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By Tim Price, on 16 January 12
“Under the circumstances, discussions with Greece and the official sector are paused for reflection on the benefits of a voluntary approach.” Debt talks “have not produced a constructive response.”
- The Institute of International Finance, January 13 2012.
“The war situation has developed not necessarily to Japan’s advantage..”
- Japanese Emperor Hirohito after the atomic bombing of Hiroshima and Nagasaki, announcing Japan’s surrender to the Allies.
There is a terrible hubris at the heart of mankind. Like every other living thing on the planet we are products of nature, but we consider ourselves to be well above it. We are beset by regular reminders of our vulnerability, but quickly dismiss them off-handedly to a spiritual plane, calling them ‘acts of God’ as if to show that we could never have prevented them. In a significant essay for Foreign Affairs, ‘The Black Swan of Cairo’ (PDF), Nassim Taleb shows how the efforts of our authorities to suppress volatility actually end up making the world less predictable and more dangerous:
Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” – that is, they become extremely vulnerable to large- scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.
There is an analogy from the natural world. In the 1960s and 1970s, mid-western American states fell victim to scores of wildfires. Constant interventions by the US Forest Service appeared to have little positive impact – if anything, the problems seemed to worsen. Over time, foresters came to appreciate that fires were a normal and healthy element of the forest ecosystem. By continually suppressing small fires, they were unwittingly creating the conditions for larger and less containable wildfires in the future. Naturally occurring fires are necessary to remove old forest cover, underbrush and debris. If they are suppressed, the inevitable fire to come has a far greater store of latent fuel at its disposal.
Economist Murray Rothbard jangled the sensibilities of the Keynesians when he wrote his classic study, ‘America’s Great Depression’:
If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery.
But politicians must be seen to be doing something – like encouraging the construction of a £33 billion white elephant rail link in the middle of an austerity recession.
Not interfering with the market’s adjustment process is simply allowing Schumpeterian ‘creative destruction’ to operate, and cleanse the forest. But that process is anathema to well-compensated entrenched interests that suckle from the teat of the State. Banks, for example. So while ‘laissez faire’ would accelerate any banking crisis and shorten the resultant economic contraction, it would reveal the identity of too many naked swimmers when the tide retreats. Instead, courtesy of highly paid lobbyists, we get a long drawn out depression. The example of Japan’s zombie banks from the 1990s is still fresh, but ignored in the west.
Rothbard identified the ways in which government can hobble the adjustment process:
- Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further.
- Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments which, in their turn, will have to be liquidated in some later depression. A government’s “easy money” policy prevents the market’s return to the necessary high interest rates.
- Keep wage rates up.
- Keep prices up.
- Stimulate consumption and discourage saving. More saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved capital even further.
- Subsidize unemployment. Any subsidization of unemployment (via unemployment “insurance”, relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.
An iatrogenic illness is one caused by the doctor himself. The economies of the west now face policy measures of the sort highlighted by Rothbard that are stated to be in our interests, but which are more likely to do harm to the patient and prolong the recession.
Taleb uses the example of the turkey before Thanksgiving. The turkey is fed for 1,000 days and every days seems to reaffirm the farmer’s generosity of spirit. Until the last day, when the turkey’s confidence and contentment is at its maximum. The “turkey problem” occurs when “a naive analysis of stability is derived from the absence of past variations”. To put it another way, the US property market cannot decline because it hasn’t declined in living memory. As Taleb puts it, as humans we inhabit two systems simultaneously: the linear and the complex. The linear is predictable and permits the use of mathematical tools of high predictive value. Complex systems, on the other hand, are marked by an absence of visible causal links between their elements, “masking a high degree of interdependence and extremely low predictability”. They also incorporate non-linear elements often called “tipping points”. One reason for the severity of the financial crisis, and the losses incurred by banks, is that bankers and financial analysts were using linear tools in a non-linear, highly complex environment otherwise known as the financial markets. The models didn’t work.
