Money For Nothing: When Fiscal And Monetary Policy Fail Simultaneously (Part II)

by: Kevin Wilson

Two massive "economic engineering” experiments were tried out during the "Great Moderation" that led to the 2006-2009 Global Financial Crisis (“GFC”), and during the Great Inflation (1965-1982).

The economic tinkering associated with these two crises involved hubris, in which economists ignored much information, strongly argued warnings, and useful procedures that could have prevented or mitigated these calamities.

These crises were both unnecessary and avoidable; the monetary and fiscal authorities have produced these major disasters almost entirely as a result of inadequate theories, models, and measurements.

The Fed is now an unaccountable fourth branch of government operating outside the Constitution "when needed," and Congress should act to limit its power.

Recession and market risks are higher going forward, so prudent investors should consider hedges like GLD or IAU, or holding physical gold; other holdings might include OTCRX, QLENX, WHOSX, TLT.

Man-made Disaster at Deepwater Horizon Wellsite, 2010


“One of the uses of history is to avoid preventable errors; but to do that, we’ve got to get the history right.” Robert J. Samuelson, 2008

“Hegel was right when he said that we learn from history that man can never learn anything from history.” George Bernard Shaw (1856-1950)

“Economic history is a long record of government policies that failed because they were designed with a bold disregard for the laws of economics.” Ludwig von Mises (1881-1973)

When the Deepwater Horizon offshore drilling rig exploded and sank in the Gulf of Mexico in April, 2010, eleven people were killed, and the largest oil spill in US history followed. How did this tragedy come to pass, given that the crew had just received safety awards and there were clear safety standards that could have prevented it? The answer is disturbing: I counted eight separate engineering failures when I examined the case in depth a few years ago. Several of these failures were “reliably fatal” (Kevin Wilson, 2016), and everyone on the rig with significant field experience must have known it, although obviously they didn’t perceive any imminent danger until right before the explosion and fire. The real point is that these engineering failures all involved violations of standard procedures that had been industry-wide for years, or even decades. Yet somehow the senior crew, the service company, and the well’s operator allowed them to happen anyway.

One theory is that the rig (owned by Transocean Ltd. [RIG]) was behind schedule, and the drilling project was over budget; so there was significant pressure to speed things up from the headquarters of the operator (BP Amoco PLC [BP]) that owned the Macondo prospect well. In response, the drilling crew, the employees of a service provider (Halliburton [HAL]), and the BP company men collectively cut corners. That is quite possible, but it seems very strange since the on-site leadership had to know they were taking great risk. In my years in the oil business I saw many mistakes made, and observed a number of dangerous incidents; but I never saw anyone make potentially fatal engineering blunders on purpose. Another theory suggests that the crew on the Deepwater Horizon collectively suffered from a “normalization of deviance” syndrome. This may have involved gradual reductions in safety over time that became (to them) imperceptible increases in seemingly isolated and limited risks, until they had increased overall catastrophic risk to a level where differently-sourced errors suddenly combined their effects to produce a disaster.

In any case, there are some parallels between a massive engineering failure like the Deepwater Horizon and the massive "economic engineering” failures of the 2006-2009 Global Financial Crisis (“GFC”), and the Great Inflation (1965-1982). Obviously no one died as a direct result of the fiscal and monetary economic policy errors associated with these disasters, so these are less drastic calamities in some ways. No huge environmental damage directly resulted from these economic disasters either. But millions of people’s lives were adversely affected for a period of years by these completely avoidable economic crises. Thus the real parallel here is that well-meaning professionals tried to engineer, or tinker with, an immensely complex US economic and financial system as if it was merely some kind of mechanism or machine for generating desirable economic results. The desired results could thus be obtained pretty much at will, or so they thought; such was their abiding self-confidence, or hubris. But in such a complex economic system, just pulling some levers to see what happens has proven on these two occasions to be a foolish exercise.

