The following is a post which first appeared at the Big Picture from Paul Brodsky & Lee Quaintance who run QB Partners, a private macro-oriented investment fund based in New York.
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We Are All Austrians Now
Things are different this time, as they always are. The great difference between today’s capital markets and those since World War II is that government is taking an overtly active role in them. The consequences of this ongoing political intervention are substantial – on investor expectations, on asset pricing, and on the perception of market risk.
The growing influence of the political element in today’s markets has de-valued the investment experiences of market participants over the last thirty years. As the quote on the Einstein poster that hangs on our office wall says; “imagination is more important than knowledge.” So true. Trying to divine value or even technical trends from extrapolating past market cycles is a risky proposition. Still, the great majority of investors are still trying to do this, which presents opportunities for those willing to break free.
Should we be surprised that 2009 winners were summarily discarded in January? (Precious metal stocks declined about 25% from their December highs through January 31 while base metal futures were liquidated with extreme prejudice during the last week in January.) No, the severity of that correction is not surprising given the magnitude of their previous run. In fact, we should be thankful. Valuable real assets were shaken from weak-handed investors with luke-warm conviction and from cycle-minded momentum players.
We repeat our view that “a return to normalcy” as defined by most contemporary economists, policy makers, market strategists and financial asset investors is not forthcoming. Developed economies are not experiencing the downside of a typical post-WWII cycle, even if one were willing to label the current environment “a deep recession”.
We remain in the early stages of a currency crisis that is being further exacerbated by highly inflationary monetary policies and ad hoc regulatory changes. Confused investors, policy makers and professional chatterers, struggling to recognize familiar economic or market clues, are desperately trying to retro-fit troubling events into familiar patterns.
Voters seem to get it. We think the upset election in Massachusetts, for example, was a continuing revolt of an increasingly angry and politically agnostic public that intuits a disconnection between generally accepted public policies and the lack of sustainable public benefits that would accrue from them. Until they are satisfied, voters of all persuasions will insist that our politicians be as liquid as our portfolios. It was inevitable that fundamental macroeconomic forces would begin to be manifest in the political sphere, and logical that it would show up at the ballot box first. After all, voters are more sensitive to the real economy than politicians and financial asset investors.
We see hefty doses of irony and opportunity in the recent “flight from risk”. We think the majority of investors are wired (or structured) to continue to seek nominal absolute or relative returns above all else, rather than positive real returns within a highly inflationary environment.
As a result, they are unable or unwilling to accurately distinguish between truly safe and truly risky assets in the current environment. This mischaracterization is leading them to poor asset selection, general economic mal-investment and substantial opportunities for investors seeking real returns
We think investors’ knee-jerk compulsion last month towards familiarity will prove costly. We agree that imperceptible future political and economic outcomes should force capital into safe havens. However, the current perception of “risk assets” defines the precise sectors to which we think investors should be migrating during chaotic times.
The long term capital-at-risk spectrum in a global paper money currency system during a period of substantial monetary inflation should generally be:
We view recent market re-allocations to paper-denominated cash and bonds as a trap. The current generation of financial asset investors are used to (or paid for) seeking interim financial returns above all else, and so they have a tendency to equate (baseless, diluting paper-denominated) cash with safety. While paper cash may decrease the risk of nominal loss, it greatly increases the risk of future purchasing power loss within an inflationary environment. So, while it can be emotionally trying to convert baseless paper to scarce resources with fluctuating daily prices (as we have done), we think it will be far more painful over time to invest using the wrong metrics.
Financial assets denominated in diluting paper must offset that diminution of value to provide a positive real return. Treasury just increased the US Monetary Base by 135% over the last 18 months and all signs point to further dilution.
Further, the vast majority of investors continue to erroneously link economic contraction to deflationary asset values because they do not consider the impact of money printing on nominal asset prices. Curiously, even those investors that acknowledge the substantial future impact of past and current monetary inflation seem unwilling or unable to get beyond their bias for cash or to own bonds because they expect contracting output.
