A sequel to 'Wizard of Oz,' starring Greenspan and Bernanke

By Hugh Hendry
The Telegraph, London
Thursday, November 27, 2008

http://www.telegraph.co.uk/finance/personalfinance/investing/3525234/Enc...

The past 30 years of economic history may have produced a daunting sequel to the original "Wizard of Oz" written by Frank Baum.

People blame this crisis on cheap money and greedy bankers. They certainly cannot be exempted. But I take a more fatalist point of view. There has to be a reason for humans to die off in their 70s and 80s. I believe it is so that the memory of a generation's mistakes is erased, allowing future ages to repeat the folly of greed and fear.

Because of this, I spend a lot of time reflecting on social mood and behaviour. Popular fiction is a particular fascination; I believe it provides a mind map of the social conscience. "The Wizard of Oz" is a personal favourite. I would contend that bullish markets produce feel-good films, like Disney animation; that bear markets produce depictions of horror and foreboding (think "Hammer House of Horror" in the 1970s and "SAW," its modern equivalent); and that social mood is linked to stock market patterns.

The original Frank Baum story was written as a political allegory of America's entry on to the gold standard in 1879. The strictures of sound money coincided with a vibrant post Civil War economy. The result was deflation: Prices fell by 1.7 percent per year between 1875 and 1896. The farmer, as depicted by the scarecrow, was held captive by falling agricultural prices and mortgages owed to the big banks, the wicked witch of the east. The spell of tight monetary policy cast a pall over the poor tin woodsman: Every time he swung his axe, he chopped off part of his body. It was a depiction of the economy's shuttered and rusting factories.

The easy-money crowd -- Bernanke and Greenspan's great grandfathers perhaps -- argued that the responsibility for the economy's woes lay with an insufficient monetary response. The gold market had a scarcity that choked the US economy into serfdom.

Instead, the populists' manifesto called for the readmission of more plentiful silver coinage into the system -- a point captured by Dorothy's silver slippers (Hollywood changed them to ruby) as she skipped along the yellow brick road (the gold standard). Print more money and remove us from penury.

Consecutive presidential elections were contested on such a return to bimetallism in 1896 and 1900.

Surprisingly, the easy-money crowd, proved unsuccessful; they were defeated by powerful bankers such as J.P. Morgan. However, the story ends with the good witch of the south (the populace) prophesying that Dorothy's silver slippers (easy-money policy) are so powerful they can fulfil her every wish.

This utopia was made possible just 13 years later with the formation of the Federal Reserve. The tin man and the scarecrow would have a more forgiving lender of last resort after all and 71 years later the wizard, called Nixon, went one step further and abolished the need for gold and silver ounces (Oz) when the U.S. reneged on its Bretton Woods commitment to sound money.

Of course today we could be watching a comparable parable unfold. The past 30 years of economic history may have produced a daunting sequel. I would suggest that tomorrow's fiction will prove much darker, perhaps in the image of Goethe's Faust.

The story would feature an apprentice printer called Bernanke. Encouraged by a wicked wizard, Greenspan, Bernanke toils at his printing press night and day producing reams of paper money. At first his monetary accommodation seems to bring unbridled prosperity. Boom follows boom, as the business cycle is seemingly abolished, house prices grow to the sky and his political stock rises. In time, the scarecrow is bought-off by crop subsidy; the tin man vacations in Vegas, having refinanced his mortgage for the 13th time; and the sorcerer's apprentice is promoted to top wizard.

However, Greenspan, now in retirement, finally reveals that his scheme has brought only "bogus riches." The printing presses have created a "zero-sum game" where dollars lose their purchasing power against God's brew of precious metals. The populace begins to save. Spending is reined in. Even the corporate sector suffers. With consumers no longer spending, there are no profits. Shares slump and the fiat kingdom collapses in anarchy.

And that is pretty much where we are today.

I withdrew my hard-earned money from a bank this summer. But it may surprise you to learn that I bought government bonds of long duration. Surely I should have bought gold? Except that I believe the way to make money is to seek opportunities through paradox.

And therein lies our brinkmanship: Everyone has skipped our story and read the conclusion. They fear financial anarchy. Gold coins are sold out. Everyone is in. And yet the price of gold has fallen this year. So, for now, I would stick with the bonds. The 18-year British gilt yields 4.8 percent but, with the Bank of England likely to follow the Fed and slash rates to 1 percent, I believe that we could see gilt yields below 3 percent. And I promise you that if bond yields broke 3 percent there would be a stampede to buy.

At this stage gold might trade close to $500 and those who missed its rally from 2002 would have the solace of schadenfreude when in reality they should be buying the stuff and selling their bonds. What delicious irony: Deflationists and inflationists could both claim to be right. But how many will have profited?

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Hugh Hendry is the co-founder of Eclectica Asset Management.

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