Bull/Bear Cycles, Business Cycles, and the Fed
Ed Bugos
[The following is an excerpt
from my 30/06/05 report to subscribers]
Since 1929 the gold (or real) value of
the US dollar has depreciated by roughly 95%; since 1933, when FDR took
the US dollar off of the gold standard (after officially depreciating
it by about 30 percent relative to gold) the gold value of the US dollar
has fallen by a further 92 percent; and finally (the cause), America’s
broad money stock has grown from US$73 billion in 1929 (according to Rothbard’s
America’s Great Depression) to almost US$10 trillion today –
which is an increase of about 130 times.
What this should tell you, besides suggesting
that the currency should have lost more than 99 percent of its value by
now, and besides confirming the quantity theory according to the Austrian
School (the non-mechanistic version), is that somewhere around 92% of
the Dow's current value is nothing but inflation. In other words, if the
gold value of the US dollar remained fixed and gold itself remained stable
throughout that period (which is neither possible nor desirable in reality),
all else equal, the Dow would be worth between just 600 and 800 of those
original 1933 gold US dollars today.
If the 130-fold expansion in the total
stock of money formed a valid basis for the calculation of ultimate intrinsic
loss in the value of money (which it doesn’t) the Dow could be said
to be worth only 77 today in 1929 dollars.
In any case, using gold as a better proxy
than the CPI (it really is) or foreign exchange alone as a measure of
the greenback’s value, Dow 600 or Dow 800 would represent only a
12–16 fold real gain from the depths of the depression between 1929
and 1933 (rather than a 200-fold nominal gain) and only a double from
its peak in 1929 (in 73 years!).
That makes for an annual real rate of return
of somewhere between 1 and 4 percent.
In other words, the value of an investment
in the index could only be expected to buy between 2 and 15 times the
amount of goods that a person would consume, rather than 200 times as
is implied by the nominal gain… and that is all before reconstructing
the Dow Industrials index according to its original components to get
a true picture of how the many inflation-induced boom/bust sequences have
affected the longevity of individual stocks. It is also before dividends;
but we could assume the bearish secondary effects of inflation on capital
structure (just mentioned) to offset the dividends paid out over the period
of time in this example. To be sure, even if the real return is that low,
it is still better than nothing (putting the cash under your mattress
or in your bank’s vaults would have lost you purchasing power over
the duration of this period), and it was still better than owning gold
– for the specific duration in this period.
But I’ve never argued explicitly
that gold is the best long term investment ever. I
have a predilection for stocks as claims on capital that can grow by yielding
profits.
It is the best long term investment in
an environment where the Inflationists run rampant amid ever-growing government
largesse, and where the risk of a potential hyperinflation runs anywhere
over the “let’s take it into consideration” barometer.
Murray Rothbard explained the business
cycle which most people continue to attribute to the boom-bust sequence
of capitalism (markets are “inherently unstable” – George
Soros) by illustrating why they are solely the product of inflation –
or monetary intervention which is the same thing.
The Austrian School business cycle theory
(Mises, Hayek, Rothbard and others have all contributed to it) tries to
integrate “cycle theory” into a general economic theory on
the grounds that if economics can’t explain an economic phenomenon,
like the business cycle, then either economics is wrong or the cycle theory
needs work.
"Study of business cycles must
be based upon a satisfactory cycle theory (cause and effect). Gazing
at sheaves of statistics without “prejudgment” is futile.
A cycle takes place in the economic world, and therefore a usable cycle
theory must be integrated with general economic theory. And yet, remarkably,
such integration, even attempted integration, is the exception, not
the rule" (Rothbard, pp 3 America's Great Depression).
Assuming then that his economics is right,
the attempt resulted in what used to be called the trade-cycle theory
but now is called the Austrian School’s business cycle theory; it
postulates that due to the way the market is supposed to work declines
in one business segment usually just reflect a shift in tastes or preferences
and therefore good fortune for another business (note by the way that
the “multiplier effect” that is taught in most schools starts
with one policy or another as its cause).
Thus he concluded that if economics is
right it is plainly not possible for general cycles of depression to occur
– in other words there is no inherent flaw in the free market or
capitalism in theory (note here that the Kondratieff model presumes a
flaw in capitalism I believe). So if that was the case, perhaps we should
look to the effects of intervention where he brilliantly observed:
“In considering general movements
in business, then, it is immediately evident that such movements must
be transmitted through the general medium of exchange—money. Money
forges the connecting link between all economic activities. If one price
goes up and another down, we may conclude that demand has shifted from
one industry to another; but if all prices move up or down together,
some change must have occurred in the monetary sphere” (pp
6 in America's Great Depression).
“…fluctuations in general
business" could now be said to be fluctuations "in the money
relation" in the sense that "any cycle in general business
must be transmitted through this money relation: the relation between
the stock of, and the demand for, money” (pp 7 in America's
Great Depression).
Anyway, the workings of the theory are
generally that a build up in the production of capital goods occurs as
a result of the effects of monetary policy (which is a constant intervention
in the “money relation”) on judgments made by businessmen
and when they prove wrong because people’s spending patterns haven’t
changed in the expected way then those “malinvestments” are
liquidated… but this crisis point can be postponed for great periods
of time by the ongoing subsidization of the build up of malinvestments
– by continuing the inflation policy in other words – by continuing
the boom.
The moment the inflationary impetus (the
boom) is abandoned, however, the crisis begets a liquidation of these
factors which explains the general depression.
The depression he continues is actually
only the market trying to return to a more normal money relation (a dynamic
equilibrium) – a market determined price structure – i.e.
where it would be without the constant intervention.
Rothbard did note in his book by the way
that the gold standard contributed to the decline in prices because it
prevented the Fed from inflating its way out of the decline in confidence
that had built critical mass and resulted in a drain of gold reserves
from the banking system; and that in the absence of the gold standard
one could expect these depressions to occur alongside increases in the
consumer price level.
In other words, as we’ve tried to
point out in the past, the seventies era of stagflation was really a depression
in a monetary environment that was not anchored to a gold standard…
it was the same as the thirties’ depression in terms of other barometers
like unemployment and “real” stock market pain. The differences
were wholly nominal, or monetary. There are a few reasons to shed light
on this theory.
First, it is pertinent to the current state
of affairs; second, it really is the only cycle theory besides Schumpeter’s
(static) general equilibrium model (of the way that “creative destruction”
works) that can be explained by appeal to economic theory (i.e. logic);
and third, it implies that even the existence of bull and bear markets
as we know them today is an illusion. An investment in the Dow under a
gold standard would have bought you more goods today if we were still
on a gold standard than it in fact can!
I don’t know if bull and bear markets
would exist without the Fed but I suspect there would be a modest increase
in the average stock price because of the reinvestment of profits contributing
to growth – but the price of any given unit of capital should fall
just like any other demanded good produced in a freely competitive environment.
For instance, the price of certain technologies
or machinery would fall; or house prices would actually fall on average
as a fresh supply of newly constructed homes comes on stream. These are
economic concepts that are unknown to over three generations of North
Americans… ever since the beginning of the 20th century.
The only thing they know of them is that
they don’t want falling house prices and they want stocks to fly.
Hence today, economic growth causes prices to rise!!
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
July 2, 2005
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