The Coming Crashes … Part 1

Dec 15, 2014 No Comments by

As we approach the end of the year, we wanted to get you thinking about your planning for 2015. Over the next three posts, we’ll feature an article by Austrian economist Robert Murphy, PhD from the October 2014 Lara Murphy Report entitled “The Coming Crash(es), Life Insurance and Gold.” We’ve broken this article into three sections to give you time to digest Dr. Murphy’s analysis and recommendations. We’ll also provided three key takeaways at the end of each segment to further guide you in your own thinking and planning. As always, we are available to work with you as you plan for 2015, please contact me at Julie Ann Hepburn.



Dr. Robert P. Murphy

In this article I’ll outline a framework for estimating the severity and possible timing of the crash.

However, I’ll also explain that there are different types of economic crises—some involving “only” a drop in equities, while more serious ones pull down the currency as well.

The best mix of assets to hold depends on the type of crisis we endure. The responsible business owner or head of household must be aware of these nuances when preparing for the coming storm—or storms.  — Robert Murphy, PhD

An Unsustainable Boom Leads to an Inevitable Bust

In this article I will take it for granted that the reader understands the basic theory of the business cycle as laid out by Austrian economists Ludwig von Mises and (Nobel laureate) Friedrich Hayek. For a full explanation, refer to the book I co-authored with Carlos Lara, “How Privatized Banking Really Works.”

However, for those readers who need a refresher, let me summarize the essential points of the Mises-Hayek theory:

Market interest rates serve a definite social function. They help communicate information among people in the economy, giving a signal of the scarcity of savings.

When people become more patient and future-oriented, they reduce consumption and save more. This tends to push down interest rates, allowing entrepreneurs to borrow more funds and invest in long-term projects, which now appear profitable with the lower discount rate used in their calculations.

The problem comes in when the interest rate falls not because of an increase in genuine saving, but rather because the commercial banks, perhaps fueled by the central bank, engage in credit expansion, in which they flood the loan market with new funds that are created through inflation.

When the commercial bank cuts interest rates to lend more money, this increased borrowing and investment doesn’t match up with lenders’ increased saving.

No, the bank created the new money “out of thin air” through the accounting practice of what economists call ‘fractional reserve banking.’

Additionally, the central bank—the Federal Reserve in the United States—contributes to the process by creating new money in the act of buying assets, such as Treasury bonds and (more recently) mortgage-backed securities.

The problem comes in when the interest rate falls not because of an increase in genuine saving, but rather because the commercial banks, perhaps fueled by the central bank, engage in credit expansion. The insidious aspect of a credit expansion is that it can create the appearance of prosperity, with firms hiring new workers and reporting large profits.

But the problem, Mises and Hayek explained, is that such a boom is an illusion.

Because there are no genuine savings backing up the new investment projects, they can’t be fulfilled. The economy is in the position of a homebuilder who thinks he has more bricks at his disposal than he really does. No matter what tricks the central bank pulls, it can’t create more physical capital goods—crude oil, aluminum, tractors, factories, etc.—just by printing up new money. The artificial boom must eventually end in a bust.

Typically, the boom comes to an end when the banks see prices rising and either slows down or reverses their injection of new money into the credit markets. With the tapering or outright reversal of monetary inflation, interest rates rise back toward their “natural” level and many entrepreneurs realize they are overseeing unsustainable enterprises. They lay off workers, scale back operations, and take other measures that everyone recognizes as “a recession.”

However, Mises also made clear that even if the banks ignored the red flags of rising prices and kept inflating, eventually the boom would still come to an end.

This would occur when the rapidly collapsing value of the currency led the public to abandon it altogether. In this “crack-up boom” the entrepreneurs would eventually realize their tragic mistake, but they would suffer a currency collapse as well as a crash in the “real economy.”1

The overriding moral of Mises and Hayek is that credit expansion doesn’t make the economy richer; creating new money only distorts the signals that the market interest rate provides to savers and borrowers. Any prosperity resting on inflation is an illusion.

An artificial boom can be propped up by continued injections of new money, but only for a while. Eventually prices begin rising at ever higher rates, and the public abandons the collapsed currency. A wise central bank would abandon its inflationary madness well before this point of the “crack-up boom.”

“Quantitative Easing” and the Stock Market

At this point, there is no dispute that the surge in the stock market since 2009 has gone hand-in-hand with the various rounds of “quantitative easing” or “QE.” The following chart makes the case plainly enough:

 Figure 1_LMR_Oct

As Figure 1 clearly indicates, ever since 2009 the stock market and the Fed’s asset purchases have moved hand-in-glove, while this was not the case prior to the crisis.

