Dylan Grice: Nikkei 63,000,000? A cheap way to buy Japanese inflation risk

Japan is no Zimbabwe. Neither was Israel, yet from 1972 to 1987 its inflation averaged nearly 85%. As its CPI rose nearly 10,000 times, its stock market rose by a factor of 6,500 … Regular readers know that I don’t generally make forecasts, but that every now and then I do go out on a limb. This is one of those occasions. Mapping Israel’s experience onto Japan would take the Nikkei from its current 9,600 to 63,000,000. This is our 15-year price target.

Conversations with History - Richard H. Thaler

Found via Simoleon Sense.

Related books:

Nudge

The Winner's Curse

AntiFragility: How to Live in a World We Don’t Understand – By Nassim Nicholas Taleb

Link to: AntiFragility: How to Live in a World We Don’t Understand

A Return to Jekyll Island: The Origins, History, and Future of the Federal Reserve - November 5–6, 2010

Link to: Panel with Ben Bernanke, Alan Greenspan, and Gerald Corrigan. Moderated by Raghuram Rajan.

Stories vs. Statistics - By John Allen Paulos

Found via Simoleon Sense.

Half a century ago the British scientist and novelist C. P. Snow bemoaned the estrangement of what he termed the “two cultures” in modern society — the literary and the scientific. These days, there is some reason to celebrate better communication between these domains, if only because of the increasingly visible salience of scientific ideas. Still a gap remains, and so I’d like here to take an oblique look at a few lesser-known contrasts and divisions between subdomains of the two cultures, specifically those between stories and statistics.

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Related books:

Once Upon A Number: The Hidden Mathematical Logic Of Stories

Innumeracy: Mathematical Illiteracy and Its Consequences

The Drunkard's Walk: How Randomness Rules Our Lives

Hussman Weekly Market Comment: Bubble, Crash, Bubble, Crash, Bubble...

Last week, the Federal Reserve confirmed its intention to engage in a second round of "quantitative easing" - purchasing about $600 billion of U.S. Treasury debt over the coming months, in addition to about $250 billion that it already planned to purchase to replace various Fannie Mae and Freddie Mac securities as they mature.

While the announcement of QE2 itself was met with a rather mixed market reaction on Wednesday, the markets launched into a speculative rampage in response to an Op-Ed piece by Bernanke that was published Thursday morning in the Washington Post. In it, Bernanke suggested that QE2 would help the economy essentially by propping up the stock market, corporate bonds, and other types of risky securities, resulting in a "virtuous circle" of economic activity. Conspicuously absent was any suggestion that the banking system was even an object of the Fed's policy at all. Indeed, Bernanke observed "Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits."

Given that interest rates are already quite depressed, Bernanke seems to be grasping at straws in justifying QE2 on the basis further slight reductions in yields. As for Bernanke's case for creating wealth effects via the stock market, one might look at this logic and conclude that while it may or may not be valid, the argument is at least the subject of reasonable debate. But that would not be true. Rather, these are undoubtedly among the most ignorant remarks ever made by a central banker.

Let's do the math.

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To a large extent, the Fed has assumed the role of creating financial bubbles because we have allowed it. The proper role of the Federal Reserve, and where its actions can be clearly effective, is to provide liquidity to the banking system in periods of financial stress or constraint, by replacing Treasury bonds held by the public with currency and bank reserves. But to expect the Fed to somehow bring about full employment is misguided. To believe that changing the mix of government liabilities in the economy (monetary policy) is a more important determinant of inflation than the total quantity of those liabilities (fiscal policy) is equally misguided. Historically, and across the world, the primary driver of inflation has always been expansion in unproductive government spending (think of Germany paying striking workers in the early 1920s, or the massive increase in Federal spending in the 1960s that resulted in large deficits and eventually inflation in the 1970s). But unproductive fiscal policies are long-run inflationary regardless of how they are financed, because they distort the tradeoff between growing government liabilities and scarce goods and services.

We are betting on the wrong horse. When the Fed acts outside of the role of liquidity provision, it does more harm than good. Worse, we have somehow accepted a situation where the Fed's actions are increasingly independent of our democratically elected government. Bernanke's unsound leadership has placed the nation's economic stability on two pillars: inflated asset prices, and actions that - in Bernanke's own words - should be "correctly viewed as an end run around the authority of the legislature" (see below).

The right horse is ourselves, and the ability of our elected representatives to create an economic environment that encourages productive investment, research, development, infrastructure, and education, while avoiding policies that promote speculation, discourage work, or defend reckless lenders from experiencing losses on bad investments.

History of the World in Seven Minutes

Link to: History of the World in Seven Minutes

Food, Freedom, and Economic Natural Selection

A news headline from San Francisco got me thinking about a larger economic and social issue. First, the news from California:

“San Francisco has become the first major U.S. city to pass a law that cracks down on the popular practice of giving away free toys with unhealthy restaurant meals for children.

San Francisco's Board of Supervisors passed the law on Tuesday on a veto-proof 8-to-3 vote. It takes effect on December 1.

