'Titanic' Tactics When the Fed Hits an Iceberg

Gary North
Lew Rockwell.com
Saturday October 27, 2007

Fifty years ago, I read Walter Lord's book on the sinking of the Titanic, A Night to Remember. Frankly, the only fact I can remember about that book is this: the lifeboats were only a little over half full. That grim fact has never left my memory. It was shocking to me then; it is shocking to me now.

If you use Google to search for "Titanic," "lifeboats," and "empty seats," you will find several hundred links. The general consensus is that there were over 400 empty seats. This account is detailed.

Many lifeboats left the ship partially full, and though 706 survivors were rescued by the Cunard Line's Carpathia [when] she arrived on the scene at about 0330, after speeding fifty-eight miles through the ice field, there were 473 empty seats. The death toll was estimated at between 1,500 and 1,635 people.

The Titanic was capable of carrying about 3,500 passengers and crew. So, the ship was not filled when it set sail.

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The lifeboats could carry fewer than 1,200 people. Today, we see this as an outrage, as indeed it was. But we should not forget that this was a government-sanctioned outrage.

Yet for all her safety features, Titanic carried just sixteen lifeboats and four collapsible boats, which could handle only 1,178 people, a meager 35 percent of the maximum passenger and crew complement of 3,511. Even so, this number exceeded the British Board of Trade's requirements, which dated from 1894 (when the largest ship afloat was 12,950 tons), under which Titanic was required to carry only enough lifeboats to seat 962 people.

The Titanic was carrying lifeboats with capacity that exceeded government standards by 22%.

PLAN AHEAD

The vision I have of the night to remember is based on the movie, A Night to Remember, and of course Titanic, which I regard as the most profitable chick flick in movie history.

I am not sure what I would have done, had I been a passenger on that ship. But as an entrepreneur, I know one thing: I would have been the first person to line up at a lifeboat. In high school, when a fire alarm sounded, by the third ring I was at the door. By the fourth, I was outside. I do not recall a single instance when I was not the first one out the door. With poor eyesight, I always sat near the front. However, there was never anything the matter with my legs.

If I had been refused access to that lifeboat – "Women and children first!" – I would have headed rapidly to another lifeboat, on the assumption that the same rule did not hold for every lifeboat. That was in fact the case that night. A lot of men got into lifeboats. I would have been prepared to offer my seat to a woman or child, but once the crewman said "lower it!" I would have sat tight.

Assuming that I got on deck late – highly unlikely – after all lifeboats had been lowered, I would have immediately gone to the closest side of the ship. I would have looked down to see if there were any empty seats in any visible lifeboat. Had I not seen any, I would have gone to the other side.

I would have seen plenty. At that point, I would have had two decisions to make:

  1. To return to my cabin to get my life preserver vs. a leap into the deep.
  2. Locating a safer place to leap from vs. jumping from the deck I was on.

With seats empty, I probably would have headed for my cabin. These seats are probably going to stay empty. Why? Because people are creatures of habit. As soon as most passengers who were left behind saw that there were no more lifeboats, they would have adjusted to the new conditions: "No exit." They would have prepared to die. Why? Because most people in a crisis think "lifeboats," not "empty seats." They think of the big picture as "no lifeboats here," rather "empty seats out there." They see no lifeboats, so they don't go looking for empty seats.
As for me, I'm an empty seat guy. If there were a commodity futures contract on the last train out, I would go long.

The water would be painfully cold. But since I was going to wind up in the water anyway, I would have decided to go swimming sooner rather than later. The longer I waited, the longer I would be swimming toward departing lifeboats.

Time was of the essence. The water was close to freezing. I would probably suffer spasms in swimming – maybe near paralysis. I would probably need a life preserver. I would have asked a crewman how to get to a lower deck. Then I would have gone to my cabin. I would have grabbed my life preserver and headed for a lower deck. I would have traded time for a lesser impact. My key to survival would be to keep my senses after impact.

In the water, I would have swum toward where I thought most of the lifeboats were clustered. If they had been moving away from the ship, then I would have tried to guess where they would be when I arrived.

Upstairs, passengers were listening to the band playing songs, although not "Nearer My God to Thee," contrary to legend. Those people were imitating the British by keeping a stiff upper lip. My approach has always been to get my lip as far away from avoidable trouble as I can, fast. Stiffness of lip offers no lure for me.

"Look out below!"

FEDERAL RESERVE POLICY

From that groaning sound, I have concluded that the Good Ship Bubble Economy has hit a monetary iceberg.

