Mauldin Reports
The Daily Reckoning presents selected articles from best selling author Bill Bonner…
- THE GODS’ NEXT BIG LAUGH
- PROMETHEUS, WITH THE CUFFS ON
- DAS PHONY KAPITAL
THE GODS’ NEXT BIG LAUGH
by Bill Bonner
Hear that noise? That’s the sound of the gods laughing They’re laughing at Northern Rock, Bear Stearns, and all the angels, archangels, seraphim and cherubim of the whole financial industry. The geniuses thought they had put an ankle bracelet on uncertainty. They believed that with their new tools they could model risk, quantify it, and control it. Now, they’re going broke…and the gods are tumbling off their chairs.
But listen up, because the biggest laughs are still ahead. Alan Greenspan, the world’s best-known civil servant since Pontius Pilate, wrote in the Financial Times this week. In the interest of saving readers’ time, we reduce his half-page circumlocution on today’s financial crisis to 4 simple words: it wasn’t his fault. An unexpected and unpredictable force had taken over in the financial markets, he explained…a kind of ‘dark matter’ that caused everyone to act a little funny. According to Mr. Greenspan the source of the proximate problem is the homebuilding industry. For some reason, (he decided not to mention what), it overbuilt. The crisis will end, he continued, "when home prices stabilize and with them the value of equity in homes supporting troubled mortgage securities."
Mr. Greenspan further explained that "trust" in the system was "badly shaken"… "when BNP Paribas revealed large unanticipated losses on U.S. subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?"
He followed this rhetorical question with what was essentially an elaborate feint, designed to send the hounds barking up the wrong tree. Risk management systems, he says, "do not fully capture what I believe has been, to date, only a peripheral addendum to business cycle and financial modeling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve." The former Fed chief has a point. The public is subject to mood swings. It is just a shame he dodged credit for his own contribution to the euphoria of ‘2002-’07.
Looking back at the long history of the market’s manic-depressive episodes, it is difficult to find an instance in which extreme mood swing was not exaggerated by something in the water. Neither the Mississippi Bubble nor the South Sea Bubble would have happened had not John Law invented the first central bank – the Banque Generale – in 1716. Americans wouldn’t have been so bumptious in ’29 had it not been for Fed chairman Benjamin Strong’s little ‘coup de whiskey’ intended to help out his friend Montagu Norman at the Bank of England. The Japanese wouldn’t have goosed their stock market up to 39,000 (currently near 12,000) had it not been for the exceptionally low interest rates following the Plaza Accords in September 1985; rates were cut four times the following year – sending Japanese property and equities soaring. And Americans never would have gone on a residential property binge had the prime rate not been kept exceptionally low for an exceptionally long period under the leadership of the very same person writing in the Financial Times this week: Alan Greenspan.
Centrally-planned prices send the wrong signals and cause people to miscalculate. And no price causes as many miscalculations as the price of credit – controlled at the short end by central bankers. Of course, anyone can make a mistake. But to make the kind of mess we’re seeing in the capital markets now, you need a theory. Of course, central bankers had one.
The foundation for modern central banking theory was laid down in the very year Alan Greenspan was born – 1926. That was when one of the first "neoclassical" economists, Professor Irving Fisher, published "A Statistical Relationship between Unemployment and Price Changes," arguing that a little inflation was a good thing, since it seemed to stimulate employment.
Then, "in the 1970s," writes Nobel Prize winner Edmund Phelps in the Wall Street Journal, "a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks – like coin throws – subject to known probabilities…"
By 2001, the Fed opened a new museum in Chicago. Visitors were invited to look at the economy as though it were a science project. They were confronted with a problem and asked what would be the appropriate response – lower rates or raise them? Then, they were given the correct answer.
Today, America’s central bank applies a "rule based monetary policy" – supposedly founded on the ‘scientific’ discoveries of Irving Fisher and his heirs. What’s the rule? Balance out inflation against unemployment. When inflation threatens, raise rates. When the economy is menaced by unemployment, cut them. And always, like a dishonest butcher, make sure your thumb lingers on the inflation side.
