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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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What the investor gets is the principal on the bond at maturityTHE COSTS OF WAR Apart from the control given to government in wartime, what are the market distortions that make equities less valuable? ? War puts particular pressure on the prices and availability of key commodities, such as oil, chemicals, and base metals. ? War distorts global trade patterns in at least two ways: It imperils the sea lanes, and it promotes protectionism by narrowing trade options to allies and neutrals. ? War is damaging to civilian productivity because of anticipatory hoarding, National Guard call-ups that break up production groups, and by diverting technology research (and leading scientific brains) away from the development of civilian goods and manufacturing systems and into war-related products and systems. ? War distorts capital investment, as high-priority, cost-plus, military related projects that have to be completed immediately get top priority. Meanwhile, civilian capital spending is cut back as companies fill defense contracts, awaiting the wars outcome to see where opportunities lie. ? War discourages consumers from making longer-term commitments, such as buying a car or a home, or moving to a new community to take a better job. (The one important exception to that rule is the sudden increase in marriages contracted just before the troopships and planes depart.) Although most investors can easily understand how World Wars I and II affected equity valuations, few seem to understand how the Cold War hurt the economy and the stock market. The Cold War was only occasionally a shooting war, but in economic terms it was the most expensive war ever fought. Over a half century, American and British taxpayersand, to a much lesser degree, other NATO taxpayers and their Japanese counterpartspaid trillions of dollars to prevent Soviet communism from invading Western Europe, and to prevent Chinese communism from taking over East Asia. For much of that period, millions of young men were drafted, thereby removing them from civilian production in farms, factories, and offices, or delayingand in many cases ruling outtheir higher education. Because the Cold War was a fixed feature of the global landscape, most people came to assume it would last forever, and they planned their lives on the assumption that the Cold Peace would continue. That is the reason so many investors failed in the early 1990s to understand the huge economic and stock market implications of winning the Cold War. Trade would be freer, defense spending would plummet across most of the world, technology companies that had relied heavily on the Pentagon would fall all over themselves to design consumer products, and capital would move across the globe with relative ease. The fall of the Berlin Wall was one of the great moments in the history of capitalism, not just of Germany. In fact, the wars end was the springboard to greater prosperity in other parts of the world than in East Germany, despite hundreds of billions of deutschemarks in aid from West Germany and massive directed capital investment (such as moving the capital from Bonn to Berlin). Communism collapsed everywhere except in North Korea, Vietnam, Laos, Cuba, and China (though enthusiastic students thronged Tiananmen Square in 1989, believing that the tide was on their side; it never penetrated into China enough to transform the government). In one of historys droller ironies, the biggest political winner of the war won primarily by Ronald Reagan and Margaret Thatcher was Bill Clinton, whose contribution to the victory was, at best, nonexistent. He came to office with the conditions that liberals had dreamed about for decades: gigantic, growing Peace Dividends that would let him cut the Pentagons budget share of GDP to less than half the level it had reached under Reagan. Those dividends let Clinton deliver something Americans had long believed no administration would ever achieve: budget surpluses on a scale that convinced independent voters (and grumpy Republicans) that he was no mere tax-and-spend Democrat. The end of the Cold War delivered something else, something far more important, but because it came in gradually, on little cat feet, few commentators noticed its appearance until long after the Cold War was over. By removing wars inflationary pull on the economy, it grew consumers real incomes without biginflationarywage increases; it reduced the cost of social security pensions and pensions for retired government employees; it dramatically lowered interest rates on the burdensome national debt and interest rates on consumer and corporate borrowing, including, most significantly, home mortgages. For me, the end of the Cold War raised a new kind of price risk: deflation. The only previous American experience with sustained negative CPI numbers was during the Great Depression. But history told us that deflation had come after almost every major war since the American Revolution, including the Napoleonic wars, the Civil War, and World War I. It hadnt come after World War II because the Cold War came so quickly on its heels that a peacetime deflationary economy never became entrenched. An economy that moves from inflation to deflation experiences the good parts of the switch first: plunging interest rates, an end to shortages, bargain prices in stores, and an improvement in the income security position of the aged and disabled. Deflations effect on stock prices can be beneficialif its controlled and corporate profits are strongor disastrousif deflation gets out of control and corporate profits collapse, as in the 1930s or in modern Japan. As an historian by training, I knew that the sustained inflation of the Cold War was