“Except for US Treasuries, what can you hold ? US Treasuries are the safe haven. For everyone, including China, it is the only option.. Once you [Americans] start issuing $1 trillion – $2 trillion.. we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”
– Luo Ping, official at the China Banking Regulatory Commission, addressing an audience in New York in early 2009.
“This is a big change and it cannot happen too quickly, but we want to use our reserves more constructively by investing in development projects around the world rather than just reflexively buying US Treasuries. In any case, we usually lose money on Treasuries, so we need to find ways to improve our return on investment.”
– Unnamed senior Chinese official, cited in an FT article, ‘Turning away from the dollar’, 10th December 2014.
The Commentary will shortly be off for its winter break. We wish all clients and readers a merry Christmas and a peaceful and prosperous New Year. See you in 2015.
“Mutually assured destruction” was a doctrine that rose to prominence during the Cold War, when the US and the USSR faced each other with nuclear arsenals so populous that they ensured that any nuclear exchange between the two great military powers would quickly lead to mutual overkill in the most literal sense. Notwithstanding the newly dismal relations between the US and Russia, “mutually assured destruction” now best describes the uneasy stand-off between an increasingly indebted US government and an increasingly monetarily frustrated China, with several trillion dollars’ worth of foreign exchange reserves looking, it would now appear, for a more productive home than US Treasury bonds of questionable inherent value. Until now, the Chinese have had little choice where to park their trillions, because only markets like the US Treasury market (and to a certain extent, gold) have been deep and liquid enough to accommodate their reserves.
The FT article, by James Kynge and Josh Noble, points to three related policy developments on the part of the Chinese authorities:
1) China’s appetite for US Treasury bonds is on the wane;
2) China is ramping up its overseas development programme for both financial and geopolitical reasons;
3) The promotion of the renminbi as a global currency “is gradually liberating Beijing from the dollar zone”.
The US has long enjoyed what Giscard d’Estaing called the “exorbitant privilege” of issuing a currency that happens to be the global reserve currency. The FT article would seem to suggest that the days of exorbitant privilege may be coming to an end – to be replaced, in time, with a bi-polar reserve currency world incorporating both the US dollar and the renminbi. (The euro might be involved, if that demonstrably dysfunctional currency bloc lasts long enough.) Here’s a quiz we often wheel out for prospective clients:
1) Which country is the world’s largest sovereign miner of gold ?
2) Which country doesn’t allow an ounce of that gold to be exported ?
3) Which country has advised its citizenry to purchase gold ?
Three questions. One answer. In each case: China. Is it plausible that, at some point yet to be determined, a (largely gold-backed) renminbi will either dethrone the US dollar or co-exist alongside it in a new global currency regime ? We think the answer is yes, on both counts.
Meanwhile the US appears to be doing everything in its power to hasten the relative decline of its own currency. There is a new ‘big figure’ to account for the size of the US national debt, which now stands at some $18 trillion. That only accounts for the on-balance sheet stuff. Factor in the off-balance sheet liabilities of the US administration and pretty soon you get to a figure (un)comfortably north of $100 trillion. It will never be paid back, of course. It never can be. The only question is which poison extinguishes it: formal repudiation, or informal inflation. Perhaps we, or future generations, get both.
So the direction of travel of two colossal ‘macro’ themes is clear (the insolvency of the US administration, and its replacement on the geopolitical / currency stage by that of the Chinese). The one question neither we, nor anybody else, can answer precisely is: when ?
There are other statements that beg the response: when Government bond yields have already entered a ‘twilight zone’ of practical irrelevance to rational and unconstrained investors. But when do they go into reverse ? When will the world’s most frustrating trade (‘the widow-maker’, i.e. shorting the Japanese government bond market) start finally to work ? When will investors be able to enter or re-enter stock markets without having to worry about the malign impact of central bank price support mechanisms (a polite way of describing asset price boosterism and state-sanctioned inflationism) ?
Here’s another statement that begs the response: when ? The US stock market is already heavily overvalued by any objective historical measure. When is Jack Bogle, the founder of the world’s largest index-tracking business, Vanguard, going to acknowledge that advocating 100% market exposure to one of the world’s most expensive markets, at its all-time high, might amount to something akin to “overly concentrated investment risk” ? Barron’s Magazine asks broadly the same question.
Lots of questions, and not many definitive answers. Some suggestions, though:
- At the asset class level, diversification – by geography, and underlying asset type – makes more sense than ever, unless you strongly believe you can anticipate the actions and intentions of central banking bureaucrats throughout the world. Warren Buffett once said that wide diversification was only required when investors do not understand what they are doing. We would revise that statement to take into account the unusual risks at play in the global macro-economic arena today: wide diversification is precisely required when central bankers do not understand what they are doing.
- Expanding on the diversification theme, explicit value (“cheapness”) today only exists meaningfully in the analytically less charted territories of the world. @RobustCap highlights the discrepancy between valuations in the US stock market versus those of Russia, China and emerging Europe. There are clearly ‘fundamental’ and corporate governance reasons that account for some of this discrepancy, but in our view certainly not the entirety of it. Some examples:
Country C.A.P.E. P/E P/B
North America 23.8 20.2 2.7x
Russia 5.2 6.8 0.7x
China 17.2 6.9 1.1x
Austria 6.8 43.4 0.9x
In emerging and ‘challenged’ markets, there are always reasons not to invest. Nevertheless, price is what you pay and value is what you get.
- Some form of renminbi exposure makes total sense as part of a diversified currency portfolio.
- US equities should be selected, if at all, with extreme care; ditto the shares of global mega-cap consumer brands, where valuations point strongly to the triumph of the herd.
- And whatever their direction of travel in the short to medium term, US Treasuries at current levels make no sense whatsoever to the discerning investor. The same holds for Gilts, Bunds, JGBs, OATs.. Arguments about Treasury yields reverting to a much lower longer term mean completely ignore a) the overwhelming current and future oversupply, and b) the utter lack of endorsement from one of their largest foreign holders. Foreign holders of US Treasuries, you have been warned. The irony is that many of you are completely price-insensitive so you will not care.
- There are other reasons to be fearful of stock market valuations, notably in pricey western markets, over and above concerns over the debt burden. As Russell Napier points out in his latest ‘The Solid Ground’ piece,
“In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis..
“Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and Emerging Market currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine.”
