James Grant, “The Trouble With Prosperity” (The Loss of fear, te rise of speculation & the risk to American savings), Random House, 1996
When reading this book, or notes, keep in mind that this book was written in 1996. Then reflect how everyone in 2008-09 is so “shocked that there was gambling in Ricks place,” or was it Wall Street?” I get the feeling that A. Greenspan’s tenure as the wizard behind the curtain led too many people astray.
Grant’s main theme is what happens when monetary policy is established to assure a perpetual prosperity instead of countering inflation. Grant maintains that a central bank trying to assure continued prosperity will always be biased toward inflation. At the same time, such a central bank will be biased to prevent major losses in financial institutions. This sounds a lot like what is going on today. I believe inflation has to return with a vengeance in a year or two. Be alert to change money instruments into inflation protected instruments.
In The Trouble With Prosperity, Grant walks us through:
• The puzzle of the markets in 1958, given the rise in interest rates and inflation
• A tall building (Wall 40) whose history characterized the troubles of the Depression.
• The Japanese real estate and stock bubbles, and their deflation (still early in 1996)
• The S&L crisis in the early 90s
Notes:
Pg. xi: Even before the Great Depression, the national government undertook a campaign to mitigate, if not eliminate, economic failure (passage of the 1913 Federal Reserve Act was intended to preempt bank runs and financial panics by providing for a currency that could expand and contract with the seasons). But trying to suppress the business cycle mitigates capitalisms genius for excelling at failure and sorting out the errors of the up cycles.
Pg. 45: Until the devaluation of 1933, $20.67 had been the lawful equivalent of one ounce of gold. Under the Gold Reserve Act of January 1934, an ounce of gold was redefined as the equivalent of $35.
Pg. 147: Recessions play a constructive role in the business cycle. And it follows, that some recessions are better than others and that the very finest may not necessarily be the shortest. A too-brief recession many not expunge the error of the preceding up cycle. It might not force enough labor and capital out of the skyscraper construction or aircraft manufacturing businesses, for example, or enough banks out of the unsafe lending field. A recession might be prematurely cut short by a government’s well intended intervention; say, by an aggressive cut in interest rates.
Pg. 190: In the 1990s, the banks found deliverance by employing roughly the same techniques that had sunk the savings and loans in the 1970s and early 1980s (& would again in 1998). They borrowed short and they invested the proceeds in government securities maturing in years (long) with all the leverage they could muster. Of course, as soon as the yield curve begins to have higher short term rates and lower long term rates the house of cards crumbles. This has happened over and over throughout history and will keep doing so as long as the losses are socialized and the earnings remain privatized.
Pg. 221: Speculation is frequently conducted with borrowed money, and the time horizon of the speculator is often shorter than that for an investor. For both of these reasons, a speculation is often more fragile than an investment. It is more susceptible to destruction by the forces of financial or economic wind and tide than is an unleveraged, long-term purchase of a bond, annuity, or mutual fund. However, the main distinction between the investor and speculator is not so much the durability of their respective operations, but the social function they respectively serve. The speculator, knowingly or not, is in the business of risk dispersal. An investor may bear just as much risk as a speculator, but the risk is incidental to the end in view: that of obtaining a stream of income, dividends, or rents.
Pg. 222: What chiefly distinguishes a speculator from a gambler is that the risk he bears comes into existence independently of the speculator’s decision to bear it. Thus, the risk of falling cotton prices antedated the decision of the cotton speculator to enter the futures market. In a world without speculators, every farmer would have to hedge his own crops, every banker his own securities, and every insurer his own promises to underwrite the next natural disaster. In gambling, no risk of loss exists before a casino patron sits down to try his luck. The risk borne by the gambler, like that by the skier, is created specifically by the participant for the occasion.
Pg 281: The obsolescence of the old ideas is not so remarkable; financial ideas are cyclical. Derivatives, managed currencies, and the lucrative, risky practice of borrowing short and lending long represent not merely accepted contemporary institutions, but also previously condemned practices. Each of these ideas was once heresy. Thus, if the Federal Reserve can facilitate a capital investment boom by suppressing the federal funds rate, why can it not keep on suppressing it? If the one correct funds rate can prolong an upturn, why should there ever be a downturn? If the U.S. can import as much as it likes, paying the in the dollars that it can issue without restraint, why does it not import every single Mercedes Benz car offered for sale?
Pg. 284: How could a conservative Swiss banker be made to understand the U.S.? In America a bankrupt retailer in everyday operation is designated by the courts to be a “debtor-in-possession.” This might seem an error in translation: surely, they must mean “creditor-in-possession.” But no, it is “debtor.” The debtor is the failed business, or more exactly, the stockholders and management of the failed business. What they possess is the business. Their possession overrides the claims of the senior creditors. Even more amazing: retaining possession, they can lawfully borrow money in bankruptcy.
Before the Chandler Act of 1938, there was no such thing as a debtor-in-possession, much less a debtor-in-possession loan. The 1938 reform permitted a DIP-finance forerunner, “trustee certificates of indebtedness.” This innovation permitted a trustee to borrow more easily to support the rehabilitation of special corporate cases (e.g., a railroad deemed essential to the public interest or an office building just a few thousand dollars short of completion). Forty years later came a new bankruptcy act and a more general application of the post-petition-financing idea: favored, so-called superpriority, status for DIP creditors and the proposition that the management that got a company into bankruptcy should remain in position to try to lead it out again. It is a situation as far removed from debtors’ prison as group therapy is from Sing Sing.
Pg. 285: Now the DIP lender is senior to every other unsecured lender; none can be paid at all until he is paid in full. Thanks to this “superpriority status,” an intelligently structured loan to a bankrupt is tantamount to an investment-grade credit. The incidence of loss in DIP-related lending has been just about zero. It even gets better. Very few DIP borrowers actually use the money. They pay the fees to borrow it but, usually, find that the mere promise of the loan is enough to restore their financial credibility. Vendors ship again confident that they will ultimately be paid. Bankruptcy has become a tool for business improvement. High up on the list of available improvements was lease-breaking, the answer to the prayers of the company that could make a profit except for the inconvenience of paying rent at the rate it had contracted. Also: pensions, health benefits, union contracts, the list goes on.
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