While we think economic malaise and political dissention in developed economies can continue into the foreseeable future, (and have tactically positioned ourselves for such), we also think markets will rise or fall independently of such chaos. Why wouldn’t they? When viewed from a monetary perspective, asset values rise or fall in nominal price terms with money and credit growth in the system. Value is another matter entirely. We see a decline in the nominal prices of unencumbered real assets in January as a gift.
Professional Wrestling
Is professional wrestling more a sport or a business? What about politics? (Need we ask?) It is easy to liken the business of politics to professional wrestling — both need a good guy and a villain to keep their constituents interested and generate revenues. Their game is to have each of us pick a side and root for it to protect our interests, whatever they may be. Wrestling is harmless, though.
Through the process of adverse selection politicians have almost universally become businesspeople. There does not seem to be a statesman anywhere near Washington today, not even a courageous personality. The door to power seems wide open for the first legitimate public servant truly willing to take personal risk to stand up to moneyed interests, regardless of where he or she sits on the political spectrum. (Third party, anyone?)
Politicians and policy makers within one nation – even the US – are ill-equipped to handle changing global economic incentives, especially when those incentives have been greatly warped by past pricing subsidies. Natural incentives among economic participants conflict too much with political imperatives, which focus on doing no harm in the near term and on punishing those who may (legally) behave in their best interests at the cost of the greater good.
While we must admit that fiscal and monetary policy makers responsible for substantial government intervention over the last two years helped “save the system”, you should not be surprised that we feel the system, as it is, should not have been saved.
Congress hasn’t seemed to figure out yet that whipping boys Alan Greenspan, Hank Paulson, Tim Geithner and Ben Bernanke did their jobs exceedingly well. (Or maybe they do know that?) Treasury, the Fed, and the US banking system made and distributed enough dollars and dollar-denominated credit to make Wall Street the center of the global economy, which (temporarily) increased nominal US consumption and GDP, US employment, US government tax receipts and US political campaign contributions.
The 800 pound gorilla now sitting in the Senate chamber is the indisputable truth that past and present policy makers are not the problem — the system is. (And the gorilla’s 1200 pound sister is the indisputable truth that Congress was supposed to oversee the Fed and the GSEs.) Lost in the commotion is that these very same politicians were responsible for synthesizing that temporary growth and are now literally to blame for today’s problems. The focus of politicians’ time now is to redirect blame and argue where the new money and credit should go, not whether it should have been created in the first place.
This is the biggest and best clue about the future. Regardless of rhetoric to the contrary, politicians and policy makers will encourage as much money and credit creation as is necessary to keep their seats. Even “fiscally conservative” Republicans have no stomach for economic contraction that would temporarily raise unemployment and reduce tax revenues. Like Democrats, Republicans most see their responsibility as public servants to administer sound fiscal policies by inserting their will on the private economy, rather than letting economies and markets sort matters out on their own.
Democrats have a conceptual edge in this fight because their historical platform is more accepting of a) economic intervention and b) monetary inflation. Since donors to “fiscally conservative Republicans” have already accepted these first two planks, arguing against distributing the new money and credit to those suffering would place any politician, regardless of flavor, in an untenable position (as both Republicans and Democratic debtors/voters are suffering).
If politicians are concerned only with the short-term, and policy makers are supposed to care about the long term, then what happens when policy makers become politicians? Not only do policy advocates on both sides of the political aisle fear contractionary forces and unemployment trends, they have accepted that the solution to reverse these trends can only be to put increasing credit in the hands of consumers.
Last month Majority Leader Reid said that his support for Bernanke was conditional. To merit confirmation, he said Bernanke “must redouble his efforts to ensure middle class families can access credit”. You just can’t make this stuff up. Our public servants want to further saddle us with even more debt so we can consume mostly foreign-made goods. (Ignorance is not a crime. Nor, it seems, is usury grounds for censure.)
