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Author - J. Anthony Boeckh
ISBN - 978-0470538777
Financial Instability:
Experience shows that debtors really come to think that they have an entitlement.
Eventually we will get to an end point and experience both inflation and deflation together.
Deflation is only a serious problem if there is excessive debt. If there is excessive debt then falling prices increase burdens.
During the expansionary phase of any particular cycle, a given level of debt appears to be much more sustainable than it actually turns out to be. The economy has become like a heroin addict, needing increasing dosages to get the same high.
The crises that the new regulations were designed to avoid don’t occur until after regulations are loosened or eliminated and stability creates complacency. A relevant example is the Glass-Steagall Act.
Conventional thinking, particularly around important turning points, is usually not very helpful because it tends to focus on the extrapolation of past trends into the future.
Four ominous signs point to disruptive nature of the long wave in the economy:
1. Income and wealth disparity in the United States widened dramatically. The current account deficit of the United States rose alarmingly to 6 percent of GDP, a direct indication that the nation was living far beyond its means.
2. Low and stable consumer price index numbers, the relatively stable U.S. dollar, and the effects of massive purchases of dollars by foreign central banks.
3. U.S. savings and capital investment as a percentage of GDP declined sharply during this period.
4. Huge trade surpluses of many developing countries led to massive financial inflows to their economies, creating credit and asset bubbles that matched or exceeded those in the United States, while at the same time creating huge capital investment in building capacity in those countries. Over capacity leads to a sharp decline in capital goods industries.
One of the greatest challenges for central banks is knowing to whom they are ultimately responsible and knowing clearly what their ultimate objectives are.
There have probably been more financial manias in the past 50 years than in any other period in history. More recent experience shows that they seem to be getting more extreme, as are the nasty consequences.
Intellegient people usually act rationally at the beginning of a mania, but gradually lose contact with reality.
All manias have financial preconditions:
1. Fall in both price inflation and interest rates
2. Accommodating monetary policies
3. Easily obtained credit
4. Latent greed
5. A readiness to take on more risk to enchance incomes or simply to get rich
6. Absolutely low level of interest rates
7. Low rate of profit
Hyman Minsky calls a “displacement” a development that is fundamentally so new and exciting that it captures the imagination of large numbers of people.
One of the most common characteristics of the late stage of a true mania is that people do not believe they are speculating, regardless of the buying fenzy and the prices being paid.
The time element needed to build this bulletproof confidence is an important ingredient in most manias. Generally, the displacement has be in place for a number of years before it cahtes the public’s attention in a major way. The rising price trend of the eventual objects of speculation can be traced back far enough so that people really believe a new era has unfolded. This creates the feeling of legitimacy and credibility to back their extreme optimisim.
To capture the imagination of millions of people, the story must be really good.
A common, although not universal, characteristic of manias is that the objects of speculation are extremely difficult to value.
From the end of the eighteenth century, there have been 21 distinct manias and crises, or approximately 10 per century.
If enough liquidity is created, it will find a home in some asset class somewhere in the world that is beyond the reach of regulators.
Asset Allocation Decision:
All investors are in a more precarious financial position than before the crash and will have to be far more disciplined, knowledgeable, and respectful of risk than they have been.
A good portfolio will have sufficient liquidity to take care of cash needs and the absorption of capital losses, and also will take into account the time horizon and risk tolerance of the investor.
The risk of small company investing can be reduced markedly by focusing on balance sheet quality, cash flow, the experience of management, and how attractive the company is as a takeover candidate.
Being underinvested when the rally starts compounds poor performance. It is impossible to sell at the high and buy at the low, which is why most investors should never be totally out of the market or totally in. Be prepared to start buying before they are sure a final bottom has occurred.
Investors should be bullish on stocks when liquidity is improving, particularly on a rate-of-change basis. This occurs when bank business loans are being liquidated, bank investments are rising relative to bank assets, short-term interest rates are falling relative to long-term interest rates, and money flowing into the riskiest bonds is increasing relative to the flow into the least risky bonds.
Most investors act pro-cyclically: Their courage decreases as the market rises and it falls when the market is declining.
The higher the price paid due to increased optimism, implicit or explicit, the greater the chance of disappointment when upward momentum ceases and the balance between buyers and sellers in the market starts to shift toward the latter. Most investors get more bullish the longer returns are above normal and get more bearish the longer they are below normal.
It is a proven fact that when the vast majority of investors hold the same opinion, it is invariably wrong and the market is at an important turning point. Most investors cannot control their emotions and as a result alternate between moods of excessive greed and fear.
At or approaching peaks, the media have enormous coverage of the bull market because the percentage of the population interested in stocks rises sharply. When media coverage reaches an extreme, it is a bad sign for the future trend of the market.
Wall Street is a sophisticated manufacturing and marketing machine that will always have unlimited products to sell to you but with the primary motivation being to maximize the bonuses of Wall street salses people and the share price of Wall Street firms, not the wealth of investors.
Gold can provide cost-effective insurance ONLY if the price is not too high, but we never know if the price is too high until after the fact. The essence of a mania is the creation of irrational valuation that destroys the notion of insurance, and this becomes particularly relevant when then price comes down from elevated levels.
A reserve currency should have some scaracity value, not be a glut on the market as a result of massive monetary stimulus, near zero interest rates, out-of-control budget deficits, sharply rishing government debt, and persistent balance of payments deficits.
When an asset class has become highly popular to nonprofessionals, the makings of a major setback are usually being put into place.
Cycles are always seductive because there appears to be a deterministic element that can be used as a substitute for time-consuming careful analysis.
Financial/investment demand is fundamentally different from consumption demand.
As long as a greater fool could be found to keep bidding up housing prices and credit was plentiful, affordabilltiy seemed to be irrelevant.
The Future
America is in a state of relative economic and political decline. Some aspects of the decline were mased by the euphoria that resulted from the debt and asset bubbles.
Reflation and bailouts create a totally artificial economy.
Power can be maintained only by a prudent balance between creation of wealth and the fiscal capacity to maintain military expenditures at the necessary levels. The connection between shifting resources away from growth and toward military and other non-growth expenditures has always hastened the decline of great powers. Empires eventually develop resistance to the sort of change that is needed for reform, particularly to generate growth, production, and an increased tax base and to reverse structural weakness in the economy. Empires in decline exhibit arrogance, conceit, and complacency; the focus of people shifts to rights from duties, and the public spirit falters.
In situations of decline, there is a feedback mechanism between declining institutions and eroding values on the one hand, and growing concentration of political power on the other. In the case of the United States, he points to the decline of traditional authority – family, religion, political parties, local communities, voluntary associations, and even class structure. The result is alienation and a rootless mass of people while the bureaucratic state becomes increasingly powerful, and beholden not to moral principles and doing the right thing, but rather to the latest polls and pressure from well-financed lobbyists.
Leaders must manage the process with wisdom and the public must exercise patience. It is not so much the rules as the competence and integrity of the regulators that will ensure a sound financial system.
Inflation is ultimately deflationary because it leads to too much debt, overpriced financial assets, and excessive investment in housing, office buildings, and industrial capacity. Inflation leads to distortions in relative prices and gives the wrong signals to people making investment decisions.
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