The End of the Great Moderation
The average investor makes far more by accident than by fund manager. And here we venture a guess: of all the times and places in which a U.S. investor might hope to get a decent return on his money, this is not one of them. Bill Bonner explains…
This week’s news told us that good times are over. "For the time being, at least," said the Governor of the Bank of England, "the ‘nice’ decade is behind us."
Of course, just because an economist or a central banker says something, it doesn’t make it so. And when a central banker who is also an economist says something, it should be treated with the skepticism of an airline schedule.
"I am obviously biased, but I find it sad to conclude that the role of serious economists in financial institutions is very limited today," said Han de Jong, Chief Economist at ABN Amro Bank to the Financial Times on February 21, 2008. "We are little more than clowns, whose purpose is to entertain clients…."
Mr. de Jong is too modest. Economists are essential to the financial industry. They distract the customers while the boys on the sales desks pick their pockets.
We say that not in contempt but admiration; the role of the financial industry – like the contemporary art market or like Las Vegas – is to separate the punters from their money. Economists help them get the job done.
This they did in the last two decades with a variety of gaudy theories. It didn’t seem to matter that the theories were contradictory and absurd. On the one hand, prices were said to move randomly – permitting them to ‘model’ risk and sell extravagant securities. On the other hand, private equity experts and fund managers pretended to know which way the ‘random’ movements would go; they claimed to be able to produce "alpha" – above market returns – on a such a regular basis they could charge "2 and 20" for it.
But while economists are usually wrong about things, the burden of the present essay is that Mr. King is right this time.
Last week, we argued that ‘alpha’ was a mountebank. The financial industry doesn’t often add much value, we pointed out. Instead, fair winds and convenient tides are what usually get investors’ little barks where they want them to go. Most of the results investors get depend upon setting sail at the right hour, from the right place, in other words, not in having a Wall Street hotshot at the tiller. Put an alpha-seeking whiz-kid out in a storm and he’ll sink along with everyone else.
In the 20-year period ’83 to ’03, for example, the price of oil barely moved. Sheep could graze peacefully in the Mideast, confident of being undisturbed. Now, everywhere they go, someone’s setting up an oil rig. The latest figures show oil exploration up 400% since 2000.
Almost a whole generation of investors got nothing from that greasy sector. Then, all of a sudden, in the following 5 years the roughnecks suddenly had money in their pockets and the wind at their backs.
Likewise, in America, you could have held residential housing for 100 years – from 1896 to 1996. You would have gotten nothing for your trouble but leaky roofs and cracked paint; prices rose only as much as consumer prices. Then, the next ten years, a tide of easy credit rushed into the residential real estate market; prices rose 70% in real terms.
Behind both these booms is a story too long to tell here. But the moral of it is simple enough. The average investor makes far more by accident than by fund manager. And here we venture a guess: of all the times and places in which a U.S. investor might hope to get a decent return on his money, this is not one of them.
But the beauty of capitalism is that people get what they’ve got coming – not matter what they think. NICE is an acronym for "non-inflationary consistent expansion," according to Mr. King. It is his way of describing what other economists called the "great moderation," a period so agreeable that they gave themselves credit for it. Macro economists believed they had finally mastered the art of central banking – so perfectly manipulating the credit cycle as to produce growth without causing the consumer price inflation that typically accompanies it.
If economic wizards were really responsible for the Great Moderation, it would be reasonable to think they could keep it going. Alas, they can no more sustain it than they can claim credit for it. What really happened, over the last 25 years, was a unique series of events and trends that now seem to have run their course. Labor rates fell as millions of new workers entered the modern economy. Now, even in China and India, salaries are rising fast. Logistical expenses declined as computers and just-in-time inventory systems were put in place; now inventories (and associated costs) are rising again. Outsourcing, globalization, deregulation, capitalization, securitization – all these trends helped keep prices down; now, all seem to have played themselves out, gone into reverse, or backfired.
Finally, the cost of money has fallen for the last 27 years. Sometimes it fell naturally. Sometimes it fell unnaturally, even grotesquely – such as when Alan Greenspan lent the Fed’s money at below the inflation rate for more than a year. Normally, cheaper money creates boom-like conditions. But normally, it comes at a cost: consumer prices soon begin to rise. As the economy "heats up," the domino of labor costs falls over; workers are in demand so they ask for more money. Then, that domino knocks over consumer price stability; prices rise. Then, a whole line of dominos topples over. Bond investors run for cover, for example, forcing up interest rates. Then, the economy "cools down," as the cost of money increases.