The problem we face now as investors will end up being existential for some banking institutions and sovereigns. Our (uncontentious) core thesis is that throughout the west, more debt has been accumulated over the past four decades than can ever be paid back. The question, effectively to be determined on a case-by-case basis, is whether bondholders are handed outright default (which looks increasingly like the case to come in Greece) or whether the authorities, in their understandable but misguided attempts to keep the show on the road, resort to a policy of inflation that could at some point easily spiral out of control. As Rothbard wrote,
The longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process.. the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while [the currency] is worth more than it will be in future. The result will be a “runaway” or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency – the lifeblood of the economy; it ruins and shatters the middle class and all “fixed income groups”; it wreaks havoc unbounded.. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.
It may be a new year, but we are beset by the same problems that have been recurring since the crisis began. In most cases, those problems have worsened. One of the few improvements has been in the recapitalisation of Anglo-Saxon banks, but continental European banks seem acutely vulnerable to the potential outcome of a disorderly sovereign default. Since the problems are the same, so are our preferred solutions: a specific focus on only the most creditworthy sovereign and quasi-sovereign debt (where it offers a positive real return); a specific focus on only the most defensive and internationally diversified equities; genuinely uncorrelated investments; and exposure to objectively the highest quality currencies, namely precious metals.
Euro zone politicians and policy makers have had plenty of time to come to terms with the continent’s problems, and continue to show no willingness to grasp admittedly difficult nettles. It is symptomatic of the balkanised and adversarial nature of politics in the euro zone (a unified body that exists in theory but barely in fact) that Christian Noyer, chairman of the French central bank, anticipated France’s credit downgrade by suggesting that Britain should be downgraded first. As the Hildebrand scandal also revealed, most of Europe’s central bankers are not fit to sweep the streets. And still time is running out. Readers of a certain age will recall a late 1980s ‘big hair’ rock anthem called ‘The Final Countdown’. It was released by essentially a one-hit wonder band. Its name was Europe.
This article was previously published at The price of everything.
By Toby Baxendale, on 6 October 11
It was recently pointed out to me that certain free market orientated friends dislike policies that fail to restore immediate growth:
Basic economic theory posits that as households and businesses become more uncertain about the future, the more they save from their after-tax incomes — and a rising savings rate in the private sector at a time of belt-tightening in the public sector is not the prescription for growth, unless somehow exports emerge as a critical safety valve. For sure, if there is one development that does seem encouraging, it is that there is something of a manufacturing renaissance taking hold, but the effects on the overall economy are going to pale next to the round of consumer retrenchment we are likely to see in coming quarters and years.
On the face of it, who would not want growth when we are on our knees awaiting the next blood letting that will inevitably unfold as the second phase of the Great Recession comes upon us?
A large credit boom such as the one we saw from the mid 90’s to the late 00’s causes many more goods to be produced, with the newly created credit, than there are savings to buy these goods. With only a limited amount of factors of production and productivity gains not creating more goods and services fast enough, we have businesses biding up resources and thus prices against each other. This causes local asset price booms. Think Dot.com. Think housing. This causes the general price level to rise, rather than fall. Productivity and technology gains should allow price falls (think of the costs of your computer over the last two decades), but economy-wide, they never do. People eventually reduce their consumption of goods, having depleted their savings. As consumers disappear, and turn their attention once more to saving, the boom goes to bust.
So what needs to happen is that prices be allowed to fall. We should embrace this process. When prices fall, the consumers become more and more confident that what they are being offered is fair value or even undervalued, and they start to increase their buying volume again. This is when the seeds of recovery start to show fruit.
We should also remember that the only way to create wealth is for entrepreneurs to find better ways to combine the existing factors of production in better ways to make goods and services that people want. They do this by using their savings to invest in better capital formation. This is done brick by brick, over time. It is done by entrepreneurs, not governments. The only thing the latter can do is provide the legal framework, the rules of the game, so that entrepreneurs can get on with producing the goods and services of the economy that satisfy the needs of their fellow man.
However the government tries to intervene — through bailouts, deficit spending, quantitative easing, credit easing, enterprise zones, ‘green’ subsidies, or tax gimmicks — they cannot help but produce uncertainty, which is the real killer of the recovery. When people aren’t sure how the rules are about to change, they put more money into precautionary savings. All private enterprises do the same: it is the only rational response.
