It can be seen that Quantum Fund combines some of the features of a stock market fund with those of a commodity fund. Historically, Quantum Fund operated at first almost exclusively in stocks; only as macroeconomic conditions became increasingly unstable did bonds and currencies assume increased importance. In the last few years macroeconomic speculation has become paramount. The degree of leverage we employ is much more modest than in pure commodity funds, and the exposure in various markets serves t~ balance as well as to leverage the portfolio. The Fund’s maximum exposure in any direction is subject to self-imposed limits. If one relied on the limits imposed by margin regulations, one would be asking for trouble, because one would be forced to liquidate positions at the most inconvenient moments. One needs a safety margin over and above the margin requirements. The safety margin can be quantified by looking at the uncommitted buying power, but it is not a reliable measure because different types of investments carry widely divergent margin requirements. For instance, most U.S. stoas require a 50% margin, foreign stocks only 30-35% and the margin on S&P futures is only 6%. Where to limit one’s exposure is one of the most difficult questions in operating a leveraged fund, and there is no hard and fast answer. As a general rule, I try not to exceed 100% of the Fund’s equity capital in any one market, but I tend to adjust my definition of what constitutes a market to suit my current thinking. For instance, I may add non-market-related stocks and market-related stocks together or keep them separate as the mood takes me. Generally speaking, I am more concerned with preserving the Fund’s capital than its recent profits, so that I tend to become more liberal with self-imposed limits when my investment concepts seem to be working. Where to draw the line between capital ‘ and profit is no easy task when practically the entire capital consists of accumulated profits. The historical record up to the beginning of the experiment is summarized below. It will be seen that the only year prior to 1985 when the Fund more than doubled was 1980, and that was followed by a debacle in 1981. During Phase 1 of the experiment, the Fund’s activities revolved mainly around macroeconomic issues; the microeconomic concepts did not change much, and their contribution to the fund’s performance was relatively insignificant. Accordingly, in summarizing the Fund’s investment posture I focused only on the macro aspect. The situation changed during the Control Period: specific investment concepts made an increasing contribution to the Fund’s performance. This was in accordance with my macro conclusion that it was time to play the stock market. Since the microplays became important only during the Control Period, I refrain from discussing them, with one exception: my play in Japanese real-estate-related stocks enters into the discussion in Phase 2. – The macro posture of the Fund is summarized in a table following each diary entry, and the activities and performance of the Fund are shown graphically at the end of each phase of the experiment. The graphic presentation for the Control Period has been The Starting Point: August 1985 147 subdivided into two parts because it is roughly twice as long as the experimental phases:Thus, the graphs are broken down into four roughly equal time periods. NOTE: Here is the key fbr the parenthetical numbers (1) through (6) that appear in the diary-entry tables throughout the real-time experiment: I (1) Includes net dollar value of futures contracts. (2) Net purchases ( + ) or sales ( – ) since previous report. (3) Reduced to a common denominator of 30-year government bonds. For instance, $100 million in face value of 4-year Treasury notes is equivalent to $28.5 million in market value of 30-year government bonds. (4) U.S. Treasury bills and notes up to two years to maturity; these also have been reduced to a common denominator of 30-year bond equividents (see note 3). (5) These bonds have cbnsiderably less volatility than U.S. government bonds. 

For instance, as of June 30, 1986, $100 million in face value of Japanese government bonds had the same volatility as roughly $66.2 million in 30-year U.S. government bonds. We have not,adjusted for this difference. (6) Net currency exposure includes stocks, bonds, futures, cash, and margins and equals the total equity of the Fsd. A short position in dollars indicates the amount by which exposure in the major currencies (DM-related European currencies, yen, and sterling) exceeds the capital of the Fund. Exposure in other currencies (mast of which do not fluctuate as much as the major currencies) are shown separately. They are not deemed relevant in calculating the Fund’s dollar exposure. Also, the percentage changes in net asset values in these tables refer to per-share figures. The figures for Quantum Fund’s aggregate equity are affected, albeit modestly, by subscriptions and redemptions. PHASE 1 : AUGUST 1985-DECEMBER 1985 1 BEGINNING OF THE EXPERIMENT: SUNDAY, AUGUST 18, 1985 * The stock market has recently adopted the thesis that the rapid rise in money supply is presaging a stronger economy. Cyclical stocks started to improve, while interest-rate-sensitive and defensive stocks suffered a setback. I had to decide what posture to adopt. I was inclined to doubt the thesis, but I did not have enough conviction to fight it. Accordingly, I did nothing. My stock portfolio consists primarily of companies that stand to benefit from corporate restructuring and of property insurance shares that follow a cycle of their own. As regards currencies, I have been leaning toward a soft-landing scenario. In fact, I could envision the possibility that a stronger economy would tend to strengthen the dollar. With so many speculators short, this could lead to a sharp, if temporary, rebound. Thus, being short the dollar was not without risk. Accordingly, I had significantly reduced my currency positions. For reasons I shall outline below, I rebuilt them in the last few days. I have been inclined to be optimistic on the prospects of a soft landing because the decline of the dollar was induced by the authorities; a spontaneous fall would have been much more dangerous. Since the reelection of Reagan, the authorities have been moving in the right direction and there seems to be a greater degree of cooperation among them. Practically all the excesses of

the Imperial Circle are in the process of being corrected: banks are returning to sounder practices, the budget deficit is being cut, and interest rates are being reduced. My optimism is tempered by the insight that the time when past excesses are corrected is the period of greatest risk. The excesses were meeting a certain need; otherwise they would not have developed in the first place. Can the system function without them? Moreover, the process of correction can develop its own momentum, setting off a self-reinforcing trend in the opposite direction. Everything hinges on the outlook of the economy. If the economy strengthened in the second half of 1985, all would be well. 150 The Real-Time Experiment Even if there were renewed weakness in 1986, the financial strucI ture would already be in a stronger position to withstand the consequences. In any case, that eventuality is too far removed to have any relevance to current investment decisions. I consider myself ill-qualified to match wits with professionals who have much more information at their disposal in predicting the actual course of the economy. That is why I have chosen to stay on the sidelines in cyclical stocks. The single most important variable is consumer spending. Some experts claim that consumers are overextended; others argue that if you make money available, the American consumer can be counted on to spend it Who am 1 to judge? The only competitive edge I have is the theory of reflexivity. It leads me t to diverge from the consensus opinion on the negative side. I believe we are in a period of credit contraction where collateral values are eroding. It would be appropriate if consumers failed to respond to stimulation. This is a typical Keynesian situation where the horse is taken to the water: will it drink? I need more evidence before I can develop any conviction on the negative side. Recently, I have perceived such signals. Perhaps the most convincing was the market action itself. The stock market was acting suspiciously badly. It may be surprising that I should accept the stock market as a valid indicator after I had enunciated the principle that markets are always biased. But I have also claimed that the market has a way of making predictions come true. Various economic reports also indicated continued weakness. For instance, auto sales were do~vn. 3did not aitrikte any great importance to these reports, because the current weakness is well recognized. What happens when General Motors starts its low interest-rate promotion will be more significant. I was much more impressed with the report that this year’s crops are going to set records. This meant that either the distress in the farming sector would increase or much more money would have to be spent on farm price support. The currencies were pushing against the upper limits of their trading range. The Bundesbank was expected to lower the discount rate, but the mark refused to give ground. On Wednesday, August 14, I decided to establish a half position in the German mark; after the German discount rate was in fact lowered and the Phase 1 : August 1985-December 1985 151 mark remained firm, I bought the rest of my position. On Thursday afternoon, the Federal Reserve announced a large increase in MI; the increase in M3 was more moderate. Bonds fell and I recognized that my thesis on currencies was going to be tested. If the conventional wisdoin prevailed, currencies ought to fall in the expectation of a strhnger economy and higher interest rates. But if the tide has tuned, holders of dollar assets ought to respond to a rise in money supply by converting part of that supply into foreign currencies. As it happened, the currencies did not yield, and my thesis was reinforced. Then came further evi,dence. On Friday, both housing starts and new permits were wee, especially for multifamily dwellings. This confirmed my suspicion that the housing industry is in trouble. In that case, commercial real estate must be in even worse shape. Bonds rallied, but the stock market continued under pressure. I am now willing to bet that the slowdown in the economy is going to deteriorate into a recession: the contraction in credit is going to outweigh the increase in money supply. 