The Great Monetary Ponzi Scheme
The Great Monetary Ponzi Scheme
Apologies for the lack of love, Bristlemouthers. I’m finally finished our end of year special reports and, thankfully, have time to think about something other than infrastructure stocks and inflation.
I read a lot of Nobel Prize winning economist Paul Krugman’s stuff over the past couple of months, including his recently updated book The return of depression economics. This article on Slate, though, really wound me up (if you read it first and then come back, this post will make a lot more sense).
I’m one of the ‘intellectually incoherent’ who believe that ‘the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion’. And I’ve got a few answers to questions Krugman claims the incoherent ones don’t have an answer to.
Krugman accepts the fact the we have investment booms and that they necessarily lead to busts. But why, he asks ‘should the ups and downs of investment demand lead to ups and downs in the economy as a whole?’
Don't say that it's obvious—although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought—a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.
Well, Paul, the reason is that investment booms and consumption booms go hand in hand. In both your country and mine, consumers have been spending more than they earn for a large part of the past decade. Why? Because the investment boom has enabled them to go on a consumption boom. Not only do they feel wealthier, but they’re convinced the 20% returns they’re making year on year are going to pay for their retirement.
Yet you’re surprised that a collapse in asset prices leads to a collapse in the wider economy? What else do you expect consumers to do when they discover they’re not half as rich as they thought they were? They are going to save more and consume less, and that is going to cause a recession.
You go on to say that ‘nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present’. The answer to that seems fairly obvious to me as well: the investment boom created capacity and jobs to service an unsustainable level of demand. While we wait for the true demand to catch up, we’re going to have surplus capacity.
Of course, your ‘easy way out’ will work. Borrow money, print money, do whatever you need to do, but don’t let that idle capacity remain idle. It worked in the early 1990s, it worked in the 2001 recession and it’s working now.
But my question to you is: where does it end? Interest rates are near zero and consumers’ ratio of debt to disposable income is the highest it’s ever been. When interest rates hit 5% in the US and 7% here, it sent the economy into a tailspin. By the time this rescue package is complete, your government is going to have one of the highest ratios of debt to GDP in the world. At some point, surely, throwing more money at the problem is no longer a viable solution?
Intellectually incoherent perhaps but, to me, your solutions have the smell of one giant ponzi scheme.
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And this guy won a Nobel prize? If ever you needed proof that rationality and fundamental understanding are not pre-requisites for pre-eminence, especially in soft sciences such as economics, then you need look no further. Austrian theory obsolete? What a laugh.
Merton and Scholes won the 1997 Nobel Memorial Prize in Economic Sciences for their option pricing model. In 1998, their hedge fund Long Term Capital Management blew up. I just thought that was worth remembering!
Steve,
Lets answer the hard question: If you were the government, what would have you done? Would you still expand the gov debt and print more money?
It's never going to happen but I'm pretty sure I'd only last a term.
In answer to your question, yes I'd expand the government debt right now (especially here in Australia where we have a lot of room to move). But I'd implement policies that encourage less consumption and more investment over the long term (the exact opposite of what we're doing). I'd explain to my constituents that we've got some serious adjustments to make and that, while we'd do our best to minimise the pain, it's going to hurt somewhat.
Then, of course, I'd get voted out of government.
At least their prize was based on a theorem. They created a model about the world, which at least required considerable intellect - though it's turned out to be fundamentally wrong (something to do with assuming markets follow normal distributions, I think). But what's this guys intellectual framework? Perhaps I don't know enough about him, but if he thinks a sharemarket has no connection to the real economy, then all I can say is PLEASE EXPLAIN.
I think Soros was correct when he said that government's #1 goal is not to necessarily do what is correct, it is to stay in power. That is exactly what we are seeing now.
Isn't that what Paul Keating did with his "Recession we had to have" . Makes economical sense but is political suicide. Let us see which politician is willing to sacrefice his carreer for their country (keeping in mind that they are the people that send our troops to faraway battlefields to fight for our freedoms, some of these diggers never return...)
Perhaps some of the rhetoric out of Germany is more along your lines, Steve? Back in March Angela Merkel was steadfast under pressure: "I will not let anyone tell me that we must spend more money" she was quoted as declaring. An article on her official website from the 19th of March (Facing the crisis together) says: '"After the crisis we must find our way back to sound finances,” emphasised the Chancellor. In this context she praised the agreement now reached by the Federalism Commission on a brake on future debts, which would allow for a maximum structural deficit of no more than 0.35 percent of Germany’s gross domestic product. The Chancellor expressed her hope that other countries too will return with greater commitment to a sound budgetary policy.'
So basically you agree with both the government's current monetary policy (printing more money) and the principle of its fiscal policy (i.e. expanding gov spending), but not the actual details of the fiscal policy (i.e. consumption vs investment).
That's still Keynesian, Steve. Isn't that in conflict with your Austrian tilt? It seems to me you're agreeing more than disagreeing with Krugman in practical terms.
I think what Steve is saying is that tough choices have to be made, and without having a golden bullet, we have to choose what WE BELIEVE to be the least bad path. It's not mathematics, and we don't fully comprehend the consequences of our actions. It's also not religion. We don't have to choose the one true faith to the exclusion of all others.