Just as in the case of the Deepwater Horizon, the economic tinkering leading up to the two crises discussed here involved ignoring all information, warnings and procedures that could have prevented the calamity. In the case of the Great Inflation, the tinkering was the direct result of a collective decision by economists and politicians to run an economic experiment on a national scale. This experiment was run from 1965 to 1982 without accurate tools for forecasting inflation risk, or potential economic output, or for gauging unemployment risk. Instead, several assumptions were made that all ultimately proved incorrect. There was also no attempt to define what failure would look like. So despite years of failure, the project wasn’t dropped until 18 years had passed.

There is also evidence that the “normalization of deviance” problem contributed to the financial meltdown in 2008. Mistakes accrued over a number of years in a number of sectors, and the risks taken were completely misunderstood by most economists, as well as most financiers. The so-called “Great Moderation” that many economists crowed about before 2008 had been repeatedly warned against on both theoretical and empirical grounds by Hyman Minsky, Wynne Godley, Steve Keen, and a few other economists. They saw this unnatural stability as prima facie evidence that instability and crisis were on the way (Steve Keen, 2017; Can We Avoid Another Financial Crisis?, Polity Press, Malden, MA, 148p). Ultimately they were proved right, and "mainstream" economists got some very expensive education.

In Part I of this series the two major recessions embedded in the Great Depression were examined as examples of the combined failure of fiscal and monetary policies. In seeking answers for how such massive failures could have occurred, several ideas were considered: 1) a steep learning curve for economists, especially those at the young Federal Reserve in the 1930s; 2) serious misunderstandings of the impact of the gold standard on Fed policy options during a financial crisis; 3) likely over-reliance on the Depression of 1920-1921 as an example of policy success, when it was probably (in retrospect) a one-off situation not to be easily repeated; 4) attempts by both the Hoover and the Roosevelt administrations to demonstrate fiscal prudence and raise confidence by balancing the budget, which in each case were in fact destructive in their effects; and 5) the failure of modern rationalism in monetary and fiscal economics to get the big macroeconomic calls right. Indeed, what was needed in the Great Depression (and the recent “GFC” as well) was not just abundant liquidity, which was a necessary but not sufficient requirement, but also a stronger sense of stability against widespread fears of insolvency.

In this second segment of the series “Money for Nothing” we will discuss two more examples where fiscal and monetary policy simultaneously failed in spite of the best efforts of many economists. Our purpose is again to see what we can learn that might be of use going forward. The two examples are (as mentioned above): 1) the Great Inflation; and 2) the “GFC.”

The Great Inflation (1965-1982)

The Great Inflation occurred because almost every economist in academia, or working at the Treasury, the White House, or the Fed agreed that a trade-off existed between unemployment and inflation that could be exploited by careful economic engineering (Robert L. Hetzel, 2013). The foundations for this idea were called “the New Economics” by the Kennedy Administration and involved the coupling of three inadvertent errors, which were also committed by all four of the succeeding administrations : 1) Keynesian active intervention in aggregate demand; 2) reliance on the Phillips Curve as a model for managing the presumed trade-off between unemployment and inflation; and 3) mismeasurement of potential output, a critical component in engineering the “controlled” economy’s moves along the presumed Phillips Curve (Michael D. Bordo & Athanasios Orphanides, 2013). The central idea was to limit unemployment and remove the likelihood of recessions through economic engineering, at the cost of a “manageable” risk of higher inflation. This was a laudable but ultimately Utopian goal.

The failure of the New Economics was manifest almost immediately after its first application, but this failure and all that followed were repeatedly diagnosed as regrettably not on track in the short term, but readily fixable in the long term. The mismeasurement of potential output and the failure to predict inflation rates exacerbated the general error, but despite repeated misses on both measures throughout the 18-year crisis, no one ever dropped the initial, flawed approach until Paul Volcker took over as Fed Chair. The Fed itself was famously under strong political pressure from various presidents and was far from independent (Kevin Wilson, 2017a). As a result only incremental changes in the New Economics approach were tried, and all were based on wildly inaccurate potential output and inflation estimates. Unfortunately, the presumed Phillips Curve relationship that drove the New Economy’s economic engineering decisions was itself found to be wildly inaccurate over time (Chart 1). This led to a choppy but occasionally significant over-supply of money to the system, which then produced (with variable lags) the Great Inflation (Chart 2).