1 suspect that the divergence between MI and M3 is an indication that the horse is not drinking. I am aeady to take on a maximum position in currencies, both on a long-term and on a short-term basis and to short bonds on the rally. If the currencies do not respond vigorously, I may have to become more cautious and take a loss on the short-term portion of my currency positions. It may be asked why I should short bonds if I expes a recession. The answer is that I expect a recession because long-term interest rates will rise on account of a weakening dollar. This is the Imperial Circle moving into reverse gear. I realize that my sale may be premature; consequently I will take only a small starting position. I am also contemplating selling the stock market short but only if it rallies in response to a declining dollar. Both my currency and my bond positions ought to work before I take on the additional exposure. The majority of my currency positions are in German marks. I also have a significant position in yen but I expect the yen to move slower and later. I should explain why. Japan has a very high savings rate and domestic investment has tapered off. By investing its savings abroad, Japan is able to maintain a level of production well in excess of domestic consumption. This is the way Japan can become a leading economic power in the world: 152 The Real-Time Experiment a high savings rate, a persistent export surplus, and an accumu1 lation of foreign assets go hand in hand to enhance Japan’s power and influence in the world. Japan is very happy with the Imperial Circle and wants to prolong it as long as possible. The policy is articulated by Japanese officials as follows: “We want the United States to prosper as the leading economic power in the world, because it allows us to prosper as number two.” In actual fact, Japan uses the United States as a cyclist uses a car in front of him: to cut the wind resistance. Japan wants to stay behind the United States as long as possible, and it is willing to finance the U.S. budget deficit to this end. Long-term capital outflows from Japan rose from $17.7 billion in 3,983 to $49.7 billion in 1984 and the trend is still rising. This has been the single t most important factor in keeping the yen down. Now that the trend of the dollar has been reversed, the yen may appreciate against the dollar, but it is likely to fall against the European currencies. I have had considerable difficulty in arriving at this conclusion. In the 1970s, Japan followed a policy of keeping the value of the yen high, creating a high hurdle that exporters had to pass in order to export profitably. The policy was very successful in favoring the industries in which Japan had the greatest competitive advantage and in discouraging the older, less profitable exports. I would have expected that in an environment where the rest of the world was increasingly unwilling to tolerate a Japanese export surplus, Japan would once again use the price mechanism to ration its exports rather than to expose itself to quantitative restrictions. This would have meant a high exchange rate policy. I failed to recognize the fundamental dissimilarity between the two sets of circumstances. In the 1970s domestic investment was still very high and available savings needed to be rationed; a high exchange rate served as an efficient method of allocating resources. Now there is an excess of savings for which outlets have to be found. Exporting capital is the best answer. The resistance to Japanese exports remains a stumbling block, but the Japanese hope to overcome it by providing generous credit terms. Hence the willingness to finance the U.S. budget deficit. The American response is ambivalent. Some elements within the administration are pushing for a higher yen; others are push- Phase 1: August 1985-December 1985 153 ing for the sale of U.S. government securities to the Japanese. Ironically, it was American pressure for the liberalization of capital markets that led to the current massive Japanese purchases of U.S. treasury bonds. The interest rate differential in favor of the U.S. was very great, ruhning as high as 6% at times. Once the floodgates were released, Japanese institutions piled in. Since the dollar has started to decline, the total return has become less favorable, but it has not discouraged Japanese investors. On the contrary, they seem to feel that the currency risk is less now that the dollar has declined. Japanese investors are even more herdlike than their American coynterparts. Should their bias shift, there could be a stampede in ,the opposite direction. But that is highly unlikely: the authorities act as shepherds, and they will do whatever is necessary to prevent a stampede. If my analysis is correct, they are likely to keep the appreciation of the yen moderate enough to preserve the prevailing bias in favor of U.S. government bonds. I should also explain ply views on oil prices. A decline is more or less inevitable. Production capacity far exceeds demand and the cartelis in the process of disintegration. Almost every member of OPEC with the $exception of Saudi Arabia and Kuwait cheats on prices. As a consequence, Saudi production has fallen to unsustainably low levels. Saudi influence within OPEC has declined in step with output. The only way Saudi Arabia could reassert control is by engaging in an all-out price war that would demonstrate the strength of its market position as gw-cost producer. But its market strength is matched by its political weakness. The result is a stalemate that leaves Saudi Arabia immobilized. Market participants are bracing themselves for the impending storm, but in the meantime calm prevails. Spot prices are quite firm, because nobody wants to carry any inventory. The longer the pressures build, the more violent the storm is likely to be when it finally occurs. The supply curve is inverted. Most producers need to generate a certain amount of dollars; as the price falls, they will try to increase the amount sold until the price falls below the point at which high cost producers can break even. Many of them will be unable to service their debt. The U.S. will be forced to introduce a protective tariff to save the domestic producers, and the protection is likely to be extended to Mexico, provided it continues to toe the line on the debt issue. 154 The Real-Time Experiment I have been carrying a short position in oil for quite a while and it has cost me a lot of money. Futures sell at a large discount from cash: carrying the position forward can cost as much as 2% a month. I am now inclined to close out the positions I hold in nearby months and establish a short position for next spring. The price would be lower, but the discount per month would also be lower. If my analysis is correct, the later the break comes the bigger it will be. The views I have outlined here are sufficient to serve as a basis for what I call macroeconomic investment decisions. But they do not answer the question: what is going to happen to the Imperial Circle? On that issue, my crystal ball is cloudy. Other things being equal, the recession, if any, ought to be a mild one. Monetary policy has been eased even before we entered a recession; inventories are tightly controlled, and a declining dollar should bring relief to the tradable goods sector, although the benefit may be felt only with a delay of 6 to 18 months. But other things are not equal. The financial structure is already under strain and it may not be able to withstand a recession: defaults could be self-reinforcing, both domestically and internationally. The financial authorities are fully aware of the danger and are determined to do everything in their power to prevent it. If it comes to a choice between recession and inflation, the odds favor inflation. This is not a forecast, but a reading of current monetary policy. Inflation would not be all bad: it would make the burden of debt more bearable both by reducing real interest rates and by boosting commodity prices. The question is whether a policy of inflation could succeed. It is likely to elicit an allergic reaction from the financial markets, inducing a “flight from the dollar and a rise in nominal interest rates. If foreigners become unwilling to finance our budget deficit, there must be a reduction in our GNP one way or another. But then, the Japanese may be willing to continue lending to us even if it provides them with a negative total return. MONDAY, SEPTEMBER 9,1985 The experiment is off to a bad start. Currencies peaked shortly after I had taken my full position and plunged precipitously in the last three days. Bonds also peaked and fell. 