I don't have an Austrian tilt. They are too libertarian even for me ('Government means always coercion and compulsion and is by necessity the opposite of liberty' - von Mises). But they have some ideas that I think are correct.
Whether I would provide stimulus or not is not the point. My argument is that it is merely a band-aid, not a solution. And if you don't come up with a solution as well as a band-aid, you're only going to contribute to a bigger wound in future - eventually one that you won't be able to patch.
Krugman is right.
Why should so much of the economy come to a halt just because some people have over extended themselves and dusted some cash while others have had their portfolios shrunk to 2005 levels (where we all poor in 2005?). And the answer is cash.
Look on the ground level for proof (not something economists like doing) - it is everywhere. For example Cochlear's announcement yesterday was sales growth down on the back of customers de-stocking. Over investment isn’t related to people wanting improved hearing yet COH sales drop as their network of customers (I’m not talking about the consumer) increase working capital to protect themselves from the GFC i.e. get some cash. They probably had the right level of working capital in the first place and will have to return to it at some stage anyway. Exactly the same is happening at Billabong with its network retail customer - destocking for cash flow reasons.
These are just two micro examples but this process is flowing all the way through the economy – some of it justified and much of it reactionary to preserve cash flow. In fact too much will prove reactionary hence the investment opportunities present. And in the meantime unnecessary unemployment occurs and productive time is wasted as everybody backs off.
I'm not sure there is a sytemic problem here. It is right for governments to rebalance the system in the same way a cop moves everyone on who slows down to look at the crash scene.
This is confusing cause and effect. The problem was one of unnecessary employment during the boom, not unnecessary unemployment after the crash. If during the boom we had too much economic activity in areas that were really not particularly beneficial or sustainable, then how can we rectify this without causing short-term unemployment? The villain here is the boom, not the medicine that follows the crash.
A possible contributor to boom and busts is the concept of interest associated with debt. Interest on debt makes sustainable growth impossible.
The money used to service the debt can only come out of existing money supply.
Therefore, loan growth is encouraged to cover existing [principal + interest] owned, which creates more debt outstanding = more money available for investments = more employment = more consumption of resources = boom economic times.
Perhaps the only way to break out of this vicious debt cycle described above is to have an "economic breather?"
Paul Grignon's: Money As Debt (47 min)
http://video.google.com/videoplay?docid=-2550156453790090544
Actually, there's some cause to claim that the obsolete economist is Keynes - or, to be more charitable, that the Keynesian prescriptions have reached the point of diminishing returns. When the savings rate sinks below zero, what's left for consumption for a rainy day? More debt? At the cost of a weakened credit rating, making it more difficult (ceteris paribus) to borrow tomorrow? How much economic growth is now added per dollar of added debt? Less than before, isn't it?
Steve's comment about encouraging more saving and less consumption leads straight into the need for an increase in the superannuation levy. This should have now been at 15% (curse you John Howard) but at least there appear to be noises in the Government about the reimplementing of Paul Keating's vision. The 6% increase over time will soak up a lot of excess consumption.
I remember the howls of anguish from "Big Business" when Keating first implemented the superannuation levy -- now many "Big Businesses" are only surviving because of these funds!!!
I worry that the nature of the economic commentary by the TII* potentially represents a distraction from its investing advice. The difficulty for me is that while I subscribe to the TII because I agree with its investing philosophy, that does not necessarily lead to agreement when it comes to economic policy and schools of economic thought (though, I don't necessarily agree with Krugman either!).
I agree with Warren Buffett’s traditional assessment, which seems to reflect Graham’s opinion, that political and economic forecasts can be a distraction to investors. Buffett is also quoted as saying that he spends “no time thinking about macroeconomic factors”, though this has not stopped him making pronouncements regarding the economy in recent years! However, Buffett’s success as an investor does not necessarily translate into credibility when providing economic policy advice, just as there have been some well-documented investing failures by good economists (e.g. Gareth's earlier comment).
I believe that investors should recognise fiscal and monetary policies as exogenous factors over which they have no control, though I accept that an investor should have an awareness of the environment in which he or she is investing.
* More recently, this blog, the special report on “Paying for the crisis: Inflation or deflation?” and the interview with Satyajit Das.
That's a very valid point. One of the reasons we started this blog was so I could write about things I'm interested in, but aren't directly relevant to investment ideas.
Having said that, I think the world has changed a lot since Graham was managing money. As long as you are aware of the limitations, and there are obviously many, I don't think it hurts to be thinking about some of these macroeconomic issues.
As an example, I'm convinced the Australian housing market is substantially overvalued. But I have the vast majority of my portfolio invested in a mortgage lender - RHG. There's a risk there that I'm extremely conscious of, but I didn't let it stop me buying what was an obviously cheap stock.
As for Buffett, he likes to keep his talk simple, but his big bets on currency suggest he spends a lot more time thinking about wider economic issues than he lets on.
