In his book, ‘Flourish’, Martin Seligman writes:
‘I am all for realism when there is a knowable reality out there that is not influenced by your expectations. When your expectations influence reality, realism sucks’ (p 236-7).
I have been thinking about the sentiments in that paragraph at various times over the last couple of days. My initial reaction was that it was wise as well as well written. The problem I now have with the passage is that in the context in which it is written it seems to imply that a realistic frame of mind is inconsistent with optimism. It seems to me that if we are realistic about the right things this can provide us with a stronger basis for optimism. (As an aside, the grammar check in Microsoft Word doesn’t agree with me that the passage was well written. It calls the second sentence a fragment and suggests that it be re-written. Robots have a tendency to be pedantic!)
I will give an example to explain why I think a realistic frame of mind can be optimistic and then consider the broad context in which the paragraph was written. A prime example of expectations influencing reality is in relation to our own behaviour e.g. in playing a sport. If you decide to be realistic about how you will respond to a given situation in future you might think that the most likely outcome is that you will perform in much the same way as you have in similar situations in the past. That might make tend to make you pessimistic about your prospects for improvement. Yet, when you think about it more deeply, a realistic frame of mind could enable you to make use of your inside knowledge of your own potential and your intentions in developing your expectations of your future performance. Your inside knowledge might thus provide you with a realistic basis for more optimistic expectations.
The context in which Seligman’s paragraph appears is in a discussion of the influence of expectations on capital markets and individual health outcomes. The evidence that he presents that expectations can influence individual health outcomes seems to me to be fairly strong. It may be worse that useless, however, for well-meaning people to use this knowledge to tell pessimists not to be so pessimistic. In my view if we want to help people we should give them plausible reasons for hope. My view on this are not be worth much, but Marty Seligman certainly doesn’t support happiness police urging people to fake positive emotion.
I can claim some professional knowledge about the effects of expectations on capital markets. Seligman’s comments on this topic were prompted by a claim by Barbara Ehrenreich that positive thinking destroyed the economy. According to her view, motivational gurus and executive coaches espousing positive thinking – using scientific props provided by academics like Martin Seligman – caused the recent global financial crisis and subsequent recession by infecting CEOs with viral optimism about economic prospects. Seligman responds that it is vacuous to suggest that the meltdown was caused by excessive optimism. Optimism causes markets to go up. Pessimism causes them to go down.
Ehrenreich is presumably suggesting that the bubble wouldn’t have burst if we didn’t have a bubble in the first place. Well, economists are still arguing about whether we did have an asset price bubble, and I don’t think many of those who think we had a bubble would lay the blame on positive psychology. In looking for the cause of the crisis we need to look for reasons why normally prudent financial institutions took on extraordinary risks. I don’t think it is necessary to look any further than the policies that central banks had pursued in the past that encouraged major financial institutions to believe that they were too big to be allowed to fail. The financial crisis occurred when the Fed decided to break with that policy and let one of the big gamblers go to the wall.
Seligman goes on to discuss asset pricing and the views of George Soros about reflexive reality. In my view he manages to make those views more comprehendible than Soros does. (My difficulty in understanding Soros was evident in this post.) According to Seligman, reality is reflexive if it ‘is influenced and sometimes even determined by expectations and perceptions’.
Economists have known for a long time that the market price of an asset is determined largely by expectations about future earnings from that asset and associated risks (reflected in discount rates). So, wealth can be considered to be a form of reflexive reality because it depends on expectations. As well as expectations about future earnings, the expectations that influence market prices at any time may include expectations that investors form about the optimism or pessimism of other investors – i.e. whether they are too optimistic or too pessimistic and how long they are likely to remain in that state.
From the perspective of the individual investor, however, the expectations of other investors are part of external reality that can be speculated about on the basis of their market behaviour, even though it isn’t knowable with any certainty. Her views about the expectations of other investors may influence her decisions to buy and sell, but her actions will have a negligible effect on market outcomes (unless she is a major player in the markets). Thus, even though asset values are determined by the combined expectations of investors, it doesn’t make sense for an individual investor to view her own expectations as influencing reality.
It seems to me that in personal investment, as in other aspects of life, it is good to have a realistic basis for optimism about the strategy one adopts. For example, consider the following advice that Warren Buffett offered retail investors. His basic message is optimistic: ‘Stocks are the things to own over time. Productivity will increase and stocks will increase with it’. Then he provides some realistic advice about how to avoid buying and selling at the wrong time and how to avoid paying high fees. This leads to even more realism: ‘Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market’. He ends up combining realism with optimism: ‘If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors’. (Comments by Warren Buffett in Spring 2008, quoted in Alice Schroeder, ‘The Snowball’, 2008, p 825.)
