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THE EXPLODING FINANCIAL BUBBLE - PRELUDE TO

HYPERINFLATION?

"Pride goeth before destruction, and a haughty spirit before a fall." Proverbs 16:18

"Always mistrust the obvious"

This is a summarized version of Don McAlvany's full 12 page January Special Issue. To receive the full report please fill in the request form at the bottom of this page.(NOTE: This is a special issue of The McAlvany Intelligence Advisor, which is not a part of the regular monthly newsletter. Feel free to copy and distribute it, to place it on your website, etc.)

Introduction

1999 was the most prosperous year ever especially in the financial markets in U.S. history. The stock market and other financial assets set new records and enormous wealth was created literally overnight out of thin air. Is the U.S. economy really that strong? Are corporate earnings and fundamentals really that good? Do they even matter any more? Have we finally reached that "new era," that financial Nirvana whereby asset values, like Jack's beanstalk, will grow to the sky overnight and keep on growing forever?

Are hard work and 8 to 5 jobs now outdated anachronisms of the "old era" to be replaced by a "new era" of day trading, instant riches and prosperity, and overwhelming financial wealth, affluence, and prosperity? Has the Internet, unlike Ponce de Leon's elusive "fountain of youth" become our perpetual "fountain of wealth" satisfying our every personal or financial whim or need?

This is now becoming the dream (or is it the delusion) of tens of millions of Americans many of whom have concluded that instant, pain-free wealth from "playing the market" is better than working for a living. We have finally found (like the "perpetual motion machine") a "perpetual money machine." All the old rules have been repealed. We are in a "new era" of perpetual wealth creation.

QUESTION: What is wrong with that picture?

ANSWER: It is a delusional psychology that emerges only once in many decades or even centuries at the peak of a speculative boom and blowoff. It is driven by rampant greed, a rampant something-for-nothing philosophy, and the very arrogant belief on the part of the masses that they are invincible, bulletproof, invulnerable to financial loss. It is a delusion and defies 6000 years of financial history. It always ends in a crash and financial disaster for its participants.

THE MOST MASSIVE MONETARY EXPANSION IN WORLD

HISTORY

QUESTION:What has caused the present, largest ever-in-history financial bubble and stock market buying frenzy?

ANSWER: The most massive monetary expansion, the most massive injection of financial liquidity into a financial system totaling trillions of dollars in U.S. or world history. It has been done by the Fed, the U.S. Treasury, and other monetary authorities since 1994 but especially over the past 16 months since September, 1998. It has created the greatest speculative buying frenzy (in U.S. financial assets) since the ill-fated Tulip Mania and financial collapse in Holland in 1637. Only this mania is a hundred times larger.

In October/November '98, in the wake of the near-collapse of Long Term Capital Management, the Fed/U.S. Treasury and monetary authorities pumped over $200 billion in new liquidity into the U.S. financial system to prop up the faltering U.S. stock market. In the last 13 weeks of 1999, the Fed pumped in another $194 billion to keep the bubble market expanding and to insulate against a Y2K-induced financial collapse which the Fed desperately feared.

In the last 60 days of 1999, the Fed expanded the adjusted monetary base at an unprecedented annualized rate of over 48% - the highest in U.S. history! Much of that excess liquidity has flowed into the U.S. stock market. The public is now stampeding into stocks like at no time in history, with stocks that have no earnings or near term prospects for earnings (i.e., they are losing money) going up 10, 15, 20 or 25 times in 1999.

In November '99 alone, margin debt rose $24 billion to $206 billion a $65 billion or 46% increase in margin debt for the year. An explosion of derivatives trading in stocks has added massive leverage to the stock market. And that does not include all the indirect borrowing that has made its way into the stock market from an increase in mortgage and other debt for the household sector as well as unprecedented stock buybacks by the corporate sector.

Underscoring the present buying panic and mania is the fact that from October 27 to December 22 (less than 60 days) the Nasdaq grew 40% that is an incomprehensible $1.4 trillion increase in market value or new wealth. Over the past nine weeks, over $2 trillion in stock market wealth has been created.