I would also suggest that there is a big difference between 'thinking about macroeconomic factors' with a view to making forecasts, and thinking about them with a view to reducing ones risks and being prudent with ones assets. If I want to live a long and happy life, the best thing I can focus on is what I eat, who I love, how much I exercise etc. However, if someone is laying landmines in my neighborhood, I better take note.
Spot on Steve,
The mistake all these traditional economists make is assuming that pre-existing financial commitments (i.e. debt) should have no sustained impact on aggregate demand, because the "real" economy is separate and distinct from the "monetary" economy. Shortfalls in private sector aggegate demand can therefore apparently be rectified simply by lowering interest rates and printing money.
This is of course completely divorced from reality. It is true that one person's debt is another's asset, but typically the debt is spread widely and the assets are concentrated. Highly democraticised debt levels result in a large concentration of wealth & purchasing power, but the wealthy do not spend the vast bulk of their income. So after a big run-up in median levels relative to income, an eventual collapse in aggregate demand is inevitable, and a semi-permanent one at that.
Short of nationalising the banking sector and cancelling the debt, there is nothing the authorities can do rectify the situation other than accepting the inevitability of a long period of economic stagnation and deleveraging. The official response is always to cut interest rates to lower debt servicing costs and encourage further debt accumulation to kick-start aggregate demand, but this of course can only work for so long. When debt levels are high enough, this will not work (as occurred in Japan and has so far occurred in the US).
Are we at the point of game over yet? In the US, the capacity for the private sector to borrow more money is exhausted, but there is still potentially the capacity for govts to gear up further to offset the fall-off in private sector debt growth (ie. a government debt bubble). But this too has limits and is a clear road to ruin. Like you say, it's little more than a giant ponzi scheme and it is remarkable how few mainstream economists actually understand any of this stuff.
The only other alternative it to attempt to inflate away the debt, but the authorities need to be careful. If bond markets eventually fear deliberate debasement, investors will dump bonds, interest rates will skyrocket, and the dollar will collapse. The US is following the textbook path to this outcome at the moment. If interest rates in any western economies went to 10-15% it would be truly game over.
Steve Keen is one of the only economists I have seen who truly seems to understand this stuff, and he has contributed enormously to my thinking on these issues. Keen's view is that the next phase of the crisis will be when private sector demand fails to recover, which is expected, and people will then realise that the huge and unsustainble budget deficits being run by Western govts are structural not cyclical!! At some point these deficits will have to be narrowed, and when the govt attempts this the economy will fall immediately back into recession IMO.
Thanks for the note,
Rgds
LT
PS the major intellectual error made by Krugman is that he completely overlooks the role of debt. His description of a world where people allocate spending between consumption and investment, and if they don't do either it is because they have "increased their demand for cash", is a theoretical world without credit that simply doesn't exist.
In a modern economy, credit functions as money. And as Keen has outlined, in a modern economy, a rise in debt creates a corresponding asset, and therefore functions to expand money and aggregate demand. What Krugman completely misses is that a collapse in the willingness/ability of people to take on credit to invest/spend results in a collapse in aggregate demand that has nothing to do with a demand to "hold cash". And if creating new money did solve the problem, it needs to be GIVEN to people, not lent - effectively cancelling the debt.
Why do good factories need to be idle? Because of a systemic deficiency of aggregate demand that is driven by excessive democratised debt that limits people's ability to spend; and the wealthy cannot/do not pick up the spending slack.
It is truly shocking that a Noble prize winning economist can still say, with a straight face, even after all we have seen, that attributing economic woes to excessive credit expansion during the boom is flawed! I quote:
How many articles have you read blaming Japan's current malaise on the excesses of the "bubble economy" of the 1980s—even though that bubble burst almost a decade ago? How many editorials have you seen warning that credit expansion in Korea or Malaysia is a terrible idea, because after all it was excessive credit expansion that created the problem in the first place?
With these types of people dictating policy, all I can say is "God help us"!!
LT
Jeremy Grantham has said the investment & economics is often characterised by the extraordinary importance of a very small number of events. In general I agree that economics is irrelevant to stockpicking, but there are exceptions - and when whole economies are at major inflection points that will completely redefine the investment landscape for the next 10-20 years.
This is different to picking short term stock market movest or interest rates - and rather goes right to the heart of valuation. For example, if consumers are borrowed to their eyeballs, it is reasonable to expect that consumer spending on big ticket items is going to have to rebase downwards at some point to more sustainable levels, and this should be factored in to your long term earnings expectations. And banks might look cheap on PERs and P/BV, but if the housing market is hugely overvalued and there has been a big credit expansion, this again has implications for value.
Value investing is the art of differentiating between what is compellingly cheap and what is cheap for a compelling reason. I would argue that most failed value investors who fall into value traps do so primarily because they have not considered the bigger structural economic picture and what makes sense/is sustainable from an industry/economic point of view. Many "value" investors got carted in financials last year because they didnt' understand the credit cycle and unsustainable basis for the broader economy etc.
So I don't believe this stuff is off base of TII.
[...] credit bubble doesn’t need to deflate now. It doesn’t need to deflate any time soon. But it is a Ponzi scheme and whether is collapses overnight or takes 20 years to deflate, the implications for the [...]
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