Investment Manager’s Letter December 2009
Last month the Financial Times named “The Lords of Finance” as Business Book of the Year for 2009.
“Liaquat Ahamed’s vivid history of how central bankers’ mistakes helped to precipitate the Great Depression bowled over the judges and swept away a strong field of finalists for the 2009 prize.”
In my, as investment manager, opinion this is one of the most important books I have read about causes of the Great Depression and World War II. It should be on the must read list of anyone interested in understanding this particular economic collapse and macro economic cycles in general. More than this, the narrative suggests some very interesting parallels to events going on today. This book offers a perspective that is new and many ways quite different than most of what has been written previously, and makes Galbraith’s “The Great Crash of 1929” seem superficial because of its focus only on events in the United States, and amateurish in its attempts to identify the causes of the great depression. “The Lords of Finance” goes into great detail about the economic events from 1914 up to the collapse of the 1930’s. The author places primary blame for the catastrophe on the return to the gold standard after World War I at the exchange rates that existed prior to the war.
Milton Freidman did an excellent job in his study of monetary policy during the Depression by pointing out mistakes of the FED after the stock market crash that turned the recession into a depression, but I have wondered about the theory that it was US monetary policy alone that caused of the American stock market bubble. I, as investment manager, find this author’s explanation more satisfying. He says that the bubble was caused by an underpriced dollar and by the gold flowing into the country throughout the 1920’s. This left the FED with the impossible task in 1928 of trying to support the European economies that were already falling into recession, and at the same time try to control the bubble growing on Wall Street.
The focus of “The Lords of Finance” is on the central bankers of the four leading economies of the time, Benjamin Strong of the New York Federal Reserve Bank, Montagu Norman of the Bank of England, Emile Moreau of the Banque de France, and Hjalmar Schacht of the Reichsbank. These central bankers were well qualified and well intentioned, yet they helped to lead their nations down the path to disaster. Clearly the bankers had lots of help from the politicians in their respective countries that created a huge mess with reparations written into the Treaty of Versailles.
The War had been very expensive and the European Countries had funded it with debt. At Paris, the politicians decided to make the loser pay everybody’s share. While this solution was satisfying for the victors, it was clearly idiotic from an economic point of view. However, the treaty was not as significant as is generally believed because the German economy remained a basket case well into the 1930’s and eventually only paid about $4 billion of the $24 billion specified by the Treaty.
According to Ahamed, as foolish as the Treaty of Versailles was, the real cause of the world wide economic collapse was the decision by the bankers to return the World to gold standard in the 1920’s. This decision placed the world economy in a straight jacket that eventually made the collapse inevitable, and probably justifies the book’s subtitle “the bankers who broke the world”.
The problem was that the price of gold was fixed too low for the United States and France and too high for Germany and England. This caused gold to flow out of England and Germany and into France and, especially, the United States. This left the countries’ central bankers with limited control over their domestic economic policy. Eventually it led to a depression in Germany that brought Hitler to power and to the great stock market bubble and crash in the United States.
Aggravating the bankers’ mistakes was the fact the Benjamin Strong died in 1928. After the death of Strong the author points out,
“Authority at the FED shifted to a group of inexperienced and ill-informed timeservers, who believed that the economy would automatically return an even keel, that there was nothing to be done to counteract deflationary forces except wait them out.”
The premise of “The Lords of Finance” is that exchange rate imbalances distorted the economies of the countries involved causing the eventual build up of pressures that led to a financial eruption that broke the world’s economy.
It is possible to find in these details some fascinating parallels to present problems in world trade. Today most of the world operates on a system of floating exchange rates that were set up after WWII specifically to prevent a repeat of the problems that Mr. Ahamed describes in his book. There are exceptions to the floating rate system, the most notable of which is that China and certain other Asian countries have chosen to peg their currency to the dollar. So the question for today’s reader is, what are the chances the Renminbi’s link to the dollar will eventually lead to the kind of disaster we saw in the thirties?
