Tuesday, 14 October 2008

'One-day wonder' market correction [updated]

$5 trillion, and counting. That's around how much the governments of the US, UK, Germany, France et al have spent in recent weeks "stabilising" markets, buying up worthless assets and nationalising banks. 

Germany, France, Austria, Spain, Italy, Sweden, Poland, and Norway pledged over $2.3 trillion just yesterday, thanks very much, to nationalise banks and spray around truck-loads of "liquid confidence," and the Brits themselves pledged around half that amount themselves to make the government sector larger than its been since Clement Attlee essentially wrote The Communist Manifesto into the British constitution.

It's possibly the single- biggest monetary inflation the world has ever seen.

And yes, after that magnanimous golden shower,  the world's stock markets are up.  Today. 

Yes, the NZ dollar has stabilised.  Today.

But if you really think that huge monetary inflation is going to have any long-term effect in changing the real value of worthless assets, in changing lead into gold -- in fixing the problem of worthless assets that has poisoned the balance sheets of the world's banks, and the problem of inflated values that poisoned those assets -- then I have some Florida swampland and Dot.Com bubble stocks to sell you.

Monetary inflation, of whatever magnitude, can't do a thing to change real values -- but it can inflate them artificially.  Monetary inflation, however fast the printing presses are working, can't do anything  to effect the necessary economic correction - but it can delay it for a few more years. Monetary inflation, however large, can't do anything to transform unsustainable businesses into sustainable profit-making ones -- but it can and will keep alive these malinvestments, those walking zombies, which are only alive in any case because of the monetary inflation of  previous years.

Says Warren Buffett about market corrections, "It's only when the tide goes out you can see who's been swimming naked."  This sea of monetary inflation won't stop the tide going out, eventually -- but it will delay the time when we can see who needs to be drowned.

You see, there is no choice about the pain of correction.  It has to happen.  Unprofitable businesses need to be liquidated and the resources therein transferred to something more profitable. Bad loans need to be liquidated, and any assets involved used as fertiliser for real growth.  People have blundered, and we have no choice about the need to liquidate those blunders so they don't go on consuming real resources.  We have no choice about correction. The only choice is how long it takes -- how long the pain of correction will last -- and how many real resources are consumed along the way.

You'd think that someone would have learned from Japan's lost decade, where the same medicine was tried in the early nineties, ensuring their necessary recovery was delayed for a decade.

You'd think someone might have learned from the meddling of Herbert Hoover, (continued by Franklin Roosevelt) whose meddling in the face of depression did precisely the opposite of what he intended: instead of protecting failing businesses and providing the funds necessary for recovery as he hoped, the failure to let the market contract and flush out the dead wood and malinvestments  merely prolonged the pain.

So, yes, the markets are up today.  But don't bet on it lasting.

UPDATE 1Read how a play-money auction shows yet another iniquity of these "bailouts": it punishes the virtuous, and rewards the profligate.

UPDATE 2Peter Boettke, among others, points out that that expecting governments to bail out businessmen leads to another significant problem for businessmen: "regime uncertainty."

    A lot of important economic concepts have filtered into journalist accounts and even everyday conversation about our current finanacial crsis.  Moral hazard, liquidity, credit contagion, deflation, etc. have all been used in various accounts that often demonstrate the old adage that "a little bit of knowledge is a dangerous thing" as much as the usefulness of these economic concepts to aid understanding.
    To my mind, one of the most important economic concepts to be developed in the past decade is Bob Higgs's [and Gene Smiley's] idea of "
regime uncertainty" and the application to which he has put that concept to use to explain the depth and length of the Great Depression.  Given the earlier application, the relevance of the concept of "regime uncertainty" to our current situation should be evident.

UPDATE 3:  Regime uncertainty?  That's what Tim Selwyn's talkin' about, y'all:

As for the stockmarkets, supposedly good barometers of humanity, 15-25% down for last week in most countries and now the US has come back 11% today. Erratic and wild fluctuations. Why? Nobody knows what the fuck is going on.