The rise in bonds was sufficient to scare me out of my small short position with a loss, but 1 held on to my currency long positions on which I now also show a loss. The only thing that has worked in my favor is oil, where I used a strong market to extend my short positions to next spring. On balance, my trading has been poor, and I am losing heavily since the start of the experiment. Fortunately, the profits I made earlier this year leave me in a still comfortable position. The cause of the reverse is a spate of statistics that indicate an economic pickup. Money supply soared, the trade deficit de- 156 The Real-Time Experiment clined, employment figures improved, as did retail sales. Auto I sales in particular exploded during the first ten days in which the auto companies offered concessionary credit terms. The evidence implies that the horse is drinking, after all. I am inclined to fight the evidence and if I look hard enough I can find enough quirks to explain most of the figures. One fact remains: the surge in auto sales is sufficient to justify the rather aggressive production schedule auto companies have been working on. Closer inspection shows that almost all the employment gains were auto related. The crucial question is: what is happening to consumer spending as a whole? Are auto sales symptomatic of consumer behavior, or will they be offset by redtic-ugd exgeilditures in other areas? We shall only know the answer when it is I too late. For the time being, I am clinging to the view that the economy is quite weak. The decline in the dollar has not been large enough to bring any relief to manufacturing. Agriculture is in worse shape than ever. Homebuilding could give the economy another boost -housing is primarily dependent on interest rates and employment-but I believe that the fallout from the contraction of credit and erosion of collateral values as exemplified by the collapse of EPIC, the Equity Planning subsidiary of the Community Savings & Loan Association of Maryland, is going to depress the construction industry. Consumer debt is heavy, and strong auto sales now will reduce sales in the future. When 1986 models go on sale next month, the economy ought to slip back to the same position it was in before the auto companies started to force-feed it with promotional credit terms. The Federal Reserve is reluctant to tighten czedit because of the many weaknesses in the financial structure. If dollars are being created faster than foreigners are willing to absorb them, the exchange rate ought to resume its decline-unless the economy is strong enough to induce the Federal Reserve to tighten. It always comes back to the same question: the strength of the economy. Since I cannot resolve it, I shall be guided by the market. The German mark seems to have established a pattern that consists of a sharp rise, an equally sharp break, and a halfway retracing of the decline followed by a period of consolidation. If the pattern holds, we ought to be at the bottom end of the second break. That would fit in well with my economic scenario. If the pattern is broken, I shall have to cut my exposure in half until I can reassess the economic scenario. This will inevitably result in a loss because, if my expectations are correct, I shall not be able to reestablish my position without paying up, and, if I am wrong, I will 158 The Real-Time Experiment have an additional loss on the half position that I kept. That is the penalty I must pay for having taken too large a position at the wrong time. If my currency positions looked safer, I would consider buying some government bonds in the next refunding because real interest rates are once again reaching unsustainable levels, especially if Saudi Arabia is really going to step up oil production. My views on the longer term outlook are once again beginning to veer toward the pessimistic side. The financial structure has sustained additional damage. I have already mentioned the EPIC story; the Farm Credit System has gone public with its problems; and the liquidity crisis in South Africa is establishing a new precedent that may encourage banks to act even faster the next time a similar situation arises. Although the U.S. economy is showing signs of strength, the position of our financial institutions is weaker than it seemed a few weeks ago. SATURDAY, SEPTEMBER 28,1985 We live in exciting times. The emergency meeting of the Group of Five finance ministers and heads of central banks at the Plaza Hotel last Sunday constitutes a historic event. It marks the official transition from a system of free floating to a system of managed floating. Readers of my chapter on reflexivity in currency markets will realize that I regard the change as overdue. I managed to hang on to my currency positions by the skin of my teeth and after the meeting of the Group of Five last Sunday, I made the killing of a lifetime. I plunged in, buying additional yen on Sunday night (Monday morni~g in &ng Kong) and hung on to them through a rising market. The profits of the last week more than made up for the accumulated losses on currency trading in the last four years, and overall I am now well ahead. What gave me the courage to hold on to my currency positions was the pronounced weakness of the stock market. The strength of the dollar depends on the strength of the economy. A decline in stock prices can have considerable influence on the spending decisions of consumers and the investment decisions of those in business. Moreover, if there is going to be a recession, it will be brought on by the decline in collateral values, and the stock market is one of the most important repositories of collateral.

The deutsche mark barely held within the perceived pattern and my nerves were sorely tested, but by the time the Group of Five met, the mark had rallied in conformity with the perceived pattern. I am glad to report that the market reaction to the meeting broke the perceived pattern. Patterns are there to be broken by historic events and the meeting truly qualifies as one. The meeting was organized at the initiative of the Treasury. The Federal Reserve was brought in relatively late. Its main purpose was to relieve the intensity of protectionist pressure. It was held on an emergency basis and no comprehensive policy was developed in advance. Still, a commitment was made and the policies will follow. How the currencies are going to be managed remains to be seen. Market intervention can be effective only in the short run: it needs to be backed up by other measures. In my opinion, most of the running will have to be done by the Japanese. In Japan, the central Esnk still has sufficient prestige and influence that it can move up the yen more or less at will; but, to keep it up, the authorities will have to stem the outflow of capital and find additional domestic uses for savings by cutting taxes or increasing governmental expenditures or both. In addition, significant steps will have to be taken to remove nontariff barriers to imports. If not enough is done, the improvement in the yen will be difficult to maintain. The problem of the European currencies is different. Speculative flows are larger and the influence of central banks weaker. The mark moved much less than the yen, indicating that speculators and holders of liquid assets remain doubtful about the significance of the new departure. If the mark continues to appreciate, the difficulty will be in arresting the trend. It would not surprise me’if Volcker spent most of his time Sunday discussing not how to bring down the dollar, but how to arrest its fall. Since the meeting 1 have concentrated on the yen because that is the currency that matters as far as protectionist sentiment is concerned, but if the policy of intervention is successful, I intend to stay with the mark’longer than with the yen. The yen will appreciate to a reasonable level, say 200 to the dollar, but the mark may become overvalued. Eventually, the real play may be in gold, especially in case of a recession in the U.S. Th action in ~tock~prices has been much worse &an, 1 expected. In fact, I bought the S&P Futures after the Group of Five meeting for a trade and I had to liquidate the position with a loss. Altogether, the market action is quite ominous. The erosion of collateral values seems’to be much worse than I anticipated a few months ago. I now believe that the economy will slip into a recession before the measures now undertaken will have had time to bring relief. I also believe that additional measures will be forthcoming. Just as protectionist pressures brought a change in the exchange rate regime, the pressure of high real interest rates may well bring a far-reaching arms agreement and d6tente at the November summit. I am worried about the next six months, but I see better prospects for positive policy initiatives than at any time since the Imperial Circle came into existence. Odalance, I do not see much scope in taking a bearish posture in stocks, although I see a lot of merit in liquidity and I wish I had more of it. My short positions in oil have been going against me. The Soviet Union cut back on deliveries and Kargh Islmd has been effectively put out of action. I decided to cover my short position for March and April by going long for January. The discount is the largest between now and January. Keeping a short position open has become very expensive. By buying for January, 1 have effectively stopped the clock; I intend to reestablish my short position later. SUNDAY, OCTOBER 20,1985 The currency market has been rife with rumors of impending action during the weekend or during Japanese Prime Minister Yasuhiro Nakasone’s visit to the United States. I am inclined to discount the rumors. In fact, I am using the current strength to somewhat reduce my short positions in the dollar. I intend to increase them further during the refunding period for U.S. government bonds. Since the Group of Five meeting, there has been a lot of controversy between the Treasury and the White House, on the one hand, and the Federal Reserve on the other, some of which has Phase 1 : August 1985-December 1985 163 seeped into the press. ,The politicians seem to advocate “dirty intervention” in currency markets, while the Federal Reserve has religiously sterilized all the dollars it sold by selling an equivalent amount of Treasury bills. 

