A Tale of Three Bubbles
My wife came home from Target early one morning after picking up a few critical supplies and relayed the following story. While waiting in line, she overheard a woman talking on her cell phone at the self-checkout registers. The woman was telling the person on the other end how she only had $200 in cash to her name and that she had been using her credit cards to get by for some time. Even though she didn’t have money for Christmas, as she told her friend, this woman planned to charge Christmas on her credit cards as well.
As I mentioned last week, over the past three months there has been a surge in credit card usage which has temporarily aided in boosting our economy. But credit, like money printing, isn’t sustainable, as evidenced by the first three major money printing bubbles that occurred in modern times.
Our story starts in Amsterdam, the home of Tulipmania, where the Bank of Amsterdam was started as a free-coinage bank. A free-coinage bank is a bank where a depositor can bring their bullion, and for a small cost receive an equal amount of coinage in return. In the early days, the Bank of Amsterdam didn’t issue credit, meaning each deposit was fully backed by bullion. The concept was wildly successful and before long bullion was flowing into Amsterdam from all over the world. This influx of bullion caused the money supply to massively expand, which led to a speculative mania in tulip bulbs.
Any time too much money flows into an economy, speculative bubbles form. Money has to flow somewhere and between 1634 and 1637 in Amsterdam, that money flowed into tulip bulbs. The main reason tulip bulbs soared in price was because buyers (mostly speculators) could buy tulip bulbs on credit with little or no money needed as a deposit. As a result, prices of even common tulip bulbs soared as much as 26 times the original cost in a month! Like all bubbles before and after, this one came crashing down when the buyers didn’t have the money to pay the sellers, who conveniently didn’t have any bulbs to sell. In a matter of a month, prices would collapse to one-twentieth of their value. Not even Isaac Newton was immune to the siren’s call of tulips because he nearly lost everything during the ensuing crash.
From tulips, we go to John Law and the Mississippi Bubble of France. John Law may be considered the father of Central Banking as he convinced an economically devastated France that he had the solution to their economic problems. Law believed that economic downturns were caused by a lack of money and that the solution was a fiat currency that could be printed at will by a central bank to deal with any shortfalls. He thought he could solve France’s problems by printing money and setting aside profits from his banking operation to pay off the large war debts that France had incurred. In May 1716, Law established the General Bank and began to implement his theories of money.
To John Law’s credit, his General Bank worked in stabilizing France’s currency and economy. Because of his success, the General Bank was retitled as the Royal Bank of France. Law then formed the Mississippi Company which was granted exclusive trading rights by the French government over the Louisiana Territory. The Louisiana Territory was believed to be loaded with riches such as gold and silver, but as we know, it isn’t. Law sold shares in the new Mississippi Company and to his credit, he allowed people to buy those shares on credit with a small down payment.
The stock price in the Mississippi Company surged and Law continued to fuel the frenzy by printing more money, which caused the share price to continue rising. Law also continued to issue new shares to investors by allowing them to make monthly payments with a small upfront deposit. Before long investors were getting rich, with some becoming newly-minted millionaires. As with any money-printing scheme, there reaches a point where investors decide to convert their paper profits to something more tangible.
Law had previously allowed investors to exchange their money for gold and silver, but as redemptions came in, Law didn’t have the physical metal to pay them. So, he limited the amount of shares someone could redeem for physical metal. However, he didn’t stop there. Shortly thereafter he would outlaw gold and silver coins, making his banknotes the only legal currency in France. Due to the excessive money printing that was going on, hyperinflation ensued. Law was forced into devaluing the paper currency in half, which caused the currency and the shares in the Mississippi Company to become worthless. Amazingly Law managed to flee France with his head intact and would later die penniless.
From France, our story takes us north to England where we meet up with the South Sea Bubble. England was at war with everyone and their debts were so high that nobody bothered to keep track of them. To fight his wars the King would issue debt, but unlike government bonds of today, it was illegal to sell the King’s debt once you bought it. Unfortunately for Charles II, the public was getting tired of financing his many wars and when he asked for more money to fund the Navy, he was denied. The precursor to the Bank of England was formed in an attempt to solve the King’s problems, but it didn’t work, and the South Sea Company would be formed specifically to convert the King’s debt into the nation’s debt.
The South Sea Company allowed the public to exchange the King’s debt for equity in the company. The public jumped at the opportunity because the shares in the South Sea Company were tradable, paid a dividend that was less than the current coupon they were receiving from the King, and had the opportunity for upside appreciation. The other benefit of investing in the South Sea Company was that it was granted the exclusive trading rights with South America, where investors were told were full of untold riches. The stock took off.
John Blunt, the head of the South Sea Company, borrowed the concept of allowing potential investors the option to buy stock on credit with a small down payment from John Law of the Mississippi Company. The idea worked and before long, investors were clamoring to get more South Sea Company stock. As the stock price appreciated, so did the King’s spending. The more stock people demanded, the more money the King received – because the South Sea Company could only issue shares of stock as long as it was backed by government debt. As you can probably guess, rather than get his fiscal house in order, Charles II continued to spend.
As the South Sea Company’s stock continued to spiral higher, the company became insolvent. Part of this was because the South American trading rights didn’t prove to be profitable and without enough revenue coming in, it was obvious to Blunt that he wouldn’t be able to pay the next dividend. Attempts were made to save the South Sea Company but eventually, it would fail when investors tried to cash in their shares. The South Sea Company didn’t have the finances to cover the redemptions.
