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A Crisis in Democracy

by Martin A. Armstrong

©Copyright April 15, 1987

Arthur William Edgar O'Shaughnessy once wrote in his classic Ode back in the 19th
century...

"We are the music-makers, And we are the dreamers of dreams, Wandering by lone
sea breakers, And sitting by desolate streams; World-losers and world-forsakers, On
whom the pale moon gleams: Yet we are the movers and shakers of the world forever, it
seems."

Perhaps we have been merely dreamers of dreams and indeed in the end we may find
our children's children one day writing of a society of "world-losers" and "world-
forsakers." Perhaps the dreams of lower interest rates have suddenly been shattered as
the Ides of March brought in its shadow the first prime rate hike in many long months.
Of course the words that poured forth from the mouths of our politicians all clearly
foretell of this event as a mere glitch in the long journey to where full employment, no
inflation and cheap money lies patiently just around the next bend. Either our fearless
leaders are lying through their dentures or they are so confused themselves that they
believe in what they actually speak. They have taken the role of a father who sits on his
child's bed and reads stories of endless wonder; the stuff that dreams are made of
which disappear in the mist of the night when the new born sun begins to rise.

Are we dealing with a glitch in a long-term journey to the land of fables where the best
of all extremes lies waiting to be plucked from a tree like the legendary golden fleece? Is
it really possible that lower interest rates lie ahead, unemployment will be banished
along with the trade deficit at the hand of a lower dollar and our politicians will suddenly
see the light and balance our fiscal budgets with the sweep of the pen? Or are we at the
beginning of the end of a dream which has overstayed its welcome? It is always nice to
be the dreamer of dreams like a child who falls fast asleep leaving behind in the world of
reality only a tiny smile for all to see. But when we gave up our youth, we gave up that
special right to dream of things which no mortal should dare. For when we wake, the
harsh consciousness of reality becomes the master of our own fate. But strange as it
may seem, the real power of the future lies within the grasp of us all, for indeed in the
end, we are the movers and the shakers of the world forever.
The golden dreams of cheap money, full employment, no inflation and prosperity for all,
has never graced the world simultaneously. Oh sure, one nation has experienced this
phenomenon for a brief period in time at the expense of its neighbors; but it has never
lasted. Such goals on a long-term basis are mere fables for children told to comfort
them and their fears of the oncoming night. The long-term models, which we have
designed, have foretold of events in a far different light than most. March, we warned,
was the ideal turning point for interest rates, particularly on the short-term. This recent
hike in the prime rate is not a freak, but a forewarning of what is yet to come. It came on
the heels of our model so quickly, that this in itself is not a omen of stability, but a
change in the winds of destiny.

At the 1985 Economic Conference held here in Princeton, I went over our long-term
models on over 300 various economic indicators from 35 different nations. In each case,
it was pointed out that the VOLATILITY was increasing with each turning point
throughout this century. The fact that the model called for the turning point to be in
March of 1987 for the short-term rates is important. But of even greater importance is
the fact that under normal conditions, a rate hike would take place within 3 months of
reaching a major turning point. In this case, the first rate hike in years came precisely on
the turning point. This is itself forewarning of even greater VOLATILITY than what was
discussed at the 1985 Economic Conference.

This subtle glitch, as everyone is calling it, is more serious than we had expected. The
mere fact that it has come so soon in conjunction with the major cyclical target,
suggests that the upside potential in interest rates will be far greater than we have been
talking about. We could easily see levels matching those of 1981 by January 1990 and
this may be too conservative at that. The confirmation as to whether or not we are in
fact in a new uptrend in interest rates overall, will arrive when the Federal Reserve
Discount Rate exceeds 6%. When that happens, then the possibility of this being a
mere glitch, will forever be erased from our financial history.

