Saturday, January 30, 2010

The Precarious State of Our Union

by Peter Schiff**

[Blogger's note: Peter Schiff is president of Euro Pacific Capital. I wanted to write a brief commentary about Mr. Obama's State of the Union speech; however, after reading Mr. Schiff's article, he explains exactly my views...enjoy!]

In this week's much anticipated State of the Union address, President Obama again demonstrated his poor understanding of the fundamental problems that confront our nation. By following the advice of the same people who helped guide our economy to the precipice of total collapse, Obama now threatens to push it over the edge.

Notwithstanding his well crafted lip service regarding future spending restraint, the essence of his current program is for more government spending and larger deficits. For all his talk about job creation, his policies will further burden those who might otherwise create those jobs with higher taxes and more regulation. While he did call for tax cuts for the middle class and offered what amounts to bailouts for those struggling to repay student loans, such cuts do nothing to promote growth in the near term and will add to the deficits in the long term.

The President spoke optimistically about the future, but in reality there is little evidence to support such an upbeat outlook. He began his speech by assuring us that the worst of the storm had passed. General Custer may have said something similar when the first wave of Indian attacks ebbed at Little Big Horn.

While Obama did have some harsh words for Wall Street (not exactly a courageous political stance), he leveled no criticism at the Federal Reserve or other government agencies that had financed and guaranteed all the ridiculous real estate speculation that precipitated the crash. And while he at least conceded that the prosperity of the last decade was based on illusions, he continued to endorse the very policies that produced the mirage in the first place.

To lead us back to brighter days, he articulated a vision of a centrally planned recovery, where clean energy and a Soviet style five-year plan to double our exports would make our economy preeminent once more. He fails to understand that the only reason our economy rose to the top in the first place is that the government left it alone.

In the words of the Spanish philosopher George Santayana, "Those who cannot learn from history are doomed to repeat it." Since our President cannot even learn from the mistakes of his immediate predecessor, to say nothing of those he made himself while in the Senate or during his first year as president, we are surely doomed to repeat them, perhaps more quickly than Santayana could have imagined.

Rather than tightening the reins on the reckless monetary policy that undermined our savings, diminished our industrial output, inflated asset bubbles, and led to reckless speculation on Wall Street and excess consumption on Main Street, we are loosing them further. Rather than repealing regulations that distort markets and create moral hazards, we are adding new ones that do more of the same. Rather than cutting government spending to reduce the burden it places on our economy, we are increasing both the amount of the spending and the size of the burden. Rather than making government smaller so that the private sector can grow, we are making government bigger and forcing the private sector to shrink. Rather than paying off our debts we are taking on even more. Rather than encouraging people to save we are enticing them to spend. Rather than creating jobs, we are merely creating unemployment benefits.

As a result, instead of seeding the soil for a real recovery we are setting the stage for a prolonged depression.

The Size and Power of the State (The Economist)

The eminent scholar Jacquez Barzun, in his masterpiece, From Dawn to Decadence, stated we live in an age of absurdity; that is, an age where the attitudes and behaviors exuded by society contradict the visible activities prevalent and commonly accepted. This would be a form of cogitative dissonance on a massive scale. I like the definition of the word “absurd” given by the Merriam-Webster dictionary. It is defined as, “ridiculously unreasonable, unsound, or incongruous.” There is no way to better describe a recent leading article I read in The Economist, which commented on the enormous expansion of government over the recent years. It is filled with half-truths, inconsistencies, omissions, and distortions. To the untrained eye, these observations are non-existent or difficult to pluck. What makes articles like this stand out is that they are sprinkled with veracity, which gives them an aura of accuracy. While providing a full-length correction of the absurdities mentioned in the article would take a book in and of itself, I will make mention of several statements that stand out and then provide an explanation that The Economist fails to mention. I don’t expect to change minds sank deep in ideology, but I do hope to motivate your thinking against what is propagated by court economists and the establishment presently in power.