Professor Fisher lived long enough to see the gods laughing at him. Just days before the stock market crash of ’29 he wrote, "stock prices have reached what look like a permanently high plateau." Then, when the crash came he said that the "market was only shaking out the lunatic fringe," and claimed that prices would soon go much higher. A few months later, Fisher had lost his fortune and his reputation, but still told investors that recovery was just around the corner.
So far, Alan Greenspan has only gotten a few chuckles, as he attempts to explain where he was and what he was doing when the world’s biggest bubble took shape. But the more he explains, the more people understand: that the ‘science’ of central banking is nothing more than claptrap, and Mr. Greenspan is a scalawag.
Regards,
Bill Bonner
The Daily Reckoning
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning . He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis . Bill’s latest book Mobs, Messiahs and Markets is an Amazon Best Seller.
PROMETHEUS, WITH THE CUFFS ON
by Bill Bonner
Money carries no passport, but it slides through almost any border. It flies no flag, but it is welcome in almost every nation. It speaks no language, but when it talks, everyone listens. But for all its passe-partout appeal, money has more enemies than friends. And the biggest threat is probably is the financial industry itself.
"Don’t worry," the bright young man at a London private banking told us, "we maintain the highest levels of professionalism and use the most sophisticated tools of modern portfolio management."
That was just what we were worried about. What follows is a lament…and a complaint…about the current state of people in the financial métier: they have been disabled by their own theories…handicapped by their own greasy trade.
We were impressed by the man in front of us. Handsome, well-dressed, well spoken in three different languages, he had spent years learning the principles of economics, finance and business management. His palaver to prospective clients was flawless. Yes, he said, the research department is keenly searching for alpha…but it knows that 80% of performance comes from careful asset allocation, which the bank’s strategists have calculated based on risk/return analyses going back a hundred years. The expected return from Japanese equities over the next five years, for example, will be precisely 7.56%…but with an anticipated volatility of 20.43%.
But then we learned that we didn’t have to live with volatility. The firm’s analysts have done extensive research, he explained; they’ve been able to find many different asset classes that had equal and opposite volatilities.
When Japanese stocks bob in one direction, for example, the firm’s Ultra-leveraged Macro Opportunity Hedge fund weaves in another.
Just throw the mathematicians a bone; they’ll figure out how to put these things together so that you can optimize your return while minimizing your risk. Then, according to the math whizzes’ calculations, you could find yourself with a 90% probability that your $100 investment will grow to somewhere between $292 and $132 in year 10. This, it should be mentioned, is a "nominal" value. Even if the target is hit, the $132 may not even buy you a cup of coffee in London. It barely buys you one now.
So many numbers… 6s and 7s…5s and 4s…every number the Arabs ever invented is brought into service. But what do they really mean?
"Can you tell us what the price of oil will be next week," we began to torment our interlocutor. "Or, how about the dollar?"
"Of course not."
"Then, how can you make projections ten years out…on investments, all of which will be greatly influenced by the price of oil, the strength of the dollar, inflation rates and completely unforeseeable events?"
"Well, these are not predictions. They are projections, based on many years of experience. Our researchers are the best in the business, with degrees from Harvard, MIT and Oxbridge. Of course, no one knows what the future will bring…but these projections are the best output of modern portfolio management."
Pointing to a helpful chart supplied by the investment firm, we continued our interrogation:
"In the last 6 months, Merrill Lynch has had to write down an amount equal to almost half its book value? UBS has written off 40%. If these financial engineers were really able to project earnings and risk out to 2 decimal places, how come they couldn’t protect themselves from this blow up?"
They ought to give special parking places to anyone who studied business, economics or finance in the last 30 years. Higher education has lowered their I.Qs. Years of toil in academia have weakened their vision and taken the common sense right out of them.
