Pushing on a string?

If you’ve ever water-skied, you know you must keep slack out of the line to stay on your feet.  If the line loosens, you have little time to take out the slack or you’ll be swimming.

The Federal Reserve, too, must keep the line tight.  Otherwise, it finds itself pushing on a string.  And, as any water skier knows, pushing on the string is of little use.

Why is the Fed pushing on a string?  Because it–like a boy with a hammer–has only one tool at it’s disposal: creating money out of thin air.

When the economy slackens, the Fed reduces interest rates (by printing or threatening to print money).  This is supposed to encourage borrowers to borrow, thus increasing economic activity.  As long as borrowers think they will get higher returns on the money they borrow than the interest rate they owe, they’ll borrow. 

But, a problem occurs if borrowers either can’t or don’t think they can get good enough returns on the money they borrow.  When that happens, the Fed can lower rates and print money all they want and the economy won’t improve.  That’s when the Fed finds itself pushing on a string.

There are serious questions about the U.S. economy being at this point.  Very smart people are concerned the Fed can’t get the economy going again, and they have powerful historic examples like the Great Depression and Japan to support their thesis.

During the Great Depression, the U.S. experienced a huge drop in economic activity, high and sustained unemployment, and significant deflation. Shrinking money supply was one of the things blamed, and so most economists have taken that as the solution to a similarly deflationary scenario like now.

Japan has been in a 20 year on-again/off-again recession.  Over this time, its stock market is down 75% and its economy hasn’t grown.  Its central bank, like the Federal Reserve, has tried lowering interest rates and quantitative easing (a euphemism for printing money).  These solutions have kept unemployment from spiking, but have done nothing to improve economic growth and have left the Japanese government with a huge load of debt.

I think these two examples are important in understanding our present situation, but most analysts and commentators miss the point.  I do think the Fed is pushing on a string, but not for the reason that most suggest.

Borrowers will only borrow if they think they can get good returns on capital.  Such lending will only be effective if positive returns on capital are earned.  For the economy to grow and standards of living to improve, you need positive returns on capital. 

The issue is not employment, nor printing money, nor interest rates, nor fiscal stimulus.  The issue is positive returns on capital.  Without that, there is no growth, only decline.

The U.S. government tried all sorts of things during the Great Depression to improve employment and get the economy going (both Hoover and Roosevelt).  The result: the worst economic decade in U.S. history.  The U.S. economy finally started growing again during World War II.  Was that because killing people and destroying property is growth?  NO!!!  It’s because the government boondoggles finally ended and individuals were able to get positive returns on capital.

Japan will not improve until positive returns on capital becomes its focus.  As long as employment and consumer demand are the focus, Japan will not grow.  Only when the Japanese economy refocuses on generating positive returns on capital will it grow again.

The same is true here in the U.S.  Printing money, lowering interest rates, giving loans to negative return on capital projects, and creating boondoggle employment will not create growth. 

The Fed is pushing on a string, but that’s because it doesn’t understand where growth comes from.  It doesn’t come from creating money or lending, it comes from positive returns on capital, and there’s nothing the Fed can do to bring that about. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Pushing on a string?


My daughter, like her mama and daddy, is a tad bit independent. 

Being terribly independent myself, I have little problem with that.  But, it can be a bit difficult at times, especially as a parent trying to get a three-year-old to brush her teeth or get dressed in the morning.

One of her teachers, Ms. Karen, was very delicate in communicating this predilection to us.  She used the sandwich approach, saying that Vivian was 1) self-directed, 2) independent to the point of being difficult, and 3) more likely to be a leader than a follower.  Mama and daddy were quite proud despite the obvious and nerve-fraying meat of the sandwich.

Like most parents, we tend to amuse ourselves with our child’s tendencies.  So, to prove Vivian’s independence to others, we simply ask her if she is a contrarian.  Naturally, she proudly states that she is NOT a contrarian (missing the irony of the statement).  Mama and daddy are quite amused, even if at her expense.

The investing world, too, is filled with it’s own Vivians–contrarian to a fault.  They don’t see themselves that way, of course.  In fact, they credit their contrarian approach for their investing success.

Don’t get me wrong, I think a contrarian approach makes a lot of sense, but not as a principle to action.  It makes sense to look at what everyone else is selling; the contrarian trash pile is an excellent place to look for bargains.  But, everything thrown away is not of value, and doing the opposite of everyone is not by itself the best approach to picking investments.

