The Escape From
& the Catastrophic Failure of Magical Thinking
Jay B Gaskill
Attorney at Law
Rise of the Swift Adaptive Traders
During every period of systemic economic dysfunction (noting that those unsustainable bubbles masquerading as booms were every bit as dysfunctional as the current super-recession), we can follow the patterns of the clever few who manage to prosper in spite of it all. These belong to that small group of Swift Adaptive Traders (I’ll be calling them SATs). These are the traders who have learned how to make money by staying ahead of the curve. SATs can prosper in a downturn in much the same way that a sailor can make forward progress against a headwind by tacking. As sailors have learned, going almost “the wrong way” into the wind can produce gains.
But is it magic?
Anything can be bundled into an asset package and anything can be traded. For example, derivatives are contractual arrangements between investors that act as risk insurance, essentially as a bet between players on the future of a fluctuating asset. Derivatives can be traded, and asset bundles containing derivatives can be traded.
In any major market decline where asset prices fall across the spectrum, some investors will gain against the grain because of derivatives. All complex and rapidly changing markets open up buy-hold-sell opportunities for those SATs who can move quickly enough. but, just as a stage magician does not violate the laws of physics, an SAT does not violate the laws of economics – it just seems like magic to politicians (who are prone to magical thinking anyway). In spite of all the complexity and confusing trades, the classic “buy low, sell high” maxim holds. Doing this magic in real time in the real world is a very sophisticated art, and not for the faint of heart or weak of stomach.
Enter the Hedge Funds. These are carefully assembled asset packages (often including derivatives) that operate by mixing asset classes, one group of which is likely to go down in the same scenario wherein others will tend to go up. When actively tweaked by SATs, hedge funds can do very well, indeed, but not uniformly. Hence the robust market in Wall Street antacids.
There are two takeaway points here:
FIRST: For any competent individual player, the SATs have a winning approach. But, like any movie stunt with the on-screen warning, “Don’t try this at home”, the same tricks, writ large, do not work for a majority of investors. This is true because most of the SAT playbook depends on operating contrary to the herd. In effect, SAT’s are reallocating assets from the slow moving, less informed, less astute investors to a quicker, smarter set. The market as a whole just is not capable of the sophistication or agility of an individual SAT. The very image of any bureaucratic agency trying to play the SAT game is a bit like a herd of sheep trying to match the dance of forest elves.
SECOND. SAT’s are not forest elves, but many economically illiterate elected officials think they might as well be. These political leaders believe in magic – defined as something very cool that they do not understand. Worse, they think that the very brand of magic that made a small cadre of SATs rich can be copied by idiots. Worse still, these politicians think that SAT strategies are directly generating real wealth, instead of reallocating existing wealth. Of course, the financial strategies of sharp traders and hedge fund managers have a certain market utility (by spreading risk and preserving reservoirs of capital even in a crash), but their buy-sell/sell-buy manipulations do not in themselves generate original wealth. One of the most revealing phrases to emerge in the last forty years is “paper wealth”, as in “how much are you worth on paper?” A lot of paper fortunes burned up in 1929. Paper fortunes have been made and lost in every succeeding bubble.
The project of original wealth generation has always been the task of the core commercial enterprises.
The Care and feeding of Core Commercial Enterprises
The core commercial enterprises are the ones that you cannot imagine any self-sustaining civilization operating without, in the same sense that we can’t imagine our basic animal existence without food, oxygen, water and shelter. Core enterprises generate wealth through the invention, production and exchange of goods and services for which human need, greed and preferences have generated a strong, persistent demand.
These enterprises include agriculture/food production, food storage, energy production, transportation, the communication networks and technologies, the manufacturing activities needed to sustain the foregoing, the creative generation and marketing of intellectual property, and, yes, even the luxury products and services that drive incentives to make wealth.
What I’ve just described are the aboriginal elements of any real economy, the earth, air, fire and water, if you will, that make up the periodic table of the elements in the great catalog of essential wealth.
The Necessary Support Systems
A working and reliable financial system is essential to facilitate the various markets in these core enterprises, and to provide a stable but fluid investment platform for new enterprises. However, if you take away the core wealth, the finance system amounts to a system of shuffling cards in a game with no stakes.
Leave it to postmodern politicians to confuse transfers of wealth with its origination!
Of course there are many other support functions, services and technologies, all of which are essential to the operation of the overall goods aan services exchange system, but they are not sufficient individually or collectively by themselves to sustain a civilization itself. Think, for example, of the transportation web for goods and services, but without the goods and services.