The Economist recognizes that the trend of government expansion must be curtailed. This is part of the periodical’s economic standard. In particular, the periodical stands for “looking for ways to make the state smaller. That is partly for philosophical reasons: we prefer to give power to individuals, rather than government.” There is absolutely no doubt of its position, which I fully agree. Yet, for the sake of what it terms as “pragmatism”, it forsakes its moral standing on this issue by essentially promoting a system that undermines the very tenets it prescribes to hold. The articles states the following:
“A further danger consists in equating 'smaller' with 'better'. As the horrors in Haiti demonstrate, countries need a state of a certain size to work at all; and more government can be good. The Economist, for instance, is relieved that politicians stepped in to bail out the banks, since the risks of tumbling into a depression were large. This newspaper also supported Mr Obama in 2008 in part because he wanted to extend health-care coverage.”

While equating smaller with better is not necessarily true, more government is always worse. I am not advocating a system where there are no laws or enforcements of contracts. On the contrary, I advocate a government set under the premise of the U.S. Constitution and Declaration of Independence, whereby voluntary transactions cannot be violated in the name of “doing good”. There is nothing in either document that promotes in favor of the central government providing health insurance or any bank bailout for that matter. The U.S. Constitution explicitly exhorts a decentralized authoritative regime. However, over the last century, this idea has been replace by the idea of collectivism. The Economist does not see this. Many policymakers and layman do not understand this shift in thinking. But in the name of “pragmatism”, The Economist is willing to accept the enlargement of the state, which is the very thing that it opposes. Confuse? Makes no sense? Yes, surmised correctly. This is the very embodiment of absurdity.

Government cannot produce economic output; it merely redistributes resources, often done by force. In essence, they are robbing Peter to pay Paul, and in the process they take a cut (i.e. pay themselves) for providing this “service.” Interest groups vote according to which political candidate will give them more money that belongs to other interest groups. Presently, the few that recognize this as form of theft are voices crying in the wilderness: there’s hardly a chance of being heard. “Oh, wait a minute,” someone might say, “the government provides security, it builds roads, it does many good things.” Of course, anyone can do “good things” with someone else’s money. This has always been the case throughout history. And let us not forget the aphorism: “the road to hell is paved with good intentions.” The foregoing statements at its core presume that people are naturally inept and cannot look out for themselves; therefore a central government is required to exist. Indeed, the government was intended to be a provider of security: as the US Constitution claims, the government has the power to protect life, liberty, and the pursuit of happiness, nothing more, nothing less.

But what obfuscates further this situation is that The Economist gives credence to the notion of “state capitalism: more and more of the world biggest companies are state-owned, and more and more of its biggest investors are now sovereign wealth funds.” This is absolutely downright silly. How can two contradictory terms be enjoined to create a coherent idea? Claiming that there is such a thing as “state capitalism” is like saying that a professional bartender runs Alcoholic Anonymous, or like saying that a fox is the best keeper of the hen house. Property rights within the framework of the law define capitalism. The state exists to enlarge itself and subsequently restrict property rights to continue that expansion. The impulse of state intrusion is dependent upon the whims of the present age by way of manipulation and control of the masses (read Le Bon’s The Crowd: A Study of the Popular Mind).

Communism and its light version, socialism, have grown out of this process; yet, The Economist, an economic and political liberal publication at times overtly promotes this philosophy. One can go on and on elucidating the lack of coherency in much of the article. But for now, this will do.

Wednesday, January 27, 2010

The Bizarro Economics of Government Spending

By Bill Bonner

[Blogger's Note: It always pays to listen/read from those hand-full of individuals who saw this economic mess coming while many slept at the wheel. Mr. Bonner is one of them!].

Good news and bad news. But which is which? The situation is so confused, we can’t tell.

The good news is that housing prices are going down. That’s what The Wall Street Journal says. “Home prices declined in November.” Good. People will be able to find more affordable housing.

Wait. That’s not good news, is it? Doesn’t that mean we’re still in a depression? Besides, another report says housing is going up. What to believe?

