Credit Crisis, Stage III

Why the credit crisis is going to get worse...

WHILE I WAS in Vienna last week for a meeting of the Society for Austrian Economic Thought, I grabbed hold of the international edition of The Wall Street Journal, writes Chris Mayer for The Daily Reckoning.

   Over a classic Viennese breakfast of coffee, a boiled egg and pastry, I stumbled across an interview with Ted Forstmann. I hadn't seen his name in years. The interview was entitled "The Credit Crisis Is Going to Get Worse".

   Forstmann once lorded over one of the world's most famous private equity firms, Forstmann Little. For a time, it was, as the Wall Street Journal notes, "the most successful private equity firm in the world, renowned for both its outsized returns and its caution."

   When things got a little too crazy, Forstmann chose not to play. For two years, he sat on $2 billion of uninvested funds. That's discipline you don't find often, not in any era.

   Ted Forstmann's caution saved his firm a lot of pain when the private equity market later collapsed. And as the interviewer made plain, old Forstmann now has that bad feeling again.

   "Buffett once told me," he said, "there are thee 'I's in every cycle. The 'innovator' – that's the first 'I'. After the innovator comes the 'imitator'. And after the imitator in the cycle comes the 'idiot'..."

   We're in the idiot phase now, says Forstmann. This phase is when financial disasters strike. It's when the market reveals all the mistakes of the prior boom. It's when all those supposedly smart people running billion-dollar financial firms get their heads handed to them.

   "The creation of much too much money caused all of this excess," he says. So he would've found agreeable company in Vienna last week.

   The inaugural meeting of the Society for Austrian Economic Thought took place in the elegant salons of the Hotel Imperial. Here, a motley crew of entrepreneurs, philosophers and economists from all over the world met to discuss the world's troubles. Austrian Economics, in case you don't know, refers to a school of thought originating largely in Vienna in the late 19th and early 20th centuries. Its great thinkers include Ludwig von Mises, for instance, who was actually born in what today is Ukraine.

   (As an aside, this sort of thing happened a lot, as the old Austro-Hungarian Empire's borders shifted in later years. Carl Menger, another founding Austrian thinker, was actually born in what is today Poland.)

   Nowadays, the term "Austrian" in economic circles refers to anybody who holds to the theories of this group. The late Murray Rothbard, another famous practitioner and my favorite of the lot, was an American, for instance. I used to write for the Mises Institute and spent several years studying the Austrians. It's the economic framework I still use.

   Anyway, I'm getting off track. One definite theme of the Society for Austrian Economic Thought meeting was the sick monetary systems of the world's economies. Dr. Andre Homberg, a friend, reader and the organizer of the event, laid it out as the Five 'D's:

• Delusions - the notion that "the welfare state can provide everyone with a free lunch and a reliable pension and health care"
• Deficits & Debts - the accumulation of enormous fiscal imbalances, particularly in the public sector
• Dollars - the debasement of the dollar and reckless credit expansion
• Derivatives - Dr. Homberg pointed out that the notional value of derivatives topped $1,000 trillion, as per a recent BIS report.

   "This excessive leverage could implode anytime and make the U.S. subprime debacle look like a day at the beach," he said.

   The end result of all this? Dr. Homberg happily explained:

   "The prices of everything that you must have will escalate at a speed that you will not believe. The prices of energy and fuel will continue to spiral higher. Food and water prices will accelerate upward and will result in a lower standard of living for yourself, your family and your loved ones."

   It was a cheery afternoon at the Society for Austrian Economic Thought meeting, let me tell you. There's nothing quite like sitting under crystal chandeliers in a decadent 100-plus-year-old salon, spooning your weichsel-chily kaltschale mit gebratener Steingarnele – a sort of cold soup with sour cherries, chili and roasted prawn – while also matter-of-factly chatting about the end of the world as we know it.

   There are plenty of reasons to feel gloomy. But even Dr. Homberg allowed that there would be great opportunities to make a lot of money. "At least for the ones that understand the forces involved," he added, "and have the courage to grab the opportunities that this process will create."

   Homberg is financially independent, in large part owing to his deft investing since 2000. I'm proud to count him as a loyal reader. Going forward, I think it will be important to stick with real assets during these inflationary times. I've got two very interesting ideas I'm researching now. Both of them are quirky oddball opportunities rich in tangible inflation-beating assets.

   Also, in thinking back to the "I" cycle, the idiots eventually make way for the innovators, the winners in the next up cycle. Among the innovators in this cycle will be those who solve or ease the high cost of oil.

   I'm currently reading an interesting book, Engines That Move Markets by Alasdair Nairn. It's all about the history-making shifts of various innovations – canals, railroads, telephones, etc. In particular, the book focuses on their impacts on markets and investing. One early lesson is how people misread key events and missed great investments in the process.

   One early quote stands out. The Quarterly Review in March 1825, noted: "What could be more palpably absurd than the prospect held of locomotives traveling twice as fast as stagecoaches?"

   Stagecoach and canal investors who doubted the power of the trains lost a lot of money. While the losers are easy to spot in retrospect, they're not usually so obvious to investors at the time, as The Quarterly Review comment shows.

   As far as identifying the winners of this process, that was also not obvious. The railroads proved poor investments for most. By the mid-1870s, 40% of American railroad bonds were in default. The real winners were the people who enjoyed the lower cost of freight - traders and merchants expanding into new markets. So, too, the winners in this crisis might not be so obvious.