President Barack Obama, who took office amid the collapse of the last financial bubble, wants to make sure his economic recovery doesn’t generate the next one.
Obama this month spoke four times in five days of the need to avoid what he called “artificial bubbles,” even in an economy that’s growing at just a 1.7 percent rate and where employment and factory usage remain below pre-recession highs.
“We have to turn the page on the bubble-and-bust mentality that created this mess,” he said in his Aug. 10 weekly radio address.
In the long run, this goal — of avoiding inflating economic bubbles that change the structure of production both as they inflate and deflate — is laudable. The best manner in which to achieve it is through the teaching and discussion of history. A key qualitative factor in most bubbles seems to be the forgetting of history, the sense that this time is different, the sense that we may have reached a new stable plateau upon which asset prices can only rise. With the rise and popularisation of notions like the Great Moderation or the end of speculation, investors put down their guard and increasingly engage in riskier behaviours, like flipping condominiums, or buying stocks with leverage. The bubble is a mentality — risks will remain at bay, sentiment will remain high, externalities won’t disrupt activity. This is fine if the risks that investors have begun to ignore never materialise, so not every asset that soars in price is a bubble. Many asset classes including treasuries and junk bonds today are at record high prices, but the Fed is determined to do whatever it takes, and so sentiment has held in spite of naysayers like Marc Faber and Peter Schiff talking of the inevitability of a crash since the recovery began in 2009. The risks have so far remained at bay. But very often the risks that are assumed to have gone away reappear, and all it takes for the market to go into freefall is for sentiment to turn and investors to start selling. Asset valuation is not a question of fundamentals. It is a question of abstractions away from fundamentals. As John Maynard Keynes noted:
[Investing] is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
What this means, as Minsky noted, is that avoiding the possibility of economic bubbles is really, really difficult (if not impossible by definition). Each stabiliser leaned upon to stabilise markets becomes another assumption lulling investors into assuming that this time is different and thus into riskier behaviours. Keynes and Minsky both recommended fiscal policy as the stabilisation lever, but fiscalism has become unfashionable and politically challenging.
Obama’s chosen mechanism for avoiding bubbles is decreasing income inequality. In fact he sees income inequality and economic bubbles as being intimately connected:
Even though our businesses are creating new jobs and have broken record profits, nearly all the income gains of the past 10 years have continued to flow to the top 1 percent. The average CEO has gotten a raise of nearly 40 percent since 2009. The average American earns less than he or she did in 1999. … This growing inequality not just of result, inequality of opportunity – this growing inequality is not just morally wrong, it’s bad economics.
Because when middle-class families have less to spend, guess what, businesses have fewer consumers. When wealth concentrates at the very top, it can inflate unstable bubbles that threaten the economy. When the rungs on the ladder of opportunity grow farther and farther apart, it undermines the very essence of America – that idea that if you work hard you can make it here.
It’s not sustainable to have an economy where the incomes of the top 1 percent has skyrocketed while the typical working household has seen their incomes decline by nearly $2,000. That’s just not a sustainable model for long-term prosperity.
This is all true. But it’s also all rhetoric. In his nearly five years in office, Obama has totally failed to get income inequality under control. According to Pew Research, since Obama came to office:
Mean net worth of households in the upper 7% of the wealth distribution rose by an estimated 28%, while the mean net worth of households in the lower 93% dropped by 4%
Research from the Bank of England shows that the main transmission mechanism used by central banks — specifically, reinflating asset prices — disproportionately favours the richest in society; those who already have assets whose prices can be lifted. The policies that Obama and Bernanke have pursued for the past 5 years have been tilted toward assisting the wealthy. The recovery has been a recovery from and for the top, while the poor have continued to experience greater social fragmentation, weakened social programs, and long-term unemployment. This has all been cemented by Obama’s own policies.
So while avoiding asset bubbles and reducing income inequality are laudable goals it is highly questionable that Obama — who has embraced an austerity agenda — will come close to achieving either.
