I Think The Doom Is Getting a Little Overdone

[MediumTex]

MT you are correct that very few economists saw this coming (Roubini was one notable exception), so I share your view about their predictive and prescriptive abilities. Perhaps the only profession held in lower esteem would be lawyers  ;)

I like it.

If you would care to, tell us more about your background and how it informs your ideas about the markets and what your thoughts are on the structure of the PP.

On the issue of long term government debt, every time I look at Japan I am reminded (to paraphrase Keynes) that "in a fiat money world governments can stay solvent longer than you can stay rational."

This may be a controversial perspective, but one thing to bear in mind when thinking about government debt is that it is just an abstraction--it's just an idea.  No one has a lien on any property of the U.S. government or any other government.  Thus, no bondholder has any of the traditional rights that a creditor would have vis-a-vis a borrower.  Now, it is certainly true that a lender is free not to loan any MORE money to a government that no longer looks like a good credit risk, but the matter of creditworthiness is also something that is a bit of an abstraction, and ultimately is something we evaluate on a relative basis--i.e., if everyone in the world had a junk credit rating then any entity with a rating above junk should be able to borrow money in the same way as a AAA borrower can today.  

Stated in a slightly different way, in the world economy there are two kinds of assets--(1) real assets that produce rents or are otherwise an efficient allocation of available natural resources, labor and technology, and (2) other assets that consist of promises, financial instruments, insurance-type arrangements, etc. emanating from the assets in category (1).  

Government debt falls squarely into category (2), and has the added feature of having no underlying collateral subject to a security interest.  Assets in class (2) could go to zero in value and the amount of capital in the world available for economic activity would be exactly the same (i.e., the amount of natural resources, labor, knowledge, plant and equipment would be exactly the same), though a more likely scenario would be that some financial assets would decline in value more than others, and ultimately the only debt that anyone would be interested in would be that which was issued by the entity with the most economic, political and military power, on a relative basis (guess who that would be).  

Alternatively, if all of the real assets in the economy were to disappear, the world economy would truly come to a standstill (assuming that there weren't resources and time available to re-build them) because the class of financial assets are really nothing more than software (i.e., an abstraction or set of ideas) that runs on the hardware of the real assets of the world economy.

I am interested in your opinions on this armchair analysis (there may be a little slack in it--it has a lot of moving parts).  In a sense, it is a fairly optimistic take on the future of an overleveraged world.  I would rather live in a world with too much leverage and too many claims on the same underlying collateral than in a world where it was mathematically impossible to provide all of the people enough calories to keep from starving.

Also, what are your thoughts on the Austrian economics view of things?  I find Von Mises analysis of the effects of artifically low interest rates to be pretty persuasive.  It's not that we are getting poorer, it's just that we are more deeply coming to understand that we were never as rich as we thought in the first place.

[MediumTex]

I just went all in on PP yesterday - and I have to admit I was a little scared buying LT Treasuries with a 3.6 yield, but I suppose even if I bought in at the wrong time I just have to let the PP take care of it.

BTW, congratulations.  I think you will be happy with your decision. 

[Pkg Man]

MT you are correct that very few economists saw this coming (Roubini was one notable exception), so I share your view about their predictive and prescriptive abilities. Perhaps the only profession held in lower esteem would be lawyers 

I like it.

If you would care to, tell us more about your background and how it informs your ideas about the markets and what your thoughts are on the structure of the PP.

I am of the Chicago/UCLA school of economic thought - very free-market and efficient-market oriented.  I have not had much exposure to the Austrian school, but due to one of your posts I ordered Human Action.  One of my fields was actually financial economics, although I haven't touched it since graduate school.  I think that Taleb (Fooled by Randomness and The Black Swan) and Shiller (Irrational Exuberance) have valid points, but I am still of the opinion that in general the capital markets are efficient, at least to the extent that I can't earn a riskless return by exploiting publicly available information, charts, etc.  As such I have always been a big fan of index funds.  For some reason though this belief in efficient markets doesn't come as easy for the government debt portion of the PP.  I realize I'm not quite consistent in that regard.

Much like an overweight doctor who smokes, I was way too heavily invested in equities, even though I knew better.  This was partly a result of neglect and partly due to a unique situation of holding a fairly large amount of stable company stock, with risk/return characteristics somewhat like a bond (until black swans appear, of course).  I thought the best approach in my situation was to diversify through stock and bond index funds.  But 2008 showed that previously low-correlated assets can become highly correlated when panic strikes.  After the 2008 debacle I realized that I needed to do something different, and somehow stumbled upon the PP.

