There exists a universal complacency that the Federal Reserve Bank can save our economy from catching the spreading Asian contagion, thereby allowing us to avoid the severe problems of deflation. Economist after economist are telling viewers on CNBC that there can be no deflation as long as the Fed continues to cut rates, and expand the money supply. Multiple stock market strategists follow who say that the stock market should not decline further as long as interest rates are being cut.

In our opinion, reducing interest rates won't save us from the deflationary problems that our global economy is now having.

The bull market in stocks is over because the credit bubble has burst. Lower short-term interest rates and an attempt to print money will not revive it. The easy money that fueled stock markets around the world has dried up, and the deflationary forces that accompany the bust side of the boom will swamp government monetary and fiscal policy until the excesses are wrung out of the economy.

History suggests that even dramatic drops in interest rates won't soften the bust side of a credit boom. Take recent Japan, where interest rates fell from 7% to almost 0% over eight years and where the Japanese central bank has tried desperately to increase the money supply. Japanese stocks just hit a 12-year low, and the IMF expects the Japanese economy to shrink by 2.5% this year. Japan's leaders say their economy stands on the verge of a "deflationary spiral."

Economic jargon calls the inability of monetary policy to reinvigorate the economy "pushing on a string". With the demise of inflation in the current global economy, this theoretical example is now all too real.

The 1930's Experience

In the 1930s, the U.S. also discovered that central bankers were no match for a ruptured credit bubble. The roaring 1920's were more similar to the current economic boom than any time period of the last one hundred years. There are certainly differences as well, but analyzing the aftermath of the 1929 Crash, which started a terrible deflationary bust in the 1930's, is instructive in showing us that "printing money" is not a panacea. The 1930's was the last time our country has experienced serious deflation. Most economists and Wall Street pundits believe that the Federal Reserve actually contributed to the economic collapse with tight monetary policy. In actuality, the Fed attempted to be extremely expansionary through 1932. After the stock market crash of 1929, the Fed cut the discount rate from 6% to 2% by the end of 1930. The discount rate dropped as low at 1.5% in 1931 as the Fed frantically bought government securities in an attempt to expand the money supply until 1933. But the problem was the "pushing on a string" phenomena. No matter how hard the Fed tried, by providing controlled reserves to the banks, it didn't succeed in increasing the money supply. The money supply actually shrunk because banks were either unable or unwilling to increase their bank lending. Potential bank customers who were judged reasonable credit risks were unwilling to borrow because their earnings prospects were deteriorating, and they knew it was foolish to borrow and buy something today when the price would be lower next month. Therefore, this was a "demand" problem from potential creditworthy borrowers. Other entities that wanted loans were often deemed to be poor credit risks in an environment of spiraling credit defaults. The problem was exacerbated as individuals hoarded cash, causing monetary velocity to plummet.

Fiscal policy was also highly expansive, with government spending jumping 42% in 1931. But despite the attempts of the Fed and the Treasury to inflate, America's depression and deflation only deepened. Famous economist Murray Rothbard said that President Hoover "acted quickly and decisively", and put into effect "the greatest program of offense and defense" against deflation and depression ever attempted in America. He concluded that the "depression was instead prolonged by inflationist and other interventionary measures."

Today's credit bubble has burst

Evidence that our own credit bubble has burst is accumulating fast. Junk bond yield spreads spiked from 2.90 percentage points to 5.15 in August. Subprime home equity lenders have been virtually shut out of the securitization market causing Southern Pacific Funding to claim bankruptcy protection. Other subprime lenders such as United Companies Financial, Conti Financial and FirstPlus Financial have seen their stocks drop 80%-90% in the last five months due to these troubles. There are serious serious problems in the mortgage arena. There will be fewer loans made and homes bought due to this credit breakdown. Because of the lower price the market will now pay for its securities, Sallie Mae announced that it would have no securities offerings this quarter. In the prior two quarters, Sallie Mae had issued securities totaling $6 billion. The "credit crunch" is here, and cutting short-term rates cannot solve this problem. I believe that we will find that the free markets will be even more unforgiving in extending credit to risky borrowers than bankers were in the 1930's.

Effects of a ruptured bubble are growing

The deflationary affects of the slowdown abroad can be seen in our manufacturing sector. Manufacturing activity slowed for the fourth consecutive month in September, but the big news was in the "prices paid" component of the purchasing managers index. Prices paid fell again in September, reaching its lowest level attained since 1949. Only 6% of purchasing executives said they paid higher prices. However, companies are not benefiting as Business Week stated recently that corporate pricing power was at a 35-year low. The performance of specific companies reflects this slowdown. And some of the companies experiencing slowdowns are consumer brand companies that some thought would be immune to a slower economy. Nike recently reported its third straight quarter of lower sales, and fourth quarter of lower profits. Gillette and Raytheon are laying off a whopping 11% and 16% of their workforce, respectively. Because of weakness abroad and at home, the giant cosmetics maker Revlon expects to earn only 10 cents a share in the 4th quarter compared to 80 cents a year ago.

Yet, stocks remain expensive. Nike, despite its poor performance, sells for 28 times earnings. Dell boasts a Nifty-Fifty-era PE of 75. And Internet stocks, the Beanie Babies of equities, remain expensive even at two-thirds the price.

If the FED can't get us out of this deflationary mess, we're all in big trouble because the stock market will undoubtedly crash and the economy enter at least a severe recession. And both history and logic tells that any centrally managed group of bureaucrats will not be able to control a multi-trillion-dollar economy. But why should this be surprising? I believe that before this is all through, central banks, the IMF and the World Bank could easily be held in the same low regard as other centrally managed bureaucracies, like the government of the former Soviet Union.

David W. Tice
20 October 1998

DAVID W. TICE manages the Prudent Bear mutual fund.
His Dallas-based research firm advises more than 150 institutional investors.
Prudent Bear Fund: http://www.prudentbear.com