In this paper (PDF), which won the 2010 Frisch Medal of the Econometric Society for its author, Nicholas Bloom shows how uncertainty can be one of the most disruptive factors for an unbalanced economy attempting recovery. He does not show how the economy comes to be so unbalanced in times of recessions, but his analysis of the impact of “uncertainty shocks” is compelling. Bloom concludes:
The uncertainty shock also induces a strong insensitivity to other economic stimuli. At high levels of uncertainty the real-option value of inaction is very large, which makes firms extremely cautious. As a result, the effects of empirically realistic general equilibrium type interest rate, wage, and price falls have a very limited short-run effect on reducing the drop and rebound in activity. This raises a second policy implication, that in the immediate aftermath of an uncertainty shock, monetary or fiscal policy is likely to be particularly ineffective
So the only way to cure this recession is for the policy makers to get out of the way, let prices fall, let debt get written off, and let people start buying again those good and services they want, at prices they can afford to pay.
Prior to 1929, this of course was the usual public policy response.
After World War I, in the belligerent countries, we had a large build-up of capital to produce weapons of destruction. This distortion away from what consumers would normally need had to unwind. In the USA, for example, this was painfully deflationary, from Jan 1920 – July 1921, but within 18 months the whole recession was over.
Since that recession we have been faced with a mix of policy activism by our elected representatives and interventions of various shapes and sizes leading for example to the prolonged Great Depression. I contend that with all the frantic policy activism we see over in Europe, especially now, we can expect the Great Recession go on for many years to come.
I know that advocating a “do nothing” policy is for a politician like advocating that all new born babies should be eaten, but sometime what seems the least palatable — letting prices fall and debts be written off — is in fact the quickest and least painful option.
As an Ironman athlete, my coach prescribes one rest day per week when I do no physical activity at all, and one calendar month per year when I remain largely inactive. This is a very important part of my training program, and it needs to be given as much attention as the swim, bike and the running aspects. Inactivity can be good!
As an investor, instead of looking at the stock market going up, down, sideways, backwards, and every which way as the herd charges around, being busy and active on a whisper here, a phrase said there, by a politician or policy maker, I suggest a different course: choose your companies based on their true fundamentals. Do they have great management? Do they have original owner participation? Do they make great products that are needed all the time? Do they have good barriers to entry? Do they have a strong balance sheets and little or no debt? Then you can make your choices, sit back and do NOTHING as a positive investment strategy.
If our bust is allowed to unfold, there will be momentary panic as the voices of the political class fall silent, but people will soon realize that as they still need to eat, drink, and keep warm. The world goes on, the sun rises and sets, and as long as people need things, there will be people who will supply those things. Entrepreneurship will never be snuffed out.
I advocate a POSITIVE policy of doing nothing.
Addendum
Since I wrote this, Sean Corrigan has sent me an article (PDF) by our friend Prof Steve Horwitz about the Hoover administration. It covers the 29 – 31 crash period, and is very pertinent to today. This administration, we are always told, was a “do nothing” free market administration, and it was Hoover’s non-policies that actually deepened the Great Depression. Horowitz concludes:
Despite overwhelming evidence to the contrary, from Hoover’s own beliefs to his actions as president to the observations of his contemporaries and modern historians, the myth of Herbert Hoover’s presidency as an example of laissez faire persists. Why that is so is beyond the scope of this study, but it surely remains a source of comfort to those among the intelligentsia who deeply believe that the Great Depression demonstrates the problems with free-market capitalism and the importance of government intervention in stabilizing a market economy. The truth, of course, is nearly the opposite. This misinterpretation of the Great Depression lies at the bottom of much of their more general belief in the deep flaws of market economies, as we have seen in the way the media and many intellectuals have cheered on the activism of Bush and Obama since 2008.
