Curtis Arnold - Inflation's Lessons from the Past

Curtis Arnold is the country's leading authority on inflation and a best-selling financial author. His latest book, HONEY, WHO SHRUNK OUR MONEY? is due out in 2006. Please visit www.curtisarnoldreport.com  for continuing coverage of the perfect financial storm and investment updates. The author is also available for speaking engagements. Contact: curtisarnold@hotmail.com.

Grandsons of Egibi

     Which came first, banking or money? One would expect the answer would be money else why would a bank be required. If we define money as coins used in ancient times, the answer is clearly that banks preceded money. Banking actually began in Babylon more than three thousand years ago – well before the advent of coinage. If you missed that question, here is a chance to redeem yourself. Which came first, banking or writing? The answer, once again, is banking. Expert archeologists unequivocally agree on this point. "Writing was invented in Mesopotamia as a method of book-keeping. The earliest known texts are lists of livestock and agricultural equipment . . . The invention of writing represented at first merely a technical advance in economic administration". . . "Numerous records exist in this script describing the activities of a number of banking houses and the prosperous merchants in Babylon and Nippur after the region became part of the Persian Empire."[i] (Oates, 1979).

In ancient Babylon, the royal palaces and temples were the first centers of banking due to their secure nature. Grain was the main deposit at first, but eventually crops, fruit, cattle, and agricultural tools were accepted. Later, deposits of precious metals were taken in as well. The depositor was issued a receipt, which would, not only allow him to redeem his goods, but that he could give to a third party. The banking operations of the temple and palace-based banks preceded coinage by well over a thousand years. Literally hundreds of thousands of cuneiform blocks that archeologists have unearthed along the Tigris and Euphrates have confirmed simple banking operations. Many of these blocks depict deposit receipts and monetary contracts.

Banking houses preceded coinage by several hundred years – the reverse of what we would later see in European monetary development – and the oldest banking house that we know of dates back to the seventh century BC. Frankly, if it sprung up in my town, it might require a public relations firm to spruce up its image. It was called: Grandsons of Egibi. They offered a wide range of banking service, including checking. (History is not clear whether that was "free checking" and whether the bank offered toasters for new accounts.) The Grandsons had a good run--about 200 years--but then disappeared from the scene. The void left by the Grandsons of Egibi was quickly filled by the young and aggressive upstart bank, Sons of Maraschu. These boys took their bank in many different directions. In addition to what we would consider traditional banking operations, the Sons expanded the bank’s operations into jewelry, canal building, the renting of fishponds, and beer distribution.

Banking looked a lot different in ancient Egypt. In Egypt, grain was king. It was their primary medium of exchange. Banks in Egypt looked more like warehouses. You would take your grain there, store it, and leave with a receipt for how much you had in the warehouse. You could give that receipt to someone else if you wanted to and the grain would then be his. The Greeks introduced coinage to Egypt but the Egyptians much preferred their grain system, which was most prominent during the third century BC. The use of this system had advantages over carrying grain around with you and even had advantages over coinage. It was said that payments among the citizens could be effected by the grain bank making account notations without money passing from one to another. Paying one’s debts through the bank had the additional advantage of officially recording the transactions, thus providing evidence in case of disputes. 

Ancient Greece, on the other hand, was a land where coinage, not grain, was king. As a result, banking developed as a way to supplement coinage and not to displace it. There were really two types of bankers in Greece. Moneychangers were the first. Because of the great variety and quality of coins in the region, moneychangers were always in demand. They were the only bankers that the public met. Merchant bankers were the second type of banker. They were more likely to make larger transactions and dealt primarily with the rich. These bankers would sometimes engage in the practice of "bottomry," whereby money was lent to merchants and ship owners engaged in overseas trade. Bottomry was the riskiest of all loans and commanded the highest rate of interest. Greek bankers kept safety deposit boxes for customers’ valuables, and offered interest-bearing current accounts. Like modern banks, Greek bankers would use these funds to make loans, providing that a borrower could put up some form of security such as precious metals or slaves.

Although Athens was the original center of banking for Greece, the island of Delos over took it in the third and second centuries BC. As you may remember from your history lessons, Delos is home to the temple of Apollo. For greater protection, treasures were stored in sealed jars, labeled, and then put into chests. Credit receipts and payments made on simple instructions, with accounts kept for each client, did the banking at Delos.[ii] The real historical importance of Delos was that it provided a link between Greek and Roman banking. Italian merchants first came to Delos for trading purposes but later settled on there and became some of the most important bankers in the city. As contact between these Romans living on Delos increased with the early Roman Empire, the Bank of Delos became the model most closely imitated by the banks of Rome.

Banking made no real strides during the Roman Empire, primarily because coinage played such a significant role in monetary affairs. Banking was actually more sophisticated in Babylonia because that empire existed prior to coinage. In Rome, mints dominated the financial scene and were solely under the control of the emperor, who had little incentive to change the system. Banking in general was relegated to money changing, and was decentralized throughout the empire.

The Lombards

After the Roman Empire collapsed, nearly all of Europe was either dismantled by warlords or ravaged by plagues. Most of the banking knowledge developed in ancient times was completely forgotten, and disappeared. Mankind had to invent it anew a thousand years later. One of the primary obstacles to the redevelopment of banking was the opposition by both the church and the state of the imposition of interest. Charging any interest at all for a loan was deemed usury and punishable by a large fine. The fear at the time was that less scrupulous individuals would exploit ordinary village craftsmen and farmers. It was not until the 16^th century that the official attitude began to change, although merchants and moneylenders had been breaking this law for quite some time.

Once commercial money lending took hold in an area, it prospered. Early city-states that embraced the practice were Milan, Genoa, and Venice. Italian bankers then spread their business throughout Europe where it took hold and prospered first in Antwerp, then Amsterdam, and finally London. This Italian banking group, known as the Lombards, opened branches throughout Europe and laid the groundwork for modern banking. Foreign exchange facilities developed along with regular deposit banking and loan availability for ordinary business activities. Some of the best customers were not only princes and wealthy merchants, but also municipal and state governments. Early major banks included the Bank of Barcelona (1401), the Bank of St. George in Genoa (1407), the Bank of Genoa (1585), and the Banco di Rialto in Venice (1587). These banks operated branches in all major European centers including London. We must credit the Italians with the invention of modern banking. Indeed, our modern word, bank, is derived from the Italian word for bench, banca. It refers to the table or counter where moneychangers conducted their business.

  The next major center of banking became Antwerp, which dominated the business during most of the sixteenth century. In the early 1600s, the torch was passed to Amsterdam. The Bank of Amsterdam, founded in 1609, was the dominant bank at the time. Some years later, London became the world’s leading financial center, but the British were slow to develop modern banking for several reasons, the most important possibly being Henry VIII, who even as late as 1521 was still defending the Seven Sacraments and opposed to usury. The fact that other European banking operations offered their services in London gave the English no real need to develop their own. Finally, gold and silver tokens were the only currency handled by the majority of the population, and goldsmiths could handle the banking needs of most of the community.

