..

DR. KURT RICHEBACHER

FrankCUrt
GERMANY

CURRENCIES AND CREDIT MARKETS

No. 244 / August 1993

"By 1929, speculation on Wall Street attained fantastic

dimensions. . It's difficult to understand
.

how highly intelligent experts seriously believed that the boom could go
on forever, how they failed
to realise that the position was becoming increasingly
dangerous with every rise in equities and
with every increase in the volume of fictitious
wealth. If

World Finance Since 1914, Paul EhuJg, p.158

Kegan Paul, Trench, Trubner, London, 1935

HIGHLIGHTS

In the last letter, we uncovered the causal linkages behind the

extremely divergent behaviour of
narrow and broad money on the one hand, and the financial markets and the real
economy on the
other.

In this issue, we give a detailed, historical perspective on how such conditions essentially give
rise
to the ominous and legendary .. financial bubble".
)
What's wrong with an asset bubble that has the wonderful
effects of raising asset valuations and
lowering interest rates? History and logic
provide a clear but stark answer.

Seeing the Fed's aggressive

money pumping, many people think that the "excess money" will
soon
spill over into commodity inflation. That's wrong. Wbat isn't realized is that the
money that has
flooded into the financial bubble is effectively locked
in.

We have shifted our view and are beginning to think the unthinkable. Having kept a
critical eye
on the actions of governments, central banks and
markets, we see the possibility for depression
in some countries.

The U.S. financial bubble frightens

I us most. Apparently, very few people are aware of the

ominous parallels between today's Wall Street bubble and the bubbles of 1927-29
recently in Japan. We
elaborate.
and more

~
For the third time in as many years, the dollar has made
an impressive recovery against the D-
mark even though the underlying bull story has failed to hold.

We warn again that the French franc will be

devalued. It is a great mistake to believe that an
economy must be strong because it has low inflation rates. It's even possible that the
entire EMS
will unravel.

Long-term capital conservation and liquidity continue to be the top priorities. We continue
to
recommend safe harbour in the short-term money securities and bonds of the
strong-policy
currency countries -

Germany, the Netherlands, Switzerland as well as Austria and Belgium.

THE U.S. BUBBLE ECONOMY

that built up in most countries during the

In view of the prodigious fmancial and economic excesses
go through sustained period of
1980s, we have always held the opinion that the world economy would
a

Compared to the complacent consensus viewpoint. which

stagnation. or at best. very anaemic growth.
just around the comer. our perspective appeared very pessimistic.
incessantly hailed a coming recovery

but disappointment over economic growth. True, the U.S.

Ever since 1990, though, there has been nothing
at an unprecedentedly anaemic pace
despite the most expansive
economy has recovered, but it has done so
although still complacent and
mix of monetary-fiscal stimulus on record.. As
a result, forecasters,

their expectations in the direction of our view.

generally optimistic. have gradually down-sized

continuously reassess our economic and financial

But new infonnation and developments cause us to
having kept a critical eye on governments. central banks and market trends,
viewpoints. Unfortunately, major countries.
that there's potential for depression in some
we are beginning to think the unthinkable
-

is due to three main reasons: first, thorough historical and theoretical research has
This shift of view
provided us with new insights; second. the more we learn, the more we are convinced of
the utter
budget deficits,
present world political leaders and policymakers; and lastly. structural
incompetence of our
slipping out of control everywhere.
dangerously swollen by the effects of recession, are

PERCEPTIONS VERSUS REALITY

development the Gennan economy's slide into

International apprehension has fixated on one maio
-

hesitancy in lowering interest rates~ Pronouncements by politicians and

recession and the Bundesbank's
is the world economy's main depressive influence.
give the impression that this
many economic reports
capitulate, they postulate, and the world economy would soon recover~
Force the Bundesbank to

widespread bias to blame Europe's recession on Germany, and the

This misplaced focus and the
that presently rules policies and the world's
Bundesbank in particular, typifies the general ignorance
is conveniently overlooked is the fact that the current recession started outside
fmancial markets. What
despite trying to forestall an economic downturn with
of Europe. It was led by other countries, who.
drastic monetary easings, couldn't do so.

to awaken to the realization that the present world economic

policymakers and economists have yet during
utterly at variance with any other period in the postwar era. Past recessions
downturn is something present
liquidations and typically played out within year. The
a
this time were all dominated by inventory
paralysis. by contrast, fmd their cause in unprecedentedly high
global economic tribulations and policy
aggregate capital and output structures of the
debt levels associated with heavy "maladjustments" in the
economies. Without a doubt, all of these imbalances
will require more than just a few years to correct.

