Supermoney, page 6
Everything in Smith’s Increment is Supercurrency, but only that Supercurrency which has just changed from stethoscopes and lollipops to a multiple of net counts as Smith’s Increment. At some point, all Supercurrency went through that process, but we count it only the first time it happens.
So we have a somewhat skewed income pattern in the society. There are people below or outside the level of M1. They have problems earning any money at all, because they are badly educated or not motivated or they can’t get to where they have to go. They have no money to speak of, whether currency, coins, or checking accounts, and many of them are on welfare. Then we have the vast majority of people, earners of M1. They go to work; their employers pay them; they spend the money at the grocery store, mail checks to the druggist, pay their taxes, stash a little into M2, and struggle on. And finally we have the Supercurrency holders, the serene owners of the M3.
The poor innocents among us do not realize the impact of a superior currency around. They still think the green stuff in their wallets is money. We can all huff and puff and work overtime, but there is no way we can catch up, because there is nothing to capitalize our earnings. And Supercurrency compounds beautifully, given a bit of time. The Rockefellers may be smart, but the gap between our smartness and theirs is not equal to the difference between our currency and theirs, by several light-years.
A friend of mine bought himself a twenty-eight-acre palazzo in Greenwich and fixed it up handsomely before the bear market. He said he could always get a million for it. I asked him who would have a million to spend on a house in spare times, and he said, “There will always be somebody whose company has gone public and gotten listed who can peel off some of the stuff and spread it around. There will be more of those guys than there will be houses with twenty-eight acres in Greenwich.”
Corporations sell stock to retire debt, to build new plants or what have you. That is not Supercurrency because on the books of the company the money received turns into the new plant. But when the Selling Stockholders dispense of their equity, they move into the Supercurrency class, at capital-gains rates.
There are other ways of compounding wealth, usually involving borrowing on the asset—the real property or the oil in the ground—and buying some more. But the most easily accessible form is Supercurrency, obtained as close to the source as possible. That is your number, M3, and if riches gleam in your eye, at least you know where they are.
While there are other forms of wealth, Supercurrency is the superior currency of the country, because if they make a profit, even the oil deals and the real estate deals and the farm deals and the equipment-leasing deals will be brought to market and sold at a multiple of their earnings so that their participants can get the real stuff, traded paper.
Obviously, the laws and mechanisms of the country are built around the protection not just of currency but also of Supercurrency. It would not be the same society—whichever way you like it—without the structure and mechanisms that support the currencies, both Super and regular. Yet a very short time ago, the structure and mechanism went through some perilous times.
What happened in 1970 helps to explain why so many investors have recent scars. The shaking of the structure was a much nearer thing than anyone realizes—that is, anyone except those who were in at the countdown—and there are some lessons to be learned.
It is not easy to have a story about something that did not quite happen, and it is particularly not easy to have that story revolve around abstractions, concepts that may be unfamiliar, and statistics. To avoid footnotes, the statistics have been chucked into the back of the book. Most of the numbers are from the Board of Governors of the Federal Reserve, or the Federal Reserve Banks of New York and St. Louis, whose help is hereby acknowledged, or from equally public sources. It is more important for a general reader to get the feel of what happened than to walk through the mechanics, so if it gets a bit abstract, just keep going.
Given what happened, there was no way for the market to stay up. Though a repetition of these events is not likely, at least for a while, there is nothing to say that they could not happen again.
The first of the two moments when the structure swayed perilously is the weekend the United States almost ran out of money. That is more metaphoric than precise, but it does serve to introduce the first of the great near misses. Most investors turn only to the stock-market page, but the stock market does not exist all by itself. There are also bond markets, commercial-paper markets, commodity markets, a banking system and so on. None of these is self-contained: money does flow and the markets are interdependent. Any disaster or near disaster brings a search for villains, who fleeced the lambs, and so on. In the Crunch, the villains were very widely dispersed; in fact, the crisis point came from a rather broad sweep of history.