The thing that struck me about the PP was that it was built around the various around economic scenarios; I am not aware of any other portfolio constructed in such a way.  Of course I immediately wanted to modify it (25% in equities seemed too low for someone of my age), but eventually came around to appreciate it as is.  HB's view of trying to divine the future was something I already subscribed to in the context of stocks, hence my belief in index funds, but I hadn't thought it through to other asset classes or how it should affect one's investing over a lifetime.  I think that the unique structure of the PP combines the thinking of the efficient markets hypothesis, the Black Swan thinking of Taleb, and Shiller's belief in the frequency of bubbles.  The futility of trying to predict the future and the use of index funds is a direct influence of the EMH, low/non correlated assets deliver a portfolio that is at least less susceptible to Black Swans than any conventional approach, and firmly-adhered-to rebalancing bands provide some protection against bubbles.  In a sense the PP hedges against the various financial economic theories.

MT I think you may be on to something in your analysis of the different types of capital.  Certainly there is a difference between a default on a promise to pay and a destruction of physical capital.  One is simply a transfer of wealth and the other a reduction in wealth.  I will give it some more thought.

Thanks for the thought provoking post.

[MediumTex]

I am of the Chicago/UCLA school of economic thought - very free-market and efficient-market oriented.  I have not had much exposure to the Austrian school, but due to one of your posts I ordered Human Action.  

Human Action is really an amazing and sweeping book.  Although it is over 1,000 pages, you feel like you are just getting a basic overview of his thinking on the topics he covers.

Von Mises had a deep and subtle understanding of human nature and he was able to write about it with great clarity.

I hope you enjoy it.

[MeDebtFree]

FYI: I was able to get a free pdf copy of Von Mises Human Action at the Von Mises Institute website.

[Storm]

Interesting topic of conversation.  I tend to subscribe more to the Austrian school of economics, and Mises is a great example.  Didn't Mises say most bubbles were caused by the misallocation of resources?  Specifically easy money that leads people to make bad business decisions and invest in companies or areas of the economy that aren't sound?  I think Peter Schiff had a great example in one of his books about a restaurant owner that has a large conference come through his town and doesn't have enough tables to fit all the customers.  He misinterprets this as an increase in demand, without enough supply (tables) so he borrows money to expand his restaurant.  After that week the conference was in town his restaurant is empty and has way more tables than it needs.  This was a misallocation of resources, because the business owner incorrectly interpreted a short-term uptick in business as an increase in long-term demand.  Businesses like this should be allowed to file bankruptcy and fail.  After all, the business owner should have done more market research before making such a huge investment with borrowed money.

What worries me the most is that in order to try and prevent deflation, our central banking policy seems to be to inflate our way out of it.  Right now they can't really do much, because QE is only buying treasury bonds from themselves and lending money back to banks where it sits doing nothing.  However, I'm worried that Bernanke may decide to lower the interest rate paid on this money the banks are parking at the Fed.  In fact, there has been speculation that he may not only lower the rate from 25 basis points to 0, but also to -25 basis points, effectively charging the banks to park their money at the Fed in order to encourage borrowing.

Such a Fed policy would surely cause numerous bad loans to be made, creating bubbles in many other areas of the economy.  It's hard to predict where these bubbles might form, but my guess is that they could be in renewable energy, healthcare IT, or any number of other industries that are hot right now.  Anyway, I was just thinking how ironic it is that in order to try and inflate our way out of the hangover from one bubble, the best the central bank can do is create countless others.

I do agree with what you said also about how markets/governments can stay irrational longer than you can bet against them... I think people like Schiff and Paul would never invest in Treasuries, mainly because they always talk about the coming insolvency of the Fed, but the simple fact is that the dollar is still the reserve currency and I can't see anything changing that in the near term, short of a catastrophic failure of some kind.  Sure, it might get devalued in 30-40 years to the point that we are all trading million dollar bills (megabucks with the gipper on the front) as in Snowcrash but I don't see it happening in the next 5-10 years.

[MediumTex]

I was talking about this with someone the other day...

When people talk about the decline of Rome, they never talk about the effect this had on the rest of the world.  I suspect that however much Rome suffered, the rest of the world suffered more (the Dark Ages and all).

