"Macro" Musings

[ERICOPOLY]

Mr. Ron Paul on balance sheet wealth illusion.

 

giofranchi

 

I thought they were merely trying to offset the deflation that is otherwise going on, but Mr. Paul suggests they are trying to create wealth. 

 

Do I simply misunderstand our stimulus spending or does Mr. Paul misunderstand/misrepresent their intentions? 

 

 

But in just a few short sentences Professor Hans-Hermann Hoppe eviscerates the Krugmans of the world by pointing out the obvious: If governments

or central banks really can create wealth simply by creating money, why does poverty exist anywhere on earth? Why haven’t successive rounds of

quantitative easing by the US Fed solved our economic recession? And if Fed money creation really works, and doesn’t create inflation, why haven’t

Americans gotten richer as the money supply has grown?

[giofranchi]

Mr. Ron Paul on balance sheet wealth illusion.

 

giofranchi

 

I thought they were merely trying to offset the deflation that is otherwise going on, but Mr. Paul suggests they are trying to create wealth. 

 

Do I simply misunderstand our stimulus spending or does Mr. Paul misunderstand/misrepresent their intentions? 

 

 

But in just a few short sentences Professor Hans-Hermann Hoppe eviscerates the Krugmans of the world by pointing out the obvious: If governments

or central banks really can create wealth simply by creating money, why does poverty exist anywhere on earth? Why haven’t successive rounds of

quantitative easing by the US Fed solved our economic recession? And if Fed money creation really works, and doesn’t create inflation, why haven’t

Americans gotten richer as the money supply has grown?

 

I think that Mr. Paul is pointing out something obvious: things have consequences, choices have consequences. And you cannot escape those consequences, simply printing more and more money. We are at the end of a 70-years debt super-cycle, that has happened over and over again trough history. You cannot party for 70 years, and then find a magical solution to feel no hangover! Of course, things can change, we are not doomed to repeat the past. But the right change would be to prevent unsustainable debt accumulation in the first place. Once the reckless path has been followed again, there is no magic wand (or magic printing press!) to avert the inevitable consequences.

I think that’s what Mr. Paul is warning us against. Is he right? I don’t know… we will see… But it makes sense to me, and I always like someone who warns me of possible dangers ahead.

 

giofranchi

[ERICOPOLY]

I think that Mr. Paul is pointing out something obvious: things have consequences, choices have consequences. And you cannot escape those consequences, simply printing more and more money.

 

He could have done that without misrepresenting the motivations of others.

 

For example, when QE is done it's not to create wealth as Mr. Paul claims.  This is just a straw man so that Ron Paul can knock it down and have an easy victory (he never looks clever when he speaks directly with Mr. Bernanke, IMO).

 

[stahleyp]

I'm not a macro guy but hasn't Klarman been pretty bearish since 2010 (I think Romnick at FPA too)?

[vinod1]

 

I think that Mr. Paul is pointing out something obvious: things have consequences, choices have consequences. And you cannot escape those consequences, simply printing more and more money. We are at the end of a 70-years debt super-cycle, that has happened over and over again trough history. You cannot party for 70 years, and then find a magical solution to feel no hangover! Of course, things can change, we are not doomed to repeat the past. But the right change would be to prevent unsustainable debt accumulation in the first place. Once the reckless path has been followed again, there is no magic wand (or magic printing press!) to avert the inevitable consequences.

I think that’s what Mr. Paul is warning us against. Is he right? I don’t know… we will see… But it makes sense to me, and I always like someone who warns me of possible dangers ahead.

 

giofranchi

 

No one is saying there is a magical solution. That is a strawman argument. Monetary policy is not the right tool to fight a liquidity trap, but Fed is doing what it can with the tools it has.

 

From "End the Depression Now"

 

Can Debt Cure a Problem Created by Debt?

 

One of the common arguments against fiscal policy in the current situation—one that sounds sensible—runs like this: “You yourself say that this crisis is the result of too much debt. Now you’re saying that the answer involves running up even more debt. That can’t possibly make sense.” Actually, it does.

But to explain why will take both some careful thinking and a look at the historical record. It’s true that people like me believe that the depression we’re in was in large part caused by the buildup of household debt, which set the stage for a Minksy moment in which highly indebted households were forced to slash their spending. How, then, can even more debt be part of the appropriate policy response?

 

The key point is that this argument against deficit spending assumes, implicitly, that debt is debt—that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves; yes, the United States has debt to China and other countries, but as we saw in chapter 3, our net debt to foreigners is relatively small and not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, we see that the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal, which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. It is, rather, a case of less patient people —people who for whatever reason want to spend sooner rather than later—borrowing from more patient people. The main limit on this kind of borrowing is the concern of those patient lenders about whether they will be repaid, which sets some kind of ceiling on each individual’s ability to borrow.

 

What happened in 2008 was a sudden downward revision of those ceilings. This downward revision has forced the debtors to pay down their debt, rapidly, which means spending much less. And the problem is that the creditors don’t face any equivalent incentive to spend more. Low interest rates help, but because of the severity of the “deleveraging shock,” even a zero interest rate isn’t low enough to get them to fill the hole left by the collapse in debtors’ demand. The result isn’t just a depressed economy: low incomes and low inflation (or even deflation) make it that much harder for the debtors to pay down their debt. What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it, which would do two things: it would make it possible to have a negative real interest rate, and it would in itself erode the outstanding debt. Yes, that would in a way be rewarding debtors for their past excesses, but economics is not a morality play. I’ll have more to say about inflation in the next chapter.