FROM ONE BUBBLE TO ANOTHER

complacent view that problems are receding that the world is safely again navigating to
There is a . . .

Japan and the United States. We

solid ground. This is particularly believed to be so in the cases of
Japan's debt bubble and its associated huge
disagree. The liquidation of enormous and asset

in real estate and industrial capacity, both domestic and international, has barely just
malinvestments
has forestalled its current problems
in the case of the United States, few realize that the Fed
begun. And
bigger liquidity crisis later by firing up a massive speculative frenzy
only by sowing the seeds of an even
,'(
on Wall Street in the stock and bond markets.

\ 1993
Currencies and Cr~dlt Markets August
 3

What's wrong with an asset bubble that has the wonderful effects of raising asset valuations and lowering
interest rates?
The hard reality of any major asset bubble is that it inevitably must end in a disastrous
bust. Historically, inflationary bubbles were usually experienced in the commodities and real estate
markets. Big stock and bond market bubbles, by contrast, have been relatively rare. However, they had
the most pernicious after-effects, one important reason probably being that fmancial speculation involves
wide public participation. The examples of the U4S. asset bubble of 1927-29 and the Japanese asset
bubble of 1987-89 are well known.

Interestingly, Governor Mieno of the

Bank. of Japan is the first central banker in history who expressly
identified and attacked "asset price inflationlt. When he first took
office at the end of 1989, he began to
raise interest rates even though consumer-price inflation was virtually He was alert to the dangers
zero4
of runaway asset speculation in Japan's real estate and equity markets and therefore tightened the
monetary
screWS4 His express aim was to prick the bubble preemptively before it would burst on its
own accord
from an even more extreme level of overvaluation causing even greater damage later on.

Mr. Mieno sent staff to study London's secondary banking crisis of 1974 and America's more recent
savings and loan disaster. We wonder whether he
also studied the U4S. asset price bubble of 1927-294

THE SEEDS AND PARALLELS OF FINANCIAL BUBBLES

What's urgently needed, it seems, is a study that explores the theory and history of asset
price bubbles
and answers three key questions: How do asset bubbles come about; how do they essentially end;
and
when they do, how are the asset markets and the real economy impacted? For the historical
us, record
., leaves little doubt as to what wiU happen with the present bubble: In the
) end, asset markets will crash all
.I
around the world and trigger prolonged depressioßS4 Apparently,
very few people are aware of the dark
parallels between today's Wall Street bubble and the ones of 1927-29 in the U~S~ and
recently in Japan4

The mix of that regularly leads to the rise of a bubble economy invariably includes
conditions
protracted
economic sluggishness and subdued inflation4 It's a mix of conditions that deludes
(Xllicymakers and
economists into the erroneous conclusion that an unìnlùbited
monetary easing is pennissible and harmless.
In fact, it's thought that if asset prices rise, so much the better. To most
people, buoyant financial markets
are a sign of health, not the warning signal of monetary inflation.

In its July issue,

The Bank Credit Analyst writes: ffStructural deflation has brought virtual price stability
(as measured by the Producer Price lndex)for thefirst lime since the early 1960s. This
has allowed the
Federal Reserve to drive short-term interest rates below the rate of inflation, causing real
negative rates,
and to pump massive amounts of liquidity into the economY4 The result has been to inflate stock
and bond
prices. Global deflation has allowed the Fed to ease with little fear of a resurgence of price inflation."
. .

THE STOCK MARKET PARALLEL

The above quote captures the current situation very welt But the key question is whether
or not economic
sluggishness permits protracted, unrestrained
monetary easing4 It brings us to the many parallels between
the present Wall Street bubble and that of 1927-294 The first
parallel, and undoubtedly the most disputed
one, is the stock market. Ever since the 1930s, economic historians have argued over the links
between
the boom and bust of the U.S. stock market of the late 1920s and the following deflationary depression. .