     Oddly enough, scriveners, not goldsmiths, emerged as bankers in England. A scrivener was somewhat like a notary republic. He was a clerical expert with legal training and his duties often involved drawing up contracts, wills, and mortgages. As trusted advisors, scriveners were also involved in tax farming. Tax farming is a system where a group of rich individuals would pay a license fee to the king for the right to collect duties and taxes locally. The scriveners would collect the taxes, deduct their commission, and send the rest to the king. Because some people could not pay their taxes, the scriveners lent out their excess commissions, thus developing into bankers. 

The First Inflation

In the ancient world, there were no ATMs, no credit cards, no checks, and not even any paper currency. Money exchanged hands by way of coins. Coins were made of gold, silver, and bronze. Like today, gold coins were the most valuable, then silver coins and finally, bronze coins. The primary need for coins in ancient times was to pay soldiers in the great civilizations’ massive armies. Soldiers in ancient times were highly trained and well paid. The might of the army was the sole determinant in the continued existence of the civilization, and therefore, a well fed and well paid army was a top priority. If soldiers were not paid, they would simply ride off into the sunset.

22 Centuries of World Dominance

The Roman Empire existed for twenty-two centuries, dating from 753 BC to 1453 AD. To put that in perspective, the Roman Empire existed for nearly ten times as long as there has been a United States of America. Imagine what we can learn by studying their history. The Roman Empire was vast, including of course, all of Great Britain. The Roman Empire expanded for over two thousand years by following a proven formula. Roman armies would conquer a territory, and force their enemies to turn over all their wealth (mostly precious metals). The men were enslaved and sent off to mines to extract even more precious metals. Thus, as the Romans conquered more lands, the empire grew ever wealthier.

Problems began to occur when the Romans ran out of territory to conquer. The empire stopped expanding and the money supply (precious metals) was not able to keep up with demand. The soldiers required pay. Moreover, by then the Romans had built a large infrastructure, which was costly to maintain. The size of government had grown enormously as well. In Rome, some 200,000 people existed on welfare. The population, especially in urban areas, had grown substantially, and Rome found itself needing to import as much as 150,000 tons of grain (mostly from North Africa) every year. To make matters worse, many of the richest mines had been nearly depleted.

The debasement occurred initially in the bronze coinages, and eventually silver. Gold coins, for the time being, remained relatively untouched.  Interestingly, the lower classes and poor primarily used the bronze coins, and therefore suffered most from the debasement. The debasement affected the wealthy--who kept their money in gold—far less. Despite occasional progress in stemming the tide of inflation, the debasement continued. Scholars argue that those in power courted power with the masses by, in effect, creating a welfare state, and that these subsidies were a major factor in the downfall of Rome.

   By 250 AD, the silver content of coins was down to 40 percent. By 270 AD, the silver content had fallen to only four percent. In 305 AD, the powerful emperor, Constantine, reformed the currency and gave the empire a new lease on life by conquering lands in the east, exacting a high tribute and bringing in much needed gold and precious metals. Additionally, he also increased taxes, which further added money to government coffers. Eventually, however, these sources could not stem the tide brought about by the factors mentioned earlier, and the debasement and inflation continued. Therefore, while it is true that Rome eventually fell to barbarian invasions of the 5^th century, the underlying cause of the fall of this great empire was inflation caused by excessive spending—primarily on welfare—by a long succession of emperors.

Too Much of a Good Thing

      In the 1500s, Spain was the greatest and richest empire in the world. It controlled most of what is now Italy, the Netherlands, the Philippines, the West Indies, Central America, and most of South America. The 1500s were considered the Golden Age in Spain in both literature and painting. What caused this empire to flourish was the large amount of precious metals (wealth) brought into the country from other nations. The large part of this wealth was in the form of silver, which came from mines in Mexico and Peru.             

     At the time, Spain believed in the mercantilists’ idea that precious metals were the true form of wealth, and that accumulating precious metals should be the number one priority of the state. To that end, they engaged in mining, piracy, and conquest. The wealth enriched Spain's royalty and the church. It outfitted the armies and navies, and it allowed for the import of exotic goods from the East.

As more silver came into the country, prices began to rise. Wage earner grumbled, as did exporters who found it difficult to sell in foreign markets. But no one really understood that the source of the inflation came from the abundance of silver, which was thought to be wealth. More units of the precious metal were required to buy the same amount of wheat or a quantity of labor, and so the prices of both increased. The higher price of wheat--traded internationally--affected both neighboring France, and to a lesser degree, England. Thus, Spain unknowingly exported its inflation to its neighbors.

Spain's biggest mistake was its assumption that precious metals alone would make them a powerful country. Flush with wealth, they failed to invest in basic industry and productive enterprises. Instead, Spain spent the vast majority of the wealth on its military, engaged throughout the world. They spent the rest on ornamentation, shrines, and other excesses of royalty. By 1600, the well had run dry due to a diminished flow of silver from American mines. As was the case with Rome, revenues no longer kept pace with the fixed expenses of the government and social structure, prompting a long decline of this once great empire.

Mercantilists

      When England rose to ascendancy as a world power in the late 1500s, they remembered how the Roman Empire had crumbled and were determined to build stockpiles of silver and gold. Thus, they created a principle called "bullionism," which dictated that the country should bring in as much bullion as possible. To achieve their goal, they engaged in an occasional war, piracy on the high seas (e.g. Sir Francis Drake and others), and foreign trade. As the spoils from wars and piracy lessened, foreign trade became their main source for accomplishing their goal. The term "mercantilism" came into play to describe that process.

      While many economists of the time clung to the idea that England should husband its bullion (bullionists), a new theory about "balance of trade" began to gain prominence in the early 1600s. Mercantilists believed that excessive imports should be discouraged and that the exchange rate should be kept as high as possible. In the booklet, The Circle of Commerce or the Balance of Trade, written in 1623, the term "balance of trade" first appeared in print. A positive balance of trade, the goal of the mercantilists, means that the nation receives more money from its exports than it spends on imports. This concept is important to understand because it affects the value of our dollar in today’s world, and the value of the dollar can affect our inflation rate. We will learn how in a later chapter. Given the ancient world and European background we have studied, we will now see how America used this world knowledge in their struggles with currency and inflation.

The Colonies

Prior to the American Revolution, colonists used furs, wampum (raw shells), crops of wheat and tobacco, Spanish and Portuguese coins and British guineas to transact their business with one another. In 1715, seventeen different forms of money were declared legal tender. It was a chaotic system and money of any kind was scarcer than the rapidly growing population. The individual colonies then decided to print their own money. The first one to do so was the Massachusetts Bay Colony in 1690. The initial need for the currency was to pay soldiers - in this case, soldiers who had been on an expedition to Quebec. This new legal tender could also be used to pay taxes and was convertible to silver and gold. Nearly all the colonies got into the act of printing their own currency, some with more abandon than others. In fact, South Carolina and Rhode Island printed so much currency that the currencies had lost nearly all of their value within twenty years.