- And since Christmas fast approaches, we can’t speak to the merits of frankincense and myrrh, but gold, that famous “6,000 year old bubble”, has always been popular, but rarely more relevant to the investor seeking a true safe haven from forced currency depreciation and an ever vaster mountain of unrepayable debt.
There has been no greater threat to life, liberty, and property throughout the ages than government. Even the most violent and brutal private individuals have been able to inflict only a mere fraction of the harm and destruction that have been caused by the use of power by political authorities.
The pursuit of legal plunder, to use Frédéric Bastiat’s well-chosen phrase, has been behind all the major economic and political disasters that have befallen mankind throughout history.
Government Spending Equals Plundering People
We often forget the fundamental
truth that governments have nothing
to spend or redistribute that they do not first take from society’s producers. The fiscal history of mankind is nothing but a long, uninterrupted account
of the methods governments have devised for seizing the income and wealth of their citizens and subjects.
Parallel to that same sad history must be an account of all the attempts by the victims of government’s legal plunder to devise counter-methods to prevent or at least limit the looting of their income and wealth by those in political power.
Every student who takes an economics course learns that governments have basically three methods for obtaining control over a portion of the people’s wealth: taxation, borrowing, and inflation––the printing of money.
It was John Maynard Keynes who pointed out in his 1919 book, The Economic Consequences of the Peace:
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they also confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some . . .
“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Limiting Government with the Gold Standard
To prevent the use of inflation by governments to attain their fiscal ends, various attempts have been made over the last 200 years to limit the power of the State to print money to cover its expenditures. In the nineteenth and early twentieth centuries the method used was the gold standard. The idea was to place the creation of money outside the control of government.
As a commodity, the amount of gold available for both monetary and non-monetary uses is determined and limited by the same market forces that determine the supply of any other freely traded good or service: the demand and price for gold for various uses relative to the cost and profitability of mining and minting it into coins or bullion, or into some other commercial form.
Any paper money in circulation under the gold standard was meant to be money substitutes––that is, notes or claims to quantities of gold that had been deposited in banks and that were used as a convenient alternative to the constant withdrawing and depositing of gold coins or bullion to facilitate everyday market exchanges.
Under the gold standard, the supply of money substitutes in circulation was meant to increase and decrease to reflect any changes in the quantity of gold in a nation’s banking system. The gold standard that existed in the late nineteenth and early twentieth centuries never worked as precisely or as rigidly as it is portrayed in some economics textbooks. But, nonetheless, the power of government to resort to the money printing press to cover its expenditures was significantly limited.
Governments, therefore, had to use one of the two other methods for acquiring their citizens’ and subjects’ income and wealth. Governments had to either tax the population or borrow money from financial institutions.
But as a number of economists have pointed out, before World
War I many of the countries of North
America and western and central Europe operated under an “unwritten
fiscal constitution.” Governments, except during times of national emergency, were expected to more or less
balance their budgets on an annual
If a national emergency
(such as a war) compelled a government to borrow money to cover its
unexpected expenditures, it was expected to run budget surpluses to
pay off any accumulated debt when the emergency had passed.
This unwritten balanced-budget rule was never rigidly practiced either, of course. But the idea that needless government debt was a waste and a drag on the economic welfare of a nation served as an important check on the growth of government spending.
When governments planned to do things, the people were more or less explicitly presented with the bill. It was more difficult for governments to promise a wide variety of benefits without also showing what the taxpayer’s burden would be.
World War I Destroyed the Gold Standard
This all changed during and after World War I. The gold standard was set aside to fund the war expenditures for all the belligerents in the conflict. And John Maynard Keynes, who in 1919 had warned about the dangers of inflation, soon was arguing that gold was a “barbarous relic” that needed to be replaced with government-managed paper money to facilitate monetary and fiscal fine-tuning.
In addition, that unwritten fiscal constitution which required annual balanced budgets was replaced with the Keynesian conception of a balanced budget over the phases of the business cycle.
In practice, of course, this set loose the fiscal demons. Restrained by neither gold nor the limits of taxation, governments around the world went into an orgy of deficit spending and money creation that led some to refer to a good part of the twentieth century as the “age of inflation.”
Politicians and bureaucrats could now far more easily offer short-run benefits to special-interest groups through growth in government power and spending, while avoiding any mention of the longer-run costs to society as a whole, in their roles as taxpayers and consumers.
The Counter-Revolution Against Keynesianism
Beginning in the late 1960s and 1970s a counter-revolution against Keynesian economics emerged, especially in the United States, which came to be identified with Milton Friedman and monetarism.
To restrain government’s ability to create inflation, Friedman proposed a “monetary rule”: the annual increase in the money supply should be limited to the average annual increase in real output in the economy. Put the creation of paper money on “automatic pilot,” and governments would once more be prevented from using the printing press to capriciously cover their expenditures.
But in the years after receiving the Nobel Prize in economics in 1984, Friedman had second thoughts about the effectiveness of his monetary rule. He stated that Public Choice theory – the use of economic theory to analyze the logic and incentives in political decision-making – persuaded him that trying to get central banks to pursue a monetary policy that would serve the long-run interest of society was a waste of time.
Just like the rest of us, politicians, bureaucrats, and central bankers have their own self-interested goals, and they will use the political power placed at their disposal to advance their interests.
Said Friedman: “We must try to set up institutions under which individuals who intend only their own gain are led by an invisible hand to serve the public interest,” He also concluded that after looking over the monetary history of the twentieth century, “Leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement.”
Separating Money from Government Control
Though Milton Friedman was unwilling to take his own argument that far, the logical conclusion of his admission that the control of money can never be trusted in the hands of the government is the need to separate money creation from the State. What is required is the denationalization of money, or in other words, the establishment of monetary freedom in society.
Under a regime of monetary freedom the government would no longer have any role in monetary and banking affairs. The people would have, to use a phrase popularized by the Austrian economist F. A. Hayek, a “choice in currency.” The law would respect and enforce all market-based, consensual contracts regardless of the currency or commodity chosen by the market participants as money. And the government would not give a special status to any particular currency through legal-tender laws as the only “lawful money.”
Monetary freedom encompasses what is known as “free banking.” That is, private banks are at liberty to accept deposits in any commodity money or currency left in their trust by depositors and to issue their own private banknotes or claims against these deposits.