We had a very telling demonstration of this connection just this month. As of Wednesday, October 15, the S&P 500 had been down more than 7% over the previous month.

Recall that the official schedule had the “taper” fully executed by October, i.e. this was supposed to be the last month of net asset purchases, $15 billion worth, under the QE3 program, after which the Fed would roll over its maturing bonds in order to keep its balance sheet at a constant size.

During Thursday, October 16, the market was again way down. But in the afternoon St. Louis Fed President James Bullard—considered a relatively “hawkish” (anti-inflation) Fed official but who is not currently a voting member of the FOMC—gave an interview to Bloomberg in which he said that the falling (price) inflation expectations should make the Fed consider a pause in the taper. In other words, Bullard was suggesting that the Fed might continue buying net assets after all.2

The stock market recovered much or all of its ground that day, depending on which index you use, and on the next day, Friday October 17, the various indices were all way up—the S&P 500 jumping 1.3% for example.

Thus, at this point there can be no argument that the Fed is driving the U.S. stock market with its asset purchases. The only disagreement is whether this is a good or bad thing.

Proponents will say that the various rounds of QE are helping to prop up aggregate demand and fending off deadly (price) deflation, thereby boosting the “real economy” and causing investors to rationally mark-up stock prices in anticipation of a genuinely stronger economy.

Pessimists, of course, will say that the stock market is poised for another crash—and this one potentially much greater than the last two.

Look at the long-term trend in the S&P 500 for example:

Figure 2_LMR_Oct

How does one interpret the above chart? Did the stock market crash first in 2000 and then again in 2008 because the government failed to prop up aggregate demand, as the Keynesians claim? Or are the Austrians right? Were the prior run-ups in the stock market really just artificial bubbles, which eventually had to pop?

Thus we see the crucial importance of understanding sound economic theory. If you agree with Mises and Hayek that injecting trillions of dollars of new money into the credit system doesn’t create genuine prosperity, then you should be extremely wary of the fate of the stock market over the short- and medium-term horizon. As Figure 2 suggests, if indeed we are in the midst of an asset bubble, then the stock market has a lot of room to crash hard.

From National Private Client Group
Part 1: Key Takeaways

  • Market interest rates serve a definite social function – they are a form of communication to people and often signal the scarcity (or strength) of savings within the economy.
  • Banks cannot create money out of thin air through the accounting practice of ‘fractional reserve banking’ without the equivalent amount of savings to balance what has been created. Credit expansion, such as this, is an illusion and only appears to create prosperity. It is not sustainable.
  • All artificially created booms must end in a crash. While the current boom may be propped up by injections of ‘new money’ – it is not sustainable. This does not create genuine prosperity, only the illusion of prosperity.
  • While the successive rounds of Quantitative Easing appear to have shored up the economy because the Federal Reserve is buying assets to drive the US stock market upward. The question is whether this is a smart move since the foundation under these actions does not rest on true increases in savings and productivity, but on the injection of ‘new money’ into an already unstable economic system.

NPCG Bottomline: The market is being artificially manipulated and you may not be able to trust the signals which the market interest rates are giving.

Please mark your calendar for April 17, 2015 when we will once again present Your Financial Destiny 2015. Dr Robert Murphy will be one of our speakers and you can learn from him firsthand how to read the signals which the market is communicating and the types of actions you can take to protect yourself. If you would like to receive Early Bird information and pre-register for the day-long seminar, please email me at YFD2015.


Dr. Robert Murphy Disclaimers

Every individual is unique. No one knows the future with certainty. I am not in this article providing direct financial advice. Before taking any action, each reader should consult with qualified and properly licensed professionals, especially to consider the tax ramifications of any decisions.

 Let me remind the financial professionals who read the LMR: If you do not have a securities license, then FINRA will not take kindly to you urging clients to sell equity holdings (perhaps to fund the acquisition of a new life insurance policy). It is important that your clients come to you, already knowing what they want to do, without you “finding the money” for them.

The Coming Crash(es), Life Insurance, and Gold

References, Part 1

1. Mises discusses the “crack-up boom” on pages 424-425 of the Scholar’s Edition of Human Action.

2. For the coverage of Bullard’s remarks, see: markets-2014-10-16.

Building Wealth, Knowledge is Power

About the author

Julie Ann Hepburn, is a Private Banking Expert and Financial Coach. She is the founder and principal of National Private Client Group, LLC , a Chicago based financial consulting group. Ms. Hepburn is a licensed finance professional, and serves as an agent and consultant for several major mutual insurance carriers. For full bio, please see:
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