A blind man could have seen the blow-up in sub-prime coming. But somehow, the geniuses missed it. What went wrong? The disabling infection may be understood by looking at how the hot shots handle risk. Of course, they don’t really have any way of knowing what real risk is; no one can know the future. For all we know, a plague will wipe us all out in the next three weeks. None of us knows what the price of oil will be next week…or next year…or 10 years from now. Nor do any of us know what real risks the oil market faces. War…weather…technological advance…who can say?
But rather than admit that it just didn’t know…the financial industry embarked on a staggering series of myths and conceits that must have taken the gods’ breath away.
Since they couldn’t know real risk, they substituted volatility as a proxy, which is a little like getting an inflatable doll to take your wife’s place at a dinner party; the conversation may be dull, but at least she won’t contradict you.
Once they had shut up risk, they could say whatever they wanted. They could pretend that price movements, for example, were like natural phenomena. It was absurd and everyone knew it. Prices depended on what people thought; volcanic eruptions did not. But Richard Fama put forward the Efficient Market Hypothesis in the 1960s as if he had stolen the gods’ fire. He claimed market data could be treated as if they were random fluctuations. If an earthquake had stuck Rome only twice in the last 100 years, the ‘risk’ of an earthquake was only 2%. For all they know, the streets of the Eternal City will rock and roll every day for the next 200 years…but this little subterfuge gave their mathematicians something to work with. Then, looking at price patterns as if they were seismic records, they could make all sorts of fantastic simulations…and come up with fancy new products, such as a Highly Leveraged, Sub-prime Debt Portfolio. Using historical norms, they pressed the junk credits together like potted meat and — in a miracle that would have floored Jesus – transformed it into Prime A.
But it was all nonsense. The prices thought to be random weren’t random at all, but the consequence of practices, ideas, and institutions built up over centuries. Change the circumstances…and the numbers changed too. As Soros puts it, markets are ‘reflexive.’ In our words, prices are neither fixed nor random…but subject to influence. For example, it was observed that stocks outperformed bonds over the longterm. Stocks for the Long Run was the title of a best-selling investment book in 1994, which argued that stocks would make you rich if you held them long enough. This long-term reward was in return for investors’ willingness to take short-term risks; they called it the risk premium…which they defined, again, as volatility. Stocks were down in some periods, but always up over the long term. Thus, for a person who could wait, there was no risk at all.
By 1999, no truth was more obvious: stocks would make you rich. By then, the whole financial world was alight…stocks had risen three times since 1994 – to over 11,000 on the Dow by the end of the year. Now, it was time to pour on the gasoline. Another best-seller appeared that year: Dow 36,000.
No one seemed to notice that those data points that convinced investors that stocks were such a great investment were registered when people thought stocks weren’t so great. For much of the stock market’s history, investors had demanded higher dividend yields from stocks than they got from bonds – to make up for the risk. And they had rarely paid more than 20 times earnings. Yet, in 1999, the p/e ratio of the S&P rose over 32 – about twice the long term average. Circumstances had changed; the insight was no longer valid. And the fire went out.
The Dow may still go to 36,000, probably when a cup of coffee goes to $132. Last we looked, it was almost 10 years later and the Dow was back to where it ended 1999. During this time, too, the dollar has lost about 30% of its purchasing power…so the investor who believed in stocks for the long run is down about a third.
To be continued…
Bill Bonner
The Daily Reckoning
DAS PHONY KAPITAL
By Bill Bonner
A good flim flam needs a good mountebank and a good mark. Two weeks ago, we pointed out that Wall Street was full of bright cads and dull sharks. Then, last week, we showed that conceited humbuggers run the central banks. Today, it is the politicians we come, not to bury, but to praise. They did their work well; they set up the marks.
The two great political figures of the last thirty years were Mrs. Thatcher and Mr. Reagan. These titans from the two sides of the Atlantic led the way to a new idea of how the world should work. Thenceforth, capitalism was king. But it was a new kind of capitalism they had crowned, one with a strange, unnatural face. It was not the old free enterprise, king of the jungle, red in tooth and claw. This new capitalism was more like the owner of a pet shop, where all the animals were cute and cuddly — and didn’t eat the customers.
