By Marc Faber www.DailyReckoning.com Tuesday, October 19, 2004
Investors should never forget the lessons of the South Sea Bubble and John Law's experiment with paper money, as discussed in Friday's Reckoning. The Mississippi Scheme in particular is relevant to the current situation in the United States; in fact, there are several lessons contemporary investors can learn from John Law's rise and ultimate demise.
It is true that Law's policies were initially a great success, boosting the French economy considerably. In fact, at his peak in 1719, Law was one of the most admired personalities in continental Europe. But the Mississippi Scheme failed, and Law fell from grace because the Banque Royale held for too long the firm belief that it could solve every problem simply by increasing the supply of paper money. When Law finally realized that the enemy was a loss in confidence in paper money and accelerating inflation, the damage had already been done.
There will surely be a time when the present "chain letter" type of fiat money operation practiced by the U.S. Federal Reserve Board will similarly no longer work and lead to a sharp depreciation of the U.S. dollar. The other possibility, of course, is that the dollar begins to depreciate, not compared to foreign currencies, but -- as was also the case at the time of John Law -- against commodities and real assets.
In my article "The South Sea Bubble and Law's Mississippi Scheme" --
-- we look at how the excessive money supply creation by the Banque Royale led to soaring prices for commodities and real estate as the French public realized that the banknotes were depreciating in value.
Concerning real estate, it is very common for prices to continue to rise for some time after a stock market bubble has burst, for two reasons. Once speculators realize that stocks have hit a peak, they shift their funds to another object of speculation. In other words, when the world is engulfed in a wave of speculation, the wave doesn't end abruptly, but tends to carry on for a while and spreads to assets other than equities, such as real estate, commodities, art, etc.
Furthermore, toward the end of a speculative stock market bubble, the smart investors and (especially in the case of the recent high-tech bubble) corporate insiders realize that prices have shot up too much and bear little resemblance to the underlying fundamentals. Therefore, they shift and diversify part or all of their funds into assets that didn't participate in the whirlwind of speculation and are consequently absolutely, or at least relatively, "cheap."
Thus, real estate prices continued to rise in Japan throughout 1990, for example, although the stock market had already topped out on Dec. 29, 1989. And in the case of Australia, real estate prices continued to rise for another two years after its stock market peaked out in the summer of 1987.
Although real estate prices can stay strong for some time after a bubble bursts, as money shifts from liquid assets into real assets, in due course, some kind of a bubble also occurs in real estate, because the property market becomes -- in the absence of a strong stock market -- the only game in town. As a result, real estate prices eventually also succumb to the forces of demand and supply and then follow the declining trend of equity prices.
The Mississippi Scheme and the South Sea Bubble are also interesting from another point of view. The wave of speculation in the period of 1717-1720 spread across the entire European continent, and the subsequent crisis was international in scope. The initial success of the Mississippi Company attracted investors from Britain to Paris, where they speculated in the company's shares. At the same time, many investors from the continent also bought shares in the South Sea Company and other hot new issues in London.
In early 1720, a bizarre reallocation of assets seems to have taken place among international investors. As we have seen, the shares of the Mississippi Company began to collapse in January 1720, but in London, the shares of the South Sea Company had only begun to take off. In other words, British and international investors were in no way perturbed by the collapse of Law's scheme. In fact, in London, the view was that the scheme had collapsed because of a political conspiracy against Law, since he was of Scottish origin.
However, in the summer of 1720, just as the South Sea stock peaked out, speculators moved funds from England to Holland and Hamburg in order to speculate on continental European insurance companies. I mention this because once excess liquidity has been created, money will flow from one sector or country to another very quickly and can lead to a series of new bubbles somewhere else.
For today's investor, however, the most interesting effect of excess liquidity creation is perhaps found in commodity prices. In the future, just as during the Mississippi Scheme, a bull market in commodities is a distinct possibility and could exceed investors' expectations. I have no doubt that the Federal Reserve Board will continue to flush the economy with liquidity, which at some point could spill over considerably into the commodities markets, as it did during the Mississippi Scheme, and also in the late 1960s, which led to a sharp rise in the price of commodities and real assets.
In particular, I want to emphasize that commodity prices can increase sharply under any economic scenario, provided that there is excessive money and credit creation and that investors' confidence in financial assets is shaken. Take the early 1970s, when commodity prices soared, even as the global economy headed for the worst recession since the 1930s. Even more impressive than the rise in the CRB Index was the performance of agricultural commodity prices. From their lows in 1968-69 to their highs in 1973-74, wheat rose by 465 percent, soybean oil by 638 percent, cotton by 317 percent, corn by 295 percent, and sugar by 1,290 percent.
Or take the deflationary Depression years of the 1930s. At the time, the price of silver had been in a bear market since 1919, but made a first bottom at 25.75 cents on Feb. 16, 1931, and a marginal new low on Dec. 29, 1932, at 24.25 cents. From there, however, silver prices advanced to 81 cents in 1935, for a gain of more than three times their lows. In addition, if an investor bought silver in 1929 instead of the Dow Jones, which was then above 300, by 1980, when silver hit $50, he would have realized a profit of close to 200 times, whereas by 1980, the Dow was up by less than three times its 1929 peak.
The most dramatic commodity bull markets all originated after extended bear markets, such as we have had since 1980 and which accelerated on the downside following the Asian crisis and again in 2001, when it became clear that the global economy was in trouble. At issue is the fact that off their lows -- whenever these lows occurred -- commodity prices experienced dramatic upward moves within brief periods.
If the global economy doesn't improve dramatically, it is likely that commodity prices will be boosted, because of further liquidity injections by the monetary authorities as well as expansionary fiscal policies. Moreover, if the U.S. economy and the investment climate for financial assets in the United States don't improve, it is likely that the U.S. dollar will weaken even more.
Now consider this: Investors have little faith in either the euro or the yen. Therefore, if in the future international investors lose confidence in U.S. dollar assets, where will they go with their liquidity?
Take as an example the Asian central banks whose assets are concentrated in U.S. dollars and who only hold about 3 percent of their reserves in gold (down from 30 percent in 1980). If the day should come when their faith in the U.S. dollar is shaken, will they pile into euros or the yen? Possibly, but it is also conceivable that, given the less-than-stellar fundamentals for these currencies, a diversification into gold will be considered.
As a holder of gold shares and physical gold myself, I sincerely hope that there will be genuine deflation in the domestic price level in the United States. In this case, the economic mess will be complete, as the default rate among corporate borrowers will soar. At the same time, the confidence and blind faith of investors in the omnipotence of Mr. Greenspan will finally collapse and lead to a panic. That in such an environment gold prices could go through the roof isn't difficult to envision.
With or without inflation, investors should therefore continue to accumulate gold and silver shares and a basket of commodity futures.