Let’s try something else… Consumer confidence rose in the latest reporting period. No argument there…

Now, that’s definitely good news, right? Nope. The better things get the more likely the feds are to clamp down on the recovery by “exiting” their stimulus efforts and reducing the deficit. That’s part of the reason stocks often decline when the news is “good” and go up when it is “bad.” Investors are afraid the feds will take away the juice. That would risk a return of the “error of ’37,”…say economists such as Paul Krugman and Richard Koo. Ignoring the calendar a bit…it would turn our president into “Herbert Hoover” Obama, as one commentator suggested.

What happened in the ’30s? Well, in the approved storyline, the feds had their stimulus foot to the floorboards…and they were happily driving right out of the depression. But fearing inflation…deficits…and a backlash against excessive spending (and believing that they were clear of the bad neighborhood) – they slowed down…they eased off their stimulus efforts in the mid-’30s. This sent the economy into another downturn and stretched the depression out for another 3 years.

It’s nonsense. What really caused the relapse of ’37 was the feds’ own meddling. But that’s not the way mainstream economists and analysts look at it. In their cockamamie view, an economy grows thanks to the good stewardship of publicly elected officials. In their view, government spending is actually BETTER than private spending. Why? Because it produces nothing of value. Really; we’re not making this up. And so what if the government doesn’t have any money? To them, money that doesn’t exist – created ‘out of thin air,’ as Keynes put it – is BETTER than real money. Because it creates consumer price inflation. Up is down. Good is bad. Better is worse. In their view, what makes a strong economy is government action. Specifically, government spending. So, anything that might incline the feds to spend less is BAD news.

According to the papers, there’s some bad news coming. ’Cause Mr. President is going to tell the nation in his State of the Union address that it’s time to put on the brakes. If we don’t, people will get the impression that government spending is out of control. We can’t have that. Because lenders might refuse to lend. Investors might refuse to invest. Voters might refuse to vote for the scalawags now in office.

On the other hand, if the Prez really does cut spending, none of the aforementioned are likely to be very happy about it. Federal spending doesn’t really make people richer; it makes them poorer. Still, appearances are what really matter. Dim economists want a president who puts into action their loopy theories. And dim voters want a president who takes action to save them from their own mistakes…especially when it means getting their hands on someone else’s money.

The stimulus offered by government spending is phony. But it appears real to the masses. Take it away and the economic consequences will appear very real too. The ‘creative destruction’ of the market will finally get to express itself. Businesses that should fail will fail. Speculators who ought to lose money will lose money. There will be blood, in other words.

Like most people, we don’t mind a little blood…as long as it’s not our own. So you can imagine how the parasites will howl when they see the knife draw near to their own arteries!

They can relax. The feds are not likely to reduce spending significantly. The deficits are structural…they’re built-in to the system…they won’t go away.

And as the depression lingers, the debt piles up…

What will happen? We don’t know. We can’t look into the future. But we can look at Japan…a country that is at least 10 years ahead of us.

Why is Japan ten years ahead? Because its stock market turned down in 1989…a decade ahead of Wall Street. And because its population is about 10 years older. And because it’s been fighting the de-leveraging process for 20 years. What can we learn? Here’s the latest from the WSJ, warning of an explosion:

“S&P lowers Japan’s outlook to negative.”

Uh oh. Not too encouraging. The rating agency told Japan that if it didn’t cut its deficits its debts would be downgraded.

Ah yes… Thanks to the Japanese, we get to see someone cross the minefield ahead of us. After 20 years, Japan hasn’t been able to get clear. But it hasn’t blown up completely, either.

But watch closely. It’s putting its feet down on some dangerous ground. Deficits have grown and grown and grown. Now, it risks an explosion with every step. This year, it will borrow $480 billion. It will receive only $405 billion in tax revenue. As far as we know, no major economy has ever run so far into the red without a blow-up.

And what can it do? They are getting the same sort of advice as Obama. They’re told they must cut the deficit to protect the currency…the economy…and the credit rating. But they’re also told that good is bad, or bad is good…that if they do the right thing – cutting the deficit – the economy will suffer. Tax revenues will fall further…widening the deficit!