UPDATE: Miles Kimball on Twitter points me toward Anat Admati’s suggestion of implementing bank capital requirements to make bubbles less damaging. This is a very fair suggestion, because it is a stabiliser that does not lean on the idea of eliminating bubbles, but the idea of limiting their impact. Obviously, rules can be gamed, but if implemented properly it could systematically limit the size of bubbles, by cutting off the fuel of leverage.
I am a solar energy enthusiast. The energetic parts of the universe are clustered around stars. We sit here on this dusty ball of rock and water, heated continually by the Sun. The difference between when we face toward our local star and when we face away from it is — in the most literal sense — day and night. Our lives on Earth are already solar-powered; the plants (and plant-eating animals) we eat get their energy from photosynthesis. The trees and other biomass we have used for energy for much of our history, as well as the fossil fuel reserves we use today are forms of stored solar energy from earlier organisms that died and were trapped under the Earth. Wind energy and tidal energy are perturbations of dynamical systems heated by solar energy. Even the nuclear energy we use extracted from fissionable uranium and plutonium is stored from supernovae in early stars that exploded and pushed the complex elements — including the carbon, nitrogen and oxygen in our bodies — out across the universe.
It is not so much a question of whether we use solar energy, but whether we use direct solar energy, or some derivative form. As our civilisation has advanced and grown, we have had to tap into larger sources to meet the demand for cheap and easily-accessible energy. Our technological sophistication and understanding of basic physics and chemistry has had to grow with our energy hunger to take advantage of different forms of energy; windmills, steam engines, oil refineries, cold water reactors and photovoltaic panels, and so on. In the long run, it is a mathematical certainty that to sustain our civilisation at present levels, or to grow and increase energy consumption we must transition to renewable energy both because quantities of fossil fuels and star fuels like uranium and plutonium on Earth are finite.
All that is necessary in the long run for renewable energy sustainability is that the level of output exceeds the level of input enough to provide a reliable energy source. Even at current solar efficiencies — and thus assuming that the technology won’t improve — photovoltaic solar generates seven times more energy than it takes to generate:
While this is not currently as good as oil or natural gas or coal, it already beats shale oil and biofuels. The beautiful thing about solar energy is that there is so much of it that the technology does not have to be greatly efficient. And prices are falling and efficiencies are improving. While some renewables like wind and hydroelectric are more efficient, they are not abundant enough to even cover the bulk of our energy needs today. In the short run, combined with hydroelectric and wind and nuclear there is a real basis for long-term renewable energy sustainability. To smooth the transition, renewable technology needs investment and development.
In the long run, while obviously renewables still cost a lot more than non-renewables in the marketplace, but we have already established that that cannot last forever. Even the supply of uranium is limited. While we may discover superior technologies like cold fusion, we should be completely prepared for the eventuality that we don’t discover a better technology. While photovoltaic solar remains the largest and most long-term source of available energy — and thus the best hope for the continuation and expansion of sustainable human civilisation — it should receive a bulk of funding and development, and we should assume that in the very long run it should meet the bulk of our energy needs. There are still challenges like solar energy storage, but these challenges are being surmounted with improved battery technologies, and improved distribution technologies such as microgrids.
Of course, if the photovoltaic solar price trend known as the Swanson Effect that has seen solar fall over 99% in cost since the 1970s continues, then solar will reach and exceed parity with other energy sources and be crowned the winner by the market based simply on low cost. After all, solar energy is superabundant compared to the alternatives, so it would not be at all surprising for it to become the cheapest. But even if the Swanson Effect does not play out and solar does not become super-cheap, direct photovoltaic solar is extremely likely to play a major role in continued human civilisation on this planet and elsewhere.
Paul Krugman says that we may have reached a “depressed equilibrium” that unemployment may remain elevated for a long, long time to come:
We had what felt like an epic intellectual debate over austerity economics, which ended, insofar as such debates ever end, with a stunning victory for the anti-austerity side — and hardly anything changed in the real world. Meanwhile, the pain caucus has found a new target, inventing dubious reasons for monetary tightening. And mass unemployment goes on.
