Buy Japanese equities while you can!

In the 1970s, the rate of inflation accelerated, partly because of easy monetary policies, which led to negative real interest rates, partly because of genuine shortages in a number of commodity markets, and partly because OPEC successfully managed to squeeze up oil prices. But by the late 1970s, the rise in commodity prices led to additional supplies and several commodities began to decline in price even before the then Fed chairman Paul Volcker tightened monetary conditions.

Similarly, soaring energy prices in the late 1970s led to an investment boom in the oil- and gas-producing industry, which increased oil production while at the same time the world learned how to use energy more efficiently. As a result, oil shortages gave way to an oil glut, which sent oil prices tumbling after 1985.

At the same time, the US consumption boom that had been engineered by Ronald Reagan in the early 1980s (driven by exploding budget deficits) began to attract a growing volume of cheap Asian imports, first from Japan, Taiwan, and South Korea, and then, in the late 1980s, also from China.

I would therefore argue that even if Paul Volcker hadn't pursued an active monetary policy that was designed to curb inflation by pushing up interest rates dramatically in 1980/81, the rate of inflation around the world would have slowed down very considerably in the course of the 1980s, as commodity markets became glutted and highly competitive imports from Asia and Mexico began to put pressure on consumer product prices in the USA.

So, with or without Paul Volcker's tight monetary policies, disinflation in the 1980s would have followed the highly inflationary 1970s. I may also remind our readers that the Kondratieff long price wave, which had turned up in the 1940s, was due to turn down sometime in the late 1970s.

It is certainly not my intention here to criticise Paul Volcker or to question his achievements at the Fed, since I think that, in addition to being a man of impeccable personal and intellectual integrity (a rare commodity at today's Fed), he was the best and most courageous Fed chairman ever.

However, the fact remains that the investment community to this day perceives Volcker's tight monetary policies at the time as having been responsible for choking off inflation in 1981, when, in fact, the rate of inflation would have declined anyway in the 1980s for the reasons I have just outlined.

In other words, after the 1980 monetary experiment, many people, and especially Mr. Greenspan, began to believe that an active monetary policy could steer economic activity on a non-inflationary steady growth course and eliminate inflationary pressures through tight monetary policies, and cyclical and structural economic downturns through easing moves!

This belief in the omnipotence of central banks was further enhanced by the easing moves in 1990/91, which were implemented to save the banking system and the Savings & Loan Associations, by similar policy moves in 1994 in order to bail out Mexico and in 1998 to avoid more severe repercussions from the LTCM crisis, by an easing move in 1999, ahead of Y2K, which proved to be totally unnecessary but which led to another 30% rise in the Nasdaq to its March 2000 peak, and by the most recent aggressive lowering of interest rates, which fuelled the housing refinancing boom.

Now, I would like you to consider for a minute what actually caused the 1990 S&L mess, the 1994 tequila crisis, the Asian crisis, the LTCM problems in 1998, and the current economic stagnation.

In each of these cases, the problems arose from loose monetary policies and the excessive use of credit. In other words, the economy - the patient - gets sick because the virus - the downward adjustments that are necessary in a free market - develops an immunity to the medicine, which then prompts the good doctor to increase the dose of medication.

The ever larger and more potent doses of medicine relieve the temporary symptoms of the patient's illness, but not its fundamental causes, which, in time, inevitably lead to a relapse and a new crisis, which grows in severity, since the causes of the sickness were neither identified nor treated.

Some readers may find this view excessively critical of the Fed's policies, but it is necessary to compare the periods from 1950 to 1973 and from 1980 to 2003. I'm not aware of a single crisis in the 1950-1973 period that came close to threatening the financial and monetary system. But what about thereafter and, in particular, in the late 1990s?

A series of crises occurred, including more recently the Asian meltdown, LTCM, Russia, Brazil, Argentina, and Japan. Moreover, we had growing economic imbalances (ballooning trade and current account deficits in the US), and all this amidst anemic global economic growth.

So, it would seem to me that Karl Marx might prove to have been right in his contention that crises become more and more destructive as the capitalistic system matures and that the ultimate breakdown will occur in a final crisis that will be so disastrous as to set fire to the framework of our capitalistic society.

'Not so,' Bernanke & Co. will argue, since central banks can print an unlimited amount of money and take extraordinary measures, which would, by intervening directly in the markets, support asset prices such as bonds, equities and homes, and therefore avoid economic downturns, especially deflationary ones.

There is some truth to this view. If a central bank prints a sufficient quantity of money and is prepared to extend an unlimited amount of credit (and to bail out troubled government-sponsored enterprises, such as will have to happen in future with Freddie Mac and Fannie Mae, the same way that China keeps its money-losing state-owned enterprises alive), then deflation in the domestic price level can easily be avoided, but only at a considerable cost.

