THE GLOOM, BOOM & DOOM REPORT
ISSN 1017-1371
Long Live Deflationary Shocks,
and Down with Central Bankers
Who Want to Prevent Them!
In all the more advanced
communities the great
majority of things are worse
done by intervention of
government, than the
individuals most interested
in the matter would do
them, or cause them to be
done, if left to themselves.
John Stuart Mill (1806–1873),
Principles of Political Economy
INTRODUCTION
I have just returned from visiting
Delhi, Mumbai, Singapore, Shanghai,
and Dubai. Mumbai and Shanghai are
both impressive cities from an
economic development point of view.
In the case of Mumbai’s inner city, the
remarkable feature is that little has
changed since my first visit to the
metropolis in 1973, except that its
buildings are now even more
dilapidated. The reason for this lack of
development of the infrastructure in
the inner city is a maze of totally
antiquated property laws that have
prevented landlords increasing the
rents on the premises they let out,
with the result that they have no
incentive to maintain their properties
in good condition. Furthermore,
tenants have the right to stay in their
apartments for as long as they wish,
and the children of tenants can even
inherit the leases taken out by their
parents, many of which date back to
before the Second World War. A
friend of mine told me that years ago
A PUBLICATION OF MARC FABER LIMITED
he inherited an apartment building in
the city for whose apartments he is
collecting a rent of less than US$1 a
month! This lack of any property
development over the last 25 years,
unlike elsewhere in Asia, is also
interesting given that economic
activity is shifting to the outskirts of
the city and to other regions of the
country, where India’s totally
incompetent government is unable to
hamper economic development to the
extent that it has in Mumbai’s inner
city. I can do no better, in describing
the Indian bureaucracy, than quote
the 11th-century Chinese poet Su
Tung P’o, who wrote:
Families when a child is born,
Want it to be intelligent.
I through intelligence
Having wrecked my life
Only hope the baby will prove
Ignorant and stupid.
Then he will crown a tranquil life
By becoming a Cabinet Minister.
Still, what is reassuring about India
is that, despite its horrendous
bureaucracy, entrepreneurs have
thrived and India is now home to
many very promising companies doing
business in all kinds of sectors, but
especially in the fields of
pharmaceuticals and software. The
good news, not only for India but for
the entire global economy, is that
entrepreneurs are like rats who
manage to survive in just about any
environment, no matter how difficult,
and that they show an impressive
ability to adapt to even the harshest
commercial and legal infrastructures
by developing a high degree of
NOVEMBER 23, 2001
immunity to these unfavourable
conditions. Moreover, entrepreneurs
can mutate rather quickly in order to
take advantage of opportunities in
sectors such as software, for which
there were no government
impediments or regulations in India.
Such is the power of free markets over
bad governments and governments’
interventions in the economy. Yet it is
discouraging to see Mumbai, the
business capital of the world’s second-
most populated country, lacking a
large foreign business community,
such as we find in New York, London,
Tokyo, Singapore, and Hong Kong,
because of the government’s inability
to provide an efficient infrastructure
and a more conducive business
environment. (Even more
discouraging is the virtually non-
existent nightlife in India’s capital,
Delhi!)
The Indian tragedy is that, in the
absence of its bureaucracy and with, to
paraphrase Adam Smith, a tolerable
administration of justice (an efficient
legal system with straightforward
commercial laws and property rights),
the country could easily grow at
around 8–10% per annum —
admittedly from a low base — and
boost per capita incomes significantly
compared to the present environment,
which allows the economy to grow at
only around 5% per annum while per
capita incomes hardly budge. Still, this
may be an opportune time for
investors to purchase Indian shares.
The Indian stock market, which
shouldn’t have a meaningful
correlation to foreign markets since
India’s economy doesn’t depend much
on foreign trade and foreign portfolio
 flows (exports amount to just 10% of
GDP), is at present extremely Figure 1 India 12-Month Forward P/E, 1993–2001
depressed and is, in my opinion,
discounting to a large extent the
country’s problems (see Figure 1). In
addition, time deposits as a percentage
of total market capitalisation, which
has declined to just 21% of GDP, are
now at an all-time high (see Figure 2).
The various listed India Funds, such as
the Jardine Fleming India Fund (JFI),
the MSDW India Investment Fund
(IIF — see Figure 3), and the India
Fund (IFN), all sell at discounts of
around 20% from net asset value and
might be a suitable vehicle for
investors wishing to participate in the Source: ABN-AMRO
Indian corporate sector. For an
investment in a fund with a stronger
bias towards a bottom-up approach to
stock selection, our readers might
Figure 2 Time Deposits as Percentage of India’s Total Market
contact Jon Thorn
Capitalisation, 1993–2001
(jon@indiacapfund.com) who
manages the Indian Capital Fund, of
which I am the chairman. Jon Thorn
has, in the past, written about India
for this report. (See his contribution
entitled “The Best of Times, The
Worst of Times” in GBD report of
July 20, 2001.)