The Chinese Renminbi has been undervalued relative to the Dollar for quite a while, as to the extent of that undervaluation no one knows for sure, but I have read estimates that claim the undervaluation has the same impact as if the Chinese imposed an import tariff of 50% to 60% on all goods imported from the United States. The end result of this mindless mercantilism is that the Chinese have accumulated $2.0 trillion in U.S. debt securities instead of purchasing $2 trillion in goods produced it this country. We have been patient in allowing a policy that has produced spectacular growth in the Chinese economy, but the truth is this policy has cost our country several million jobs.
One thing we know for sure is that it was over 20% higher three years ago. From 2006 to the summer of 2008, the Chinese government temporary removed its dollar peg and allowed the Renminbi to appreciate by 20% against the dollar. In July of last year the peg was reestablished at a new higher level.
Despite this adjustment, we are still running a trade deficit with China today. This imbalance is the result of intentional and continuous intervention by Chinese monetary officials in the currency market to keep the Chinese currency undervalued. They do this because it benefits their economy by giving Chinese goods a competitive advantage in the American and world market place. This is great for the Chinese companies that produce these goods and for the American Consumer. Unfortunately, this imbalance also steals jobs from the American Economy and lowers wages for American workers.
There is an interesting parallel with of our situation today and what was happening in the thirties, only this time, for America, the shoe is on the other foot. China is the country that is experiencing trade surpluses and huge currency inflows. If the parallel holds, it could mean China is the country that is steaming toward the iceberg.
Now, we find that United States is in a position similar to Britain in the 1930’s, where an overvalued currency was destroying the country’s competitive position in world trade. Actually, we hear the same arguments today from Washington that British politicians used in 1925 justify a $4.84 Pound. It was based on false pride in their currency that ignored economic reality and the country’s best interest.
Currently, we also hear grumbling by Chinese government officials about acts of American protectionism such as the tariffs that are imposed on steel imports. They conveniently ignore the fact that these tariffs are small compared to the price advantage that they gain by keeping Renminbi pegged to the Dollar at a price that gives Chinese goods a competitive advantage to those produced in the United States. In addition, the Chinese conveniently ignore chronic, wholesale copyright infringement — pure theft of American intellectual property.
The currency problem is compounded by the fact that the Hong Kong Dollar and the Singapore Dollar are also pegged to our Dollar. This means that as the U.S. Dollar depreciates, goods from these countries get cheaper compared to goods produced by the rest of the world. This again is great for China and Hong Kong, but not so great for the rest of the world. The pain is being felt particularly in Europe where the already overvalued Euro is appreciating against the dollar and because of the peg, against the Renminbi.
The financial press and American politicians are currently in a state of panic about the fate of the US Dollar. What they should be concerned about is the undervaluation of the Renminbi. Since the Dollar is now undervalued against most of the currencies of the developed world one should wonder whether this is really a dollar problem, and it is not really a Renminbi problem.
US trade deficit has been cut in half in the last year and half. How much of this is a result of our recession, and how much is the result the Renminbi appreciation while it was un-pegged is an open question, but it is possible to say that the remainder of our trade deficit might disappear if Renminbi were allowed to appreciate to a real parity with the Dollar.
China has benefited mightily in the last ten to fifteen years from their government’s currency policy. But few benefits continue for this long without becoming mixed. Whether this kind of stimulation will lead China to the same destination that American reached in 1929 is an interesting question. Jim Grant says China is a Bubble, and that the pop is a question of when, not if. China has been working industriously to import jobs at the expense of the developed countries for years. It is just possible that they have I doing this also created the psychological basis necessary for bubble formation. So stay tuned.
We have clearly passed though the period where deregulation was popular and now are currently embarked on a period where there is a lot of clamor for new regulation. Before we get too enamored with this prospect, I think it might be well to review the regulatory successes (or lack thereof) of the last one hundred years. In the United States the Twentieth Century began with the re-establishment of a central bank with the Federal Reserve Act of 1913. Looking back, I think that we will have to admit the Federal Reserve has been something of a mixed bag. In “The Lords of Finance”, Liaquat Ahamed blames the Great Depression of the world’s four largest central banks;
“… in this book I maintain that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920’s, others after the first crises set in-by any measure the most dramatic sequence of collective blunders ever made by financial officials.”
