation process. The Fed is NOT trying to save investors nor will it EVER bail out any fund for that reason. What is at stake here is that the positions of LTCM, which were in fact the political views of Europe and not the economic realities of a flawed single currency policy. There is no way that the Euro can begin in 1999 and offer a stable currency environment over the next 4 years while the economies of Europe are still moving in different directions.
A FINE MESS YOU’VE GOTTEN US INTO OLI
Whenever panic strikes, immediately governments spring into action. They will inevitably seek more regulation than less, more power and control whenever possible and seek to lay the blame upon external forces other than themselves. We must step back and deal with reality. This entire mess was set in motion back in 1985 with the formation of the G5. The aftermath of the Reagan tax cuts changed the dynamics of the US economy. No major foreign manufacturer could be found in the United States BEFORE the Reagan tax cuts. Afterwards, a 33% US corporate tax rate compared to 60-70% in Japan and Europe, provided the incentive for business to move directly into the domestic US economy. That shift in global capital flows in early 1980s caused the dollar to rise dramatically going into 1985. Because of trade, James Baker, then current Secretary of the Treasury organized the G5 at the time. The G5 was formed in September 1985 and boldly began a program of attempting to manipulate the world economy by vocally stating that they wanted to see a 40% decline in the US dollar. They scared the marketplace and the traders followed their direction. By 1987, the 40% depreciation in the dollar was accomplished. The problem was simple. The G5 was looking at manipulating currency values for the sake of trade. They never considered what might happen when capital investment lost 40% on their US bonds and shares. This mistake set in motion the 1987 Crash. Capital was forced out of the US and then concentrated within Japan leading to a bubble top in their economy by the end of 1989.
When Japan peaked, crashed and burned, capital began to look around the world for value. They immediately focused upon Southeast Asia, China and Russia. 1989 marked not merely the peak in Japan, but also the changes in China and the fall of communism in Russia. With these events, emerging markets began. An expectation that vast sums of money could be made if you were the first to get into these areas was appealing. The IMF encourages such investments and loved the chance to find some way of becoming useful. The first crack came 4 years later in Mexico. The IMF bailout appeared to have worked, when in fact Mexico only repackaged its debt and sold it into the Euro market taking those funds and paying off the US Treasury. In reality, the debt was never paid, it was merely redistributed. Nonetheless, the details were never fully aired and Clinton was eager to take the credit for the Mexican bailout so no one bothered to ask the hard questions about how Mexico could pay off billions in such a short period of time.
The Mexican bailout created the FALSE image that the IMF was this new agency that could solve the problems of the world. Meanwhile, capital shifts from South East Asia were underway and the new focus became Russia. Nearly 50% of all new money raised by mutual funds prior to 1994 had been for emerging markets and now Russian stories of untold wealth acted like a bug light on a hot summer night. Capital, looking for high yields, was far too eager to believe in the ability of the IMF. When capital continued to migrate from Asia toward Russia, the first crack appeared in Thailand during late 1997. While the IMF rallied to the moment, it sought to impose old ideas from a fixed exchange rate world into a new modern age of floating exchange rates. It insisted that nations hold their currencies at all costs and they did. The reserves of all nations right up to Korea vanished under the ill-fated philosophies of the IMF. The drain was far too great and the demands for capital funding by the IMF rose exponentially. They poured billions down the drain into both Asia and Russia and to this day have NOTHING to show for it other than sheer chaos and rising social unrest.
In November of 1997, I was invited to Beijing and met with the Ministry of Finance. I was asked what advice I could give concerning the future of China and the Asian Crisis. In a straightforward manner I suggested to keep their markets closed until 2003. That advice was shocking and the reply I quickly received was that it was not the same advice that the US government or IMF was offering. My reply again was that “PEI is not the US government nor was it the IMF.” We warned at that meeting that if China opened its markets and currency to the world economy before a full economic transition was complete, they would suffer the fate of South East Asia and watch their currency be demoralized. Thank God China has adhered to that policy for now or else the world might be in far worse shape had China been attacked in the aftermath of a Russian collapse.
There is no simple answer we can give to put the world back together again. Perhaps it should have never been allowed to explode in the first place. We must realize that each action we take to solve this problem today, we run the risk of setting in motion a new set of problems in a few years. Unfortunately, the Russian collapse and the demise of LTCM have exposed for the world to see the weakness that exists within Europe itself. The Euro cannot possibly be pulled off under current global conditions yet the political forces will not back away from the Euro or postpone it for fear that they may never again get this far. The Euro will be another attempt at holding a fixed exchange rate mechanism against the odds of diverting economies within Europe itself, as was the case in Asia. The ECB (European Central Bank) will BY LAW be forced to pump cash from the north into the weaker economies of the south in a futile attempt to create a single currency. If Europe wants to truly expand its economy and to reduce unemployment, it does not need a single currency; it needs to abandon its socialistic policies.
The seeds of trouble for the Euro run very deep. Germany right now has postwar record high unemployment with simultaneous record corporate profits. Any NORMAL economic model would suggest that when the economy is at its PEAK, unemployment should be at its LOWEST point. The European economic model defies all rational economic behavior and seeks to thwart the free market economy principles. By preventing companies from firing workers, they may gain the votes of their labor unions, while companies stand back and refuse to hire unless absolutely necessary or move offshore. We must now ask the real question. If unemployment is at record highs at the peak of this business cycle, can it possibly be reduced as the cycle turns down into 2002?
The Russian debacle has set in motion a series of revealing events that will still establish trends that perhaps cannot be stopped by any G7 meeting. In fact, unless the governments of the world accept some responsibility for manipulation and over-regulation of the world economy that have brought us to the brink of yet another major financial crisis, the worst is yet to come.
The hedge funds have been the leading cause of the “convergence” trades throughout Europe. We are sitting in awe at the percentage declines throughout European share indices as hedge fund liquidation runs ramped. Most of these trades have bought into the unrealistic political dreams about what many have called “Euroland” and what we are now facing is the contagion hitting Europe itself. We should NOT be fooled by the decline in the dollar, the sharp rise in the German mark or the yen. In all cases, the massive unwinding of cross-rate positions has seriously disrupted the global trends within the currency markets. Euroland has now fallen, demoralized and exposed. The success or failure of the Euro will no longer be dependent upon idealistic political hype. The success of Euroland will now depend entirely upon the real underlying economic conditions and it can no longer count on capital inflows that will be buying into a dream.
The G7 meeting this weekend will bring to many a final flicker of hope. Hope that their shares will once again rise to new highs if someone puts the global problems to rest. We may see the silent capitulation of the IMF and its subjugation to the G7 itself as a reporting body. We will hear calls for boosting up the IMF and the leaders of the G7 will hope that the world will once again believe in this fallen angel of mercy. We may even hear grand new proposals for restructuring the world monetary system and there will be some closet aspirations that even suggest a one-world currency, but not publicly as yet. All these announcements are possible along with the IMF “liquefying” its own assets, which is a code word for selling off its gold reserves. In the end, any rally will still be merely a relief, but we cannot hope for the impossible.
We have been warning in our forecasts for the past 15 years that our computer models have targeted the year 2003 as the final collapse in the floating exchange rate system. As we draw closer to that forecast date, our computer does not seem to be so crazy any more. Unfortunately, when it comes to confusion and volatility, the worst is yet to come as we move closer to the end of this business cycle in 2002.85.