The politicians argue that sterilized intervention never works in the long run, but if the sale of dollars is allowed to increase the money supply the exchange rate is bound to fall. Volqker’s reply is that there is no need to be so aggressive because the dollar is going to decline anyhow. If the markets are flooded with dollars, the dollar may go into a free fall that may be difficult to arrest. Volcker seems to be more concerned with preventing a collapse than with inducing a decline, and E sympathize with what 1 ticlieve ta be his position. If I were in his place I would keep interest rates stable until the refunding is completed, selling foreigners all the dollars they want for the purchase of government securities, and I would lower interest rates after the auctions. This would ensure that the auctions are successful; and it would provide me with a large war chest to arrest the decline of the dollar when it has gone far enough. The economyqis very weak and both interest rates and the dollar need to be bought down. By waiting with an interest rate reduction until after the auctions I could make a large-scale, sterilized sale of dollars at a level that would look very good later. It is this line of argument that prompts me to bysome dollars now. The market may be disappointed if there is no immediate action on interest rates, allowing the Federal Reserve to sell dollars at higher prices. That is when I want to increase my short position even furtiler. I am also interested in buying bocds in iire refunding unless they go up too much in the meantime. I have not made any major moves in the stock market but I have whittled down my long positions and enlarged my short positions to a point where I seem to have a slight negative market exposure, although my long positions far outweigh my shorts in actual dollar amounts. I am increasing my short positions in Texas and California banks. SATURDAY, NOVEMBER 2,1985 I got my timing wrong. My dollar sales looked good until the Japanese central bank surprised me and the rest of the market by

raising short-term interest rates. I took this as the beginning of a new phase in the Group of Five plan in which exchange rates are influenced not only by direct intervention but also by adjusting interest rates. Accordingly, I piled into the yen. When the yen moved, I also bought back the marks I had sold. I lost money on the trade but ended up with the increased position I wanted. At today’s prices I have a profit on the maneuver. Phase 1: August 1985-December 1985 165 There is something unsound about increasing one’s exposure in the course of a trend because it makes one vulnerable to a temporary reversal. It will be recalled that a reversal came close to making me disgorge my currencies at the wrong time earlier in this experiment. The reason I am nevertheless willing to increase my exposure is that I’believe that the scope for a reversal has diminished. One of thy generalizations I established about freely floating exchange rates is that short-term volatility is greatest at turning points and diminishes as a trend becomes established. That is the case now. The fact that we are no longer in a system of freely floating exchange rates should diminish the risk of a reversal even further. Market particfpazta hava not y& recognized the new rules; the amount of exposure they are willing to carry is influenced by the volatility they have experienced in the past. The same is true of me, or I would have reached my present level of exposure much earlier, and I would have made even more money on the move. By the time all the participants have adjusted, the rules of thei game will change again. If the authorities handle the situation well, the rewards for speculating in currencies will become commensurate with the risks. Eventually, speculation will be discouraged by the lack of rewards, the authorities will have attained their goal, and it will be time for me to stop speculating. I have also missed the beginning of a move in bonds. When interest rates rose in Japan and to a lesser Germany, the market recognized that interest rates must fall in the United States and bond prices rose in anticipation. My well-laid plan of buying in the auction was preempted. I had to run after a moving vehicle and climb aboard the best I could. So far, i kave-estzblished a half position at not very good prices. I intend to double up in the next auction series in November. I must also consider increasing my stock market exposure for reasons that I shall explain. This is a good time to reassess the entire outlook. The controversy surrounding the Gramm-Rudman amendment has clearly demonstrated that public opinion is in favor of cutting the budget deficit. The Gramm-Rudman amendment was a brilliant device to enable the president to cut programs that would be otherwise untouchable. The cuts would start to take effect after the 1986 elections. The House of Representatives has gone one better by insisting that the cuts should start in the current fiscal year and 166 The Real-Time Experiment fall more heavily on defense. The Senate version would have 4 favored the Republicans in the 1986 election, but the House Democrats turned the table by exempting many social programs and bringing forward the effective date. The White House is in a quandary: it must do something about the budget deficit in order to pave the way to lower interest rates, but to raise taxes before the 1986 elections would be suicidal. There is a way out: to reach some accommodation with the Soviet Union at the summit meeting and reduce defense spending. The budget issue would be resolved and the Republicans could run in the 1986 election as the party of peace. It remains to be seen whether Reagan is interested in this soluiion. If it came to pass, we would enter a phase of great prosperity 4 with lower interest rates, a lower dollar, and a stock market boom. The enthusiasm generated by these moves would help to get the economy going again and the Baker Plan announced at the recent annual meeting of the World Bank in Seoul would help to keep the heavily indebted countries from collapsing. Mergermania would receive one last push from lower interest rates but it would eventually run out of steam because rising stock prices would make new deals uneconomic. With the benefits of corporate restructuring, profits would soar in a more benign environment and, with the shrinkage of equity capital that has occurred, stock prices could go through the roof. Eventually, the boom would be followed by a bust in which the uneconomic deals come apart and the international debt problem also comes back to haunt us, but stock prices would have to rise before they can collapse. That is why I am contemplating raising my stock market exposure. We are approaching the moment of truth. If Reagan flubs his opportunity, the consequences could be serious. We are hovering on the edge of a recession and we need both lower interest rates and a lower dollar to prevent an unraveling of credit. Even then, quite a lot of monetary stimulation may be needed to get the economy going again. It takes time for the decline in the value of the dollar to bring relief from import competition. In the first instance, the expectation of higher prices may divert domestic demand to imported goods. Only a significant drop in short-term interest rates, accompanied by better bond and stock prices, could reverse sentiment in time to prevent a recession. Without an agreement on Gramm-Rudman, the bond market could be disap- Phase 1 : August 1985-December 1985 167 pointed, the Federal Reserve would be reluctant to lower interest rates aggressively, and the erosion in collateral values would continue. The collapse of the International Tin Council provides a perfect illustration of the erosjon of collateral values. The collapse of OPEC is only a matte; of time now. I am increasing my short positions in oil for Jqnuary to March delivery. By the same token I am buying oil-refining stocks, because the increased flow should help their margins. As for the big picture, the next couple of weeks will tell the tale. The summit meeting is on November 19 and thelbudget debate has to be resolved before the nextaauction can take place. That is W~JJ I have decided to wait until the auction before taking a full position in bonds. SATURDAY, NOVEMBER 9,1985 My views on currencies are being tested. After a sharp rise in the yen, there was a sharp reversal last Thursday. I was told that the Bundesbank had bought dollars below DM 2.60 but it sold them again at DM 2.645 on Friday. In accordance with my contention that there is less risk in the market I refused to be panicked. The bond market is poised for a breakout on the upside. There are large option positions in Treasury bond futurss that expire next Friday. If the futures price moves above 80 before then, I intend to sell all or part of my position, because I believe the market is vulnerable. The White House cannot compromise on the budget befose the summit on November 19 and the Democrats will continue to press their advantage. This means a stalemate for the next week or so, followed by an auction as soon as it is resolved. I would be happy to withdraw from the market with a profit, putting me in a strong position to buy at the time of the auction. The stock market has also been strong. Divergences have persisted but the market broadened out on Friday. A breakout in bonds could coincide with a temporary top in the stock market, to be followed by a correction. I want to use that opportunity to cover my shorts and prepare to take a long position. If the correction does not occur, I shall cover my shorts with a loss and if the summit is successful go long at higher prices. 

