Monetary History May Be Repeating Itself

Inflation has been a problem for all of three months.  It has been building, of course, going back to the depths of 2009.  But only recently has it penetrated levels that resemble the ominous beginnings of the Great Recession.  Despite protestations and an elegant tapestry of quotations from economists and monetary policymakers, the economy still refuses to ignite a self-sustaining recovery.

We can go back to the 1970’s for historical comparisons and guidance during inflation or stagflation.  The circumstances of that decade, in my opinion, are not quite similar enough to justify direct juxtaposition.  There are, no doubt, lessons to be learned from too much credit production, but the current period is rather lacking in that important regard.

Consumer credit, loans for small businesses and mortgage activity are all significantly lower now than even the worst days of the credit crisis – a very notable contrast to the decade of the 1970’s.  If inflation is in the driver’s seat, and I believe it is, it is not in the traditional mould.

To me, the primary cause of the current and latest imbalance is nothing but the dollar.  All one has to do is compare charts of various unrelated commodities with movements in the US dollar against the Australian dollar (a proxy for resource purchasing power and demand) and the correlation is pretty obvious.  While correlation does not necessarily mean causation, the number of coincidences within those charts, especially exactly coincidental inflection points, is hard to simply ignore.

The one historical precedent for this kind of economic behaviour is 1937.  It was the depression within a depression.  It is the reason the decade of 1930’s is now known as the Great Depression. 

After the bottom in 1933, the economy seemed to be on a solid recovery.  Activity returned to every industry and debilitating deflation was left behind with the banking panics.

Part of the correction out of deflation was certainly due to government interference beginning with Executive Order 6102, signed by newly inaugurated President Roosevelt on April 5, 1933.  This move effectively confiscated private gold inventories (private holdings of gold coins were allowed) in the name of combating “hoarding”.  In return, citizens were given $20.67 per ounce in Federal Reserve Notes (dollars).

Less than a year later, The United States Gold Reserve Act of 1934 outlawed most private gold holdings.  Beyond that, the “official” price of gold was fixed at $35, a 69% premium.  The government had effectively devalued the dollar by a staggering 41%.  For those private citizens that turned in their “hoards”, they had just been delivered a 41% reduction in purchasing power by being forced to hold dollars.

Previous to these moves, gold had been flowing outside the US and constraining money and credit.  With the dollar devalued and a new official gold fix, the outflows reversed to inflows and money stock began to expand.  The devaluation of the dollar led to a monetary recovery that was thought to have put the economy on a fully sustainable track. 

It was slow at first, but by early 1935 industrial production and factory employment were rising above 1933 levels (13% and 14%, respectively), but still well below the 1929 peak (-28% and –22% respectively).  There was improvement in freight car loadings (+5% since 1933, -42% since 1929), an important economic indicator at the time, and even department store sales (+9% since 1933, -34% since 1929).

Money gold stock had risen 112% from 1933 and allowed for a 13% increase in bank holdings of loans and securities.  Unfortunately, all of that increase in bank credit was invested in US Treasury securities.  This is a very close parallel to 2009/11:  banks had become cautious about lending to the real economy, so marginal flow of money went through Washington.

The growth in money stock due to gold had allowed prices to expand in close relation to money growth – the CPI averaged about 3% annual growth in 1934 and 1935.  Corporate earnings had grown 71% since the bottom in 1933.

Policymakers, investors, even the general public believed the worst was over and prosperity was returning.  From April 1935 to March 1937, railroad stocks jumped 117%, while industrial stocks rose 94%. 

While there was clearly investor enthusiasm for the recovery, actual economic activity was not quite as robust.  Freight car loadings and industrial production had grown a healthy 41% through December 1936, but department store sales were less inspiring, rising about 30%.  This, of course, meant that inventories were building throughout the supply chain, buoyed by the return of inflation.

Unfortunately, 1937 would turn out to be a disaster.  Industrial production plummeted by 37% through May 1938.  Freight car loadings fell 34%, while department store sales were off 18%.  Factory employment collapsed 26%.  It was a serious blow, both economically and psychologically, to a traumatized public.

The cause of the collapse is more complex than the scope of my discussion here, but in short it was a reversal in monetary movements (some believe it was an unwinding of New Deal policies, and, no doubt, that played a small role, certainly the Revenue Act of 1936).  In short, the Federal Reserve had begun to worry about inflation pressures – the late 1920’s were still fresh in their minds.  It had also acquired new regulatory powers over the banking system, the ability to set required reserve levels.

In the monetary growth out of 1933 and 1934, banks began to hold massive reserve balances as a hedge against any future turmoil.  Policymakers fretted those large reserves, should they ever be unleashed into the credit markets (sound familiar?).  There was also a lot of concern over the levels of inventories.  So they used their new powers, announcing in July 1936 an increase in bank reserve requirements effective August 1936. 

Banks reacted immediately by slowing the growth in credit.  By October 1936 banks were outright selling securities.  Total bank loans and investments that  had begun to slow as early as July, fell into contraction by March 1937.  Interest rates for risky credit bottomed in February 1937, especially for industrial and railroad bonds, moving far higher through 1937 and into 1938.

Those stock prices that overreached economic fundamentals crashed.  Industrial stocks dropped 45%, while railroad stocks fell by 67%.

There are a couple of ideas to take away from all this as it relates to today.  Dollar-driven inflation is not indicative of any sort of sustainable demand, and is therefore susceptible to just this kind of liquidity reversal.  Second, inflation-driven inventory restocking is even more vulnerable to reversal.  Without a true fundamental pick up in demand from end users, the entire supply chain can collapse (or re-collapse) once liquidity reverses.

Unfortunately, we have seen this already in 2010.  In another coincidence, the economy nearly lapsed into contraction last year after the Fed stopped buying mortgage-backed securities and US treasuries on March 31, 2010. 

Recent data is not at all encouraging.  It does not matter if the latest spike in unemployment claims is temporary, there should not be any spike to begin with since profit levels are so high.  The ISM Services diffusion index fell dramatically and is now only a small margin above contraction.  First quarter GDP of 1.75% is not indicative of any real recovery. 

If we begin to put all of these factors together (inventory-driven production, sluggish overall growth, continued and unending employment concerns, stocks that only go in one direction) and the warnings of 1937 become even more potent.  When economic fundamentals do not match the enthusiasm for equities, the results can be disastrous. 

Even robust corporate earnings are no comfort.  From the time the Fed interfered in required bank reserves in July 1936 until the economy fully collapsed in September 1937, earnings on the S&P 500 grew another 33%!  In the end, liquidity is no substitute for a fully functioning, free-flowing economy.