an aberration. Four decades in which the only question about inflation was, How high? had long since convinced most people that inflation was ubiquitous and inevitable. Volcker, Reagan, Thatcher, and their allies might drive inflation down to tolerable levels, but it would come back. It always had. (Always, of course, meant history since 1945. Anything before that didnt have meaning to most people.) The leading recent work on the question of price stability through the ages is David Hackett Fischers The Great Wave (New York: Oxford University Press, 1996). Fischer analyzes price data from Europe and America for nearly all of the Second Millennium, demonstrating conclusively that, apart from crop failures and other natural disasters, inflation on a multiyear basis is associated with wars and preparation for wars. The experience of the age of Pax Britannica (1815-1914) is proof of that assertion. Prices were essentially unchanged for a century. The only significant inflationary period occurred during the U.S. Civil War, which had a near-catastrophic impact on the English cloth millers. (Cotton prices in the 1860s, for example, were at times higher than they would be at any time for more than 125 years.) For readers who doubt the claim of nearly a century of price stability, and who cant face the thought of plowing through a textbook of economic history, here are three palatable research works: Pride and Prejudice, Jane Austen, 1813 The Adventures of Sherlock Holmes, A. Conan Doyle, 1892 Gladstone: A Biography, Roy Jenkins, 1995 ? In Pride and Prejudice, Mrs. Bennet and her five daughters would share on Mr. Bennets death a legacy of 5000 (pounds); invested in the 4 percent War Bonds, they would earn 200 a year, or 33 each, enough to provide genteel subsistence for a gentlewoman. ? In The Adventure of the Copper Beeches of The Adventures of Sherlock Holmes, Violet Hunter consults the great detective about a mysterious employment offer for a governess. One reason for her suspicion was the salary, which was 120 a yearthree times the market rate for the services of an educated gentlewoman. Seventynine years after Pride and Prejudice, and the cost of living was virtually unchanged. ? In his magisterial biography of Gladstone, Lord Jenkins, himself a former Chancellor of the Exchequer, provides scrupulous detail on Gladstones budgets when he was at the Treasury, and thereafter as Prime Minister. He suggests in a footnote that the reader multiply the sums by 50 to get modern equivalents, adding that there was essentially no inflation during the 19th century. Yes, there wasand isone big difference between the world of Pax Britannica and the world of Pax Americana: Britain was on the gold standard. Paper money was exchangeable for gold, and pounds were circulated in gold sovereign form. The Bank of England couldnt print unlimited quantities of money to buy the governments debt, because as soon as inflation appeared, people would come down to Threadneedle Street to cash their bank notes in for gold. In the modern era, the restraint on inflationary printing of money comes from modern monetary techniques and from the holders of trillions of dollars of global bonds. Ed Yardeni calls these holders the bond vigilantes because they have shown they will dump their bonds and run for cash or gold if governments resort to inflationary tactics. When they sell bonds heavily, interest rates soar, and there are widespread demands for restraint. (In replying to a question about how hed like to be reincarnated, James Carville, Clintons 1992 campaign manager, said hed like to come back as the bond market, because its so powerful.) The other important difference between the world of Pax Britannica and the present is that modern governments have assumed major roles in the economy as income stabilizers. In Elizabeth Bennets time, the poor had recourse to what might be in their parishs poor box, but not to much else. In our time, governments operate large schemes to protect incomes, including unemployment benefits, social security, legal exemptions for unions, farm programs, winter works programs, and so on. The result is that wages dont collapse when deflation hits, as they did during tough times in the 19th century. POSTWAR DEFLATION My view in 1992, and since, was that despite big governments everywhere, the risk to the price system was moving rapidly from inflation to deflation. I began telling clients back then that interest rates would continue to fall along with inflation rates, and I told them to buy long-term zero coupon bonds to capitalize on the onset of deflation. (A zero coupon bond pays no interestever. What the investor gets is the principal on the bond at maturity. Very long zeros sell for small percentages of face value. When long-term interest rates fall, zero coupon bonds can easily double in value, because they are so heavily levered. Despite the roaring bull market of the late 1990s, the holder of a 30-year zero Treasury bond acquired in 1994 would have far outperformed the stock market had he or she held on to it until today.) Most clients insisted deflation was dead. I argued that no stake had been driven through its heart. Proof that it still stalked the world could be seen in Japan. A great deflationary drama was unfolding therea decelerating, stately, kabuki dance of death. Asset deflationin the form of falling prices for stocks and real estatewas moving into the general economy. Consumer prices had stopped rising and were starting to fall. Huge overcapacity in Japanese factories meant that they kept on producing to maintain global market share and to cover their machinery costs even when prices fell below break-even levels. Because Japan was the worlds second largest trading nation, those made-in-Japan deflationary forces were being exported. |
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