While the systemic model, with its top-down, consequentialist policies put in place specifically to produce stability, often produces stability over the short run, it at least as often produces unimaginably wild instability over the long run.
This is a problem that crosses platforms. A common analogy is the fires in managed forests. While top-down policies designed to systematically control and extinguish small fires prevent problems in the short run, the lack of fires to clean out the dried brush ultimately leads to uncontrollable infernos.
I am more likely to write about an almost identical problem on this blog: the Federal Reserve. While top-down policies designed to systematically control and extinguish market phenomena like inflation and unemployment often allow for stability in the short run, the lack of market responsiveness ultimately leads to catastrophic crashes, runaway inflation, and heavy unemployment.
This is something that I have been thinking on quite a bit recently, and I have come to the conclusion that we have to embrace the chaos. Ultimately, we’re in for a wild ride no matter what, so why delay the reckoning? Let’s deal with the problems in incremental and manageable ways, preferably at the level of the individual. The only alternative seems to be waiting for intractable problems later.
The reason I bring this up now is because Motor Trend magazine recently published an article called “The Beginning of the End of Driving.” Read the following excerpt and try to tell me you remain unworried about the systemic vulnerabilities.
Continental plans to have autonomous assistance available for limited freeway driving and for construction areas by 2015, says senior vice president Ralf Lenninger. It will add low-speed city capability in 2017, followed by two-lane highway and country road driverless car technology about the end of the decade. The company calls this “the car you can’t crash,” and it will meet the company’s goal for a zero-percent accident rate.
Here is a link from the Daily Reckoning of Australia, showing why government debt blows up. It has a liberal dose of Bastiat (pun intended), and it draws some interesting parallels between Japan and the United States.
I suggest that you read the whole thing. (It’s not that long, you whiners!) But here’s an interesting excerpt to pique your interest:
What really happens is this: the private sector gets too deeply in debt (thanks largely to the Fed’s artificially low rates and EZ money policies). Then, it panics. It cuts spending. Lenders – who over-extended credit – should go broke.
Instead, the feds bail them out, shifting the public’s real resources to failed businesses and incompetent managers. The bad debt is transferred to the public. Then, the private sector… attempting to build up savings and improve its financial health… puts its money in the safest possible place – government bonds! Still more debt, in other words.
The government takes the money and gives it to its favourite sectors… its clients… its pets… its campaign contributors and vote-getters. The public would be appalled if it realised how its savings were being thrown around. But it wants safety above all. And it believes the feds will be good for the money; they always have been. After all, if you can’t trust the government, who can you trust?
Who can you trust indeed? I’m not in the business of giving investment advice, but I’d suggest tangible assets. Check out the article to see what the stock market has done relative to tangible assets over the last 15 years or so. It will either shock you or depress you, or possibly both.
I was recently made aware of an interesting phenomenon called the “Zero Stroke” or the “Cipher Stroke.” It has an article on Wikipedia, so it must be a real thing.
Zero stroke or cipher stroke was a mental disorder, reportedly diagnosed by physicians in Germany under the Weimar Republic and said to be caused by hyperinflation of the early 1920s. The disorder was primarily characterized by the desire of patients to write endless rows of zeros, which are also referred to as ciphers.
Now that we’re in for the four more years of the Obamar Republic, with Ben Bernanke getting free rein to dump Benjamins out of his fleet of helicopters, I wonder whether the Zero Stroke will return?
Maybe it’s the next big thing in psychology!
Far more interesting than Bloomberg’s clumsy attempt at evenhanded journalism in the last post is Jim Chanos’s interview on Bloomberg Market News. Some money quotes (pardon the obvious pun):
In fact, after the two last crises, in ’99 and ’04, when nonperforming loans went crazy in China without even a recession, the Chinese banking system was not recapitalized like ours was. It was papered over. So going into this credit expansion, Chinese banks are banks are sitting on lots of bonds from these so-called “asset management companies,” and they’re keeping them on their books at par…
Again, this sounds eerily familiar to the sort of mess the United States got themselves into by ignoring real values of housing property in favor of the par value of securitized property loans. One little dip in value of the underlying asset, and the whole house of cards tumbles.
Of course, more recently, we are finding the same thing going on in Europe. Because the European prudential banking regulators assigned essentially a zero risk to sovereign debt (allowing for essentially zero reserves to cover it), banks are now finding that these assets that they loaded up on are weighted far more heavily that their real-life risk would have dictated.
This is nothing new. I have been arguing for quite some time that banking regulations, in particular prudential capital regulations, set people up to fail. Rather than preparing for the next black swan, regulators create it by using a backward-looking measure of risk. Everyone piles into the debt that regulators have blessed as “safe,” and when it eventually does go down, it goes down hard.