The question now is this: Is the scrape long enough so that it has punched a gaping hole in all of the watertight bulkheads?

Before a recession, there are conflicting opinions on this crucial question. One of the signs of this conflict is increasing volatility of the various stock markets. Wild swings take place like the one on October 24: 200 points down for most of the day, the Dow closed down 0.98 point. The bulls and the bears fight for supremacy. The market goes nowhere, wildly.

Alan Greenspan took over as Chairman of the Board of Governors of the Federal Reserve System in October, 1987, just days before the legendary 508-point decline: 22%. His response, like the FED's, was to pump in fiat money – "liquidity." That kept the economy from falling into a recession. Only in 1990–91 did the recession finally hit. The FED's response was the same: increased fiat money. For the next decade, there was no recession.

The NASDAQ's collapse began in mid-March, 2000, which followed the peak of the Dow and the S&P 500 in January. This did not persuade the FED to lower the target federal funds rate. At its March 21 meeting, the FOMC raised the target rate from 5.75% to 6%. Then, incredibly, at the May 16 meeting, it raised the rate half a point to 6.5%. How could the FED in March, 2000 hike the FedFunds target rate by .25 percentage point, two weeks after the stock markets had peaked? How could it do it again in May? Didn't they see what was coming? Obviously, they didn't.

Investors also did not see. The Dow was above 11,000 all through 2000.

Only at the January 3, 2001 meeting did the FOMC lower the target rate to 6%. On January 31, it lowered it to 5.5%. At the March 20 meeting, as the recession was beginning (we learned two years later), the rate was cut to 5%. This was a major cut, as were the cuts that followed.

In the spring of 2001, the recession began. The Dow fell briefly to 9,000. It immediately rebounded above 11,000, as the FED began cutting rates. But 9-11 caused a decline to 8,000.

By November 6, the month that the recession ended, the rate was at 2%. On December 11, it was cut to 1.75% – simply unheard of. One word suffices to describe what happened in 2001: panic. The FED was in sheer panic mode. On November 2, 2002, the rate was cut again to 1.25%.

At first, the stock market responded positively to these rate cuts. It went from 8,000 after 9-11 to well over 10,000 in the spring of 2002. But then it fell. It bottomed at just above 7,000 that fall. It began its long-term recovery in the spring of 2003.

By then, the FedFunds target rate was 1.25%. Then it was cut one last time: June, 2003. There it stayed for a year.

The increases, rising by .25 percentage point at each FOMC meeting, continued until June 29, 2006, when the target rate peaked at 5.75%. There it remained until the September 18, 2007 meeting, when it was cut by half a point.

This rate cut would seem to indicate a shift in monetary policy. So far, it hasn't. The adjusted monetary base has risen at about 1.6% per annum since mid-March. From August 15 until October 10, the adjusted monetary base fell by 1%. That's right: fell. This was during a crisis in the subprime mortgage market. [Note: This chart is updated frequently, so it loses relevance.]

There is no evidence of monetary inflation in the one monetary aggregate that the FED controls directly. In response to the surfacing of the subprime mortgage crisis, which created a panic-driven sell-off of brokerage shares in mid-August, the FED adopted a policy of monetary deflation. Got that? Deflation.

In response, the major brokerage shares soared. You can see this in the following chart of an index known as the XBD, which is published by the American Stock Exchange.

So, in summary, in the three-year period from mid-2004 to September 18, 2007, the FOMC raised the target rate for the FedFunds market from 1% to 5.75%, and the stock market rose from 7,000 to over 12,000. That's "rose." As in "went up a lot."

Then, in response to the subprime crisis in August, the FOMC did two things: (1) it reduced the monetary base; (2) it cut the target rate by half a point.

If there is some economic theory or technical investment strategy that explains all this, let me know. What happened was not intuitive.

NOT SO SMART AFTER ALL

On October 24, a report hit the financial wires that Merrill Lynch – bullish on America – has lost an estimated $8 billion in its subprime mortgage-related investments.

The Dow fell 200 points in response. But then the rumor came: "The FOMC will reduce the FedFunds rate target at its next meeting at the end of the month." The market then rose by 200 points. It closed for the day down by 0.98.

What was the verifiable news? That the geniuses at the nation's largest brokerage house have lost $8 billion in the unfolding disaster of the subprime mortgage market. What was the rumored news? That the FOMC, which 98% of forecasters had already believed would cut the FedFunds target rate, would in fact cut the FedFunds target rate.