There could hardly be a stronger
contrast than travelling to Shanghai
after Mumbai: whereas inner-city
Mumbai has stagnated in terms of
infrastructure and real estate
development, Shanghai has emerged Source: ABN-AMRO
as a modern and impressive city over
the last decade. In fact, the rapid
development of its physical and
commercial infrastructure is
unprecedented in history. Figure 3 Morgan Stanley India Investment Fund (IIF), 1994–2001
Furthermore, as an Indian minister
pointed out to me, although it was
achieved at a certain price in terms of
human rights, the success Shanghai
has achieved in improving people’s
standard of living and per capita
incomes far outweighs those
shortcomings. I have been visiting
Shanghai regularly since 1989, and on
each visit I am struck anew by its
continuously changing skyline and the
extent and speed of its modernisation.
And this is the same city that, ten
Volume
years ago when I first began to write
about its impending emergence as
Asia’s most important commercial and
financial metropolis, businessmen in Source: BigCharts.com
Hong Kong dismissed as being far too

2 The Gloom, Boom & Doom Report November 2001

bureaucratic and lacking the necessary
educational infrastructure to develop!
I also visited Suzhou, a city I
hadn’t visited for over three years. At
that time, there were just two
industrial parks under construction on
the outskirts of the city; now there are
factories everywhere, with trucks
continuously moving goods to and
from Shanghai’s port along a newly
built highway. While I am fully aware
of the problems that are endemic to
the Chinese economy, including the
difficulties facing foreign companies
wanting to make money (due largely
to the tremendous overcapacities in
all industrial sectors and the inevitable
“speed-bumps” the Chinese economy
will periodically hit), the changes that
have occurred in China in the last few
years are simply extraordinary. (And
you may recall that I am rather well
known for my somewhat cautious
views about the health of China’s
social and financial system.) While
seated comfortably, on my way back to
Hong Kong, in a business class seat on
China Eastern Airlines with
significantly more legroom than in
any first class seat of a US air carrier,
not to mention the far friendlier
service, I mused how in the future
airlines such as China Eastern and
China Southern would dominate the
skies, while the Swissairs of this world,
with their high cost structures, would
become extinct.
My visit to the United Arab
Emirates also held some surprises. As
in the case of Shanghai, both Abu
Dhabi and Dubai have developed
rapidly in the last few years and have
now become far more cosmopolitan
than in the past. In particular, Dubai
has emerged as an important trading
centre, being the gateway to a large
number of Middle Eastern, Central
Asian, and North African nations, as
well as an enjoyable entertainment
and tourist centre for well-to-do
people from around the region.
Whereas Shanghai is impressive
because of its size and rising economic
power, Abu Dhabi and Dubai impress
the visitor because of the money the
ruling families have spent over the last
few years on building extravagant
gardens and parks, as well as
monumental hotels. In fact, Dubai is
November 2001
worth visiting just to see the Burj Al
Arab Hotel, the world’s only seven-
star hotel, whose stunning
architectural structure rises to more
than 40 storeys from a man-made
island in the Persian Gulf.
Admittedly, one could argue that the
Middle Eastern economies are
“artificial”, since they depend largely
on the price of just one commodity —
oil. But what is the difference between
the Middle Eastern economic system,
which depends on the price of oil, and
the Western industrialised nations,
which over the last few years have
increasingly become dependent on the
price of their stock markets for
economic growth? And on what
would you rather bet your future: oil,
whose price is now rather depressed
(at least in real terms); or Western
stock markets, which by any valuation
standard still appear to be expensive?
The purpose of this brief
description of my recent trip is not,
however, to draw any conclusions
about the relative investment merits
of emerging economies compared to
the Western industrialised nations.
(For such an analysis, see GBD reports
of May 16, 2001, entitled “Emerging
Markets: An Unpopular but Depressed
Asset Class”, and of July 20, 2001,
entitled “If the Purchase of Emerging
Stock Markets is ‘Financial Suicide’,
What Then is the Buying of US
Equities?”.) Rather, it is to note that,
Figure 4 Performance of Asian and Japanese Markets Relative to
the United States, 1991–2001
Asia ex Japan/US stock market index
[index 1994, MVM=Mean, RT=Effective, FC=standard)
Japanese index/US stock market index
[index 1994, MVM=Mean, RT=Effective, FC=standard)
Source: Gaveco
despite the fact that the emerging
markets have grossly underperformed
the Western developed markets since
1990 (see Figure 4), impressive
economic progress has taken place in
most developing economies over the
last ten years. Who, ten years ago,
had heard of Bangalore and of India’s
now famous software and
pharmaceutical companies, or spoke at
dinner parties about Shanghai’s
stunning development and China’s
large trade surplus with the United
States? And who at that time was
aware of Emirates Airlines, an airline
that is now certainly better managed
than Swissair or Sabena in recent
years, or of the Emirates Tower Hotel
Group, which owns and manages
several luxury properties in Dubai
(among them the Burj Al Arab Hotel)
and now also runs the Carlton Tower
Hotel on London’s Cadogan Square?
While I am aware of all the
shortcomings of globalisation, it would
seem to me that, over the last ten
years or so, whole regions that in the
past were absent from our Western
market economy and which shunned
our capitalistic system as a result of
their adherence to socialist ideologies
and to the ideas of self-reliance and
hostility towards foreign investments
have ºnow been fairly well integrated
into a “global economic system”.
