The 1920s was a decade known in the US as the "Roaring Twenties' or the "Golden Twenties" in Europe. There was immense prosperity, stock and real estate markets were booming and cultural norms were changing in response.
In a five year period till 1929, the Dow Jones increased five-fold, to 381 points. Just days before the Crash in October 1929, the Yale economist, Irving Fisher, said that "stock prices has reached what looked like a permanently high plateau." A millionaire at the time, Fischer did not sell his portfolio after the crash as he waited for markets to rebound but, unfortunately, died penniless.
The entire decade of the 1930s was lost to the Great Depression that followed.
What was interesting was the role the Federal Reserve may have played in this and the parallels to the global economy today.
Great Britain was the dominant economic and military power in the world in the 1920s. Britain was running trade deficits with the US and had to either settle these by sending the US gold as payment (gold, as it has been throughout history, was real money then) or raise interest rates, something it was loath to do for political purposes.
The US wanted to support Britain and keep its exports competitive. The Fed pumped excess paper reserves into the US banking system to drop interest rates to bring them in line with Britain. This was meant to help stem the gold loss Britain was struggling with.
Alan Greenspan (former Federal Reserve Chairman), in a 1966 essay titled "Gold and Economic Freedom" describes what happened next:
The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market - triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence.
As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's.
Following the tech meltdown in 2000 and the events of 9/11, the Federal Reserve dropped interest rates to their lowest levels in 45 years and began to pump massive amounts of liquidity into the US economy. Other countries followed, which led to global boom in stock and real estate markets as a result of excess liquidity in the global economy.
Currently, Eurozone money supply (M3) is growing at an annualized rate of 10.9% and M2 in the US grew at 9.7%, well in excess of the rate of GDP growth, which was an anemic 1.3% in the US in the last quarter.
In 1929 total credit market debt, as a percentage of US GDP, rose to an unprecedented level of 270%. In 2002, for the first time since then, the ratio was higher and at the end of 2006, this ratio was 331%.
The sea of cheap money and debt has fuelled a speculative binge that is now threatened by the weakness in the US economy and the strength of the Chinese economy. China is trying to do for the US what the US did for Britain in the 1920s.
China has seen unprecedented economic growth since 1982, when Communist Premier Deng Tsio Ping pronounced "To be rich is glorious" and unleashed the inherently capitalistic impulses of the people of Mainland China.
Growing at an annual rate averaging 10.2% over 25 years, China has transformed itself from a third world nation to the third largest economy in the world.
What this has done is create the risk of an implosion in China.
Chinese M2 swelled by 18.2% over last year. With GDP growing at a rate of 11.2% the Chinese economy is soaring.
Despite repeated efforts by the Chinese government to cool the economy and rein in credit expansion, investor frenzy continues to grow as the Shanghai Stock Exchange has risen by 107% in a year.
China's foreign exchange reserves have risen dramatically to US$ 1.2 trillion. They grew by $ 136 billion in the first quarter of 2007, double the growth of the previous quarter. 70% of China's reserves are estimated to be in US$.
Why is this a problem? Because China is choking on its reserves of US dollars. China's trade surplus with the US was $ 262 billion in 2006. Fixed asset investments have grown at an annual rate of 27.2% as foreign capital flows into China at record levels.
To keep the yuan pegged to the US dollar in order to keep the price of its exports competitive, the Chinese government has to buy those dollars and issue yuan to exporters and business who received those dollars. This creates monetary expansion and excessive liquidity in China. The net result is overinvestment in production and speculation in real estate and the stock market.
When the Shanghai stock Exchange fell by 7% in Feb 2007, there was a global reaction with markets tumbling worldwide. The Chinese stock market is in dangerously overbought territory today:
Similarly, despite the US economy slowing, the Dow Jones and the S&P 500 are in record levels. What happens when these markets correct?
China has a massive problem with employment. Between 1996 and 2002, Chinese state owned enterprises shed 59 million jobs, leading to a nationwide unemployment rate of 81 million in 2004.
With mass migration of workers into urban areas, China is compelled to create jobs as an antidote to potential unrest from large scale unemployment. Its banking system subsidises private companies with low interest loans in order to create employment, which has led to a severe problem of bad bank loans.