 

Just to go back for a moment to my point that debt is not all the same: yes, debt relief would reduce the assets of the creditors at the same time, and by the same amount, as it reduced the liabilities of the debtors. But the debtors are being forced to cut spending, while the creditors aren’t, so this is a net positive for economy wide spending. But what if neither inflation nor sufficient debt relief can, or at any rate will, be delivered? Well, suppose a third party can come in: the government. Suppose that it can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson, or pay schoolteacher salaries. The true social cost of these things will be very low, because the government will be employing resources that would otherwise be unemployed. And it also makes it easier for the debtors to pay down their debt; if the government maintains its spending long enough, it can bring debtors to the point where they’re no longer being forced into emergency debt reduction and where further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt, but the point is that debt will have been shifted away from the players whose debt is doing the economic damage, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

 

The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can—and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.

 

I have been pissed off with Krugman's columns in NYT for various reasons (too partisan) but his book is a gem.

 

Vinod

[giofranchi]

 

I think that Mr. Paul is pointing out something obvious: things have consequences, choices have consequences. And you cannot escape those consequences, simply printing more and more money. We are at the end of a 70-years debt super-cycle, that has happened over and over again trough history. You cannot party for 70 years, and then find a magical solution to feel no hangover! Of course, things can change, we are not doomed to repeat the past. But the right change would be to prevent unsustainable debt accumulation in the first place. Once the reckless path has been followed again, there is no magic wand (or magic printing press!) to avert the inevitable consequences.

I think that’s what Mr. Paul is warning us against. Is he right? I don’t know… we will see… But it makes sense to me, and I always like someone who warns me of possible dangers ahead.

 

giofranchi

 

No one is saying there is a magical solution. That is a strawman argument. Monetary policy is not the right tool to fight a liquidity trap, but Fed is doing what it can with the tools it has.

 

From "End the Depression Now"

 

Can Debt Cure a Problem Created by Debt?

 

One of the common arguments against fiscal policy in the current situation—one that sounds sensible—runs like this: “You yourself say that this crisis is the result of too much debt. Now you’re saying that the answer involves running up even more debt. That can’t possibly make sense.” Actually, it does.

But to explain why will take both some careful thinking and a look at the historical record. It’s true that people like me believe that the depression we’re in was in large part caused by the buildup of household debt, which set the stage for a Minksy moment in which highly indebted households were forced to slash their spending. How, then, can even more debt be part of the appropriate policy response?

 

The key point is that this argument against deficit spending assumes, implicitly, that debt is debt—that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves; yes, the United States has debt to China and other countries, but as we saw in chapter 3, our net debt to foreigners is relatively small and not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, we see that the overall level of debt makes no difference to aggregate net worth—one person’s liability is another person’s asset. It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal, which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. Think of it this way: when debt is rising, it’s not the economy as a whole borrowing more money. It is, rather, a case of less patient people —people who for whatever reason want to spend sooner rather than later—borrowing from more patient people. The main limit on this kind of borrowing is the concern of those patient lenders about whether they will be repaid, which sets some kind of ceiling on each individual’s ability to borrow.

 

What happened in 2008 was a sudden downward revision of those ceilings. This downward revision has forced the debtors to pay down their debt, rapidly, which means spending much less. And the problem is that the creditors don’t face any equivalent incentive to spend more. Low interest rates help, but because of the severity of the “deleveraging shock,” even a zero interest rate isn’t low enough to get them to fill the hole left by the collapse in debtors’ demand. The result isn’t just a depressed economy: low incomes and low inflation (or even deflation) make it that much harder for the debtors to pay down their debt. What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it, which would do two things: it would make it possible to have a negative real interest rate, and it would in itself erode the outstanding debt. Yes, that would in a way be rewarding debtors for their past excesses, but economics is not a morality play. I’ll have more to say about inflation in the next chapter.

 

Just to go back for a moment to my point that debt is not all the same: yes, debt relief would reduce the assets of the creditors at the same time, and by the same amount, as it reduced the liabilities of the debtors. But the debtors are being forced to cut spending, while the creditors aren’t, so this is a net positive for economy wide spending. But what if neither inflation nor sufficient debt relief can, or at any rate will, be delivered? Well, suppose a third party can come in: the government. Suppose that it can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson, or pay schoolteacher salaries. The true social cost of these things will be very low, because the government will be employing resources that would otherwise be unemployed. And it also makes it easier for the debtors to pay down their debt; if the government maintains its spending long enough, it can bring debtors to the point where they’re no longer being forced into emergency debt reduction and where further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt, but the point is that debt will have been shifted away from the players whose debt is doing the economic damage, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

 

The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can—and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.

 

I have been pissed off with Krugman's columns in NYT for various reasons (too partisan) but his book is a gem.

 

Vinod

 

Well Vinod, if you believe that… As far as I am concerned, only a professor or a journalist could have written something like that… Listen, I really hate complicated things. Because they might seem brilliant and convincing, but they just don’t work. Every businessman knows that. In business the only things that work are the ones easiest to implement and the outcome of which is almost certain. Everything else is a waste of time and resources 90% of the times.

In a system much more complex than a single business, like the global economies are, the principle of simplicity should be followed even more rigorously. Krugman writes:

 

What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it

 

That’s simple.