First, it is clear that such policies do lead to a depreciation of the currency, either against currencies of countries that resist following the same policies of massive monetisation and state bailouts (policies which are based on, for me at least, incomprehensible sophism among the economic academia), or against gold, commodities, and hard assets in general. The rise in domestic prices then leads at some point to a 'scarcity of circulating medium', which necessitates the creation of even more credit and paper money.

The phenomenon and economic consequences of monetisation are well documented and explained by Professor Bresciani-Turroni in The Economics of Inflation (first published in 1931 and reprinted by Augustus M. Kelley, London, in 1968). Bresciani-Turroni describes in this wonderful book all the social and economic aspects of the Weimar hyperinflation between 1918 and 1923, some of which I shall now summarise. (This is one of the few books every investor should read in order to understand the dangers, as well as the opportunities, that hyperinflating countries offer.)

Referring to the summer of 1923, when hyperinflation was in full swing, Bresciani-Turroni writes:

The sudden rise in prices caused an intense demand for the circulating medium to arise, because the existing quantity was not sufficient for the volume of transactions. At the same time the State's need of money increased rapidly (budget deficits) Private banks, besieged by their clients, found it impossible to meet the demand for money. These phenomena, which appeared in Germany after a sharp rise in the exchange, made the increase of issues appear as unavoidable as the inevitable consequence of the rise in prices which had been provoked by the depreciation of the exchange. The opinion, on this subject, formed in administrative circles, is clearly expressed in the following words of Helfferich (at the time, the finance minister): 'To follow the good counsel of stopping the printing of notes would mean - as long as the causes which are upsetting the German exchange continue to operate - refusing to economic life the circulating medium necessary for transactions, payments of salaries and wages, etc., it would mean that in a very short time the entire public, and above all the Reich, could no longer pay merchants, employees, or workers. In a few weeks, besides the printing of notes, factories, mines, railways and post office, national and local governments, in short, all national and economic life would be stopped.'

As mentioned earlier, the 'printing of money' in Weimar Germany led at some point to rising inflation and a total collapse of the value of the paper mark against foreign currencies and gold, which encouraged wild speculation on the foreign exchange and stock markets, during which smart operators and large industrial groups accumulated large fortunes at the expense of small savers and the working class.

According to Bresciani-Turroni, the dollar, which was quoted at the end of November 1921 at 276 marks (the mark had already lost 90% of its value since 1918), rose by August 1922 above 1,900 marks; and then to 8,337 in December and to 1, 2, 3, and 5 million marks by August 1923!

In the meantime, an index of German share prices (1913 = 100) rose from 126 in January 1918 to 531,300,000 in September 1923, and to 23,680,000 million in November 1923 amidst extremely high volatility. (In dollar terms, because of the currency depreciation, the same index (1913 = 100) fell from 101.55 in January 1918 to 2.72 in October 1922, before recovering to 39.36 in November 1923.)

The extremely high volatility of the stock market is a typical feature of hyperinflating economies. In the case of Brazil in the 1980s, we had several rallies of over 100% - even in dollar terms. This offers for investors in hyperinflating economies huge capital gain opportunities and serves as a warning for being heavily short in 'money printing' economies. However, despite all these powerful rallies, the index in dollar terms made its final low in 1991!

What is noteworthy about the German hyperinflation in the 1918-1923 period is that, whereas the corporate sector and speculators survived this period quite well, the German public and the overall economy suffered badly, a fact that is evident from several economic indicators.

So, while an index of nominal wages rose from 1 in 1913 to 9.9 in December 1920 and to 862 billion in December 1923, the index of real wages fell from 100 in 1913 to as low as 47.6 in July 1923. The downtrend in real wages during the hyperinflation had a very negative impact on German standards of living, the overall economy and especially on consumption. On a per capita basis, the consumption of meat, which had reached 52 kilograms before the First World War, fell to 22 kilograms in 1923. Moreover, even beer consumption suffered. From the fourth quarter of 1921 to the fourth quarter of 1923, beer consumption dropped by 35%!

In short, the 1918 to 1923 period represents compelling evidence that the increase in the quantity of money (then 'ad extremis') does not stimulate economic activity but creates a series of disequilibria, accelerating inflation rates, a collapse in the currency and eventually a crisis.

In particular, excessively easy monetary policies or as Bernanke would say 'the printing of money' leads, as time goes by, to rising interest rates. In 1918 - 1923 Germany, each time interest rates rose, more money was printed in order to create negative real interest rates and to avoid a liquidity crisis, which subsequently led to even higher inflation rates, a further collapse in the exchange rate, and renewed rises in interest rates.