So how does this end? Here’s a depressing thought: maybe it doesn’t.
True, something could come along — a new technology that induces lots of investment, a war, or maybe just a sufficient accumulation of “use, decay, and obsolescence”, as Keynes put it. But at this point I have real doubts about whether there will be events that force policy action.
First of all, I think many of us used to believe that sustained high unemployment would lead to substantial, perhaps accelerating deflation — and that this would push policymakers into doing something forceful. It’s now clear, however, that the relationship between inflation and unemployment flattens out at low inflation rates.
Last week, I wrote a piece arguing much the same thing:
It is also possible that we have reached what John Maynard Keynes called a “depressed equilibrium” where capital continues to be hoarded and not used to raise employment levels back to the pre-crash norm, and grow the economy out of the slump. With a private sector awash in debt and refusing to take on more to act as a source of growth, the only other agency with the ability to borrow and spend the economy back to growth is the government.
As the rate of technological growth accelerates, the chances of a technology shock that greatly increases investment seems to rise. New technologies coming onto the market in the coming years — lower-cost photovoltaic solar, 3-D printing, synthetic fossil fuels and more exotic things like asteroid mining — have a lot of potential to create a lot of demand. Yet, just as advanced manufacturing technologies have done in the past, they may end up destroying more jobs than they create. This could further accelerate the big post-2008 redistribution trend — falling wage and salary incomes and rising corporate profits as a percentage of GDP:
This general trend toward the obsolescence of labour is worrying. With less and less demand for labour in the economy due to things like robots, computerisation and job migration we could see more and more people sitting around doing nothing and collecting unemployment cheques. Perhaps this is the accidental fulfilment of the leisure society that Keynes envisaged. As humanity has gotten better at fulfilling our material needs, it takes less labour to do so. The unemployed are caught between a rock and a hard place; social and governmental expectations that able-bodied people should work, up against the economic reality that the demand for labour just doesn’t exist.
Without a technology shock or other exogenous shock, there may be another route out of the depressed equilibrium, and mass unemployment. I am not entirely convinced by Krugman’s argument that high unemployment won’t produce systemic price deflation. With core inflation at its lowest point in history in the United States and falling it does appear possible that the deflationary trend is beginning to accelerate even as headline unemployment gradually creeps down. This has after all been the norm in Japan for the last twenty years. With accelerating deflation, it seems much likelier that we will see both monetary and fiscal policy throwing money at lowering unemployment. But in the long run, if the trend toward the obsolescence of labour continues, this may only buy some temporary respite for the unemployed. In the long run, individuals, governments and society may have to adjust attitudes toward work and employment and adapt to a new normal encompassing less work, and more leisure.
Niall Ferguson’s bizarre attack on John Maynard Keynes which he has now apologised for — claiming that Keynes’ lack of children led to him taking an irresponsible attitude to the long run — has prompted many apt responses regarding the fact that Keynes and his wife tried multiple times to have children, and that Keynes wrote many works that showed an acute thoughtfulness regarding the long run in essays such as Economic Possibilities For Our Grandchildren.
But as soon as I heard Ferguson’s remarks, I re-read Keynes’ famous quote in full:
But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
Keynes is actually saying the opposite of what Ferguson implied he was saying. Keynes is saying that economists who say that in the long run unemployment will fall and markets will move back toward equilibrium are making themselves useless. That unemployment will sooner-or-later fall is almost inevitable — eventually storms end, and rough seas become calm again.