SATURDAY, NOVEMBER 23,1985 The markets continue to preempt me. Both stocks and bonds rose strongly in advance of the summit meeting and the buying opportunity I was waiting for in connection with the government bond auction did not materialize. Instead of selling my bonds, I increased my position and I also bought some stock index futures 

because I did not want to miss a strategic opportunity on account of a tactical error. I also took a significant position in Japanese bond futures. This is a new market in which I have no previous experience, but the market participants I compete with must have even less experience. The Japanese bond futures market collapsed (from 102 to 170 The Real-Time Experiment 92) when the Japanese government raised short-term interest t rates. Experience has taught me that the best buying opportunities in long-term bonds present themselves when the yield curve is inverted-which is the case in Japan today. The rise in Japanese interest rates is bound to be temporary: the Group of Five wants to stimulate worldwide economic activity, not to dampen it. A reduction in U.S. interest rates would be matched by the other major industrial countries and, if the impact on exchange rates can be neutralized, the reduction may go further than currently envisioned. I am making the same bet in Japan as in the U.S. and the odds seem even better. I sm now fully invested in all directions: stocks, bonds, and currencies. I would have obtained better prices if I had not tried I to finesse it, or if the finesse had worked-but the main thing is that I reached the posture I wanted. I am looking for an opportunity to shift from bonds to stocks but I consider it prudent not to increase my overall exposure any further. Events have unfolded more or less as I expected. The only hitch was in the Gramm-Rudman amendment. Congress passed a one-month extension of the debt ceiling, enabling the auction to go forward while the fate of Gramm-Rudman remains unresolved. The summit meeting lived up to my expectations. I believe a radical shift in U.S.-Soviet relations is in the making. Both sides need to reduce their military spending and both sides have much to gain from closer cooperation. The opportunity was there and President Reagan seized it. By not making any concessions on Star Wars, Reagan has put himself in a position to usher in another period of detente without exp~sing himself to criticism for selling out to the Russians. In this context, the Gramm-Rudman amendment may come in positively useful as a mechanism for cutting the military budget without appearing to want to. The most eminently cuttable part of the military budget is retirement benefits-Stockman made an impassioned plea on the subject before quitting-and Gramm-Rudman may provide the perfect excuse. I expect a fairly stiff version of Gramm-Rudman to be enacted-one that is closer to the House version than to the Senate. In the present setting, that would no longer be as detrimental to the Republicans’ election chances in 1986 as it seemed a few weeks ago. Gramm-Rudman would be followed by a discount rate cut in Phase 1 : August 1985-December 1985 171 short order. That is what makes me take on the maximum exposure in bonds at the piesent time. I realize there may be some indigestion in the market after the auctions, but if my analysis is correct there is still something left to go for. After a discount rate c;ut I intend to cut my bond exposure and increase my stock positions. Stocks are more open-ended on the upside than bonds. If and when the economy rebounds, stocks will do better than bonds. If the economy continues to languish, the reduction in short-term interest rates may go much further than currently expected, but the dollar would also come under pressure so that the yield curve is likely to steepen. It should be remembered that d6tente is bearish fa: the dollas vis-l-vis European currencies. If one wants to stay in bonds, the place to be is the short end. We may be on the verge of a great stock market boom. Industrial companies have suffered from a combination of inadequate prices and inadequate demand. These adverse conditions have resulted in the wholesale restructuring of corporate America. Many companies have been swallowed up by takeovers and leveraged buyouts. Those which have survived have tightened their belts, disposing of losing divibions and cutting corporate overhead. Productive capacity has been cut rather than increased, and market share has been concenti-ated in fewer hands. The lower dollar is now in the process of relaxing pricing pressures; if there is any pickup in demand, it goes straight to the bottom lb. Lower interest rates and the lower inflation rate combine to make a given level of earnings more valuable. After a period when industrial shares were selling at a discount from their breakup value we may enter a period when they once again sell at a premim. But before we get there, we are likely to experience another wave of takeovers, induced by the decline in interest rates. END OF PHASE 1: SUNDAY, DECEMBER 8,1985 This may be a good point to terminate the real-time experiment. I have assumed maximum market exposure in all directions and I have also announced my intention to shift gradually from bonds to stocks within the constraints of prudence. At present a large part of my stock market exposure is in the form of index futures. With the passage of time I shall try to develop specific stock investment concepts, and my performance will be increasingly influenced by the validity of those concepts. To keep a detailed account of my investment activities beyond this point would take us too far afield from the subject of the experiment, namely, predicting the future of the Imperial Circle. I shall continue my periodic diary but it will serve the purpose of control and not of formulating a prediction. In other words, I wish to “freeze” my expectations about the future of the Imperial 

Circle at the present time and submit it to the test of events. Needless to say, I shalt continue changing my portfolio as I see fit. I have about as firm a conviction about the shape of things to come as I shall ever hgve, as witnessed by the level of market exposure I am willing t’o assume. At the beginning of the experiment 1 said that my crygtal ball about the longer term outlook was rather cloudy. The experiment has brought about a remarkable transformation: I now have a relatively clear vision of the future and that vision differs significantly from the admittedly tentative views I started with. I regarded the Imperial Circle as a temporary expedient whose internal contmdictions were bOu~d to render .it unsustainable, and my presumption was that the problems that the Imperial Circle had managed to keep at bay would resurface with renewed vigor after its disintegration. Specifically, the Imperial Circle constituteil an artificial extension of the period of credit expansion with the U.S. government acting as “borrower of last resort.” When the Imperial Circle ceased to attract capital from abroad in ever-inbreasing quantities, the last engine of economic stimulation would be extinguished, and the contraction of credit would create an’untenable situation. Without a significant expansion of money supply the burden of debt would become unbearable; with a significant expansion, the dollar would go into a free fall. I am now beginning to discern the outlines of awther temporary solution that may succeed in unwinding the excesses of the Imperial Circle without plunging us into a vicious circle. The solution consists of switching from fiscal to monetary stimulation in the United States and controlling the descent of the dollar through international cooperation. The new constellation is almost the exact opposite of the Imperial Circle: a weaker dollar and a subdued economy are accompanied by lower budget and trade deficits and, most important, by lower interest rates. With the help of a weaker dollar, prices