Chart 1: The Phillips Curve’s Gyrations over Time


Chart 2: Money Supply and Inflation, 1960-2010


Currency in circulation soared from $39.7 billion in December 1964 to $144.4 billion in December 1981, an increase of some 264% (Scott Sumner, 2013). Even higher spikes in money supply growth also occurred in the two recessions that ended respectively in 2002 and 2009, but inflation wasn’t an issue in these latter cases because the excess money supply was injected into deflationary environments with high unemployment. But in the 1970s, the high money supply growth came amidst much higher and rising trend inflation, with a sharply falling dollar after 1971, and it led to dangerously high, entrenched expectations of further inflation (Karl Smith, 2013).

Essentially what happened was that a nearly two-decade economic crisis was forced upon the entire world (with certain notable exceptions) by a purpose-driven US national experiment (Robert L. Hetzel, 2013; Op cit.) in Keynesian economics carried out relentlessly under five presidential administrations, with full cooperation from the Fed. However, a series of unintended errors combined to produce a completely unexpected, long nightmare period of stagflation and high unemployment (Chart 3). These errors arose from four probable sources: 1) what turned out to be poorly supported economic theory (Owen F. Humpage, 2014); 2) significant economic ignorance that was unfortunately never fully understood or admitted (Robert J. Samuelson, 2010; Op cit.); 3) poor measurements of certain crucial parameters (Allan H. Meltzer book on the Fed reviewed by Futurecasts blog, 2010); and 4) outright incompetence brought on by political pressure that caused the Fed to consistently err on the side of inflation to theoretically hold unemployment down in aid of the political leadership (cf. Thomas F. Cargill & Gerald P. O’Driscoll, Jr., 2013).

Chart 3: Inflation and Unemployment, 1973-1981


These mistakes were almost entirely both unnecessary and avoidable. Indeed, Nobel Laureate Milton Friedman fought long and hard against the New Economics, and was highly critical of the theory behind expansionary (inflationary) monetary policies at the Fed well before the Great Inflation even started (i.e., starting in 1958; Robert L. Hetzel, 1998). Friedman’s seminal works on monetarism were published starting in 1963 with his co-author Anna Schwartz, but this body of work was ignored by the economics profession for many years. Full-blown stagflation kicked in by the early 1970s, but still Friedman’s dictum about monetary policy and inflation was ignored. Repeated failures to accurately predict potential output, inflation, and unemployment throughout the Great Inflation were met with mere tinkering and large portions of baseless optimism that “next time they would get it right.” They never did.

Many people think that the Great Inflation was greatly worsened by the twin oil price spikes of the 1970s. However, this does not really seem to be an accurate diagnosis of what happened. As shown in Chart 4, the oil price spikes had only minor effects on inflation. The Vietnam War has also been blamed for inflation, but US inflation peaked long after the war ended. The major inflationary effects were clearly driven instead by “too much money chasing too few goods” (Robert J. Samuelson, 2010; The Great Inflation and its Aftermath, Random House Inc., New York, 316p), combined with fiscally unsound and massive deficit spending (Peter Boettke, 2009). However, other factors probably also contributed to the problem. There is strong evidence that when President Nixon took the US off the gold peg in 1971 in response to a run on gold, and thereby ended the Bretton Woods currency system, the ultimate effects were profoundly inflationary (Michael Bryan, 2013). The dollar plummeted (Chart 5) as gold rose from its previous peg of $35.00 to a post-Bretton Woods official price of $42.22; by January 1980 the market price of gold had risen to an all-time high (Chart 6) of $850/ounce (Peter L. Bernstein, 2000; The Power of Gold: The History of an Obsession, John Wiley & Sons, New York, 432p).