 

To cure the debt problem with more debt… I don’t understand how it should work: so, either I am dumb, or it is too complicated.

Probably, the former.  :(

 

giofranchi

 

[giofranchi]

Recent Dylan Grice's speech.

 

Would Keynes be a Keynesian today?

 

giofranchi

Dylan_Grice-Witch_Hunts_Inflation_Fears_and_Why_Im_Bearish_in_2013.pdf

[vinod1]

 

Well Vinod, if you believe that… As far as I am concerned, only a professor or a journalist could have written something like that… Listen, I really hate complicated things. Because they might seem brilliant and convincing, but they just don’t work. Every businessman knows that. In business the only things that work are the ones easiest to implement and the outcome of which is almost certain. Everything else is a waste of time and resources 90% of the times.

In a system much more complex than a single business, like the global economies are, the principle of simplicity should be followed even more rigorously. Krugman writes:

 

What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it

 

That’s simple.

 

To cure the debt problem with more debt… I don’t understand how it should work: so, either I am dumb, or it is too complicated.

Probably, the former.  :(

 

giofranchi

 

No, no, no. I think you choose not to understand since it does not conform to your view of the world. :) I do that all the time.

 

On this particular issue, I have changed my own opinion on this a couple of years back. I would lay out my understanding briefly and you can point out where you disagree. I am talking just about US here.

 

Consumers took out more debt than they can service over the past several years for a variety of reasons (housing bubble, easy loans, falling interest rates, central bank encouragement, stagnating wages, etc.). The financial crisis of 2008-2009 with falling asset prices, unemployment, etc made debt servicing more difficult for consumers who have logically pulled back from spending and started saving, thus beginning the process of reducing debt levels. The reduced spending by consumers creates headwinds for the economy resulting in sub par growth and also reduces government revenues.

 

The government at this time can choose not to do much and just let nature take its course and let those who have recklessly borrowed more money suffer. The result would be that economy would take a much sharper downturn, housing and other assets deflate, bad banks get wiped out, lenders take haircuts on the money lent. Once this process works through, economy regains strength. The problem with this approach is that it would cause tremendous suffering. We are probably talking about GDP declines of peak to trough of something like 10-15%, unemployment shooting to 20%, etc. Jim Grant, Hussman, Rodriguez and many others think this should be the process that should be followed. There is a moral component to this line of reasoning.

 

This approach has been argued as the quicker way to resolve the crisis, but we cannot be sure about that. We have tried this in 1929 with disastrous results.

 

The other approach has been for Government to step in and try to take debt for a while as the consumer slowly deleverages. The Government does take on debt so Government spending would try to offset some of the reduction in spending by consumers. Monetary policy is kept as loose as possible via various mechanisms to allow borrowers to deleverage via lower interest rates or via higher inflation. We do know this is not sustainable for ever and this is not without risks. But this would be the best of the bad options.

 

Vinod

[vinod1]

giofranchi,

 

Some info on the liquidationist school:

 

http://www.mannmuseum.com/american-policies-during-the-great-depression/2/

 

Contemplating the wreck of his country's economy and his own political career, Herbert Hoover wrote bitterly in retrospect about those in his administration who had advised inaction during the downslide:

 

The 'leave-it-alone liquidationists' headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'. He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'

 

But Hoover had been one of the most enthusiastic proponents of "liquidationism" during the Great Depression. And the unwillingness to use policy to prop up the economy during the slide into the Depression was backed by a large chorus, and approved by the most eminent economists.

 

For example, from Harvard Joseph Schumpeter argued that there was a "presumption against remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future." From Schumpeter's perspective, "depressions are not simply evils, which we might attempt to suppress, but forms of something which has to be done, namely, adjustment to change." This socially productive function of depressions creates "the chief difficulty" faced by economic policy makers. For "most of what would be effective in remedying a depression would be equally effective in preventing this adjustment."

 

From London, Friedrich Hayek found it:

 

...still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilize' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production...

 

Hayek and company believed that enterprises are gambles which sometimes fail: a future comes to pass in which certain investments should not have been made. The best that can be done in such circumstances is to shut down those production processes that turned out to have been based on assumptions about future demands that did not come to pass. The liquidation of such investments and businesses releases factors of production from unprofitable uses; they can then be redeployed in other sectors of the technologically dynamic economy. Without the initial liquidation the redeployment cannot take place. And, said Hayek, depressions are this process of liquidation and preparation for the redeployment of resources.

 

As Schumpeter put it, policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: "inflation pushed far enough [would] undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, [and]... would, in the end, lead to a collapse worse than the one it was called in to remedy." For "recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead"

 

This doctrine--that in the long run the Great Depression would turn out to have been "good medicine" for the economy, and that proponents of stimulative policies were shortsighted enemies of the public welfare--drew anguished cries of dissent from those less hindered by their theoretical blinders. British economist Ralph Hawtrey scorned those who, like Robbins and Hayek, wrote at the nadir of the Great Depression that the greatest danger the economy faced was inflation. It was, Hawtrey said, the equivalent of "Crying, 'Fire! Fire!' in Noah's flood."

 

Vinod

[ERICOPOLY]

giofranchi,

 

Some info on the liquidationist school:

 

http://www.mannmuseum.com/american-policies-during-the-great-depression/2/

 

Contemplating the wreck of his country's economy and his own political career, Herbert Hoover wrote bitterly in retrospect about those in his administration who had advised inaction during the downslide:

 

The 'leave-it-alone liquidationists' headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'. He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'

 

But Hoover had been one of the most enthusiastic proponents of "liquidationism" during the Great Depression. And the unwillingness to use policy to prop up the economy during the slide into the Depression was backed by a large chorus, and approved by the most eminent economists.