)
Currencies and Credit Markets \ August 1993
 4

There exist two diametrically opposing explanations. One camp asserts that the depression of the 1930s
owed little or nothing to the Wall Street crash. In this view, there were two other main culprits that
caused the downturn: a banking crisis and the drastic monetary contraction that took place after 1930
which allegedly was to have been caused by an overly tight monetary policy following the crash. The
attractive aspect of this theory is that it implies that the savage deflation and depression of the 1930s was
merely the cause of a policy mistake. All that would have been required to correct it, therefore, would
have been a determined policy of monetary ease on the Fed's part.

This view, which is more or less today's accepted explanation, was first articulated by Professor Milton
Friedman in his book, Monetary History of the United States, published in 1963. Referring to an average
rate of decline in wholesale prices of 1 % per year between 1923 to 1929, he discarded the opinion that
the 19208 were a period of inflation. The thought that an inflationary stock market bubble might cause
deflation and depression once it burst was completely alien to him.

displaced the previous theory that

Mr. Friedman's assessment of the cause of the Great Depression soon
had wide acceptance. This theory instead held that the Wall Street crash and the following crisis was
really the unavoidable sequel to the monetary and speculative excesses that had preceded it. In other
words, the damaging monetary mischief had taken place earlier in 1927-29, and not later in the early
1930s. The crash and deflationary depression that followed were the predictable and inescapable
consequence of the earlier excesses.

We have always sided with the latter, more orthodox view. During the depression years, this was the
majority if not the consensus view in any case. Today, very few people are aware of the stock market
connection. Everyone believes that it was the tight monetary policies of the Fed that triggered the crash
and the following depression. Professor lIVing Fisher, most famous for IDS glorification of the stock
market boom as a harbinger of a "New Eralt of price stability and low interest rates retreated to the
orthodox view after the crash. He consented that "stock price inflation" was the main cause of trouble
and conceded in hindsight, "perhaps a once-for-all sharp increase in the rediscount rate two years ago
might have prevented the market crash later."

What really did happen in 1927-29 that led to Fisher's reborn conclusion?

THE SAGA OF 1927-29

It all began in the autumn of 1927.

Confronted with a sharply weakening U.S. economy and pressures
from the British to support the pound, the Fed cut its interest rates and flooded the banks with reserves.
The aim of these actions was to stimulate a credit expansion. But, as business credit demand failed to
materialize, the banks instead used the new reserves to add to their bond holdings and security loans. By
doing so, they not only created new deposits but also forced up bond prices and thereby lowered long-term
interest rates. In the end, the chief effect of the Fed easing was an inflation of stock and bond prices.

To quote a League of Nations report of 1931: "The credit expansion which took place during this period
went largely into the financing of speculation." What we see is that financial speculation was
overstimulated at the expense of economic activity. Sounds familiar, doesn't it?

What had happened in the real economy was that fixed investment slackened, particularly in building and
construction, while consumer spending took off, most probably fuelled by the
ephemeral profits of the

\
Currmdes and Credit Markets August 1993
 5

stock market boom. Yet~ industrial production peaked in

May-June of 1929 and was already declirùng
well before the stock market crash "of that Fall. Nonetheless, it was a
very moderate downturn. Only after
Ú1e stock
market had crashed did the economy begin its plunge in earnest

For economists of the Austrian school, the stock market bubble

from its creation to its final bursting
-

was the key development that definitively and dramatically framed and started the following
catastrophic depression. Not to be forgotten were the evil side-effects that resulted from the financial
bubble: overconsumption, overvaluation of assets, huge
malinvesbnents, overindebtedness, and illiquidity.
When the stock marlcet finally collapsed, everything else collapsed, too.

Austriantheory (Mises, Hayek, etc..) tends to stress wasteful malinvestments and structural maladjusnnents
in the real economy as the main causes of a following crisis.
Large malinvestments in real estate playa
regular role. Other sectors can be involved as well.. In Úle case of Japan, recently~ the bubble also
fostered an enormous spending binge on industrial investment. By contrast, both
U.S. bubbles -

1927-29
and today spurred spending binges particularly in consumption..
-

FLEETING LIQUIDITY

Structural maladjusbnents are a very important factor in the demise of a bubble. Even more dangerous
are the liquidity effects of a financial inflation. As long as the bubble inflates, it essentially creates a
mirage of rising consumer wealth and abounding liquidity. In the 19205, a new liquidity theory arose
asserting that easily "stùftablett
assets, like bonds or shares, represented real liquidity. It found many
willing believers. Today, even Fed publications insinuate that bond and equity mutual funds "liquid
are
\ It
.J etwugh to substitute for M2.