The Japanese economy has become so dependent on debt-fueled government spending that, take it away and things fall apart. In the long run, that is exactly what should happen. The economy needs a shake-up…so it can rebuild on more solid foundations. But what politician wants to risk his own blood?

Tuesday, January 26, 2010

A Blast From The Past - A Tribute To You, Mr. Obama

I wrote the following piece in late 2008, just prior to the victory of Mr. Obama. Given that he is going to be giving his state of the union address this evening, i present you with this blast from the past...


Saturday, January 23, 2010

The Monetary Base (as-of week ending 1/21/10)

This is the most recent graph of the adjusted monetary base, which is produced by the St. Louis Federal Reserve Bank.

What is evident is the pace of growth has moderated, and most recently, has declined. Should this continue, an sharp fall in the real and stock market is inevitable. However, if the Central Bank ramps up money creation, it risks making the forthcoming price inflation worse. Price inflation has not reared its ugly head because banks have not lent the money provided by the FED. Banks are not lending because not only there are fewer worthy borrowers but also because their balance sheets are still weak. As a result, excess reserves--the amount of money exceeding the legal requirement--are still elevated. If these reserves were disbursed into the economy, then fractional reserve banking would multiply money many times over. Price inflation is envitable in this environment.

There are only two feasible options going forward: 1) reduce the monetary base, thereby reducing the money supply. This will cause yields to increase, markets to fall, and creating a severe economic slump. 2) Increase the monetary base, thereby stocking inflation, and potentially killing the currency. What is always difficult to assess is the severity of either outcome.

Stay tuned...

Wednesday, January 20, 2010

Ben Bernanke has learnt so little

By Edward Chancellor
Published: January 10 2010 (Financial Times)

[Note: Mr. Chancelor is a member of GMO’s asset allocation team]

Academic economists and central bankers have long argued that asset price bubbles cannot be identified before they burst.

Furthermore, they deny that monetary policy is responsible for creating bubbles. It seemed likely the financial crisis, which followed an era of low rates and housing bubbles, would lead them to reassess these views. Yet despite the economic calamity, the Bernanke-led Federal Reserve has adopted a remarkably unrepentant line.

In his first speech of the year, Ben Bernanke commends policymakers (including himself) for their “forceful responses...that have] avoided an utter collapse of the global financial system.”

However, Mr Bernanke isn’t taking any responsibility for taking us to that brink. The prolonged period of low interest rates after the technology bust, he maintains, was justified because the recovery was weak and there was a risk of deflation.

Did ultra-low rates have the unintended consequence of inflating a housing bubble? Absolutely not, says Mr Bernanke. Given quiescent inflation, interest rates weren’t inappropriate. Besides, house prices started to take off in the late 1990s before the easy money era. The Fed chief cites a recent paper by his own staffers ( Jane Dokko et al, Monetary Policy and the Housing Bubble) that reports “only a small portion of the increase in house prices earlier this decade can be attributed to the stance of US monetary policy”.

The Fed researchers arrive at this institutionally comforting conclusion by using the same econometric models that failed to identify any connection between low rates and the incipient housing bubble at the time. These models have grandiose names, such as “vector autoregression” and “dynamic stochastic general equilibrium”, and employ complex statistical formulae that are beyond the comprehension of laymen. The fact these models were of no use in forecasting the financial crisis is conveniently overlooked.

The unrepentant central bankers also claim that the “setting of monetary policy [after 2002] appeared to follow the broad contours that would be expected given conventional macroeconomic views”. That these views denied the existence of the housing bubble at the time of its formation is also overlooked. In economics, apparently, it is better to fail conventionally than to succeed unconventionally.

Mr Bernanke’s compliant researchers find only a “tenuous connection” between low interest rates after 2002 and the housing bubble. Instead, they blame the housing boom on financial innovation – in particular, mortgage securitisation. They conclude that better regulation rather than a more restrictive monetary policy will prevent dangerous bubbles from forming in future.