Few countries contain all of the elements of the core commercial enterprises. Therefore all but the most self-sufficient nations trade internationally or die. The USA is luckier than most in that respect, but we can safely paraphrase John Donne’s line here: In the 21st century, no nation is an economic island.
The Free Money Delusion
For the last half century, the most dangerous and persistent copycat reasoning of the political class was something like – “If an SAT can borrow funds, then trade his or her way to wealth, why not the government?”
The political elites that have driven American fiscal policy for the last fifty years acted as though magic was at work.
I am reminded of the Cargo Cult in post WWII New Guinea: Those simple souls built faux airports and control towers from bamboo, hoping vainly that the giant metal birds carrying wonderful cargo would return to bring back prosperity.
The multi-trillion dollar deficits of the current economic train wreck are the 21st century political equivalent of a Cargo Cult.
THE SEDUCTION OF MAGICAL THINKING
What was the appeal of this magic? Two circumstances fed the political delusion:
That Wall Street Celebrity Intoxication
Some celebrity Wall Street players have entangled themselves in politics in order to gain sufficient influence to mitigate harmful legislation. They have mingled with politicians of the left, in many cases exploiting their educational links with the intelligentsia of the left. And the most susceptible members of the political class have swooned.
For the political class, Wall Street was not just another interest group to be courted and pampered; it was a power center to be cultivated. The interpenetration of the interests and concerns of the main Wall Street players and those who managed union and public sector pension funds has sealed the deal: Wall Street mavens have gone from the malefactors of great wealth that Teddy Roosevelt maligned, to valued political allies. To be fair, the investor class is hardly monolithic, but key figures within that larger group have become trusted policy advisors and, privately, a major source of campaign funds for leading political figures in both parties. All this took place while members of the political class remained blithely ignorant about how real wealth is created and maintained.
Guru Intoxication: Keynes as Shaman and Drug Dealer
John Maynard Keynes (1883-1946) was the famous British economist who advanced the provocative notion that governments could and should smooth out the business cycle by manipulating the supply of money. This was to be accomplished by creating new currency (easy enough to do since every modern government has gone off the gold standard), and by directly spending it. Or by creating new money and lending it out at zero interest or by borrowing money against a promised prosperity in the future, and by directly spending it. Of course when countries play the borrowing game they create “sovereign debt”. They tend to collaterize these loans with the promise that the sovereign will use its taxing power -or fiat money creation power as a last resort. How is that working out?
Reality check: Ultimately, all sovereigns must pay the borrowed money back, not because their debtors can sue them but because when their credit-worthiness falls into question, only fools will lend them more. Note here that the Chinese are not fools.
KEYNES WAS NO MAGICIAN
Here is a short description of Keynes’ theory, excerpted from the “Concise Encyclopedia of Economics” — available on the web “Library of Economics and Liberty”:
“Keynes’s General Theory revolutionized the way economists think about economics. It… introduced the notion of aggregate demand as the sum of consumption, investment, and government spending; and … that full employment could be maintained only with the help of government spending…Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? The General Theory advocated deficit spending during economic downturns to maintain full employment.”
The most foolish thing Keynes ever advocated (and – to be fair – later partly retracted) was his example that full employment can be attained by burying money and employing people to dig it up.
“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” The General Theory of Employment, Interest and Money by John Maynard Keynes (1935).
To his credit, Keynes, in his later years came to the view that the deficits run in lean times were to be made up by surpluses in the fat ones, and he even agreed that tax cuts might be as effective as direct government spending in boosting economic activity.
The magical thinking of the political class here becomes evident once you factor in a realistic understanding of wealth-creation: Currency manipulation works as a real “stimulus” only to the extent that core commercial enterprises are positively affected. This is why, in part, the so called “stimulus bill” has produced disappointing results. Modern political machines tend to buy votes from key constituencies, if possible without taxing or alienating other key constituencies. The worship of Keynes-as-Guru provided cover for these politicians to use faux money and irresponsible fiscal behavior to please everyone. Keynes would not have approved, but the invocation of his name worked in much the same way as a corrupt or misguided physician (playing the Keynes role) who tells a drug addict, “don’t worry, heroin is fine for you right now.”
THE GREAT RISK
Once the sovereign debt/deficit addiction took hold inside the Beltway, constituencies and feedback loops formed to keep it going. This process is the perfect economic analog to a narcotics addition. The next major crash may be the equivalent of an addict hitting bottom. But when an entire country hits bottom, the results are very ugly. This is a good time to review the history of Germany’s Weimar republic and the rise of Hitler.