Chanos continues talking about the lack of recapitalization in Chinese banks:
In the case of Agricultural Bank of China, which we’re short, those restructuring receivables, if you look on the balance sheet, are equal to over 100% of their tangible book. The Chinese banking system is built on quicksand.
I have been arguing for some time as well that the Chinese banking system is simply written on paper. That paper will be passed around as long as people believe that there is something backing it. Once word gets round that there isn’t, you had better hope that you aren’t the one left holding the paper.
Of course, this is what happens, ultimately, when money is not an asset, or even based on an asset. Money that is worth what the government says it is worth will soon be worth nothing.
Unfortunately, I believe there will be many U.S. investors caught holding the bag here. And when this happens, it will make MF Global look like pattycake.
This is an object lesson in what happens when investments are built on artificially cheap credit and not the stock of savings. While Jon Corzine has inanely admitted that “I don’t know where the money went,” the better question – for both MF and China – would be, where did the money come from?
…Not that it ever was, but when Slate magazine (yes, that Slate magazine) runs a story like this one by Bethany McLean, you know that the idea of eliminating the Fed is finally reaching the consciousness of masses. It’s about time.
In the article, called “Fed-Bashing Three Ways,” McLean notes some very prominent Fed skeptics including Jeremy Grantham, CIO of Boston money manager GMO, Jim Grant of Grant’s Interest Rate Observer, the ubiquitous-when-it-comes-to-Fed-bashing Ron Paul, and Kevin Duffy of the Bearing Fund. It also quotes some others who are skeptics of Fed action, if not its existence per se. But the top prize goes to Duffy, for this truly awesome quote:
Kevin Duffy, who co-manages a small hedge fund called the Bearing Fund, says that criticizing Fed policy, rather than the Fed itself, is “a bit like dismissing Stalin and Mao as well-intended but not the right men for the job.”
They also throw in a mention of the great Murray Rothbard and his book “The Case Against the Fed,” as well as some very heartening poll numbers, including a tally of 45% of the general population favoring the elimination of the central bank. However, despite the good news, not all is well in the public discourse. Consider another article in Slate magazine today, entitled “Gold Rush – what would happen if we returned to the gold standard?” In this article, author Christopher Beam brings us back to the depressing reality of Slate by seriously misunderstanding the nature of money in the very first paragraph of his hypothetical!
First he posits, the question “Say the United States decided to peg the dollar to the price of gold. What would happen?” He answers with this:
First, the government would have to decide what the price of gold is. That’s a lot harder than it sounds. In theory, there’s an ideal rate at which to peg currency against gold. We just don’t know what it is. Gold is notoriously volatile—its price has doubled over the last two years. If the Federal Reserve were to simply fix the dollar to the price of gold on a given day, and demand for gold changed drastically, it would wreak havoc on the economy.
Gold is volatile? I’ve never known gold to get drunk and punch people in the face. Let’s define our terms. “Volatile” means that the price of gold in dollar terms fluctuates. Beam never stops to wonder why. Right now, paper and faith in government convene to form what we call the dollar and use as money. In a truly gold-standard nation, gold is the money, and the dollar is merely a proxy – an avatar.
By never removing the central bank from the equation, never considering the possibility of a country that does not manipulate its interest rates, and assuming a country that runs a constant, rolling national debt, Beam never gets to the heart of the matter. Maybe it is currently a political impossibility, but by never considering an alternative arrangement, Beam doesn’t really add anything to the discourse.
QE2 has touched off quite the furore lately, and from around the world, but among the most interesting comments are those from domestic investment professionals, who are charged with making money from madness. Throwing his hat into the ring today is Jim Jubak, from MSN Money. In an article entitled “Oops, has the Fed done it again?”, Jubak lays out the story behind QE2, and how it is just another step in a by-now-very-familiar cycle: pump up the money supply, watch the economy take off, the economy crashes terribly, so in response, pump up the money supply.
Happily, he also offers some investing advice. (Not that I endorse Jim Jubak or any professional stock picker, but if you choose to heed the advice, so much the better that you found it here.)
Let’s go through the article:
2000. 2007. 2011.
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world’s emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world’s emerging economies have started to worry about what will happen if all the hot money flowing into their economies and markets suddenly starts flowing out.
“As long as the world exercises no restraint in issuing global currencies such as the dollar,” Xia Bin, an adviser to the People’s Bank of China, said, “then the occurrence of another crisis is inevitable.”
The only problem with this lead-in is the fact that it references only the past decade. In fact, the world is full of examples of monetary manipulation, asset bubbles, and currency crises. For a very good reference text (yep, it’s a whole book), I’d recommend Jesus Huerta de Soto’s Money, Bank Credit and Economic Cycles, published for free by the Mises Institute.
