So hurricane Irene is over with, but it didn’t take long for economic commentators to make fools of themselves.
David Kotok is the chairman and chief investment officer of Cumberland Advisors. He was on the radio with Larry Kudlow, who asked him about the economic impact of Irene. Kudlow noted how Irene tracked over 1/10th of the nation’s economic output. Here is Kotok writing about it to his investors afterward about Cumberland’s response:
“We are now upping our estimate of fourth-quarter GDP in the US economy. Billions will be spent on rebuilding and recovery. That will put some people back to work, at least temporarily. We speculate that Washington may set aside the usual destructive and divisive partisan political wrangling and act in the interest of the nation. That means there will be a flow of federal financial assistance to the disaster areas.”
This is horrible, horrible reasoning. It is the old broken window fallacy, which we see trotted out by otherwise intelligent people anytime there is a natural disaster. These people say that destruction is an economic boost, as we busily rebuild what was lost.
It’s a shame people continue to repeat this. The great economist Frederic Bastiat killed this idea decisively in an 1850 essay, “That Which Is Seen and That Which Is Unseen.” It remains a classic essay on economic reasoning.
In his usual witty manner, Bastiat wrote a parable about a boy who breaks a window. The “seen” is the glassmakers who have new business they didn’t have before. That’s what people like Kotok focus on. But as Bastiat wrote:
“It is not seen that as our shopkeeper has spent 6 francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his 6 francs in some way, which this accident has prevented.”
Kotok’s point about federal assistance is particularly depressing, because he seems unable to recognize that this is simply money taken from someone else.
Please don’t fall for the broken window fallacy. And please correct anyone you hear using it. It seems the first step in basic economic literacy. Hurricane Irene was a dead loss for the economy. Period.
By the way, Frederic Bastiat is an old favorite of mine and was influential in shaping my economic views early on. I have a handsome two-volume collection of his works, put out by the Ludwig von Mises Institute. I highly recommend the set for anyone looking for sound logic applied to economic questions. Bastiat is enjoyable to read and not like any economist you’ve ever read.
For those not inclined to read that much, I recommend Henry Hazlitt’s Economics in One Lesson. Hazlitt devotes a whole chapter to the broken window fallacy. His book is my No. 1 recommendation for anyone looking to learn the key ideas of economics. It’s a classic.
Now, let’s turn our attention to the volatile stock market…
The market is rallying off its recent lows. This rebound is surprising if you focus on the bad economic news and the potential for another recession. But it’s not surprising if you look at stocks compared with what else you might do with your money.
A couple of weeks ago, I wrote about how “relative to Treasuries, stocks haven’t been this attractive in more than 30 years.” Shortly after the panic, lots of money came out of the market and went to Treasuries. It was a tidal wave of money, which pushed the short-term T-bill negative for a brief moment. But it would be irrational to stay there for long, given where stocks are.
James Bianco, of Bianco Research, added to that thesis in a report to clients. His chart shows price-earnings ratios for the last half-century, along with his projection of 2011 earnings. Take a look:
“Low rates benefit p/e (price-earnings ratios) more” than slowing economic growth hurts them, Bianco maintains. Based on the 10-year Treasury rate of 2.2%, he thinks fair value for the S&P 500 would be at least 14 times earnings. That’s 1,358 on the S&P, which would mean a 13.5% rise from here.
Of course, you could poke holes in this a few different ways. Interest rates could rise. And earnings could fall. So far, neither has happened. Corporate profits for the first half of the year have been strong, for example.
I find the above interesting, but I don’t really care all that much either way. In my investment letters, Capital & Crisis and Mayer’s Special Situations, I never recommend “buying the stock market.” I recommend buying specific stocks. Specific businesses. And I look to hold onto them and not trade them. I will use the market to add to or sell when prices suit me. But otherwise, I let the market do what it will do.
Still, it can be helpful sometimes to have a sense for the backdrop on the overall market. In the late 1990s, it helped to understand the market was frothy. By 2000, it made no sense at all, with even ho-hum companies like Coca-Cola commanding a price-earnings ratio of 50 times. It helped to know in the late 2000s that there was a housing bubble. It meant you skated around banks, real estate and housing stocks.
Today, though, there are no such extremes in the stock market as a whole. I think the market is in some gray middle area — neither cheap nor dear.
Chris Mayer,for The Daily Reckoning
Chris Mayer is managing editor of the Capital and Crisis and Mayer's Special Situations newsletters. Graduating magna cum laude with a degree in finance and an MBA from the University of Maryland, he began his business career as a corporate banker. Mayer left the banking industry after ten years and signed on with Agora Financial. His book, Invest Like a Dealmaker, Secrets of a Former Banking Insider, documents his ability to analyze macro issues and micro investment opportunities to produce an exceptional long-term track record of winning ideas. In April 2012, Chris released his newest book World Right Side Up: Investing Across Six Continents.
If Obama follows Cumberland’s logic, he would send the army all over the hurricane path and make sure everything is destroyed. Then send in the air force to bomb it to stone age.
Now hire millions of people to rebuild the east coast. Isn’t that wonderful?
Paul Krugman would certainly endorse the idea.
“This is horrible, horrible reasoning.”
not for the bankers or infestors. since the repairs will not be paid for by savings or taxation that means they will be paid for by borrowing. that means more interest payments to the bankers and infestors. nothing wrong with their reasoning at all.
Obama will announce more “shovel ready jobs” when he addresses the nation on September 7. Perhaps he could employ a battalion of workers to dig a trench from coast to coast and then another to follow right behind and fill it back in. This would ensure full employment for many people and have a “ripple effect” on the economy as a whole. Actually though, I think the Prez has already shoveled enough on us, what he’s shoveling I’m not going to say!
Actually I find a problem with the broken window analogy. It assumes that the money was going to be spent anyway, if not on the window than on something else. What if the shopkeeper had planned to keep the money in a savings account or even worse, under his mattress where it’s not circulating in the economy at all? By spending on the glass repair it stimulates the economy as a whole, gets those dollars back in circulation. I remember a whole lot of happy roofers back when Hurricane Andrew tore through Florida.
GMan said: ”
This is horrible, horrible reasoning.”
not for the bankers or infestors. since the repairs will not be paid for by savings or taxation that means they will be paid for by borrowing. that means more interest payments to the bankers and infestors. nothing wrong with their reasoning at all.”
This has been the same rationale behind the explosion in the financial services sector of our economy relative to the productive sector where folks actually build useful things that someone would want to buy. And you’ve seen where this has led us.
“And you’ve seen where this has led us.”
and we also see where it has led the bankers and infestors. why should they be unhappy about any of this?
Oh, I agree but it’s a state of affairs that certainly cannot continue on forever. The parasites will consume the host in the end and then what? If it had not been for the massive Federal bailout of the financial services sector in ’08 and ’09 the investment bankers would have already gone the way of Lehmnan Bros and we could have begun the important task of rebuilding our economy along productive lines.
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