O'Shaughnessy's words themselves express the overall role of us all in this battle
between the free markets and the aspirations of our Napoleonic forms of financial
governments who seek to manipulate and control our economic social interaction. For
indeed we are perhaps a bunch of world losers who really do not know what lies ahead,
but the mystical aspect behind our power lies in our sheer numbers. Government
intervention can never work for a variety of reasons. If the central banks wish to support
the dollar, and the free market forces continue to add selling pressure, the only way the
central banks can hold their ground in terms of supporting the dollar will be to
continually buy all that is offered. The outstanding supply of paper money in circulation
vastly outnumbers the buying power of the central banks. Even collectively, their total
influence upon the money supply can at best reach 6-7% or roughly the amount of
reserves it requires from its member banks. Thus, these scares which inflict the
currencies sporadically, have been merely temporary. The forces of volatility are always
influenced by psychological implications of the central banks rather than the real
amount of currencies they buy or sell through their intervention practices.
The central bank's influence upon the credit structure is perhaps greater than its
influence over cash itself and to exercise that influence will require discount rate hikes!
As long as capital continues to run away from the bond market and into equities and
gold, the selling of the dollar will continue at least on a short-term basis. The prospects
of a trade war with Japan will only further weaken the dollar's posture in the short-term
and interest rates will rise in an effort to attract capital away from the equity markets.
The dreams of dreamers who foretold of the promised land of lower interest rates will
have turned into a dark and frightening nightmare.

There is no doubt that we have listened to a lot of things politically these past two years.
We have been told that our trade deficit could be reversed if we only force the dollar
lower. Well nearly two years later and with a 40% lower dollar since 1985, the trade
deficit has continued to worsen. These trade figures are now being used to embark on a
tit-for-tat trade war with Japan, who has by and large justly deserved it to some degree.
But those who now spout forth warnings that we will slip into another world depression
due to protectionism (as they cite the Smoot-Hawley Tariff Act for creating the world
depression in 1931), not only do they have their historical facts a bit out of order, but
their reliance upon these current trade figures is not on solid ground either.

Have our government officials been disrupting the foreign exchange markets and are
they liable to disrupt the interest rate markets based upon solid trade data for a just
cause? The answer is NO! The first thing you should know is that the trade deficit
figures are NOT actual sales or capital flows which are being counted as is the case
with the money supply figures, new housing starts, retail sales or the consumer price
index. Most of these indexes we hear of are actual hard numbers which are seasonally
adjusted. But the figures used in the balance of trade status are NOT! These figures are
purely a census, which means they are put together by doing a survey. The data
collected is not only unreliable, it is grossly distorted.

Unless the trade balance census is broadened to redefine this change which has taken
place in our economy, the trade deficit figures which are being reported will not get a
heck of a lot better. This fooling around with the foreign exchange markets to help the
manufacturing sector in some areas hurts the bulk of the American population by
inflicting upon them an abnormal increased level of volatility in not merely foreign
exchange, but in the equity markets, bond markets as well as gold and interest rates. To
throw more salt on the wound, it doesn't matter how low you force the dollar, the
consumer has no other choice but to buy foreign manufactured goods in many cases.
Stereos, VCR’s, televisions, appliances, and many other areas of manufactured goods
have little or no American domestic produced counterpart who will benefit from a trade
war or a lower dollar. It will only increase the price of those goods to the American
consumer which will spark inflation and then the Fed will raise interest rates to combat
the inflation. The consumer loses no matter what happens!

Another aspect of forcing the dollar lower comes to light when one looks at the influence
it has had upon the markets here in the United States. The decline in the dollar has
sparked a flood of foreign buying in all areas of U.S. assets. If we look at the following
table we can see the difference between a U.S. investor's perspective and that of a
German or Swiss investor.

02/85 03/87 % Change

Dow Jones 1300 2400 +184%

DMark 29c 56c +193%

Swiss 34c 68c +200%

This table clearly illustrates that the advance in the Dow Jones Industrials has not
outpaced the decline in the dollar. Therefore, if you had invested in the stock market in
1985 and then cashed all your stocks in during March of '87, you would say you did
quite well. But if you flew to Switzerland to buy a house which you had priced 2 years
ago, even if the local real estate market did not appreciate in Switzerland, the house will
have cost you 16% more over and above the 184% in profits you made on the Dow in
two years!

