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Getting rid of the FedRobert Wutscher Some philosophy stuff to get out of the way first In a previous article I mentioned that my articles are designed to be counter-intuitive. I am uncomfortable with that notion and feel the need to qualify that statement. It is only counter-intuitive in relation to the current world we live in, where common sense principles have been inverted. Common sense principles (depending on your perspective) such as:
I also mentioned possible shock to emotions. We need to recognise that emotions are there to protect us. They protect us from new views that if accepted would shatter our current beliefs which are absolutely necessary in order for us to experience and maintain a sense of wholeness, meaning or direction in life. After all we have just put up our investment positions on the basis of some beliefs. Notice how our emotions can get effected when the market turns against our beliefs. Views are easier to accept if they are commonly held as we seek validation through others. This is also the reason why investors take comfort in herding. But all beliefs are also limiting. Only slowly do we ever change our views if we are open to new ideas. Try explaining to a socialist why there should be more deregulation or to a capitalist, why government intervention may be necessary and you should begin to get an idea of how emotions kick in to protect their personal sense of wholeness and meaning based on their common beliefs. Our aversions to other ideas or other types of ideas are based on the same principle. Awareness (consciousness) is like a current of electric charge. Our emotions serve as insulation to whatever beliefs we have currently managed to weave together, in whatever crude form, in our understanding of the world. Too much awareness and we could blow a fuse. This is also the reason why we all experience setbacks from time to time and can actually learn from them. It is because the charge of our awareness is growing with time and if we refuse to change our inherent beliefs on the basis of that new awareness we will experience the setback to teach us what within our individual psyche needs to give. How we can integrate that new awareness into ourselves. Depending on the individual, the lesson can be smooth or it can be hard. Some even choose never to learn from their setbacks. I believe we are at a juncture in our social evolution where, as we refuse to give in to some of those commonly held "common sense" views described above as a society, we will be forced to confront them in a hard way. It is the task of economics to help us better understand these common sense views, how they may in a certain way be correct, but also how they can be wrong. I do not believe that economics can always provide us with neat one sided solutions. I believe it can only ever provide us with choices and with a better understanding of the choices we enter into. In economics, as in this temporal world in general, there is no such thing as a benefit without a cost. (1) Why free markets are better for social evolution Is the Fed better at eliminating the business cycle than the free markets? Was not the setting up of the Fed partly because of man's attempt to avert crises, which always hit the banks as first in line the hardest? Through its central management of the monetary economy, the Fed has demonstrated its repeated attempts at eliminating the business cycle. But how can we eliminate the business cycle if we merely do away with the Fed? One answer, which I hope to convey by means of a brief example of the background to corporate leverage, lies in our unique individual readiness to adapt within society based on our collective experiences to conditions prevailing in the external environment. How we adapt to natural laws that would have asserted themselves in a more spontaneous manner had it not been for central planning of some aspect of the market. To a large extent, the efforts of the central bank together with deregulatory measures that served to increase its influence on the market, has made record growth in M&A and private equity possible. (2) With an almost seemingly never ending period of economic stability, the business cycle appeared to be finally vanquished. Or where problems did arise, the central bank could be relied upon to get us out of trouble very quickly. This afforded a great complacency with regard to risk and the holding of reserves by corporates in the form of both cash and equity. Whereas in the past, such reserves were maintained in order to ride out the dips in business cycles, the maintenance of too much equity was now considered as barbarous as Keynes considered the ownership of gold under the former monetary regime. The judicious use of leverage that was made possible was applied not only to extract cash from companies upfront (to be applied to further deals or conspicuous consumption), but also to engineer significantly higher returns on equity. Despite the fact that this allowed for increased income transfers to the banking sector, shareholders could still be tempted because although they would be receiving less profits at the aggregate level, individual shareholders could obtain more in percentage terms (as return on equity) as well as extracting more money to apply elsewhere (mortgaging the next generation). This works until all cash has been euphemistically "unlocked" from all companies. The analogy of a cash sucking vampire draining liquidity from their productive uses may be appropriate here. Now let us consider you, the good old conservative financial director or CEO and owner of company A. Would you be able to compete against what was offered if you too could "unlock" all that cash sitting in your company by simply taking on more debt? What about the demands from your other shareholders? OK, maybe you can resist the temptation, because after all you do have superior foresight that at some point the tide will turn. But what if you needed to expand production just to keep up with your competitors? As prospective shareholders look upon your rather "conservative" return on equity figures, do you think you are going to get a good deal on your stock placement without effecting too much dilution to yourself? Damned if you do and damned if you don't! Now if we did not have the central bank, there is nothing to preclude us from still experiencing the ups and downs of the business cycle.(3) But by experiencing the ups and downs, we adapt our behaviours. As CEOs, we may consider it more prudent to hold higher equity reserves. And an artificially maintained boom would not be there to prove us wrong over time. The Austrian Business Cycle Theorists are right when they say that money creation, largely through the elasticity of money, is the cause of the business cycle. Where some of them may be wrong is to assume that we can do without an elastic currency or that in the absence of one, that there would be no more cycles. The Nobel laureate Austrian economist Hayek recognised that we cannot easily do without an elastic currency. (4) The adaptation of behaviours in response to natural manifestations of the business cycle will tend to dampen the business cycle. If we anticipate that the boom will have an end as collective experience generally teaches us, more and more individuals may learn to adapt their behaviour through a natural evolutionary process of "survival of the fittest". (5) The result is an ever stronger manifestation of a dampening of the business cycle. Any complacency that sets in leading some individuals to adopt imprudent behaviour again (particularly over the natural cycle of generation changes), will quickly be averted through punishment by the market. This will be because the imprudent behaviour will manifest in a higher amplitude of the business cycle. And not to the detriment of those that remained prudent in their behaviours! Quite contrary to the experiences of our CEO in the example above, who had time running against him because of the artificial actions of the central bank. Not only are some greedy or speculative individuals kept in check, but even a greedier or simply more speculative or experimental society as a whole may experience a cycle of higher amplitude compared to a more conservative and thrifty society of another country. Only the complacency afforded by long periods of artificial suspension of natural cycles, do we as individuals remain subject to the vagaries or even tyranny of unlearnt lessons of society as a whole. If we hold the belief that individuals sometimes learn lessons from hard times, why should we deny our children such lessons? Trying to eliminate the business cycle may have been the wrong goal of central bankers. Apart from now learning that it may have been hubris, we might now experience one of much harsher times that we would neither have wished upon our children. Notes and references:
### Jan 29, 2010 The shadow economist, Robert Wutscher, is a retired financial due diligence specialist who has taken up the study of economics. His study has turned to the shadow side of economics: what most economists ignore, suppress or fail to account for in their models under the light of mainstream economic consensus methodology. A rich resource exists in many old economists who have passed away with insights that do not sit comfortably in today's quantitative models and with warnings/lessons of the past going unheeded. The modern consensus methodology is primarily based on quantitative methods and generally considers only economic aspects and assumptions that are amenable to quantitative analysis, even if this can only be done with abstraction of reality or of the mathematics itself. It ignores other concepts essential to human decision making, that may be too hard to quantify and that may be hidden in the shadows of the aggregates and averages that form the edifice of macroeconomics and econometrics. The shadow economist is new on the block and will generally challenge the conventionally held wisdom even that of the gold bugs. He welcomes constructive criticism. He can be reached at rwutscher@telkomsa.net 321gold Ltd |