Bresciani-Turroni maintains that, as a result of these events, a 'vicious circle' was established: 'the exchange depreciated; internal prices rose; note-issues were increased; the increase of the quantity of paper money lowered once more the value of the mark in terms of gold; prices rose once more; and so on'.

In the book's final chapter, Bresciani-Turroni concluded that:

The inflation retarded the crisis for some time, but this broke out later, throwing millions out of employment (emphasis added). At first inflation stimulated production because of the divergence between the internal and external values of the mark (devaluation), but later it exercised an increasingly disadvantageous influence, disorganizing and limiting production. It annihilated thrift; it made reform of the national budget impossible for years; it obstructed the solution of the Reparations question; it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people accumulating wealth and forming a class of usurpers of national property, whilst millions of individuals were thrown into poverty. It was a distressing preoccupation and constant torment of innumerable families; it poisoned the German people by spreading among all classes the spirit of speculation (emphasis added) and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. It is indeed easy enough to understand why the record of the sad years 1919-23 always weighs like a nightmare on the German people.

I think it is important for investors to fully understand the long-term consequences of the world now being hostage to a bunch of central bankers who are willing to print money. With the example of an extreme case of money supply expansion and credit creation, I have tried to demonstrates that boosting the monetary aggregates in no way solves, but in fact in due course aggravates, the economic conditions of a country. In fact, the first signs of inflation occurred in Germany in the housing market, which then necessitated the increase in note issues in order to avoid a rise in interest rates.

In this respect, I would like our readers to consider, what would happen if, in the US, for one reason or another, interest rates started to rise. Would it not likely prompt the Fed to ease even more, in order to keep the housing market from collapsing and, in the process, inflict some near-term pain on the economy?

The optimists will, of course, point out that in the present deflationary environment, there is no possible way for interest rates to rise. However, I see it somewhat differently, in as far as the excessive money creation of the last few years has led to some inflation, but not of the kind that is visible as yet in the goods markets, where prices are mostly declining.

The inflation I am alluding to here occurred in financial assets - notably, equities and, more recently, in the prices of bonds, and also in residential homes. The problem with this kind of inflation, which was - certainly in the case of equities and homes and, to some extent, more recently in the case of bonds - a direct consequence of the Fed's easy monetary and lax credit policies, is that whenever tight monetary policies are necessary, their implementation could cause serious pain in a system that has been hooked on credit.

I concede that tightening moves may not be necessary for quite some time. However, I can see several scenarios under which even without tightening moves by the Fed interest rates would rise.

In one of these scenarios, asset inflation would spill over into the commodities, goods, and service markets and would be, in my humble opinion, discounted by rising bond yields - this well in advance of the price inflation showing up in the doctored inflation figures published by the government.

The sudden rise in interest rates amid still benign inflation figures would then prompt Mr. Greenspan to erroneously believe that the Fed hasn't eased sufficiently. Another tidal wave of liquidity would then be injected into the system in the hope of bringing down rates. But by then the bond and foreign exchange markets would no longer be fooled! A violent downward adjustment in the dollar exchange rate and in bond prices would immediately follow.

So, if the present easy monetary policies continue to be pursued - and, given the statements that have been made by senior Fed officials, Mr. Greenspan's track record of easing, and Mr. Bush's unshakeable determination to be re-elected, we must not doubt for a minute that they will be implemented at whatever longer-term cost to the economy - a further decline in the dollar and a rise in interest rates is only a matter of time.

Thus whereas from an investment point of view the early 1980s provided a once-in-a-lifetime opportunity to purchase bonds (when short term interest rates rose far above long rates), the current period is likely to provide a similar opportunity to sell bonds.

In fact, once interest rates rise to the kind of level that I expect they will rise to in the next ten years and the dollar weakens further, it will in retrospect have been totally irrelevant whether ten-year US Treasury bonds were sold at a yield of 3.5% or 2.5% or 4% (it would appear to me that the recent drop in the bond market is 'impulsive' and is the first symptom that the bond market isn't going to be fooled by Bernanke& Co. for long).

In the kind of reflation scenario we are discussing, stocks will rise in nominal terms - at times, as we have seen, very sharply. But in real terms, they are likely to decline, as the coming additional US dollar depreciation (mostly against hard assets including real estate, collectibles, commodities, especially precious metals) will offset the nominal stock market gains.

The global reflation that I am talking about could last for several years and provide great, although very speculative, investment opportunities. Hard assets and emerging market equities aside, the latter which we discussed last month, Japanese stocks would be one of the prime beneficiaries of this (in the long term) financially suicidal central bank policy.

In a global reflation, Japanese interest rates would likely rise in percentage terms more than other interest rates around the world, and such a rise would bring about a huge reallocation of financial assets from bonds into equities. Thus, I reiterate my earlier recommendation to short Japanese bonds and buy Japanese equities.