Preventing Inflation (1978-1983)

Several years ago I read a very insightful book titled:

Secrets of the Temple: How the Federal Reserve Runs the Country
by William Grieder.

Most of this commentary comes from the insights gained from that book. The book is an historical perspective of the difficult time the Federal Reserve faced during the late '70s and '80s. It was a time when a new word came to be commonly in the English language. The word was "stagflation."

1. Stag(nant) - Not moving or flowing; motionless.
2. (in)flation - a progressive increase in the general level of prices brought about by an increase in the amount of money in circulation or by increases in costs.

It was a time when a higher percentage of people were unemployed and prices of goods increasing in price because money was being created at a high rate. A Federal Reserve chairman's worst nightmare.

So how is money created? One way is for banks to loan money out. Let's take a look at how this happens in community with just one bank:

• Bailey, Building and Loan has $100,000 from depositors. Should it keep the money in its vaults? Not if it wants to make money.
• It should keep some on hand for requests for withdrawls, but the rest it should lend out to help others in the community build homes, create businesses and the like.
• If it keeps $20,000 on hand and homes are $5,000 a piece. It loans out $5000 of the money to a builder to build a contracted home. That builder then deposits the money back in the BB&L so that he can make withdrawls to pay his subcontractors. Now the bank adds the $5,000 to its books. Instead of $100,000 it now has $105, 000 in total entries.
• If the subcontractors deposit the money they have been paid back into the BB&L then more money/growth is created.

How is money destroyed? Simple, by defaults on a loan. When a bank has to write off a bad loan it takes it as a loss on their accounting books and the money is gone.


In the late 1970s inflation was so high that people in many places of the US began to take advantage of purchasing a home on a long term loan and with the commitment to pay back the loan in inflated dollars. The longer the term the easier it would be to pay back the money with inflated dollars.

For example:

• Fred goes to the bank and qualifies for a $100,000 loan because he has a job that pays him $40,000 dollars a year and he borrows the money a 8% interest. His monthly payments will be $818.03
  
• If inflation is currently 13% and he continues making his $813 each month, by the time he has been paying 20 years on the home, his wages will have risen to compensate for inflation and instead of trying to make payments on his $40,000/year salary he is earning $460,000 dollars annually. Now the $813.03 is paid easily.
  

Now we know our example borrower, Fred, never made his $460,000 salary, but there was a reason why.

During this time of high inflation the lending rates stipulated by the Federal Reserve were less than the rate of inflation. It was impossible for the banks to make money because the purchasing power of money was falling faster than the interest the bank could earn on the loan. The Federal Reserve heard its member banks complain about this loss of money every time the met.

The Federal Reserve chairman at the time was Arthur F. Burns, who was appointed by President Nixon. He seemed to listen more to the President than the member banks of the Federal Reserve. In other words, his views were not independent from the President's. This caused Fed policies to conflict with that of its member banks. Mr. Burns was asked to resign and he was replace by a new chairman named Paul Volker.

Mr. Volker understood that the value of money would continue to fall as long rates remained low. Rates, during his tenure were raised to heights never seen before, with the highest times being 17%-20% interest annually. At those lofty rates businesses and individuals could not borrow money without great sacrifice. Since lending didn't take place as fast the growth of the amount of the money the economy slowed. High interest rates also encouraged people to save money instead of borrowing or spending. As spending slowed it caused hard times for many businesses, some of which defaulted on their loans, causing money to be destroyed. This destruction of money

Mr. Volker followed the philosophy of former Fed Chairman William Martin who said the job of the Federal Reserve is "to take away the punch bowl just as the party gets going," referring to the need to raise interest rates when the economy is at its most active. Mr. Volker kept the interest rates so high for so long that all of the excess money that was in the economy was removed through defaults on loans. Banks were forced to be more careful when lending money and individuals were were much more likely to save money because of the hardships they were going through or might go through. When rates were again lowered the faith in the dollar was restored and the economy was again healthy.

Lessons on the "Herd Mentality" and Timing

Back in December 1999 I, like everyone else, was involved in the stock market. I saw myself as such a smart guy that I thought I could quit my job and make money by sitting in front a computer screen trading stocks. I would simply outsmart all of the other people involved. My strategy was easy, get up in the morning, identify the stocks that were going up, buy them and then before the market closed, sell. It was too easy!