Let me turn the perspective around for the American readers so you can clearly see
what has really happened and why you have NOT made any money on this bull market
whatsoever from a real honest international purchasing power perspective.

During 1985, the British pound fell sharply to US$1.03 sparking quite an uproar. From
the local perspective, the price of housing in London was rising rapidly. In the
fashionable sectors of London where the non-British residents normally lived, the pearly
white townhouses of Victoria and Kensington began to rise in price rapidly by 20 to 30%
almost instantaneously. All the buying came from the non-British citizens. Suddenly it
was like a one-day sale at Harrods. To the British, all they saw was real estate rising
like crazy. To the non-Brit, the price had just been reduced drastically in terms of
dollars, yen, dmarks and francs. The property values rose in DIRECT proportion to the
decline in value of the pound as expressed in foreign exchange (from US$1.40 to the
pound to US$1.03). From the British perspective, they saw massive inflation. From the
international perspective, London property values rose back to where they had been
prior to the fall in the pound from US$1.40 to US$1.03.

What is happening here in the U.S. currently as the dollar has declined by 40% between
1985 and 1987 is exactly the same experience as that of the British between 1983 and
1985. All foreign buying coming into the U.S. property markets on the part of foreign
investors is being driven by the very same forces of asset inflation driven by sharp and
swift foreign exchange fluctuations in value. But when this foreign buying comes into the
U.S. markets, be it stocks, bonds, real estate, or gold, it is not considered to be part of
the American balance or trade. Yet in reality, this influx of capital swells the local money
supply and creates great booms, but in its wake lies the seeds of inflation!
We are not benefiting at all from this lower dollar as a society on the whole for many
reasons. If we sold our house and realized a sudden 40% gain in two years, we have
merely kept up with the depreciation in the dollar. But the government then considers
that we have just made a profit and we must pay our taxes. So if you made 40% and
then paid a 20% tax, your net is 32%. You lose since the price of housing in overall
terms has risen! Therefore, if you stayed in the same region, you will find that your net
worth in international terms has just been reduced by the taxes paid to the state.
Consequently, your standard of living is gradually reduced with every swing back and
forth in the value of the dollar.

We have a hard time understanding that the real cost of government intervention into
the foreign exchange markets may be in the bottom line. This taxing of so-called profits,
which are none other than adjustments to foreign exchange fluctuations, the higher cost
of goods which have no counterpart in American manufacture, the transfer of assets
from domestic into foreign hands and the effect upon the volatility level in all markets
from stocks and bonds to gold and real estate, combine to make our financial lives far
from an easy road to follow. We are losing money and assets without ever knowing
what is happening and such things can only be seen in the gradual decline of our
standard of living in the years ahead. What young couple can afford a house today
unless both work full-time. That was not the case just 20 years ago. It is now for the
majority. And at that, the new homes are of far less quality than before. This is how the
standard of living declines.

Therefore, this new turn upward in interest rates is not a fluke. It is now the time when
all this craziness filters over into the interest rates which will become yet another tool to
defend a dollar which should never have been manipulated in the first place. Everything
in life has its price. It is one giant chain reaction without end. Every short cut we take
merely forces us to respond to another problem somewhere else along the way.

Nothing happens in a trend for no reason. Every move is a clue to the future. When gold
peaked in January 1980 at $875 on Monday the 21st, by Friday of that same week gold
had fallen to $630. It was under $500 by February. By March, everyone was talking
about the decline being only temporary as gold rallied to $730. But that sharp decline
between January and February was a warning in itself. Then too the words which
spouted forth were joining together forming phrases which uttered wonderful dreams of
how it was a temporary correction and that gold would rally beyond a $1,000 in the end.
Nothing fundamentally had changed just yet. Russia was still in Afghanistan and
inflation was still soaring. But that correction meant a great deal to the long-term. This
was not a freak occurrence which should have been ignored, it was the sign of the
beginning of deflation.