The return to the gold standard in the twenties, with the price of gold fixed, had the effect of removing from gold producing companies any incentive to increase production. The result was that the production of gold in the 1920’s lagged behind the increase in the World GDP. With the price of gold fixed at 1914 prices, liquidity was being drained from the countries that needed it the most, and sent it flowing to the United States to create a stock market bubble. To make things worse, the stagnation of the world’s money supply was at a time when countries were struggling out from under massive debts from World War I, and the last thing they needed was deflation.
The result of the dysfunctional gold standard was eventually a series of crises that started with a depression in Germany in 1928 and was followed by the stock market crash in America in 1929 and then the serial bank panics that started in 1930. By 1931, Europe was already in a depression that became considerably worse than anything that was subsequently experienced by the United States. The economic collapse caused political instability in Germany that brought Hitler to power, and in consequence led to World War II, the holocaust, and eventually the deaths of fifty million people.
What is clear from this story is that much of the disaster of the 1930’s was the unintended consequence of action by well intended, reasonably intelligent people who thought they were doing the right thing, clearly, when it comes to regulations and regulators, good intentions and reasonably intelligent are not good enough.
That is not to say that we learned nothing from the lessons of the 1930’s. So far, we have been able to avoid many of the blunders made by the central bankers then. We are only one year into this crisis and the last chapter of this story is yet to be written, but it appears the FED has performed well post crisis. Pre-crisis is a different story; the FED’s performance in feeding Bubbles, while not quite on a par with the central bankers in the thirties, still leaves Greenspan at the top of my prep list.
Alan Greenspan considered himself a libertarian, yet when put in a position of power he became a compulsive economic tinkerer who added to our economic lexicon such marvelous concepts as the “goldilocks economy”, “the soft landing”, the “Greenspan put”, and the bailout of Long Term Capital Management. We do not know how Ayn Rand felt about “Moral Hazard” but clearly Greenspan was not familiar with the concept. The FED had a lot of help in bubble building from their friends in Congress and executive branch. Liberal legislators passed laws to encourage the spread of home ownership to people with limited incomes (i.e. limited ability to pay the mortgage but presumably not a limited ability to vote in the next election) that pretty well mandated the de facto bankruptcy of Fanny and Freddy. Greenspan, in his book “The Age of Turbulence”, said that while he was constantly fielding calls from Capitol Hill pleading for the FED to lower interest rates, he did not, in his seventeen years in office, receive one call from a legislator requesting that he raise interest rates. These Congressmen, having now demonstrated their good intentions and economic wisdom by past behavior, are now asking that they be given more authority over the Federal Reserve Board.
It is certain that the regulations inspired by the Great Depression have done some good. For example, the existence of the FDIC has successfully prevented the kind of bank runs that we saw in 1931 – 1933, but all the laws and regulations of the “New Deal” did nothing to change the cyclical nature of our economy, the imperfect nature of human existence, or prevent the current crisis. I would argue that the FED, by sustaining the up cycles and delaying the corrections, may well have turned what should have been a normal correction into a crash. I may be a bit dim, but do not understand how anyone could believe that our economic performance will be improved by giving more authority to the congress.
I am not arguing against regulation. No society can function without rules, but good rules should be simple and they should be as unobtrusive as possible. Much as we would like to, we cannot design a perfect economic system, and the rules we write now will benefit if we start with low expectations. Pain is the mother of wisdom but that does not mean that all lessons should be written into laws or that more power should be given to government.
It important to remember, as we try to assemble rules that will prevent future disasters, that this is at best a naive pursuit. Further, the one great lesson to be learned from the last one hundred years is that, while the power of government to do good is limited and ambiguous, its power to do evil (even unintentionally) is unlimited.