Wednesday, March 24, 2010

Stock Market Will Be Flat over Next Ten Years--Boomers Will Work 'til They Drop

The Great Depression lasted nearly ten years. The reason for depressions is that the Federal Reserve Bank creates excessive liquidity. The liquidity is used to stimulate the economy, but the stimulation is in the wrong place. For example, there may be no demand for an additional shoe store at 6% interest, but if interest rates are brought down to 4% then a new shoe store becomes viable. But the new shoe store will be sustainable only at 4% rates. If rates are kept that low, the amount of money created will exceed the value to the economy that the shoe store adds. The result is inflation. The public starts to realize that it is subsidizing businesses that cannot be reasonably justified. Everyone is paying out money through inflation so that the shoe store can stay in business. Better to make the shoemaker welfare payments and not waste so much money. The public starts to protest. The Fed then contracts the money supply, raising interest rates back to 6% or even 7%. The shoe store closes. In 1980 the prime rate was in the twenties. The higher interest rates throw more businesses out of business than were started due to the initial stimulus. A depression occurs.

What has forestalled the inflation is overseas sovereign investors' subsidization. Never before in history have other countries been willing to make themselves poorer by purchasing the additional liquidity that a country creates to keep interest rates low. This phenomenon will not last forever. It could last for 10 years, though.

Because there has been inflation in line with the past 20 years (eg., in the 3-4% range, and recently none due to credit contraction) there has been little impetus to raise interest rates. In fact they have been reduced in order to limit the effects of the bank credit contraction, which occurred for the very same reason as inflation. The Fed created excessive reserves, and mismanaged banks lent money via credit cards and mortgages that were unlikely to be repaid. When this pattern of lending had to change, there was a market collapse.

Because of these policies the country has been becoming poorer but not through inflation. Rather, the credit collapse caused people to lose jobs even though interest rates have not been raised.

Interest rates are now almost as low as they can be. If rates are raised significantly, additional businesses will be closed. If rates continue this low for long, the foreign subsidies to our economy will eventually end. The Fed has created an unsustainable system.

The period of time that this will take to clear up will be longer than the Great Depression. If you count the market decline of 2001 as part of this cycle, it already has been as long as the Great Depression. It may not be cleared up in the Boomers' lifetime.

That leads to the question of what Boomers are to do about retirement. The savings rate has been low, and few boomers have the assets to retire. A rising stock market such as existed up until 2000, ten years ago, would have subsidized the Boomers and allowed them to retire. As well, Social Security has been curtailed since their parents' day (the retirement age will be 67 or likely older), and anyway, Social Security is insufficient for retirement for all except the poor.

But the Boomers may be forced into retirement because of job losses due to the Federal Reserve Bank's being forced to raise rates. If the economy had been allowed to progress naturally there would have been better businesses, more innovation, less overseas plant transfers and a more dynamic economy. The misallocations due to the Fed would have been smaller.

If there were no Fed there would have been no problem.

In inflation-adjusted terms the stock market will not be able to advance until the misallocation of credit has been cleared up; the real estate market is stable and advancing; firms can be subsidized with additional Federal Reserve monetary creation; and inflation is stable. That is, for the stock market to begin advancing the basis for a new bubble will need to be created. This is what Jimmy Carter and Ronald Reagan did in 1979-1982 by allowing Paul Volcker to contract the amount of money and raise interest rates to very high real levels.

True reform of the American economy so that innovation is spurred in the way it was in the late 19th century will require major economic upheaval and abolition of the Federal Reserve Bank.

I doubt that either party has the courage to do this now. Hence, the stock market will not in the long term advance in real terms, although it might advance in nominal (not inflation adjusted) terms if the Fed continues to subsidize it through monetary expansion. In that case hyper-inflation with non-asset holders getting squeezed as real wages are further diminished is a real possibility.


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