China needs to keep its economy growing through export growth. To do this it has had to suppress the value of the yuan relative to the US dollar, which means that it is artificially supporting the US dollar, as the US once tried to do for Great Britain's gold reserves.
Excessive liquidity is what we see all around us, in the form of:
Potentially, a major part of global liquidity has been the Yen carry trade. With negative real interest rates in Japan, foreign investors have been able to borrow money in yen and invest in higher yielding assets globally, which has added to speculation in many markets.
With the Bank of Japan now raising interest rates, there is a danger of the carry trade being unwound precipitously (due to higher financing costs and yen appreciation), particularly if the markets begin to fall sharply. The size of this carry trade is not known (estimates range as high as $ 1 trillion but this number would be further leveraged), but as Goldman Sachs chief economist Jim O'Neill observed in February, "There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over," he said. "The yen carry trade has reached 5pc of Japan's GDP. This is enormous and highly risky, as we are now seeing."
The US dollar is coming under increased pressure as the European Central Bank and the Bank of Japan continue to raise interest rates.
The US dollar has been supported in recent years by the Asian banks which had invested immense sums in US debt to prop up the dollar (and prevent their own currencies rising in order to help their export growth strategy).
In October 2006 the Australian Treasurer, Peter Costello, said that "the strategy has changed" and that China and other Asian central banks were looking at alternate investments to the US dollar. He called for an orderly withdrawal from the US dollar by these banks.
The US trade deficit was $ 196 billion in the fourth quarter, or 6% of GDP. In 1985, when the US dollar began a 3 year, 30% fall, the trade deficit as a percentage of GDP was only half of what it is now.
The all-time low on the US Dollar Index has been 78.19 in Sept 1992.
If the US dollar plunges below 80 (due to a recession or foreigners buying less US debt/assets), there is likely to be an increased selling of US assets as their prices decline in foreign currency terms. This would lead to a rise in US interest rates, hurting both the US stock and bond markets. Real estate worldwide would be negatively affected as interest rates would rise in most currencies as liquidity dried up.
The ultimate beneficiary of such turmoil would be gold and silver. Inflation is already beyond target levels in most countries due to expansive monetary policies and gold is near $ 700 as a result of a supply-demand imbalance, threat of inflation, geopolitical uncertainties, and the potential decline in the reserve status of the US dollar.
In the 1979 movie, "The China Syndrome", the threat posed was a potential meltdown at a US nuclear power plant. The premise was that the molten core reactor could go out of control and melt through the core of the earth, emerging all the way to China.
(The physics and geography was wrong as the core could not have flowed against gravity to reach China, and that the India Ocean was actually at the other end of the planet, if it could have).
But the essential fear of things going out of control is true today and the US and China are the two primary potential causes of a global economic meltdown.
The Acamar Journal is a free newsletter distributed semi-monthly.
To receive the Acamar Journal, please send an email to subscribe@acamar.ca or visit us at www.acamaronline.com
The Acamar Journal is intended to provide factual and timely research on general economic trends, opinions about trends in specific industry sectors, information on specific companies, references to other publications and reports that may be of interest to investors, and information on general trading strategies. Acamar Asia Consultants Inc. ("Acamar Asia") is not a registered investment dealer or adviser, and is a subsidiary of Acamar Advisors Inc.
Although the statements of facts in this report have been obtained from and are based upon sources Acamar Asia believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute Acamar Asia's judgment as of the date of this report and are subject to change without notice. Acamar Asia makes no warranties, express or implied, as to results to be obtained from use of information in this report, and makes no express or implied warranties of merchantability or fitness for a particular purpose or use.
This report is for informational purposes only and is not intended to be advice, or an offer or a solicitation with respect to the purchase or sale of any security. This report does not take into account the investment objectives, financial situation or particular needs of any particular person. Investors are advised that investing in securities entails certain risks, and they should obtain individual financial advice and undertake extensive due diligence based on their own particular circumstances before making any investment decisions.
Acamar Asia may from time to time perform corporate communications or other services for companies mentioned in this report. Acamar Asia and/or its principals may be compensated for such services, in the form of fees and/or options. In addition, Acamar Asia or any individuals preparing this report may at any time have a position in any securities or options of issuers mentioned in this report. Directors, shareholders or employees of Acamar Asia may be a director or officer of a company mentioned in this report.