But when unemployment has been high for years, and when the unemployed become so discouraged that they drop out of the labour force in vast numbers it is useless to merely quip that sooner or later markets will restore equilibrium. Having soaring unemployment, discouraged workers, rusting skills, dilapidated infrastructure, weak growth and idle capital now and potentially for years to come is a grossly and grotesquely irresponsible position. The effects of mass unemployment are damaging and lingering to families:
The stress of unemployment can lead to declines in individual and family well-being (Belle & Bullock, 2011). The burden of unemployment can also affect outcomes for children. The stress and depressive symptoms associated with job loss can negatively affect parenting practices such as increasing punitive and arbitrary punishment (McLoyd, 1998). As a result, children report more distress and depressive symptoms. Depression in children and adolescents is linked to multiple negative outcomes, including academic problems, substance abuse, high-risk sexual behavior, physical health problems, impaired social relationships and increased risk of suicide (Birmaher et al., 1996; Chen & Paterson, 2006; Le, Munoz, Ippen, & Stoddard, 2003; Verona & Javdani, 2011; Stolberg, Clark, & Bongar, 2002).
And damaging to wider communities:
Widespread unemployment in neighborhoods reduces resources, which may result in inadequate and low-quality housing, underfunded schools, restricted access to services and public transportation, and limited opportunities for employment, making it more difficult for people to return to work (Brisson, Roll, & East, 2009). Unemployed persons also report less neighborhood belonging than their employed counterparts, a finding with implications for neighborhood safety and community well-being (Steward et al., 2009).
Keynes’ point in the quote Ferguson was discussing was that economists should seek ways and means to minimise such damaging long-term effects. So whether or not we agree with Keynes’ philosophical and political conclusions, it is absolutely misleading to claim that “in the long run we’re all dead” was a call for hedonism or economic irresponsibility.
Any serious criticism of Keynes’ thought requires that critics have actually read and understood Keynes and not just absorbed second-hand caricatures of his ideas.
Current estimates of what is known in the UK as the M4 money supply — cash outside banks, plus private-sector retail bank and building society deposits, plus private-sector wholesale bank and building society deposits and certificates of deposit — show a serious contrast between Britain and the United States:
Could this divergence explain the strong divergence between UK and US real GDP?
I doubt it. It’s a chicken and egg question — does a prolonged deleveraging cycle explain real GDP weakness, or does real GDP weakness explain the prolonged deleveraging cycle? It may in fact be a self-reinforcing spiral effect where the first leads to the second and the second leads to more of the first, and so on. But there are a lot of other factors all of which may be contributing to the worsening situation — protracted weakness in business confidence, tax hikes, spending cuts, weak growth in the Eurozone, elevated youth unemployment, and uncertainty. All these factors are probably contributing to some degree to the weak GDP growth, and the prolonged deleveraging, and thus Britain’s depressionary economic condition.
But we can say that the difference cannot be that Britain’s monetary policy has not been aggressive enough. Britain’s monetary policy has been far more aggressive than that of the United States:
How can we break the cycle? Well, as the above graph shows, more quantitative easing is unlikely to have a beneficial effect. The transmission mechanism is broken. What good is new money if it’s just sitting unused on bank balance sheets? What new productive or useful output can be summoned simply by stuffing the banks full of money if they won’t lend it?
The sad truth is that a huge part of the financial sector has failed. Its inefficiencies and fragilities were exposed in 2008, as a default cascade washed it into a liquidity crisis. And yet we have bailed it out, stuffed it full of money in the hope that this will bring us a new prosperity, in the delusional hope that by repeating the mistakes of the past, we can have a prosperous future.
The sad truth is that the broken, sclerotic parts of the financial sector must fail or be dismantled before the banks will start lending again, start putting monies into the hands of people who can create, innovate and produce our way to growth.
A number of economists and economics writers have considered the possibility of allowing the Federal Reserve to drop interest rates below zero in order to make holding onto money costlier and encouraging individuals and firms to spend, spend, spend.