It is good to be optimistic, but even better to have a realistic basis for optimism.
My preceding post was also about Martin Seligman’s book, ‘Flourish’.
Join the forum discussion on this post - (1) Posts
UK financial writer Dominic Frisby argues “that both metals [gold and silver] are still in a bull-market phase. Any mania is yet to come.”
In support, he notes that in 1980 gold bullion went from $400 to $873 an ounce in only 36 trading days, with silver trading from $16 to $50 in 37 days. The current market is not exhibiting those sort of price moves.
He also proposes looking at the value of the US gold reserves compared to money on issue as an indicator of a bubble – “in 1980 … the market value of the 260 million ounces of gold held by the USA in Fort Knox came in at $221bn, yet only some $160bn of paper money was in issue” so if “the market value of the gold held in Fort Knox once again exceeds the number of US dollars the US authorities have issued, then gold will be in bubble territory once again, in that it will be trading at levels above its intrinsic value”.
Dominic closes his article with his definition of a bubble that I think may explain why a lot of financial commentators are consistently negative on gold: “A bubble is a bull market in which you don’t have a position”. However, I doubt we will see many of them change their view and buy gold, because these days the internet means all their previous statements are recorded and easily searchable and I can’t see them admitting they were wrong.
Raghuram Rajan’s book Fault Lines (Princeton University Press for the international edition, and Harper Collins for an Indian
edition with a special chapter on India) is possibly the most thought-provoking contribution in the aftermath of the economic and
financial crisis that has engulfed the West after 2007 with significant global repercussions.
The epilogue of the book summarizes its punch line:
The crisis has resulted from a confusion about the
appropriate roles of the government and the market. We need to find
the right balance again, and I am hopeful we will.
The key idea of Fault Lines is to focus on slow-moving tectonic plates in the global economy: consumption by borrowing in
countries with fiscal deficits, excess savings in exporting countries that are fiscally in surplus, and growing sophistication of the
financial sector. None of these movements might seem dangerous in itself, but when these plates come together and collide, the global economy can get badly shaken. To most players focused narrowly on their own positions, leave alone the movements of the plate they stand on, the earthquake – like this crisis – may seem an unfortunate happenstance. In the analytical framework of Fault Lines, the crisis was not a pure accident and that more severe crises could arise in future unless the root causes are addressed sufficiently soon.
The book presents two important government distortions in the global economy and their underlying causes. These are (i) the push for universal home ownership in the United States, and (ii) export-led growth in countries such as Germany and China. Together,
these policies have led to massive “global imbalances”, with some countries such as the United States, the United Kingdom and
Spain persistently being in deficit, and borrowing from the surplus, exporting nations. While pursuit for home ownership affordability and growth do not necessarily have to be distortionary, the book makes the sharp observation that these have been occurring at the expense of something more important but subtle.
In the United States, there has been growing income inequality, which combined with a relatively feeble safety net for the poor and
unemployed, has created pressure on politicians to find quick ways to bridge the inequality. Instead of improving the long-run
competitiveness of labor force for a global market with a changing mix of industries and required skills, governments have adopted the short-run option “let them eat credit” (the title of Chapter One). The presence of government-sponsored financial firms in
the United States (Fannie Mae and Freddie Mac, in particular) enabled exercising such an option readily through a push for priority
lending to the low-income households (sub-prime mortgages).
In case of surplus countries, it has been the problem of exporting to grow (the title of Chapter Two). Their single-minded focus on exports has led governments to ignore the domestic sector, preventing sufficient redeployment of surplus for internal development, and somewhat perversely, even boosted domestic savings rates significantly due to lack of adequate safety nets (at
least in case of China, if not in case of Germany). As someone mentioned in a recent dinner conversation: Each child in China is
saving to fund post-retirement expenses not just of two parents but also of four grandparents. These savings have thus had no place to go but outside, giving rise to massive capital inflows that fueled the housing sector expansion in the US, the UK and Spain.
What is fascinating is that Fault Lines explains how these lop-sided government policies of two separate sets of countries have
interacted with each other – and with the financial sector – in fueling the expansion to levels of unsustainable housing bubbles. The
idea here is that the invisible hand operating through the price when the price is distorted can also lead to massive distortions in the
allocation of capital. The financial sector in developed world is so sophisticated and amoral (a great choice of word by the author) that its dispassionate pursuit of profits leads it to direct capital to wherever there is a relative mis-pricing. So if governments are
subsidizing home ownership, efforts will be made to deploy all free capital of the world to the housing sector. If some governments are finding it cheap to borrow because savings are seeking them out, the financial sector will grow at a sufficient rate to absorb and support expansion of housing credit through these capital inflows.