To the extent these banknotes and claims are recognized and trusted by a growing number of people in the wider economic community, they may circulate as convenient money substitutes. Such private banks would settle their mutual claims against each other on behalf of their respective depositors through private clearinghouses that would have international connections as well.
Few advocates of the free market have included the privatization of the monetary system among their proposed economic policy reforms. The most notable advocate of monetary freedom and free banking in the twentieth century was the Austrian economist Ludwig von Mises, who demonstrated that as long as governments and their central banks have monopoly control over the monetary system inflations and the business cycle are virtually inevitable, with all of their distorting and devastating effects.
But the last 30 years have seen the emergence of a body of serious and detailed literature on the desirability and workability of a fully private and competitive free-banking system as an alternative to government central banking.
Self-Interest and Monetary Freedom
Its political advantage is that it completely removes all monetary matters from the hands of government. However effective the old gold standard may have been before the First World War, it nonetheless remained a government-managed monetary system that opened the door to eventual abuse.
Furthermore, a free-banking system fulfills Milton Friedman’s recommendation that the monetary order should be one that harnesses private interest for the advancement of the public interest through the “invisible hand” of the market process.
The interests of depositors in a reliable banking system would coincide with the self-interest of profit-seeking financial intermediaries. A likely unintended consequence would be a more stable and adaptable monetary system than the systems of monetary central planning the world labors under now.
Of course, a system of monetary freedom does not do away with the continuing motives for government to grow and spend. Even limits on the government’s ability to create money to finance its expenditures does not preclude fiscal irresponsibility, with damaging economic consequences for a large segment of the population through deficit spending and growing national debt.
Monetary Freedom and a Philosophy of Liberty
In the long run, the only way to limit the growth of government spending and power over society is to change political and ideological thinking. As long as many people want government to use its power to tax and regulate to benefit them at the expense of others, it will retain its power and continue to grow.
Monetary and fiscal reform is ultimately inseparable from the rebirth and implementation of a philosophy of freedom that sees government limited to the protection of each individual’s right to his life, liberty, and honestly acquired property.
As Ludwig von Mises expressed it ninety years ago in the aftermath of the First World War and during the Great German Inflation of the early 1920s:
“What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas.”
If the belief in and desire for personal and economic liberty can gain hold and grow once more in people’s hearts and minds, monetary freedom and fiscal restraint will eventually come by logical necessity.
[Editor’s note: this piece first appeared here http://www.epictimes.com/richardebeling/2014/12/the-case-for-monetary-freedom-and-free-banking/]
Last week I wrote that contrary to the prevailing mood US dollar strength could reverse at any time. This week I look at another aspect of the dollar, which almost certainly will become a significant source of supply: a global shift out of it by foreign holders.
As well as multinational corporations that account in dollars, there are non-US entities that use dollars purely for trade. And so long as governments intervene in currency markets, governments end up with those trade dollars in their foreign reserves. Some of these governments are now pushing hard to replace the dollar, having seen its debasement, which is beyond their control. This has upset nations like China, and that is before we speculate about any geopolitical angle.
The consequence of China’s currency management has been a massive accumulation of dollars which China cannot easily sell. All she can do is stop accumulating them and not reinvest the proceeds from maturing Treasuries, and this has broadly been her policy for at least the last year. So this problem has been in the works for some time and doubtless contributed to China’s determination to reduce her dependency on the dollar. Furthermore, it is why thirteen months ago George Osborne was summoned (that is the only word for it) to Beijing to discuss a move to urgently develop offshore renminbi capital markets, utilising the historic links between Hong Kong and London. Since then, it is reported that last month over 22% of China’s external trade was settled in its own currency.
Given the short time involved, it is clear that there is a major change happening in cross-border trade hardly noticed by financial commentators. But this is not all: sanctions against Russia have turned her urgently against the dollar as well, and together with China these two nations dominate and carry with them the bulk of Asia, representing nearly four billion rapidly industrialising souls. To this we should add the Middle East, most of whose oil is now exported to China, India and South-East Asia, making the petro-dollar potentially redundant as well.
In a dollar-centric currency system, China is restricted in what she can do, because with nearly $4 trillion in total foreign exchange reserves she cannot sell enough dollars to make a difference without driving the renminbi substantially higher. In the past she has reduced her dollar balances by selling them for other currencies, such as the euro, but she cannot rely on the other major central banks to neutralise the market effect of her dollar sales on her behalf. Partly for this reason China now intends to redeploy her reserves into international investment to develop her export markets for capital goods, as well as into major infrastructure projects, such as the $40bn Silk Road scheme.
This simply amounts to dispersing China’s dollars into diverse hands to conceal their disposal. Meanwhile currency markets have charged off in the opposite direction, with the dollar’s strength undermining commodity prices, most noticeably oil, very much to China’s benefit. And while the talking-heads are debating the effect on Russia and America’s shale, they are oblivious to the potential tsunami of dollars just waiting for the opportunity to return to the good old US of A.
“What will futurity make of the Ph.D. standard ? Likely, it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the Crash of, say, 2016, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal Reserve’s methods.
“I expect you’ll wind up saying something like this: “My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017). We seem to have miscalculated.”
– Excerpt from James Grant’s November 2014 Cato speech. Hat-tip to Alex Stanczyk.
You can be for gold, or you can be for paper, but you cannot possibly be for both. It may soon be time to take a stand. The arguments in favour of gold are well known, and just as widely ignored by the paperbugs, who have a belief system at least as curious because its end product is destined to fail – we just do not know precisely when. The price of gold is weakly correlated to other prices in financial markets, as the last three years have clearly demonstrated. Indeed gold may be the only asset whose price is being suppressed by the monetary authorities, as opposed to those sundry instruments whose prices are being just as artificially inflated to offer the illusion of health in the financial system (stocks and bonds being the primary financial victims). Beware appearances in an unhinged financial system, because they can be dangerously deceptive. It is quite easy to manipulate the paper price of gold on a financial futures exchange if you never have to make delivery of the physical asset and are content to play games with paper. At some point that will change. Contrary to popular belief, gold is supremely liquid, though its supply is not inexhaustible. It is no-one’s liability – this aspect may be one of the most crucial in the months to come, as and when investors learn to start fearing counterparty risk all over again. Gold offers a degree of protection against uncertainty. And unlike paper money, there are fundamental and finite limits to its creation and supply.