Miles Kimball details one such plan:
The US Federal Reserve’s new determination to keep buying mortgage-backed securities until the economy gets better, better known as quantitative easing, is controversial. Although a few commentators don’t think the economy needs any more stimulus, many others are unnerved because the Fed is using untested tools. (For example, see Michael Snyder’s collection of “10 Shocking Quotes About What QE3 Is Going To Do To America.”) Normally the Fed simply lowers short-term interest rates (and in particular the federal funds rate at which banks lend to each other overnight) by purchasing three-month Treasury bills. But it has basically hit the floor on the federal funds rate. If the Fed could lower the federal funds rate as far as chairman Ben Bernanke and his colleagues wanted, it would be much less controversial. The monetary policy cognoscenti would be comfortable with a tool they know well, and those who don’t understand monetary policy as well would be more likely to trust that the Fed knew what it was doing. By contrast, buying large quantities of long-term government bonds or mortgage-backed securities is seen as exotic and threatening by monetary policy outsiders; and it gives monetary policy insiders the uneasy feeling that they don’t know their footing and could fall into some unexpected crevasse at any time.
So why can’t the Fed just lower the federal funds rate further? The problem may surprise you: it is those green pieces of paper in your wallet. Because they earn an interest rate of zero, no one is willing to lend at an interest rate more than a hair below zero. In Denmark, the central bank actually set the interest rate to negative -.2 % per year toward the end of August this year, which people might be willing to accept for the convenience of a certificate of deposit instead of a pile of currency, but it would be hard to go much lower before people did prefer a pile of currency. Let me make this concrete. In an economic situation like the one we are now in, we would like to encourage a company thinking about building a factory in a couple of years to build that factory now instead. If someone would lend to them at an interest rate of -3.33% per year, the company could borrow $1 million to build the factory now, and pay back something like $900,000 on the loan three years later. (Despite the negative interest rate, compounding makes the amount to be paid back a bit bigger, but not by much.) That would be a good enough deal that the company might move up its schedule for building the factory. But everything runs aground on the fact that any potential lender, just by putting $1 million worth of green pieces of paper in a vault could get back $1 million three years later, which is a lot better than getting back a little over $900,000 three years later. The fact that people could store paper money and get an interest rate of zero, minus storage costs, has deterred the Fed from bothering to lower the interest rate a bit more and forcing them to store paper money to get the best rate (as Denmark’s central bank may cause people to do).
The bottom line is that all we have to do to give the Fed (and other central banks) unlimited power to lower short-term interest rates is to demote paper currency from its role as a yardstick for prices and other economic values—what economists call the “unit of account” function of money. Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars. More and more, people use some form of electronic payment already, with debit cards and credit cards, so this wouldn’t be such a big change. It would be a little less convenient for those who insisted on continuing to use currency, but even there, it would just be a matter of figuring out with a pocket calculator how many extra paper dollars it would take to make up for the fact that each one was worth less than an electronic dollar. That’s it, and we wouldn’t have to worry about the Fed or any other central bank ever again seeming relatively powerless in the face of a long slump.
First of all, I question the feasibility of even producing a negative rate of interest, even via electronic currency. Electronic currency has practically zero storage costs. What is to stop offshore or black market banking entities offering a non-negative interest rate? After all, it is not hard to offer a higher-than-negative rate of interest for the privilege of holding (and leveraging) currency. A true negative interest rate environment may prove as unattainable as division by zero.
But assuming that such a thing is achievable, I think that a negative rate of interest will completely undermine the entire economic system in clear and visible ways that I shall discuss below (“white swans”), and probably also — because such a system has never been tried, and it is a radical departure from the present norms — in unpredictable and emergent ways (“black swans”).
Money has historically had multiple functions; a medium of exchange, a unit of account, a store of purchasing power. To institute a zero interest rate policy is to disable money’s role as a store of purchasing power. But to institute a negative interest rate policy is to reverse money’s role as a store of purchasing power, and turn money into a drain on purchasing power.
Money evolved organically to possess all three of these characteristics, because all three characteristics have been economically important and useful. To try to strip currency of one of its essential functions is to risk the rejection of that currency.