Before the 1929 crash, the markets were seen as being awash in liquidity. But all this
wonderful liquidity
instantly disappeared when stock prices tumbled. Between 1929 and 1933, the total value of all
outstanding shares declined an estimated $85 billion or 90% of their valuey
an amount nearly
corresponding to the total of aggregate
U.S. Gross Domestic Product (GDP).. A similar crash today would
involve a collapse in stock values of more than $5 trillion. A wealth destruction of such
magnitude is
bound to unleash enormous deflationary dynamics.

In his book, The Great Crash 1929, J.K.. Galbraith wrote that a good knowledge of what happened
in~ 1929
remains our best safeguard against the recurrence of the unhappy events of those days. Obviously
notlúng
has been learnt..

The one way to avoid crash is to prevent a major asset boom to begin with. During the 1920s.,
a
many
people some also in the Fed
-

greatly worned about the stock market boom. 11Iey saw it as a

-

symptom of an inflation that eventually would be vulnerable to a terrible bust.. By contrast, today's Fed
hails the booming markets and the sharp fall in long-term interest rates
as a great testament to its excellent
anti -inflationary policies..

In reality, the Fed's monetary easing over the last two to three years has been the loosest on record. It's
certainly much more lax than it was in the 1920s. The money flooding into the sto.ck
and bond markets
seems to be gushing out of a bottomless spring. But just as it did in the 1920s, the
monetary largesse only
hyper-stimulates the financial markets while the real economy responds only sluggishly. Most obviously,
the river of speculative money doesn~t spring from a sav!ogs booæ. It finds its
origin in three sources,

Currencies and Credit Markets \ August 1993

 6

all precipitated by the Fed: first, through its unlimited supply of bank reserves; second, a very low Fed
funds rate of 3% forcing paltry returns on certificates of deposits; and third, a yield curve of
unprecedented steepness..

Combined, these three conditions powerfully propel money into U..S. stocks and bonds, and in the process,
inflate their market values.. It's the classic pattern of an I.asset price bubble." Without a doubt, it's
nothing other than the Fed's money pump that"s belùnd the inflation of paper wealth.

Just as the Fed's easing is the most aggressive on record, the inflation in the stock market far exceeds that
1
of 1927-29, too.. The price-eamings-ratio (PER) for industrial stocks in early 1929 hit a high of 16.2.
Just before the crash the PER was only 13.5~ Presently, the average PER ratio for the Dow Jones \
Industrial stocks is at a lofty 32. The S&P 500 multiple is
currently much higher than in 1929, too, at
a ratio of 22.5. To make things worse, not only are valuations less attractive today, so are fundamentals.

In the 19208, the United States had much higher savings and the Federal budget was in surplus. Today,
stocks are soaring on the back of an abysmal savings ratio and a record-high budget deficit.

THE LEVERS BEHIND THE BUBBLE

How has the present U..S. fmancial

bubble been engineered? TIle two charts on the opposite page give
ingredients: soaring bank reserves, leading to soaring bank
a clear
answer. They exhibit the three main
purchases of bonds, in turn leading to soaring bond and stock prices.

Chronologically and causally, the financial inflation works like tlùs: first, heavy bond purchases by the
Fed persistently keep bank reserves in excess of banks' reserve requirements; second, the banks put these
excess reselVes to profitable use through massive bond purchases, leveraging up the Fed's initial reserves
injections by a large multiple; and third, the bank purchases create an equal amount of bank deposits
(money supply) and tend to lower long-tenn interest rates. As long as the Fed complies and keeps adding
reserves, it becomes a self reinforcing daisy chain.

1be data shows that this is exactly what happened. To begin with, in 1991-92, the Fed bought
$59
government bonds amounting
$213.5
to
billion,
billion.
B~ purchases of government or government agency bonds
the Fed7s purchases. Brokers bought an
in turn amounted to or almost four times
additional $69 billion. Altogether, these three fmancial intennediaries gobbled up $341 billion worth of
government bonds representing 59% of total net issues during these two years. Foreigners took a further
$114 billion out of the government bond market during this period.