 

For example, from Harvard Joseph Schumpeter argued that there was a "presumption against remedial measures which work through money and credit. Policies of this class are particularly apt to produce additional trouble for the future." From Schumpeter's perspective, "depressions are not simply evils, which we might attempt to suppress, but forms of something which has to be done, namely, adjustment to change." This socially productive function of depressions creates "the chief difficulty" faced by economic policy makers. For "most of what would be effective in remedying a depression would be equally effective in preventing this adjustment."

 

From London, Friedrich Hayek found it:

 

...still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilize' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production...

 

Hayek and company believed that enterprises are gambles which sometimes fail: a future comes to pass in which certain investments should not have been made. The best that can be done in such circumstances is to shut down those production processes that turned out to have been based on assumptions about future demands that did not come to pass. The liquidation of such investments and businesses releases factors of production from unprofitable uses; they can then be redeployed in other sectors of the technologically dynamic economy. Without the initial liquidation the redeployment cannot take place. And, said Hayek, depressions are this process of liquidation and preparation for the redeployment of resources.

 

As Schumpeter put it, policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: "inflation pushed far enough [would] undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, [and]... would, in the end, lead to a collapse worse than the one it was called in to remedy." For "recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another [worse] crisis ahead"

 

This doctrine--that in the long run the Great Depression would turn out to have been "good medicine" for the economy, and that proponents of stimulative policies were shortsighted enemies of the public welfare--drew anguished cries of dissent from those less hindered by their theoretical blinders. British economist Ralph Hawtrey scorned those who, like Robbins and Hayek, wrote at the nadir of the Great Depression that the greatest danger the economy faced was inflation. It was, Hawtrey said, the equivalent of "Crying, 'Fire! Fire!' in Noah's flood."

 

Vinod

 

There's nothing like history to see how deceptively simple approaches have worked out in the past.

 

[premfan]

 

Well Vinod, if you believe that As far as I am concerned, only a professor or a journalist could have written something like that Listen, I really hate complicated things. Because they might seem brilliant and convincing, but they just dont work. Every businessman knows that. In business the only things that work are the ones easiest to implement and the outcome of which is almost certain. Everything else is a waste of time and resources 90% of the times.

In a system much more complex than a single business, like the global economies are, the principle of simplicity should be followed even more rigorously. Krugman writes:

 

What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it

 

Thats simple.

 

To cure the debt problem with more debt I dont understand how it should work: so, either I am dumb, or it is too complicated.

Probably, the former.  :(

 

giofranchi

 

No, no, no. I think you choose not to understand since it does not conform to your view of the world. :) I do that all the time.

 

On this particular issue, I have changed my own opinion on this a couple of years back. I would lay out my understanding briefly and you can point out where you disagree. I am talking just about US here.

 

Consumers took out more debt than they can service over the past several years for a variety of reasons (housing bubble, easy loans, falling interest rates, central bank encouragement, stagnating wages, etc.). The financial crisis of 2008-2009 with falling asset prices, unemployment, etc made debt servicing more difficult for consumers who have logically pulled back from spending and started saving, thus beginning the process of reducing debt levels. The reduced spending by consumers creates headwinds for the economy resulting in sub par growth and also reduces government revenues.

 

The government at this time can choose not to do much and just let nature take its course and let those who have recklessly borrowed more money suffer. The result would be that economy would take a much sharper downturn, housing and other assets deflate, bad banks get wiped out, lenders take haircuts on the money lent. Once this process works through, economy regains strength. The problem with this approach is that it would cause tremendous suffering. We are probably talking about GDP declines of peak to trough of something like 10-15%, unemployment shooting to 20%, etc. Jim Grant, Hussman, Rodriguez and many others think this should be the process that should be followed. There is a moral component to this line of reasoning.

 

This approach has been argued as the quicker way to resolve the crisis, but we cannot be sure about that. We have tried this in 1929 with disastrous results.

 

The other approach has been for Government to step in and try to take debt for a while as the consumer slowly deleverages. The Government does take on debt so Government spending would try to offset some of the reduction in spending by consumers. Monetary policy is kept as loose as possible via various mechanisms to allow borrowers to deleverage via lower interest rates or via higher inflation. We do know this is not sustainable for ever and this is not without risks. But this would be the best of the bad options.

 

Vinod

 

Lets keep it simple: Whoever makes the rules ultimately wins the game.   Choose your players ( stocks or whatever), set YOUR rules, and play a game that you can win.  In the macro world the rules keep changing.  You cant play the game ( macro game) if you dont know the rules.

[giofranchi]

 

Well Vinod, if you believe that… As far as I am concerned, only a professor or a journalist could have written something like that… Listen, I really hate complicated things. Because they might seem brilliant and convincing, but they just don’t work. Every businessman knows that. In business the only things that work are the ones easiest to implement and the outcome of which is almost certain. Everything else is a waste of time and resources 90% of the times.

In a system much more complex than a single business, like the global economies are, the principle of simplicity should be followed even more rigorously. Krugman writes:

 

What can be done? One answer is to find some way to reduce the real value of the debt. Debt relief could do this; so could inflation, if you can get it

 

That’s simple.