The capriciousness with which the colonies printed currency eventually forced the English Parliament to restrict and eventually ban the colonies altogether from printing money. The Bubble Act—legislation arising from the South Sea Bubble which stated that only companies legally authorized to do so could engage in currency printing—was used to support their actions. The final, all-inclusive ban on issuing legal tender came in 1764. After that, the colonies were short on cash, even though the British were raising taxes.

As you can guess, once the Revolutionary War began, the colonies geared up the printing presses to pay for the war. Where else would they get the money? They certainly could not tax the colonists taxes were one of the reasons they declared war! When the first paper note rolled off the presses, it was called the "Continental." Congress had given its OK on June 22, 1975. At the same time, individual states issued their own notes. In fact, the total supply of notes was so great that inflation took off at a runaway clip. The government bid goods away from civilians, thus forcing up prices and diverting material from peacetime to wartime use. While harmful to civilians, the government needed to pay the army and equip itself for war.

Inflation took its toll on our first official currency. Within a year, the value of the Continental had begun to fall. The impact of the inflation was similar to what we had seen during other inflations. The inflation affected some more than others. One author of the time put it this way: "The aged who had retired from the scenes of active business found their substance melting away. The widow experienced a frustration of all her deceased husband’s well-meant tenderness. The blooming virgin who had a liberal patrimony was legally stripped of everything but her personal charms and virtues."[iii]

As in any post-inflationary period, there was hell to pay in the war’s aftermath. By then, the value of the Continental had depreciated by a factor of 100 to 1. The country was left in financial shambles and a depression soon followed the inflation. Unemployment rose and many ex-soldiers were imprisoned for debt. Farmers who had borrowed money at wartime prices were left unable to pay their debts and found themselves facing foreclosure on their farms. Something had to be done. 

In 1787, when the Constitutional Convention convened, reforming the currency was a top priority. Our founding fathers met the challenge when they wrote Article 1 of the Constitution. The clauses that follow literally form the fiscal and financial foundation of our country: (a) "Congress (not the States) shall have power to coin money, regulate the value thereof and of foreign coin (b) No state shall coin money, emit bills of credit, make anything but gold and silver tender in payment of debts and (c) Congress is to have the power to lay and collect taxes, duties and excises, and to pay the debts of the United States." These ideas were the combined effort of Thomas Jefferson, Alexander Hamilton, and Robert Morris, a Pennsylvania banker who had played a major role in financing the Revolution.

In retrospect, we must conclude that in certain emergencies, such as during wartime, the ability to print excessive paper money can be a good thing. Benjamin Franklin, after the war was over, had this to say about the Continental: ". . . And indeed the whole is a mystery even to the politicians how we have been able to continue a war for four years without money and how we could pay with paper that had no previously fixed fund appropriated specifically to redeem it. This currency, as we manage it is a wonderful machine. It performs its office when we issue it it pays and clothes troops and provides victuals and ammunition . . ."[iv] We certainly could not argue with that, but Ben Franklin failed to allude to and what we have to recognize is that government induced inflation spawns unjust financial inequities upon differing sectors of the population. Maybe another way to put it is there is no such thing as a free lunch. Someone always has to foot the bill.

  In 1792, America passed the Coinage Act, adopting the dollar as the official American unit. The government decided that the dollar would be bimetallist – in other words, redeemable in either gold or silver. The actual coin was 15 parts silver and 1 part gold. The government minted copper pennies and half-cents as well. The first mint, built in Philadelphia, began minting coins in 1794. While struggles abounded, our fledgling country got to its knees and started moving forward. Like other civilizations that we studied earlier, America grew by exploration and trade. As we pushed west, massive gold discoveries stimulated the economies of the frontier and brought wealth to the country. Both the money supply and population grew with each passing decade. With the exception of one cyclical downturn from 1837-1843, the country continued to prosper. However, not everyone prospered equally. By 1861, ideological and financial quarreling among the states led to a conflict that nearly destroyed our country.

Money for Nothing

The outbreak of the Civil War required each side to raise money quickly to finance their military efforts. Both sides had only three alternatives: raise money through taxes, borrow money, or print money. Each side used a combination of all three. The Union instigated two different taxes during the course of the war. The first was a direct tax levied on each of the states in proportion to their population. The second was a general income tax. Neither tax was productive in the overall scheme of things. The North also issued bonds as well. In the end, both sides financed the majority of the cost of the war by printing money. The new currency--called "Greenbacks" because of the color of the ink used in printing--was a fiat currency from the beginning because it was not convertible to gold. During the course of the war, prices approximately doubled in the North.

         It is interesting to note that regular dealings in gold began on the New York Stock Exchange in 1862. Manufacturers purchased gold to pay foreign suppliers who would not accept the Greenback. There were, of course, speculators in gold. It was considered patriotic for loyal citizens to sell their accumulated gold and so hold down the premium of gold over the Greenback.

         The Confederates did not fare nearly as well with their financing. Their attempts at taxation were met with stiff resistance, as Southerners in general were even more strongly opposed to taxation. While they were able to borrow some money from France and Spain by using their cotton as collateral, the amounts fell far short of what they needed. Thus, they quickly resorted to printing Confederate notes. These began to depreciate even quicker than the Union’s dollars and, as the war wore on, the increased money in circulation began to chase a diminishing quantity of goods. By the end of the war, prices had increased some 28-fold.

Two Beers, Please

The German inflation of 1922-1923 was a granddaddy of inflations. In Germany, the government in power turned on the printing presses full throttle. Why would they do this? After Germany lost WW I, the country was saddled with huge financial debts that they could not pay. Germany felt it had no other choice but to print money in order to meet its obligations. This soon led to an inflationary spiral that could not be stopped.

If you have heard any references at all to the German inflation, it is likely that you learned about people standing in lines with wheelbarrows of money just to buy a loaf of bread. There are many other references equally as ludicrous. At one point, factories paid workers twice a day. If workers did not spend their money right away, it would lose considerable value. After work, they were known to order two beers at once, fearing the price of the second beer might be higher if they waited until they finished the first. There was a bright side: If someone bought a bottle of wine, he was often able to sell the empty bottle for more the next day than he had paid for the full bottle.

The effect of the inflation, of course, was to wipe out the value of all the savings of the middle class. Economic chaos ensued and along with it political chaos and uncertainty. The German people were thus more than open to listen to a politician who could change their fate. Not long after that, Hitler emerged on the scene. When you imagine all the destruction caused by Hitler in the subsequent two decades, and think that he might never had come to power if the middle class had not been devastated by inflation, you cannot help but be more aware when you hear "money supply" on the evening news.

South of the Border

There were also a number of hyperinflations in South American countries--Brazil, Argentina, Bolivia and Peru to name a few—during the twentieth century. The cause of inflation in these countries was too much debt. These countries, lacking industrialization, were blessed with an abundance of natural resources. They were anxious to boost their standards of living and become like America. The United States was more than willing to help and loaned them billions of dollars. The U.S. believed that the stronger our neighbors became economically, the more our trade with them would benefit. Of course, our banks saw the opportunity to make high interest rate loans.

