The Spectre of Weimar

I don't agree with all of the contentions of the market forecaster and "Elliott Wave" theorist Robert Prechter -- who has, by the way, recently predicted a sub-1000 Dow! -- but I think he is absolutely correct when he notes that bear and bull markets have something to do with efficient pricing and the rational distribution of capital and a whole lot to do with the herding of people (or rather their money) into and out of various asset classes.  

There's an old story (I've heard it retold in multiple variations) of a Wall Street tycoon who in September 1929, noticed that his shoe-shine boy was peppering his daily chatter with various stock tips and revelations of "sure winners." The pinstriped mogul concluded that when shoe-shine boys are dabbling in equities, the market must be massively over-bought. He went up to his office and sold everything and was unaffected by the subsequent crash.

When I was in college, I was much like the proverbial shoe-shine boy: I had turned a few thousand into 20 grand in unrealized profits by buying companies I knew little about. I was very proud of myself. I, of course, ended up significantly poorer than I began once the bubble in Global Crossing, eToys, Lucent Technologies and the like finally burst. I remember my mom telling me that it wasn't just greedy undergrads who had entered the market: her handyman had apparently opened up an Ameritrade account and was buying stocks on margin! I assume he didn't fare much better than I did.

The point here is that major tops, bottoms, and turning points occur at moments of absolute certainty on the part of the general public. Remember back to the mid-2000s when you'd get instructed by women at cocktail parties about how "housing only goes up" and "it doesn't make sense to rent." It was a good time to sell your house. Moreover, once the go-with-the-flow Business Week reported on the "death of equities" in 1979, a wise man would have concluded that it was the right time to start loading up on stocks.

Bad advice

Bad advice: Time, July 13, 2005; Business Week, August 13, 1979. (Image: Market Oracle)

When Daniel Gross of Newsweek -- a useful font of liberal conventional wisdom -- reported last April that "America is Back!" he sounded a unequivocal sell signal for all who have ears to hear. 

America's Back

I mention this because there are compelling reasons to believe that we are about to experience a horrifying deflation/inflation whiplash.

Most everyone has been convinced of falling (or at least, stable) prices in assets. This has inspired some good behavior. With the exception of the federal government, most individuals, businesses, states, and municipalities have been de-leveraging: that is, selling assets, liquidating or retracting credit, reducing inventory, and saving money. Among economists and market watchers, "deflation" (defined here as falling prices in goods and assets) is reality, inflation but theory.  (And this despite the fact that the Fed has doubled the monetary base over the past two years.)

Cash is now king, but at some point soon, everyone will be trying to get rid of his cash, on any and everything, in fits of hysteria. 

I am not predicting that this will happen in the coming months; and it might not occur for a couple of years. (I am confident that run-away inflation will occur within the next decade.) What I am stressing here is that this dramatic shift in public sentiment will occur in a flash of the eye, spontaneously, seemingly overnight. 

It's worth noting that, as Ambrose Evans-Pritchard reports, at this point of widespread fear of falling prices, some insiders have become curiously interested in the Weimar hyperinflation. 

Ebay is offering a well-thumbed volume of "Dying of Money: Lessons of the Great German and American Inflations" at a starting bid of $699 (shipping free.. thanks a lot). [As of this writing, the Amazon marketplace has the book available for $229!]

The crucial passage comes in Chapter 17 entitled "Velocity". Each big inflation -- whether the early 1920s in Germany, or the Korean and Vietnam wars in the US -- starts with a passive expansion of the quantity money. This sits inert for a surprisingly long time. Asset prices may go up, but latent price inflation is disguised. The effect is much like lighter fuel on a camp fire before the match is struck. People’s willingness to hold money can change suddenly for a "psychological and spontaneous reason" , causing a spike in the velocity of money. It can occur at lightning speed, over a few weeks. The shift invariably catches economists by surprise. They wait too long to drain the excess money.

"Velocity took an almost right-angle turn upward in the summer of 1922," said Mr O Parsson. Reichsbank officials were baffled. They could not fathom why the German people had started to behave differently almost two years after the bank had already boosted the money supply. He contends that public patience snapped abruptly once people lost trust and began to "smell a government rat".

