Moral Hazard

“We cannot guarantee success, but we can deserve it.”

– George Washington

In a small town in the Midwest, a man would have to sneak around, under the eyes of his neighbors, in order to get up to something. Then, word would get around…and soon the whole thing would be over.

But here in Paris, there are moral hazards on every street corner, which is what we like about the place. Here, a man can get into trouble and stay there for a long time before it catches up to him. And if he has no vice when he arrived in town, he can pick one up quickly and develop it into a life-long companion.

After work, your editor could sit down at the Paradis, have a few drinks and a cigarette, and then wander over to the rue St. Denis and enjoy himself with Brigitte or Francoise for a modest outlay.

If he were more ambitious about his vices, he could take up gambling…stock market speculating…or even theft. He might begin picking pockets on the metro and work his way up…first to robbing his partners or defrauding investors…and then, on to the big time, he could go into politics.

Homo Economicus: Always a Price to Pay

There is a certain rhythm to moral hazards. Whether petty or great, all are exhilarating at the beginning…and heartbreaking at the end. For there is always a price to pay.

“All the universe is moral,” wrote Emerson early in the 19th century. Now, no one believes it…except us.

And yet, the cycle is same for market booms, empires, and even an individual life. What tickles the fancy so much at the d undefined but, saddens it at the finale.

“Whatever your weakness,” says Richard Russell, “the market will find it.”

Greedy investors wait too long to sell – and lose their money. Fear keeps others from ever buying in the first place. Laziness gets others – who fail to do their homework and get carried along by mob sentiments into buying the most popular stocks at their most absurd prices.

Homo Economicus: No Moral to the Story

“I ought to have sold at the top,” says the one. “I ought to have bought at the bottom,” says the other. “I ought to have looked at the balance sheet,” says the third. “I ought not to have drunk that last bottle,” says the fifth.

But modern economists act as if the story had no moral…as if there were no ‘oughts.’ Everything happens according to cause and effect, they believe.

There is no such thing as a stock that is too expensive or too cheap, they say…because the stock market is perfect. It finds the exactly ideal price every minute of every day.

There is no such thing as moral failing either. A man cannot be faulted for buying a stock at its perfect price.

And prices would be perfect, if the man were the man that economists think he is. In their minds, man is a rational, profit-optimizing machine. That is, he is unlike any man anyone ever met…he is Homo Economicus…the mythical creature of economists’ imaginations…always making the right decision after carefully weighing the available information.

Real men rarely weigh anything carefully – except perhaps sirloin steaks when they buy them by the pound. Many never met a moral hazard that they didn’t like.

And when they participate in collective undertakings – such as politics, war, football games or stock market booms – they immediately become even bigger boobs, making fools of themselves as regularly as faucet drips.

Economists then imagine that the economy functions as a sort of machine, too – with Homo Economicus popping up and down like valve lifters. No moral hazards present themselves…for a machine is as inert to larceny as it is to a short skirt.

Homo Economicus: On the Way to Hell

You can put a pack of cards or a fifth of whiskey in front of a machine, come back an hour later, and the machine still won’t have touched them. Not so a human being. All he needs is an opportunity, and he’s on his way to Hell!

The term ‘moral hazard’ has a special meaning as well as a general one.

“The idea is simple,” explains Jeffrey Tucker in an article published by the Mises Institute in December of 1998, “If you are continually willing to protect people from the consequences of their own errors, your benevolence will be factored into the future decisions of the persons rescued. In the long run, they will make even more errors. The principle exists at all levels. The teacher who changes grades when students plead hardship isn’t helping in the long run. The teacher is rewarding and thereby encouraging poor study habits. He is creating moral hazard.”

The new, collectivized world of the late 20th century was full of accommodating teachers and forgiving wives. Investors paid too much for stocks. Businesses and consumers borrowed too much. And the whole world seemed to believe what couldn’t be true – that the dollar was more valuable than gold. For nearly 20 years, gold went down while the dollar went up.

Gold ought to have gone up. Since the beginning of Alan Greenspan’s term, the Monetary Base has almost tripled. In the most recent few years of Mr. Greenspan’s term, short- term interest rates have been driven down to barely a fifth of what they were two years ago.