What protection ? There is, of course, one argument against gold that seems to trump all others and blares loudly to sceptical ears. Its price in US dollars has recently fallen. Not in rubles, and not perhaps in yen, of course, but certainly in US dollars. Perhaps gold is really a currency, then, as opposed to a tiresome commodity ? But the belief system of the paperbug dies hard.
The curious might ask why so many central banks are busily repatriating their gold ? Or why so many Asian central banks are busily accumulating it ? It is surely not just, in Ben Bernanke’s weasel words, tradition ?
If you plot the assets of central banks against the gold price, you see a more or less perfect fit going back at least to 2002. It is almost as if gold were linked in some way to money. That correlative trend for some reason broke down in 2012 and has yet to re-emerge. We think it will return, because 6,000 years of human history weigh heavily in its favour.
Or you can put your faith in paper. History, however, would not recommend it. Fiat money has a 100% failure rate.
Please note that we are not advocating gold to the exclusion of all else within the context of a balanced investment portfolio. There is a role for objectively creditworthy debt, especially if deflation really does take hold – it’s just that the provision of objectively creditworthy bonds in a global debt bubble is now vanishingly small. There is a role for listed businesses run by principled, decent management, where the market’s assessment of value for those businesses sits comfortably below those businesses’ intrinsic worth. But you need to look far and wide for such opportunities, because six years of central and commercial banks playing games with paper have made many stock markets thoroughly unattractive to the discerning value investor. We suggest looking in Asia. There is a role for price momentum strategies which, having disappointed for several years, though not catastrophically so, now appear to be getting a second wind, from the likes of deflating oil prices, periphery currencies, and so on.
As investors we are all trapped within a horrifying bubble. We must play the hand we’ve been dealt, however bad it is. But there are now growing signs of end-of-bubble instability. The system does not appear remotely sound. Since political vision in Europe, in particular, is clearly absent, the field has been left to central bankers to run amok. The only question we cannot answer is: precisely when does the centre fail ? The correct response is to recall the words of the famed value investor Peter Cundill, when he confided in his diary:
“The most important attribute for success in value investing is patience, patience, and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
But the absence of patience by the majority of investors is fine, because it leaves more money on the table for the rest of us. The only question remaining is: in what exact form should we hold that money ?
Be patient, and do please set aside thirty minutes to listen to James Grant’s quietly passionate and wonderfully articulate Cato Institute speech. It will be time well spent.
Each commodity market has its own story to tell: oil prices are falling because OPEC can’t agree production cuts, steel faces a glut from overcapacity, and even the price of maize has fallen, presumably because of good harvests.
In local currencies this is not so much the case. Of course, the difference between prices in local currencies and prices in US dollars is reflected in the weakness of most currencies against the dollar in the foreign exchange markets. This tells us that whatever is happening in each individual commodity and in each individual currency the common factor is the US dollar.
This is obvious perhaps, but the fall in commodity prices and the rise in the US dollar have to be seen in context. We should note that for most of the global population, the concern that we are facing global deflation (by which is commonly meant falling prices) is not yet true. Nor is a conclusion that the fall in the oil price indicates a sudden collapse in demand for energy. When the dollar price of oil began to slide, so did the exchange rates for all the other major currencies, confirming a significant part of oil’s price move came from dollar strength, which would have also been true of commodity prices generally.
All we can say is that on average there has been a shift of preferences towards holding dollars and away from holding commodities. Looked at in this light we can see that a trend of destocking can develop solely for financial rather than business reasons, because businesses which account in dollars face financial losses on excess inventory. It is the function of speculators to anticipate these decisions, which is what we have seen in recent months.
Macro-economists, who are Keynesian or monetarist by definition, are beginning to interpret falling commodity prices and a rising dollar as evidence of insufficient aggregate demand, which left unchecked will lead to deflation, increasing unemployment, bankruptcies, falling asset prices, and bank insolvencies. It is, they say, an outcome to be avoided at all costs by ensuring that aggregate demand is stimulated so that none of this happens.
Whether or not they are right in this assessment is not the point. They neglect to allow that some of the move in commodity prices is due to the currency itself as the numéraire of all prices.
For evidence of this we need look no further than the attitude of the Fed and every other central bank that targets price inflation as part of their monetary policy. In forming monetary policy there is no allowance for the possibility, nay likelihood, that in future there will be a change in preferences against the dollar, or any other currency for that matter, and in favour of anything else. The tragedy of this lack of market comprehension is that it’s a fair bet that monetary policy will not only succeed in limiting the rise of the dollar as it is designed to do, but end up undermining it when preferences shift the other way.
The moral of the story is that the Fed may be able to fool some of the people all of the time and all of the people some of the time, but worst of all they are fooling themselves. And we should bear in mind that dollar strength is only a trend which can easily reverse at any time.
“Finally, as expectations of rapid inflation evaporate, I want to contribute to the debate about the November 15, 2010 letter signed by 23 US academics, economists and money managers warning on the Fed’s QE strategy. Bloomberg News did what I would call a hatchet job on the signatories essentially saying how wrong they have been and seeking their current views. It certainly made for an entertaining read. Needless to say, shortly afterwards Paul Krugman waded in with his typically understated style to twist the knife in still deeper. Cliff Asness, one of the signatories of the original letter, despite observing that “responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary”, penned a rather wittyresponse. Do read these articles at your leisure. But having been one of the few to accurately predict the deflation quagmire into which we have now sunk, I believe I am more entitled than many to have a view on this subject. Had I been asked I would certainly have signed the letter and would still sign it now. The unfolding deflationary quagmire into which we are sinking will get worse and there will be more Fed QE. But do I think QE will solve our problems? I certainly do not. I think ultimately it will make things far, far worse.”
– SocGen’s Albert Edwards, ‘Is the next (and last) phase of the Ice Age now upon us ?’ (20 November 2014)
On Monday 15th November 2010, the following open letter to Ben Bernanke was published:
“We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
“We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
“We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
“The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.”
Among the 23 signatories to the letter were Cliff Asness of AQR Capital, Jim Chanos of Kynikos Associates, Niall Ferguson of Harvard University, James Grant of Grant’s Interest Rate Observer, and Seth Klarman of Baupost Group.
Words matter. Their meanings matter. Since we have a high degree of respect for the so-called Austrian economic school, we will use Mises’ own definition of inflation:
“..an increase in the quantity of money.. that is not offset by a corresponding increase in the need for money.”