That was what was so nice about the ‘nice’ years. The dominos wouldn’t budge. Thanks to so many things working so hard to keep prices down, the normal process of self-correction broke down. As demand for labor increased, new, cheaper workers were found overseas. And even though the supply of dollars increased twice as fast as GDP, the domino with the CPI on it stayed right where it was.
Alas, those happy days are over. The Great Moderation is finished. This week, oil rose over $130 a barrel. T. Boone Pickens said it would hit $150 this year. And America’s core producer price index registered its biggest increase in 17 years.
Of course, the real level of consumer price inflation is probably far higher than the official numbers. The raw data suggest price increases closer to 10% per year than the 4% the US Department of Labor confesses. But the economists have their ways of making the numbers say whatever they want. In March, for example, the consumer price index was "seasonally adjusted" from 0.9% down to 0.3%. In April, wouldn’t you know it, another seasonal adjustment took the number from 0.6% down to 0.2%. We don’t know what the real number should be; no one does. But Mervyn King is right; the season has changed.
Until next week,
The Daily Reckoning
May 23, 2008 — London, England
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: Surviving the Public Spectacle in Finance and Politics, written with co-author Lila Rajiva, is available no.
The oil market paused to catch its breath yesterday. Crude fell to $130, after hitting the $135 mark. Gold, too, took a step back – falling $10 to $918. Stocks, meanwhile, advanced a baby step – the Dow rose 24 points.
But we interrupt the news to bring you this question from a Daily Reckoning sufferer: "Why are you always so negative…so gloomy…and darned pessimistic?"
We would like to set the record straight. We are neither gloomy nor pessimistic. People who know us well say that we are often cheerful and fairly pleasant company. Even in adversity, we manage to keep a sense of humor. In fact, friends say we smile when bad things happen, provided, of course, they happen to someone else. And we often laugh gaily when reading the obituaries, as long as we don’t find our name mentioned.
Even as to matters financial and economic, we are far from gloomy. Quite the contrary. ‘Is the world going to hell in a handcart?’ Go ahead, ask us.
Glad you asked. The answer is ‘no’. Emphatically not. Definitely not. No question about it, no.
For most of the world’s people, things are getting better. A few years ago, billions of people – and about a third of the world’s landmass – was governed by dunderheaded communists. People stood in long lines to buy a tin of coffee…and then, when they got to the head of the line, the coffee ran out. The lucky few could save the money for 10 years to buy a car…and then wait three more years for it be ready for them. The car they got was the engineering world’s answer to the duck-billed platypus – awkward, ugly and frequently immobile. There were also purges, mass starvation, 5-Year Plans, and gulags. Tens of millions died prematurely; tens of millions of others would have preferred it that way.
Now, things are so much better. There are still communists and ex-communists running things in China and a few other benighted places. But even there, they aren’t quite as evil and stupid as they used to be. In fact, in some ways they are less evil and less stupid than people running things in the U.S. of A. The tax rate in Russia is only 13%, for example. Nor are Russian troops in Afghanistan or Iraq – trying to keep the locals in line; now the ‘peacekeepers’ sport the stars and stripes.
On the Forbes list of richest people in the world, the No. 5 billionaire is from India. In fact, India has 36 billionaires.
"Of those 36 Indian billionaires, 14 of them became billionaires just last year," Chris Mayer tells us. "In other words, the number of Indian billionaires swelled by 64% in the space of 12 months…or a new billionaire created every month! India has the most billionaires of any country in Asia – even more than Japan now. And new millionaires are being created at a rate of 47 every day.
"The richest of them all – the fifth richest man in the world – is Lakshmi Mittal, worth $32 billion. He made his fortune in steel. Born in India, the ‘Carnegie of Calcutta’ now makes his residence in Great Britain, where he is that nation’s richest man."
He’s ready to tell you all about them in a FREE special report called India Rising: The Three Best Ways to Profit From India’s Explosive Growth. Right now, though, let me tell you why he’s the guy to trust when it comes to choosing the right stocks in India.
You may already have figured out where we’re going with this, dear reader. Yes, things are getting better in most of the world. People who were desperately poor a generation ago are now not so desperate. Wages are rising fast in the big, developing countries – Brazil, Russia, India and China. With higher incomes typically come better sanitation and better diets, which raise life expectancies. Then, of course, TV, automobiles, high-rise housing, electronic gadgets, suburbs and economists come along too – but nothing is perfect.
So you see, on the whole, things are improving; the world is becoming – if not a better place – at least a more comfortable place for most people. In this view, by the way, we are hardly alone. Most people have noticed.