How would I react in the case of negative nominal interest rates? I’d convert into a liquid medium that was not subject to a negative rate of interest. That could be a nonmonetary asset, a foreign currency, a digital currency or a precious metal. I would actively seek ways to opt out of using the negative-yielding currency at all — if I could get by using alternative currencies, digital currencies, barter, then I would. I would only ever possess a negative-yielding currency for transactions (e.g. taxes) in which the other party insisted upon the negative-yielding currency, and would then only hold it for a minimal period of time. It seems only reasonable that other individuals — seeking to avoid a draining asset — would maximise their utility by rejecting the draining currency whenever and wherever possible.
In Kimball’s theory, this unwillingness to hold currency is supposed to stimulate the economy by encouraging productive economic activity and investment. But is that necessarily true? I don’t think so. So long as there are alternative stores of purchasing power, there is no guarantee that this policy would result in a higher rate of economic activity.
And it will drive economic activity underground. While governments may relish the prospect of higher tax revenues (due to more economic activity becoming electronic, and therefore trackable and traceable), in the present depressionary environment recorded and taxable economic activity could even fall as more economic activity goes underground to avoid negative rates. Increasingly authoritarian measures might be taken — probably at great cost — to encourage citizens into using the negative-yielding legal tender.
Banking would be turned upside down. Lending at a negative rate of interest — and suffering from the likely reality that negative rates discourages deposits — banks would be forced to look to riskier or offshore or black market activities to achieve profits. Even if banks continued to lend at low positive rates, the negative rates of interest offered to depositors would surely lead to a mass depositor exodus (perhaps to offshore or black market banks offering higher rates), probably leading to liquidity crises and banking panics.
As Izabella Kaminska wrote in July:
The simple fact of the matter is that in a negative carry world – or a flat yield environment for that matter – there is no role or purpose for banks because banks are forced into economically destructive practices in order to stay profitable.
Additionally, a negative-yielding environment will result in reduced income for those on a fixed income. One interesting effect of the present zero-interest rate environment is that more elderly people — presumably starved of sufficient retirement income — are returning to the labour force, which is in turn crowding out younger inexperienced workers, who are suffering from very high rates of unemployment and underemployment. A negative-yielding environment would probably exacerbate this effect.
So on the surface, the possibility of negative nominal rates seems deeply problematic.
Japan has spent almost twenty years at the zero bound, in spite of multiple rounds of quantitative easing and stimulus. Yet Japan remains mired in depression. The fact remains that both conventional and unconventional monetary policy has proven ineffective in resuscitating Japanese growth. My hypothesis remains that the real issue is the weight of excessive total debt (Japan’s total debt load remains as precipitously high as ever) and that no amount of rate cuts, quantitative easing or unconventional monetary intervention will prove effective. I hypothesise that a return to growth for a depressionary post-bubble economy requires a substantial chunk of the debt load (and thus future debt service costs) being either liquidated, forgiven or (often very difficult and slow) paid down.
If one thing has changed in the last one hundred years in economics it has been the huge outgrowth in the usage of mathematics:
This is largely a bad development, for a number of reasons.
First of all layers of mathematics acts as a barrier to public understanding. While mathematics is a useful language for communicating complex ideas, those without training in mathematics will struggle to grasp what an author is trying to communicate if a paper consists mostly of equations untranslated into English. This is bad practice; it is easier to baffle with bullshit in an unfamiliar language than it is in plain English.
Second, mathematical models are always simplifications. Human action and economic behaviour is complex and unpredictable. While mathematical models can sometimes approximate a pattern quite well and so have some limited uses as toys, the complexity of human behaviour means that there are always unmodelled variables that can throw off a model’s output. Over-reliance upon or excessive faith in mathematical models can lead to bad forecasting and bad policy decisions. The grand theoretical-mathematical approach to economics is fundamentally flawed.
Third, attempting to smudge the human reality of economics into cold mathematical shackles is degenerative. Economics is a human subject. Human behaviour is not mechanical, it is not mechanistic. Physicists can very accurately model the trajectories of rocks in space. But economists cannot accurately model the trajectories of prices, employment and interest rates down on the rocky ground.
Economics would benefit from self-restraint in regard to the usage of mathematics. Alfred Marshall made some useful suggestions:
- Use mathematics as shorthand language, rather than as an engine of inquiry.
