The great deformation – part II

When we left off yesterday, we were explaining how the feds had un-learned the three critical lessons of more than 2,000 years of market history:

1) Make sure the money is backed by gold (otherwise it loses its value).

2) Don’t let the government spend too much money (otherwise it will cause havoc).

3) Don’t try to centrally plan an economy, especially not with dictated prices (or you’ll soon have a wealth-destroying mess on your hands).

Gold was taken out of the money by two measures – one in ’68, the other in ’71.

The US Federal budget was last balanced (not counting Social Security contributions) in 1974. It hasn’t been balanced since.

And after 1980, when the Republican Party became the party of big spenders, there was no hope of controlling federal deficits. Both the major parties were in favour of spending more than the government collected in taxes.

The Republicans wanted to spend on an activist agenda overseas. The Democrats wanted to spend on an activist agenda at home. In the resulting compromise, they agreed to overspend on both.

Meanwhile, prices were manipulated lightly before, then heavily after the Panic of ’87. Richard Nixon had tried general price controls in ’71. Those were quietly abandoned and quickly forgotten.

But after the Panic of ’87, Alan Greenspan began to manage the one, most important price in capitalism: the price of capital. Naturally, he and his successors managed it in a downward direction, until it hit zero in 2009.

That’s where the Fed’s key rate has been for the last five and a half years.

FREE daily investment email from MoneyWeek
Receive our thought-provoking investment email Money Morning every weekday morning, plus occasional promotions, & become a smarter investor.

Please enter a valid email address

To sign up, enter your email address:

As the price of credit went down, the price of assets went up. One bubble followed another. Techs in 2000. Houses in 2007. Now just about everything is inflating fast. Even consumer prices are beginning to show signs of bloating.

This inflation was more or less what the feds were looking for. They wanted to mislead the economy into thinking that there was more ‘demand’ than there really was. They also wanted people to think they were richer than they really were.

On this last objective, they were rewarded with rampant speculation, risk taking, complacency, and grotesque distortions.

Putting money in the hands of the moneyed classes led the rich to feel a little cavalier about it. The fix was in and they knew it.

And they quickly realised that speculating on further distortions was a better use of their time and money than investing in the kind of plant, equipment and new ventures that would actually create more wealth.

This was the stupidest part of the feds’ programme. By making it appear that real capital had no value (wasn’t the price of it near zero?), they gave investors little incentive to create more of it.

Instead, speculators took their cheap money and used it for various forms of gambling and financial engineering.

Buy-backs, buy-outs, LBOs, M&A – corporate debt rose as corporate managers figured out ways to get more fast money into their own pockets.

One of the classics was to buy a corporation, then have the corporation borrow heavily (which even the junkiest business could do) and then pay out huge fees to managers and manipulators.

Lending standards are so lax and lenders so forgiving, the sharpies can get away with almost anything.

David Stockman elaborates: “…it is plainly evident that most of the massive expansion of business credit since the last peak has gone into… stock buybacks, LBOs [leveraged buyouts] and cash M&A [mergers and acquisitions] deals – not expansion of productive business assets. Indeed, total non-financial business credit outstanding has risen from $11 trillion in December 2007 to $13.8 trillion at present, or by 25%, yet real business investment in plants and equipment is still $70 billion or 5% below its pre-crisis peak.”

None of this should be surprising. It’s what you get when you lend too much money and rates are too low.

It’s like a woman who sells her body too cheaply; customers don’t appreciate it.

And the result? Remember Say’s law: real demand comes from real output, not just printing money.

If you could boost real demand simply by printing money, we’d all be rich already.

The feds’ phoney cheap money fed speculation and starved capital investment; real demand goes down, not up.

FREE daily investment email from MoneyWeek
Receive our thought-provoking investment email Money Morning every weekday morning, plus occasional promotions, & become a smarter investor.

Please enter a valid email address

To sign up, enter your email address:

• Stay up to date with MoneyWeek: Follow us on TwitterFacebook and Google+

MoneyWeek magazine

Latest issue:

Magazine cover
Cleaning up

Profiting from the fight against pollution

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues

Which investment platform?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from. They all offer various fee structures to suit individual investing habits.
Find out which one is best for you.

29 May 1660: Charles II restored to the throne  

While Charles II was formally proclaimed King by parliament in April, he only reached London on this day in 1660.

The Kids' Portfolio: the four best funds to buy for your children

Investing for your children's long-term future is an excellent idea. But what should you buy? The Kids' Portfolio is a simple collection of four funds intended to be tucked away for 20 to 40 years.