Chart 4: Inflation vs. CPI Ex-Energy, 1971-1985


Chart 5: The US Dollar Index Declined 29% from 1971 to 1981


Chart 6: The Gold Rally of the 1970s


Curiously, Germany and Switzerland avoided most of the ravages of the Great Inflation (Michael D. Bordo & Athanasios Orphanides (2013; Op cit.) because they didn’t subscribe to the New Economics. They thought rather that inflation was primarily a monetary phenomenon. This is a particularly damning piece of evidence, because inflation in many other countries (e.g., the US, the UK, Canada, France, Italy, and Japan, etc.) absolutely soared from 1965 to 1982. In the US, inflation topped out at 13.5% in 1980, but the average inflation over the 10 years ending in 1981 was 8.74%. This was bad enough; but there were also four recessions (of increasing severity) between 1969 and 1982 (Chart 7). The first two of these recessions occurred rather shockingly in the midst of elevated inflation rates; in fact, the one in 1973-1975 was partially caused by the first great oil price spike. The second two recessions (also accompanied by high inflation rates) were triggered by the fight against high inflation by Fed Chair Paul Volcker; however, the first of these (1980) was partially triggered by the second great oil price spike.

Chart 7: The Four Recessions of the Great Inflation


To put the Great Inflation in perspective, consider the following facts. A Hershey chocolate bar cost $0.04 in 1962, but had risen to $0.75 (18x) by 1994 (Robert J. Samuelson, 2010; Op cit.). A hamburger cost $0.28 in 1962, but rose to $1.65 (6x) by 1994. A full-size Chevrolet sedan cost $2,529 in 1962, but had risen to a whopping $19,495 (7.7x) by 1994. A 30-year fixed home mortgage averaged 5.8% in 1965; the same thing in 1980 averaged 12.7%. The prime rate at banks was 4.5% in 1965, but rose to 15.3% by 1980. I personally bought a house in 1981 with a nominal 18.75% mortgage, which was bought down by the seller (at great expense) to 13.75%. If you had invested $10,000 in the S & P 500 at the beginning of 1972, ten years later (at the end of 1981) the real (inflation-adjusted) value of your investment would have dropped to $8,222. On the other hand, if you had put that money in a commodity producer’s stock, for example Exxon Mobil Corp. (XOM), on January 2, 1972, you would have paid $0.2925/share, buying 34,188 shares; ten years later (December 31, 1981) the stock sold for $0.9396/share and there had been two 2:1 stock splits during that decade, plus 40 quarterly dividend payouts. The holding period return for XOM (estimated at 12.85x plus dividends) handily beat the average inflation rate of 8.74% (2.31x compounded over ten years).

The Great Financial Crisis or “GFC” (2006-2009)

I have already written a few articles about what went wrong during the “GFC” (e.g., Kevin Wilson, 2017a; Op cit.); Kevin Wilson, 2017b). Summarizing these, it is clear that the entire global financial system collapsed when a gigantic credit bubble (centered on the US housing market) burst. The epicenter of this global financial earthquake was thus the US. The US credit bubble was formed over a period of years by the combined influences of too-loose Fed monetary policy, massive Fed and SEC regulatory failure, executive branch and Congressional interference in the mortgage markets, government-supported moral hazard, poor corporate governance, and massive fraud on many levels (Financial Crisis Inquiry Commission, 2011; The Financial Crisis Inquiry Report, PublicAffairs/Perseus Books Group, New York, 545p). This credit bubble and the “GFC” that followed it were primarily caused by the failure of the government in multiple administrations and at multiple agencies to control fiscal, regulatory, supervisory and monetary policies in such a way as to prevent extreme risk levels on Wall Street and in the shadow banking sector from rising to the point of catastrophe.