Mrs. Thatcher and Mr. Reagan and their followers had seen how centrally planned economies worked; the Chinese and Russians showed what happened when bureaucrats ran an economy. The free market seemed like the best alternative. But the trouble was, these new ‘conservatives’ had no real respect for it. Instead of quaking before it in genuine fear and awe, like Moses before the burning bush, they began to believe that they could be its master. Then, they developed a whole host of fantasies about what this tamed beast could do for them.
Not only could the free market solve the problem of poverty, it could solve almost every other problem too. It was a social panacea. Just look at the wealthy countries, they said. Switzerland is clean and prosperous. By contrast, communist China is a dump. People are healthier and happier in capitalist countries, where they have better automobiles and lower birthrates. Science, supported by the free market, would find cures to diseases too…and even help people live longer. The logic was simple enough: free enterprise made people rich. And with their money, they could do wonders — cleaning up the factories, building hospitals and clinics, organizing public day care and Pilates classes…even getting rid of smoking!
Nothing was too absurd or contradictory for the True Believers. Gradually, they began to confuse the fruit with the tree…and then mistake the tree for a lamppost. Financial incentives were thought to be the key to everything. If an executive failed to maximize shareholder value, it was because his bonus was not large enough. If students showed poor test results, it was because teachers were paid by the job, not by the outcome. And if terrorists attacked a building in New York, it was because they lacked financial opportunities in Cairo. (Later, people were dumbfounded when doctors who had worked for the National Health Service tried to blow up cars in Glasgow and London.)
The ideas were slippery but they greased the skids. Soon, the marks were ready to go along with anything. Shareholders consented to hundreds of millions in bonuses and stock options for key executives. Investors signed up for hedge funds, willingly giving managers "2% and 20%" for putting quarters in the slot machine for them. Taxpayers allowed huge tax cuts – widely believed to be aiding the wealthy – because they looked forward to the day when they would be wealthy too. And almost everyone, everywhere eagerly went on a spending spree, in the belief that this new, kindler, gentler capitalism would add wealth faster than they could get rid of it. And if they overspent, hyper-capitalism would soon catch up.
In public finance, this delusion led to Dick Cheney’s famous quip: "Deficits don’t matter." This, in turn, led to the greatest explosion of government red ink the planet had ever seen. During the first seven years of the George W. Bush administration, about $20 trillion was added to the U.S. ‘financing gap’ – more than under all America’s other presidents put together.
What was good for the top was good for the bottom. Private households, too, ran deficits of their own. Savings rates fell close to zero while U.S. household debt rose from less than $2 trillion in the first year of the Reagan administration to nearly $13 trillion in the 6th year of the present administration.
In Britain the story is about the same. Before the Thatcher revolution, household debt was about 65% of household income. By 1988, it had reached 100%. And by 2007, it was more than 150%.
When a consumer spends a dollar he earned, it is taken in as income to the businesses that receive it. But it offset by a cost too – a wage expense. But if the consumer spends a borrowed dollar, it comes to business like manna from heaven, with no balancing wage cost. Higher profits, greater leverage, more debt — it was all catnip to Wall Street. Financial assets were only 4.5 times GDP in 1980. Now they are 10 times as large. But that is nothing compared to the sugary confections of the credit industry. Credit default swaps, alone, are said to be worth $45 trillion.
The earnings of the financial sector equaled only 10% of total corporate earnings in 1980. By 2007, they made up 40% of the total, even though they still only employed 5% of the workforce.
But, "that game is now up," says the Economist. The "new" capitalism was a fraud. It didn’t make people rich. It only allowed them to get rich – or poor – depending on what they did with it. Americans used their economic freedom to ruin themselves. But that’s just the way capitalism really works. You don’t get what you expect…or what you want; you get what you deserve.
Bill Bonner
The Daily Reckoning
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning . He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis . Bill’s latest book Mobs, Messiahs and Markets was written with co-author Lila Rajiva.