“[L]owering rates or providing ample liquidity when problems materialize, but not raising them as imbalances build up, can be rather insidious in the longer run,” concedes a working paper from the Bank of International Settlements. “They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”

By the beginning of 2003, there were an estimated $9 trillion of U.S. dollar assets in foreign hands…and three times as many in circulation as there had been in 1987. The hazards had never been greater…nor ever so hard to see…

More Monday…

Bill Bonner
Paris, France
January 10, 2003

————

The U.N. has revised its world growth estimate for 2003, says yesterday’s news. It’s expecting 2.75% growth.

Not too bad. It would be better, says the U.N. report but, alas, the U.S. economy is “without decisive momentum.’

The decisive momentum in America has long been supplied by consumers. For the last 5 decades, they just kept spending their little derrieres off. Consumer spending as a percentage of the economy has steadily increased…to 70%, the highest ever. But lately, consumers can’t seem to make up their minds. Should they spend…or save? Buy or sell? Laugh or cry? Consumer credit fell in November by $2.2 billion…the first time it has done that in 5 years. And then came the “worst holiday shopping season in 30 years”.

What if the American consumer suddenly decides he’s bought enough…spent enough…borrowed enough…and, generally, had enough?

This is the whole world’s worry. “Now is no time for restrictive budgets,” said France’s president Jacques Chirac, voicing an opinion that could have come from almost any government official of any country in the world. Every central bank is inflating…every government is providing ‘fiscal stimulus’. And everyone is counting on the American consumer to continue spending.

“He can’t keep it up forever,” we point out. As a consumer economy ages…it takes more and more stimulation to produce anything. In 2001, for example, it took $65 worth of new debt for every single dollar of extra output.

Consumers are aging, too. And getting a little desperate. The Kansas City Star reports that ‘reverse mortgages’ are catching on among retired people. Instead of giving up equity little by little by repeated refinancing, the reverse mortgage allows them to get rid of all the remaining equity…and get paid out over time.

The consumer ought to grow cautious…sell a few shares…buy a little gold…and pay down his debts. Maybe this will be the year he does so.

But let’s see what happened on Wall Street. Eric?

————

Eric Fry, checking in from the Big Apple…

– The bulls will not be denied their January rally…and who are we to deny them their momentary respite? We would sooner deny a condemned man his last cigarette. As the “buy” orders poured into the NYSE yesterday, the Dow soared 181 points to 8,776. The Nasdaq jumped 31 points to 1,076.

– Meanwhile, bonds tumbled and gold rested. The 10-year Treasury note dropped sharply yesterday, driving its yield up to 4.16% from 3.98% on Wednesday. Maybe the President’s $687 billion spending plan isn’t such a great thing for bondholders after all. Gold slipped 60 cents to $353.70 an ounce.

– It is no secret that the Daily Reckoning teams on both sides of the Atlantic believe that gold ought to rise and that the dollar ought to fall. One big reason the dollar ought to continue weakening is that investing in U.S. assets is no longer as pleasant an experience as it used to be.

– Throughout the 1990s, the U.S. stock market was a sort of financial geisha to foreign capital. The market was so hospitable that foreign capital all but refused to leave. But these days, the geisha is a gangster. The moment foreign capital steps foot on our shores, it is accosted by falling asset values denominated in a depreciating currency. This inhospitable treatment seems to be frightening foreign capital already, as evidenced by the dollar’s steep decline against the euro over the last 12 months. We should not be surprised if many more foreign investors begin to pack up their valises and head home.

– “From across the seas,” Jim Grant explains, “America is perceived as a hegemonic power or, alternatively, as the Great Satan. It is also seen as a kind of growth stock. What growing enterprises do, in the course of growing, is finance themselves, and the world is (or has been) more than willing to lend and invest in the 50 states. However, there are signs of a change in these perceptions and proclivities. More and more, foreign dollars are finding their way into government obligations instead of into the kind of business investment that contributes to growth.”