- Keep to them till you have done.
- Translate into English.
- Then illustrate by examples that are important in real life
- Burn the mathematics.
- If you can’t succeed in 4, burn 3. This I do often.
I hope the blowout growth in mathematics in economics is a bubble that soon bursts.
Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
Sir John Templeton
Buy the fear, sell the greed. Since bottoming-out in 2009 markets have seen an uptrend in equity prices:
Now it seems like the euphoria is setting in. And in perfectly, deliciously ironic time, as shares of AIG — the behemoth at the heart of the 2008 crash — are returning to the market. Because reintroducing bailed-out companies to the market worked well last time didn’t it?
Markets are down a hair today, but the theme of the morning is clear: Uber-bullishness. Everywhere.
This is the most unanimously bullish moment we can recall since the crisis began.
Note that this comes as US indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.
Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally.
Bank of America’s Mary Ann Bartels:
Macros bought the NASDAQ 100 to a net long for the first time since June, continued to buy the S&P 500 and commodities, increased EM & EAFE exposures, sold USD and 10-year Treasuries. In addition, macros reduced large cap preference.
J.P. Morgan’s Jan Loeys:
We think the positive environment for risk assets can and will last over the next 3-6 months. And this is not because of a strong economy, as we foresee below potential global growth over the next year and are below consensus expectations. Overall, we continue to see data that signal that world growth is in a bottoming process.
SocGen’s Sebastian Galy:
The market decided rose tinted glasses were not enough, put on its dark shades and hit the nightlife.
And the uber-bullishness is based on what? Hopium. Hope that the Fed will unleash QE3, or nominal GDP level targeting and buy, buy, buy — because what the market really needs right now is more bond flippers, right? Hope that Europeans have finally gotten their act together in respect to buying up periphery debt to create a ceiling on borrowing costs. Hope that this time is different in China, and that throwing a huge splash of stimulus cash at infrastructure will soften the landing.
But in the midst of all that hopium, let’s consider at least that quantitative easing hasn’t really reduced unemployment — and that Japan is still mired in a liquidity trap even after twenty years of printing. Let’s not forget that there is still a huge crushing weight of old debt weighing down on the world. Let’s not forget that the prospect of war in the middle east still hangs over the world (and oil). Let’s not forget that the iron ore bubble is bursting. Let’s not forget that a severe drought (as well as stupid ethanol subsidies) have raised food prices, and that food price spikes often produce downturns. Let’s not forget the increasing tension in the pacific between the United States and China (because the last time the world was in a global depression, it ended in a global conflict).
It would be unwise for me to predict an imminent severe downturn — after all markets are irrational and can stay irrational far longer than people can often stay solvent. But this could very well be the final blow-out top before the hopium wears off, and reality kicks in. Buying the fear and selling the greed usually works.
John Cochrane thinks that central banks can attain the price-stability of the gold standard without actually having a gold standard:
While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.
The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.
The obvious point is that the CPI is a relatively poor indicator of inflation and bubbles. During Greenspan’s tenure in charge of the Federal Reserve, huge quantities of new liquidity were created, much of which poured into housing and stock bubbles. CPI doesn’t include stock prices, and it doesn’t include housing prices; a monetary policy that is fixed to CPI wouldn’t be able to respond to growing bubbles in either sector. Cochrane is not really advocating for anything like the gold standard, just another form of Greenspanesque (mis)management.
Historically, what the gold standard meant was longer-term price stability, punctuated by frequent and wild short-term swings in purchasing power:
In its simplest form (the gold coin standard), gold constrains the monetary base to the amount of gold above ground. The aim is to prevent bubble-formation (in other words, monetary growth beyond the economy’s inherent productivity) because monetary growth would be limited to the amount of gold dug out of the ground, and the amount of gold dug out of the ground is limited to the amount of productivity society can afford to spend on mining gold.