These figures leave little doubt as to what's belùnd the sharp decline in U.S. long-term interest rates. If's
not personal and institutional savings; it's the Fed, banks, brokers and non-residents. Additionally, the
1
above figures make a mockery of the notion that the sharp rise in U.S. bond prices reflects declining J
inflationaryexpectations on the part of the public. During 1991-92, the public's (individuals and non-bank
200/0
institutions) share of treasury and agency bond purchases was barely of the totaL

Recent statistics show continuation of the same dynamics. During the first quarter of 1993, the U.S.
a

government fully 83% of total credit growth.

absorbed Moreover, 58% of the government's credit
requirement was fmanced by the Fed, banks, brokers and foreigners.

What's good for the bond market has been good for the stock market as well. Lower long-tenn interest

\
Currencies and Credit Markets August 1993
 7

u.s. ADJUSTED RESERVES VERSUS THE DOW JONES

INDUSTRIAL AVERAGE
100 Monthly 3700

3500
95 ADJ. RESERVES
- -
DJIA
~ 111
"... ...
3300
C;U
Q DJIA -
RH Scale .
3100
::j
III
'&~
85 .,r
I ãi
\t1'/'
.,JI1tt

cñ ,-, 2900

~ fJ) .... 2700

~
í\ 0
~; w ",
m
,I
jJ
75 25CO
Q:

a 2300
,
70
-<
"/,11 2100
ó5
~
." ", 19m
60 1700
I 87 88 89 90 Ql 92 93

Sourca: u.s. Federal Reserve Bank of St.. Louis ForlIUlt: CCM

u.s. BANKS: GOVERNMENT INVESTMENTS

% of Total Loans and Investments, Monthly
25.0%

23..0%

21..0%

19..0%

17..0%

15..0%

13..0%

If 11111111111111111f H lUff II Ii I
11.0" KIlUf fllill UtlllIlHtHtfttHHIlU HHfHttHffHtH tUIU 1ft If If IIllltUHI fll II II It IU It" filtH

I 80 I 81 I 82 I 83 1 84 1 85 I 86 I I I 89 I 90 I I I
l 87 88 91 92 93

Source: Federal ReserYe Format: CCM

i
rates have driven up stock valuations. But the biggest propellant for the stock market has been the rate
shock of extremely low short-teon interest rates.. Legions of investors have fled low-yielding bank
deposits and bought equity mutual funds, believing Wall Street propaganda that share prices can only rise..

Clearly, what we see is a notorious "bubble" fuelled by the most aggressive monetary ease on record.
What's obvious, too, is this: If the Fed ever dares to moderate its monetary ease, the bubble would surely
burst As banks and brokers begin to dump their bonds, long-tenn interest rates would shoot up, bursting
the stock market boom and aborting the economic recovery..

\
CUlTmdu and Credit Marketa August 1993
 8

WILL FINANCIAL INFLA nON SPREAD?

Given the rampant inflation in the financial markets, what are the implications for the markets and the
economy over the longer run? What will be the object of the next great speculation? Is the U.S. economy
on the verge of an inflationary spiral or a deflation? lbe common answer we hear and read more and
more of lately, is to expect an impending commodity inflation.

lbe reasoning seems plausible. Bank reserves, the monetary base, and M 1, are all soaring at double-digit
rates and, as such, are telltale signs of rampant inflation. While the main object of the underlying inflation
are financial markets for the time being, the thinking goes that the excess money wiU sooner or later
switch its attentions from overvalued fmancial assets to cheap commodities. When that happens,
commodity prices are expected to boom. Therefore, the great recommendation is to buy commodities
before the stampede begins.

Delusions create illusions. The great delusion in this case is the premise that all the money that has been
inflating the financial bubble will be available to inflate commodity prices tomorrow. That's wrong. Such
a big switch is simply not feasible. What isn't realized is that all the money that went into the bubble is
now locked in. In order to exit, the owners of the inflated assets will have to find others who are ready
and able to buy them at the given prices. Who is going to be left to buy when the bulls want to sell?
To bailout the bulls would require an even more massive monetization by the banks, which is unlikely
since they are already overloaded with bonds.