Accepting Hoover’s role as the father of the New Deal would challenge the fundamental argument at the core of their preferred narrative that laissez faire made matters worse during the Depression and that government intervention was the solution. Everyone agrees that Hoover’s presidency made things worse, but for the critics of capitalism to accept the truth of Hoover’s activist policies would require that they question the effectiveness of such activism and drop the claim that laissez faire failed. In the past three years the failure of massive government intervention to deal with our own economic crisis has become clearer each day. Facing a failed ideology, it should not come as a surprise that defenders of the interventionist faith would cling to the Hoover myth like a plank in the ocean. Un- fortunately for them, the historical facts are not on their side and, unfortunately for the American economy, the persistence of the Hoover myth continues to justify the counterproductive policies of the Obama administration and thereby prevents markets from generating the economic recovery of which they are fully capable.
By Steven Baker MP, on 1 June 11
From Deception of Government Intervention (1964) – an essay in Mises’ anthology Economic Freedom and Interventionism – we learn how governments adopted “the third way”:
Faced with the tremendous challenge of totalitarianism, the ruling parties of the West do not venture to preserve the system of free enterprise that gave to their nations the highest standard of living ever attained in history. They ignore the fact that conditions for all citizens of the United States and those other countries which have not put too many obstacles in the way of free enterprise are much more favorable than conditions for the inhabitants of the totalitarian countries. They think that it is necessary to abandon the market economy and to adopt a middle-of-the-road policy that is supposed to avoid the alleged deficiencies of the capitalistic economy. They aim at a system which, as they see it, is as far from socialism as it is from capitalism and which is better than either of those two. By direct intervention of the government, they want to remove what they consider unsatisfactory in the market economy.
Such a policy of government interference with the market phenomena was already recommended by Marx and Engels in the Communist Manifesto. But the authors of the Communist Manifesto considered the ten groups of interventionist measures they suggested as measures to bring about step-by-step full socialism. However, in our time the government spokesmen and the politicians of the left recommend the same measures as a method, even as the only method, to salvage capitalism.
In the aftermath of the financial crisis, we are now going down a road towards ‘judgement-based’ regulation of financial firms in an attempt to salvage capitalism.
It is proposed that firms will be supervised by what amount to shadow management teams of disinterested, public-spirited individuals more able to reach sound views than firms’ own management teams: they shall possess “the optimal experience and technical ability”.
Quite where these mythical philosopher kings are to be found, I do not know. Presumably, financial firms and regulators already hire the best people available. And the notion that the best people will work for the regulator despite inevitably higher rewards in the firms themselves is silly.
Financial firms will find their business subject to the day-to-day judgement of government officials. To think that those officials will be more capable than the institutions’ traders and managers is a fantasy. The outcome will be, as it has been, a surprise financial catastrophe as regulators fail to foresee the future and, since they are bound to converge on “best practice”, fail as one.
A free society is not one based on constant official interference with business. It is one based on cooperation, choice, competition, profit & loss, predictable rules fixed well in advance and exit from the market: that is, property, contract and the classical rule of law.
Rather than resort to fantastic ideas about the effectiveness of government interference with market phenomena, we would do better to reapply the principles of a free society. Financial institutions should be no exception, for government intervention caused the crisis [1,2].
Postscript: Marx and Engels’ ten measures are available here.
By Toby Baxendale, on 4 June 10
There are many possible routes to sound money. On the 18th of May, I outlined my plan to reform the banking system. Yesterday we published an alternative proposal from our Founding Fellow Dr. Anthony J. Evans. Today I’d like to highlight some pure Austrian thinking from Philipp Bagus, Assistant Professor at Universidad Rey Juan Carlos, Madrid.
His paper is entitled Monetary Reform – The Case for Button-Pushing. The abstract lays out his approach:
In this paper I present a monetary reform plan that seeks to achieve a sound monetary system. I suggest the following three criteria of a good reform: it must be ethical, it must be based on sound economic theory and it must leave room for evolutionary processes. Based on these criteria and applying them to the monetary system, I argue for an immediate cancellation of all government intervention into the monetary realm.
Bagus concludes
Most plans for monetary reform have been interventionist and unethical and they impose results. This is partly so, because of a problematic underlying economic theory regarding deflation. Sometimes the reform plans are in apparent contradiction to other writings of the very same author. An ethical, dynamical reform based on value free economic analysis consists in the immediate abstention of state intervention into monetary affairs (“button-pushing”). This plan would very likely imply the deflation of the old money and the purge of the banking system, i.e. those consequences that other reforms tried to avoid. Even though this plan is far away from getting only near to a political approval it is important to show its advantages. It can serve as a standard for comparison.