II:
The Day the Music Almost Died
1:
THE DAY THE MUSIC ALMOST DIED THE BANKS JUNE 1970
IN a Crunch, the country runs very dry of money. It is hard to understand that a country can run out of money because, after all, countries by definition can print money. But they can also be overtaken by events, after which the printing power does not alleviate the pain.
Everybody could tell, that June weekend in 1970, that a Crunch was on: it was difficult for small borrowers to breathe, and their ribs hurt. If you wanted to buy a $40,000 house, five years previous you might have put up $6,000 in cash and paid 5½ percent for twenty-five years. Now, in the late spring of 1970, the savings and loan wanted $15,000 down and 8½ percent, if it would make the loan at all, and some did not. Some smaller businesses were even worse off. They had been, let us say, used to taking out a bank loan for taxes, and then repaying that loan over a year. Now they were told the loan would be cut down or out, and if they went to other banks, the other banks said they weren’t taking any new clients. That meant the small borrower was out on the street, hustling for money wherever he could find it.
Interest rates were at their highest levels in a hundred years. The prime lending rate at banks had been as high as 8½ percent, and some said there was no reason it could not go to 10 or 12 or 15 percent. If the prime rate is at 15 percent, that is such a new ball game that the Dow Jones averages could fairly surely be predicted to sell at 002.
There are bankers around who say there was no crisis in 1970; you could always get money if you wanted it—you might have to pay 20 percent interest for it, that’s all. Or maybe take it in blocked dinars. Even the use of the word “crisis” is controversial—it always is—but the Federal Reserve Bank of New York used it in a retrospective. As that June weekend begins to fade, the crisis seems less acute. By the time of the annual report of the Fed’s Board of Governors, the language applied to the events was “serious uncertainties.”
The liquidity crisis of that time didn’t have much to do with the inability of buyers and sellers of stock to find each other and touch fingertips. Liquidity in this case meant usable funds, borrowable funds for American business. A decade ago nobody could imagine that money in the United States was finite. It was like all the rest of our natural resources: there was plenty for everybody, you could get what you needed, and you certainly didn’t have to worry about running out. The discovery that the supply of money was limited seems to have had a profound social effect as well, for, as with middle age, it does mean that you may be able to think of what you would like to do, but that does not mean you get to do it.
There were two popular off-the-top-of-the-head rationales for the Crunch, and both of them were true. One was that nobody had bothered to finance the Vietnam war. There were no major increased taxes to pay for Vietnam, for reasons well spelled out by political commentators. It was not supposed to last that long, and increased taxes would endanger the Great Society program. The second reason was “inflation psychology,” which meant that you had better buy it today, because tomorrow it, whatever it might be, would cost more. Right after the summer the money almost ran out, I had a long talk with the treasurer of the telephone company in one of our major industrial states. The telephone company has excellent credit, and even in a Crunch it can borrow. This particular treasurer—and his appropriate committee—committed his company to pay more than 9 percent for twenty years. If he had waited through the crisis, it might have cost his company only 8 percent or even less. One percent on many millions of dollars can buy a lot of telephones. I wanted to know if he felt dumb, though I didn’t put the question quite so baldly. He said he didn’t, and he had worked out a nice rationale. He had had a leeway of only six or eight months, he said, in which to borrow the money.
“The rates were eight percent, so I decided to wait a bit,” he said. “Then they went to eight and a half. That is historically very high, so I wanted to wait until the rate came back to eight. Then the rates were nine—more than nine—and there was talk that they might go to ten or twelve. We needed the money, and I had run out of time. So I had to do it.”
I pressed him a bit.
“Listen,” he said, “we borrow money all the time, and if the rates stay down I’ll borrow some more and then the average won’t look so bad. Anyway, I’m retiring in four years.”
It still sounded dumb to me, but then I have never had to borrow money for the telephone company, and quarterbacking is easier from the grandstand, especially after the game is over. Even Presidents know that.