   It takes more than just money, however, to turn around a third world country. It also requires efficient fiscal policies and governments relatively free of corruption, neither of which was the case in these countries. Regarding fiscal policy, whenever governments must placate the poor in order to stay in office, disaster soon results. Jeffrey Sachs comments, "High income inequality in Latin America contributes to intense political pressures for macroeconomic policies to raise the incomes of lower income groups, which in turn contributes to bad policy choices and weak economic performance."[v]

         The political infrastructure in these countries was simply not mature enough to effectively utilize such large amounts of capital. When world markets realized that, their currencies began to depreciate against the dollar. Once this ball started rolling, it became clear that it would take more and more of their own currency to repay the dollars they had borrowed. There are similarities to the German inflation after World War I. In that case, Germany was required to make large reparation payments to the allies. Not having the money, they used the only solution they could come up with: print money. In the case of the South American countries, although their debts were willing incurred, their solution was the same.

          As inflation heated up, powerful special interest groups found that inflation actually benefited them. Most prominent were influential landowners who had borrowed money from the government at low interest rates and wanted to repay their loans in the future with a depreciated currency. Labor groups also feared job losses if the government reversed course and tightened credit. Politicians usually found it easier to go with the flow than to impose the discipline required to turn back inflation.  Politicians who did not heed the wants of these special interest groups were soon removed from office. For example, in Bolivia--where inflation peaked at 24,000 percent in 1989--there were no less than 15 different Presidents during a six-year period from 1979 to 1985. We will now briefly examine the economic histories of the two largest countries in South America, Brazil and Argentina, to better understand just how crazy it is south of the border.

Brazilian rule began under Portugal in 1500. Portuguese rule continued until a military uprising in 1889. Although a republic was claimed, it is important to note that military dictatorships ruled the country until the 1920s, when the first civilian president came to power. Military coups and dictators continued, however, up until 1985. In 1989, the reigning president was impeached for corruption.

Brazil can lay claim to having the longest, continuous recorded inflation of any country in history. Since 1937, prices increased in all but one year. During a very long stretch, 1951 – 1982, the average annual increase was a whopping 37 percent.[vi] The basic cause of the Brazilian inflation, as in the cases previously studied, was the extraordinary monetary expansion each and every year. Quite to the amazement of most economists, however, this constant influx of new money into the economy, while inflationary, accommodated rapid growth for decades. In fact, since the 1950s, the GDP of Brazil has grown at almost double the pace of the U.S.

    One of the strategies that the government employed to promote growth was to charge a very low interest rate to industrial developers. The rate charged would always be less than the rate of inflation so developers could borrow at a negative real interest rate. This low rate of interest combined with government subsidies put the developers in a position of profitability, even if their projects produced losses.

    In each known instance, whenever a country experienced inflation rates as high as Brazil’s, it was doomed to failure. So how did Brazil managed to continue to grow with such outlandish inflation? One way was by using a device called "indexing." With indexing, as the government prints more money, it adjusts the prices of everything to accommodate the increased money supply. For example, if the government increases the money supply by 60 percent, it then dictates a new price level 60 percent higher for all essential goods such as wages, rents, insurance, etc. Thus, the public feels as so there has been no real change.

During the 1970’s, like many Latin American countries, Brazil borrowed heavily from U.S., European, and Japanese banks. Much of the money went to expand certain sectors of the economy such as the automobile industry, petrochemicals, and steel, as well as into the initiation and completion of large infrastructure projects. Brazil grew rapidly during this period. However, in the 1980s, interest rates around the world surged, making it difficult for Brazil and other Latin American countries to pay their loans. With capital no longer flowing into the country, growth rates turned negative. It was time for Brazil to face some hard economic realities and make much needed reforms. They suspended payments on their debts to foreign countries, froze prices, and abandoned their indexation policy. They accepted trade liberalization, deregulation, and privatization.

While the economic reforms helped, inflation remained stubborn. In 1994, Brazil replaced its currency with a new one, the Real. For a while, prices stabilized. In 1999, the government unhitched the Real from the dollar and allowed the currency to float. An important piece of legislation, the Fiscal Responsibility Law, was enacted which established limits for expenditures by the government. As of late, inflation rates have been just under ten percent – high by our standards but benign when compared with Brazil’s inflationary history. As of 2003 under the presidency of Lula da Silva, the economic reform program recommended by the IMF (International Monetary Fund) was on track.

In South America, Argentina is second in size and population only to Brazil. In the areas of fiscal mismanagement and inflation, however, Argentina wins easily. How did it all get so bad? To understand, let us briefly review its history. Argentina developed under Spain’s colonial rule for almost 300 years before declaring its freedom in 1810. Because the inflations we are going to examine did not occur until the 20^th century, we will skip ahead and pick up the story after WW II. Juan D. Peron was elected in 1946 and held the Presidency with his wife, Eva, by his side from until 1955. At that time, a military coup overthrew his government and exiled him from the country.

Peron later returned to power with a new wife (Eva died in 1975) as his Vice President. After Peron died in 1974, his current wife, Isabel Martinez de Peron, became the first female head of state in the Western Hemisphere. By 1975, the inflation rate in Argentina was 355 percent and the country was on the brink of economic and political collapse. Another military coup took place and martial law was imposed. These military coups are rarely a good thing in South America in this case, there were 2300 political murders and 10,000 political arrests. Another 30,000 people just seemed to disappear without a trace. Military leaders came and went over the next several years. In 1982, Argentina was invaded the Falkland Islands (a British territory). Britain quickly squashed this nearsighted military campaign, leaving Argentina with an unprecedented foreign debt and an inflation rate approaching 900 percent.

Argentina continued to burn through military leaders in the 1980s and 1990s, but the economy just kept getting worse. (My guess is that soldiers do not take many credit hours in economics at these South American military schools.) By 1998, Argentina had fallen deeply into recession. In 2001, the IMF came to the rescue with almost 22 billion dollars of emergency aid. Argentina was near economic collapse. It defaulted on 155 billion dollars of foreign debt and devalued the peso, the country’s currency. The devaluation caused much of the savings of the middle class to be wiped out. A new president, elected in 2003, has declared war on corruption and vowed to reform the courts and police. We will see. Corruption seems to be a common theme in Latin American countries, and when those in power are stealing the country blind, you really cannot expect the economy to run smoothly. Argentina still owes over 100 billion dollars to foreign creditors. Who is going to lend them money with their record of accomplishment? Once a country destroys its credibility in the world, it takes a long time before trust can be regained.

Meet the Manias

Just as it is important that we understand how inflation works, as investors who wish to protect our money and profit whenever we can, we need to understand manias (bubbles) as well. While Japan experienced a bubble in the 1980s, for the most part Americans were unaffected. America had not experienced a bubble since the stock market bubble of the 1920s, and prior to that, the Florida land boom earlier in that decade.