Hyperinflation would make Americans long for the days of falling prices.  

As it happens, another book from the 1970s entitled "When Money Dies: the Nightmare of The Weimar Hyper-Inflation" has just been reprinted. Written by former Tory MEP Adam Fergusson -- endorsed by Warren Buffett as a must-read -- it is a vivid account drawn from the diaries of those who lived through the turmoil in Germany, Austria, and Hungary as the empires were broken up.

Near civil war between town and country was a pervasive feature of this break-down in social order. Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding. The diary of one young woman described the scene at her cousin’s farm.

"In the cart I saw three slaughtered pigs. The cowshed was drenched in blood. One cow had been slaughtered where it stood and the meat torn from its bones. The monsters had slit the udder of the finest milch cow, so that she had to be put out of her misery immediately. In the granary, a rag soaked with petrol was still smouldering to show what these beasts had intended," she wrote.

Grand pianos became a currency or sorts as pauperized members of the civil service elites traded the symbols of their old status for a sack of potatoes and a side of bacon. There is a harrowing moment when each middle-class families first starts to undertand that its gilt-edged securities and War Loan will never recover. Irreversible ruin lies ahead. Elderly couples gassed themselves in their apartments.

Foreigners with dollars, pounds, Swiss francs, or Czech crowns lived in opulence. They were hated. "Times made us cynical. Everybody saw an enemy in everybody else," said Erna von Pustau, daughter of a Hamburg fish merchant.

Great numbers of people failed to see it coming. "My relations and friends were stupid. They didn’t understand what inflation meant. Our solicitors were no better. My mother’s bank manager gave her appalling advice," said one well-connected woman.

"You used to see the appearance of their flats gradually changing. One remembered where there used to be a picture or a carpet, or a secretaire. Eventually their rooms would be almost empty. Some of them begged -- not in the streets -- but by making casual visits. One knew too well what they had come for."

Corruption became rampant. People were stripped of their coat and shoes at knife-point on the street. The winners were those who -- by luck or design -- had borrowed heavily from banks to buy hard assets, or industrial conglomerates that had issued debentures. There was a great transfer of wealth from saver to debtor, though the Reichstag later passed a law linking old contracts to the gold price. Creditors clawed back something.

A conspiracy theory took root that the inflation was a Jewish plot to ruin Germany. The currency became known as "Judefetzen" (Jew- confetti), hinting at the chain of events that would lead to Kristallnacht a decade later.

While the Weimar tale is a timeless study of social disintegration, it cannot shed much light on events today. The final trigger for the 1923 collapse was the French occupation of the Ruhr, which ripped a great chunk out of German industry and set off mass resistance.

Lloyd George suspected that the French were trying to precipitate the disintegration of Germany by sponsoring a break-away Rhineland state (as indeed they were). For a brief moment rebels set up a separatist government in Dusseldorf. With poetic justice, the crisis recoiled against Paris and destroyed the franc.

The Carthaginian peace of Versailles had by then poisoned everything. It was a patriotic duty not to pay taxes that would be sequestered for reparation payments to the enemy. Influenced by the Bolsheviks, Germany had become a Communist cauldron. partakists tried to take Berlin. Worker `soviets' proliferated. Dockers and shipworkers occupied police stations and set up barricades in Hamburg. Communist Red Centuries fought deadly street battles with right-wing militia.

Nostalgics plotted the restoration of Bavaria’s Wittelsbach monarchy and the old currency, the gold-backed thaler. The Bremen Senate issued its own notes tied to gold. Others issued currencies linked to the price of rye.

This is not a picture of America, or Britain, or Europe in 2010. But we should be careful of embracing the opposite and overly-reassuring assumption that this is a mild replay of Japan’s Lost Decade, that is to say a slow and largely benign slide into deflation as debt deleveraging exerts its discipline.

Japan was the world’s biggest external creditor when the Nikkei bubble burst twenty years ago. It had a private savings rate of 15pc of GDP. The Japanese people have gradually cut this rate to 2pc, cushioning the effects of the long slump. The Anglo-Saxons have no such cushion.

There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then -- and only then -- will central banks go to far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.

When hyperinflation hits, who knows how much these books will go for?