The Fed has returned to its old view, maintained during the Greenspan years, that bubbles cannot be recognised ex ante. Nor does the Bernanke Fed accept that glaring macroeconomic imbalances that characterised the last decade – such as the rapid growth of private sector credit, the falling savings rate, and the gaping current account deficit of the mid-2000s – were useful leading indicators of an approaching crisis.

It seems incredible that Mr Bernanke and his colleagues have learnt so little from the recent calamity.

For a start, securitisation is unlikely to be a prime cause of the global housing bubble since home prices soared in many countries, such as Spain and Australia, which didn’t abound with exotic mortgage products. Given the dollar’s role as the global reserve currency, the Fed’s loose monetary policy had a far more extensive effect. Furthermore, housing bubbles are not difficult to spot. At GMO, we look at the ratio of home prices to median household income. When this ratio reaches two-standard deviations from the mean, we’re pretty confident a bubble has formed.

The connection between a loose monetary policy and asset price bubbles is pretty obvious to anyone with the slightest economic intuition: low rates make it cheaper to borrow, while acquisitions financed with credit drive up asset prices.

The Victorian economist Walter Bagehot was fond of repeating that “John Bull can stand many things but he can’t stand 2 per cent”. That is to say, when interest rates are very low people will be driven to speculate. Bagehot would certainly have understood that when the Fed Funds rate was cut to 1 per cent in 2003, a bubble in housing and other assets was likely to develop.

Saturday, January 16, 2010

Intolerance of small crises led to this big one

This is my critique of a recent op-ed written by Poland's finance minister. While the minister makes some eloquent and logical arguments, he misses on some key points. Below you will find his full-length article, along with my bold-faced commentary interjected throughout.


The financial crisis was not a crisis of capitalism or globalisation. Instead it is a crisis of the "deep Keynesian project", according to which the aim of economic policy should be the maximum smoothing out of fluctuations in the real economy (as long as consumer price inflation is kept under reasonable control). While the tools of this policy approach were very different in the boom years preceding the crisis from traditional Keynesian ones, relying more on monetary than on fiscal policy, the fundamental aim was quintessentially Keynesian. The crisis is the logical outcome of the success of this policy for almost 20 years.

Absolutely. To add more granularity to Mr. Rostowski’s statements, central banks and foreign governments went on a spending spree. That is, the former printed money out of thin air while the latter consumed (i.e. their citizen’s wealth) what they did not have. What alleviated the price inflation push was the unparallel liberalization of the Chinese economy and the influx of cheap labor force once communism fell in Europe. In fact, this crisis has been in the making ever since the independent monetary restraint in the form of the gold standard was loosened (in 1914) and absolutely done away with it (in 1971).

What drives the market is the balance between fear and greed. If economic policy eliminates fear, only greed remains, and there is no mechanism to limit "irrational exuberance". This was the fundamental cause of the crisis. Moral hazard and herd behaviour are natural consequences.

This is one way to look at it. Indeed, fear and greed can be seen as the opposite ends of a spectrum. The large majority would concede that greed is never good; and the same can be said of fear. The market, which is ultimately made up of people willing to bid and offer what is deemed in their best interest, is not an absolutely impersonal and autonomous force. Society, through its moral attributes, undergirds the function of the market. Having said that, the only limitation placed on the market must come from society itself, not from any outside agent (e.g. government), whose ultimate actions must invariably be exerted through force. Therefore, there is already an innate mechanism to limit irrational exuberance (i.e. society): contrary to popular belief, the consumer determines prices, not business. Interfering with this mechanism inevitably leads to moral hazard and perverse incentives that manifest themselves in herd behavior.

The essence of global monetary policy before the crisis was the "Greenspan put" - the attempt of the then Federal Reserve chairman to prop up the securities markets by lowering interest rates, so as to avoid even mild recessions. The danger is that this policy will be continued after the crisis. The natural state of capital markets from which fear has been removed is the generation of asset bubbles. If global policymakers do not understand this, bubbles are likely to proliferate through carry trade from the US and other countries with minimal interest rates and weak currencies.

