THE BEAR'S LAIR Market-place gods had it right
By Martin Hutchinson
Since November 2000, this column has warned of a wide variety of economic and
market disasters that have appeared impending. With almost 400 columns, a
number have been plain flat-out wrong, as well as the innumerable ones that
were more or less repetitive of previous effusions.
Nevertheless, in the past few months, this column's varying predictions of doom
have had a markedly better track record: as Rudyard Kipling would have put it,
the gods of the copybook headings appear to have reawakened and to be taking
their revenge for even minor economic transgressions.
Kipling wrote The Gods of the Copybook Headings in 1919, at a time of
sadness and disillusionment after losing a son in World
War I. The central theme of the poem is that whatever temporary beliefs we may
acquire through market fluctuations or fashionable collectivist nostrums,
eventually the old eternal truths of the children's copybook return and punish
us for our deviation from their instructions:
Then the Gods of the
Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more.
Kipling was an instinctive economist; that verse of the poem describes pretty
well how the wizards of the tech boom and the housing boom withdrew at the peak
of the market, and the gods of the copybook headings took control of the
subsequent debacle. Traditional truths about the market that had been thought
outdated and irrelevant were revealed to be the factors in underlying control.
Copybook headings whose gods have come back to haunt us already include the
following:
Don't inflate broad money faster then nominal GDP: This modernized
version of the gold standard is the copybook heading by which monetarists seek
to control inflation and suppress asset bubbles. It was followed by Federal
Reserve Board chairman Paul Volcker and his successor Alan Greenspan in his
first seven years in office, then abandoned in early 1995, since when M3 money
supply has increased 70% faster than nominal GDP. Its abandonment resulted in
series of asset bubbles, the most dangerous of which was that in housing
because of the debt involved. Its god appears to have been rather sleepy,
allowing 12 years of misbehavior from 1995 to 2007, but is exceptionally
powerful and malignant when roused, as we are now discovering.
Initial public offering companies should have a solid earnings track record
before venturing into the market: We had fun tickling the sleeping nose
of this one in 1998-99, but he eventually awoke. A very noisy god, but only
moderately powerful, he caused a substantial stock market crash but failed to
suppress market "animal spirits" altogether.
Average house prices should not rise much above 3.2 times average earnings:
This god's copybook heading controlled the housing market from World War II
until the late 1990s, but we flouted him after 2000. A god who is not often
ignored, he has a vindictive tendency, and makes sure we remember not to mock
him for at least a generation after he awakens.
Whoever makes a loan has responsibility if it goes wrong afterwards: This
copybook heading, a principle of traditional banking, was flouted by the
securitization market, in which loan originators were able to escape
responsibility for poor credit decisions. The result was an orgy of poor
housing lending, involving not simply poor credit decisions but outright fraud,
connived in by loan originators who collected their fees and passed the
fraudulent paper on to Wall Street and international investors. In this
disaster, Wall Street was self-deluded, drunk with excessive money supply; the
real crooks were the mortgage brokers, mostly a bunch of used-car salesmen who
had never been closer to Wall Street than a day trip to the Statue of Liberty.
The securitization market will survive only under careful limitations that
ensure that, at least to some degree, this god is obeyed.
Don't take risks that you don't understand: Flouted openly in most
bubbles, this god was drugged during this one by perverted science, the
"value-at-risk" (VAR) risk-management technique, which controlled risk just
fine provided that the markets involved were not in fact risky. In Wall
Street's defense, the proof that VAR was a load of codswallop required fairly
sophisticated mathematics and so was available only to a few noisy skeptics
like myself and Benoit Mandelbrot, whose previous invention, fractal geometry,
was unknown to the intellectually uncurious workaholics of Wall Street.
The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing
in liquid instruments: Not only was this copybook heading flouted, its
flouting was made worse by two insidious techniques. First, banks pushed assets
off their balance sheet by use of "structured investment vehicles" funded by
commercial paper. Second, brokers started buying illiquid assets such as real
estate and private equity participations, which had been at most a modest part
of their balance sheets traditionally. This god's revenge is traditionally very
costly, and is proving so again.
Investments should be recorded in the books at the lower of cost or market value
until they are sold: This time around the accounting profession adopted
"mark to market" accounting, which allowed investments to be "marked up" on
rises in value, with mark-up earnings reported and bonuses paid even when the
investments had not been sold. Wall Street is now bleating about
"mark-to-market" because it requires mark-downs of investments that have fallen
in value; the real reason why it should be dropped is its enabling of spurious
mark-ups, of which the Street took full advantage. Mark-to-market is highly
pro-cyclical and provides counterproductive incentives to fallible and greedy
bankers. This copybook heading god is rather young and junior; it is not yet
clear how severe his revenge will be.
As well as the above gods whose revenge has already become partly or fully
apparent, recent events have flouted further copybook headings and will also in
due course produce appropriate retribution:
"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real
estate. It will purge the rottenness out of the system. High costs of living
and high living will come down. People will work harder, live a more moral
life. Values will be adjusted, and enterprising people will pick up from less
competent people." It is not clear whether Treasury Secretary Andrew Mellon was
acting merely as the mouthpiece of the copybook heading gods when he made this
pronouncement in December 1929, or whether he then or subsequently became such
a god through apotheosis.
In any case, presidents Herbert Hoover and Franklin Roosevelt ignoring this
advice in 1929-41 gave us the Great Depression, and ignoring it in the 1990s
gave Japan its 13-year downturn. With the US$700 billion bailout plan we have
ignored it again; we are devoting newly scarce capital to the most unproductive
possible use, propping up the price of dead assets.
In an era of capital scarcity, the bailout will undoubtedly prolong and deepen
the recession. Mellon, a kindly man, would probably not wish this fate upon us,
but maybe as a god he has a duty to enforce the copybook headings strictly.
"Allow capital to flow to its most productive uses." This heading is always
flouted during bubbles, when capital is allocated to innumerable unproductive
dot-coms or ugly undesirable McMansions. However, it can also be flouted during
downturns, when the government rescues failing industries, devoting capital to
the dying and unproductive. Examples of this abound, notably in Britain in the
1960s and 1970s and in France in the 1980s and 1990s. In this case there is not
just the $700 billion debt bailout, but the $200 billion rescue of Fannie Mae
and Freddie Mac, the $50 billion rescue of the automobile industry and the
clearly impending bailouts of various states and municipalities to be
considered. In downturns, capital is scarce, insufficient to fund all the good
investments available. Hence flouting this copybook heading during a downturn
produces a much nastier revenge by its god, killing off far more new and
productive investments than it would in a boom and slowing long-term economic
growth to a crawl.
"Keep the fiscal deficit to a level that prevents the public debt/GDP ratio
from rising." This, originally propounded by Gordon Brown when UK chancellor of
the Exchequer, is the wimpiest possible version of the copybook heading warning
against budget deficits. It is true that stricter versions of the heading can
be relaxed if we are using a fiat money, since monetary policy can accommodate
moderate deficits more easily than a gold standard. However the above is the
bare minimum, which the United States is about to flout, both in the short term
through $1 trillion deficits from recession and bailouts and in the long term
through the actuarial problems in social security and Medicare. The revenge of
this god is exquisitely cruel; he turns the country into Argentina.
We can speculate as to why the past decade has seen such a record level of
copybook heading flouting. Maybe the baby boom generation, who have been in
charge, were affected so badly by the permissive theories of Dr Spock and the
"flower-power" 1960s that they have an excessive tendency to reject
conventional wisdom in the form of the copybook headings. In any case, market
behavior in the past year is pretty good evidence that the gods are not happy.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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