Since practically none of us living in the 1990s were alive to experience those bubbles, we had never really learned the lessons of the past when the Internet stocks and the entire NASDAQ rocketed to unsustainable heights in the late 1990s. The stock market crash in 2000 and subsequent bear market affected nearly all Americans to one degree or another. I personally know many people who were bankrupted.

While in hindsight, bubbles seem obvious, while you are caught up in the world wind, human emotions (primarily greed) take over. The fact is that there is a lot of money to be made in bubbles – fortunes in fact. The hard part is judging when to get out. Because prices in bubbles rise the fastest near the end of a bubble, staying in as long as possible can make the difference between a good trade and making a small fortune. We have all been through the NASDAQ bubble and we are now in a real estate bubble. However, let me assure you, people are making fortunes in the real estate bubble. A good portion of this book will examine the real estate bubble so I will leave the details for later. For now, let us educate ourselves about some other bubbles in history.

Tulip Mania was the first nationwide mania in history, occurring in Holland in the 1630s. During that time, the growing of tulips was a thriving industry and demand from Paris society for their beautiful and unique blooms was insatiable. Flamed and striped blooms were particularly fashionable, and the more rare the specimen, the higher the price the bulbs would bring. Since futures markets, trading primarily tea and pepper, had already been established in Holland, it was natural to trade tulip bulbs on the futures markets as well. Each season, there would be an auction for the bulbs so speculators could wager, by way of futures markets, what different types of bulbs would bring.

  The fact that nearly anyone with a small parcel of land could grow tulips made the industry accessible to the public and fueled the frenzy. Even local pubs held their own informal futures markets. Nearly everyone speculated, almost as people bet on major sporting events today. Credit was readily available, allowing almost the masses to get in on the action. Many people put up their houses and personal goods as collateral. During one auction, prices of average bulbs had increased by twenty times since the last season’s auction, while a few of the more rare bulbs had increased as much as two hundred times.

As is the case in most manias, there is never a clear reason why prices stop going higher and instead start to fall, but in bubbles or manias, that is always the result. Tulip Mania lasted only a few years. When it finally burst in 1637, prices plunged 95 percent. While subsequent economic damage to the country as a whole was minimal, who knows how many individuals may have suffered financial ruin.

The next bubble occurred in England during the late 1600s. For the first time in history, England had created a national debt. Until then, banking systems had not developed the sophistication needed to allow the government to sell bonds to the public. Now, for the first time in history, the government had sold bonds and annuities to the public. A man or woman approaching retirement might give the government their life savings in return for a monthly interest payment for life. All was well and good.

The South Sea Company was a very successful private company (the Microsoft of its time) that made its money from worldwide trade. One day they decided to put all their extra cash to work by buying the government's debt. Instead of interest payments, owners of the debt would be issued shares of South Sea Company stock. Since the stock was paying very high dividends and was appreciating rapidly, the public thought they were getting a good deal and rushed to convert their government bonds and annuities to South Sea Company stock. Easy credit allowed nearly everyone to join the cause, and the stock shares soared in price. Imagine taking your IRA, invested safely in annuities, and putting it all in AOL stock. Eventually, some investors began to see that the stock looked terribly inflated and those investors began to sell. The selling fed upon itself as people rushed for the exits. Before the selling was over, thousands of people had lost their lives’ savings. How similar does this sound to the Internet bubble almost three hundred years later?

The Mississippi Bubble is synonymous with the name of one man, John Law. During the early 18^th century in France, John Law was considered a brilliant financier, and held the title of Minister of Finance. Law rejected mercantilism. He argued that there simply was not enough silver and gold in France to sustain and grow the economy, and it was only logical that the government print paper money. Given his reputation, the French government gave him the authority to create a bank that would issue a currency backed by gold and fully redeemable upon demand. The early effect on the economy was positive, and the added liquidity helped the country pull out of a looming depression. As is usually the case, however, the money printing got a little out of hand. In a year, prices had doubled.

It was his next scheme that led to the eventual bubble. In 1717, Law created a private company called the Mississippi Company and bought the national debt just as the South Sea Company had done in England. Within two years, the company merged with the French East India Company and the French government granted it a monopoly to carry on trade with the East Indies and China. With the initial success of the company, the newly issued currency was now chasing, not only limited supplies of silver and gold, but also stock in the Mississippi Company. During 1719 alone, shares increased by twenty times. Interestingly, it was during this time that the word "millionaire" was coined. Law promoted the company with extensive advertising, claiming that Louisiana held vast wealth in the way of mountains filled with silver and gold. Of course, nothing could have been further from the truth.

When share prices got out of control, the government tried to "fix" the share price at a lower level. This idea, of course, drew enormous wrath from public speculators and the government soon backed down. It was enough to put doubt in the public’s mind, however, regarding the true value of the shares they had purchased. Next, Law initiated an edict that the currency was no longer convertible, even at a reduced ratio, to silver and gold. What precious metals remaining in France sought refuge elsewhere, leaving the public only with a rapidly depreciating currency and shares of stock in the Mississippi Company. As word filtered back from the States that Louisiana was nothing but one big swamp, panic selling ensued and the John Law's house of cards fell apart. A popular song of the day epitomized the public’s mood.

My shares which on Monday I bought
Were worth millions on Tuesday I thought.
So on Wednesday I chose my abode:
In my carriage on Thursday I rode
To the ball room on Friday I went
To the workhouse next day I was sent.[vii]

While the French government did not send John Law to the workhouse, they did exile him from France without his family, and eventually died in poverty. France was in financial shambles, and it would not recover throughout the rest of the century. John Law's experiment taught us, not one, but two lessons. The first is that a currency without backing of some type is essentially a fiat currency - i.e. only as good as the promises of the government that prints it. The second is that a bubble exists when speculators bid up the price of shares or a commodity beyond its fundamental value in expectation that it will at some time in the future produce an income that will more than justify the price paid. As we learned, that rarely occurs.

Turning Japanese

While we can learn something from each of the three bubbles or manias that we just studied, Japan's bubble—first in stocks and then in real estate—hits even closer to home. Not a bubble that occurred centuries ago, Japan's bubble is not only recent but also broad in scope. In the 1980s, Japan was on its way to becoming the wealthiest, most sophisticated country in the world. A decade later, its wealth had been cut in half. How did it happen and what can we learn from the Japanese experience?

If we look back to the initial cause of Japan’s inflation and ensuing economic bubble, we might be shocked to learn that the blame could be put on Richard Nixon, who, as we learned earlier, closed the gold window in 1971. In today’s world, monetary actions of any one country can have an extreme effect on others. With the financial power of the United States and the dollar now being the de facto world currency, it is often said that when the U.S. sneezes, the rest of the world catches a cold. After the U.S. went off the gold standard in 1971, much of the world preferred to own Yen instead of dollars. The Yen, therefore, began a slow but steady climb in value relative to the dollar. With the Yen priced higher than before, Japan was less competitive in the world market and it became more difficult for their companies to export products to the United States. Because Japan depends so much on its exports--electronics, TVs, automobiles--it needed to do something about it. What it did was to print more Yen and buy dollars with the newly created fiat currency.