This conveys the following information to me: (1) the best and the brightest hot-shots in the financial brokerage industry never saw the subprime mess coming; (2) the best and the brightest stock fund portfolio managers believe in the FOMC as the equivalent of the tooth fairy.

As of October 25, 2007, 174 mortgage lending firms have either gone out of business of have merged with solvent firms since December, 2006. This is tracked on www.ml-implode.com.

The FED under Greenspan lured lenders and home buyers into what have now become visible disasters. But for most of this period, 1991–2005, the policy seemed to create great wealth: rising home prices. That is a long period of success. So, when signs appeared in mid-2005 that the housing market had peaked, and some of us hard-money writers began warning about this, nobody paid attention. But the reality is here.

This brings us back to something that Ludwig von Mises warned against in 1912: when central banks manipulate money in order to lower market interest rates, the entire capitalist class is deceived into believing that more capital is available. Today, almost a century later, this deception is not only still widespread, it is worse. Investors believe that the central bank's ability to lower a target overnight rate enables it to raise stock prices by fiat – not by creating capital, but merely by making a public announcement of a target rate. What Mises described as an error regarding the actual supply of capital has descended into something bizarre: faith in the ability of a central bank to increase the value of capital (stocks) merely by making an announcement – with or without a change in monetary policy. On the basis of this announcement, investors redeploy money from debt to equity. They will do this even in response to a rumor about the announcement.

And yet . . . Merrill Lynch really did lose $8 billion. Very smart people did some very foolish things with investors' money. This capital has now gone into the land where the tooth fairy lives, the land of broken teeth and broken dreams.

Nowhere are dreams more broken than in central California. This is the hot, dry part of the state where most people did not want to live in my youth, the place where Okies and Arkies arrived in 1935. Then came the housing boom. CBS News (Oct. 10) reported on the recent economic carnage. Home builders are walking away from half-completed developments and half-completed homes. They cannot sell anything at yesterday's retail prices.

So developers are scrambling to get rid of houses they can't sell. Many are turning to auctions.

"You don't know where the bottom is, and so an auction will tell you if you hit the bottom and where it is," said Craig Barton of Anderson Homes.

But as Anderson Homes searches for the bottom, those who bought from the developer at the top feel betrayed. Sherry and Percy Berquist, who paid $597,000 last year were shocked to see $335,000 set as the opening bid for an identical house to be auctioned. The developer may be able to absorb that loss. The Berquists can't.

"It's gonna be very tough," said Sherry Berquist.

Across the street Amy Sturdevant paid $585,000 for a house. But now the developer has set $295,000 as the opening bid for similar houses down the street.

"I feel like my parents' grave has been robbed. This was an inheritance. I sit out here and I look at this," said Sturdevant.

In every mania, a few emotion-driven people buy at the top. This now-deflating housing mania was debt-funded. You could still get jumbo loans (above $417,000) last July at fairly low rates. Today, you can't. There is no indication that anyone will be able to do so in time for these now debt-burdened people to get out from under their upside-down mortgages. They must now make mostly interest payments for the next 15 years just to pay off the equity that they have lost in one year. They are prisoners in their McMansions. They will not be able to move out. If a better career opportunity comes up more than 150 miles away, they will have to skip it.

For what? To live in an uncompleted subdivision that will not be completed for many years.

This is the price of central bank policies designed by very smart people. They are very smart people who think that they are wiser than free markets.

They aren't.

CONCLUSION

The U.S. housing market is down – on paper – by over a trillion dollars, CBS News reports. But who knows how much? The report cited one forecast that says it will be down by another $3 trillion in a year. I think this estimate is plausible.

Median prices are down by about 4%, year to year – the first national decline since 1933. Sales are down by 8% nationally, and by 25% in the Southwest.

Why are prices not falling faster? Because sellers think this decline is temporary, that in a year, their homes will be worth what they were a year ago. Sellers learn slowly. Their homes will not rebound just because sellers think they are special, that they can beat the market.

In a year, there will be real fear. Sellers will not be able to sell. Inventories will be much higher. Sellers will be stuck in their homes, or worse, paying the mortgage on their now-empty houses and rent on the one in the new location.

Contracts that are contingent on the sale of a home by the buyer will fall through. Reality will set in.

Some sellers will run out of bargaining room. That is when you should be there with cash.

If you are seller, think "Titanic." Lower your price now and get out while the ship is still afloat. The water will be just as cold next year. Put on a life vest and jump, before the lifeboats float out of swimming distance.

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