I was reminded of this when I saw how many big, smart, and vastly more-successful-than-me investors had invested in British Petroleum (BP) during the second quarter.

Did they invest in BP simply because everyone was selling?  This makes some sense because it’s obvious that many sellers were irrational, simply selling to get it off their books no matter at what price.  As a trading strategy, I suppose I follow that reasoning.

If you had followed BP for years, understood its value, and then bought when the price tanked, I can understand that, too.  That shows an appreciation for the nature of the investment, the risks involved, and the price to value relationship.

But, to buy it as a long term investment simply because others are selling makes little sense.  As Warren Buffett put it, if you aren’t willing to own an investment for 10 years, why would you want to own it for 10 minutes? 

I didn’t buy BP because I thought it was a terrible company before the Horizon rig blew up in the Gulf of Mexico.  It had been carefully cultivating its green image and spouting “beyond petroleum” blather while racking up lousy returns and the worst environmental record in big oil (just for reference, the most profitable company, Exxon, has one of the best). 

Not only did I judge BP poorly, I also thought its long term risks were almost incalculable.  Few thought Three Mile Island would halt one of the cleanest, most efficient energy sources in America, but it did.  Knowing how irrational people were about that, why would I think a huge oil spill in the Gulf would be different?

Contrarians buy what others are selling without necessarily  understanding their purchase.  The strategy works like a charm…until it doesn’t.  That’s why a lot of contrarians tout their records as proof.  But, investing has a huge element of luck as well as skill, so both short and long records can be deceiving. 

Exhibit 1 is Bill Miller’s record at Legg Mason Value.  He beat the market every year for 15 years, then got crushed from 2006 to 2008 (down -56% vs. the market’s -23%).  I’m certain he did more research than a pure contrarian, but he also owned Bear Stearns, Countrywide Credit, Fannie Mae and a host of other companies with terrible business models.  After all, he had made a fortune and his reputation buying lousy banks in the early 1990’s that were bailed out by the government.  Not surprisingly, he was cursing the government for not bailing out his investments in 2008.

A contrarian approach works as a good starting point, but it’s not the whole enchilada.  You need to do a lot more research and be very honest with yourself (if you don’t really know, you’d better walk away). 

Excellent long term investment results are as much about not stepping on landmines as buying good investments.  A pure contrarian approach will eventually find landmines and lead to a blow-up.

Now, if I could only convince Vivian that contrarianism isn’t its own end…

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.


Unemployment puzzle

Unemployment in the U.S. has stayed at a stubbornly high 9.5%.  This has puzzled many economists, politicians, commentators and individuals.

In almost all post-WWII recessions, employment has recovered more quickly toward normal levels.  But not this time.  In fact, unemployment hasn’t stayed this stubbornly high since the Great Depression.

I think I understand why, and, if I’m right, it means unemployment will stay high for quite some time.  I believe there are two causes: interest rate policy and the unemployment safety net.

When the government sets interest rates, they will of necessity always be above or below where free-market rates would settle in the natural supply and demand for funds.  Just like any government price control, it will always and everywhere lead to either surplus or shortage

When rates are set too high, new investments won’t be made where demand would otherwise exist, leading to mis-allocation of capital and an economic slowdown.  When rates are set too low, new investments will be made where demand would otherwise not exist, once again mis-allocating capital, but with a boom and bust cycle ensuing.

Because the majority prefers lower interest rates and we live in a democracy, too low interest rates are most often what we experience.  That leads to an escalating over-investment and crash cycle.

Remember the dot-com boom?  Prior to that episode, the Federal Reserve had dropped interest rates to fight the Asian contagion, Russian default and Long Term Capital Management debacle of 1997-1998.  In 1999, rates were maintained at artificially low levels to deal with the phantom Y2K problem.  The result: a dramatic over-investment in technology, media and telecom that resulted in a tremendous mis-allocation of capital and employees.  To this day, fiber-optic cable that was deployed 10 years ago still hasn’t been fully utilized.  To this day, people who were employed in technology, media and telecom during the boom are transitioning into other fields.