UPDATE 4: Peter Schiff points out Americans blew through their savings in the Dot.Com failure, too few people want to lend to Americans now, so top pay for all the rescue plans "we're reaching for the printing press. 

Weimar Republic here we (all) come.


  1. Dear PC,

    To put it in a blunt manner - For as long as the rotten tooth are not extracted, the pain and swelling remain.


  2. So what is the best strategy now for someone wishing to preserve their wealth? Should one start selling up hard to liquidate assets and convert everything into cash or perhaps gold? I know you are not a financial adviser but you or your readers should have some ideas as to what to do now with the breathing space we may have gained.

  3. I disagree this is some sort of 'one day wonder', especially with regards to our neck of the woods - the ASX and NZX.

    I predicted, on October 3rd, the market would bottom out at around 4000 points and that indeed happened...(albeit somewhat more quickly than I had expected)

    The NZ and Australian economies are fundamentally sound so it is difficult to see how any company listed on either exchange is now 'overvalued'...(offhand I cannot think of one)...a different situation to, say, six months ago.

    I would consider most non-financial Australian stocks to be a 'buy' at their current prices...certainly not overvalued assets any longer.

  4. I'd say "are you gonna bet on that," but I believe you will be. :-)

  5. I never 'bet'...except on sure things ha ha!

    A good example of what I am saying is Harvey Norman.

    I can remember, earlier in the year, trading their shares at $5-00 ...an absurd price. Utter madness!

    I was writing blog entries a couple of months back about the idiocy of people buying at $3-60/$3-70 when Mr Harvey himself came out and said business was tough.

    Now, however, their share price is down to $2-50 - $2-80 ...and that is a fair price; I no longer would consider Harvey Norman shares to be an overvalued asset which is was just a couple of months back...(and there is a huge difference between $2-50 and $3-70, if you know what I mean?)

    A buy at $2-50(ish) a sell at $2-80(ish)

  6. PC I've read many accounts of the crisis, this is the first I've seen that says what governments are doing is inflationary or, if it is, that that matters very much.

    There are presumably two ways governments can finance these purchases. One, by printing money. Or two, by diverting real resources. So far as I am aware the US government and European governments are not planning to finance these purchases with printing presses. They are going to borrow and, presumably, raise future taxes or cut spending to pay for it. It isn't at all clear why that should automatically lead to inflation, which is simply to say money will be created at a faster rate than the resources it chases. Indeed, there are protections (admittedly increasingly limited, in NZ's case) in place to prevent inflation financing.

    Perhaps I am missing your point, but on its face I think your inflation call is suspicious and needs expansion.

  7. Your economic posts over the last three weeks have been superb Peter.

  8. the drunken watchman15 Oct 2008, 07:52:00

    Matt B....

    do you have information regarding the amounts governments are 'borrowing' to bail out the banks etc, vis a vis the amount 'printed'?

    And by 'borrowing', do you mean the issuing of bonds etc, or actual borrowing real money from real investors. In the case of the latter, whom?


  9. I tried the play money auction in my Year 10 social studies class yesterday. Every now and then I would say "I don't think the economy is going very well so I'm going to increase the money supply" - whereby I would issue a lot more money to all the students. Students quickly realised that the prices had shot up but the items for sale were no different. The smart ones realised that they needed to purchase items quickly because every time I increased the money supply, their existing cash became worthless. A great lesson in what inflation does to an economy - if I may say so myself.

  10. Matt B: I must confess I've seen very little that even addresses where the money is coming from -- indicating that even to most business journalists the question is unimportant.

    However, the point would be that to the extent the bailouts strengthen the asset base of banks, to that extent the banks are allowed to issue many times that increased bogus "value" in credit. That's inflation right there in the sense that I'm meaning it: ie., inflation of the money supply, with all the destructive consequences we're now living with.

    And to the extent that the bailout money is paid for by borrowing from the pool of real savings, or by taxing from real profits, it takes real resources away from businessmen and companies able to effect real productivity, which is what is so desperately needed.