Beyond the political posturing can there be any doubt that a reconfirmed Ben Bernanke will drop dollars on debtors if need be? When push comes to shove, politicians will inflate away the burden of private sector debt repayment (by shifting the burden to the public sector), thereby temporarily stimulating the economy. Any policy maker that gets in the way or doesn’t act fast enough will be replaced.
We anticipate unsettled political and economic environments to continue as long as the political dimension tries to kick the can further down the road. The longer this persists, the more frayed societies will become. Ultimately, meaningful change — in asset pricing, market incentives, the current global monetary regime and even the global economic architecture – will be re-defined, naturally or by fiat. Today’s crop of meek bought-and-paid-for politicians and policy makers will look foolish to all.
C’mon Barack!
Yes, Mr. Nixon, we have all been Keynesians for the past 39 years. Go ahead, Mr. Obama – make us Austrians now.
Debt promotion and distribution is not a fundamentally sustainable business model or a blueprint for a sustainable economy because it creates no capital and it shifts wealth from potential capital producers in the private sector (at all income levels) to financial intermediaries, to government, and to foreign capital producers. Legislators and policy makers still do not seem to grasp this, or they are unwilling to behave as though they do.
If Barack Obama were to adopt a more Austrian approach to economics he could make the US economy globally competitive again, (and sustainable to boot), and would encourage the global economy to function harmoniously.
The Austrian School views economies through the prism of natural economic incentives. It relies on the tendency of people to work for capital and then save it for the goods and services they want to consume. Money itself becomes a store of value.
Government policies and intervention would be acceptable, when need be, but only upon approval of the people. The government’s role would be relegated to protector of laws and property rights. It would also be an honest broker when natural imbalances from capitalism occur, as they always do. However, government would not be preeminent and, as it is today, omnipotent.
Would a society that accommodates a freer economic model be the death knell for today’s working class? No, in fact due to the unfathomable and growing debt assumed by developed societies over the last thirty years, the prospects for today’s working class look far bleaker than they would if the working class could earn and save at a global wage that reflected a global equilibrium.
Liberals should be screaming for such a system because it swings power back to the worker and away from the more successful among us that have access to credit. Conservatives should endorse it too because it encourages a more objective society.
Austrian economics was discredited under the twentieth century dominance of Keynesianism, which allows governments to actively insert itself into otherwise naturally functioning private economies.
Politicians and policy makers that control government have conflicting incentives, which introduces subjectivity into more organic economic incentives. Over time, this politically-synthesized subjectivity tends to grow in relation to commercial incentives. The 1971 abandonment of the Bretton Woods system of monetary discipline (abolishing the gold exchange standard), which then allowed governments and banking systems to create as much money and credit (claims on money) as they wished, was a consequence of the subjectivity that active government brings to economies.
Once this subjectivity was accepted and became internalized by most all economic participants, Keynesian societies had to rely on the self-policing of governments (i.e. the human politicians that comprise them) and banking systems.
We can see how that turned out. Who wouldn’t want the power to make money from thin air and spend it as they see fit? The current economic system in the developed world is now corrupted beyond repair, especially given the more natural commercial and economic incentives being practiced and followed in emerging economies. Those of us in the West and in Japan can’t delude ourselves any longer.
Keynesianism replaced true capital with infinite money and credit, which in turn produced general economic mal-investment. It is a system that should be and will be discredited, as the Austrian School was last century.
Austrian economics clearly defines the distinction between money and credit. Further, it argues quite persuasively that growth in unreserved credit ultimately inflates assets, goods, input, and wage bubbles. At the core then of a Keynesian business cycle lies an unreserved credit cycle. Unreserved credit extension creates the illusion of wealth-creating opportunities that further invites mal-investment.