In other words, inflation has already occurred, inasmuch as the Federal Reserve has increased the US monetary base from roughly $800 billion, pre-Lehman Crisis, to roughly $3.9 trillion today.
What the signatories likely meant when they referred to inflation in their original open letter to Bernanke was the popular interpretation of the word – that second-order rise in the prices of goods and services that typically follows aggressive base money inflation. Note, as many of them observed when prodded by Bloomberg’s yellow journalists, that their original warning carried no specific date on which their inflation might arise. To put it in terms which Ben Bernanke himself might struggle to understand, just because something has not happened during the course of four years does not mean it will never happen. We say this advisedly, given that the former central bank governor himself made the following observation in response to a question about the US housing market in July 2005:
“INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
“BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” [Emphasis ours.]
To paraphrase Ben Bernanke, “We’ve never had a decline in house prices on a nationwide basis – therefore we never will.”
One more quote from Mises is relevant here, when he warns about the essential characteristic of inflation being its creation by the State:
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy.”
Many observers of today’s financial situation are scouring the markets for evidence of second-order inflation (specifically, CPI inflation) whilst either losing sight of, or not even being aware of, the primary inflation, per the Austrian school definition.
James Grant, responding to Bloomberg, commented:
“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation – not at the checkout counter, necessarily, but on Wall Street.”
“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.”
“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words – although I think there have been some words as well – have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”
And from the vantage point of November 2014, only an academic could deny that the signatories were wholly correct to warn of the financial market distortion that ensues from aggressive money printing.
Ever since Lehman Brothers failed and the Second Great Depression began, like every other investor on the planet we have wrestled with the arguments over inflation (as commonly understood) versus deflation. Now some of the fog has lifted from the battlefield. Despite the creation of trillions of dollars (and pounds and yen) in base money, the forces of deflation – a.k.a. the financial markets – are in the ascendancy, testimony to the scale of private sector deleveraging that has occurred even as government money and debt issuance have gone into overdrive. And Albert Edwards is surely right that as the forces of deflation worsen, they will be met with ever more aggressive QE from the Fed and from representatives of other heavily indebted governments. This is not a recipe for stability. This is the precursor to absolute financial chaos.
Because the price of every tradeable financial asset is now subject to the whim and caprice of government, rational macro-economic analysis (i.e. top-down investing and asset allocation) has become impossible. Only bottom-up analysis now offers any real potential for adding value at the portfolio level. We discount the relevance of debt instruments almost entirely, but we continue to see merit in listed businesses run by principled and shareholder-friendly management, where the shares of those businesses trade at a significant discount to any fair assessment of their underlying intrinsic value. A word of caution is warranted – these sort of value opportunities are vanishingly scarce in the US markets, precisely because of the distorting market effects of which the signatories to the November 2010 letter warned; today, value investors must venture much further afield. The safe havens may be all gone, but we still believe that pockets of inherent value are out there for those with the tenacity, conviction and patience to seek them out.
Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences such as laboratory where experiments could be conducted could lead to a major break-through in our understanding of the world of economics.
But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. Why is that so?
A laboratory is a must in physics, for there a scientist can isolate various factors relating to the object of inquiry.
Although the scientist can isolate various factors he doesn’t, however, know the laws that govern these factors.
All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified.
He can never be certain regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.1
Contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements.
However, in economics we have certain knowledge about certain things, which in turn could help us to understand the world of economics.
For instance, we know that an increase in money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth generators to non wealth generating activities. This is certain knowledge and doesn’t need to be verified.
We also know that for a given amount of goods an increase in money supply all other things being equal must lead to more money paid for a unit of a good –an increase in the prices of goods. (Remember a price is the amount of money per unit of a good).
We also know that if in the country A money supply grows at a faster pace than money supply in the country B then over time, all other things being equal, the currency of A must depreciate versus the currency of B. This knowledge emanates from the law of scarcity.
Hence for something that is certain knowledge, there is no requirement for any empirical testing.
How this certain knowledge can be applied?
For instance, if we observe an increase in money supply – we can conclude that this resulted in a diversion of real wealth from wealth generators to non-wealth generating activities. It has resulted in the weakening of the wealth generating process.
This knowledge however, cannot tell us about the state of the pool of real wealth and when the so-called economy is going to crumble.
Whilst we can derive certain conclusions from some factors, however, the complex interaction of various factors means that there is no way for us to know the importance of each factor at any given point in time.
Some factors such as money supply – because it operates with a time lag, could provide us with useful information about the future events – such as boom-bust cycles and price inflation.
(Note that a change in money supply doesn’t affect all the markets instantly. It goes from one individual to another individual – from one market to another market. It is this that causes the time lag from changes in money and its effect on various markets).
Contrary to the natural sciences, in economics, by means of the knowledge that every effect must have a cause and by means of the law of scarcity (the more we have of something the less valuable it becomes), we can derive the entire body of economics knowledge.
This knowledge, once derived, is certain and doesn’t need to be verified by some kind of laboratory.
1. Murray N. Rothbard, “Towards a Reconstruction of Utility and Welfare Economics”, On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J.: D.Van Nostrand, 1956), p3.
“Sir, Adair Turner suggests some version of monetary financing is the only way to break Japan’s deflation and deal with the debt overhang (“Print money to fund the deficit – that is the fastest way to raise rates”, Comment, November 11). This was precisely how Korekiyo Takahashi, Japanese finance minister from 1931 to 1936, broke the deflation of the 1930s. The policy was discredited because of the hyperinflation that followed.”
– Letter to the Financial Times, 11th November 2014. Emphasis ours. Name withheld to protect the innocent.
“Don’t need to read the book – here is the premise. Business dreams are nothing more than greed. And you greedy business people should pay for those who are not cut out to take risk. You did not build your business – you owe everyone for your opportunity – you may have worked harder, taken more risk and even failed and picked yourself up at great personal risk and injury (yes we often lose relationships and loved ones fall out along the way). However, none the less you are not entitled to what you make. Forget the fact that the real reason we have massive wealth today is we can now reach the global consumers – not just local – so the numbers are larger. Nonetheless the fact is that is not fair – and fair is something life now guarantees – social engineers demand that you suspend the laws of nature and reward all things equally. 2 plus 2 = 5 so does 3 plus 3 = 5; everything is now levelled by social engineers. We need to be responsible for those who choose not to take risk, want a 9 to 5 job and health benefits and vacation. The world is entitled to that – it is only right – so you must be taxed to make up for those who are too lazy to compete, simply don’t try, or fail. In short the rich must mop up the gap for the also ran’s. Everyone gets a ribbon. There are exceptions – if you are Google, BAIDU, Apple or someone so cool or cute or a liberal who will tell people they should pay more taxes – you aren’t to be held to the same standard as everyone else.”
