A lesson from Hans Christian Andersen
Sometimes I think that we learn all we need to know in life as children, and then somehow forget it all as adults. On my frequent walks through Central Park, I pass the statue of the famous Danish writer Hans Christian Andersen, famous for his fairy tales. One of his stories has made a lasting impression on me. It's the tale of two enterprising weavers who promise a vain emperor new clothes which will be invisible to those who are unfit for their positions at court. As you may remember, when the emperor chooses to parade his new attire, only a child in the crowd dares to say he is not wearing anything at all. Let us, for a moment, look at the financial world through the eyes of that child.
New market highs in the land of make-believe
Around the globe equity, bond, and real estate markets hover at all-time highs. Valuations are extended to the limits, growth languishes, and we are beginning to question the quality of the weavers' work -- no matter how embellished their fairy tale has become. The weavers' fabric turns out to be the ballooning debts, the threads are zero interest rates, and it's all beautifully colored with relentless money printing.
Free market and its invisible hand vs. state interventionism and its firm visible grip
We recognize the free market's ability to establish prices for goods, services and assets, through the natural forces of supply and demand. However, we also acknowledge the power and the extent of market manipulation through massive state interventionism, which passes today as "counter-cyclical pro-growth policies. " Increasingly, we worry that this may be a failing strategy inspired by John Maynard Keynes' faith that the state apparatus, and its ruling elite, will always save the day.
Laws of economics: a quick refresher
Most of us got our grounding in economics some time after we heard fairy tales like "The Emperor's New Clothes." No matter when you took Economics 101, the three basic precepts are the same:
- In order to invest or consume we are always spending our or other people's savings, and we must repay those funds. Thus, there is a limit to what we can afford.
- When countries have a trade imbalance, the country with a surplus accumulates the currency, and the country with a deficit eventually runs out of money. Then the exchange rate gets adjusted, and the trade is rebalanced - eventually you can't buy what you can't afford, can you?
- If a government wants to borrow more money, the formula is simple: the more it borrows, the higher the rate it has to pay. Eventually it has to stop borrowing because it can't afford to keep up payments.
You can see how there is a series of natural checks in this system.
Where are the limits in our brave new world?
Over the years, these fundamental laws have been suspended. The situation resembles that of a builder constructing an ever-higher dam with ever-weaker material. "Look, I stopped the river for good!" he declares. We are smarter than that - aren't we?
One factor that contributes to our illusions is the effect of fractional reserve banking, which permits creating more credit out of the same amount of deposits. It helps us enjoy economic booms, but also brings us regular busts, when the credit shrinks. As much as we appreciate the benefits of fractional reserve banking in good times, we need to remember the risks it carries, when the tide turns. Contrary to a growing popular belief, more and more credit is not the remedy for each and every downturn.
Secondly, trade imbalances can be maintained and extended - but not indefinitely. The printing presses of our trade partners' central banks play a key role. Their newly printed money buys our currency, which they use to buy our public debt, which we provide with on-going, never-ending budget deficits. Again, the limit to what we can "afford" gets extended, maybe even becomes unlimited - at least for the time being. Eventually, we would need to adjust our consumption.
Thirdly, what happens when the government wants to borrow more and more? Anyone who has studied economics might have heard of the crowding-out effect. When government spending drives down private spending, and the government absorbs all the available lending capacity in the economy, the interest rates (the cost to borrow) goes UP. These are simple laws of supply and demand. Free market interest rates go up, when the demand for capital goes up. This is the normal cause and effect.
But what happens if the government doesn't need to rely on savings or the limited lending capacity of the economy? What if the central bank buys government debt with newly created money? Interest rates will likely stay unchanged or even fall, especially if they are controlled by an all-powerful central bank. That's something we've experienced around the world over the last ten years. There is no limit on what the government can afford to borrow, and the prevailing belief is that more debt is a cure for any temporary weakness in the economy.
Back to the basics: capital
The foundation of a free market capitalistic economy is capital, i.e., the accumulated savings of all market participants. Capital is needed to finance our investments and our consumption. There should be a free market for that capital for those who have it (supply) as well as for those who want it to invest or spend (demand) - price discovery at its best!
Who is wearing invisible clothes now?
In our real-life parable, the savers are the last ones wearing real clothes, and instead of being praised for it, they are despised. Invisible clothes are proudly worn by everyone else. Governments spend money they don't have and make promises they can't possibly keep. Corporations borrow to buy businesses, pay dividends, and repurchase shares, which they can't really afford. Consumer drive cars, wear suits and live in homes, none of which are really theirs.
War on savers won at last?
The outcome of recent trends and the evolution of contemporary economics put us in a peculiar position where the very foundation of the system - savers and investors -- is under attack. The artificial zero rate environment established by central banks pumping an unprecedented supply of money into the system has made savers' and investors' capital almost irrelevant. Legitimately-earned ready-to-invest capital is commingled with legally-counterfeited freshly-printed money. Thus, the praise of spending beyond one's means and seeing credit as an ultimate remedy puts rational, responsible savers in an unfavorable position. Finally, we see emerging support for eliminating cash to improve the effectiveness of a monetary policy. That's the same policy which has brought us both real and increasingly often nominal negative interest rates, which is yet another assault on savers. As a result, savers are enticed to spend, and borrow rather than invest.
This recent phenomenon brings not so fond memories of some questionable ideas of the past. Karl Marx shared his disapproval of savers calling them "hoarders", and John Maynard Keynes argued for "euthanasia of a rentier" expressing his dislike for thrift, and farsightedness. Lastly, Ben Bernanke not long ago blamed alleged "savings glut" for economic trouble, and challenges facing monetary policy.
New peaks of experimental economics
As a civilization with at least 5,000 years of experience with money, finance, and credit, we have never before reached the current levels of financial fantasy that bring us back to the vision of an unclothed emperor parading before his subjects who support his illusion so as not to be considered "hopelessly stupid."
The correct incentives that lead to prosperity are temporarily out of favor. If history offers any guidance, the natural laws of economics can be suspended only for so long. We have to admit that sometimes we feel like characters in Samuel Beckett's famous tragicomedy - "Waiting for Godot". We'll wait.
Having the courage of a child in the crowd
As contrarian investors, we often risk being considered "hopelessly stupid." Yet we have no choice - we must find the courage of that little child in the crowd who speaks his mind.
In our role as investment managers taking good care of family fortunes over generations, we have to take steps to position our clients' portfolios in these perilous times, where shortsightedness, complacency and passivity can prove exceptionally dangerous to wealth preservation. Blind faith and trust in the weavers' words may get us in trouble.
The procession must go on!
This is how Hans Christian Andersen ends the tale:
"'But he doesn't have anything on!' said a small child.
'Good Lord, let us hear the voice of an innocent child!' said the father, and whispered to another what the child had said. 'A small child said that he doesn't have anything on!'
Finally, everyone was saying, 'He doesn't have anything on!'
The emperor shuddered, for he knew that they were right, but he thought, 'The procession must go on!' He carried himself even more proudly, and the chamberlains walked along behind carrying the train that wasn't there."
Maybe the procession must go on, but we choose not to follow an emperor wearing nothing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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