Moreover, there is no doubt in my
mind that over the same period, an
The Gloom, Boom & Doom Report 3
 unprecedented amount of knowledge,
new ideas, technology, management
techniques, and capital was transferred
to these developing economies.
However, such a major and rapid
change for the global economy — the
integration of close to three billion
people into the world’s economy
who, until the late 1980s, were
participating only on the periphery of
the capitalistic market economy —
also brings about a state of lasting
disequilibrium. Following an initial
boom that lasted from the mid-1980s
to the mid-1990s, the emerging
economies experienced severe crises in
the late 1990s. These crises were
accompanied by significant currency
devaluations or, in the case of China,
by a deflationary environment, which
in aggregate badly deflated the price
level of the emerging world. In turn,
the emerging world is now exporting
their deflated price level to the
Western world and contributing to a
structural “deflationary shock” in the
global economy, very much in the
same way the opening of the western
territories in the US and the opening
of Australia to the production of grain
in the second half of the 19th century
led to a deflationary period that lasted
from the mid-1860s to 1900 (see
Figure 5).
DEFLATIONARY SHOCKS
In a free market economy, prices will
rise and fall depending on demand
and supply. A deflationary shock is
brought about by supply rising much
faster than demand, a condition that
is usually brought about by some major
technological breakthrough. The
application of a new innovation leads
to greater efficiencies of production or
to new sources of production, or to a
combination of both. In the second
half of the 19th century, the earlier
construction of canals and railroads
and the emergence of efficient trans-
ocean steamships lowered
transportation costs by around 90%
and allowed grain grown in the
western territories of the US and in
Australia to reach Europe, leading to
declining agricultural prices
throughout the world. Thus, we can
say that the application of new
4 The Gloom, Boom & Doom Report
Figure 5 Wholesale Prices in France, Germany, and the United
States, 1820–1896
Source: David Hackett Fischer, The Great Wave
inventions led to the opening of new
territories. The combination of these
two factors in turn increased the
supply of agricultural products, which
were then the world’s most important
commodities and largely drove the
business cycle. (Simply put,
agricultural commodities were then to
the world what oil is today to the
Middle Eastern economies, with rising
prices leading to periods of economic
expansion and falling prices to
recessions or below trend-line
growth.)
Compare this to the current
environment. The opening salvo to
the current deflationary shock was
fired as long ago as 1956, when
Malcolm McLean (the founder of Sea-
Land) introduced the first container
ship. The container was one of the
greatest inventions ever, because it
allowed for efficient and speedy
transportation and avoided the costly
and time-consuming process of
stevedores loading and unloading, and
stowing cargo from ships to trucks, and
vice versa. It is difficult to imagine
that world trade could have expanded
by as much as it has over the last 50
years or so without containers. Then
came the Boeing 747, which lowered
the cost of air travel and air-freight;
the fax machine in the early 1980s,
which significantly boosted the
efficiency of transmitting information;
and later the PC and the Internet,
which brought down the cost of
communication to almost zero. At the
same time, foreign exchange controls
were removed around the world and a
global capital market permitted the
easy and speedy transfer of funds into
regions that promised high returns.
Thus, when the ideology of socialism
came to an end and numerous
countries such as China became
increasingly integrated into the
market economy, several new
technologies and a global financial
market were in place to facilitate and
speed up the process of
industrialisation, with the result that
the world is now faced with enormous
new sources of supplies of
manufactured goods and tradable
services, in the same way that Western
Europe was inundated in the second
half of the 19th century by agricultural
products coming from the American
West, which led to the fall in prices
referred to above.
That deflation is being exported,
in the case of manufactured goods and
commodities, from emerging
economies to the industrialised
nations, including Japan, is evident
from declining import prices (see
Figure 6) and, in the case of services,
from the growing trend to outsource
all kinds of accounting,
communication, and information
functions to countries such as the
Caribbean Islands, Mexico, and India.
In fact, the current deflationary shock
would reach far greater proportions if,
along with the free flow of goods and
capital, labour could move freely from
one region of the world to another.
