The Number That Blows Up The World, “Everything Bubble” Edition

We’re deluged with numbers these days, many of them huge, ominous departures from historical norms. But one matters more than the others. To understand why let’s start with some history.

In the 1960s the US entered the expensive and divisive Vietnam War, while simultaneously creating major entitlement programs including (also very expensive) Medicare. In the 1970s, commodity prices, led by oil, started to rise due in part to the billions of new dollars sloshing around in the world, and in part to Middle East turmoil.

The above combined to produce rising inflation and a falling dollar, wreaking havoc in the foreign exchange markets and raising doubts about the viability of the dollar as the world’s reserve currency. It was a huge mess.

But the US recognized the gravity of the situation and, led by Federal Reserve chairman Paul Volker, responded aggressively by jacking up interest rates to double-digit levels. The Fed Funds rate hit nearly 16% in late 1979.

Fed Funds rate 1970s 10-year Treasury yield

This spike in interest rates, not surprisingly, sent the economy into recession in 1981 and shaved about 25% from the S&P 500.

S&P 500 1980 - 1982 10-year Treasury yield

But the harsh medicine saved the patient. Higher interest rates attracted global investment capital to the US and squeezed inflation out of the system. After falling by 29% versus the world’s other major currencies in the 1970s, the dollar went back to being the world’s rock-solid reserve asset in the 1980s. And the economy recovered and began a long run of mostly good times that culminated in today’s epic bull market.

USD index 1971 - 1984 10-year Treasury yield

An empty toolbox …

The lesson? There is a fix for rising inflation and financial instability: higher interest rates. But unfortunately, we no longer have that tool. In the 1970s, monetary chaos notwithstanding, the US was actually in pretty good financial shape. The debts of governments, corporations, and individuals were all very low by today’s standards, which means higher interest rates could claim fewer over-leveraged victims while enriching savers with rising interest income.

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