Collectively we are indeed the movers and the shakers. Ask yourself if you find interest
rates reasonable enough to warrant buying now? Would you hold off waiting for 5% or
6% mortgage rates? The problem that we face is ourselves. Collectively we are satisfied
with where rates have been and we are buying despite what everyone claims about a
lower rate future. We all have collectively brought about this turn in interest rates and it
is not a freak coincidence but a warning that the tide has quite possibly changed once
again.

Figuring out exactly where we are on the long-term scale of things is never easy. Long-
term trends are slow movers and they begin always with the subtle movements which
make no sense and strike in the midst of the night when least expected. Only as time
goes on will additional fundamentals rise forth to the surface. Only then will we all
gradually come to the same conclusion that rates are in fact headed for higher ground
and not dreamland.

Back in April 1981, the Economic Confidence model turned, which pointed to a
deflationary trend into July 1985. Everyone said it was crazy to forecast deflation. With
deficits rising how could deflation emerge? Inflation was all around us; they said.
Deflation was not merely impossible, it was INCONCEIVABLE!

Just prior to the 1985 Economic Conference I was asked to appear on Financial News
Network (National Cable TV). The commentator asked me what was going to be
revealed at that conference concerning the long-term outlook. I replied that deflation
was at an end and that we would now begin a gradual shift back towards inflation with a
rise in gold and the stock market simultaneously. He looked surprised and asked how
could I possibly call for inflation when deflation was all around us? I responded, they
asked me in 1981 when I forecasted deflation how could I possibly forecast such a thing
when inflation was all around us? You never see the real turning point on a long-term
model until you are normally 2 years away.

My opinions of what the future will be like have always been different than most. I am
not a doomsday pessimist who foresees another world depression nor do I preach a
return to the gold standard. In that department, we kissed those dreams good-bye a
long time ago and returning to a hard money policy is too unrealistic for this day and
age of instantaneous capital movement. Indeed the monetary system will collapse and
be reborn. However, it will not be through a massive destructive wave of deflation as
once plagued the world during the 1930s. The collapse that is forthcoming will be one of
inflation inflicted by the paper money system. Government will move to replace our
current world monetary system, not with gold, but with electronic banking.

The fuse which will ignite this change in events will be a world seriously burdened and
over-extended with debt. It will be the leverage effect of debt itself which will make the
future more volatile and regretfully, inescapable!

As the deficits grow larger, and the need to raise taxes builds, the next popular move
will be into the electronic banking system where money becomes accessed totally by
your credit or debit card. Salaries will be automatically deposited and bills automatically
deducted along with taxes. The excuse will be simple. We have heard it from
Washington before. If the underground economy paid its fair share of taxes, they say,
there would be no deficit, only surpluses. Therefore it will not be government's fault, but
the private sector's fault for not paying its fair share! Such a new system will solve that
problem.

This is the way of the future and it will not be that far off on the horizon. This circus
game with jawboning the dollar up and down to influence trade balances, will soon
backfire and the sheer increased volatility in foreign exchange will alone raise the voices
of business who will demand exchange controls as a simple means to end the risk in
conducting international trade.

The years ahead will be interesting indeed. However, they will not bring back old
methods nor will old ideas suffice. We are on the verge of a new generation in economic
experimentation and the sad part about it, is the sublime fact that there very well may be
little other choice. For every action there is always the inevitable reaction, and for
everything holy it is said there exists the unholy. In this case the robust and jubilant bull
market in the equities will not a happen without its price. While the stock brokers cheer
and the investors celebrate, further down the road lies a price waiting to be paid. That
price of this current bull market is something again which few foresee. But in some
respects, the footprints of the past show clearly all the wrong turns we have made which
have brought us to where we are today.

The most important parallel from the 1929 saga is not of bank collapses and shoe shine
boys bearing market tips. The importance from a parallel standpoint is the interaction of
capital flows from not merely one nation to another, but from one market to another. As
discussed on numerous occasions before, the bonds collapsed as stocks soared
between 1927 and 1929. It was the flight of capital from bonds and banks into equities
which sparked greater problems in world debt. Those same influences are at work today
and they will not simply go away. The price that we must eventually pay for this bull
market in stocks world-wide will be higher interest rates as governments and banks are
forced to compete for capital against a buoyant stock market. When they clearly realize
that they are losing that battle, then they will seek to write new laws to protect us from
our foolish selves.