In hindsight, that was not a good idea, but it would be almost two decades later until people figured that out. Japan's printing presses began to roll, slowly at first, but by 1973, money supply was growing at 25 percent a year. There is always a lag between money supply creation and inflation, and in this case, that lag was almost two years. However, as you and I could have predicted, by 1975 Japan was experiencing an inflation rate of 20 percent. Remember, the initial response to an increased money supply is always good the economy has receives a shot of monetary adrenalin.  Probably a more accurate metaphor for the effects of money supply--one that takes into account both its subsequent effects as well as its present effects--would be to compare it to alcohol.

When an alcoholic starts drinking, he first experiences a sense of euphoria and well-being. When the effects began to wear off, he can get them back by drinking more. Nothing bad happens for a long time. In the case of economies, printing money allows governments to spend more money without raising taxes. The added money in circulation improves business conditions because everyone has more to spend. Employment picks up because business is good and businesses can afford to hire more employees. Everyone is happy at first, and that is why inflation is such an easy, if shortsighted political remedy. We will return to this metaphor when we finish with Japan, but for now, let us go to the party that was once called Japan Inc.

As money built up in the Japanese economy, two areas that benefited were real estate and the stock market. The demand was so strong for commercial real estate that land prices shot up 45 per cent in one year. As real estate prices soared, lenders were more than happy to lend on the new higher valuations. Corporations were able to borrow on their land holdings to invest more in their companies. Money also flowed into the stock market, which rose 500 per cent between 1971 and 1985, and then tripled in only five years. In the 1980s, the Japanese economy was the most successful the world had ever seen. If you were alive at the time, you may remember the outrage in America when the Japanese literally started to buy our country piece by piece. They bought much of our government debt, commercial properties in major cities, the Exxon Building in Rockefeller Center, and even Hollywood studios in California.

Then, in 1985, a meeting took place of several of the world’s top finance ministers, and an agreement was made that would prick the economic bubble of Japan. The major industrialized countries--at the urging of the U.S. Treasury Secretary--literally gained up against Japan, but this time, instead of using military tactics as in WW II, they employed financial tactics. Their strategy was to drive the value of the dollar down against the Yen. Since their meeting took place at the Plaza Hotel in New York City, the agreement was later called the Plaza Accord.

As the Yen rose in value, the Japanese found it more difficult to sell their exports, especially in the United States where, within just a few months, Japanese products were costing nearly double what they had prior to the Plaza Accord. The bubble had been pricked, and when air starts to escape from a bubble it is difficult to stop and impossible to reverse. As you would expect, the effect of Japan’s reduced exports was a sudden drop in its GDP. As their economy slowed, the Bank of Japan cut interest rates four times in a year. As you know, cutting interest rates expands credit and thus has the same effect as printing money. It worked. Just when it seemed like the show was over--as evidenced by corporate profits already in decline--Japan Inc. took off with renewed vigor.

Buoyed by the liquidity surge from the credit easing, both real estate and stock market prices rocketed higher. At one point, the value of real estate in Japan was estimated at four times that of America. In the late 1980s, the value of commercial properties tripled. Please note that what Japan was experiencing at this time was "asset inflation" and "credit inflation." In 1989, the official rate of inflation was only three per cent, very similar to what we are experiencing at the time of this writing in the United States. Asset inflation means that the price of an asset--in this case stocks and real estate--becomes inflated. Credit inflation means that, instead of printing money, credit is extended. The net effect is the same. Credit inflation carries the same implications both on the upside and downside as does monetary inflation.

Residential property prices increased rapidly too, so that 100-year mortgages were required in order to keep payments affordable. Those that owned property often borrowed against it to invest in the stock market. Stock prices went hyperbolic, the Nikkei tripling during the next five years. The Japanese, traditionally a country of savers, went on a borrowing binge. However, borrowing is not the same as income and, unlike income, borrowing eventually has to be unwound.

For example, assume that my house has just doubled in value. I decide to borrow $100,000 against my equity. I take that $100,000 and use it to buy a boat. Thousands of other people do likewise. The boat builder can hardly keep up so he leases more space, buys new boat building equipment, and hires new employees. The boat builder has no idea that all his customers’ borrowed money to buy his boats, nor does he probably care.

However, if his customers at some point in time lose their jobs and can no longer afford their second mortgage payment, they will need to sell their boats. With thousands of nearly new boats on the market, however, he will quickly feel the impact on his sales. He will need to lay off workers himself and may even lose his business if he is not able to make the payments on his new boat building equipment and pay for his newly leased space. As we will soon learn, when the bubble economy imploded in Japan, 5000 companies declared bankruptcy.

By 1989, the Bank of Japan had to admit that the rise in real estate prices was turning into a bubble, and they began to worry about loaning money. To slow the buying, they raised the discount rate by three-quarters of a point. They continued to ratchet the rate higher until, by the end of the year, it stood at 3.75 percent, having been at 2.5 percent in the spring. Short-term rates now stood at 6.25 percent.

There is always some point in the interest rate spectrum that will stop a market in its tracks, and 6.25 percent on short-term rates proved to be the magic number. Stocks buckled and the Nikkei saw its peak at 38,915 by the end of 1989. Despite a sharp correction, investors were not convinced that the bull market was over. Unemployment was low and so was inflation. The public at large was still in a bullish mood, especially when it came to real estate that continued to move higher despite the initial interest rate hikes.

To thwart real estate speculation, the Bank of Japan again increased the discount rate--this time to 5.0 percent--in March of 1990. The stock market continued lower under the pressure of higher rates, and the first cracks in the real estate bubble began to appear in expensive big city real estate. By 1991, businesses were feeling the pinch and 5000 companies went bankrupt. By 1993, all property values were down by 50 percent. Many of you reading this book lost money in the U.S. bear market of 2000. However, depending upon where you live and how tech oriented your portfolio had been, you may have more than made up your losses with real estate appreciation. Imagine, instead, that in addition to stock market losses, the value of your house was cut in half. That was the predicament many Japanese found themselves in by 1993.

The drop in property values made one trillion dollars in loans uncollectible. The banking system collapsed under the debt and required a massive government bail out. Interest rates were ratchet down, but it was too late. With life savings wiped out and asset prices dropping, no one wanted to borrow money at any price. Consumers hoarded any money they could get their hands on. Why would someone want to buy durable goods today when he could buy it cheaper next week? (Just the reverse of what we witnessed in the German inflation.)

Unemployment climbed from nearly zero to 5 percent. While not high by our standards, Japan is accustomed to almost full employment because they have the oldest population in the world and their work force relative to the population is very small. Companies that survived cut overtime and slashed benefits. While it is customary in Japan to keep your job for life, employers tried to force workers to resign voluntarily using humiliation and harassment techniques, such as pay cuts and nonsense assignments. One business thrived during the 1990s, however. Psychiatric clinics found a plethora of new clients suffering from depression. In fact, so many peopled were jumping in front of subways that the government installed mirrors in the subways at frequent intervals with signs that urged any who were about to end their life to look in the mirror and reconsider.