Agree. The “fear” Mr. Rostowski refers to here is actually the fear by the large corporations of going bankrupt because either the Central Bank or the government will not bail them out. Anyone with any business sense will realize that income losses frighten owners because consistent red marks will ultimately put an end to their endeavors. Remove that fear through implicit guarantees (moral hazard) and what you have is a recipe for disaster. The magnitude of the disaster will be in proportion to the level of distortion by the government. Against this backdrop, expect the next crisis to be greater in comparison to the recent one we experienced.

Weak regulation and supervision were not the fundamental problems, although they can and should be improved. Countries not in crisis - China, Poland and much of Latin America - were, above all, those with low leverage, not those with sophisticated financial supervision.

Good point. The hot shots in DC seem oblivious to this fact.

In the 1970s, ordinary Keynesianism was discredited when the Phillips curve collapsed. The alleged trade-off between inflation and unemployment turned out not to exist. Keynesian policy merely justified ever larger budget deficits and higher inflation, until policymakers understood that it led only to higher permanent unemployment. The old goal of reasonably balanced state budgets was rehabilitated.

And yet politicians, policymakers, and the majority of the economic profession call for the same failed policies to be enacted. We are witnessing the incarnation of the Biblical proverb that says, “as a dog returns to its vomit, so a fool repeats his folly.”

Moral hazard must be reduced. Fear should be greater on Wall Street and in the City of London to reduce the fear of ordinary citizens. Very loose monetary policy is rebuilding financial institutions' capital, which is good, but it must not be allowed to go on for so long that new bubbles arise.

There is a conceptual problem here. Loose monetary policy, which is basically printing money out of thin air, is not creating capital. It is digits, paper with ink which has no intrinsic value. Sure, it fetches some price, but it has no value. This is why we say that our current monetary system is fiat-based—that is, money created by decree. Capital, on the other hand, is not so easily created. It is the excess of what is consumed by the private economy. Simply printing money and calling it capital is disingenuous at best and the lack of understanding the nature of money at worst.

It is impossible to accept, unless we are blind by cognitive dissonance, the same institutional policy and framework (promoted and endorse by central banks) that generate the boom/bust cycle. Bubbles will inevitably arise any time loose monetary policy is executed, just as Mr. Rostowski previously commented.

The easy institutional change that is needed is to limit the size of financial groups. To judge from the current economic policy debate, especially in the US, banks that are too big to fail continue to prevail. Such banks capture their governments and are subject to loose budget constraints of an almost Soviet-era type, because they know the government will bail them out. Strong implicit state guarantees mean that greed untempered by fear will be their rational behaviour.

What is the right size of a financial group? Why just financial groups and not other industries? Who determines the size of these firms? Who will be responsible to ensure that firm size is not determined by political means? These are just a few questions that Mr. Rostowski avoids. There is nothing inheritably wrong with the size of a financial group (or any company for that matter), so long as it is achieved in a competitive environment, within the framework of the law, and without special treatment. In other words, if a firm has a competitive advantage because it provides a low-cost service that people want, then there is nothing immoral with having a large market share. However, if the firm has a government-sponsored monopoly (e.g. only domestic airlines can provide service within the U.S.), then the market share is not the result of competitive forces but rather manipulated ones. However, putting Mr. Rostowski consideration into practice will create bureaucracy, the very same system that generates the policies he is gently excoriating.

There should never be a policy of “too-big-to-fail.” Failure to comply will only breed in the future more of the behavior that such policy is purported to be curtailing. This fact cannot be circumvented.

The harder institutional change is to induce policymakers to give up the "deep Keynesian project". This is very hard, because policymakers probably will never be rewarded for allowing small crises or small recessions. Yet, this is the only way to avoid herd behaviour and so to prevent big financial crises and "Great Recessions".

Politicians will almost never give up power they have attained. The objective of the politician once he/she is in power is to perpetuate that power, if not for him or her, then for the party or interests they represent. Politicians will never let a small (or big) crisis go to waste. It will be used for their chief end.