– ‘cg12348’ responds to the FT’s announcement that Thomas Piketty’s ‘Capital’ has won the FT / McKinsey Business Book of the Year Award, 11th November 2014.
“@cg12348, I think you succeeded in discrediting yourself comprehensively. You didn’t read the book. You do not in fact know what is in it. But you just “know” what is in it. One can only hope that you do a little more work in your business ventures.”
– Martin Wolf responds to ‘cg12348’.
“Socialism in general has a record of failure so blatant that only an intellectual could ignore or evade it..”
“Since this is an era when many people are concerned about ‘fairness’ and ‘social justice,’ what is your ‘fair share’ of what someone else has worked for?”
– Thomas Sowell.
Forbes recently published an article suggesting that Google might be poised to enter the fund management sector. The article in question linked to an earlier FT piece by Madison Marriage (‘Google study heightens fund industry fears’, 28.9.2014) reporting that the company had, two years ago, commissioned a specialist research firm for advice about initiating an asset management offering. An unnamed US fund house reportedly told FTfm that Google entering the market was its “biggest fear”. An executive from Schroders was reported to be “concerned” and senior executives at Barclays Wealth & Investment Management were reported to perceive the arrival of the likes of Google and Facebook on their turf as a “real threat”. Campbell Fleming of Threadneedle was quoted in the FT piece as saying,
“Google would find the fund management market more difficult than it thinks. There are significant barriers to entry and it’s not something you could get into overnight.”
Bluntly, faced with backing Google or a large fund management incumbent, we’d be inclined to back Google. Perhaps most surprising, though, were the remarks by Catherine Tillotson of Scorpio Partnership, who said,
“There probably is a subsection of investors who would have confidence in Google, but I think the vast majority of investors want a relationship with an entity which can supply them with high quality information, market knowledge and a view on that market. I think it is unlikely they would turn to Google for those qualities.”
We happen to think that many investors would turn precisely to Google for those qualities – assuming they found those qualities remotely relevant to their objective in the first place. So what, precisely, do we think investors really want from their fund manager ? All things equal, it’s quite likely that investment performance consistent with an agreed mandate is likely to be high on the list; “high quality information, market knowledge and a view on that market” are, to our way of thinking, almost entirely subjective attributes and largely irrelevant compared to the fundamental premise of delivering decent investment returns.
After roughly 20 years of the Internet slowly achieving almost complete penetration of the investor market across the developed world, fund management feels destined to get ‘Internetted’ (or disintermediated) in the same way that the music and journalism industries have been. The time is ripe, in other words, for a fresh approach; the pickings for incumbents have been easy for far too long, and investors are surely open to the prospect of dealing with new entrants with a fundamentally different approach.
Another thing prospective digital entrants into the fund management marketplace have going for them is that they haven’t spent the last several years routinely cheating their clients, be it in the form of the subprime mortgage debacle, payment protection insurance mis-selling, Libor rigging, foreign exchange rigging, precious metals rigging.. Virtually no subsidiary of a full service banking organisation can say the same.
Sean Park, founder of Anthemis, suggests (quite fairly, in our view) that the demand for a fresh approach to financial services has never been stronger. In part, this is because
“..the global wealth management and asset allocation paradigm is fundamentally broken. Or rather it’s a model that is past its sell-by date and is increasingly failing its ultimate customers. The “conventional wisdom” has disconnected from its “source code” meaning that the industry has forgotten the original reasons why things were initially done in a certain way and these practices have simply taken on quasi-mystical status, above questioning.. which means that the system is unable and unwilling to adapt to fundamentally changed conditions (technological, economic, financial, cultural, demographic..)
“And so opportunities (to take a step back and do things differently) abound..
“Coming back to the.. “broken asset allocation paradigm” – the constraints (real, i.e. regulatory and imagined, i.e. convention) and processes around traditional asset management and allocation (across the spectrum of asset classes) now mean that it is almost impossible to do anything but offer mediocre products and returns if operating from within the mainstream framework. (Indeed the rise and rise of low cost ETF / passive products is testimony to this – if you can’t do anything clever, at least minimise the costs as much as possible..) The real opportunities arise when you have an unconstrained approach – when the only thing driving investment decisions is, well, analysis of investment opportunities – irrespective of what they may be, how they may be structured, and how many boxes in some cover-my-ass due diligence list they may tick (or not)..”
As we have written extensively of late, one of those practices that have taken on “quasi-mystical status” is benchmarking, especially with reference to the bond market. This is an accident waiting to happen given that we coexist with the world’s biggest bond market bubble.
Another problem is that low cost tracking products are fine provided that they’re not flying off the shelf with various asset markets at their all-time highs. But they are, and they are.
We have a great deal of sympathy with the view that the fundamental nature of business became transformed with the widespread adoption of the worldwide web. There is no reason why fund management should be exempt from this trend. What was previously an almost entirely adversarial competition between a limited number of gigantic firms has now become a more collaborational competition between a much more diverse array of boutique managers who also happen to be fighting gigantic incumbents. Here is just one example. Last week we came across a tweet from @FritzValue (blog:http://fritzinvestments.wordpress.com/) that touched on the theme of ‘discipline in an investment process’. With his approval we republish it here:
8am – 10am: Read trade journals and regional newspapers for ideas on companies with 1) new products, 2) new regulation, 3) restructurings, 4) expansions, 5) context for investment ideas
10am – 6pm: Find new ideas. Read 1) company announcements.. 2) annual reports from A-Z or 3) annual reports of companies screened for buybacks / insider buying / dividend omission, etc.
7pm – 10pm: Read books to understand the world / improve forecasts / fine tune investment process
Before each investment:
1) What do you think will happen to the company and by consequence the stock price ?
2) Go through a personal investment checklist
3) Use someone else or yourself as a devil’s advocate to disprove your own investment theses
4) Have we reached “peak negativity” / has narrative played out ?
5) Are fundamentals improving ?
6) Why is it cheap ? Especially if it screens well in the eyes of other investors – i.e. exciting story, other investors, low P/E, etc.