One could even argue that there was
November 2001

Figure 6 US Import Price Index (yearly percent change),
1990–2001
Source: yardeni.com
far more freedom of movement a
century ago than there is today,
because of much tighter migration
policies now. But if there was a
completely free movement of labour
in our times, we would see millions of
people from poor countries migrating
to countries with high price levels and
seeking employment at high wages in
countries such as Japan, the US, and
Western Europe, and temporarily
depressing wages in the manufacturing
and service sectors of those
economies. However, totally free
movement of people would not
necessarily damage these economies in
the long run, but rather would benefit
them. This is so because if current
tight migration laws are maintained,
more and more businesses will simply
migrate to low-cost countries such as
China, Mexico, and India (for
services), leading to above trend-line
growth in these countries and below
trend-line growth in the industrialised
nations. Just imagine the effect of free
migration on Japan’s economy! The
unfavourable demographic trends
would be reversed and, with pressure
on wages, the country’s competitive
position would improve. A borderless
world, which would consist not only
of the free movement of goods and
capital, but also of labour, would
almost certainly increase the world’s
GDP significantly — at least in real
November 2001
terms — and benefit people living in
poorer countries, where even those
people who didn’t migrate would have
a better chance of finding
employment. Unfortunately, the
current strict migration policies in
industrialised nations are unlikely to
change (especially given the events of
September 11), but even so, emerging
economies are in a position to export
deflation. In the manufacturing sector
this trend is already well under way
and will accelerate, as, given the
current recessionary environment,
companies in high-cost countries (the
developed countries) will shift far
more production to emerging
economies in order to cut costs. And
since emerging economies with their
low wages and, frequently, the absence
of property rights can put
infrastructure, such as roads, bridges,
tunnels, power plants, airports,
harbours, and so on in place at a far
lower cost than the industrialised
countries, and given their almost
unlimited reservoir of cheap labour,
countries such as China will in future
further increase their competitive
manufacturing advantage over the
developed countries.
However, the service sector isn’t
immune from this trend, as we have
seen in the case of India’s software,
call-centre, and accounting industries.
The entire international
transportation service industry could
be taken over by emerging economies
with their low wages. It should be
evident that while European airlines
with their high wage costs and poor
management will fail, Asian airlines
with their low labour costs will take
over their business. The same is
occurring in the shipping and cruise
line industry, where most crew
members originate nowadays from
developing countries. Similarly, in the
trucking industry, Mexican drivers
with their lower wages will
increasingly ship cargo between
Mexico and the US at the expense of
their American counterparts.
Then there is the retirement and
health-care industry. In the same way
that there was a huge migration of
well-heeled elderly northern
Europeans to lower-cost and
climatically more appealing places
such as the Canary Islands, Majorca,
and Ibiza, and along the entire
Spanish coast, which has contributed
to these regions’ economic growth in
the last 20 years, I can see that, in
time, more and more people from the
industrialised countries will retire in
developing countries where the costs
of living are just a fraction of what
they are at home. Naturally, this trend
would accelerate significantly if
government officials in the developing
countries had the sense to refrain from
their continuous anti-foreign rhetoric
and allowed foreigners to own
property. (The retirement industry
will only really take off in emerging
economies if foreigners have the right
to own landed property. This is,
however, a thorny issue in most
developing countries, because their
false sense of patriotism or, even
worse, their nationalistic bias makes
them think that the foreign,
ownership of land amounts to selling
out their precious nation to evil and
barbaric foreign intruders, when in
fact, as a percentage of their total
property market, foreigners would be
unlikely ever to own more than 1%.)
But just think how the money spent
by 100,000 retirees would boost the
economy of a country such as the
Philippines, Thailand, Indonesia, or
Malaysia. Assuming, very
conservatively, an annual spending of
The Gloom, Boom & Doom Report 5
 US$20,000 per foreigner (but more
likely US$30,000), US$2 billion (or
US$3 billion) would flow to these
countries’ bottom line right away, not
to mention the know-how and skills
these retirees would bring with them,
and the estates their soft hearts would
leave behind to their new-found
communities! Yet, while this
migration trend is well under way
within Europe (from north to south)
and in the US (from everywhere to
Florida, Arizona, and Nevada), it still
represents only a trickle towards
developing countries. Still, younger
people, who by the time they retire
will have travelled widely and perhaps
lived in several different countries,
will be far more likely to adopt new
homes in foreign countries than their
parents who grew up, lived, and
worked in the same city all their lives
and travelled abroad only
infrequently. (This trend will also be
reinforced by the rising number of
multiracial families.)
The other service sector that is
increasingly becoming tradable is
health care. There are a growing
number of people who travel from
Europe to Singapore for dental care
(much cheaper) and to Bangkok for
all kinds of bizarre operations. In
countries such as India, the
Philippines, and Thailand there are
excellent health-care facilities that
cost a fraction of what they cost in
Western countries.
Sceptics of this deflationary shock
scenario will, of course, argue that
while some deflationary pressures do
exist in the manufacturing sector,
there will be no problem for most
services, as people simply wouldn’t
travel from a high-cost country to, say,
Thailand just for a comparatively
inexpensive meal or to, say, Burundi
for a cheap haircut. Moreover, they
would be correct in pointing out that
at present the migration flows still
favour the developed countries, with
far more people from poor countries
moving to rich countries than vice
versa. But consider the following. If so
many large companies have already
found it advantageous to move their
back-office, and occasionally their
front-office, functions from expensive
downtown areas to cheaper locations
6 The Gloom, Boom & Doom Report
in the suburbs or even the countryside,
how great a step is it in a highly cost-
conscious world to move at least some
processing functions to places such as
India, the Philippines, Russia, or
China? Moreover, it should be
understood that there are businesses in
the service industry that create
wealth, as well as those that have
stepped in to perform the work
formerly performed by housewives
who are now working women
supporting their families. Thus, I can
see the positive contribution to
economic growth that service sector
companies such as temporary work
agencies and courier services like DHL
and Federal Express are making. Less
clear is the benefit to the economy of
having to eat breakfast, lunch, and
dinner in a coffee shop, of spending
hours each day driving your children
to daycare centres, and of having a
cleaner come daily to your house
because your wife works at a
McDonald’s outlet and earns less than
the value added if she had stayed
home and looked after the household!