As for current policy, the present, very loose, monetary policy should be enough - we do not need a very loose fiscal policy also. The fiscal stimulus measures in 2008 and 2009 were hardly necessary. The recession is over and very little of the stimulus has yet arrived. It will do so in 2010 and 2011 when no longer needed. Automatic stabilisers - less tax collection and larger social transfers - were probably sufficient and certainly timely. Any additional discretionary public expenditures should have been avoided and should now be withdrawn.

The fiscal stimulus measures simply distort capital allocation within an economy. For instance, the tax credit for first time homebuyers in the U.S. caused a spur in demand for houses. Similarly, the “cash-for-clunkers” scheme caused an in increase in demand for new cars. Had these measures not been in place such purchases would not have occurred (or at least at the pace that they did). Therefore, it is of no surprise that once these palliative measures subsided, demand went with it [note: the home-buying credit has been extended, so demand has not fully equilibrated]. Always and everywhere discretionary public expenditures must be avoided not only for the reasons just mentioned but also because it must be funded by taking resources from an individual who could have put it to better use.

Instead, our major challenge is to contain public expenditure and restore fiscal balance. The big concern for the west is elevated public debt. It is doubtful whether debt levels above 100 per cent of gross domestic product are fiscally sustainable, but more and more countries are heading that way. The world needs smaller and more rational entitlement systems, not more discretionary spending, which has a tendency to become permanent. There should be no new mandatory expenditures for years to come.

Agree. Yet, making this a reality will take political courage (read: resign to overarching federal power). While I remain hopeful that this will happen, I am not sanguine it will occur in an orderly fashion. That is, I perceive a major fiscal crisis ultimately emanating from the exorbitant debt load.

The one big success in the current global crisis has been that no protectionist spiral has developed, but one success and many failures does not amount to an impressive scorecard.

Taking an objective look at the politicians’ scorecards, this is hardly ever the case

Tuesday, January 12, 2010

The Myth of Retirement

Recently I had a conversation with a colleague. It originated as I shared with him an article regarding the current state of the economy written by renown money manager. His response, while astute and thought provoking, was said from the wrong perspective. He asked, “what am I going to do with this information…is it going to help me make money?” He went on to explain to me his retirement position and of those of his next of kin whom he indirectly advises. He seemed anxious to jump into the stock market, given that it’s increased about 40% in a little less than a year. He is making close to zero simply sitting on cash and feels left behind in light of the big advance by the stock market. But therein lays the heart of the problem: the need to do something…the need to pick up nickels in front of an oncoming train.

Let me give you an example of what I am talking about. Assume you were able to buy an index of the market (S&P 500) in 2002. Assume you bought at a low of that year (~ 800). If you held the position for about 6 years (and were smart enough to close it), the value increased to ~ 1,500, or about 11% annualized return, just before the market crashed in 2008. Not bad in terms of simply parking your money at the bank at 2-3%. But lo and behold, you are not like the minority and kept the position and saw it dwindle to about 680 (in March 2009). At that time you had accumulated a negative return. Parking your money at the bank would have been a much better investment. Consider the present perceived value of the market, 1,130; even at this point, your annualized return (from the starting point of 2002) is 4.7%, a meager amount if you take into account risk and price inflation.

The whole point of this back-of-the-envelope exercise is to demonstrate how “the best laid plans of mice and men often go awry.” People will make investment decision for their retirement believing the value of the currency (and portfolio) will increase. We are living at a time that nothing can be taken for granted. For a large majority of people (80%, using Pareto’s Law) sooner or later they will come to grips that they have been living in fantasy island with regard to their retirement plans. The only sensible retirement plan that has worked throughout human history is to have no retirement plan—unless, of course, you are an individual physically unable to work. The reality of our times is that those who feel they are in firm ground when it comes to their investment portfolio, yet unaware (or disbelieve) of the risks that lurk in the economy today, will be the ones most hurt—not only because they will have lost lots of money, but because their pride and sense of accomplishment will have been reduce even more.