    If you find anything there "suspicious," I an only imagine it's because you view inflation of the money supply to "fix" falling prices and its consequent creation of destructive malinvestments differently than I do.

  11. Nice, Craig. I lived in Israel in '84; inflation running about 300% from memory.

    Best example of the falling value of the shekel was a car dealership in Jerusalem. Ex rates were broadcast at midday each day. About 11.50am a chap would collect all the pricetags from under the wipers ... and bring out the new (increased) ones about 20 mins later.

    Moral of the story was to do your shopping early - or better still, hold hard currency!

  12. aa, I think you should have 25% - 50% of your cash in gold right now.

    Why? If banks are really insolvent, more countries will go under. With the underwriting they took on, we might be in for a ripple effect never seen before.

    Stocks in Asia probably won't be that much effected either, and food commodities will probably hold their value as well.

    As you might have seen from the missing analysis in every newspaper and every TV station, nobody really knows what's going on. That ain't gonna improve with governments injecting money. If you don't know the cause, you're not gonna solve it.

    Only the Austrian school right now has decent analysis and insight. But if they're right I don't know. They can prove they're right by outperforming everyone (in the long run), and I'm not aware of anyone doing that.

  13. matt b: most of what governments (especially EU) currently are doing is with preferred shares. So they're diluting existing share holders.

  14. Craig: That's simply outrageous that you're teaching real economic principles in a socialist studies class.

    Whatever next?

    ERO should be told forthwith. Or even fifthwith. :-)

  15. PC

    Thanks. Don't get me wrong, we are in total agreement about the danger and destructiveness of government interventions of this magnitude. All I am saying is that pouring equity into banks, making them solvent, and restoring their ability to offer credit is separate to an expansion of the money supply. Presumably the US government could do all this and leave the money supply and therefore inflation unchanged overall. I see a distinction between the two, that is all.

    The US government is paying for all this with debt, and it is possible it will in future resort to printing presses to destroy the real value of that debt - but judging by what I hear are low interest rates in the US nobody seems to be anticipating that.

    Even if an increase in the inflation rate is a real possibility - isn't that the smaller concern, the greater being the danger to liberty and welfare, from the fact that governments now own banks.

    They will find it hard to exit the industry, the political pressure to extend credit to high-risk borrowers will increase not decline over time, and - most dangerously of all - instead of a single economic lever to play with (the money stock) they now have 100. The great achievement of monetarism was to keep it simple for governments. To me the ultimate danger in all this is the economy's levers are put back into the hands of politicians.

  16. matt b: most of what governments (especially EU) currently are doing is with preferred shares. So they're diluting existing share holders.

    That's what they buying Berend. They question is how they're paying for it.

  17. I'm not sure we do agree totally, Matt -- although we're on the same page with the dangers of nationalising banks -- but I don't really think you recognise the full degree of govt interference, and how it caused the problems we're now in.

    The problem I identified above is not the "inflation rate" as measured by that illusory "basket of goods" that the Stats Department trolls around with, but inflation of the money supply as measured by both the expansion of the amount of money in the economy that is available for immediate use in exchange, and the huge expansion of credit in the fractional reserve banking system based on what has proved in some cases to the illusory rise of value in what has proved to be nearly worthless "assets." [See here for a chart of the expansion/inflation in US dollars.]

    The former is only one symptom of which the latter is the usual cause, (and in a time of falling prices even an enormous inflation of the money supply can be hidden behind the CPI, as it was for most of this decade and the last), but it's the inflation of the money supply itself (usually from the printing press) and enormously inflationary credit expansion (created in this case by trying to inflate asset values so as to "leverage" up the available credit) that I see as the danger.

    It's just more of the same thing that caused the bubbles, the boom and all the malinvestments -- in other words to putting us on the brink of an inflationary depression in the first place -- and leads to the danger of a genuine crack-up boom.