Once again, the story of what happened can be seen from the tables of the Federal Reserve, this one called Funds Raised, Nonfinancial Sectors. Vietnam and inflation were indeed the causes of the Crunch, but from the Fed’s figures we can see that the stage was well set, for the demand for credit had increased by more than twice the savings that could supply it.
In the early sixties, the demands for money were more or less consistent with the growth of personal and corporate savings. But by 1964 the demands for credit by business and by state and local governments had begun to increase. After a period of fairly slow economic growth, business began to spend for new capacity and new technology. By 1965 corporations had more than doubled their 1960 borrowing, from $14 billion to $29.6 billion. State and local governments increased their borrowing 40 percent. And in consumer credit and mortgage, individuals and households increased their borrowing 72 percent.
All this was against an increase in the gross national product of 36 percent and in personal savings of 40 percent. Against that 40 percent, the total of credit demands by all borrowers moved up ninety percent. So that even before the escalation in the Vietnam war, much of the flexibility in the credit system had been lost. The demand for funds was already pushing the available supply.
Then between 1965 and 1968 the Federal Government increased its expenditures by $60 billion—about half of it related to defense—without raising the taxes to cover this burst of spending. In 1966 the Federal Reserve made one stab at an anti-inflationary policy by restricting the money supply; then, its fingertips burned by the brief “crunch” of that year, during the two years following, it let loose a $24 billion addition to the money supply. In mid-1968 Congress passed a 10 percent income tax surcharge, which was supposed to take the steam out of the economy that had been supplied by all that new money.
By that time the momentum of inflation had really taken hold. Much of the borrowing was short-term, because the borrower didn’t want to commit himself to a lifetime of high interest rates. It was a dumb corporate treasurer who had not borrowed at 4½ percent back in 1964. Besides, borrowing was a way to boost the earnings per share of the stock, and that was what the stock market wanted—increasing earnings per share. So off to the market they went, better late than never. And individuals did not cut back on spending as much as all the econometric models suggested they would, because they had no choice. Their spending was more for the essentials of life than for the so-called discretionary items. The cost of those essentials increased faster than personal income. If you wanted a house, the mortgage cost that much more—if indeed you could get a mortgage—and if you needed a doctor or a hospital, that cost a lot more. The state and local governments had to meet increases in teachers’ salaries, in paving contracts, and so on.
American business, impressed with the ugliness of cash as an asset, increased its borrowing to $47.9 billion in 1969, almost three and a half times the 1960 total. The banks had about loaned out the amounts they were permitted to by the Fed; they went to Europe and borrowed Eurodollars—dollars that had been generated abroad or taken abroad—and then reloaned them here.
The Federal Reserve figured inflation could be cut back if borrowing could be cut back, and it began to restrict the borrowing of its associate banks. It even moved to cut off the borrowing of Eurodollars. But the lead time of the corporations did not permit them to turn around so quickly. The money was committed to be spent. So the corporations, in aggregate, borrowed up full at the banks, edged out of the long-term debt market, and began to sign IOU’s: short-term commercial paper.
Some say the Federal Reserve indirectly encouraged the growth of this paper by forbidding banks to pay the going interest rate on large time deposits. Some say the banks steered their clients into paper because they couldn’t accommodate them; certainly the dealers in that paper sold their product aggressively. Commercial paper is just that: an IOU. It says that Sears, Roebuck or Chrysler or what-have-you promises to pay you, in thirty or sixty or ninety days, the face amount. Most commercial paper does not have a maturity of more than ninety days, and much of it matures in under thirty days. The buyers of commercial paper are big buyers: the smallest customary denomination is $25,000, and some pieces run $1 million. Some pension funds and banks buy commercial paper, but most often the buyers are corporate treasurers who want to put money to work for just a few days at a higher rate than Treasury bills and similar instruments will yield.
