Bonds & Interest Rates

The 'Mistake of 1937'

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Posted by Steve Saville

on Tuesday, 01 May 2012 07:47

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 19th April 2012.

The US Great Depression lasted from 1929 until 1945, but the deflationary phase of the Depression effectively ended in 1932. Regardless of whether you define deflation and inflation in terms of money supply or prices, there was almost continuous inflation in the US after 1932. The inflation was, however, briefly interrupted during 1937-1938, when a leveling-off in the money supply and a sudden economic downturn led to sharp declines in equity and commodity prices. The 1937-1938 downturn is sometimes called the "mistake of 1937" by those who believe that it only occurred because the Fed tightened monetary policy prematurely. According to the believers in this theory, the US economy would have continued to recover from the collapse of 1929-1932 if not for the Fed's premature tightening. Significantly, Ben Bernanke is one of the believers.

Believers in the theory that the collapse of 1937-1938 was caused by the Fed's premature tightening of monetary conditions are partially right in that modest Fed tightening during the second half of 1936 and the first half of 1937[1] was probably the catalyst for the collapse. The question that this theory fails to address is: if a genuine economic recovery had got underway in 1933, then why did the recovery fall apart so rapidly and so completely following only a minor tweaking of monetary conditions? The answer is that the recovery wasn't real; it was an illusion based on increasing money supply. When economic growth is mainly the result of increasing money supply then stopping, or even just slowing, the rate of money-supply growth will likely bring about a collapse.

(As an aside, the recovery's flimsy monetary underpinning is part of the reason why, like the recovery that began in mid 2009, it was essentially "jobless" (the unemployment rate remained very high throughout the 1933-1937 rebound). However, there was more to the relentlessly high unemployment of the 1930s than the Fed's counter-productive monetary machinations. Actions taken by the Hoover and Roosevelt administrations to raise the price of labour can also be given a lot of credit for keeping people out of work.)

This prompts the question: shouldn't the Fed have continued to 'support' the economy with a constant flow of new money until a real recovery was able to take hold?

The above question ignores the fact that the flow of new money (monetary inflation) leads to more mal-investment and thus not only gets in the way of a real recovery, but also further weakens the economic structure. Had the Fed continued to provide monetary support for an additional year then the collapse would have commenced in mid 1938 rather than mid 1937. Also, it would have been even more devastating thanks to an additional year of mal-investment. As Ludwig von Mises pointed out long ago: "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

The above question also ignores the fact that in real time the central bank finds itself between the proverbial rock and a hard place. Even when the economy is subject to natural deflationary forces, as it was in the mid-1930s, the unnatural creation of new money by the central bank will eventually cause evidence of an inflation problem -- in the form of rising prices for important commodities and some goods and services -- to emerge. After a while, the pressure on the central bank to curtail the inflation problem can become greater than the pressure on the central bank to 'support' the economy with a continuing flow of new money.

By the third quarter of 1936 the pressure on the Fed to curtail the inflation problem had become dominant, but if the Fed had ignored this pressure and instead persisted with its price-boosting policies -- the path that Monday-morning Keynesians[2] now say should have been taken -- then the end result would have been an even more severe economic downturn once monetary conditions were eventually tightened. Alternatively, the Fed could have chosen to rapidly inflate the money supply indefinitely, in which case the end result would have been total catastrophe for both the US dollar and the US economy.

A picture of what happened during 1937-1938 is displayed below. On the chart the 1937-1938 downturn looks minor in comparison to the 1929-1932 downturn, but it was substantial nonetheless. The Dow Industrials Index lost more than half of its value, but perhaps of greater significance was the quick one-third decline in manufacturing output. Considering the relative importance of manufacturing in those days, this effectively means that the economy quickly shrunk by one-third.

The chart also shows that the Fed made no attempt to tighten via a higher official interest rate. As explained in Note (1) below, the Fed used other means to restrict the flow of new money.


That many of today's most influential policymakers and economists believe that a severe downturn could have been avoided during the late-1930s if only the Fed had maintained its ultra-easy monetary stance means that the wrong lesson has been learned from history. This, in turn, almost certainly means that the Fed will stay loose for longer in the face of blatant evidence of an inflation problem this time around, and that the Fed will be quicker than ever to engineer a money-supply boost in reaction to the next bout of economic weakness.

[1] The Fed started tightening the monetary reins in August of 1936. It never went as far as hiking the official interest rate (the "Discount Rate"), but it did increase bank reserve requirements and took actions to prevent gold in-flows to the US Treasury from boosting the Monetary Base. The result was a leveling-off in the money supply during the 2-year period beginning in late-1936.

[2] A Monday-morning Keynesian is an economist who always knows, with the benefit of hindsight, how much 'stimulus' should have been provided to the economy to bring about a sustainable recovery. Since these economists begin with the premise that monetary and/or fiscal stimulus helps the economy, if an economy tanks despite the concerted application of stimulus measures they inevitably conclude that the stimulus was insufficient. They never seriously question the correctness of the underlying premise.