My colleague is emblematic of a belief of many in our generation: a sound portfolio will save you. I asked my colleague what he had invested. His response: a mix of equity and fixed-income mutual fund. We are heading into a storm where money will fail and his portfolio will dwindle to irrelevance in value in his lifetime. What is tragic and sad about it is that people like him don’t (or refuse to) see it coming.

Saturday, January 9, 2010

Bill Gross: "Let's Get Fisical"

Bill Gross, Managing Director of PIMCO, asks a question all of us should ask, “what has become of the American nation?” He addresses the question in his most recent “Investment Outlook” commentary. The answer is not as difficult as it may seem, if there are no hidden agendas or ulterior motives. Mr. Gross’ missive is excellent, yet also impressive given that he was one of the cheerleaders of Geithner’s financial bailout announced in the early part of 2009. This last part does not take anything away from Mr. Gross uncanny ability. It is merely evidence that anyone, irrespective of their level of intelligence and talents, can be taken for a ride or swept away by somebody else’s “good intentions”.

It is worthwhile to read all of Mr. Gross’ commentary, which you can find here. However, here are some of his most remarkable statements:

“Conceived with the vision of liberty and justice for all, we have descended in the clutches of corporate and other special interests to a second world state defined by K Street instead of Independence Square.”

“What amazes me most of all is that politicians can be bought so cheaply.”

“The fact is that American citizens have never been as divorced from their representatives – and if that description fits the Democratic Congress now in control – then it applies to Republicans as well – past and present. So you watch Fox, or is it MSNBC? O’Reilly or Olbermann? It doesn’t matter. You’re just being conned into rooting for a team that basically runs the same plays called by lookalike coaches on different sidelines. A “ballot box” pox on all their houses – Senators, Representatives and Presidents alike.”

He goes on to explain about the major economic themes prevalent in our current environment, particularly about Central Bankers’ level of quantitative easing and its effect in the economy.


Saturday, January 2, 2010

Lessons of 2009: not all wrongs are wrong

Make no mistake, reality is often very far away from fantasy. What we think we know almost always does not turn out like we think it will. Or as the aphorism says,”we don’t get what we expect, we get what we deserve.” We overestimate our best guesses and underestimate our worst guesses. Behavioral psychologists call this the anchoring hubris, which directly affects the way we assess probabilities. Everyone is affected by it, including yours truly. That said, as I look back to 2009, one of my prediction related to a significant contraction in the stock market during the fall. It obviously did not happen that way. As I assess the breakdown in estimation, I come to the conclusion that the anchoring hubris got the best of me. However, I still stand by the gist of my prediction: chiefly that an economic crisis that will pale the last one, stemming from unprecedented market interventions, is on its way. The only caveat is that this time I will not attach a particular time frame, since the effects of the implementation of “Keynesian” monetary and fiscal policies may last longer than anticipated. I expect there to be lingering effects, even after exit strategies are implemented. But my expectation that a major stock market reversal and a catastrophic economic environment (including social unrest) are coming upon us almost certainly is a foregone conclusion.

The problems with the American economy are irreversible. Debt has continued to balloon. This was not only a problem of the Bush II administration; the root of the debt problem lies in the breakdown of the international monetary gold standard in 1971. If prior American Presidents drove at the speed limit in terms of American debt, then current President Obama would be pulled over for excessive speeding. Over the last couple of years America has added more debt to its economy than the combined period since its independence. This debt will never be repaid, despite political rhetoric claiming otherwise. How do I know his? Ask yourself this question: how can an institution that is effectively bankrupt pay it bills? The obvious answer is that it can’t. Connected to this problem is the future of the U.S. dollar. The Federal Reserve has printed more little green papers unlike any other time in American history. The adjusted monetary base has more than double (to about $2 trillion) since the beginning of the credit crisis. Among the ultimate effects of these policies are an increase in interest rates and price inflation, not to mention social unrest.

I wish I knew exactly when the manifestation of these events will happen because measuring the Keynesian policy effects has been challenging. However, this does not abrogate the fact exquisitely stated by Ludwig Von Mises, "There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." Not all wrongs (my timing judgment) are wrong. Whoever has ears to hear, let him hear.