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There are many mistaken notions which beset economic thinking about gov emment debt. One of the biggest is that govemment deficit financing has no effect on credit availability in the private sector. To support this assertion, some analysts point to the 1982-83 period, when deficits were not only high but on the rise, while nominal interest rates fell.

In fact, a study I carried out in January 1983 shows a characteristic inverse relationship between deficits and nominal interest rates; interest rates virtually always drop during periods of high deficits and rise as deficits decrease. But this doesnt mean that deficits have no effect on credit availability. It is a huge mistake to equate low nominal interest rates with the real interest in borrowing money.

The main reason for the inverse relationship of interest rates and deficit spend ing is the policies of the Fed. During periods of recession, unemployment rises, businesses ut back production and borrow less, and profits diminish, with the net effect that govemment revenues decline. Simultaneously, the demand for govemment social services and guarantee programs increases because of economic hardship. Consequently, the level of govemment deficit spending increases during times of economic recession.

Acquiescing to anti -recessionary political pressures, the Fed then pumps money into the system by purchasing huge quantities of govemment securities on the open market, creating excess reserves and artificially driving down the gross market rate of interest. The low interest rates are a mere facade that mask the lack of real capital available for borrowing.

Nevertheless, the low nominal interest rates draw entrepreneurs in, and a stimulated recovery begins. As the recovery gains momentum and the level of borrowing picks up, the demand for credit increases relative to the supply, and interest rates begin to move up. Jobs are created, tax revenues increase, and the deficit, or at least its rate of growth, declines.

Another important impact deficit spending has on the credit markets is dictated by the law of supply and demand. The economic facts of the matter are that any

time the govemment borrows money in the market, it is taking potential resources out of the private sector and putting them into the govemment sector.

Money borrowed is a claim on unconsumed goods, and at any point only a limited amount of unconsumed goods are available on the market. Therefore, when the govemment borrows money, it gains a claim on unconsumed goods that would otherwise be available to the private market. Nothing can change this simple fact. When the Fed pumps so much money into the credit market that interest rates remain unchanged or even drop in the face of massive govemment borrowing, it simply masks or waters down what is actually occurring-the artificial lowering of the market rate of interest, the distortion of economic calculation, and the misallocation of resources.

An historical example of this process began in 1969. The Fed reduced the rate of growth of the money supply, interest rates shot up, and the country went spiraling into recession. Credit demand faded, and interest rates began to decrease. Because tax revenues diminished and govemment spending increased, the budget figures moved from a surplus in 1969 to a deficit of $2.8 billion in 1970 to $23.4 billion in 1972!

The discount rate moved steadily downward from 6% in 1970 to 4.5% in 1971. Then the credit expansion began to have its expected impact. Business activity increased. Employment was stimulated. Company eamings began to improve. As a result. Federal tax revenues increased, and the deficit plummeted to $4.7 billion by 1974.

Consumer prices were also affected-they soared! The CPI (1982-1984 = 100) moved 10 full points from 35.6 in 1969 to 46.6 in 1974-over a 28°k increase in just five years!

Faced with rising consumer prices, the Fed once again put on the brakes and. once again, recession stmck. From 1974 to 1976 the discount rate dropped from 8% to 51/4% while the deficit soared from $4.7 billion to $66.4 billion. And the cycle continues today.

Another prevailing fallacy is that tax increases are a cure for deficits. As Parkinsons Law states, "Expenditures rise to meet income." The net level of taxes has increased in every administration since the Kennedy administration, while deficits have grown to all-time highs. The only way to cut deficits is to cut the budget.

As if direct deficit spending isnt bad enough, there is another growing burden which James Grant calls "the latent deficit"-all the contingent liabilities and govemment guarantees accumulated since the

New Deal. The face value of U.S. govemment insurance programs has grown from $662 billion in 1979 to $4,214 trillion in 1989. Direct loans, loan guarantees, and GSEs (Govemment Sponsored Enterprises) have grown from $200 billion in 1970 to $1,558 trillion in 1989.

To put some of these figures in more concrete terms, almost 75% of all farm loans are facilita ted by the govemment, and approximately 88% of housing mortgages are federally supported by some means. 14

1 dont want to sound like a prophet of doom, but this process has to stop sooner or later. When it does, because of the huge scale of what has been happening, we

are going to see the most severe economic correction-bust-in history, provided the govemment lets the correction mn its course. But depending on how the Fed, the Executive, and Congress handle the problem, we could continue for a long time to come with spurts of stimulated economic growth followed by short, sharp recessions which slow down the expansionary, inflationary process.

As a speculator in this kind of economic climate, you have to be constantly aware of the downside possibilities. You have to carefully monitor Fed and Treasury activities and pronouncements and be prepared for the markets response.


Market forces-supply and demand-ultimately determine the long-term price trend of any market. But part of the supply and demand equation in any market is the supply and demand for money and credit. Whether you are trading stock indexes, individual stocks, or commodities, both Fed and govemment fiscal policies dramatically affect money and credit and therefore the price trend.