  18. matt b, you're right, the answer might be a bit more complicated and differ per country.

    A guarantee doesn't cost anything, so we can leave those out.

    The US raised the money by going into debt, but I suppose you knew that (government bonds).

    But you're probably after bank bail outs in the EU, which I think is a more critical story. Would you believe it how hard it is to find the numbers here?

    Here's how I believe it works. The governments there are not giving money to existing shareholders, instead the banks just print more shares, diluting existing shares, and give those to the governments.

    The governments act as guarantee. So at this stage no money has actually changed hands. Of course the banks can use this money at which time the government actually has to put up.

    For the Netherlands I have some numbers: they raise the money on the market against 4% interest (it's nice being a triple A). But given above, I doubt they actually have raised that money yet. So like the US they will increase debt.

    But it's a very interesting question actually, so hopefully readers here have more to contribute.

  19. matt b, just found this, it's not about how this will lead to inflation, but how it makes inflation tempting:

    When Governments spend vast sums of money to shore up the banking system, you just know that it would be all too convenient for it to let inflation erode the national debt incurred in the process. Even before these gigantic expenditures, Britain's true level of national debt, according to the economist Liam Halligan – the Government won't give the real figure including off-balance sheet liabilities – is over £1,300bn. This is equivalent to £50,000 per household. Perhaps Gordon Brown might call it "imprudence with a purpose" – he dumped Prudence some time ago, although he kept on telling everyone that they were still an item.

  20. 20 - 25% of your money in gold eh?

    If you had purchased gold bullion when things were getting a bit out of hand last week, the value of your gold would have plummeted $95-90 per ounce, soared $27-50 per ounce, dropped $14-20 per ounce, risen $19-00 and today (as I write this) is down $16-00 per ounce.

    Goodness knows why anyone with half a brain would not want to ride that rather stomach churning rollercoaster....

  21. Elijah, and in the mean time not a single gram of your gold would have been lost. At the end of the day you would have exactly the same amount of gold.

  22. Well...ummmmm...indeed.

    Berend, I remember the day of the Fieldays in Hamilton.

    I ended up in a discussion with some friends about the share price of BHP, the large Australian mining company.

    On that day you could have bought 1000 BHP shares for $43-00 and stuck them in the bottom drawer.

    They are trading at $29-95 as I write this...and not a single share would have been lost, you would still have exactly the same amount of shares

    Gosh, silly me!

  23. Hi PC, I do squarely blame this fiasco on government for producing this mess, and I *think* I have some idea of just how central the government is in all this.

    First, in 1999 the US government encouraged lending to people with insufficient credit.

    Two, the US government implicitly backed Fannie and Freddie. This backing truncated downside returns and made risk taking very profitable. (this, by the way, is why deposit insurance may be a very bad idea in NZ - Berend take note: guarantees are not costless. No sir.)

    Three, and in part a consequence of Two, lending institutions asked that capital requirements be relaxed. The government consented. Given protection from downside risk, this was hugely profitable, but being leveraged to the hilt made these institutions vulnerable to default by borrowers.

    And four, it is government rules on land use which created the housing bubble that, when popped, precipitated defaults and then this crisis.

    That is a lot of interference, undoubtedly there is more, but I think that is the primary sources of this problem. That this fiasco could be confused with a market failure of some kind is mind boggling.

  24. "That this fiasco could be confused with a market failure of some kind is mind boggling."

    Oh for sure.

    But you're still just talking symptoms: the fundamental cause goes way back beyond 1999. It goes all the way back to 1913 ...

  25. Thanks Berend for the advice on buying gold. It would be interesting to analyse how an investor would have fared just prior to the depression of the thirties if he converted half his shares into gold, lost his shares, then cashed up the gold in 1945.

    It seems that gold has its risks though. Do you buy actual gold bars and keep them in a safe deposit box or just buy bits of paper that say you own gold? I seem to remember a lot of people losing everything in the Gold Corp debacle back in the eighties.