are going to rise somewhat faster than previously, rendering the change in real interest rates all the more pronounced. Declining real interest rates, together with a possible pickup in exports, will replace the budget deficit as the main driving force in the economy. Rising prices will help to counteract the erosion of collateral values and prevent a selfreinforcing, deflationary process from taking hold. At the same time, the coordination of economic policies will keep the decline of the dollar within bounds, thereby eliminating the possibility of 174 The Real-Time Experiment a self-reinforcing inflationary process. The outcome would be a ‘ greater degree of stability than we have experienced since the breakdown of Bretton Woods. Using the notation adopted earlier, we can depict the key relationship in the newly emerging state of affairs as follows: The picture is much simpler than that of the Imperial Circle beexchange rates are stabilized. The extent to which interest rates will decline depends on the amount of stimulation that will I be necessary to keep the economy from sliding into a recession. Although the new constellation is almost the exact opposite of the Imperial Circle, there is one essential difference between them. The new constellation is the deliberate outcome of a concerted economic policy, whereas the Imperial Circle was the unintended consequence of conflicting economic policies. The Imperial Circle was self-reinforcing until it became excessive and ripe for a reversal; the reversal would also become self-reinforcing unless it were deliberately controlled. The mechanism of control is the management of exchange rates in the first instance and the coordination of monetary and fiscal policies in the second. It is the emergence of a concerted economic policy that has caused me to change my expectations in the course of the experiment. I was aware of the possibility of such a policy emerging and I stressed the difference between the first and the second Reagan administrations. During the three months of the experiment, there occurred several historic events that converted a mere possibility into a historical reality: the Group of Five meeting, the Baker speech in Seoul, the Grarnm-Rudman amendment and the summit meeting in Geneva. What makes the emergence of the new economic direction so fascinating is that the actual policy measures of which it will be made up have not even been formulated. The Group of Five meeting was merely a commitment to follow a coordinated exchange rate policy, not an agreement on what that policy is; the Baker Plan for international debt is certainly not a plan but merely the announcement of a need for a plan; the summit meeting may mark a new departure in relations between the superpowers, but it pro- Phase 1 : August 1985-December 1985 175 duced no concrete results; and the fate of the Gramm-Rudman amendment is still uncertain at the time of writing. The actual policies are yet to be formulated. How far they will reach will depend partly, on the farsightedness of the policymakers but mainly on the pressure of necessity. Necessity may be defined in this context as the need to preserve the integrity of the financial and trading sy tems, or, in other words, to forestall a collapse in credit and to k eep protectionism at bay. The definition is rather cavalier: it does not rule out individual defaults or particular instances of trade restraint; the crucial issue is that neither Success is far from assured. Past experience is not encouraging. A somewhat similar set of circumstances led to the collapse of both credit and international trade in the 1930s. But exactly because the memory of the: 1930s is still so vivid, the prospect that we shall avoid similar mistakes is rather favorable. There is general agreement on some policy objectives: a controlled descent of the dollar and a concerted reduction in interest rates. There is less agreement on other points: how to reduce the U.S. budget deficit and how to stimulate the economies of the debtor countries. It is difficult to obtain concerted action even on the generally agreed objectives. For instance; Japan was obliged to raise interest rates because the United States was unable to resolve the issue of the budget deficit in time. How can one have any cddence that appropriate action will be taken in those areas where even the agreement on objectives is missing? Clearly, the situation is far from riskless, and, as we shall see, the risks are the greatest in the short term. It is exa~tly be, ‘-3use the risks are so great, and their severity is recognized, that one can have a fair degree of confidence that the necessary measures will be forthcoming. I am not the only one to think so: the financial markets have endorsed the new policy departure in no uncertain fashion. The rise in bond and stock prices is helpful in two ways: it encourages the authorities to pursue the course on which they have embarked, and it enhances the chances of success. For instance, the strength of the bond market enlarges the Federal Reserve’s freedom of action in lowering interest rates. We are dealing with a reflexive process where the direction of economic policy and the direction of the financial markets mutually reinforce each other. It is the response of the financial markets that has given me the 176 The Real-Time Experiment courage to take on such a large market exposure. It will be recalled t that in the case of currencies when the change in trend was still uncertain I was much more tentative and when the market moved against me I was a hair’s breadth away from cutting back my position. In fact, the real-time experiment was instrumental in helping me to hang in there because seeing my ideas clearly formulated strengthened my convictions. My success in the marketplace has reinforced my confidence in my ability to predict the course of events even further. 1985 is shaping up as a recordbreaking year for Quantum Fund: a more than 100% appreciation within a year is heady stuff. I have to be careful. Using the concept of reflexivity to predict the -future course of events is itself a reflexive process, and a high degree of success is often the precursor to a severe setback. It is clear from the experiment that my perceptions are partial and subject to correction by events. If I begin to lay store on my longer term expectations-and what is worse, go public with them-I may be setting myself up for a great fall. It is a danger I intend to guard against. It will be interesting to see, when we control the experiment, what will have remained of my current game plan. Actually, it is less dangerous to cany a large market exposure at the present juncture than to predict the eventual outcome of the policies that are now being formulated. The mere fact that there is an attempt to take charge of the world economy is sufficient to give the financial markets a boost and, even if the hopes are going to be disappointed, it will take time for the failure to become evident; thus the attempt at a concerted policy should be sufficient to sustain the present rally for a while. The eventual outcome is quite another matter. There can be no assurance that the market’s expectations will be fulfilled. I must beware not to allow my confidence in a bull market to affect my judgment about the real world. I have become so involved in the market that I find it difficult to maintain perspective. I shall try to assess the future of the Imperial Circle in two different ways: one is to identify the “thesis” that the current market rally incorporates and evaluate its chances of success; the other is to locate the present moment within the theoretical framework of credit expansion and contraction that I have been trying to formulate. Both approaches employ the concept of reflexivity, but the first one sticks closely to the reflexivity inherent in financial markets while the second seeks to explore the reflex- Phase 1 : August 1985-December 1985 177 ive connection betweep credit and collateral values. Needless to say, I am on much surer grounds with the first approach. I believe the market has come around to the view that the economy is fundamentally, weak and inflation nonexistent. A brief rally in cyclical stockslin early summer has petered out and the highs reached then have still not been surpassed. That rally has been based on the mistaken expectation of an imminent pickup in the economy, and it was very narrow: other segments of the stock market were declining while the cyclicals rose. It was followed by a general market decline that was cushioned by takeover and stock buy-back activity. Commodities also made new lows and have been lagging Sn the current recovery. Metals, in particular, have acted very poorly in relation to currencies. The recent stock market rally is much more broadly based than the earlier