These three bubbles happened about 300 years ago and if you look closely, you can see that early formation of what has become our modern central bank. John Law, who was in prison for murder before becoming the most powerful man in France, pioneered the concepts of printing money and borrowing money to buy stocks. John Blunt of the South Sea Company pioneered an early version of Quantitative Easing, which was an elaborate scheme to buy debt in exchange for stock – today central banks buy debt in exchange for cash. Three hundred years ago these ideas failed miserably. Yet today, our central bankers follow Keynesian monetary policy which was based on John Law’s theories! The big difference today is that people think we will have a different outcome. If the solution to our problem is printing more money, then maybe, but printing more money has never worked.
There are lessons we can learn from these three bubbles:
Each one of the bubbles occurred due to a massive expansion in the money supply that led to rampant speculation in tulips or stocks. The United States has been printing money for the past 15 years and on a global basis, more money has been printed since the Great Financial Crisis than ever before. While these bubbles are isolated, today every major central bank is trying to print their way to economic prosperity. My fear is that when this money-printing scheme fails, it will take down the entire global economy.
Fiat monetary systems are prone to large booms and busts. This could be solved by going back to the gold standard, but that would force governments to live within their means. While a stable currency is a good idea, until hyperinflation occurs, nothing will change.
Following each past bursting bubble there was a massive deflationary shock. U.S. Treasury bonds perform extremely well during deflationary shocks, which is why they are in our current portfolios. They are a hedge against a systematic failure.
Food prices also soared following each of these bursting bubbles, which is why we also own agricultural commodities. Food prices soar because governments usually choose to print more money when bubbles pop. I expect that the Federal Reserve or other central banks will be forced to print to rebuild the money supply.
Each one of these bubbles burst when investors decided it was time to cash in. When the selling starts, that’s the point where it becomes obvious that there is a huge amount of leverage – both the Mississippi Company and South Sea Company sold shares on margin, and today there is a record amount of leverage against the stock market. When bubbles burst, leverage gets unwound quickly, which is why I believe the next recession will see a significant drawdown in equity values.
During a bubble, investors aren’t too worried about what is backing their investment, but when the bubble bursts, investors run to the oldest safe havens in existence – gold and silver. That’s exactly what happened in the three past bubbles highlighted in this newsletter and is a big reason why I have such a strong interest in gold and silver. Plus, precious metals perform extremely well when the money supply expands, which it usually does following a deflationary shock.
While I don’t know when this bubble will pop, what I do know is this is a global money printing scheme unlike anything we’ve seen in history. Given every money-printing bubble has completely collapsed, I’m not willing to bet that this time will be different.
Video Topic of the Week – The Fed’s Next Big Problem
Short-term interest rates are rising, which the Fed will interpret as a sign of inflation. Will the Fed try to contain rising interest rates, or will they crash the stock market? All money-printing schemes eventually fail and this time, the Fed is in a no-win situation.
Chart of the Week – Smart Money
Is the smart money buying or selling? Check out this week’s charts to find out!
Portfolio Shield™ Update
No updates this week. Work progresses on the new strategy.
Weekly Broad Market / Economy Commentary
Debt has mushroomed this year as the U.S. economy added $14 trillion in new debt which only managed to add $4.8 trillion of growth. In highly indebted societies, such as ours, an exponential amount of debt needs to be added to keep the economy growing. Our current debt-to-GDP ratio is at 250%, which is higher than the 2008-09 peak of 225%.
Credit expansion at all levels has fueled our economy for the past two years and in the last three months, credit card debt, in particular, exploded. Normal credit card growth is 5-6%, but in the past three months, the rate of credit card growth jumped to 15-20% — unsustainable. The data continues to indicate that the consumer is tapped out. It’s only a matter of time before they cut spending, which will directly affect the economy since the consumer represents 70% of our economy.
If it wasn’t for the expansion in credit card debt, retail sales would be continuing to contract. Consumers charged $35 billion over the past eight years, while retail sales grew by $16 billion. To make matters worse, 9.3% of all credit card loans are past due. Not exactly a sign of a booming economy. To make matters worse, every 0.25% increase in the Federal Funds rate adds $200 per year in interest expenses for every $5,000 in credit card debt. With credit card debt at record high levels, consumers are about to face higher minimum payments come January.
The personal savings rate has fallen to 3%, which is a level last seen before the 2008-09 recession when the public was completely tapped out. While the savings rate can fall further, it doesn’t usually fall much more before households stop spending to rebuild their balance sheet. This will be a huge headwind for corporate profits and the stock market in the coming year.
The Treasury market had an adverse reaction to the passage of the tax bill – and it should. Interest rates rise, and bond prices fall at the hint of additional liquidity entering the economy. Since most experts believe the tax cuts won’t pay for themselves, yields rose in response to the expectation that the government will have to print more money. But yields only rose for three days.
Yields also rose in repose to the Fed adding liquidity or easing last week before the tax cut vote. For those who watch the weekly video or look at the charts, the Federal Reserve’s balance sheet increased last week when they should have been decreasing it. That increase in the Fed’s balance sheet will push interest rates higher. Given the Fed is expected to honor their claim of reducing their balance sheet, interest rates should resume their downward trend. I suspect this is a short-term move up in Treasury yields that should prove to be transitory.