  26. hi aa, I don't think you can become rich by investing in gold :-)

    It's more a safety net: keep what you've got. It doesn't do a lot else. In 2004 there were predictions that gold would reach above 1000 USD an ounce, which clearly hasn't happened (discounting jumps, they're irrelevant, and only intesting for speculators).

    If you've got a billion, it's probably not wise even to invest 25% in gold. But for the common folk, you can either invest in gold stocks or just the physical stuff.

    A convenient method is the Perth Mint Certificate Program. I think the minimum is just about 5,000 or so. All their liabilities are covered with real stuff.

    Really nobody knows where this is gonna end. The bankers + journos are now claiming, that yes, stocks are crashing, but that's just because fear about the real economy, we saved the banks. They make it up as they go.

    If a lot of banks are insolvent, which is what some claim, we haven't seen the end yet.

  27. “Fundamentally sound” - the condition in which an economy finds itself immediately after a stock market collapse.

    More great advice to your readers from your much loved 'expert'.

    How can coys be fundamentally sound if there is no credit? Coys can not survive without credit...

    And any amateur trend follower will not be seduced by counter-trend rallies.

  28. Well, Ruth, after a lifetime of successful endeavours to numerous to mention...I am sure you are the expert to listen to.

  29. PC, here is a definition of malinvestment from Mises that linked to:

    An investment in wrong lines which leads to capital losses. Malinvestment results from the inability of investors to foresee correctly, at the time of investment, either (1) the future pattern of consumer demand, or (2) the future availability of more efficient means for satisfying a correctly foreseen consumer demand. Example of (1): An investment of available savings in a manner that cannot produce as much consumer satisfaction as the same funds could produce if invested differently. Example of (2): An investment which, before the end of its expected useful life, becomes obsolete due to the unforeseen development of more efficient means for satisfying the same consumer demand. Malinvestment is always the result of the inability of human beings to foresee future conditions correctly. However, such human errors and the resulting malinvestments are most frequently compounded by the illusions created by undetected inflation (q.v.) or credit expansion (q.v.). From the viewpoint of attaining maximum potential consumer satisfaction, every political intervention, other than that needed for the preservation of the market society, must lead to malinvestment.

    Now, can one of yous, ie yourself, Julian or LGM can give a good explanation of what's the meaning of the lines that I am highlighting in the above quote?

    Isn't those lines meant that malinvestments is caused by the failure to foresee the future? How can you roughly see the future if you dismiss mathematical forecasting in its entirety? If the article emphasized that future projection (foreseeing) can be achieved by one of the following (but not limited to them):

    #1) random guessing,
    #2) psychic power,
    #3) mathematical modeling

    so, which is the more appropriate one that the Mise's article is implying indirectly to adopt? If none of those, ie, #1), #2) or #3), then the article is bullshit and you should delete it from your post.

  30. FF, you're still hung up on mathematics as being the only way to explain the world.

    But the idea that you can predict the future mathematically to three significant figures is an illusion mathematical economics fosters, but never delivers on.

    Just see, for example how Treasury's predictions of last year -- which had no idea the world's economies would collapse -- are very different from the PREFU predictions produced a few weeks back, and which are themselves already out of date.

    This is not the sort of "foresight" economics or anything else can provide.

    But basic reasoning skills, however, and an understanding of causality will allow you to make predictions with some certainty. But it's a different kind of prediction.
    For example:
    * If I pour my glass upside down, then all things being equal the beer will run out.
    * If I combine Hydrochloric Acid with Sodium Hydroxide, then all things being equal I'll produce water and salt.
    *If I post on mathematical economics, you'll reply to it.

    These things are all predictions based on causality, not just on correlation.

    Let's apply the same approach to economics.

    "One may anticipate the nature of the future socialist society," said Ludwig von Mises in 1920, fully seventy years before the rest of the world was to become convinced. "There will be hundreds and thousands of factories in operation. Very few of these will be producing wares ready for use; in the majority of cases what will be manufactured will be unfinished goods and production goods… Every good will go through a whole series of stages before it is ready for use. In the ceaseless toil and moil of this process, however, the administration will be without any means of testing their bearings."