Corporate players are not absolved from blame, of course, far from it; rather, although they behaved horribly badly, this was actually a given in a typical credit bubble. Indeed, it has long been known that corporations and investors will generally act irrationally and make extremely dangerous decisions if given incentives to do so (Charles P. Kindleberger, 2000; Manias, Panics, and Crashes, 4 th Ed., John Wiley & Sons, 290p). History is replete with examples of “irrational exuberance” and “animal spirits” (cf. George A. Akerlof & Robert J. Shiller, 2009; Animal Spirits, Princeton University Press, Princeton, NJ, 230p) reaching levels that lead to disaster. It is the business of the Fed, the SEC, the OCC, the FDIC, and other regulators to keep these irrational tendencies in check, and to mitigate the systemic risk that capitalism naturally produces when left to its own devices. It is the explicit duty of these agencies to do these things.

It is also the duty of Congress to make adequate laws regulating corporations, banks, and securities markets, and it is the duty of the executive branch to enforce these laws. Contrary to popular mythology, there was plenty of warning, years in advance of the crisis. A number of economists and financial observers gave repeated early warnings of the impending meltdown (Kevin Wilson, 2018). Essentially all of these warnings were ignored by the Fed, the SEC, the OCC, Fannie Mae, Freddie Mac, Congress, and the executive branch. Only the FDIC can be said to have done its job. The economics profession was so sure of its victory over the business cycle (much as it was when it engineered the Great Inflation) and so proud of the so-called “Great Moderation” (that it took credit for having engineered), that the old warnings of Hyman Minsky and the renewed warnings of economists like Godley, Pettifor, Baker, Keen, and others were shrugged off as the apocryphal mutterings of outsiders and Cassandras. The financial crisis of 2006-2009 was therefore both predictable and avoidable.

The housing part of the bubble finally began to burst in June, 2006 (Chart 8) and by July, 2007 (Chart 9), the carnage had spread to the consumer credit sector. The TED spread first exploded upwards in mid-2007, indicating a big spike in perceived inter-bank credit risk (Chart 10); this was the proverbial canary in the coal mine for the “GFC.” Almost simultaneously the first subprime sector hedge funds in the US failed (US Federal Reserve Bank of St. Louis, 2011). High yield spreads also exploded upwards in 2007, and they eventually rose to a breathtaking 22% by 2009 (Chart 11). The resulting financial crisis was in full swing then by early 2008 or sooner. It was specifically caused by: 1) extreme leverage in the investment banking and insurance sectors; 2) huge and opaque derivatives positions that could not be unwound once liquidity disappeared, thus calling into question the solvency of many large firms; 3) extreme moral hazard signaled by ad hoc Fed monetary policy, extremely lax regulation and supervision (amounting to complete regulatory capture), extremely poor corporate risk management, and a long record of federal bailouts (Barry Ritholtz & Aaron Task, Bailout Nation, 2009; John Wiley & Sons, New York, 332p); 4) rating agency conflicts of interest; 5) deregulation by the Clinton and Bush 43 administrations (1992-2008); 5) failure to shrink the massive systemic risk associated with Too-Big-To-Fail banks; and 6) failure to regulate or supervise shadow banking activities. There were many other contributing factors as well as the six I’ve listed, but these are probably the main ones.

Chart 8: Housing Bubble Burst in 2006


Chart 9: Consumer Credit Bubble Burst in 2007


Chart 10: The TED Spread First Exploded Upwards in 2007


Chart 11: High Yield Bond Spreads Exploded Upwards in 2007


I commented specifically on the Fed’s failures in advance of the crisis some time ago (Kevin Wilson, 2017c):

“It is not that boom-bust cycles are somehow to be avoided via Fed action, because they seem like they must be a natural occurrence in any economic system. Rather, it seems to me that the Fed has made boom-bust cycles much bigger in amplitude, in effect rolling us back to the Gilded Age, when tycoons ran everything (including the banking system) and huge suffering was forced onto the masses by excessive boom-bust cycles. The distinction between recent boom-bust cycles and those of the 1800s seems less clear than one would expect. Certainly the tremendous bust in 2008-2009 was of the same order of magnitude as many previous crashes and depressions prior to 1945. But since the Fed was specifically put in place in 1913 to prevent or at least control the kinds of systemic meltdowns and depressions seen in 1873 or 1907, and to stabilize the currency, and since neither of these goals has actually been achieved in recent decades, it may be time to reform the Fed.”