To fight the dot-com wipe-out, the Fed again resorted to extra-low rates.  These low rates encouraged people to speculate again, but this time in the housing and credit markets.  The result, again, was a huge mis-allocation of capital.  Many more homes were built than people could afford.  Many more loans were made because home ownership was seen as an inherent good.  Many more cars were built and auto loans were made because rates were so low.  The result was a tremendous mis-allocation of dollars and people to the housing, financial and auto markets than otherwise would have existed.

Now, of course, many of those who had been employed in housing, finance and the auto field are unemployed.  The mis-allocation of capital to those fields has led millions to be trained to do something for which the market had no need. 

And, this is where the unemployment safety net comes in.  When those employed in technology, median and telecom lost their jobs, they had to find new ones.  Because they weren’t offered unemployment benefits for 99 months, they went and found new jobs.  Many of those jobs, ironically, were in the housing, finance and automotive fields that were being artificially spurred by too-low interest rates!

I’m not blaming unemployment insurance as a political statement.  I’m pointing to facts.

Rogoff and Reinhart’s work (This Time Is Different) shows how employment recovers much more quickly in emerging economies without unemployment benefits.  Whether a recession or banking crisis hits, emerging economies recover employment more quickly. 

Anecdotically, I’ve heard several stories of people who could get full- or part-time work, but elect not to because they’d be paid less to work than not to work!  It’s not a political statement to say that many people prefer to be paid not to work than to work. 

Combine huge mis-allocations of capital due to interest policy with a huge unemployment safety net, and you have a recipe for sustained, high unemployment.  (As another example: see Europe.)

Or, consider the Great Depression.  Interest rates were held artificially low after World War I to allow France and Britain to less onerously pay back war debts.  The result was first a huge real estate boom and bust in the mid 1920’s and then the stock market boom and bust in the late 1920’s and early 1930’s. 

Just like recently, artificially low interest rates led millions into fields that had no fundamental end demand (at that time, most of it was related to farming and banking).  When the inevitable bust came, millions were laid off from those fields and provided unemployment benefits. 

Interest rate policy leads to mis-allocations of capital and large groups being unemployed.  Unemployment safety nets then encourage those unemployed not to look for new work.  It’s a recipe for high and sustained unemployment every time.

If I’m right, we’ll have high and sustained unemployment until capital is correctly allocated (not likely with–once again–artificially low interest rates) and/or the unemployment safety net is removed, neither of which seem likely in the short or intermediate term. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Unemployment puzzle

Beggar thy neighbor

I was surprised this week to read several reports that Europe announced improving production and business confidence, particularly out of Germany.  Several European companies announced better than expected earnings, too. 

After all, weren’t financial commentators the world over (including yours truly) prattling on a couple of months ago that Europe was coming apart at the seams?

And then I remembered the phrase “beggar thy neighbor.”  It refers to the political policy of devaluing one’s currency and/or erecting trade barriers to boost one country’s economy at the expense of other economies. 

It’s called beggar thy neighbor because it only works as long as your neighboring countries don’t react (hence the begging).  If they erect their own trade barriers or devalue their currency, then the game is up and everyone ends up worse off.  Like most boondoggles, it only seems to work as long as you focus on the surface and not the aggregate.

Because I have a sarcastic sense of humor, I couldn’t help but be amused by all the Germans who were coldly saying, a few short months ago, that the Club Med countries should be dumped from the euro currency and even the European Union.  Now that the Club Meds have caused the euro to drop, Germany seems to be making out like a bandit. 

The main reason is that Germany is mostly an export economy (like China and Japan).  In fact, China overtook Germany only last year as the world’s largest exporter.  Germany’s economy would grind to a halt if it weren’t selling to others.  Not surprisingly, the euro dropping benefited them most.

But, it won’t last too long.  Even now, U.S., Japanese and Chinese politicians are most likely forming policies that will lead to our own devalued currencies or new trade barriers that will eliminate the euro advantage.  The effort will succeed in kicking Europe–particularly German–in the shins, but it won’t make anyone better off.

In the long run, people adjust to currency changes.  Over time, a burger in Asia, Europe and America will cost about the same in real value.  Buyers and sellers adjust the prices they are willing to pay and receive until things are back to the way they were.  Currency depreciations don’t work for long, and trade barriers just reduce everyone’s standard of living. 

Beggar thy neighbor doesn’t work, unless of course your goal is to get elected in the short run.  It may be the only thing less productive than re-arranging deck chairs on the Titanic.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beggar thy neighbor