Saturday, February 28, 2009

Mr. Market Miscalculates

The title of this post references a book recently written by James Grant, publisher of Grant's Interest Rate Observer and a frequent reference of this site.  After reading his book (insightful and witty read), some things really struck me and warrant some discussion.

The credit bubble, which for all intents and purposes, has burst, has been the culmination of 20 plus years of credit growth in excess of GDP, fueled by easy money, and a paper currency not backed by anything.

People with advanced degrees are no better at predicting the future than you and I.  Why we put faith into central bankers with regards to economic forecasts, inflation forecasts is a fool's errand.  Targeting one aspect of monetary policy (e.g. inflation) will only beget more of it, as one becomes so fixed on the measure (in this case "core" CPI) that one ignore the other moving parts that will contribute (i.e. excess money channeled into financial assets and easy credit).  
A gold standard, with its faults, is better than the blind faith put in oracles, as it has a built in corrective mechanism.  If a country's economy or government issues too much debt, people will demand a higher return or convert their debts for gold.  Either the borrower has the choice of de-leveraging, go broke on higher rates, or exhaust their gold reserves.    Nations cannot have perpetual current account deficits with gold, they are forced to live within their means.  Gold is a hedge against nations deliberately debasing their currency as way of avoiding the hard choices with structural issues (eg. health care in Canada, Social Security and Medicare in the U.S.) and reducing the scope of government.
Alan Greenspan, who once was a believer in Gold back in the days he hung around with Ayn Rand, oversaw this credit bubble and long-term debasement of the currency.    Grant goes back through history, and shows that monetary arrangements never last long.  Bretton Woods lasted barely twenty five years, and the years of the U.S. dollar being the world's reserve currency and totally backed by nothing  will in all likelihood be not much longer.  This will only be expedited by Obama's massive expansion of the U.S. Federal government, leading to equally massive and unheard of deficits.   The tax projections outlined in his budget will not pay for this.   Even if he taxed all income over $200,000 at 100%, he would still run deficits.   His choices are to increase taxes on everyone or keep running deficits, debase the dollar, and let everybody's standard of living decline gradually.    Sooner or later, the creditor nations, who are generally no friends of America, will demand a higher return than the paltry rates they are getting right now.   They will rightfully want to be compensated for currency risk, inflation risk, and credit risk.    With that in mind, interest rates have nowhere to go but up, and up a lot they will go.

People can talk about "new paradigms", "new economies", "great moderations" in markets and economics, but the reality is that there is nothing really new in economics and markets.   This is because there is one constant:  human behavior.   People have their prejudices, change their mind on a dime, are irrational, myopic, emotional, greedy, feaful, prideful, to name a few things.  This is why models do not work:  even through people as a whole are constant, their behavior within their range of behavior what they do can swing wildly and without explanation.   This is why "markets can remain irrational longer than I can remain solvent."
A subset of this notion is the hard reality that the vast majority of the time, everything reverts to the mean.  If one has several years of above average returns, it becomes increasingly likely that it will correct itself back to the long-term trend line.   The stock market, commodities markets, and housing markets are bearing this out.   Specifically, think about the stock market during the tech bubble with its 20%+ returns, and how people were predicting Dow 10,000 (James Glassman really looks like a chump now!) and how with the internet and technologies were going to have the prosperity go on forever in an environment of low interest rates and inflation.   Excuse me, if the markets give us 20% annual returns for the foreseeable future with low inflation, wouldn't that imply that by simply investing my money and using the power of compounding interest, I could just put in $10,000 and be a millionaire in 20 years and never work again; but if everybody was retired due to their stock market riches, who would be working for the businesses who trade on the indices that require the 20% perpetual returns???  See the inherent problem with bubble returns - when returns start exceeding fundamentals, you plant the seeds of a crash, and eventually the return to normalcy.


Realist Theorist said...

I'm reading that book right now. Since it is a reprint of articles, I use it as a "filler book", reading an article or two while I've got something else as my primary reading.

What I like about Grant is his historical approach. Economics needs more of that. His description of the "Kansas land boom" was uncannily similar to what we just went through.

The one criticism I have of his books that he does not pull things together at a very broad level. So, while he's head and shoulders above the rationalistic approaches to economics, I would love to see more principle-induction and more conceptual-integration from him.

On the lessons for economics, I think some of the big ones are:

- Those monetarists who focus on money, need to think more abstractly of "buying power". Buying power is the end-product from which they then need to trace backward to money. In doing so, they need to study the interaction of various "layers" of money, to understand what factors determine the ratio of two contiguous layers.

- Many price-level indicators evolved as measures to judge the movement of real-wages. Therefore, they underweight price levels of assets. Buying power goes toward all expenditure -- capital as well as current. Therefore, we need to have some measure of nominal/real expenditure that covers all types of expenditure.

Mitch said...

I would have to concur with your observations. I also think the observation that he makes that monetary systems generally do not last very long was interesting. Perhaps we have had enough of money backed by good intentions of a civil servant.

It reminds me of when I started my previous career as a stockbroker, and a veteran trader told me the first two books I should read to understand markets were "Zen and the art of motorcycle maintenance" and "Extraordinary popular delusions and the madness of crowds" Both have served me well.

Realist Theorist said...

"... monetary systems generally do not last very long ... Perhaps we have had enough of money backed by good intentions of a civil servant."

I've definitely had enough! Lol!

I've got to think that this crisis has made some people around the world much more wary of the U.S. financial system (to put it mildly). The dollar and US treasuries are strong, but I think that's because people realize that there are few good places to turn. I imagine many people are promising themselves that they've learned their lesson for the longer term.

It is harder to see: if not the dollar or gold, then what?

Mitch said...

Milton Friedman was an advocate of a bi-metalic standard of gold and silver exchangeable at a fixed ratio. He describes it in his book Money Mischief. He believe that by linking the prices of gold and silver, one could temper the more extreme swings in prices.

He then talks about how this all related to William Jennings Bryan... another book I would recommend as one of his "lighter" books.