I have also written at some length about the deeply flawed responses of the Fed, the SEC, and the Treasury, once the crisis actually took hold. Here is a quote from one of my previous missives (Kevin Wilson, 2017a; Op cit.):

“Walter Bagehot is actually most famous for his so-called 'Bagehot's Dictum,’ i.e., ‘In times of financial crisis central banks should lend freely to solvent depository institutions, yet only against sound collateral and at interest rates high enough to dissuade those borrowers that are not genuinely in need.’ This advice, and that of J. P. Morgan, was comprehensively ignored during the Great Financial Crisis (‘GFC’). In fact, insolvent firms were saved in large numbers, the bigger the better; sound collateral was not given in many cases; and interest rates were set so low on bailout funds that many firms around the world lined up for the Fed’s easy money. The rotten culture on Wall Street was such that some of that bailout money ended up being used for executive bonuses, according to the New York Attorney General’s office, as reported by Stephen Bernard of ABC News (2010). Other sums provided by bailout programs like “TARP,” “CPP,” “SBLF,” etc., were used to finance merger & acquisition activity, the repayment of other bailout loans, and many other uses. One thing that really didn’t happen (in spite of promises to the contrary) was an expansion of bank lending to help the economy.”

I have commented previously on the Fed’s extreme policy experimentation and secret bailout decisions during the “GFC” (Kevin Wilson, 2017b; Op cit.):

“The standard response of the Fed, which is to lower interest rates dramatically in a crisis, was taken to the extreme of the zero bound by December 2008, and this descent happened very rapidly. Yet this demonstrably had no effect on the markets…”

“… Anyway, direct fiscal intervention was aided by Congress and the Bush Administration, most notably via the infamous TARP funding program ($350 billion in the first funding tranche) for banks and insurers; but that was completely dwarfed later by the then-secret Federal Reserve bailout funds ($7.7 trillion in loans) given mainly to the largest US financial corporations… Another $9 trillion (!) was loaned out to foreign corporations.”

So basically the entire spectrum of operational powers available to the US Treasury and the Federal Reserve were deployed during the crisis, plus a few major interventions that were almost certainly unconstitutional (e.g., John Hussman, 2008; John Hussman, 2010). Virtually everything the Fed and the Treasury did on their own or proposed to Congress, was deemed an acceptable intervention by virtue of its expedience; this was true regardless of cost, fairness, moral hazard, or constitutionality. In other words, the panic reached deeply into the corridors of government. So as a result we avoided a repeat of the Great Depression, at least in the short term. This suggests to some that Bagehot’s Dictum is wrong, and violating it was why we survived 2008 without a depression. However, I would maintain that the game isn’t over, and that we could be facing a second great crisis much like the second phase of the Great Depression in 1937. Indeed, I would argue that because we failed to make effective reforms like those made in the wake of the Great Depression, such a renewed crisis is inevitable.

As I stated in an article on the still extant risks in the system (Kevin Wilson, 2018; Op cit.):

“For example, although they are better capitalized now, the big US investment banks are much bigger now than they were back when they helped bring down the system in 2008; yet even then they were deemed by the authorities to be “too-big-to-fail” (Matt Egan, 2017). The derivatives (e.g., “CDO’s”) which caused so much mayhem in 2008 are traded through a clearinghouse now, but according to famous investor David Einhorn, this clearinghouse is itself just another ‘too-big-to-fail’ institution that will likely fail itself when counter-parties actually have serious problems again; in other words, he maintains that none of the problems of the financial crisis have been solved (Jacob Wolinsky, 2017).”