Over the past 14 weeks, our already overleveraged financial sector increased its commercial paper borrowings another $123 billion to $1.1 trillion, while the broad money supply (M3) increased $230 billion to $6.8 trillion. We are presently seeing the greatest credit expansion in U.S. history and most of it is pouring into the stock market. Some is also beginning to pour into real estate.

ARE WE ENTERING HYPERINFLATION?

QUESTION: What is happening?

ANSWER: The Fed and the U.S. monetary authorities have triggered a hyperinflation which is currently manifesting itself in financial assets (primarily stock). It is now beginning to roll into real estate where prices in certain California real estate markets are now rising 25 to 35% per year. It is likely that at some point in the coming months, this hyperinflation in financial assets will roll into wages and prices. Indeed, industrial commodities were up almost 40% in price in 1999.

If the present hyperinflation in financial assets rolls into the real economy, our currency could be destroyed in a matter of days or weeks. This phenomenon is beginning to take hold all over the world. Hyperinflations are normally followed by financial/economic collapse and the rise of a dictatorship. The hyperinflation of the German Weimar Republic was followed by economic collapse and the rise of Adolf Hitler and the Nazi Third Reich.

WHAT IS A "CRACK-UP BOOM"?

Ludwig Von Mises, history's greatest free market (Austrian) economist, wrote in his epic work The Theory of Money and Credit about a concept he called the "crack-up boom." As he wrote: "The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system."

Dr. Frank Shostak, a leading Austrian economist and Chief Economist at Ord Minnett in Sidney, Australia, explained the concept of "crack-up boom." According to Von Mises, "whenever people are observing ever expanding money supply they start to form expectations that the purchasing power of money will fall. Once they become convinced that the monetary pumping will never stop and consequently prices of goods and services will continue to rise, they will spend their money as fast as possible," i.e., their demand for money will fall.

"Ultimately this could reach an extreme," i.e., no one wants to hold money and there is a flight to real goods. This Von Mises calls a crack-up boom. "In other words, the increase in the money supply that generates expectations of a fall in money's purchasing power leads to the fall in the demand for money. Eventually, prices of real goods are rising to such high levels that people don't have enough money to buy them. Consequently it is not possible to conduct monetary transactions. The monetary system breaks down."

When Von Mises wrote about credit excesses precipitating a flight to real goods (i.e., super or hyperinflation), he may not have envisioned today's stampede into stocks. Nevertheless, there are some strong similarities in his "crack-up boom" and in the stampede to convert money into stocks today fed and exacerbated by the Fed's promiscuous, non-stop monetary expansion. So we have the masses dumping cash to borrow more money to buy more stock. The same is beginning to happen in the real estate market and could begin to happen in commodities and other real goods including the much maligned, manipulated, and suppressed gold and silver markets.

The Fed may be losing control. Von Mises describes an accelerating situation which finally eventuates, wherein the monetary authorities must keep injecting more and more financial credit on an accelerating basis into the bubble to keep it going. When they slow it down, to stop the monetary inflating, the bubble collapses.

This is like a drug addict who must take ever increasing doses of drugs to maintain the same high. There is a principle of diminishing returns at work and if he levels off, slows down, or stops the drug intake, he will crash. The same thing applies in accelerating inflation, hyperinflation or a "crack-up boom."

For the first time since the 1970s, this writer now believes that there is the potential for high and rising inflation in the U.S. possibly leading to super or hyperinflation. A financial collapse will surely follow.

IN SUMMARY

Americans are still partying on the deck of the Titanic driven by raw unadulterated greed, materialism, pride and arrogance believing that nothing can touch them, nothing can bring them down. They are very wise and indestructible in their own eyes. They just dodged the Y2K bullet (or so they believe) or was it an iceberg? But they don't see that there are other, even larger icebergs directly ahead. The Bible says that "pride comes before the fall." Americans are a very proud and prosperous people and this writer suspects they are headed for a major fall in the not-too-distant future.