Unfortunately, although gold levels are fixed, levels of credit creation are potentially infinite (and even where levels of credit creation are fixed by reserve requirements, shadow credit creation can still allow for explosive credit growth as happened after the repeal of Glass-Steagall). For example, the 1920s — a period with a gold standard — experienced huge asset bubble formation via huge levels of credit creation.
In any case, I don’t think that the current monetary regimes (or governments — who love to have the power to monetise debt) will ever change their minds. The overwhelming consensus of academic economists is that the gold standard is bad and dangerous.
In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:
If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.
That question is skewed. A gold standard can also be a discretionary regime; gold can be devalued, it can be supplemented with silver, and it can be multiplied by credit. And the concept of “price-stability” is hugely subjective; the Fed today defines “price stability” as a consistent 2% inflation (which on an infinite timeline correlates to an infinite level of inflation — the only stable thing being the rate at which the purchasing power of a dollar decreases).
If anything, the events of 2008 — which I interpret as a predictable and preventable housing, securitisation, and debt bubble stemming very much from central bank mismanagement of the money supply under Greenspan — secured the reputation of central banking among academic economists, because the bailouts, low rates and quantitative easing have prevented the feared debt-deflation that Milton Friedman and Ben Bernanke postulated as the thing that prolonged and worsened the Great Depression.
The Japanese example shows that crashed modern economies with excessive debt loads can remain stagnant for long periods of time. My view is that such nations are in a deleveraging trap; Japan (and more recently the Western nations) hit an excessive level of debt relative to GDP and industry at the peak of the bubble. As debt rises, debt servicing costs rise, leaving less income for investment, consumption, etc.
Throughout Japan’s lost decade, and indeed the years that followed, total debt levels (measured in GDP) have remained consistently high. Simply, the central bank did not devalue by anywhere near enough to decrease the real debt load, but nor have they devalued too little to result in a large-scale liquidation episode. They have just kept the economy in stasis, with enough liquidity to keep the debt serviceable, and not enough to really allow for severe reduction. The main change has been a transfer of debt from the private sector, to the public sector (a phenomenon which is also occurring in the United States and United Kingdom).
Eventually — because the costs of the deleveraging trap makes organically growth very difficult — the debt will either be forgiven, inflated or defaulted away. Endless rounds of tepid QE (which is debt additive, and so adds to the debt problem) just postpone that difficult decision. The deleveraging trap preserves the value of past debts at the cost of future growth.
Under the harsh discipline of a gold standard, such prevarication is not possible. Without the ability to inflate, overleveraged banks, individuals and governments would default on their debt. Income would rapidly fall, and economies would likely deflate and become severely depressed.
Yet liquidation is not all bad. The example of 1907 — prior to the era of central banking — illustrates this.
As the WSJ noted:
The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.
Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.
Although liquidation episodes are painful, the clear benefit is that a big crash and depression clears out old debt. Under the present regimes, the weight of old debt remains a burden to the economy.
But Cochrane talking about imposing a CPI-standard (or Greenspan talking about returning to the gold standard) is irrelevant; the bubble has happened, it burst, and now central banks must try to deal with the fallout. Even after trillions of dollars of reflation, economies remain depressed, unemployment remains elevated and total debt (relative to GDP) remains huge. The Fed — almost 100 years old — is in a fight for its life. Trying to balance the competing interests of creditors — particularly those productive foreign nations like China that produce much of America’s consumption and finance her deficits — against future growth is a hugely challenging task. The dangers to Western economies from creditor nations engaging in punitive trade measures as a retaliatory measure to central bank debasement remain large (and the rhetoric is growing fiercer). Bernanke is walking a tightrope over alligators.
In any case even if a gold standard were to be reimposed in the future, history shows that it is unlikely to be an effective stop against credit bubbles. Credit bubbles happen because value is subjective and humans are excitable, and no regime has proven itself capable of fully guarding against that. Once a credit bubble forms, the possibilities are the same — liquidation, inflation or debt forgiveness. Today, central banks must eventually make a choice, or the forces of history will decide instead.