 

To cure the debt problem with more debt… I don’t understand how it should work: so, either I am dumb, or it is too complicated.

Probably, the former.  :(

 

giofranchi

 

No, no, no. I think you choose not to understand since it does not conform to your view of the world. :) I do that all the time.

 

On this particular issue, I have changed my own opinion on this a couple of years back. I would lay out my understanding briefly and you can point out where you disagree. I am talking just about US here.

 

Consumers took out more debt than they can service over the past several years for a variety of reasons (housing bubble, easy loans, falling interest rates, central bank encouragement, stagnating wages, etc.). The financial crisis of 2008-2009 with falling asset prices, unemployment, etc made debt servicing more difficult for consumers who have logically pulled back from spending and started saving, thus beginning the process of reducing debt levels. The reduced spending by consumers creates headwinds for the economy resulting in sub par growth and also reduces government revenues.

 

The government at this time can choose not to do much and just let nature take its course and let those who have recklessly borrowed more money suffer. The result would be that economy would take a much sharper downturn, housing and other assets deflate, bad banks get wiped out, lenders take haircuts on the money lent. Once this process works through, economy regains strength. The problem with this approach is that it would cause tremendous suffering. We are probably talking about GDP declines of peak to trough of something like 10-15%, unemployment shooting to 20%, etc. Jim Grant, Hussman, Rodriguez and many others think this should be the process that should be followed. There is a moral component to this line of reasoning.

 

This approach has been argued as the quicker way to resolve the crisis, but we cannot be sure about that. We have tried this in 1929 with disastrous results.

 

The other approach has been for Government to step in and try to take debt for a while as the consumer slowly deleverages. The Government does take on debt so Government spending would try to offset some of the reduction in spending by consumers. Monetary policy is kept as loose as possible via various mechanisms to allow borrowers to deleverage via lower interest rates or via higher inflation. We do know this is not sustainable for ever and this is not without risks. But this would be the best of the bad options.

 

Vinod

 

Vinod,

thank you for everything you have written. All your thoughts are very well expressed and convincing. I agree with all of them. I probably misunderstood Mr. Krugman’s point. When I speak of debt, I always think about TOTAL debt. Because total debt is what really matters. So I implicitly thought he was advocating a further increase in total debt as a percentage of GDP... Now you have explained to me that his idea is to increase only government debt, while decreasing private debt, hoping that way to slowly decrease total debt to a more manageable level.

In fact, that is something I can understand.  ;)

What I still don’t understand is why people choose to point at 1929, when they don’t like to leave the markets alone, and never refer to the Weimar Republic in Germany or Japan during the last 20 years. First of all, the Great Depression saw mixed policies: from 1929 until 1932 the markets were left to adjust alone, just like Mr. Mellon suggested. But from 1933 until 1937 the New Deal implemented some of the most interventionist policies ever conceived. The results from 1938 until 1949 were far from convincing… Second, the examples of the Weimar Republic and recent Japan clearly show that government interventions might fail to be very useful.

So, here is my “view of the world”, as you put it: there is no easy way out.

I don’t know of a single MAJOR (there are some exceptions, like Canada in the ‘90s and others, but they all were on a far smaller scale) deleveraging in history which didn’t have bad consequences. Let the markets alone: restructurings: bad consequences. Intervene: austerity + inflation: bad consequences. A little bit of restructurings + a little bit of austerity + a little bit of inflation: probably the best solution: bad consequences.

My view of the world: the moment you get into debt, you are screwed up.

Mr. Vanderbilt said about debt: “If you had bought a hundred shares instead of a thousand, you could have held on. Never be in too great hurry to get rich.”

So, here is the only true solution! I repeat: “Never be in too great hurry to get rich.” As long as we won’t be able to control and subdue our greed and ego, nothing will change, and we will always get into trouble. Once in trouble: bad consequences.

So, I don’t believe in anyone who claims to possess the only right formula to get us out of this mess like a walk in the park. To me they are just charlatans.

Where does this all lead me? Well, it actually has some investing implications. If most asset classes are far from cheap, not many bargains can be found, and bad consequences are possibly lurking down the road, I would be very careful… meaning that I would pile on cash reserves.

Right now is the time where I prefer to own “a hundred shares instead of a thousand”.

 

giofranchi

[txitxo]

 

Where does this all lead me? Well, it actually has some investing implications. If most asset classes are far from cheap, not many bargains can be found, and bad consequences are possibly lurking down the road, I would be very careful… meaning that I would pile on cash reserves.

Right now is the time where I prefer to own “a hundred shares instead of a thousand”.

 

giofranchi

 

  I think macro is complicated in some aspects but very simple in others.

 

What we can know is that:

 

- This deleveraging, as any other on Earth except for Great Britain's after the Napoleonic Wars, will be solved by default, by strong inflation or by a combination of the two (Rogoff and Reinhart, see Ray Dalio too). There is no mathematical way developed countries are going to pay what they currently owe in real terms if you add up sovereign debt, pension and health care commitments. 

 

- In the developed world, the most powerful political constituency are middle-aged and old people, who apart from real state, are mostly invested in bonds and cash. These people also know that pensions will never keep up with prices, no matter how many laws promise to index them. They are aware that default or inflation will be an economic disaster for them, which means that before any government attempts to default or inflate its debt away, things have to get really ugly, 1930's, blood-on-the-streets ugly. There has to be such a terrible crisis that even people who know that they are going to lose a good chunk of their life savings see inflationary policies as a lesser evil. A very good bet therefore is that before inflation, there HAS to be deflation, nasty deflation. Inflation won't start casually.

