King Cash

Down, down, down...

Oil is at a five-month low. Russian stocks are 20% below their high. Commodities are back to 2010 levels.

Everything is going down. Even gold.

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Wait a minute. Since we know from Einstein that all motion is relative, everything CAN'T be going down. If everything were going down, everything would be standing still. Something must be going up as a point of reference.

So what's going up?

Cash!

Cash is going up against oil, houses, stocks, copper, commodities of all sorts and just about everything else.

Cash is king.

Why? Because we are in a Great Correction. And in a great correction, prices are corrected. In a bubble, prices tend to go up. This tends to push up animal spirits, encouraging investors and business people to do things that they will later regret. They build houses no one can afford and shopping centres no one really needs. Then, these things and the loans against them appear as 'assets' on the books of banks, pension funds, hedge funds, private equity outfits, you name it.

Later, as the correction continues, markets discover that these assets' are not worth quite as much as they thought. Prices go down. Some assets' become liabilities. They are underwater, with more debt than equity.

Labour rates fall too. There are fewer projects that "make sense" and they need fewer workers. Business falls off. Unemployment goes up. Salaries go down.

As prices fall, they must fall against something. So they fall against cash. Cash becomes more valuable. You can buy more real assets with every unit. People who hold their cash through a correction usually do well. They are able to buy quality assets, at the bottom, at large discounts to their previous prices.

That's why so many people are willing to lend money to the feds for such low interest rates. They figures it's as good as cash.

All this is obvious and hardly worth mentioning. In a better world, we'd all know what was going on and we could all predict what would happen next: the mistakes would be written off, defaulted on, foreclosed, and marked down.

And then, the economy could get up, dust itself off, and get back to work.

That's what used to happen. The first American depression came in 1819. Cotton prices collapsed. Farms were foreclosed. Banks failed. It was over by 1821 two years later.

Then, there was the Panic of 1837. New York brokerage houses failed. Farm prices collapsed. A bank president committed suicide. But it was over by 1843 six years later.

The Panic of 1857 was triggered by the bankruptcy of Ohio Life Insurance and Trust Company. Railroad speculators were ruined. Stocks plunged. Nearly a thousand companies went broke. The resulting depression was hard but short. Recovery began two years later.

The Panic of 1873 led to a five-year depression. And the Panic of 1893 hit even harder with a crash on Wall Street, 16,000 business failures and a 15% unemployment rate. Four years later, the economy was running hot again.

The aftermath of WWI brought the Depression of 1921. By many measures it was as bad as the Great Depression. But it was quick two years later it was over.

And then, came the Great Depression itself. What made it so great? The feds! Until the 1930s, the feds let the economy take care of itself. Interest rates? They were set by willing buyers and sellers, not by economists working for the government. Monetary policy? Fiscal policy? There were none.

When it was time for a correction, Mr Market took out a wrecking ball and knocked down the mistakes of the previous boom. The debris was quickly swept away and it was off to the races again.

Even as late as the 1930s, Andrew Mellon, then Secretary of the US Treasury, advised President Hoover to "liquidate" everything. His idea was to give the correction a helping hand. Rather than wait for the correction to do its work, he'd swing the wrecking ball himself.

That is just what he did in the 1920s. He was Treasury Secretary in 1921 too. And instead of trying to fight the slump of '21-'23, he helped it on its way. Instead of 'countercyclical stimulus' measures, he gave the nation 'pro-cyclical' measures. That is, he didn't increase government spending in order to provide the economy with fiscal stimulus. He cut government spending in order to leave more money in the hands of consumers, investors, and business people.

And it worked. Scarcely 24 months after the beginning of the depression it was over with unemployment back to 5%.

But the world changed between '21 and '31. By the 30s, the feds had the bit between their teeth. In Germany, the Nazis were already consolidating power and gathering tinder for the Reichstag. In Italy, Mussolini and his gang were wearing funny outfits and plotting out an empire. Stalin was reorganising Soviet agriculture which would result in millions of deaths by starvation. And in the Western democracies, the meddlers were taking over too.

Instead of thanking Mellon for his input, the feds tried to impeach him! In a few months, Mellon was gone. And then US economic policy was firmly in the hands of people who thought they could do better.

The gist of the new policy was that corrections must be stopped at all cost. Depressions must be fought. Bankruptcies must be prevented. Markets must be controlled! By bureaucrats!

This new policy was what made the Great Depression great. Mr Market may have wanted to correct his mistakes; but the feds wouldn't let him. The depression continued, off and on, throughout the 30s and the 40s too. It didn't really end until the 1950s.

You might expect the feds would have learned from that experience. Compared to the laissez-faire policies of Andrew Mellon their activism was a complete, miserable failure.

Learn? Are you kidding. We're now in thesixth year of the crisis that began with the collapse of subprime in April '07. Does it show any sign of letting up? Any sign of coming to an end?

Nope?

The feds have fought the correction every step of the way with everything they've got. They've tried monetary stimulus taking rates down to zero. They've tried fiscal stimulus with $1trn budget deficits for the lastfour years and no end in sight. They've tried 'unconventional' measures too such as QE I, QE II and The Twist. Last year, the Fed funded more than 60% of the US deficit with printed money. And the Fed has increased its holdings of US debt some 3.5 times since 2008, from $479bn in September, 2008 to $1.66trn in March, 2012.

So, put on your seat belts. Sit back. Relax.

Eventually, the correction will do its work. But it could take a long, long time.

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