A company treasurer or a country bank buying commercial paper expects to get its money back in a few days, plus interest. If the U.S. Treasury will pay him 7 percent for those days, he may get 8½ percent from commercial paper. Obviously he believes the commercial paper is a good risk, or he could not take a chance with all that money for only a few days’ worth of extra interest. Traditionally, a company is supposed to have bank credit equal to its outstanding commercial paper. After the debacle, or near debacle, questions were asked and lawsuits filed: how come the credit behind the paper hadn’t been thoroughly analyzed? The answer will not be found here; the question is part of the feeling of the time. But obviously the buyers once thought all the paper was good; they were wrong about a small part of it; then for a time, they thought no paper was good.
With the banks tight and their ability to sell bonds limited, American corporations sold IOU’s, commercial paper. From 1966 to 1970, the amount of outstanding commercial paper more than quadrupled, from $9 billion to nearly $40 billion. For the twelve months up to the June Crunch weekend, it had doubled.
The lack of liquidity in the economy had its roots half a decade back. Much of the borrowing done by business had been under at least some assumptions that sales would be good, but they were disappointing. The flow of cash in corporations was 10 to 30 percent below expectations, and that in itself built up the necessity to borrow.
By June of 1970 the sixth largest enterprise in the United States and the largest railroad in the country, the Penn Central, was busted, busted enough to be very slow to pay the conductors on its trains. It was having trouble renewing, or rolling over, its maturing commercial paper, and it had $200 million outstanding. For weeks, the Penn Central’s bankers had worked night and day on an emergency loan to be guaranteed by the U.S. Government. The Administration lobbied in Congress for the loan. On Friday, June 19, the bankers were so confident that they gathered in the Northwest Conference Room on the tenth floor of the Federal Reserve Bank of New York to sign the papers as soon as word came from Washington that the government guarantee would be in effect. But the word did not come.
Congressional disapproval had been hardening. The $200-million loan, said Wright Patman, chairman of the House Banking Committee, would be “only the beginning of the welfare program for this giant corporation.” It would risk “hundreds of millions of the taxpayers’ money in a highly questionable scheme.” (Later, Patman told Congress that the Administration had asked the Federal Reserve Bank of New York to check out the loan; the Bank replied that the loan “would provide no significant relief to the Company,” that it “could not recommend approval of the proposed loan on the basis of factors normally considered in appraising credit risks,” and that it did not see how the taxpayers would ever get their money back. But the Administration, said Patman, did not bother to give Congress that report when it was lobbying. All this is in the Congressional Record.)
Shortly before 5 P.M., a government official, the intended guarantor of the loan, told the assembled bankers in New York that there would be no approval.
“The bankers who had been working on the project so intensely,” said the notes of a later Federal Reserve meeting, “were shell-shocked but not resentful. They left our building and went to the uptown office of the First National City Bank, where they tried to figure out how they could protect themselves.”
In Philadelphia, the Penn Central’s lawyers began to draw up the bankruptcy papers; they would rather, they reasoned, march in orderly under a white flag than have some creditor put them into bankruptcy. The Penn Central’s chairman, Paul Gorman, and three of his directors went to Washington to see Patman on Saturday. Patman had not changed his mind. The directors went back to Philadelphia. The Penn Central’s board met again in Philadelphia on Sunday and threw in the towel; one of the lawyers drove to the suburban home of U.S. District Judge C. William Kraft, Jr., with the papers. Sunday is always a good day to go busted.
Once the Penn Central had handed over the papers, it did not have to pay its debts, except under reorganization. Most important for this story, it would not pay the holders of its IOU’s, its commercial paper. They could paper their bathrooms with all $200 million. The corporate treasurers who had thought they would put money out at a better rate than Treasury bills would get back neither interest nor principal, at least not without lengthy lawsuits. They would lose all the money they had put up. The Walt Disney Corporation lost $1.5 million that way, American Express $4.8 million, Homestake Mining $1 million, and so on. (The paper holders eventually sued everybody in sight, and some settled for a fractional reimbursement from the dealers.)