7) Decide what will be needed for you to admit defeat / sell the position
If you lose focus, sell all the positions, take a break and start again.
Only expose yourself to serious and intelligent people on Twitter / investor letters / media and avoid the noise that other investors expose themselves to.”
Fabulous advice, that has the additional advantage of being completely free. While we spend quite a bit of time agonising over the State’s ever more desperate attempts to keep a debt-fuelled Ponzi scheme on the road, we take heart from the fact that – through social media – an alternative community exists that doesn’t just know what’s going on but is perfectly happy to share its informed opinions with that community at no cost to users whatsoever. O brave new world, that has such people in it !
Spring 2010: A gradual recovery
Autumn 2010: A gradual and uneven recovery
Spring 2011: European recovery maintains momentum amid new risks
Autumn 2011: A recovery in distress
Spring 2012: Towards a slow recovery
Autumn 2012: Sailing through rough waters
Winter 2012: Gradually overcoming headwinds
Spring 2013: Adjustment continues
Autumn 2013: Gradual recovery, external risks
Winter 2013: Recovery gaining ground
Spring 2014: Growth becoming broader-based
Autumn 2014: Slow recovery with very low inflation.. ”
European Commission economic headlines, as highlighted by Jason Karaian of Quartz, in ‘How to talk about a European recovery that never arrives’.
“Well we know where we’re going
But we don’t know where we’ve been
And we know what we’re knowing
But we can’t say what we’ve seen
And we’re not little children
And we know what we want
And the future is certain
Give us time to work it out
We’re on a road to nowhere..”
‘Road to nowhere’ by Talking Heads.
In 1975, Charles Ellis, the founder of Greenwich Associates, wrote one of the most powerful and memorable metaphors in the history of finance. Simon Ramo had previously studied the strategy of one particular sport in ‘Extraordinary tennis for the ordinary tennis player’. Ellis went on to adapt Ramo’s study to describe the practical business of investing. His essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it. His thesis runs as follows. Whereas the game of tennis is won by professionals, the game of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches through natural talent honed by long practice, investors tend to lose (in relative, if not necessarily absolute terms) through unforced errors. Success in investing, in other words, comes not from over-reach, in straining to make the winning shot, but simply through the avoidance of easy errors.
Ellis was making another point. As far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This was a mathematical inevitability given the over-crowded nature of the institutional fund marketplace, the fact that every buyer requires a seller, and the impact of management fees on returns from an index. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution ?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; and 6,800 hedge funds.
Perhaps the most pernicious characteristic of active fund management is the tendency towards benchmarking (whether closet or overt). Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond-indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits.
There is now a grave risk that an overzealous commitment to benchmarking is about to lead hundreds of billions of dollars of invested capital off a cliff. Why ? To begin with, trillions of dollars’ worth of equities and bonds now sport prices that can no longer be trusted in any way, having been roundly boosted, squeezed, coaxed and manipulated for the dubious ends of quantitative easing. The most important characteristic of any investment is the price at which it is bought, which will ultimately determine whether that investment falls into the camp of ‘success’ or ‘failure’. At some point, enough elephantine funds will come to appreciate that the assets they have been so blithely accumulating may end up being vulnerable to the last bid – or lack thereof – on an exchange. When a sufficient number of elephants start charging inelegantly towards the door, not all of them will make it through unscathed. Corporate bonds, in particular, thanks to heightened regulatory oversight, are not so much a wonderland of infinite liquidity, but an accident in the secondary market waiting to happen. We recall words we last heard in the dark days of 2008:
“When you’re a distressed seller of an illiquid asset in a market panic, it’s not even like being in a crowded theatre that’s on fire. It’s like being in a crowded theatre that’s on fire and the only way you can get out is by persuading somebody outside to swap places with you.”
The second reason we may soon see a true bonfire of inanities is that benchmarked government bond investors have chosen collectively to lose their minds (or the capital of their end investors). They have stampeded into an asset class historically and euphemistically referred to as “risk free” which is actually fraught with rising credit risk and systemic inflation risk – inflation, perversely, being the only solution to the debt mountain that will enable the debt culture to persist in any form. (Sufficient economic growth for ongoing debt service we now consider impossible, certainly within the context of the euro zone; any major act of default or debt repudiation, in a debt-based monetary system, is the equivalent of Armageddon.) As Japan has just demonstrated, whatever deflationary tendencies are experienced in the indebted western economies will be met with ever greater inflationary impulses. The beatings will continue until morale improves – and until bondholders have been largely destroyed. When will the elephants start thinking about banking profits and shuffling nervously towards the door ?
Meanwhile, central bankers continue to waltz effetely in the policy vacuum left by politicians. As Paul Singer of Elliott Management recently wrote,
“Either out of ideology or incompetence, all major developed governments have given up (did they ever really try?) attempting to use solid, fundamental policies to create sustainable, strong growth in output, incomes, innovation, entrepreneurship and good jobs. The policies that are needed (in the areas of tax, regulatory, labour, education and training, energy, rule of law, and trade) are not unknown, nor are they too complicated for even the most simple-minded politician to understand. But in most developed countries, there is and has been complete policy paralysis on the growth-generation side, as elected officials have delegated the entirety of the task to central bankers.”
And as Singer fairly points out, whether as workers, consumers or investors, we inhabit a world of “fake growth, fake money, fake jobs, fake stability, fake inflation numbers”.
Top down macro-economic analysis is all well and good, but in an investment world beset by such profound fakery, only bottom-up analysis can offer anything approaching tangible value. In the words of one Asian fund manager,
“The owner of a[n Asian] biscuit company doesn’t sit fretting about Portuguese debt but worries about selling more biscuits than the guy down the road.”
So there is hope of a sort for the survival of true capitalism, albeit from Asian biscuit makers. Perhaps even from the shares of biscuit makers in Europe – at the right price.
“Sir, Your editorial “A Nobel award for work of true economic value” (October 15) cites the witty and memorable line of J M Keynes about wishing that economists could be “humble, competent people, on a level with dentists”, which concludes his provocative 1930 essay on the economic future. You fail to convey, however, the irony and condescension of the original text of the arrogant, intellectual elitist Keynes, who, while superlatively competent, was assuredly not humble. With the passage of 84 years, the irony has changed directions, for modern dentistry is based on real science, and has made huge advances in scientific knowledge, applied technology and practice, to the great benefit of mankind. It is obviously far ahead of economics in these respects, and it is indeed unlikely that economics will ever be able to rise to the level of dentistry.”