 

What we don't know (and can't possibly know): when and how this will happen. I think Japan is a misleading case, because of its incredible economic strength and social cohesion. Any other country but Japan would have collapsed into default or hyperinflation 10 years ago. So things may move faster that we expect. Or not.

 

How does this translate into an investment thesis? If you are very smart (or think that you are) as Ray Dalio, Kyle Bass or Hugh Hendry, you can try to make money off it, by guessing right the timing and sequence of events.

 

  If you are not, I don't think the solution is to raise cash and try to time the market, unless you are absolutely constrained to invest in a single country. The best way to protect yourself is to keep away from expensive markets and be fully invested in cheap ones. At the bottom of the Great Depression, the Shiller P/E index fell to 5.6, in the 80's it fell to 6.7. If you invest at a Shiller P/E of 11, you'll see a 40% drop. If you invest at a Shiller P/E of 23, you may see your investments drop by 70%. So if you are in a cheap market and Armageddon arrives, you'll survive, and if it doesn't, you will still do very well, probably outperforming those invested in more expensive markets. 

 

  It is interesting that Mark Spitznagel's results also predict an eventual >70% drop in the US market from current levels. At market bottoms you get Tobin's Q of ~0.3, now we are above 1.

 

http://www.universa.net/UniversaSpitznagel_research_20110613.pdf

 

So what will cause stocks to collapse? A Japanese implosion, war in Iran with long-term closure of the Hormuz straits, a disordered break-up of the Eurozone, war in the China Sea. Take your pick, there is plenty of trouble brewing in the world. 

 

[giofranchi]

 

Where does this all lead me? Well, it actually has some investing implications. If most asset classes are far from cheap, not many bargains can be found, and bad consequences are possibly lurking down the road, I would be very careful… meaning that I would pile on cash reserves.

Right now is the time where I prefer to own “a hundred shares instead of a thousand”.

 

giofranchi

 

  I think macro is complicated in some aspects but very simple in others.

 

What we can know is that:

 

- This deleveraging, as any other on Earth except for Great Britain's after the Napoleonic Wars, will be solved by default, by strong inflation or by a combination of the two (Rogoff and Reinhart, see Ray Dalio too). There is no mathematical way developed countries are going to pay what they currently owe in real terms if you add up sovereign debt, pension and health care commitments. 

 

- In the developed world, the most powerful political constituency are middle-aged and old people, who apart from real state, are mostly invested in bonds and cash. These people also know that pensions will never keep up with prices, no matter how many laws promise to index them. They are aware that default or inflation will be an economic disaster for them, which means that before any government attempts to default or inflate its debt away, things have to get really ugly, 1930's, blood-on-the-streets ugly. There has to be such a terrible crisis that even people who know that they are going to lose a good chunk of their life savings see inflationary policies as a lesser evil. A very good bet therefore is that before inflation, there HAS to be deflation, nasty deflation. Inflation won't start casually.

 

What we don't know (and can't possibly know): when and how this will happen. I think Japan is a misleading case, because of its incredible economic strength and social cohesion. Any other country but Japan would have collapsed into default or hyperinflation 10 years ago. So things may move faster that we expect. Or not.

 

How does this translate into an investment thesis? If you are very smart (or think that you are) as Ray Dalio, Kyle Bass or Hugh Hendry, you can try to make money off it, by guessing right the timing and sequence of events.

 

  If you are not, I don't think the solution is to raise cash and try to time the market, unless you are absolutely constrained to invest in a single country. The best way to protect yourself is to keep away from expensive markets and be fully invested in cheap ones. At the bottom of the Great Depression, the Shiller P/E index fell to 5.6, in the 80's it fell to 6.7. If you invest at a Shiller P/E of 11, you'll see a 40% drop. If you invest at a Shiller P/E of 23, you may see your investments drop by 70%. So if you are in a cheap market and Armageddon arrives, you'll survive, and if it doesn't, you will still do very well, probably outperforming those invested in more expensive markets. 

 

  It is interesting that Mark Spitznagel's results also predict an eventual >70% drop in the US market from current levels. At market bottoms you get Tobin's Q of ~0.3, now we are above 1.

 

http://www.universa.net/UniversaSpitznagel_research_20110613.pdf

 

So what will cause stocks to collapse? A Japanese implosion, war in Iran with long-term closure of the Hormuz straits, a disordered break-up of the Eurozone, war in the China Sea. Take your pick, there is plenty of trouble brewing in the world.

 

txitxo,

I agree with you: if you can find great bargains, go for them! Always! The fact is I know just a few companies that I like. And, being just a few, I think I know them well enough to really be able to judge at which price they become true bargains. I am no trader, and I cannot muster the confidence to, let’s say, find some statistically cheap Japanese stocks, spend some time on them, and think that I am smart enough to call them true bargains, while the market clearly disagrees with my thesis. I know that some people follow that approach and are very successful. So, I am not saying it doesn’t work. Far from me! What I am saying, instead, is just that my temperament is not suited to follow that approach.