But under the influence of vocal
feminists, many women have come to
believe that staying at home and
raising their children is a demeaning
job, while earning a salary for one’s
work — even if it is associated with
high transportation costs in addition
to income taxes — is personally far
more rewarding and glamorous. In
general, I believe that services that
add significant value to an economy,
as compared to those which simply
serve as substitutes for the old
“household” economy, can be more
easily outsourced to other countries.
(If the US government was a profit-
driven corporation, it would outsource
the entire social security
administration and the IRS to India.)
While it is true that there are far
more migrants from less-developed
countries into the developed countries
than the other way around, the
incoming migrants have the tendency
to keep wages in the industrialised
countries from rising much — in some
cases, they can even depress them —
as a large flow of migrants increases
the supply of labour. Conversely, the
flow of migrants from rich countries to
countries with a low price level tends
to raise prices in those countries that
receive these more affluent migrants.
Just have a look at how prices have
moved up in southern Spain, and in
the Balearic and Canary Islands, over
the last ten to 20 years. In this respect,
a quick look at the Hong Kong
economy might shed some light on
the subject of the phenomenon of a
deflationary shock.
Manufacturing has already almost
entirely left Hong Kong for locations
across the border in China. Even
services are increasingly moving across
the border, not only for the export/
import-related service sector, but also
for some functions in the financial
sector. And while Hong Kong people
don’t travel to China for a haircut,
they do go there for shopping and for
entertainment. Moreover, on long
weekends Hong Kong almost empties
itself, as people from Hong Kong find
it cheaper and more pleasant to go to
Thailand, the Philippines, or China
for a couple of days than to stay at
home in expensive Hong Kong.
Moreover, increasing numbers of
Hong Kong people are moving their
homes to nearby places in China
because of the huge accommodation
cost savings — a trend that would
certainly accelerate if the Hong Kong
government decided to open the
border to adjacent Shenzhen 24 hours
a day. (At present, the border closes at
11 pm and reopens at 5 am, because
the parasitic Hong Kong property
developers, who basically run Hong
Kong, fear that a totally open border
would depress real estate prices in
Hong Kong even further.) In addition
to the increasing numbers of Hong
Kong Chinese who are living in or
retiring to China, retiring expatriates
are leaving Hong Kong for less-
expensive places offering a higher
quality of life, such as can be found in
Europe, Australia, New Zealand, or
Southeast Asia. In the meantime,
Hong Kong is host to a large flow of
migrants from China, who have, in
recent years, kept wages from rising
and are therefore a thorn in the side of
the local labour unions. Thus, at least
in Hong Kong, a structural
deflationary shock from the opening
of China is clearly evident and this
deflationary trend will, in my
November 2001
opinion, continue to depress the the exploitation of the American such as in Shanghai and Beijing could
territory’s asset prices, including continent and other new regions and perform well after the more than 50%
shares and real estate. catapulted America into the role of capital value decline they have
The questions we have now to the world’s leading industrial power, experienced since the end of 1995.
address regarding this deflationary resembled far more a deflationary The 1873–1900 period was also
shock scenario are whether such a boom than a shock! Moreover, while highly beneficial to holders of fixed
condition is something to be owners of agricultural land in Europe interest securities who reaped large
concerned about, and whether performed poorly, real estate in cities gains from deflation. The yield on
monetary policies can reverse this rose again after the 1873–1878 crisis, British Consols fell from a high of
deflationary trend. because of the accelerating process of 3.41% in 1866 to a low of 2.21% in
urbanisation. This was particularly 1897, and in the US the yield on
THE ECONOMIC true of the US, where real estate in higher-grade railroad bonds declined
CONSEQUENCES OF A southern California soared in the years from 6.49% in 1861 to 3.07% in
DEFLATIONARY SHOCK preceding 1886. Thus, while real 1899. Deflation was obviously not
estate may not be particularly particularly favourable for corporate
American economists such as Paul attractive in the present deflationary profits, and bonds therefore out-
Krugman and economic policy period (certainly not in financial performed equities after 1876 (see
decision makers such as we find in the centres), selected real estate markets Figure 8).
US Treasury and the Fed would do
anything to avoid a deflationary
shock, fearing that deflation means Figure 7 The Rise of Real Wages, 1800–1896
depression. But let’s look at the
evidence. It is true that the period
between 1873 and 1900 wasn’t a
golden era of prosperity. Grain
farmers, particularly in Europe, were
in deep trouble. with political
consequences that included the
Populist movement in the US, the
“revolt of the field” in Britain, and
rural unrest in Europe and Russia.