Overall, it does not sound too good does it? Welcome to deflation. If you thought inflation was a bad thing, you definitely do not want to experience a deflation. Neither does our government. That is why Greenspan was so quick to lower interest rates after the NASDAQ crash. Trying to avoid inflation on one hand and deflation on the other is like walking a tightrope. It is important that you understand the evils of deflation and learn to recognize its signs because it is something that you may need to deal with in the future.

Some argue that the similarities are eerie. Graphs of the Nikkei vs. the NASDAQ are almost identical, with our market displaced ten years ahead. Just as in Japan, real estate prices in the United States have continued higher, even after the NASDAQ crash. Federal Reserve policy can often tilt the scales in favor or inflation or deflation. Although the Fed tries to steer a course down the middle, their actions sometimes resemble a car swerving down a mountain road. If they over steer or under steer, the economy goes over a cliff. Because the Japanese experience is such a recent memory--and because Alan Greenspan has stated as much--I believe that the Federal Reserve would tend to over steer in the direction of inflation rather than risk deflation. After all, deflation is practically synonymous with depression whereas inflation, for a period, benefits much of the economy.

The problem is that once inflation becomes imbedded in the economy, so do inflationary expectations. An inflationary premium is then added to everything we buy. For example, if automakers know that the cost of labor is going up, they will raise car prices to try to bring in an extra profit to pay for the upcoming wage increases. Every business acts the same way so that an inflation premium--due to expectations of higher costs--gets built into the economy. Inflation then takes on a life of its own. Even if the government does stop goosing the economy, inflation will still go higher on its own.

Only when the government takes steps in the opposite direction—e.g. hiking rates or using any of the other tools at their disposal--will inflation give up. As we learned in Chapter One, when inflation is still present but declining, it is call disinflation. Disinflation is not a bad thing, but like inflation, it can take on a life of its own as well. If consumers or businesses believe that prices may not be higher in the future and possibly lower, they will hold off on purchases. The economy then begins to slide as consumer spending and capital spending declines. At this stage, the Federal Reserve attempts to control the slide and ease the economy into a "soft landing." If they are not successful, disinflation turns into deflation (when the CPI goes below zero) and we experience the same hell as Japan did throughout the 1990s.

The most important thing to understand here is that inflation always leads to deflation. If I am right and we see inflation first, there will be a window to opportunity to make money and that is what the latter part of this book is all about. The time to make hay, however, will be short. You will not simply be able to make inflationary bets and walk away. You will need to be vigilant and alert for signs that the party is ending and a long hangover is about to set in. It will then be time to batten down the hatches.

Another important lesson to learn from the Japanese experience is that, although inflation kicked off the boom, inflation itself was well under control prior to the stock market and real estate prices going ballistic. Instead of textbook inflation, we saw subtle credit inflation, followed by asset inflation. The asset inflation was indeed a mania. Now do you see why we studied, not only historical inflations, but bubbles and manias as well? It is because we do not know what we will encounter ahead. We need to be able to recognize a particular condition when we see it, and understand its most likely outcome.

It is important that we not only monitor monetary policy with regard to money printing but that we also keep our eyes on what is happening with credit in order to get the complete picture. There is no doubt that the real estate boom, which began in earnest shortly after the NASDAQ crash, has been largely a boom financed by easy credit. Pundits worry that if interest rates rise, the housing boom will end. That is certainly a 64,000-dollar question and one we will explore in detail later in the book.

Back in the U.S.A

We left off with our abbreviated economic history of the United States after the Civil War. The next major event we will look at is the Great Depression, and we will examine it only in passing because the Great Depression had little to do with inflation per se. In fact, our interest in the Great Depression has more to do with our interest in Federal Reserve policy. In 1922, the Reserve Banks were given the authority to regulate credit conditions by buying and selling government securities, and in 1924 they used that authority to simulate the economy. Granted, they overdid it somewhat. An economic boom, which got out of hand, occurred shortly thereafter. Speculation had run rampant, the first example being the Florida land boom and later, the overheated stock market. For the first time in history, one could buy stocks on margin, a policy that encouraged even further speculation.

Public optimism, a necessary component of all booms, ran high in the 1920s. For the first time, even ordinary citizens could afford automobiles. In ten years, automobile ownership had tripled. The 1920s also witnessed the spread of electricity, formerly only found in big cities, to the entire country. Homemakers enjoyed modern conveniences like vacuum cleaners and washing machines. Most importantly, the expansion of radio, led by NBC in 1926, gave the country a sense of culture and unity not known before.

            In October of 1928, Benjamin Strong, the much-heralded head of the Fed, passed away, leaving the institution divided and leaderless. The Fed failed to tighten credit when they had the chance. As we have learned, all speculative frenzies end, and the end of this one was to occur on October 29, 1929, the date of the stock market crash, which marked the beginning of the Great Depression.

Having failed to tighten credit when they should have, the Fed did just the opposite after the crash occurred. Between 1929 and 1933, the Fed intensified the recessionary forces by cutting the money supply by one-third, converting a serious, but by no means unusual slowdown into a catastrophic recession. There is near universal agreement among scholars that the Great Depression was aggravated by a serious failure of the Federal Reserve. Years later, the eminent economist, J.K. Galbraith stated in his 1955 book, The Great Crash of 1929, that the Federal Reserve Board in those times was a "body of startling incompetence."[viii]

We when reflect about our own personal history and that of our parents, we often refer to an age by citing a decade – e.g. the band played fifties music or she was a child of the sixties, etc. The name of a decade alone conjures up specific images, which define a way of life for the period. Therefore, we might more easily get a feel for inflation during our parents’ and our own lifetimes by examining inflation decade by decade. The methodology we will use will be to total each of ten year’s inflation rates for the decade and divide by ten. That should give us a generalized approximation of the inflation rate for each decade.

During the 1910s, inflation averaged 15 percent as we fought WW I. During the 1920s, inflation averaged zero percent. Are you surprised? You shouldn't be. Business was good, which is not usually the case when inflation is high. We did not experience consumer inflation in the 1920s, but we did experience an asset bubble because of easy credit. In the 1930s, the average inflation rate was negative one and one-half percent. The deflation of the decade led to high unemployment and general misery. The 1940s average inflation rate was negative one percent. For the first half of the decade we were still struggling with a bad economy.

The 1950s saw inflation average one percent. It was an era of rising optimism and good business conditions. The stock market practically doubled from 1953 to 1955. Just as the 1920s saw the radio as a sign of strong technological progress, which boosted public optimism, the television came into widespread use in the 1950s, creating the same effect. Many couples were having babies and moving from small apartments to new three-bedroom homes.