flurry in cyclicals; it follows on the heels of a bond market rally and it was preceded by a decline in the dollar. Obviously the markets are discounting a decline in the economy. Whether it will deteri~rate further is an open question. Economists are almost unanimous in ruling out a recession, but the stock and bond markets are acting as though it were an accomplished fact: stock prices are rising because investors are “looking across the valley.” It is possible that the slowdown of the past year served as the equivalent of a recession; alternatively, there is some further weakness to come. Either way, the sequence of events is highly unusual and investors have beedaken by surprise: none of the technical indicators that normally signal a significant upturn in the stock market has been present. The November 27 lead article in the Wall Street Journal entitled “Strange Rally” has highlighted this fact. Every recession since the end of the Second World War has been preceded by the Federal Reserve tightening the money supply, causing an inverted yield curve to appear at some point along the line. An inverted yield curve preceded the rally in the summer of 1982, but we have not seen an inverted yield curve since. The explanation for the current sequence of events has to be sought elsewhere. That is where the second approach using my hypothesis about the credit cycle comes in handy. It will be recalled that I envision a reflexive relationship between the act of lending and the value of the collateral that serves as security for the loans. Net new lending acts as a stimulant that 178 The Real-Time Experiment enhances the borrowers’ ability to service their debt. As the amount of debt outstanding grows, an increasing portion of new lending goes to service outstanding debt and credit has to grow exponentially to maintain its stimulating effect. Eventually the growth of credit has to slow down with a negative effect on collateral values. If the collateral has been fully utilized, the decline in collateral values precipitates further liquidation of credit, giving rise to a typical boomlbust sequence. Using this model, I contend that the postwar period of credit expansion has run its course and we are now in a period of credit contraction as far as the real economy is concerned. All previous postwar recessions occurred during the expiillsiontuy phase: that is why they had to be induced by tight money. We are now in the contractionary phase where a slowdown need not be induced: in the absence of new stimulants, such as a growing budget deficit, the erosion of collateral values will do the job. The trouble is that real life is not as simple as the model I have been working with. In particular, the transition from credit expansion to credit contraction does not occur at a single point of time because it would precipitate an implosion that the authorities are determined to prevent. Official intervention complicates matters. The turning point does not occur at a single moment of time, but different segments of the credit structure follow different timetables. To locate our position in the credit cycle, it is necessary to disaggregate the process and consider the main elements of credit separately. This approach yields 1982 as the turning point for the heavily indebted countries, 1984 as the turning point for U.S. financial institutions, and 1986 as the turning poi& for the U.S. budget deficit. The contraction of credit in less developed countries has probably reached its peak in 1984; the adjustment process is largely responsible for the oversupply of basic commodities. The adjustment process by U.S. banks and savings and loan institutions has only recently begun to make its effect felt on collateral values in real estate, land, shipping, and the oil industry. The reduction in the budget deficit has not yet taken effect and it is to be expected that it will be fully compensated for by a reduction in interest rates. Two more important pieces need to be fitted into the jigsaw puzzle: mergermania and consumer spending. Leveraged buyouts and other manifestations of mergermania are great users of credit but they tend to produce a corresponding Phase 1 : August 1985-December 1985 179 amount of liquid assets. Superficially, they seem to be expansionary but in fact they fit into the declining phase of the credit cycle: they increase the total amount of debt without stimulating the economy. Cash flow is, used to service debt rather than to purchase physical assets; t$e disposal of assets adds to the downward pressure on collateral dalues; and the sale of junk bonds tends to steepen the yield curve: the net effect on the economy is depressing rather than stimulafing. Consumer spending is the great unknown. Consumer indebtedness has been rising steadily over the years, and repayment terms have been extended to a point where it is hard to see how they can be extended cny further. Until recently, houses could be bought with a 5% down payment and auto loans could be repaid over five years. Delinquencies in consumer loans have risen ominously in the course of 1985, but the simultaneous decline in interest rates and the dollar should alleviate the situation. Will these ,developments merely serve to contain the delinquency problem, or will they stimulate new demand? That is the crucial question on which the near-term outlook hinges. If consumer spending remains sluggish, the bull market in bonds and stocks may have considerable staying power; in fact, we could have one of the great bull markets of all times. A pickup in the domestic savings rate would offset the reduction in the inflow of foreign capital allowing interest rates to dgcline in spite of the decline in the dollar. The stock market would benefit from both developments. Lower interest rates would enhance the value of a given level of earnings, and the lower dollar would enhance the level of earnings by mitigating pricing pressures from imports. In a sluggish economy the cost of labor would remain depressed. Threatened by adverse economic conditions and corporate takeovers, managements have redeployed assets and reduced overhead expenses; as conditions improve, the benefits flow directly down to the bottom line. As interest rates decline, there would be one last rush of corporate takeovers and leveraged buyouts, in the course of wh’ch exaggerated prices may be paid; but recent events make past a quisitions more viable and deals that may have been unsound w 1 en consummated are now looking healthier. Eventually the hise in stock prices should render leveraged buyouts uneconomic, and merger activity should peter out. That would be a very p’ositive development for the real economy because it 180 The Real-Time Experiment would enhance the attraction of investing in physical assets stim4 ulating not only demand but also supply. Should we reach that point, our economy would be healthier than it has been for some time. The boom may eventually get out of hand and set us up for a great crash, but share prices would have to rise a great deal before we reach that point. It is an argument for buying stocks now. On the other hand, if consumer spending does pick up under the impetus of lower interest rates, the boom in financial markets will be short-lived and the real economy is likely to follow the stop-go pattern familiar from the British example. With inadequate domestic savings and doaesti~ iaveshnent, the excess of both credit and consumption would have to be met from abroad 4 and we would be back in the situation that prevailed at the end of the Imperial Circle. Either we raise interest rates, restarting the Imperial Circle and choking off the domestic economy, or we print money, setting in motion a vicious circle in the opposite direction. Reality is likely to fall between these extremes, but that is not saying much because the extremes open up an almost infinite range of possibilities. I am no better qualified to predict consumer behavior than I was at the beginning of the experiment. All I can do is evaluate the consequences of the various alternatives. It can be seen that a period of subdued consumer spending could do much to correct the last two major areas of excess credit. Mergermania would run out of steam as the stock market rises and the overindebtedness of consumers would be corrected as the savings rate rises and lenders tighter1 their criteria. Mer a while, conditions would-be ripe for more balanced growth. When past excesses are being corrected it is always a period of maximum risk. That is the case now. There have already been a number of minor catastrophes: the EPIC debacle has been followed by others in the real estate lending arena; the Federal Savings and Loan Insurance Corporation and the Farm Credit System have gone public with their woes; the International Tin Council has been unable to meet its