My biggest wins have come from the ability to predict the consequences of govemment policies (combined with other methods, of course). But my biggest losses came when I assumed that the govemment would behave rationally.

For example, in July 1982 I had one of the largest long positions of my life. We were in a bear market, and Dow Theory gave me a buy signal. I went long the world, and within three weeks was up $385,000.

But on July 23, Bob Dole came out with a tax bill proposing the largest tax increase in the history of the world. I made the mistake of believing Reagans campaign promise not to raise taxes and assumed the bill would never pass. The market fell 12 out of the next 14 days, and by the time I got out of the position, my profit had tumed into a loss. I posted a loss of over $93,000 for the month, the second largest losing month of my career. (Actually, the losses were about twice that; the $93,000 was just for Interstate.)

The market bottomed on August 12, when the news arrived on the market that the Fed would ease. The psychology of what happens in this kind of case is really amazing, if you think about it. The federal govemment, operating at a deficit, increases taxes at the tail end of a bear market to help alleviate the burden of deficits.

The Fed, fearing that the increased tax burden will drive the economy deeper into recession, realizes that the only way the tax bill will do any good is if business is stimulate d into recovery, so they pump money into the system, which drives down interest rates, and business begins to expand. In essence, by expanding credit, the Fed provides the govemment with the resources to pay the bill of the new tax law. And people call this a free marker economy!

Another case where I lost money by believing in politicians occurred in Novem ber 1984, after Reagans reelection. His proposed new tax law was presented as "simplified" and "revenue neutraL" I believed him, and was long more than ever

in my life-pages and pages of calls on stocks. It tumed out that "revenue neutral" meant that the govemment was going to take money from corporations and give it to individuals, and the market went down nine of eleven days. I lost over 5349,000 that month, by far the largest monthly loss of my career, and, again, my actual total losses were almost double that.

My failure in these two cases was not thinking like a politician, but at least I leamed something. I leamed that you can count on politicians to take the expedient route, the "pragmatic approach," no matter what their expressed intentions are. I became almost cynical as I watched an avowed gold standard and laissezfair advocate, Alan Greenspan, take the chairmanship of the Federal Re serve Board and tum into an expert at saying nothing with far too many words-the hallmark of every "good" politician. I watched the federal budget grow and deficits soar under an administration that ran on a campaign of "limited govemment" and "a retum to free market principles." I watched the economic bubble inflate, driven by the most rapid credit expansion in U.S. economic history. By mid-1987.1 was poised, waiting for the needle that would pop the bubble, and the rest is history.

Make no mistake about it, the Fed is a political institution subject to the pressures of the lobbyists and constituencies of Congress and the President. Why" Its the nature of the beast. Any man who tries to remain aloof from those pressures will lose both his influence and, eventually, his position. It is naive to expect the Fed to act as a tmly "independent agency." In large part, the members of the Fed are forced to act on the basis of the short-term, pragmatic policies of the patty in power, not on the basis of sound economic policy. A trading mle that you wont see in the chapter on trading mles is: "Never go long politicians-and the Fed is a group of politicians."

Predicting the long-term trend based on govemment fiscal and monetary policy is basically a matter of thinking in fundamental economic principles in the context of the nature of the business cycle. The central problem is one of being vigilant and of assuming a politicians mindset when evaluating the pronouncements of the President, the Secretary of the T reasury, and key members of the Fed. There are really only two long-term possibilities-prices are going to trend up, or they are going to trend down. And the tuming points will occur when the Fed changes its policies to accommodate govemment fiscal policy or to actively reverse a market downtrend. At the risk of being redundant, I will repeat the Von Mises quote I used at the beginning of this chapter. By this time, the meaning should be more clear:

The wavelike movement affecting the economic system, th e recurrence of periods of boom which are followed by periods of depression [recession], is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The altemative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.


In this chapter, we have seen that the business cycle is the result of credit expan sions and contractions, induced by govemment fiat, and controlled in monopolistic fashion by the Federal Reserve and the fiscal policy makers in govemment. We have also seen that as long as the govemment controls monetary policy, there will be booms and busts. And as long as there are booms and busts, there will be an opportunity for the speculator to make money both on the upside and the downside. It is ironic that as an advocate of a purely free market, most of my knowledge would become obsolete if the Fed were put out of business and we went on the gold standard. But, unfortunately, I dont see that happening, at least not in my lifetime.

As long as govemment induces these cyclical fluctuations by manipulating the money and credit markets, it is the speculators job to profit from it. By monitoring both govemment policy and the policy makers, you can often anticipate their actions and therefore predict the economic consequences. It all goes back to what I spoke about in the first chapter-thinking in principles.

When Fed policies and govemment fiscal policies fly in the face of basic eco nomic principles, draw conclusions based on the fundamental economic principles involved, and youll be tight. The problem from there is one of timing-timing how long it will take the markets to recognize and react to the effects of faulty govemment policy. And thats where knowledge of Dow Theory, technical methods, and all of the essentials Ive talked about so far-come into play.

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