The adverse effects will filter over into foreign exchange and it will be the combination of
all these events which will carve the handwriting into the wall, not just on it. The solution
to all such things will be as it has in the past. Government's inability to control the free
market forces will be blamed and their excuse will as always be the same. They need
more power to do the job. We are indeed the movers and the shakers. Collectively we
may know not what we are doing but in the end our response to the movement of the
whole remains the true deciding factor in the end exactly as O'Shaughnessy once
wrote.

You may think that this tale of the encroachment of government is a bit overdone on my
part. But the course of history is in fact on my side. Government always evolves in this
manner rising out of panic and turmoil with more power than it had before.

James Madison once wrote...


"I believe there are more instances of the abridgment of the freedom of the people by
gradual and silent encroachments of those in power than by violent and sudden
usurpations."

Even Thomas Jefferson warned of the dangers which government offers...

"Sometimes it is said that man cannot be trusted with the government of himself. Can
he, then, be trusted with the government of others? Or have we found angels in the
forms of kings to govern him? Let history answer this question.!"

The future will spawn a crisis of a different sort indeed and its forthcoming can be read
easily upon the chart patterns of bonds, stocks, gold and clearly in foreign exchange.
The forthcoming crisis will be a Crisis in Democracy for to control our financial destiny in
a more orderly fashion, we will give up much of our rights to privacy in our personal
financial affairs. If this is correct, then gold has bottomed in terms of dollars in 1985
exactly in tune with the Economic Confidence Model, the interest rates will rise from
1987, stocks will explode beyond the wildest expectations of the majority perhaps
exceeding 5,000 on the Dow by 1990, and the dollar will fall to new record lows under
that of 1980 in the Dmark and Swiss franc. If all these things come to pass, the outcome
will indeed bring forth a Crisis in Democracy such as we have never before witnessed in
this century. Government will be unable to resist more controls in the face of volatility
beyond our wildest imaginations.

The writings of Madison, Jefferson, Adams and others all bear witness to this
evolutionary process in government power. It was for these same reasons why the
United States came into being. It is said that history repeats; perhaps it is not so much
history which is on a repetitive cycle, but instead it may be man who fails to learn from
his own mistakes and past misfortunes.

From an investment standpoint, enjoy the bull market in stocks. It should move through
some fitful starts and stops here and there, but in the end, it will show us all the true
meaning of a raging bull. Gold's advance in terms of dollars is still just getting started. It
has some testing to do on the downside and it will not advance upward in a greater
proportion to the dollar's decline. Nevertheless, long-term gold remains in a sound
position. Weep for the poor soul who has not the courage to leave the safe and secure
atmosphere of the bond market, for he will be the real loser in the years ahead. If there
is anything we should have learned from the past 15 years, it's definitely to go with the
flow. No trend lasts forever it's just one of those times when the present must depart
from the recent past.

The volatility which will besiege all markets will be the child of our past memories. When
interest rates rallied steadily and gold soared to new highs in the late 1970’s and early
1980’s, the majority stood by in disbelief. With each new high in record territory,
everyone remarked that it was the high and that it couldn't possibly move any higher.
But both gold and interest rates eventually pressed beyond what everyone expected
and only when those trends came near the end did the majority call for $1,000 gold and
a 25% prime.

Today we are all aware that interest rates can return to 20% because they have been
there before. We will not standby in disbelief as we did before, but instead we will all be
much hastier to respond than we were the last time around. This natural tendency of us
all will definitely spark a more rapid decline in bonds and a very rapid advance in gold
when the key support and resistance levels are broken in the future. The balance of this
decade will in fact bring with it record moves in all markets far greater than anyone is
expecting at this stage in the game. Learn well from the past for it is our only guide to
the future. What has happened before is always within the scope of possibility and each
generation may believe that it has built a better mousetrap, but not one has yet escaped
the turmoil of its consequences.

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