Given the buoyant markets presently, stocks and bonds are highly liquid assets for their owners. But
whenever the inflated transaction levels cease, the markets are bound to weaken. lbe worst thing that
could happen is a massive exodus attempt. Any heavy selling would instantly trigger a price collapse.
That is what precisely happened in 1929-33. Any inflationary bubble~ whatever the asset real estate,
-

commodities, gold, stocks, or bonds -

essentially ends in a crash.

The present U.S. financial bubble is already far too big to be reined in without a crash. Unfortunately,
a large-scale destruction of personal wealth and liquidity at some point is virtually inescapable. The
outcome would be very different than the one commodity bulls presently foresee. Far from leading to
rising commodity prices, any flight from the overvalued financial assets would have just the opposite
effect: devastation of private wealth and liquidity would spread deflation far and wide.

ILLUSIONS OF LIQUIDITY

While Wall Street still sees an economy and a fmancial system awash in liquidity driving up stock and
bond prices, we see an economy and financial system that is becoming increasingly illiquid. It's plain to

see. Broad money (M2) is falling dramatically short of current growth in debt, GOP and the market
capitalization of stocks and bonds.

The following graphs show this progressive shortfall of M2 relative to overall debt and the decline of
liquidity relative to the capitalization of U.S. fmancial markets. Inflation doesn't start this way, deflations
and depressions do.

To us, the evidence we've shown seems conclusive. The present financial boom is a bubble that will burst
one day with great depressive effects on the economy. But just as in 1927-29, as long as the euphoria

Currencies and Credit Markets \ Augu~ 1993

 9

u.s. LIQUIDITY TRENDS

M2 AS A % OF TOTAL DEBT AND GDP
Quarterly
85"- "

64% .
, 47%
. .

83%
82% ".
, . 42% -i
Q
A.
a 81" ~
. ..
. ..
,-
CJ ..
Õ

/'
.
....
0
80% ., \.1 ,...
,
. \I.. 37% I-
Õ
tl. 59%
I, _,
"#
58% M2. % of GOP -
LH Scale
v,
.

, . 32%
57% .
I'
56% M2. % of T otat Debt = RH Scale

55% 27%
1821831 &4186188 187( 4el 8el10j 711121131741161781711181181801811821831&4186188187(88 )891 ao 1811921831

Source: Federal Reserve Format: CCM

CASH TO EQUITY AND FIXED-INCOME MARKET CAPIT ALIZA nON

145% This ratio is the total

of lime deposits
135% (CDs), savings
deposits, money
125% market funds to total
capitalization of the
115% equity (NYSE.
AMEX. NASDAQ)
105% and fixed-income
market (Lehman
95% Aggregate).

86%

75%

65%

55%
47.WVo

45%
~.~~1~~3~~6~e~7~~8pOp1P2P3p4p6pep7p8~8~O~1~2~3~4~6~~7~8~9~O~1~2~31

Source: Arbor Trading Group IDe, Lehman Brothers. Ibbotson Assodatu, Federal Reserve or St. Louis

on Wall Street lasts, it fuels optimism on the real economy. That brings us to the important question of
the currency markets.

WEAK UNDERPINNINGS TO THE DOLLAR EUPHORIA

Dollar bullishness hasn't been so strong since the fall of 1989. The consensus sees the U.S. dollar soaring
to DM 1..80-2..00 by year-end, driven up by a strong u.s. economic recovery. The reasoning
is that
an
associated rise in inflation would inevitably cause the Fed to shift to a monetary tightening. At the same

Currmdes and Credit Markets \ August. 1993

 10

time, Germany's slide into recession is expected to force the Bundesbank to slash its interest rates. This
combination of events is envisioned to send the dollar off on a skyward trajectory.

Well, for the third time in as many years, the dollar has made an impressive recovery against the D-mark
even though the underlying bull story has failed to hold. Instead of forging ahead, the U.S. economy's
recovery is so anaemic that any rise in U.S. interest rates7 no matter how modest, is virtually unthinkable.
Conversely, the Bundesbank has not been flustered. It is ~iding its time in lowering rates.