Returns on agricultural land, both in
terms of real estate prices and rents,
fell. But on the other hand, real wages
rose practically everywhere more
rapidly than in the first three-quarters
Source: David Hackett Fischer, The Great Wave
of the 19th century (see Figure 7), as a
result of meaningful productivity
improvements in agriculture and
manufacturing. Thus, the European Figure 8 Relative Strength of US Stock Prices vs Railroad Bond
landowning class lost out, as they not Prices, 1857–1899
only faced declining rents and
agricultural prices but also rising real
wages. However, we should not forget
that the economic development of
many new regions which led to
exports of Mississippi cotton,
Argentine beef, Australian wheat,
New Zealand mutton, African ore,
and Canadian timber, combined with
declining transportation costs (the
Suez Canal opened in 1869), created
an integrated global market for
commodities, boosted world trade,
and brought about large economies of
scale. Thus, landowners aside, the
deflationary shock that had been 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99

brought about by new technologies Source: The International Institute for Economic Research
and inventions, and which permitted

November 2001 The Gloom, Boom & Doom Report 7

 In sum, I would argue that while
the entire 19th century was
characterised by a deflationary trend
(commodity prices and interest rates
in 1900 were half those of 1800), it
was a century during which enormous
economic progress took place
accompanied by strong population
growth. Therefore, there is, in
principle, nothing to fear from
deflation. However, the reason so
many economists fear deflationary
periods is that they only look back at
the Depression years of the 1930s,
which were truly a deflationary bust.
However, instead of analysing the
various causes of the bust following
1929, they focus on the devastation
the deflationary bust brought about,
when, in fact, the Depression was
only a consequence of the previous
speculative credit-driven boom that
led to the excesses of the 1920s. Had
these economists studied the 1920s’
speculative boom more carefully, they
might have implemented economic
policies during the 1990s that could
have reduced the risk of a similar
occurrence in the years to come. In
his book Booms and Depressions,
published in 1932, Irving Fisher made
the “over-indebtedness” responsible
for the Depression, meaning “that
debts are out-of-line with, are too big
relative to other economic factors”.
According to Fisher, over-
indebtedness is brought about by
“new opportunities to invest at a big
profit … such as through new
inventions, new industries,
development of new resources,
opening of new lands or new markets.
Easy money is the greatest cause of
over-borrowing” (Irving Fisher, The
Debt Deflation Theory of the Great
Depression, London, 1933).
Therefore, whether deflation leads to
a deflationary boom, as in the latter
years of the 19th century, or to a
bust, as after 1929, would seem to
depend very much on the level of
debt in the economic system prior to
the deflation. This observation seems
to have been confirmed by the
deflation in Latin America in the
1980s following the petrodollar boom
(in nominal terms there was
inflation, but because of the currency
collapse there was deflation in real
8 The Gloom, Boom & Doom Report
terms or adjusted for the US dollar
exchange rate), the Japanese
deflation following 1989, and the
Asian crisis after 1997. Therefore,
given the current high level of
consumer and corporate debts in the
US, there is a serious risk of a
deflationary bust. Moreover, even if
a deflationary bust can be avoided
and some kind of deflationary boom
were to occur in the years to come,
we should not forget that the
deflationary boom of the 1873–
1900 period led to a huge
geopolitical change, with Britain
being a relative loser while the US
became the world’s leading
industrialised and political power.
Whether in the years to come China
will challenge the economic
hegemony of the US remains to be
seen, but having witnessed with my
own eyes what China has achieved in
the last ten years, it is possible that,
in the manufacturing sector at least,
China could overtake the US within
the next ten to 20 years (with the
proviso that there is social stability).
Also, in terms of investment strategy,
investors should not forget that in
the period from 1873 to 1900 and,
even more so, from 1929 to 1941,
bonds significantly outperformed
equities.
THE EFFECTIVENESS OF
MONETARY POLICIES IN A
DEFLATIONARY
ENVIRONMENT
Assume that, in the years following
the boom of 1866–1873, the world
had cut interest rates as rapidly, and
eased monetary conditions by as
much, as was recently done in the
US. Do you really think that, under
such conditions, the opening of the
American West to agriculture and
the subsequent glut of agricultural
commodities on the world’s markets
that led to their price declines would
not have occurred? In my opinion,
such monetary policies would
actually have accelerated this process,
since even more railroads would have
been built and the American
continent would have been opened at
an even faster rate. One point ought
to be obvious: lower interest rates and
easier monetary policies would in no
way have reduced the production of
agricultural commodities or retarded
the process of industrialisation, which
with its productivity improvements
led to a fall in prices for steel, coal,
transportation, and so on. Also,
would Japan be worse off today had
interest rates not been reduced to
almost zero? It’s unlikely, since
almost-zero interest rates, combined
with large fiscal deficits, allowed the
debt levels in Japan to grow in the
1990s to unprecedented levels for an
industrialised nation. Had, instead,
the Japanese government let the
post-1989 crisis run its course and not
intervened, more pain would have
been incurred in 1992, but Japan
today would be in a far healthier
financial and economic position. In
fact, I would argue that Japan’s
problem is that it didn’t have enough
deflation, which would have brought
its price level more in line with those
of other Asian countries, shut down
excess capacity, and bankrupted weak
companies, which are now going —
or will eventually go — out of
business anyway, but with a much
larger debt burden than would have
been the case five or eight years ago!