Right now I am certain that the stock price of every company I follow, and would like to increase my investment in, is bound to fall significantly, should a market meltdown come. So, given my “minuscule investment universe”, what do you suggest I should do? If you were me, not able to invest in Japan, not able to invest in Europe, not able to invest in Brazil, China, or anywhere else, and only interested to invest in a bunch of north-American stocks, I have full confidence to put my firm’s whole net worth in, what would you do? Wouldn’t you agree with me that the so-called “opportunity cost” is way too high right now?

Paraphrasing Mr. Buffett, you should invest as if you could just make 10 investments in your whole life… ok, that’s too extreme, but really: if you could just make 10 investments in your whole life, what would you do right now?

 

giofranchi

[ERICOPOLY]

What I still don’t understand is why people choose to point at 1929, when they don’t like to leave the markets alone, and never refer to the Weimar Republic in Germany or Japan during the last 20 years.

 

Japan had a much larger bubble and it's population is shrinking.

 

Why is that a good example but 1929 is not?

 

And besides, hasn't the US been quicker to face it's bad private sector debts, compared to Japan?  I thought that was a result of having all these securitized loans in shadow banking that quickly went bad and were written off.  Whereas Japan was (I'm told) slow to clear the bad debts.

[Yours Truly]

What I still don’t understand is why people choose to point at 1929, when they don’t like to leave the markets alone, and never refer to the Weimar Republic in Germany or Japan during the last 20 years.

 

Japan had a much larger bubble and it's population is shrinking.

 

Great capital allocation skills by the government via reducing share count!

[PlanMaestro]

Yes, the Japanese banking mess was larger, and slower to clean.

 

http://variantperceptions.wordpress.com/2010/11/28/holding-banking-doomsayers-accountable/

 

And on and a per worker basis, that accounts for the demographic shift, Japan didn't do that badly in the 2000s.

 

http://variantperceptions.wordpress.com/2010/11/28/two-more-japan-charts/

 

Japan had a much larger bubble and it's population is shrinking.

 

Why is that a good example but 1929 is not?

 

And besides, hasn't the US been quicker to face it's bad private sector debts, compared to Japan?  I thought that was a result of having all these securitized loans in shadow banking that quickly went bad and were written off.  Whereas Japan was (I'm told) slow to clear the bad debts.

[txitxo]

 

So, given my “minuscule investment universe”, what do you suggest I should do? If you were me, not able to invest in Japan, not able to invest in Europe, not able to invest in Brazil, China, or anywhere else, and only interested to invest in a bunch of north-American stocks,

 

giofranchi

 

If you *must* invest in NA, and nowhere else, well, then obviously lots of FFH and cash.

 

 

 

[Sportgamma]

 

So, given my “minuscule investment universe”, what do you suggest I should do? If you were me, not able to invest in Japan, not able to invest in Europe, not able to invest in Brazil, China, or anywhere else, and only interested to invest in a bunch of north-American stocks,

 

giofranchi

 

If you *must* invest in NA, and nowhere else, well, then obviously lots of FFH and cash.

 

How about LINTA, BAM, LUK as well. Registered in NA, international exposure and has the management and cash to act if opportunities come their way.

[txitxo]

 

So, given my “minuscule investment universe”, what do you suggest I should do? If you were me, not able to invest in Japan, not able to invest in Europe, not able to invest in Brazil, China, or anywhere else, and only interested to invest in a bunch of north-American stocks,

 

giofranchi

 

If you *must* invest in NA, and nowhere else, well, then obviously lots of FFH and cash.

 

How about LINTA, BAM, LUK as well. Registered in NA, international exposure and has the management and cash to act if opportunities come their way.

 

LUK (and L and GLRE) are below book value, so they are probably good buys in the long term. BAM is a very solid company, with nice international exposure. But I'd be very surprised if you can't buy any of them much cheaper in the next year or two.

 

[vinod1]

 

Vinod,

thank you for everything you have written. All your thoughts are very well expressed and convincing. I agree with all of them. I probably misunderstood Mr. Krugman’s point. When I speak of debt, I always think about TOTAL debt. Because total debt is what really matters. So I implicitly thought he was advocating a further increase in total debt as a percentage of GDP... Now you have explained to me that his idea is to increase only government debt, while decreasing private debt, hoping that way to slowly decrease total debt to a more manageable level.

In fact, that is something I can understand.  ;)

What I still don’t understand is why people choose to point at 1929, when they don’t like to leave the markets alone, and never refer to the Weimar Republic in Germany or Japan during the last 20 years. First of all, the Great Depression saw mixed policies: from 1929 until 1932 the markets were left to adjust alone, just like Mr. Mellon suggested. But from 1933 until 1937 the New Deal implemented some of the most interventionist policies ever conceived. The results from 1938 until 1949 were far from convincing… Second, the examples of the Weimar Republic and recent Japan clearly show that government interventions might fail to be very useful.

So, here is my “view of the world”, as you put it: there is no easy way out.

I don’t know of a single MAJOR (there are some exceptions, like Canada in the ‘90s and others, but they all were on a far smaller scale) deleveraging in history which didn’t have bad consequences. Let the markets alone: restructurings: bad consequences. Intervene: austerity + inflation: bad consequences. A little bit of restructurings + a little bit of austerity + a little bit of inflation: probably the best solution: bad consequences.

My view of the world: the moment you get into debt, you are screwed up.

Mr. Vanderbilt said about debt: “If you had bought a hundred shares instead of a thousand, you could have held on. Never be in too great hurry to get rich.”