obligations, tin trading on the London Metal Exchange has been suspended, and many metal traders are going out of business; the largest Japanese shipping company has gone broke; just now the Singapore Stock Exchange has had to close for a few days; and there are obviously other Phase 1: August 1985-December 1985 181 events yet to come. We are facing at least two shocks that exceed in magnitude anything we have experienced to date. One relates to oil, the other to international debt. The collapse of oil prices is only a matter of time. Once it begins it will not stop of its owh volition. Most countries operate with a perverse supply curve: ihe lower the price of oil, the more they need to sell in order to meet their needs. Left to itself, the price of oil could temporarily fall to a single digit, but it will not be left to itself. Domestic industry will have to be protected below $22, otherwise the losses would exceed the capacity of the banks to absorb them. I would expect to see some kind of protection that woukl also extend to Mexico and Canada. I wonder how the North Sea producers will be protected. The problem will be a difficult one for the European Economic Community to resolve. How it is dealt with may determine the future of the Common Market. The problem of international debt has not gone away. Indeed, the debt of the less developed countries has continued to grow, although some countries have been able to improve their debt ratios. Negative resource transfers probably reached their peak in 1984 and, as debtor countries insist on reflating their economies, negative resources transfers are beginning to decline. The cohesion of the lenders’ collective has eroded. The run on South Africa, in particular, has driven a wedge between American and European banks. In the United States, the interests omoney center banks and regional banks diverge. The Baker Plan demonstrates an awareness of the problem but it falls far short of a solution. Until a solution is developed, the system remains accident prone, although it is not clear where the next accident is likely to occur. The banking system is now strong enough to withstand a single shock; the danger is that several shocks may coincide. – There is yet a third danger that will develop as the stock market boom gathers momentum: the danger of a crash in the stock market. At present, market participants are still very conscious of the problems and as a consequence are quite liquid. But it is in the nature of a boom that it attracts ever-increasing amounts of credit. If a financial shock occurs when many stock market participants are overextended, margin liquidation could cause an implosion of stock prices. We are a long way from that stage: at present, a sudden financial shock, like the failure of yet another bank, could 182 The Real-Time Experiment cause a short, sharp break in prices, but the market would recover. I The bull market is likely to be punctuated with such breaks until participants will cease to fear them. That is when we shall be set up for a crash. The financial system has been severely tested and the testing is not yet over. The fact is that the system survived and the recent changes in economic management improve the chances that it will continue to survive. The process of credit contraction has been accomplished without a bust so far and one can now see a way in which it could be completed without a bust, albeit at the cost of a prolonged period of substandard growth. Substandard growth is less than desirable almost by definition, 4 but it may meet the policy objectives of the present administration perfectly. It has been long recognized that conditions in which goods and services are freely available are more rewarding to the owners of capital than conditions in which resources are fully employed. Not only does a larger share of the national product accrue to the owners of capital but entrepreneurs enjoy much greater freedom of action. That is certainly the case today. The reins of government are in the hands of people who believe in free enterprise and encourage it to the greatest possible extent or even beyond. Incidentally, Japan has also found it advantageous, for different reasons, to expand its economy at a rate that is decidedly below its potential. Japan wants to become a great power in the world and the way to achieve that status is not by encouraging domestic consumption but by maintaining a high domestic savings rate that is used first to build up productive capacity at h~me and then to acquire assets abroad. Japan has yielded to American pressure by raising the value of its currency but it will change its domestic economic policy only to the extent that is necessary to support the yen. One of the most potent reasons for expecting economic growth to remain sluggish is that it suits the policy objectives of the two leading countries. The constellation that seems to be emerging as a sequence to the Imperial Circle deserves to be described as the Golden Age of Capitalism. It is hard to believe that the golden days of capitalism could come back again. After all, untrammeled free enterprise has produced horrendous results in the past. Are we to repeat the same Phase 1 : August 1985-December 1985 183 experience again? Hopefully not. Perhaps we have learned something from past mistake$. The fatal flaw of a free market system is its inherent instability. The belief that financial markets are self-regulating is simply false. Fortunately, Secretary Baker is aware of this fact and the administration has behn to exert active economic leadership since he moved to the Treasury. Certainly it is not laissez-faire that has brought us to1 the threshhold of a new golden age of capitalism but a concerted economic policy designed to counteract the excesses of a free market system. It remains to be seen how well we have learned our lessons. In any case, the benefits of the new golden age are very unevenly spread. It is in the nature of capitalism that the gap between winners and losers is rather wide. Large segments of the population, especially in the financial, technology, service, and defense sectors, are flourishing. Others, especially in the older industries, agriculture, and the welfare sector, are suffering. Fortunes are made in financial deals and shareholders wield more power than at any timk in the last fifty years; at the same time, bankruptcies are also at a fifty-year high, in both size and numbers. Debtor countries are wallowing in depression and a whole continent, Africa, is starving; at the same time China is converting to a free market system with all possible speed and the Soviet Union is on the verge of moving in the same direction, albeit much more cautiously. Why the Reagan administration has been so successful in achieving its objectives is a fascinating question. To all intents and purposes the Democrats have been reduced to the party of losers, as manifested by the fact that it is the Democrats who push for protectionism in Congress, while President Reagan has an unquestionable gift for making Americans feel like winners. But the improvement in sentiment has been achieved at the cost of considerable deterioration in the underlying reality, as manifested in our national indebtedness. Frankly, I have been surprised by the vitality of resurgent capitalism. I considered the Imperial Circle as a temporary expedient that was bound to break down. Seeing it replaced by a new arrangement that can be described as the Golden Age of Capitalism, I must acknowledge the adaptability of the system and its ability to survive. It remains to be seen whether policymakers succeed in containing its weaknesses: the inherent in- 184 The Real-Time Experiment stability of financial markets and the iniquities caused by 4 instability. 

I have decided to move forward the date of switching from bonds to stocks. I am influenced partly by the prospect for “the bull market of a lifetime” that I have just articulated and partly by more practical considerations. A cut in the discount rate may not follow immediately upon agreement on Gramm-Rudman. Markets are firm and the Federal Reserve is cautious. The statistics for December may lbok quite good, partly because the Christmas shopping season is crowded into fewer days and partly because investment orders may be placed before the end of the year to beat the changes’ in taxation. The next advance indicators may also look good because they include stock prices and money supply. In these circumstances, bonds may be vulnerable and stocks may offer better prospects on the upside. The thesis I have just formulated is beginning to enter investors’ ccneci~usnscses, yet caution is still prevalent. The year’s end is seasonally a strong period: we could have some fireworks in the next four to five weeks. 

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