As to whether the 1930s’
Depression could have been avoided
with easier monetary policies is a
much-debated subject, with
economists such as Milton Friedman
arguing that economic policy
mistakes post-1929 were the cause of
the Depression, while the Austrian
school of economists maintains that
the crisis was brought about by easy
monetary policies prior to 1929,
which led to over-investments and
“over-indebtedness”, as well as to
speculative excesses in the stock
market, which in turn brought about
the subsequent deflationary slump.
Also, in the case of Latin America
post-1981, easy monetary policies
combined with large fiscal deficits
brought about the worst of all
possible worlds: hyperinflation and
depression. And in the case of Asia
post the 1997 crisis, I could make the
case that easy monetary policies have
had the effect of badly retarding the
necessary reforms and of leaving the
debt overhang problems largely
November 2001
unresolved. Thus, it is by no means particular importance. In particular, impressive than the 1995 or 1998
certain that current monetary with increased frequency of usage, bull phases that followed the Fed’s
policies in the US will be effective in the effectiveness of drugs tends to easing on these occasions.)
reviving the economy. diminish and occasionally disappears Now, compare this to the present.
There are some more points to altogether as bacteria and viruses Liquidity has been pouring into the
consider. In his highly recommended develop immunity. In this respect, it system, with the Fed fund rate having
book, Manias, Panics, and Crashes is interesting to note that when the been cut by 450 basis points since the
(Basic Books, 1978), Charles tightening cycle ended in the final beginning of the year! But what was
Kindleberger devotes a chapter to months of 1994, the stock market the result? The stock market has
“the lender of last resort”, which soared in 1995 by more than 40% to rallied recently, but whereas in the
“stands ready to halt a run out of real new highs. Then, in 1998, following past such massive easing moves
and illiquid financial assets into the LTCM debacle, monetary produced new highs in the stock
money, by making more money conditions were eased once again and market within months, today the
available”. According to Professor within a few months the market stock market averages and its leading
Kindleberger, “How much? To made new highs (see Figure 9). Later, constituents such as Cisco (see Figure
whom? On what terms? When? These in the final months of 1999, 10) still remain well below their year
constitute some of the dilemmas of monetary conditions were massively 2000 highs. In other words, monetary
the lender of last resort, after it is eased once again because of the interventions seem to have become
determined, first, whether there unfounded concerns about the larger in size, but at the same time
should be one, and second, who it problems associated with Y2K and less effective in boosting or
should be. All these issues derive the market again made new highs. supporting the stock market and,
from the basic dilemma that if the (Given the huge liquidity injection at along with it, the economy.
market knows it is to be supported by the time, the rise was far less Moreover, if these monetary
a lender of last resort, it will feel less
(little? no?) responsibility for the
effective functioning of money and Figure 9 S&P 500, 1997–2001
capital markets during the next
boom. The public good of the lender
of last resort weakens the private
responsibility of ‘sound’ banking.”
Kindleberger then goes on to give
examples of where interventions by
the lender of last resort (usually the
central bank) worked and occasions
when they failed. In particular, he
emphasises the importance of the
timing of the intervention. “‘Too
Source: BigChar ts.com Exchange provides no volume data
little, and too late’ is one of the
saddest phrases in the lexicon not
only of central banking but of all
activity. ‘Too much, too early’ is not
an evident improvement. Enough at Figure 10
the right moment is better than Cisco Systems, Inc.,
either. But how much is enough? 1995–2001
When is the right time?”
Kindleberger further states: “If, then,
one admits the necessity for a lender
of last resort after a speculative boom,
and believes that it is impossible for
restrictive measures to slow down the
boom at the optimal rate without
precipitating collapse, the lender of
last resort faces dilemmas of amount
and timing … As for timing, it is an
art. That says nothing — and
everything.”
Therefore, as is well known in the
medical field, dosage and timing of Source: The Stock Picture
the administration of drugs are of

November 2001 The Gloom, Boom & Doom Report 9

 interventions are as timely as the US
Treasury’s decision to halt the sale of
30-year Treasury bonds when yields
are relatively low (why did the US
Treasury not discontinue such sales in
1981, when long-term Treasury bond
yields reached 15%?), then we may
be in for some nasty surprises. In fact,
I believe that the Fed’s intervention
in the market will make matters
worse in the long run, because any
intervention in the free market
leads to unintended consequences.
One of these is, undoubtedly, the
refinancing boom in the housing
market (see Figure 11) and zero
interest rate auto loans, both of
which simply borrow demand from
the future. Once interest rates no
longer decline, and it wouldn’t
surprise me if the Treasury’s decision
to halt the sale of 30-year bonds has
put a top in place for US government
bonds and marked the low of interest
rates, the refinancing boom will come
to an abrupt end, while auto sales will
collapse once the zero interest rate
auto loans policy is discontinued (not
to mention that zero interest rate
loans will eat badly into the
automakers’ profits). At the same
time, low interest rates will
temporarily ensure the “survival of
the weakest”, not the “survival of the
fittest”, and prevent excess capacities
being shut down. In addition, easy
monetary conditions will lead to
further capacity expansion in Eastern
Europe, Russia, and especially China,
thus reinforcing the over-capacity
problem and the deflationary
corporate profit environment.