Clearly there have been incentive-based distortions in the financial sector, especially due the short-term nature of accounting-based compensation that ignores true long-term risks. The book explains, however, that the bigger issue was something else: that the imbalance of capital flows and the ease of pushing sub-prime home ownership – both due to government distortions – meant the
financial sector was essentially a conduit to making happen what the rest of the world was seeking to achieve. In the process, banks made a ton of bad loans (but the governments were happy with that till it all really blew up). And some parts of the financial sector pursued this role even more aggressively than one could have imagined due to the steady entrenchment of too-big-to-fail expectations — large banks being repeatedly bailed out through government forbearance and enjoying Central-Bank monetary stimulus each time markets turned south.
Some may question the basis of this argument by saying – why did we see credit expansion across board and not just in low-income
households? Here, Fault Lines focuses on a rather fascinating phenomenon that recoveries from recent recessions, especially in the
United States, have remained “jobless” for extended periods of time. Perhaps as a subconscious response to this (or due to
ideologies in other cases), Central Banks have tended to provide massive monetary stimulus to get the financial sector to push the
household consumption and real sector investment harder and harder through greater lending and intermediation. Such stimulus,
unfortunately, again serves to transfer rents from households to the financial sector (by keeping interest rates low) and produces
mispriced risk. Thus, the economy moved “from bubble to bubble” (the title of Chapter Five), until the most recent bubble could not be mopped up by anyone, not even the most innovative Central Bank of all, despite its own best efforts.
In essence, Fault Lines connects the dots visible to all of us in a rather ingenious manner to provide an explanation of what brought about the perfect storm we have recently weathered.While the book is worth it even just for its explanation of why we had a crisis now rather than at some other points of time, it goes the extra mile and proposes valuable reforms, focusing on all three
issues: building a better safety net in the United States (see in particular, the suggestions to improve education access to all and
extend a greater level of unemployment insurance), reducing the global imbalances, and improving the regulation of the financial sector so that it (and its financiers) pay for mopping up of bubbles it fueled, rather than governments and Central Banks passing on these costs to taxpayers.
The book also helps understand why export-based Chinese and German growth, and their effective vendor financing of consumption in the US and Euro-zone countries, may ultimately face limits as consumption slows. These countries are now being forced to become the stimulators of growth and run the risk of planting seeds of bubbles in their own economies. This is how hidden fractures still threaten the world economy, as the book’s subtitle goes. It also leads one to reconsider that India’s slower growth rate than China, while not entirely faultless, might however be more balanced given its lack of extreme export reliance.
Raghuram Rajan’s writings are always cogent and based in sound set of facts. But this book is special in the sense that here he paints on a much larger canvas, covering bases from distributional issues within income strata of society, to the persistent capital imbalances across large countries of the world, and the ruthless profit-maximizing incentives of modern market-based financial sector.
There is a lot going on in the book. But it is written with great examples and cases – almost lyrical at times (even has a fascinatingpoem recounted in the chapter “The Fable of the Bees Replayed”), and should be accessible to one and all. It willcertainly question some long-held biases about current state ofeconomic conditions in Western countries. But it is hard to not take a deep breath and ponder once you have read it all. In many ways, it shows that when economic conditions so demand or induce, the developed world behaves much the same way as the developing world: they are both after all driven by choices of human beings and the book lays out somecommon patterns of global economic behavior – in households, marketsand governments.
The Great Credit Contraction grinds on as the system continues evaporating. People are realizing the true nature of the worldwide fiat currency and fractional reserve banking system that is built on a fraudulent premise and has become a Ponzi scam of epic proportions, the largest in the history of the world. Capital, both real and fictions, has begun burrowing down the liquidity pyramid while the upper layers evaporate. Recent developments in the one month United States Treasuries appear to portend another round of credit crisis.
THE TREASURY BUBBLE
A year ago I discussed how the Treasury bubble was the largest of all and explained both how and why it would burst. I prognosticated:
However, as more capital piles into them it drives rates lower and lower. Eventually Treasury Bill rates reach 0% or even go negative. This presents a problem.
Why hold a Treasury Bill with a bank, broker, custodian bank or the Federal Reserve itself when you could take possession of physical Federal Reserve Notes?
Taking possession eliminates at least two types of risks. First, is any potential counter-party risk with whoever is holding the Treasury Bill for you. Second, ‘political risk’ which is a much larger threat. …
As the yields on Treasury Bills approach 0% they have the return of cash but do not have the benefits of cash as they may be impregnated with counter-party risk or have decreased liquidity. In other words, Treasury Bills and cash have the same benefit profile but not the same safety and liquidity profile. This analysis also applies to demand deposits with the bank such as checking accounts or CDs. All the downside but none of the upside.
Predictably the Treasury bubble burst. Poof!