We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://www.speculative-investor.com/new/freesamples.html


Bonds & Interest Rates

Lonesome dove

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Posted by G.I. - The Economist

on Friday, 27 April 2012 09:13

by G.I.

For the blogosphere, the most entertaining part of the Federal Reserve's meeting today was Ben Bernanke's defence during the press conference against Paul Krugman’s charge that he has betrayed his academic past in failing to ease more aggressively and aim for higher inflation.

That is a pity because while it was great theater, it obscured a more important revelation. Not only is Mr Bernanke still a dove, he is increasingly an isolated dove, and that isolation has significant consequences for monetary policy, the economy and the markets.

The statement released by the FOMC was largely as expected and a non-event for markets: “economic growth [will] remain moderate over coming quarters and then … pick up gradually,” inflation will fall from its temporarily elevated levels to 2% or lower, and the Fed expects to keep interest rates “at exceptionally low levels … at least through late 2014.”

The projections released along with the statement were far more interesting. FOMC members reduced their forecasts for the unemployment rate, and nudged up the outlook for inflation. That hawkish combination was made doubly so by the fact that just four of the 17 FOMC members think the Fed should start tightening after 2014, down from six in January.

The hawkish impression was reinforced by Mr Bernanke’s defence against Mr Krugman (whose name never came up but whose New York Times Magazine article, judging by the questions, had been read by all the reporters in the room). Mr Bernanke flatly rejected the accusation that he is acting inconsistently from the advice he gave the Bank of Japan over a decade ago, noting that Japan was in deflation then and America is not now, in no small part thanks to the aggressively easy monetary policy the Fed has pursued. He went on to argue that deliberately targeting higher inflation as Mr Krugman advises (because it would reduce real interest rates) in pursuit of a slightly faster fall in unemployment was a “reckless” tradeoff. Judging from my twitter feed, Mr Krugman’s partisans outnumber Mr Bernanke’s by a hefty margin. Mr Krugman himself dismissed Mr Bernanke’s response as “Disappointing stuff.”


Lonesome collared 595


Bonds & Interest Rates

The Burgeoning Scam Market

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Posted by Bill Bonner

on Thursday, 26 April 2012 10:12

By Bill Bonner

“Monetary policy cannot fulfill each and every market expectation.”

So said the head of the Bundesbank, Jens Weidmann.

Why not, investors want to know.

Mr. Weidmann was talking to The Wall Street Journal. He was explaining why Germany was sticking to its guns. They don’t use that expression in Germany. But you know what he meant.

“The crisis can be solved only by embarking on often-painful structural reforms,” he insisted. “If policy makers think they can avoid this they will try to.”

Mr. Weidmann is talking about the present. He is also describing the future. In the old world there is a backlash growing against the Germans and their financial guns. Austerity doesn’t seem to work. Countries try it. They cut spending. They fire people. They get nothing from it. Their budgets are still far out of balance, with deficits way above the 3% limit demanded by the European Union. Unemployment goes up. GDP goes down. Unhappy mobs start breaking windows. Why bother?

Look what is happening in Britain, for example. The Telegraph reports:

The unexpected 0.2pc contraction in UK growth followed a 0.3pc fall in gross domestic product (GDP) in the fourth quarter of 2011, signalling a technical recession and Britain’s first double-dip since 1975.

Economists had expected the Office for National Statistics data to show the economy grew by 0.1pc between January and March.

The Prime Minister said the figure was “very, very disappointing” but added that that it would be “absolute folly” to change course and jeopardise Britain’s low borrowing rates. He told Parliament:

“We inherited from [Labour] a budget deficit of 11pc. That is bigger than Greece, bigger than Spain, bigger than Portugal [...] The one thing we mustn’t do is abandon spending and deficit reduction plans, because the solution to a debt crisis cannot be more debt.”

Of course, you might look at these facts and conclude that they are not trying hard enough. Instead of making smallish cuts…why not make big ones? Why not actually balance government budgets so that they can tell German central bankers to drop dead?

Everyone agrees that that would be too radical. It would invite “social upheaval.” Apparently, actually living within your means is no longer politically or socially acceptable. You have to live beyond your means… The only question is ‘who will pay for it?’ The answers to that question are not easy. When debt levels were low, the answer was probably ‘future generations of taxpayers.’ At today’s debt levels it is unlikely that the debt will ever reach future generations. And with so much of the debt now being taken up by the central bank the burden shifts, from lenders to borrowers, taxpayers and consumers. Good debts may fall on debtors…even those who are not even born yet. But bad debt and inflation float down like leaves…blown by the winds…and eventually dropping down on innocent passers-by.