But what about the U.S. economy? What about U.S. stocks? The dollar?
Ah…that…well…even as to these things we are optimistic. The United States needs a correction; we think it will get one. And here we part company with the vast mob of windy know-it-alls and kibitzers who make up our sorry trade. Most believe that if public officials merely yank on the right lever at the right time…or turn the right knob exactly the right amount…things will get better and better, forever and ever, amen.
We don’t think the world works that way. Instead, night follows day…no matter how smart we are. Mistakes are made…errors are punished…the world turns; sooner or later, every person ends in the grave…every generation is superseded by another one…every country disappears from the map…every enterprise goes out of business…and every boom ends in a bust.
Is that a gloomy outlook? Not at all; it’s just the way things work.
Hallelujah…otherwise, time would stop…the earth would stand still…and the whole universe would collapse in on itself, back to where it was before the Big Bang, as dense as a neo-con’s brain and as small as a tax collector’s heart.
Thank goodness, the United States is going into "corrective mode," despite all the efforts of Ben Bernanke, the U.S. Congress, George W. Bush and every pundit, coast to coast, with an opinion.
*** For the benefit of new readers, we are long emerging markets, gold, and Japan. We are short U.S. stocks, bonds, the dollar and real estate. We are, recently, short oil too.
Looking at the long term, we suspect that oil will be expensive for a long time. But in their enthusiasm, markets tend to overdo it. Our guess is that they’re overdoing it in the oil market now…or close to it.
But let us turn back to the U.S. economy.
"The aggressive rate-cutting campaign by the US central bank may be at an end," says an article in the International Herald Tribune. The Fed is caught in the same trap as are all Americans. Prices are rising, but the economy is soft. Consumer price increases are probably nearer to 10% per year…than to the 4% reported by the Labor Department.
Wholesale and raw materials prices are soaring. And while wages are increasing in the developing world, there are few people in the United States reporting higher earnings.
This puts workers – especially the proles who compete most directly with foreign factory labor – in a tough spot. They often drive big, gas gourmand pick-up trucks. They typically live far from their jobs (they were lured to far out suburbs during the recent housing boom). And now they’re paying almost $4 a gallon for gas and $5 for a hamburger – not to mention health insurance.
This is a situation that calls out for correction. America’s consumer economy needs to consume less. That is what is happening…and what is dragging the whole economy down with it.
"Consumers are too tapped out to lead the economy out of its troubles, according to a report on household credit released Wednesday," says CNNMoney.
"And even after things turn around, consumers weighed down by debt won’t be able to spend as they did in the past.
"Americans have little money on hand and banks aren’t eager to lend anymore," said Scott Hoyt, senior director of consumer economics at Moody’s Economy.com, which compiled the quarterly outlook report with Equifax. Consumers had the lowest percentage of unspent cash in the first quarter of 2008 since fall 1991, the report found.
"It will also take years for consumers to straighten out their household budgets since their debt burdens are near record highs. Americans put 14.3% of their disposable income toward debt in the first quarter, near the record 14.5% reached at the end of 2006. By comparison, the rate was 12.3% in 2000.
"Consumers just don’t have the cash right now that they had a few years ago," said Hoyt, who expects the recovery to begin in the second half of 2008. "This obviously impacts their ability to spend, their confidence, their ability to service their debt and it’s going to continue even as the economy recovers."
"Before the 1980s, consumer spending made up about 63% of the nation’s gross domestic product, a key measure of the economy. Since then, it has grown to about 70% as Americans took on more debt to fuel their buying habits.
"Going forward, consumer spending will likely drift back to about 67% of GDP, Hoyt said. Americans simply can’t sustain a near-zero savings rate and an ever-growing debt load."
*** Among the things that are correcting is the financial industry. In the long boom that began in the early ’80s and continued until 2007, finance contributed an ever-larger piece of U.S. corporate earnings – from near 10% to near 40%. Now that the credit cycle has turned down, so have the earnings of the financial sector. Obviously, the finance sector grows by lending people money. When their debts get too big, they have to stop borrowing and start paying back. The downside of a credit cycle brings the financial industry less profit.
"We had a spectacular era of financial success that was extended by the subprime mortgage mania to 2007," says Barton Biggs, who was chief global strategist at Morgan Stanley until 2003. "But I think the golden age of Wall Street is over."
"When you’re in a hole," David Walker, former U.S. Comptroller General and star of our documentary, I.O.U.S.A., said this morning on CNBC’s SquawkBox, "stop digging."