Please read the whole paper.
Bagus also has some very valuable insights to offer on the subject of maturity mismatching, which featured heavily in the debate over my Emperor’s New Clothes proposal.
By Steven Baker MP, on 17 December 09
Via FT.com / US / Economy & Fed – Fed signals pullback in liquidity supports, we learn:
The Federal Reserve on Wednesday upgraded its assessment of the US economy and highlighted its intention to shut down most of its crisis-fighting liquidity facilities in early 2010.
And consequently:
Stocks eased slightly after the Fed statement, while the yield curve in the bond market steepened.
Which brings us on to Roger Koppl’s Big Players and the Economic Theory of Expectations.
I am indebted to Cobden Centre supporter Bruno Prior for introducing me to Koppl’s work which extends the tradition of Ludwig von Mises, Friedrich Hayek and others, unusually, applying empirical methods to demonstrate the application of the theory.
Koppl demonstrates, with extensive reference to other scholars, that investment and all other economic actions depend on “subjective” expectations. He then presents a theory of expectations which assumes people interpret their situations in unpredictable ways. This theory includes a theory of “Big Players”:
Big Players are privileged actors who disrupt markets. A Big Player has three defining characteristics. He is big in the sense that his actions influence the market under study. He is insensitive to the discipline of profit and loss. He is arbitrary in the sense that his actions depend on discretion rather than any set of rules. Big Players have power and use it.
We learn that Big Players reduce the reliability of expectations, thereby disrupting markets. They encourage herding and produce perverse effects on entrepreneurship: traders must pay attention to the Big Player and not the fundamentals.
And so we find today, for example, the markets moving in response to the Fed not the realities of the economy…
By Steven Baker MP, on 11 August 09
 Steven Baker presents a precis of de Soto’s Money, Bank Credit and Economic Cycles pp650-653, setting out an argument which was famously expounded by von Mises in Socialism. This article originally appeared on stevebaker.info.
To attempt to coordinate society through coercion is an intellectual error: it is impossible for an institution to obtain the information needed to establish social coordination by decree. There are four reasons:
- It is impossible to obtain, store and process the vast amount of practical information in the minds of different people.
- Most of the necessary information is subjective, practical, tacit and non-verbal: it cannot be transmitted.
- Information which people have not yet discovered or created and which arises from the market process cannot be transmitted.
- Coercion — that is, regulation — prevents the discovery or creation of the necessary information.
These are the arguments developed at length by von Mises in Socialism. Von Mises demonstrates the impossibility of socialism and of effective state intervention in the economy. His thesis explains theoretically why the socialist economies of the Eastern Bloc failed. It also explains the growth of the tensions, maladjustments and inefficiencies in western economies which have led to our present crisis.
Crisis is the inevitable outcome of the application of coercion and privilege by government, which systematically worsens social maladjustments, hinders the creativity of entrepreneurs, distorts economic information, encourages irresponsibility, corrupts individuals and encourages the underground economy.
These arguments are directly applicable to the financial and banking system which has now failed. The system is characterized by private banking with a fractional reserve, controlled by a central bank which determines monetary policy and which has a monopoly on the issue of legal tender. The system shares characteristics with a socialist economy in that:
- The whole system is planned by the central bank.
- Banks are commonly excluded from general bankruptcy proceedings.
- Bank failures are prevented by socializing the costs of their failure.
- The entire system rests on the government monopoly on currency.
- The system is based on the privilege granted to banks of creating loans out of nothing by holding only a fractional reserve on deposits.
- Legally, banks enjoy privileges otherwise only granted to governments.
- A vast and inordinately complex set of regulations applies to banks.
- There is little or no supervision of government intervention in bank crises and in many cases, intervention is determined ad hoc, disregarding principles of rationality, efficiency and effectiveness.
In banking and credit, the situation resembles that of the socialist countries of the former Eastern Bloc. Central planning is endemic in banking and finance and it is therefore not surprising that we are living through the same inefficiency and failure which has plagued command economies, ultimately causing their collapse.
Further Reading
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