Keynesian economic theory is a spectacular 21st century failure due to the operation of three factors, all of which have been recently demonstrated in the laboratory of real world experience:
(1) The utter lack of discipline of popular democracies, whose politicians are ever seduced by the promise of a free fiscal lunch;
(2) the profound impact of the world economy, the monetary effects of which are fully capable of swamping local currency and money supply policies, and;
(3) The complete incompetence of government bureaucracies when it comes to the creation of wealth-generating enterprises.
The edifice of Keynesian-derived policy among the Western democracies has been discredited. That which remains should be cautiously implemented by clear eyed economists and political leaders who have undergone reality therapy.
The Grand Delusion:
Phantom Gold, Hollow Bubbles
There is one inexorable law of economics, one that towers over all the rest, the rule that no ruler has the power to repeal: the law of supply and demand.
No asset is worth more than what a real purchaser is willing and able to pay for it. A glut of supply will drive down prices for any fixed asset class and a surge of demand will drive up prices, increasing pressure to augment supply, whenever that is feasible.
Ironically, the supply/demand law is the single most ignored economic principle among politicians of the leftish persuasion. Two blatant signs of magical thinking inside the Beltway and at 1600 Pennsylvania Avenue emerged shortly after the presidential election.
- In the face of a credit and banking collapse, US Treasury Secretary Timothy Geithner and others led the charge to dump a huge ($.8 tr.) dose of deficit-financed (i.e., borrowed) money into the economy to spur demand, apparently on the bizarre theory that supply will magically materialize and lift production. But supply is mostly imported from Asia, where the borrowed funds mostly come at a time when US sovereign debt exceeds current income. Even worse, the contents of the stimulus package was left to the politicians in charge of the US House of Representatives to determine, leading to the all-too-predictable result that the vast bulk of the appropriations became payoffs to core constituencies instead of targeted spending for core commercial enterprises in the form of special tax relief. Unsurprisingly, this was an overall failure. Apparently to the surprise only of the clueless Beltway economists, this one-off spending spree turned out to be a one-off spending spree. Thus the White House and allies have effectively emptying the cupboard, leaving only nickels and dimes for further “stimulus” spending.
The whole emergency stimulus spending scheme was predicated on the existence of stores of sovereign and private loan collateral (noting that the Chinese are not fools). And the movers and shakers behind the effort pretended (or delusionally believed) that there was far more collateral than there really was. This whole effort was done in concert with the quixotic employment of borrowed funds to artificially prop up the ratio of US collateral to US debt. Sound crazy? The collateral was US real estate. It represented the replacement of the abandoned gold standard with a fools’ gold standard. It was one more misguided attempt by a government (in this case, one that key US officials should have known better) to ignore or even repeal the supply/demand law. US real estate is still significantly overvalued (in at least the areas occupied by 80% of the nation’s income-generating population) because the supply exceeds demand. Our leaders-in-charge apparently hoped against all evidence that on this one occasion the iron laws of supply and demand could be repealed by government fiat. This magical thinkingwas of a piece with the old Chinese regime’s periodic “five year” plans that decreed increased production and prosperity, only to fail utterly each time in succession.
In the present moment, the real estate collateral scam has failed, and the fiscal hollowness of the American situation is nakedly exposed for all to see. We can take some small comfort in the fact that Western Europe has taken pretty much the same path and has ended in the same dead-end alley. I said small comfort.
Monetary Policy: Inflation, Deflation
& the Illusion of Control
“Monetary” Keynesians have been appointed and reappointed to the Federal Reserve bureaucracy for decades. The distinction between fiscal and monetary actions to affect the US money supply is not trivial. It has to do, on the one hand, with the formal taxation and appropriation actions of the federal government that create deficits – and the occasional surplus, (fiscal policy), and on the other hand, the interest rate tweaks and currency-creation actions of the Federal Reserve banking system (monetary policy). When, as now, the two are out of synch, far too much responsibility is loaded on the Federal Reserve, an agency that has no power to restrain federal fiscal deficits.
It should tell us something that the fed has kept the interest rates (its primary economic tool) as close to zero % as in any time in memory. This means that the fed retains little, if any power – except via blatant currency creation – to augment the effective money supply in the current economy.
So why not just print more money?
The lack of discipline in Washington DC may yet take the country to that brink though the Chair of the Federal Reserve, Ben Bernanke, has made it clear that he does not want to do this. The code phrase for creating fiat money is “monetizing the debt”.
Bernanke’s reluctance is well founded. Any significant increase in the raw money supply without an increase in the supply of goods and services will create inflation, quite possibly catastrophic hyper-inflation. History provides us with a long list of bad examples – Austria 1914-1923, Weimar Germany 1922-3, Brazil 1986-1994. Note that in Weimar Germany, inflation-driven economic instability led to political chaos and to the government’s takeover by Hitler in 1932.
