During 2013, massive infusions of liquidity—initiated by the Fed and pursued by the world’s major central banks over five years—finally succeeded in overcoming the negative effects of the global financial crisis. In Europe, the acute stage of the eurozone crisis was declared to be over and signs of growth emerged even in Japan after two decades of hopeless stagnation.
In the United States, growth was anemic but steady, and the labor market, while still depressed, showed some improvement. Major stock market indices broke out of recent ranges, with the Dow Jones Industrial Average setting a new record above 16,000 while the technology-dominated NASDAQ Composite Index surpassed 4,000 for the first time since 2000.
This was a nice anniversary gift to the Fed, which was established 100 years ago, in late December 1913. However, the year 1913 is in many respects ominous, and it may provide a cautionary tale in today’s economic and political environment.
A Century Ago
Historians claim that the modern era began in 1914, with the start of what became known as the Great War. This makes 1913 the last full year of the old 19th century. Indeed, back then the world was still ruled by crowned heads and dominated by a handful of enormous empires, with Europe as its unquestioned center.
World War I shattered that stable and mostly peaceful environment and created a fundamentally new world order, defined by shrinking distances, rapid technological and social change and the emergence of hundreds of nations. It also ushered in instability, repression and organized murder on a previously unimagined scale: In the 1914-1950 period, in “civilized” Europe alone upwards of 50 million people were killed in wars and actions by oppressive governments. Over the past 100 years, untold millions died from such causes around the world.
While 1913 was a remarkably peaceful year, many of the forces that were unleashed in August 1914 were already in place. Horses and railways were the main means of traversing distances and hauling cargo, but automobiles, airplanes and radio—the three technologies that began to shrink distances and bring the world closer together—had already been invented. The machines of warfare had demonstrated their potential to kill and injure half a century before, during the American Civil War. Still many people in Europe, anticipating the looming military conflict, believed it would be short and even benefit the moral health of their nations.
The U.S., Russia, Germany and Japan, which dominated the next century, were already well on their way to becoming industrial powers and were coming into conflict with one another. The 16th Amendment, which introduced the income tax in the U.S. and made America’s emergence as the global superpower possible, was ratified in 1913, as well.
Some developments of recent years, including potentially tectonic shifts that gained visibility during 2013, parallel events of a century ago. Taken together, they suggest the imminent end of one broadly defined economic period—or cyclical wave, to use Kondratieff’s terminology—and the start of a new one.
Information technologies have matured dramatically, and the early stage of rapid growth and constant change has been completed. They have already changed the face of warfare, but as they have been employed only on a limited scale, in remote local conflicts, we have not yet seen their true destructive power.
On the economic front, China’s leaders have signaled a transition from export-led development, which has made the country a manufacturing superpower in just two decades, to domestic consumption, in particular relaxing the one-child policy. The U.S., after achieving a natural gas revolution, has followed up with an oil revolution. This will eventually make North America not just self-sufficient in energy but a major exporter of oil, gas and related technologies. Meanwhile the Middle East, after the Arab Spring’s brief promise, has sunk into low-grade sectarian strife. That volatile region has been described as today’s Balkans, which unleashed the European conflict in 1914.
Perhaps the most important change has taken place quietly at the Fed in the final years of its first century. It is the policy that has become known as QE, which stands for quantitative easing and which brings to mind the luxury liner QEII, making it appear a fun-filled cruise to some exciting destination. During this cruise, the Fed has tripled the size of its balance sheet, to nearly $4 trillion, and under the ongoing QE3 policy, the central bank currently prints $85 billion a month in new money, monetizing the national debt in the process. This is a cruise to an unknown destination: Nothing like it has ever been tried in history—or, rather, has ever been done without massive inflation and currency debasement.
The Madoff Fed
Fed officials have repeatedly dismissed concerns about a new asset bubble in the stock market, and many market analysts point out that universal fears of such a bubble are the main safeguard against it. Nevertheless, it is hard not to draw parallels between the run-up in stock prices during 2013 and the infusion of over $1 trillion in newly minted dollars into the U.S. financial system over the same time period.
The current bull market is indeed very different from the dot-com bubble in the 1990s. Back then, investors were somewhat naive, becoming infatuated with the Internet, the talk of the “new economy” and the idea that “high-tech never suffers a cyclical downturn.” Similarly, the housing bubble 10 years later was driven by the mantra: “house prices don’t fall” and “homeowners never default on their mortgages.” This time, there is no good story underlying the run-up in prices: The economy remains weak, consumer incomes are stagnant and federal debt continues to mount.
What now sustains investors and speculators is the “Fed put” —the strong belief that the Fed, first under Ben Bernanke and now under Janet Yellen, will continue to pump in money until the economy rebounds and will not dare taper off dramatically for fear of collapsing the stock market.
This is strongly reminiscent of any good old Ponzi scheme. A pyramid will continue to swell the incomes of its participants as long as it is able to attract sufficient new funds. In an infinite world, no pyramid will ever have to end. Since there doesn’t seem to be a restriction on the Fed’s money printing, the bull market could go on and on—even though the longer a pyramid is allowed to continue, the bigger the eventual losses.
In fact, the Fed is running something like Bernie Madoff’s infamous operation: Just like in Madoff’s scheme, which also had a legitimate, highly profitable business existing in parallel, the Fed’s pyramid scheme interconnects with a very successful enterprise, the U.S. economy.
Even though the Fed has little to fear from inflation according to a conventional economy-wide measure such as the consumer price index or GDP deflator—and the imminent fall in energy prices will reduce inflation further—there still has been a clear debasement of currency. Mind-boggling cash hoards have appeared on corporate balance sheets, in the top 1% income bracket and at foreign central banks. China alone holds $3.7 trillion in reserves. The art market has gone through the roof: At end-2013, works by contemporary masters have started to fetch well over $100 million.
The art market, incidentally, was booming in the pre-World War I years, as well. In 1913, the famous Armory Show was held in New York. It introduced Americans to the European art of the day, making U.S. collectors the biggest art buyers starting in the 1920s.
The Fed is confident it could taper QE3 and in time sell all the mortgage-backed and Treasury securities back to investors, thus restoring the value of the dollar. But another lesson from a century ago may also be relevant. After the end of the war, the defeated Germany began printing money to pay its bills—just as the Fed has been creating money to buy up U.S. debt. Soon enough, the German currency was no longer worth the paper it was printed on and the price of a loaf of bread was measured in wheelbarrows of cash.