– At least SOME money is still flowing our way. That’s the good news. The bad news is that a T-bond is much easier to sell than a factory. So if/as/when foreigners decide to head for the exits, they’ll be able to do so instantly, by selling their vast holdings of bonds and stocks. The dollar’s fate – more than ever – rests in the hands of foreign investors…

– “After nearly three years of doom and gloom, we as much as anyone would like to believe that tech spending will improve in earnest this year,” writes Mark Veverka of Barron’s. “But we can’t. The evidence simply isn’t there to support the notion that corporate buyers are ready to load up on new hardware, software and services.”

– Veverka cites the findings of a recent Goldman Sachs information-technology (IT) spending survey. According to the survey, IT spending will be bad in 2003…really, really bad. “Contrary to reports of stabilizing IT spending and investor optimism heading into 2003,” Goldman’s report observes, “our latest survey (which was conducted prior to the holidays in December) shows worsening across the board, with some of our indicators hitting new lows and a bias toward an expectation of further tightening.”

– Specifically, the survey reveals that IT spending is likely to FALL in 2003. That’s a first. “Remember,” writes Veverka, “this is an industry that was used to seeing 14% annual hikes in corporate IT spending during the boom…Now respondents to the survey say they expect to spend LESS in 2003 than the year before.”

– More worrisome, key components of the Goldman survey are deteriorating rapidly. “For example, the percentage of Goldman’s respondents in December who expected spending to decline swelled to 37%, from 23% in October and 16% in August. In fact, the Goldman analysts say they have never seen a more dramatic swing in their annual weighted survey than the most recent one.”

– Notwithstanding the grim IT-spending outlook anticipated by the folks who actually do the spending (or not), Wall Street analysts expect a recovery in the sector, as they always do.

– Last week, a couple analysts from Deutsche Bank Securities upped their earnings estimates for several semiconductor companies. In a classic example of what passes for research on Wall Street, the two analysts urged their clients to buy stocks like Applied Materials and Novellus Systems – not because sales will be improving in 2003, but only because the analysts expect the valuation multiples on the stocks to fatten up a bit. Specifically, they predict that Novellus will trade higher from its current valuation of two and a half times book value to a more opulent valuation of three and a half times book value. For the record, NVLS is also selling for a rich 64 times estimated 2003 earnings.

– In earlier financial epochs, two and a half times book value and 64 times forward earnings did not constitute “compelling value.” We can think of no reason why the current epoch ought to be any different.

————–

Back in Paris…

*** Jeremy Siegel, author of Stocks for the Long Run, is on the front cover of this month’s Worth magazine, promising to tell us “How to Play the Next Bull Market.”

We don’t know, of course, but Siegel may be getting ahead of himself. After stocks crashed in ’29, investors thought they were pretty safe buying 4 years later. Surely, stocks had found the bottom. But, “it took another 8 years, several bear markets, and then a war,” explains Ray DeVoe, “before the stock market really took off.”

After the boom of the ’60s, it took a long time again before another bull market began…and even longer for investors to take an interest in it. “From November ’71 through October ’79, investors made net withdrawals from equity funds in every month but one,” DeVoe points out. “Not until November 1981 were there two consecutive months of net inflows – even thought the S&P rose five of the six years from ’75 to through ’80.”

*** How far are we from ‘the bottom?’ Currently, Barron’s calculates the P/E of the S&P 500 at 34. The dividend yield is 1.7% and the S&P sells for 4.2 times book value. Looking at 14 cyclical bottoms (not big, bad bear bottoms such as the one we’re likely to have this time), ISI found that the highest P/E of any of them was 16.3 in the fall of 1960. The lowest dividend yield was 3.4% in October 1987. And the highest price to book was 2.24 times, in October 1990. By every measure, today’s stocks are nearly twice as high as the highest bear market lows ever recorded.

*** Today’s Figaro reports that 4 ‘homeless’ people have died in Paris from exposure to cold since temperatures dropped on Saturday. It might have said that 4 bums were too drunk to come in from the cold…or 4 lunatics were too crazy to do so. But this is the Age of Crowds…wherein people no longer get what they deserve…but what society gives them. More below…