The fed is also appropriately worried about deflation, a protracted collapse of incomes that depresses demand that tends to paralyze new investment. But when the deflation is limited to a single asset class, such as the US real estate inventory, the goal should be to isolate the effects, rather than squander staggering federal resources in a vain effort to repeal the law of supply and demand. Any serious effort to adjust supply and demand in the US real estate inventory in the near term would only work by degrading the supply. This would involve arson.
The notion, recently advanced, that the decline in the value of “perceived home equity” is depressing consumer spending” invites us into a trap. For the reasons I outline below, we have run the course of a consumption driven economy. We can no longer rely on consumer demand to fuel a recovery. This will require up to transition back to a production economy, something more like the USA of the 1950’s experienced.
Chairman Bernanke has hinted in his recent comments that all is not well with the US fiscal policy. He is being circumspect because he does not want to ignite a panic by telling the whole truth: The cumulative fiscal irresponsibility of the US government leaves the fed with almost no maneuvering room to fix things, and a reckoning probably cannot be avoided.
BUT CAN WE BREAK OUT OF THIS?
Yet every day that our policy makers operate in a fantasy construct will make the necessary steps more difficult to take. We may not be able to withstand one more bubble and one more crash – especially if the bubble is sovereign debt and the crash is the collapse of our currency.
To see your way out of a deep pit, the perspective of altitude, distance and time is helpful. Let’s rise above the whole mess for a moment and take the long perspective. This is what we can see:
For decades the USA has been a consumption-driven economy shored up by borrowing that closed the income gap caused by all our public and private spending.
Over roughly the same period, post-communist China has been a production-driven economy kept going by a lid on spending and wages.
Neither model is sustainable for much longer.
The USA needs to become a production-driven economy, living within its income, and the Chinese economy needs to make the adjustment to a more consumption-driven economy.
The Chinese will or will not work to accomplish that in time. They certainly cannot be expected to take steps solely in order to benefit the USA. For this and a host of other reasons, we need to extricate ourselves from the position of China’s principal debtor as soon as possible.
LAUNCHING AN AMERICAN TIGER ECONOMY
It can be done. But the project requires competent and realistic leadership and a critical mass of the members of political class, all persuaded to make the necessary structural changes.
Our breakout into sustained growth and prosperity – effectively launching an American tiger economy – will depend on recreating an environment in which core commercial enterprises can once again flourish here. The broad outlines of the necessary US economic transition from debt-dependent consumption economy to an investment-driven one can be summarized here in five bullet points.
· US government spending must be brought into line with actual income, leaving an annual surplus to apply to the staggering sovereign debt. This must be done as quickly as practicable.
· US government taxation and spending must be reconfigured to reduce the economic burdens on our core commercial enterprises, and to avoid all unnecessary spending that does not directly or indirectly benefit those core enterprises.
· The US government must refrain hereafter from picking economic winners and losers, whether by subsidizing preferred winners or bailing out favorite losers.
· The entire taxation and regulatory bureaucracy in this country must be overhauled to attract and facilitate the inflow of business capital, and to enhance the security and stability of long term investments in profitable enterprises, particularly those in the core group.
· US policy should be sharply and comprehensively concentrated on regenerating a production-driven economy. The days when we could borrow and buy our way back into prosperity are over.
Every crisis is an opportunity. Trillions of dollars of private capital are parked around the world, waiting for the world’s next profit and growth center to open up. The way out of our current predicament is to become that center.
My argument will be more fully developed in a coming article, called “Breakout”.
Among all the developed countries in the world, the USA still holds the key to the next major economic development of the 21st century. China and India are poised to launch themselves into the 1950’s. Western Europe may be able to reboot itself into a more solvent version of the 1990’s.
But we have the capacity, the economic culture and infrastructure to launch ourselves into the 22nd century. The only restraints holding us back are of our own making. Our chains were made in the USA, and the lock and key are of our own design. Our liberation is up to us.
Jay B Gaskill is a California lawyer who served as the Alameda County Public defender before her left his “life of crime” to devote full time to writing. His profile is posted at www.jaygaskill.com/Profile.pdf .
Books by Jay B Gaskill currently available:
The Lost Souls Coffee Shop is an allegory for the human condition.
The Stranded Ones is a near-future novel about a potential Armageddon-scale “immigration” problem. Hint: They’re not from around here.
Both books are sold as e-books by Amazon, Barnes and Noble, ireadiwrite Publishing and 10 other on-line book retailers. To locate a vendor, Google “Jay B Gaskill” and the book’s title.
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