But, don’t I contradict myself? On
the one hand I believe that the US
Treasury bond market has reached or
is close to a top, and on the other
hand I believe that the deflationary
forces will be exacerbated by easy
monetary conditions. Moreover, I
explained earlier that, in previous
periods of a deflationary shock, bonds
outperformed equities. However, it is
possible that in order for bonds to
outperform equities, bond prices
wouldn’t necessarily have to rally
much, but could either remain just
around the current level or decline
less than equities. In other words,
under this scenario, for the next
10 The Gloom, Boom & Doom Report
Figure 11 US Mortgage Refinancing Applications Index,
1997–2001
Source: ABN-AMRO
couple of years, equities could return
less than ten-year Treasury bond
yields, which at present are hovering
a tad below 4.4%. And as to the
deflationary scenario I have outlined
above, which may be reinforced by
easy monetary policies and at the
same time a relatively poor
performance of bonds, the answer
may be found in the movement of the
US dollar against foreign currencies,
especially against the Chinese
renminbi, and commodities. In time,
the expansionary monetary policies
of the Fed are likely to weaken the
US dollar, if not against the Yen,
then against the Euro and, sometime
in the future, against the Chinese
renminbi and commodity prices.
Moreover, I would make the case
that had the Fed not intervened
aggressively in the money market and
pushed down interest rates by 450
basis points since the beginning of
the year, interest rates on long-term
bonds might very well be lower than
they are now. The injection of too
much liquidity into the system keeps
inflationary expectations artificially
high; therefore, while interest rates
do decline, real rates (interest rates
adjusted for inflation) remain high or
even rise. Thus, even under my
deflationary shock scenario, coming
largely from the rise of China’s
manufacturing sector and new
technologies, interest rates could
remain very high in real terms. This
would particularly be the case for
corporate bonds, which in such a
deflationary scenario would
continuously suffer from a
deteriorating credit quality. Finally, I
also want to make the case here that
if the world had had no central banks
over the last 20 years and monetary
growth had been kept constant at,
say, 3% per annum, it is likely that
the wild swings we have experienced
in the global economy since 1990
would have been avoided. Without
central banks, market forces would
have contained the speculative
booms and the colossal busts that
followed them far better than the
central bankers have managed to do.
As John Stuart Mill observed, “the
great majority of things are worse
done by intervention of government”
than the market would do them if left
alone.
CONCLUSION
In the same way that the opening of
the American continent in the 19th
century led to a deflationary boom,
the rise of China and other emerging
economies is spreading deflation
around the world. A mild form of
deflation, such as we had under the
gold standard of the 19th century, is
probably desirable. It ensures the
survival of the most efficient
entrepreneurs and producers, while
rapidly eliminating weak companies
and inefficient market participants. A
deflationary environment also forces
November 2001
companies to continuously look for
new methods of production in order to
boost productivity and lower costs.
Moreover, deflation forces a more
conservative approach towards
borrowings and investments by the
corporate sector, as the real cost of
money remains relatively high. Lastly,
in deflationary periods, real income
gains by wage earners are usually
higher than in inflationary periods.
The problem with deflation is not
deflation, but the preceding inflation,
which is usually exacerbated by
monetary policies and during which
debts are out of line with and “are too
big relative to other economic
factors” (Irving Fisher). As Fisher
pointed out, “Easy money is the
greatest cause of over-borrowing.”
I very much doubt that current
US monetary policies will be
effective in combating deflation. The
process of deflation may be retarded,
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November 2001
but in the same way that agricultural
commodity prices would have
declined in the 19th century even
under extremely loose monetary
conditions, the deflationary shock for
the manufacturing sector brought
about by the opening of China and
other regions in the world cannot be
avoided. Moreover, it would appear
that the Fed has implemented larger
and larger monetary interventions,
but successively with less and less
impact on economic activity.
In terms of investment strategy, I
am afraid that investors will have to
become accustomed to far lower
returns in the next few years than
they enjoyed during the 1982–2000
bull market for bonds and stocks.
As previously stated, I believe that at
very best the stock market will
fluctuate (wildly) in a trading range
of between 950 and 1,250 for the
S&P 500, but that eventually a
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resolution on the downside is very
likely, with stocks bottoming out at
far lower levels. I also doubt that real
estate will perform well, and the now
ongoing deflation for commercial
properties (see enclosure on next
page) will eventually also spread into
the residential sector. Long-term US
government bonds are unlikely to
rally much further, but in a
deflationary environment for
corporate profits a 4% return will be
high compared to the returns I expect
for US stocks. In addition, high-grade
corporate bonds yielding above 6%
are relatively attractive for tax-
exempt accounts.
The recent rally that began on
September 21 is likely to fizzle out, as
corporate profits will continue to
disappoint. A test of the September
lows, and more likely a break of
these lows, should therefore be
expected next year.
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Source: Financial Times, October 8, 2001 Marc Faber Limited
Enclosure 1