If you’re uncomfortable with a “hardline” Austrian viewpoint, I would also recommend the more “agnostic” financial history entitled “Devil Take the Hindmost,” by Edward Chancellor. For far more Keynesian take (but still mostly objective), I’d suggest the updated “Manias, Panics, and Crashes: A History of Financial Crises,” by Charles Kindleberger.
But 10 years after the bear market began in March 2000, the Nasdaq has barely recovered half its losses. From a high of 5,048.62, the market had clawed back to 2,578.98 at the close Nov. 5. That means the Nasdaq Composite Index is still down 49%.
True enough. Again, though we haven’t recovered from 2000, it seems the more important point is the fact that we haven’t learned our lesson from the late 17th century, when the first modern financial bubbles appeared in response to financial manipulation.
In the fourth quarter of 2002, when short-term interest rates were 1.23%, the real median price of a U.S. house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005, the real median price was up to $262,634. That’s a 33% increase in the median price of a house in just three years — without inflation. That’s extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. It was possible to buy and flip for a quick profit. Possible to refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn’t ask questions about your income or credit record.
By 2006, this price appreciation had peaked. The median real price of a house that year ranged from $250,000 to $263,000. But by the second quarter of 2007, it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That’s a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (And because the house they live in is by far the most valuable asset most families own, and because home ownership rates in the United States are much higher than stock ownership rates, that 36% drop in housing prices was more devastating for most families than a 77% drop in stock prices.)
There’s your housing crisis in a nutshell. This is why the 2008 downturn has been called the most devastating since the Great Depression, but it isn’t surprising that housing was affected. Capital investments, including hard assets and real estate are very prone to overinvestment (“malinvestment”) in the Austrian parlance when credit is artificially cheapened.
And now on to the present:
That track record suggests that “What, me worry?” isn’t a reasonable response to the Federal Reserve’s two rounds of quantitative easing, a strategy that pumps money into the economy to try to get it moving more quickly. The first round, which ended only this spring, saw the Fed buy $1.7 trillion in Treasurys and mortgage-backed securities. The new round announced last week would add $600 billion of Treasury buying to the total.
The dangers of these two programs to the U.S. economy are scary enough. The Federal Reserve is buying all these debt instruments on the cuff. The Fed doesn’t actually have the money to pay for these purchases. Instead, it is creating dollars out of thin air — printing them, figuratively at least — and at the same time creating a huge liability on the Fed’s own balance sheet. Of course, the Fed may be able to pay off that liability by selling the bonds back to the market someday, but you’re entitled to wonder where the buyers for $2.3 trillion in U.S. debt and mortgage-backed debt are going to come from.
If you’re the kind of person who worries when you see a big debt and no obvious way to pay it off, then the Federal Reserve’s current balance sheet undoubtedly worries you.
Why yes. Yes it does. In investment terms, the short-run questions are which assets will be pumped up, but the real long-term question is when will the next crash be, and how much worse will QE1 and QE2 make it? Unfortunately for the rest of the world, the fact that we’re dynamiting our own financial system is not something that other countries can sit on the sidelines and watch. Given the prominence of the United States and its dollar, we are affecting the entire world. And the results will not be pretty. Jubak again:
But those aren’t the possibilities that worry me most or that have overseas central bankers screaming in protest. The big problem is what will happen to that $2.3 trillion created by the Fed. The dollars certainly don’t all stay in the United States.
So far, China, India, Germany and Brazil have been very public in their disdain for our reckless wielding of this financial A-Bomb. I doubt it stops there, especially when the defaults begin. You’ll note that Brazil has been critical; they’ve also been a serial defaulter. Just as speculators plugged money into housing in 2004, watched it soar, and then lost their shirts when it came crashing to earth in 2008, so I fully expect at least one country to take off on the back of asset inflation, excite investors as the “next big thing,” and come crashing spectacularly down several years from now in one big default. It would not surprise me if Brazil falls into that category. Of course, we’d better hope China doesn’t – they have nukes.
And speaking of nukes, the inimitable Peter Schiff has an article today in the Business Insider entitled “Bernanke is Engaging in the Monetary Equivalent of Nuclear War.” An excerpt:
As the world awaits another $600 billion flood from Bernanke’s printing press, central bank governors from Brasília to Tokyo are preparing to respond in kind. This is the monetary equivalent of a nuclear war, except instead of radiation, bombs of inflation threaten to make the world economy uninhabitable for saving and productive enterprise.
…Chinese Commerce Minister Chen Deming said as much in an interview on October 26: “Uncontrolled” issuance of dollars is “bringing China the shock of imported inflation.” Most emerging markets are the same way. In order to prevent rapid economic dislocations, and often to appease their powerful export lobbies, these countries seek to maintain a status quo versus the dollar – whether through inflation as with China or capital controls as with Brazil and South Korea, or both.
In short, the currency war is really just the rest of the world trying to shield itself from a barrage of nuclear dollars.