READ MORE: The Burgeoning Scam Market



Bonds & Interest Rates

Guest Post: Will Bond Investors And Savers Have To Hold Forced Government Loans At Some Point In The Future?

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Posted by Gunter Leitold via Zerohedge

on Wednesday, 25 April 2012 18:58

Submitted by Gunter Leitold

Will bond investors and savers have to hold forced government loans at some point in the future?

Numerous governments of developed countries are likely to fail when trying to liquidate their large debt burdens in an orderly way. Japan, for example, steadily widened its debt load over the past 22 years and thereby constructed the largest bankruptcy waiting to happen. Since 1990, new borrowings and interest payments were the biggest contributors to build up the Japanese state of pre-insolvency. While Japanese government bond yields have been around 2.6% p.a. on average, these yields were still 2% above nominal GDP growth of just 0.6%.

The chance of not being able to de-leverage is dangerously high when the free market requires a nation to pay interest rates significantly above its nominal growth rate. The nations of the European periphery, Portugal, Spain, Italy and Ireland currently overpay nominal growth rates in the long term bond market by 11,01%, 5.84%, 5.09% and 4.38% respectively. They are directly heading towards the need of a restructuring while Greece has a good chance of requiring a second one.

Nominal interest rates set around 1% - 2% below nominal growth rates for a significant period of time would be needed to help these countries to leave the debt build-up course behind. This change of interest rates would erase mark-to-market losses on sovereign bond positions for the semi-solvent banking sector, but it would also wipe out the carry and leave them without earning power on this part of the balance sheet. However, some of them would still need to restructure. Keeping the high government interest rates in place will lead to some spectacular restructurings in the future.

I assume if central planners decide to circumvent the already manipulated bond market and enforce much lower interest rates by implementing forced loans, there would be a big uproar for some time in the market. However, the negative wealth effect on the private sector would be more foreseeable and stretched out over a longer period of time. This definitely would decrease uncertainty. In my opinion, this measure would actually help to break through the downward spiral and avoid the much more devastating course towards a restructuring event with its negative side effects.

Everyone and their dog realizes that suffering the whole pain of a restructuring event at once is a bad alternative compared to spreading the pain over a longer period of time and spreading it in an orderly and less uncertain way.

It seems that the free market does not provide this option without harsh government intervention. The free market tends towards capital flight, wider risk spreads and thereby makes a restructuring event at the end of the road more likely. Greece for that matter has been half-solved at best and therefore has a good chance of being back on the brink soon.

I believe that at some point, we may see the implementation of a temporary regime which includes forced government loans for domestic private sector participants paired with strict capital controls for as long as the de-leveraging is going on.




Bonds & Interest Rates

Subprime State of Mind

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Posted by Bill Bonner

on Friday, 20 April 2012 09:48

By Bill Bonner

Memories take time. Like history. Or wine. Or cement.

At first, they are loose, fluid…and watery. Then, over time, they dry up…and develop more body…more shape…more substance.

Our recollections from our trip to Argentina are still congealing…setting up like a stone wall. We’ll show it to you in the days ahead.

But today, let’s turn from the pampas to the developed world…to the world of money. That is, let us turn our attention from the vivid world of real things and real people…to the absurd blah blah world of economics.

What happened in the 2 months we were gone? Anything important? Not that we can tell from the papers. The headlines are almost the same as they were when we left.

The Great Correction, for example, hasn’t gone away. Instead, it seems to be intensifying.

In America, 11 million homeowners are still ‘underwater.’ Every one of these houses is a candidate for foreclosure…and every one puts downward pressure on the housing market, which has been falling for the last 5 years with hardly a let-up.

Yes, Dear Reader, this month marks the 5th anniversary of the Great Correction. It began in April ’07, when its weakest link — subprime mortgage debt — snapped. Since then housing has been losing value. And with 11 million houses still priced below the amount of their mortgages, this housing bear market could last for another 5 years before it finally comes to an end.

When housing goes down so do the balance sheets of America’s households. And without improving balance sheets it is very unlikely that households will substantially increase spending. This will leave the economy hobbling along about as it is now…with the lowest growth rate of any post-war ‘recovery’…and completely dependent on more loose change from the feds.

No, that hasn’t changed either. When we left the feds were still trying to sort out a debt crisis by adding more debt. Nothing has changed since. America’s feds keep lending money they don’t have to borrowers who can’t pay it back.

This time, students are the subprime borrowers. Can you imagine a more subprime group? Students don’t have jobs. They’ve never proven they can earn money. Their credit histories are as thin as their resumes. And yet the feds have extended $1 trillion to this group. How long will be before that blows up? Probably not too long.

Meanwhile, in Europe, subprime debt is concentrated at the government level. The subprime borrowers were the countries at the periphery of Europe — Ireland, Portugal, Greece and Spain — who would have a very hard time paying their bills when the lending stopped. When we left, Greece was struggling. Now, it’s Spain.

Read more HERE



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