PILING INTO ONE MONTH TREASURIES
The one month Treasury has recently traded with negative rates. This portends another round of the credit crisis which could very easily have its catalyst in either another sovereign debt downgrade of either Japan or Portugal or in Austria with banks owning a large amounts of primarily mortgage assets denominated in foreign currency in primarily Slovakia but also the Czech Republic, Hungary and Croatia.
The last few weeks shows just how close the rates are towards 0%. Of course, real interest rates are already negative. But a weak FRN$ would help meet Obama’s goal to double exports which would not be helped by his proposed discretionary spending freeze.
MONEY MARKET FUNDS
One tool many investors use as a proxy for their cash are money market funds. Many view these as like-cash vehicles just like many viewed auction-rate securities as like-cash vehicles for 25 years. On 18 September 2009 I explained that I closed my Paypal money market fund because money market funds had lost government backing. On 27 January 2010 Nasdaq.com reported:
The U.S. Securities and Exchange Commission approved by a 4-1 vote Wednesday rules designed to shore up the resiliency of money- market mutual funds, with general support from the industry, although fund representatives are uncomfortable with a few points. …
The rules also would permit a money-market fund’s board of directors to suspend redemptions if the fund is about to “break the buck” by having a net asset value fall below $1 per share. Currently the board must request an order from the SEC to suspend redemptions.
“The halting of redemptions will stem the motivation for runs. It also will eliminate the need for a failing fund to sell securities into a potentially de- stabilized market and further drive down prices,” Schapiro said.
For those with too much time on their hands who want to see what the proposed rule looked like I would direct you to page 32,714 of the 8 July 2009 Federal Register under proposed rule 22(e)-3. I find the discretion of the Director of the Division of Investment Management in this instance to be particularly egregious.
Treasuries are below money market funds in the liquidity pyramid because there is more safety and liquidity. If a money market fund has redemptions suspended then that asset is not very liquid and will likely find their value evaporate. This is precisely what happened with auction-rate securities and in some cases overnight investors went from thinking they held a like-cash instrument to finding themselves holding 40 year student loans that received no payments for several years.
WHERE IS REAL SAFETY AND LIQUIDITY
On May 20, 1999 Alan Greenspan testified before Congress, “And gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and in the ultimate value of the currency and that historically has always been the reason why governments hold gold.”
During the 1990’s Mr. Rubin had devised the gold leasing scheme with the intent being elucidated by Dr. Greenspan’s testimony in 1998, “Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.”
Because of massive governmental intervention for decades through either patent activities such as legal tender laws, the tax code, etc. or latent activities such as surreptitious leasing of gold into the market the result is a massively suppressed gold price.
The tremendous amount of evidence accumulated by the Gold Anti-Trust Action Committee ought to be examined by any serious investor or money manager. As Mr. Robert Landis, a graduate of Princeton University, Harvard Law School and member of the New York Bar, asserted years ago, “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”
Nevertheless it is very difficult to assess an accurate value of gold, silver or platinum in this era and for a specific time period where almost all financial professionals are infected with the financial insanity virus, the system is riddled with chronic fingers of instability and it somehow muddles along like a terrifically abused zombie. There is already a one world currency, gold, and it poses a mortal threat to fiat currency.
As the next round of the credit crisis plays out it may be worse than the earlier iterations. All of the interventions have not addressed the root causes and are actually textbook responses for someone who would want to intentionally exacerbate the greater depression.
As Ludwig von Mises predicted decades ago in chapter 20 of Human Action, ‘The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. … But then finally the masses wake up. … A breakdown occurs. The crack-up boom appears.’
New credit creation is nearly non-existant, banks are hoarding reserves so they can win the Friday bank failure lottery and the velocity of currency has slowed to glacial speeds. Because gold and the FRN$ abut in the liquidity pyramid they tend to have an inverse correlation. Buying gold and other tangible assets, I particularly like the extremely rare and useful platinum, is the only place to go for safety from the specter of the FRN$ evaporating through hyperinflation because of all the quantitative easing.
After all, with a gold coin in hand, or with a reputable third party like the company GoldMoney, I can remain solvent longer than the market can remain irrational. Gold is not an investment but real cash because it is ‘risk-free’ and an instrument for wealth preservation not wealth generation. Far into the future and long after these money market funds are frozen, retirement accounts are nationalized to buy FRN$s that are evaporated into nothing via hyperinflation the gold or platinum coin will still have value because they are tangible assets that are not subject to counter-party risk.
DISCLOSURE: Long physical gold, silver and platinum with no interest TLT, the problematic SLV or GLD ETFs or the platinum ETFs.
Frederic Mishkin says not all bubbles are a threat to the economy (link):
“Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.
But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy…”