Changing people’s minds, apparently, has very little to do with winning the argument. Since people tend to make decisions emotionally, ‘evidence’ is a secondary issue. We are attempting to argue that the policy of QE, quantitative easing, is not just pointless but expensively pointless. Apparently, instead of using cold logic, we will have to reframe our argument as follows:
Agree with our argumentative opponents;
Reframe the problem;
Introduce a new solution;
Provide a way to “save face”.
In terms of argumentative opponents, they don’t come much bigger than the former Fed chairman himself, Ben Bernanke. And it was Bernanke himself who rather pompously declared, shortly before leaving the Fed this year, that
“The problem with QE is it works in practice, but it doesn’t work in theory.”
There is, of course, no counter-factual. We will never know what might have happened if, say, the world’s central banks had elected not to throw trillions of dollars at the world’s largest banks and instead let the free market work its magic on an overleveraged financial system. But to suggest credibly that QE has worked, we first have to agree on a definition of what “work” means, and on what problem QE was meant to solve. If the objective of QE was to drive down longer term interest rates, given that short term rates were already at zero, then we would have to concede that in this somewhat narrow context, QE has “worked”. But we doubt whether that objective was front and centre for those people – we could variously call them “savers”, “investors”, “the unemployed” or “honest workers” – who are doubtless wondering when the economy will emerge from its current state of depression. As James Grant recently observed in the FT (“Low rates are jamming the economy’s vital signals”), it’s quite remarkable how, thus far, savers in particular have largely suffered in silence.
So yes, QE has “succeeded” in driving down interest rates. But we should probably reframe the problem. The problem isn’t that interest rates were or are too high. Quite the reverse: interest rates are clearly already too low – at least for savers, and for that matter investors in the euro zone and elsewhere. All the way out to 3 year maturities, investors in German government bonds, for example, are now faced with negative interest rates, and still they’re buying. This isn’t monetary policy success; this is madness. We think the QE debate should be reframed: has QE done anything to reform an economic and monetary system urgently in need of restructuring ? We think the answer, self-evidently, is “No”. The answer is also “No” to the question: “Can you solve a crisis of too much indebtedness by a) adding more debt to the pile and simultaneously b) suppressing interest rates ?” The toxic combination of more credit creation and global financial repression will merely make the ultimate Minsky moment that much more spectacular.
What accentuates the problem is market noise. @Robustcap fairly points out that there are (at least) four groups at play in the markets – and that at least three of them aren’t adding to the sum of human wisdom:
Group 1 comprises newsletter writers, and other dogmatic “End of the world newsletter salesmen” using every outlet to say “I told you so…” (even though some of them have been saying so for the last 1000 S&P handles..).
Group 2 comprises Perma-Bulls and other Wall Street product salesmen, offering “This is a buying opportunity” and other standard from-the-hip statements whenever the Vix index reaches 30 and the market trades 10% off from its high, at any time.
Group 3 includes “any moron with a $1500 E-trade account, twitter, Facebook etc…”, summing to roughly 99% nonsense and noise.
Group 4, however, comprises “True investors and traders” asking questions such as, “Is this a good price ?”; “Is this a good level ?”; “What is my risk stepping in here, on either side ?”; “Am I getting better value than I am paying for ?”; “What is the downside / upside ?” etc.
“With the “magnification” of noise by social media and the internet in general, one must shut off the first three groups and try to engage, find, follow, communicate with the fourth group only, those looking at FACTS, none dogmatic, understand value, risk, technicals and fundamentals and most importantly those who have no agenda and nothing to sell.”
To Jim Rickards, simply printing money and gifting it to the banks through the somewhat magical money creation process of QE is like treating cancer with aspirin: the supposed “solution” does nothing to address the root cause of the problem. The West is trapped in a secular depression and “normal” cyclical solutions, such as monetary policy measures, are not just inappropriate, but damnably expensive for the rest of us. Only widespread economic restructuring will do. And that involves hard decisions on the part of politicians. Thus far, politicians have shown themselves predictably not up to the task. Or in the words of Jean-Claude Juncker,
“We all know what to do; we just don’t know how to get re-elected after we’ve done it.”
And let’s not forget that other notable Junckerism,
“When it becomes serious, you have to lie.”
No cheers for democracy, then.
So, back to the debate:
Yes, QE has driven down long term interest rates.
But the problem wasn’t the cost of capital. The problem was, and remains, an oversupply of debt, insufficient economic growth, and the risk, now fast becoming realised, of widespread debt deflation. To put it another way, the world appears to be turning Japanese after all, despite the best efforts of central bankers and despite the non-efforts of politicians.
The solution is fundamental economic restructuring along with measures that can sustainedly boost economic growth rather than just enriching the already rich through artificial financial asset price boosterism. Government spending cuts will not be optional, although tax cuts might be. The expansion of credit must end – or it will end in an entirely involuntary market-driven process that will be extraordinarily messy.
How to “save face” ?
This is where we start to view the world, once again, through the prism of investments – not least since we’re not policy makers. For those wondering why a) markets have become that much more volatile recently (and not just stocks – see the recent wild trading in the US 10 year government bond) and b) inflation (other than in financial asset prices) seems weirdly quiescent – the answer has been best expressed by both Jim Rickards and by the good folk at Incrementum. The pertinent metaphor is that of the tug of war. The image below (source: Incrementum) states the case.
The blue team represents the markets. The markets want deflation, and they want the world’s unsustainable debt pile to be reduced. There are three ways to reduce the debt pile. One is to engineer sufficient economic growth (no longer feasible, in our view) to service the debt. The second is to default (which, in a debt-based monetary system, amounts to Armageddon). The third brings us over to the red team: explicit, state-sanctioned inflationism, and financial repression. The reason why markets have become so volatile is that from day to day, the blue and red teams of deflationary and inflationary forces are duking it out, and neither side has yet been convincingly victorious. Who ultimately wins ? We think we know the answer, but the outcome will likely be a function of politics as much as investment forces (“markets”). While we wait for the outcome, we believe the most prudent and pragmatic course of action is to seek shelter in the least overpriced corners of the market. For us, that means explicit, compelling value and deep value equity. Nothing else, and certainly nothing by way of traditional government or corporate debt investments, or any form of equity or bond market index-tracking, makes any sense at all.