Schiff and company act like the U.S. is the new Rome and as soon as it passes away someone else will step into its place.  It sometimes works that way (the U.S. took Britain's place about 100 years ago), but often the decline of the dominant political and economic force leads to a chaotic vacuum that isn't really good for anyone. 

On the subject of Bernanke, I think he is simply a disciple of a flawed system.

I assume everyone has seen the Keynes/Hayek rap.  If not, it's worth a few minutes of your time:

http://cafehayek.com/2010/01/keynes-vs- ... video.html

[Storm]

Great video... Funny and still informative.

I assume you've probably also seen this Carrie Underwood parody video "Before He Trades"  http://www.youtube.com/watch?v=wU1pD4xPe2M

[Wonk]

I was talking about this with someone the other day...

When people talk about the decline of Rome, they never talk about the effect this had on the rest of the world.  I suspect that however much Rome suffered, the rest of the world suffered more (the Dark Ages and all).

Schiff and company act like the U.S. is the new Rome and as soon as it passes away someone else will step into its place.  It sometimes works that way (the U.S. took Britain's place about 100 years ago), but often the decline of the dominant political and economic force leads to a chaotic vacuum that isn't really good for anyone. 

I really like Jim Rickard's insight and he's mentioned "The Collapse of Complex Societies" as an interesting read.  I haven't read it yet but the Rome references provide an interesting case study.

http://www.amazon.com/Collapse-Complex- ... 052138673X

[MediumTex]

I really like Jim Rickard's insight and he's mentioned "The Collapse of Complex Societies" as an interesting read.  I haven't read it yet but the Rome references provide an interesting case study.

http://www.amazon.com/Collapse-Complex- ... 052138673X

I've read Tainter's book.  He has an interesting argument (though it actually only takes a few pages, not a whole book, to make). 

I think there are some Tainter articles on the web that basically give you the book in a nutshell.

[Storm]

WSJ article about Hayek and Keynes:

http://online.wsj.com/article_email/SB1 ... DcyWj.html

[MediumTex]

I think the next few weeks and months may be less bad than people are imagining, which would suggest a higher S&P 500, flat or higher gold (due to higher inflation expectations, as opposed to fear), and a higher yield on the 30 year bond.

I think that sometimes, even if the macro picture hasn't changed much, people just get tired of being pessimistic and begin to the move in the other direction for a while.

We'll see how my prediction pans out.

I will come back to this post in a month or so.

Numbers at the time of my prediction:

S&P 500: 1067
Gold: 1226.50
LT Treasury: 3.62%

I'm going to call this one a "hit" and close out my prediction today, with the following numbers as of 9/13/2010:

S&P 500: 1121
Gold: 1245.10
LT Treasury: 3.85%

[Storm]

I would call that a hit as well.  Who could have predicted things would go the other way?  It was looking a little "doomy" a month ago.  Although the next month could put us back in "doom" territory.  It started today with a big pop in gold, drop in bond yields, and rumors of QE2 heating up:

http://www.reuters.com/article/idUSN149625720100914

"A string of stories that suggest the (U.S. Federal Reserve) is closer to QE2 than the market might appreciate offers by far the best explanation for the price action in the last 24 hours, including: higher gold, broad-based USD weakness, rallying Treasuries, curve flatteners and modest positive risk trades," said Alan Ruskin, global head for G10 FX at Deutsche Bank in New York.

[Libertarian666]

Personally, I think the doom is way underdone. Since absolutely nothing has been fixed or even improved, but in fact has been made far worse by all of the government bailouts and other meddling, I expect a sudden crash of the dollar and gold to go "to da moon".

And no, the markets cannot remain irrational longer than I can remain solvent. As I do not use investment leverage, I cannot be shaken out no matter how wild the swings get.

[Pkg Man]

Economists are an odd group (I should know), but according to the way they measure recessions then the recession that began 12/07 probably ended sometime during the summer of '09.

It's official:  The recession ended in June of 09

Business Cycle Dating Committee, National Bureau of Economic Research

CAMBRIDGE September 20, 2010 - The Business Cycle Dating Committee of the National Bureau of Economic Research met yesterday by conference call. At its meeting, the committee determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II. Previously the longest postwar recessions were those of 1973-75 and 1981-82, both of which lasted 16 months.


You can read the entire press release here: http://www.nber.org/cycles/sept2010.html

Note that all of this is somewhat of an academic exercise as there is judgement involved in deciding when a recession begins and ends.