In 1960, John Kennedy became President. He expanded confidence in the country with his stimulative economic programs and ambitious space programs. The 1960s saw inflation rise to an average of five percent. After Kennedy was assassinated, the mood of the country changed. Eventually, the good feelings that had lasted throughout the 1950s and into the early 1960s gave way to resentment and mistrust because of the Viet Nam War.

By the 1970s, inflation averaged eleven percent. Excessive money printing to finance the war and Johnson's "Great Society" programs set the stage for inflation. High energy prices (oil reached the equivalent of $100 a barrel in today's dollars) dealt the final blow, sending the economy into stagflation. By the 1980s, the Fed's austerity under the leadership of Paul Volker, brought the average inflation down to 5 percent and launched what would become the greatest stock market boom in our live times. The 1990s averaged only two percent, allowing business confidence to build and the stock market boom to continue.

The record clearly reinforces the point that the economy thrives when inflation is low and suffers when inflation is high. Furthermore, it shows us that deflation is most undesirable as it goes hand in hand with depression and high unemployment. Clearly, history has proven it is necessary to walk a fine line with inflation: It must be kept low (2% - 5% has proven ideal), but it cannot be allowed to go negative, which by definition would then be deflation. We must remember that the overall inflation rate has little effect on asset bubbles and busts. During the 1920s, although inflation was low, the credit-induced stock market bubble eventually wiped out the savings of millions of Americans when it burst. Furthermore, the aftermath of the bubble led to the Great Depression. Had not the Fed acted quickly to reduce rates after the NASDAQ crash, we may have suffered the same fate. However, the easy credit simply caused the substitution of a new bubble (real estate) for the older bubble (stocks).

We have covered a lot of economic territory in this chapter. We have gone back thousands of years to ancient civilizations, learning about money, banking, credit, and inflations. We have studied economies from Europe, South America, Asia, and our own since colonists first began building our society. Additionally, we have examined booms and busts both here and abroad. Now we are ready to examine the last bubble, The Internet Bubble, the ramifications of which will be with us for years to come.

Irrational Exuberance

The term "irrational exuberance" gained national attention in 1997, when Alan Greenspan used it to characterize the stock market boom. Months later, to the confusion of everyone, he changed his tune, claiming that we were in a "new era."

Bull markets in stocks are often called booms until later when a crash and the subsequent bear market takes away much of the gain. In hindsight, they are then called bubbles. I suppose every bubble begins as a boom and at some point along the way turns into a bubble. The great bull market in stocks from 1982 to 2000 would fit that description. The majority of the bull market was justified by strong fundamentals. Inflation was four percent at the beginning of the bull market and later dropped to three, and finally two percent. Additionally, the tax climate was excellent. In 1997, Congress cut the top capital gains rate from 28 percent to 20 percent. Talk of further cuts lent credence to holding stocks until lower tax rates would take affect.

A constant influx of money from the mutual fund industry acted as growth hormone to the market throughout the 1990s. During the bull market, the number of mutual funds increased ten-fold, while the number of people owning mutual funds grew from 6.2 million in 1982 to 119.8 million in 1998.[ix] Beside a rising market, the main source of mutual fund growth was a phenomenal increase in the number of 401 (k)s. Prior to 1981, most employees owned defined-benefit plans, which paid a fixed pension to them upon retirement. In 1981, 401(k) plan were created, which allowed employees to contribute tax-deferred amounts from their paychecks, which often was matched by their employers. More importantly, the plans allowed employees to invest their contributions in a wide selection of mutual funds.

While these were all powerful driving forces behind the bull market, when a boom turns into a bubble, nothing can take the place of "attitude." By 1997, unless you could recite the "new era" mantra, justifying the fundamentals became increasingly difficult. By that time, the PE ratio on stocks had surpassed its former record high set in September 1929, just weeks before the Great Crash.

Ironically, the internet, itself, could have been partially responsible for the bubble. While personal computers had been used by the public since the early 1980s, the World Wide Web made the PC something nearly everyone felt they had to have. The public began surfing the Web in 1994. Because of their favorable experience with the Web, the public perceived that the technology would change the world. They believed that technology companies, associated with that enterprise, stood at the beginning of a great new era where everyone would get rich.

In the 1980s and 1990s, getting rich became increasingly important to the baby boom generation. Never before had a generation been more materialistic. In a survey by Roper-Starch, when Americans were asked what the "good life" meant to them, in 1975, 38 percent picked "a lot of money." In 1994, that number had risen to 63 percent.[x] Certainly, the possibility of getting rich quick in the stock market held a great deal of appeal. Additionally, trading stocks became a way for some, who had been affected by downsizing, to take control of their lives. While trading the stock market, one could be his own boss and the sky was the limit.

With a personal computer and a small stake, anyone could get into the trading business. What made that possible were online, discount brokerage firms. Lower commissions made it practical to trade almost as often as one liked. Without a doubt, the entry of an army of new online traders added fuel and momentum during the final stages of the bull market. According to the SEC, in 1997, there were 3.7 million online accounts. By 1999, there were 9.7 million.[xi]

The media played a large role in keeping the public excited and optimistic. In 1998, the New York Times best-seller list featured books like Harry Dent's The Roaring 2000s: Building the Wealth and Lifestyle You Desire in the Greatest Boom in History. On TV, CNBC provided an ongoing source of hope for traders and investors. CNBC offered the public an uninterrupted stream of stock market coverage along with interviews with bullish CEOs and market analysts whose job it was to keep the public pumped.

Wall Street analysts follow approximately 6000 companies. In 1989, the analyst community recommended sells on 9.1 percent of those companies. In 1999, just prior to the crash, only one percent of their recommendations were sells.[xii] There are two reasons analysts rarely issue sell recommendations. The first is that the companies will exclude them from any further interviews or access to their key executives when they are preparing earning forecasts. The second is that often their own brokerage firms have underwriting deals with those same companies. According to well-known interest rate analyst, James Grant, "Honesty was never a profit center on Wall Street, but the brokers used to keep up appearances. Now they have stopped pretending. More than ever, securities research, as it is called, is a branch of sales. Investor, beware."[xiii]

When the stock market bubble burst in 2000, the reasons were no different from any other bubble. Stocks were wildly overvalued businesses had expanded too quickly and had taken on too much debt and the companies were saturated with technology. (They had acquired enough bandwidth, routers, and computers to last for a long time.) First, internet stocks fell, then the rest of the tech market, and finally the whole market itself. The country narrowly avoided a steep recession only because the Fed ratcheted interest rates down quickly. The low interest rates offered by banks for mortgage financing ignited the real estate boom, which eventually took on the same psychological characteristics that fueled the stock market just a few years earlier. We will study the real estate market in some depth in a later chapter. Next, however, we are going to learn more about how our country's economy got into the tight spot it is in today. Our current predicament is a cumulative result of the monetary and fiscal policies of the past six administrations – and there is certainly enough blame to go around.

MORE INFORMATION ABOUT THE COMING INFLATION CRISIS AND HOW TO PROFIT FROM IT IS AVAILABLE AT: WWW.CURTISARNOLDREPORT.COM