“Furthermore, the level of assets in the derivatives market has soared from the $182 trillion in nominal value seen in 2008, to a present nominal value of some $500 trillion (Joseph Moss, 2017). Actual gross risk exposure to derivatives assets is about $3.0 trillion – plenty big enough to take down the system again if the wrong things happen. What concerns me is that we know so little about what counter-party risk is like, in spite of that being one of the central themes of the panic in 2008. The big banks are still allowed to game the system by using foreign subsidiaries to keep their trades private and perhaps even keep them off their balance sheets. In fact, the top six US banks are now so complexly structured that they collectively own over 14,400 subsidiaries. So there is the same complexity risk that we saw in 2008, or perhaps even more.”

Conclusions for Part II

Economic engineering on a massive scale produced the Great Inflation of 1965-1982. Economic engineering may also have produced the “Great Moderation” that led up to the “GFC” (2006-2009). Failed theories, inadequate measurements of risk parameters and model inputs, wholly inadequate and over-simplified econometric models, and an absolute disdain for contrary economic analyses or opinions from “outsiders” is what led to these two great economic and financial crises. The audit of the Fed in 2011 showed that it was willing to grab astounding amounts of power without oversight or accountability. That power has yet to be ceded by the Fed or taken back by Congress. The Treasury acted in concert with the Fed in 2008, and there was significant duplicity employed in the proposals and communications of both of these authorities to Congress and the American people during the “GFC.”

In the process of blowing bubbles and then saving us from them, Fed Chairs Greenspan, Bernanke and Yellen have taken it upon themselves (in the absence of leadership and supervision from Congress) to create an ad hoc fourth branch of government, subject to none of the checks and balances of the Constitution. I am sure the Founders would not approve, and I am also quite sure that in the next crisis, soon to arrive, we will see the Fed and the Treasury grab even more power, if we let them. Given their abysmal track records in the Great Inflation and the “GFC,” we are fools if we trust them with so much unfettered and unaccountable power. Indeed, the entire notion of a centrally managed economy is wrong-headed as currently understood, in my opinion. There is no doubt it has repeatedly proven to be highly destructive to the general welfare in actual practice. We should still use economic policy making going forward, but we should use it far more sparingly and with much more skepticism, based on its record of producing occasional global economic disasters.

In Part III of this series we will discuss three examples where monetary and fiscal policies appear to have actually worked well. The first is the Panic of 1907, which involved a combined private/public bailout of banks and trusts to avoid a more severe financial crisis. The second is the Depression of 1920-21, which was not treated with any massive federal interventions, and yet whose subsequent recovery was both swift and strong. The third is the “Great Disinflation” (1980-1986), which was the recovery from the Great Inflation engineered by Fed Chair Paul Volcker. Both of these cases are full of interesting twists and turns, and serve to illustrate both the problems economists face in trying to manage crises, and the potential solutions that have worked well on at least these two occasions.

Given the current long-term sell-off and the state of certain national economies, it makes sense to invest some money in a gold fund like SPDR Gold Shares (GLD), but only as a short-term hedging trade, not a buy-and-hold position. The I-Shares Gold Trust (IAU) is an alternative ETF that may be safer for those who want to hold it for a somewhat longer period of time. But the safest form of gold in the event of a true financial apocalypse is physical gold. Also, for those discounting a possible near-term recession, some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (OTCRX), or the AQR Long/Short Equity Fund (QLENX) could be held to protect assets in the event of a sharper market dip associated with deteriorating economic data. Those in a more defensive frame of mind because of the expected eventual market slide should also hold some long Treasuries, in spite of bearish arguments to the contrary, as a stock market crash would be hugely supportive of bond prices: examples include the Wasatch-Hoisington Treasury Fund (WHOSX), and the I-Shares 20+ Yr. Treasury Bond ETF (TLT).

Disclosure: I am/we are long GLD, OTCRX, WHOSX, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.