    And now, as a former member of the Soviet Academy of Sciences said in 1992, "From my life and study in Moscow, I can attest to the truth of this prediction. In an economy, nearly every consumption good requires several stages of production. The more natural resources used and the more complex the technology involved, the more stages of production are required. Yet lacking an ability to see a production process through to ends that consumers desire, Soviet socialism produced only military hardware, useless goods, goods to make other goods, while consumers were deprived of bare essentials."

    You see now the sort of "predictions" which Mises is talking about?

    Far from being bullshit, his concept is tremendously powerful, and itself allows us to foresee the disastrous future consequences of an inflationary boom -- but not to three significant figures.

  31. PC said...
    which had no idea the world's economies would collapse

    So, folks at Mises would have done so? I don't think so. I think that you misunderstood the term forecast. You seem to equate it to psychic, which is not. Forecast done by human intuitions or models, I can guarantee you that models will outperform humans if both subjected to a multi-trial on the same data.

    PC said...
    These things are all predictions based on causality, not just on correlation.

    Models are based on causality which I have posted it in a previous message on a different thread here last week.

    BTW, you advocated here of how Mises established the causes of inflation and business cycle, because of over-regulation. How did Mises know that? Did he use correlation analysis or he simply made a good guess? Which one? If he proposed it by simply guessing, then his opinion must be dismissed, no ifs no buts. If he used some form of correlation analysis, then you're contradicting yourself here.

    Using models (simple or complex) to confirm a speculation about the nature of something is more powerful than simply endless guessing and this is fact. This doesn't mean that models are God, but they enable one to take a short cut to a very complex problem.

    PC said...
    You see now the sort of "predictions" which Mises is talking about?

    Not I don't get it. Because what Mises talked about in the context of his definition of malinvestments was something that business owners, investors, fund managers, financial analysts , economists, etc,... had been aware of?

    Mises's quoted : "One may anticipate the nature of the future socialist society,". This is something knowable. I can anticipate that the economy of Fiji will continue to take a dive in the next 12 months because of Baniaramma's refuse to hold general election early next year which had brought economic sanctions to Fiji. How hard is it for a NZ business manager who frequently travels to Fiji to do business ? Not hard to figure that out really, if that is the kind of forecast that Mises talked about. If the malinvestments that discussed at Mises blog is about that sort of forecast, then I have to say, that the target crowd of that article were for the really daft investors. Informed investors can already anticipate these things/events in the future with or without reading that definition of malinvestment from the Mises blog.

  32. PC

    Re FF
    "*If I post on mathematical economics, you'll reply to it."

    Did you need a mathematical model to predict that! 'Cause it's better than accurate to three significant figures.


  33. FF

    "This is something knowable."

    Which is the point PC made to you already.

    One establishes knowledge by observing entities in reality, estabilshing what their attributes are, understanding them and how they act under various circumstances.

    Mises explained the boom-bust cycle, how it occurred and what the causes were. Building from his work, Reisman was able to predict the present crash and direct our attention to the causes. Further he demonstrated what the solution is to prevent it occurring again and how to minimise its deleterious effects.

    As you know, none of the academic modellers managed to achieve ANY of that. They lacked the fundamental understanding of that which they were modelling. So, as you've admitted previously, the best that could be done was to "optimise" the losses after the crash had already started (big deal). They had no idea what was coming (kind of reminiscent of Pearl Harbour on a certain Sunday morning).

    Take home message for FF:- You do not require mathematical modelling to establish knowledge of reality. Mathematics does not control human action.

    Seriously, what you need to do is put the computer and those academic papers away for 12 months and go out and get a real job in productive industry. Do stuff. Stop theorising about it. Do. I'm serious. Do it and see what you learn. At the end of that year you'll be horrified by how much you didn't know or even suspect at the start... That's step one. You need to take it.



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