Detennined dollar bulls, it seems, never allow inconvenient facts to disturb them. Far from deploring U.S.
economic sluggishness, it is hailed as the best of all worlds, assuring monetary ease and bullish financial
markets forever. By contrast, the Bundesbank's cautious policy is presented from the distressing
perspective that the longer it drags its feet, the worse the economic shambles and the sharper the interest
rate cuts will have to be later.

AN ASSESSMENT OF GERMANY

Temporarily, the German economy appeared to be in a free fall compared to the U.S. economy's moderate
downturn.. With its large industrial sector and its high investment ratio, though, the German economy is
naturally far more exposed to cyclical fluctuation than the U.S. economy. Additionally, German
unification, with its attendant spending surge, exaggerated and prolonged the prior boom.

Essentially, the German economy's rate of decline has slowed and is presently flattening out Yet, this
says nothing about any impending recovery and its likely steepness. There is an unrealistic expectation
in Germany and Europe, as reflected in buoyant share markets, that
U.S. growth will lead a world
recovery. We are not so optimistic_ We a
see general disapJX>intment over economic growth taking place
as an interdependent world pays for its past excesses. Still, it's importantfor the investor toassess which
economies are relatively weaker or stronger.

For long time now, markets have been spewing doom and gloom over
a
Germany, which, indeed, suffered
a shatp downturn. But this is a horror story which is starting to get rather stale as far as the foreign
exchange maIkets are concerned. Neither the fantasies about the demise of the German economy and its
currency nor the optimism on the U.S. economy are based on reality.

It is true that the Kohl goverrunent has financially mishandled unification and has turned It Into a
extremely large burden for West Gennany. However, German financial and economic fundamentals are
much stronger than most people seem to realize. Importantly, it is the one major country that steered clear
of the financial excesses that ravaged most other economies in the 1980s.

It is not an exaggeration to say that Germany was an anomaly in the 1980s. While the Anglo-Saxon
countries experienced consumer-led and debt-fmanced growth, German expansion was investment- and
export-led. In Germany's case, capital formation soared at the expense of consumer and government
spending. Compames and banks saw rising profits. No consumer borrowing binge and corporate
leveraging boom occurred as in the Anglo-Saxon
countries. Households maintained a high savings ratio
and still do. In fact, credit during this period expanded at its slowest pace of the postwar period.

Still, two things went to inflationary excess in the late 1980s: exports and the related industrial
investments. The inflation that fuelled the overexpansion of these two, though, occurred outside of

Currendes and Credit Markets \ August. 1993

 11

Germany, mainly in Britain~ Italy~ Spain. etc. Soaring, inflated demand in these countries spilled over
. .

into Gennany, especially as Europe's currency system became rigid after 1987. TIùs created a second
problem for Germany besides the demands of unification. It now has to digest these related
maladjustments in industrial invesbnent.

Considering the immensity of the fiscal burden of unification, running at about 6% of GDP, it is sureLy
most remarkable that Germany still has a considerable surplus in merchandise trade. Compare this with
the fact that the U.S. trade deficit has deteriornted sharply despite a very sub-par recovery. Looking
forward, in coming months markets should awaken to the fundamental weakness on the U.S. dollar side
of the currency axis. The doom and gloom on Germany is not likely to get any worse. To repeat, we
see huge risks in the U.S. financial bubble. Literally, U.S. markets are living on borrowed time.

THE RISE AND FALL OF THE FRENCH FRANC

The speculative pirates roving the international currency markets are looking for new victims from which
to extort easy and big plunder. This time the Danish krone and the French franc are on the firing line..
Considering the recent hubris about the franc replacing the D-mark as Europe's anchor currency, its new

fall from grace has an air of húmiliation.

We have been warning that the French franc will þe devalued. The basic reason for this view is our
conviction that the world economy will be weaker than generally expected and that the French economy
is much too vulnerable to endure extremely high real interest rates much longer.. It is a great mistake to

believe that an economy must be strong because it has low inflation rates.

With an unemployment rate of 11~5% already of a recession, there is something obviously

near the start
wrong with the French economy. Following a credit boom in the 1980s which financed heavy corporate
leveraging and over-investment in commercial real estate, the French today are experiencing
liquidity a

crunch~ Therefore, ooth the economy and its fmancial system urgently need sharply lower interest rates.
While the Bundesbank may assist the French to a point, it should be apparent that it cannot deliver the
low interest rates that France so desperately needs. French politicians should have known this long ago.