I thought I was above average. I also thought that reading books would quickly help me become smarter than the rest. I read as many as time permitted. Some of the books were:

1. Reminiscences of a Stock Operator
   
2. Trading for a Living: Psychology, Trading Tactics, Money Management
3. Beyond Greed and Fear
   

I enjoyed reading them. However, many of the things I read caused me concern and conflicted with my trading strategy. Statements like:

"A group of three or more ads touting the same opportunity on the same page of a major newspaper warns of a top."
- Trading for a Living, page 215

Not only did I see ads in the newspapers, but commercials, infomercials, radio and television news stories, it was everywhere. I reasoned with myself, I was not like all of the others. I could react quicker, therefore I would avoid getting hurt financially.

Little did I realize that I was just part of the trading herd. My trading strategy wasn't a true strategy, it was a five second to five minute technical analysis before making the trade. What I was forgetting was that I was just an ordinary guy. I wasn't a professional but I wanted to be. Most everyone has this problem, even a large percentage of the professionals get caught up in this "Herd Mentality."

After learning how to read stock charts, I began to see tops in the stock market. It looked to me as if the market was going to go down. But the market didn't go down. For weeks money was still being won and lost. I saw stocks climb to ridiculous prices and so attempted to short the stock (borrow someone else's stock, through the broker, to sell with the intent to buy back the stock at a later time and lower price, pocketing the difference.) I knew that the stock was grossly overpriced, however the price would keep climbing and I would be force to buy back at a higher price and lose money in the process.

For example, I sold Rambus short at $209 dollars, throughout the day the stock price fell to $189. I felt good about it and went to sleep feeling good, I had studied and felt that it was way overpriced (what wasn't?) The next morning, a broker covering the stock came out just before the opening bell and said, "we reiterate a strong buy." Ten minutes later I felt lucky to buy back at $217 dollars. The current price of Rambus is $19 dollars and change. I was right but I was too early and my correctness depended on timing the trade correctly. Too hard for just an ordinary guy with less than $200,000 dollars to trade.

Needless to say, I learned two very important lessons:

1. Ordinary people get hurt financially when doing things simply because everyone else is and mistakenly think they can't afford to miss the opportunity.
2. Even though I might be right when making an investment, if timing was important in order to make money, I could still lose by being forced out. I needed to invest in things where timing wasn't involved.
   

Speaking Out

I finally decided to take the plunge into blogging. Why? Well, the reason is simple.

The US Congress was responsible enough to stand up to the Secretary of the United States Treasury, telling him that he couldn't simply request of 700 thousand million dollars and not have some accountability built into that request. Henry Pauson stated that he needed the U.S. taxpayers money to spend as he saw fit and that he would get us out of this crisis, without any oversight.

I was angry, how could someone demand a sum of money that large, an amount so large that the sum total of all the current working class citizens would not be able to pay back in our collective lifetimes. My children and children's children would be the individuals responsible for this bailout. How could we attempt to sell them out so quickly?

I was so angry that I contacted both my Senators and Congressmen telling them that they couldn't do this to my grandchildren. The day of the congressional vote came, I waited.... When I read that the bill had been defeated I breathed a sigh of relief. "The system works," I thought.

President Bush publicly stated, "There are disagreements over aspects of the rescue plan, but there is no disagreement that something substantial must be done." "OK," I thought, "maybe something should be done about it." - Bailout plan agreement expected by Sunday: U.S. Democrat I began to question my opinion, thinking that that maybe we should do something to save our financial system. I didn't seem like the correct thing to do but maybe we did need to do "something substantial."

The Senate got involved and quickly the resolution was passed by both houses. Then I read this bill that was so important and critical to the welfare of our financial system that it contained an extra 110 thousand million dollars for spending on things like - wooden arrows, rum, health care, economic development in American Samoa, bicycle commuters, Indians, recycling, and oil spills. "(Please read the sad details here) Where do these guys live for crying out loud!! Wasn't the bill risky enough without adding 110 billion dollars more!

That was the last straw! I need to speak up. I can no longer sit on my hands and just say nothing (after all, I need to type with something.) I don't claim to be anything other than an "ordinary" guy. I have been studying for three years now attempting to understand what I saw in the markets. So, being just an "ordinary" guy maybe I can contribute by stating in "ordinary" terms how we got into this mess. Hence, the blog "Ordinary Economics."