The ultimate reconciliation of credit inflations must be credit deflation that must then be offset by further monetary inflation. (This explains today’s environment.) Under a hard money system, credit deflations would prevail. Under a notional paper money system, monetary inflation prevails. Under either scenario, however, debt deflates in real terms.
Austrian School advocates are frequently identified as proponents of a monetary gold standard. This is really just a subset of their monetary views, which sees the free and unchecked extension of unreserved credit as the ultimate travesty. In today’s society, the monopoly power granted exclusively to banking systems in the developed world is terribly misused during periods of credit expansion. History clearly bears this out. In the end, it is the modern saver who bears the burden during the ensuing credit deflation.
We should change the game and transfer power back towards the private sector. Politicians could then argue about what they feel would be the optimal uses of their tax receipts, such as defense or national health care. Or, we can continue on as we have.
Burning Matches
All global currency values now rely solely upon confidence in global public policy. The current global monetary regime has become a confidence game that people in positions of power are foisting upon the disparate masses. Too harsh, you say? We don’t think so. The current powers-that-be are not operating in the best interests of people across all income levels and they should be called out on it.
The current system ensures no capital will be produced among the most indebted economies, which in turn implies there will be a transfer of wealth to less indebted economies.
All global economies no longer have currencies that act as stores of value, which means that paper currency holders cannot save. One cannot gain future purchasing power by placing earnings in a savings account. Alternatively, one cannot afford to pull his or her wealth or liquidity out of market-based investments without suffering a decline in purchasing power. Worse still, deeply indebted developed societies need even more money to repay outstanding claims (as well as to pay taxes). With risk-free interest rates way below the rate of monetary dilution, no matter where we put our savings we are all holding burning matches.
Have you asked yourself why interest rates are so low when the demand for money is so high? Could it be because governments and banks need the money and have the power to borrow it (from the people) and manage its pricing?
The people have no choice in the matter. Most Americans, for example, have not accumulated unencumbered purchasing power. Or, if they once had it, they have subsequently had to re-allocate it from savings to equity – in homes and corporate shares. (This re-allocation was entirely rational given that saving it over the last twenty years would have provided negative real rates of return when compared to the loss of purchasing power brought about by monetary and credit inflation.)
The net effect is that the great majority of Americans would have negative net-worths, were we to subtract the value of our liabilities from the current liquidation value of our assets. And given US demographics, it seems obvious that the natural pace of diminishment of our liabilities (through amortization) will not be fast enough to produce positive net-worths were we all to stagger our equity liquidations over the next 10 years.
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We know it is unrealistic to expect global leaders to stand idly by while economies naturally shrink to sizes capable of sustaining longer-term output and employment levels, even if such economic pain would bring global economies out of its contractionary cycle quicker. Given the already very high levels of public and private debt as percentages of annual output and assets, (about 600% and 200% respectively), it stands to reason that without policy intervention, output and assets would shrink/devalue in nominal terms. Public discontent would surely rise, in turn compelling further political intervention.
We shouldn’t expect Paul Volcker to save the day. He was able to raise interest rates to drain the system three decades ago because developed countries were not nearly as levered then. The US budget deficit was about 2.5% of GDP in 1980 as opposed to about 13% today. More importantly, the private sector was nowhere near as indebted and in fact had net savings. Today’s global economy presents a very different set of circumstances.
The insidious cycle of monetary inflation is upon us and there is no way out. The best argument we know for being absolutely sure that monetary policy makers will not withdraw Monetary Base or credit from the system is because they have not done it yet. In their eyes, there will always be an economic imperative to do no harm in the short term. Applied to today’s highly leveraged developed economies, monetary and credit contraction equals output contraction.
The alternative — further credit promotion without end — is unconscionable because it makes the problem worse. Yet that is the plan. Politicians across the spectrum have tacitly agreed that the most rational and expedient way out is to destroy currencies slowly so that debtors do not suffer sudden bankruptcy brought about by overwhelming credit deflation.