The French argument that Maastricht (the European agenda for monetary unification) and a fixed rate
against the D-mark have absolute priority in their policy is absurd. This decision has nothing to do with

economics but everything with the aspirations and obsessions of the French politicians. A devaluation of
the French franc, they fear, would defmitely jeopardize the common European currency plan, which from
the French politicos point of view, would have been the happy end of the D-mark's anchor role in Europe.

CONCLUSIONS

The world economy is mired with countries that are either experiencing outright recession or shaky,
unsustaìnabl~ recoveries. For the time being, flllancial markets revel in this scenario presuming that it
means easy money and financial nirvana f1as far as the eye can see.t1

Very few are able to see the ominous underpinning to the buoyant financial markets and the economic
optimism~ As we have tried to show, the excesses of the 1980s still hold their legacy. Don't be fooled.
These past excesses have just been papered over and transformed into the guise of prosperous, appreciating
II
fmancial markets -
a huge and dangerous "financial bubble.

Currencies and Credit Markets \ August 1993

 12 ~)
usually I
say this: They are
knowledge of "financial bubbles" we can
Based on our theoretical and historical It is a great mistake to
and violent chapter of maladjusted and sick economies.
the last. most precarious. liquidity. Instead. we think. they will prove
markets retlect abounding
conclude that the buoyant financial by broad money. remains at record lows.
liquidity trap. True liquidity as measured
to be a giant
huge deflationary implications
at some poinL It will have
A massive destruction of wealth is inevitable
Only the timing is unclear.
economies particularly. and the world economy in general.
for the overinflated
growing confusion.
is sharply increased volatility and rotation
in the markets reflecting
Already. there
speculation among investors. That's a warning signal.
uncertainty and short-term

as long as the
EMS persists. What may be
recession and currency turmoils
Europe will remain mired in The fact remains that
is a general tloating
just to take the speculative heat out of the markets.
required to the urgent needs of France and Derunark.
to lower rates is toO limited relative
the Bundesbank's leeway
bubble in the
the fmandal
world economic growth. In fact, once
We fear continued disappoinlments on hold in some countries.
madc.ets. we expect to see
economic depressions take
U.S. bursts. impacting world
in the world making it virtually
spots
is possible. There are many trouble
Over the short-term. anything the European
impossible predict which one will erupt firsL If the French franc devalues soon.
to potentially buoying the U.S. dollar for a time.
System (EMS) will have effectively unravelled.
in the U.S. and the recognition of
a
MonetarY bubble"
is this: a bust of the "financial
But the reality in the end
will be hugely negative for the
dollar.
renewed economic downturn
...\

./
times? As we have
investors do to preserve their
wealth during these volatile
What should conservative along more certain long-tenn trends.
is a mugs game. It is better to invest
often stated. short-term timing the safest harbours.
and the best balanced economies are
To that end. countries with the least excesses
For American investors. there is little else to do other
We stand by our long-running recommendations: diversify into hard currencies.
safe harbour in riskless sholt-tenn
money and to
than to continue seeking in the strong-currency countries. namely
America should stick with bonds
Investors outside of North
Netherlands. Switzerland. Austria
and Belgiwn.
Germany. the

September 1, 1993
Next MaIling:

by:
All riP*- resened
C"dlt Muuu: Dr. Kurt Rlchebãcher
Publllher ad Editor, CllfNllCÚslUUl
7889 Sixteen Rd.. Caistor Centre,
Mulberry Press Ine.
SubtcrlpdOll ad AdmlnistratlOlllnqulries:
416--957..0602.
Ontario, CANADA. LOR lEO.
TELEPHONE: 416-957-0601 FAX:
5US 400.00
OM 600.00. Subiaiben outside or Europe:
U Europe:
Anna" SubKrtptlon Rata: lnua.
4UUf tuldtWSS is støùd.
II o"'J f14ntÚlú4 wlu. tIu IOUTU
R.proádioa of JHUf oftlu
lUlIIl,.1I

Rlchebicher 1993
Copyrlaht; Dr. Kw1

\
CurreDdeI aud Credit Markebl Aqust 1993