So, here is the only true solution! I repeat: “Never be in too great hurry to get rich.” As long as we won’t be able to control and subdue our greed and ego, nothing will change, and we will always get into trouble. Once in trouble: bad consequences.

So, I don’t believe in anyone who claims to possess the only right formula to get us out of this mess like a walk in the park. To me they are just charlatans.

Where does this all lead me? Well, it actually has some investing implications. If most asset classes are far from cheap, not many bargains can be found, and bad consequences are possibly lurking down the road, I would be very careful… meaning that I would pile on cash reserves.

Right now is the time where I prefer to own “a hundred shares instead of a thousand”.

 

giofranchi

 

giofranchi

 

1. To your point about comparing to Weimar Republic in Germany or Japan during the last 20 years.

 

I do not think US position now can be compared to Weimar Republic in Germany of 1920's. The magnitude of the monetary increase is several orders of magnitude higher in Germany. When we are talking about inflation in US we are talking about 3%, 4% or 5% or even high single digits. Compared to US GDP, all the US monetary increase is still a smallish number compared to the increases required for hyperinflation.

 

The situation US is in could be compared to either 1929 GD in US or Japan in the last 20 years. As Richard Koo points out these are both cases of a "Balance Sheet Recession". Here a lot of private sector balance sheets needs to be repaired. The defining characteristic of this case is that private sector moves away from their usual profit maximization to debt minimization.

 

Japan's stock market is down 75% from its peak, whiles its real estate is down 70% from its peak. The fact that they have been able to avoid a great depression type economic contraction, I think they did pretty good. Given that US has been much more aggressive I think US would do much better compared to Japan.

 

Either way there is a price to be paid and it might end up as either sub par economic growth for a while, higher inflation, more economic uncertanity, etc.

 

2. To you point about "once you go into debt you are screwed". I agree and think most of the policy makers realize this as well but they cannot come out and say that. It is now a matter of coming out of this with the as little collateral damage as possible.

 

3. To your point about investment implications. I have no idea of how this all plays out, only thing I know is that risk is much much higher than normal.  The prices of overall market in general does not seem to reflect this risk. So I have repositioned my portfolio for the last two years with this in mind. This means several things:

- Portfolio with much higher cash allocation.

- Strict selling criteria. Selling any business which exceeds 80% of IV unless there is a clear and imminent catalyst.

- Portfolio concentrated on extreme value leveraged via LEAPS or Warrants. So I can have like a 80% nominal portfolio exposure while having very roughly around 70% cash.

 

Vinod

[giofranchi]

Vinod, Eric, PlanMaestro, thank you very much for the nice discussion.

 

1) When I referred to Germany in the ‘20s or Japan in the ‘90s, I didn’t certainly mean that they were the same as the US and Europe today… it is obvious they were not! I just referred to them as the last major deleveragings in modern history, where interventionist policies played a most important role. I think it is very dangerous to delve too deeply into the details of each situation. I don’t think that complex systems, like global macro economies are, could be so easily understood. And to infer lessons, and therefore courses of action, from something not properly understood is always very dangerous. I think we should leave it to the plain, incontrovertible evidence: have interventionist policies succeeded with flying colors in the past? NO.

 

2) The markets left alone are brutal. No doubt about that. And something too brutal isn’t politically acceptable. No doubt about that either. And that notwithstanding, markets left alone are the only ones which truly provide the right incentives for much needed changes.

For instance:

a) The Glass-Steagall Act was approved in 1933, because the market had been so brutal with banks. Vice versa, today banks are almost as powerful as they were in 2007, almost as if nothing had happened in between… Mr. Fisher can talk and propose very sensible solutions, but, as long as TBTF banks wield so much power, it will all be in vain.  :(

b) US Personal Saving Rate in 2009 reached 6% from 2% in 2007. It is back to 3.6% today… Very bad!  :(

Suffering will never be accepted by politicians and will always be postponed and diluted as much as possible. But, unfortunately, suffering is also the only potent spur that makes people do the right thing.

 

giofranchi

 

[ERICOPOLY]

Vice versa, today banks are almost as powerful as they were in 2007, almost as if nothing had happened in between…

 

They can't so much as take a piss today without getting approval.  Here we are waiting for "permission" to pay a dividend.

[giofranchi]

Vice versa, today banks are almost as powerful as they were in 2007, almost as if nothing had happened in between…

 

They can't so much as take a piss today without getting approval.  Here we are waiting for "permission" to pay a dividend.

 

Well, if you had to assign a probability to the fact that Mr. Fisher's proposal will truly be implemented, which would it be?  ???

 

giofranchi

[ERICOPOLY]

Vice versa, today banks are almost as powerful as they were in 2007, almost as if nothing had happened in between…

 

They can't so much as take a piss today without getting approval.  Here we are waiting for "permission" to pay a dividend.

 

Well, if you had to assign a probability to the fact that Mr. Fisher's proposal will truly be implemented, which would it be?  ???

 

giofranchi

 

Low probability.  Why?  I don't think "the people" even want it.

 

For example, I bank with Wells Fargo.  It's not because they have a gun to my head, it's because I've moved from Los Altos Hills, to Eugene, to Los Angeles, then on to Seattle, and now Montecito.

 

Never have I had to open a new bank account.  It's very convenient.

 

Why would I want Mr. Fisher to create a law that says Wells Fargo can only be a small community bank?  What a pain in the rear in today's world where you don't grow up, work, and die in your same small community.