If policy makers and politicians want to keep control over their economies (a presumption we are willing to make), then they don’t have a choice but to destroy their currencies in some way, shape or form.
And so we think policy makers are embracing currency debasement with gusto. They are transferring paper-denominated credit from private to public balance sheets and they are doing so on a global basis. We are experiencing global currency devaluations in absolute terms (vis-à-vis natural and sustainable resources); yet these devaluations are being masked because relative currency valuations are being held comparatively constant through policy intervention. This is not the ranting of conspiracy theorists because we can see FX capital flows and the re-pricing of global resources.
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There is a solution. Mr. Obama, de-value the dollar formally and simultaneously peg it to gold. In doing so, you and other policy makers in the developed world would be able to arrange terms and manage the outcome of a new monetary regime and a sustainable global economy.
As we wrote last July:
Potential Endgame: A Managed USD Devaluation
As we first hypothesized last fall (2008), we think there is a growing likelihood that policy makers will see the handwriting on the wall for the US dollar and act to pre-empt the utter economic chaos they will have wrought from copious money printing. The pragmatic solution would be to formally devalue, and peg, the US dollar to gold.
It would work like this: The Fed would monetize gold at a substantial premium to its current nominal price. As we quantified through the SGP (the Shadow Gold Price, which uses the Bretton Woods monetary discipline to value paper money to gold), the gold price peg would have to approximate $6000/oz to remediate all past monetary inflation. (Since this discussion in July 2009, that price has risen to about $8,000/oz.) We doubt this would occur. It would be more likely that the Fed would announce a public tender for privately held gold at, say, $3000/oz. Any gold tendered would be funded with the creation of new Federal Reserve Notes.
While this would be massively inflationary it would also be discrete in its application. In other words, once the Fed acquired enough gold from the free market at $3,000/oz, a gold price peg for the dollar could be established and maintained. The solvency of the banking system would be re-established by such measures, as most assets would appreciate in nominal dollar terms to the point that loan books, etc. would once again be fully-secured.
The positive consequences of formally devaluing and pegging the dollar to gold would be obvious: the burden of repaying public and private sector debt would be inflated away versus the higher nominal revenues, wages and public tax receipts, and by pegging it to gold the US dollar would again gain credibility in the world – and probably increase its reserve status.
The negative consequences would be that dollar holders and creditors (bond investors and banks holding debt as their assets) would find the value of their cash/assets diminish substantially in real terms. Pension funds, bond funds and banks would be hurt.
So what? It is happening anyway, only more slowly. Remember, there are only two ways the financial system can de-lever in today’s environment:
- Asset/collateral values contract or,
- Monetary reserves increase
In the first instance, the highly levered banking system is most likely to be wiped out. In the second, the currency is most likely to be ultimately wiped out.
Dollars can gain absolute purchasing power value only if less of them exist tomorrow than today. If fewer dollars were to exist tomorrow, then dollar denominated debt currently outstanding could not be repaid (in fact many more dollars must be printed to pay off future claims on already existing debt). Therefore, dollars cannot gain value in real terms unless no more are printed AND unless dollar-denominated debt is defaulted upon.
That will never happen. Voters will never proactively sacrifice their balance sheets or lifestyles in the short term so they will never let their politicians drain reserves.
Beyond the loud proclamations, there will be no relief forthcoming from Washington given the current regime. Maybe policy makers are just trying to suspend reality as long as they can, hoping something from another dimension provides enough cover to press the economic reset button (as World War II did in the 1930s)? We just don’t know.
To prevent a contracting economy and contracting wealth then, policy makers will continue to contrive new dollars so that they can, in effect, refinance current claims. This process creates even more debt. Thus, the public will eventually figure out that their dollars are debt that cannot be repaid. Dollar holders will stop working.
Mr. Obama, this is your moment. This is your time. This is your place. You are The Man and this would be change we could all believe in.
Best,
Lee & Paul