The law, like an ordinance passed earlier this year in nearby Santa Clara County, would require that restaurant kids' meals meet certain nutritional standards before they could be sold with toys.

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The San Francisco law would allow toys to be given away with kids' meals that have less than 600 calories, contain fruits and vegetables, and include beverages without excessive fat or sugar.

Backers of the ordinance say it aims to promote healthy eating habits while combating childhood obesity.”

I think this is very, very wrong for two main reasons: 1) freedom of choice; and 2) there are large differences of opinion on what is healthy and what is not healthy. Starting with the freedom aspect, let’s review one of my favorite answers from Jeff Bezos. In a 2001 interview, Bezos was asked “What does the American Dream mean to you?” His reply:

“I think I already answered it, because I think the American Dream is about liberty. But I'll add one other thing to what I said earlier. Liberty, giving people the freedom to do what they want -- as long as they're not hurting somebody else -- is super important. I think it's the core essence of the American Dream. I think at times we as a people get confused about it.

I think people should carefully reread the first part of the Declaration of Independence, because I think sometimes we as a society start to get confused and think that we have a right to happiness, but if you read the Declaration of Independence, it talks about "life, liberty and the pursuit of happiness." Nobody has a right to happiness. You should have a right to pursue it, and I think the core of that is liberty.”

Passing a law that says you can’t give a toy as part of a meal if you are a restaurant is a severe violation of the type of freedom in which the USA was founded. How would you feel if you went to a restaurant and you were not legally allowed to order dessert? Or not legally allowed to order your favorite meal anymore because a law was passed prohibiting it because our country, on average, is too fat? Which starts to get at my second point. As readers who have read some of the health-related things I’ve posted (i.e 1, i.e. 2), I believe that a high-fat, low-carb diet is a healthy diet, and that a low-fat, low-calorie diet can be extremely unhealthy. I think saturated fats are good and that whole grains are incredibly unhealthy. Whether you agree with me or not on these things does not matter. What matters is that it will sound like gospel to some and completely crazy to others. There is the same disagreement among doctors and health professionals. They can all look at the same studies and data, and yet many very intelligent, rational people come to completely different conclusions. Yes, childhood obesity is a problem, but basing a law on something health professionals can’t even agree on in which the details depend on the beliefs and biases of the politicians making the law is wrong on a much broader, social scale in my opinion.

And of course, there is another area with similar opposing views and government intervention that is more meaningful to investors: economics. People’s thoughts on whether or not what the government and Fed is doing is right or wrong and helpful or harmful will be vastly different depending on whether or not they are a Keynesian, Monetarist or Austrian when it comes to economic philosophy. But what cannot really be disputed is that the size and extent of intervention and money creation is something that this country has never before seen. And it is being done in an environment similar to the health example above: intelligent and prominent people who have studied the data and centuries of economic history violently disagree on the eventual affects of recent actions, and the decisions are being made based on the opinions and biases of the majority at the top.

At a CFA conference in May, Seth Klarman described last year’s market as a “Hostess Twinkie market” because “….virtually everything was being manipulated by the government. Nothing was natural in the markets. Interest rates were held at zero, the government was buying all kinds of securities—notably, mortgage securities—and who knows what else has ended up on the Fed’s balance sheet.” He continued:

“I am worried to this day about what would happen to the markets, to the economy if, in the midst of all these manipulations, we realized that they are, in fact, a Twinkie. I think the answer is that no one knows, including those in Washington.”

And no one still knows, at least not for certain. The size of this intervention has never happened before. Species evolve through natural selection. Small advantages within a species create a higher probability of survival and reproduction that eventually leads the advantaged trait to become widespread. And the economies of countries are similar as well. The industrial and technological revolutions and the opening up of markets were some of the things that helped drastically change the global output of countries such as the US and UK compared to China and India from 1750-1980 and that have now allowed the latter countries to close the gap.

A free market economy is supposed to let the poor capital allocators, bad decision makers, and bad businesses fail and the good, productive, and innovative ones rise to take their places. That is how markets and economies evolve into a species better adapted to survive and thrive in the future. But the government and Fed intervention have either outright prevented (in some cases) or significantly slowed the process of creative destruction from happening. And slowing this process down is akin to slowing down the male praying mantis as he tries to escape from passing his genes along to a hungry female.

Link

I believe that data and history prove that Ancel Keys was wrong when it came to his diet and health recommendations. A good comparison in economics to Keys in the health world would be Alan Greenspan and Ben Bernanke. Will their philosophies and interventions prove to be misguided? Have we given too much power to too few? Time will tell, but in 2008, Greenspan showed that getting the top position at the Fed doesn’t mean that you’ve figured it all out. When asked if his ideology pushed him to make decisions that he wished he had not made, Sir Greenspan responded with: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”

The Absolute Return Letter - November 2010: Four Rather Sick Patients

For a world which continues to be on life support – in the form of unsustainably large fiscal stimulus and near zero interest rates – policy makers are fast running out of options. One of the options left is quantitative easing and rumours are rife that the Fed and the BoE are both contemplating another round. But how effective is QE? Evidence from Japan suggests that, as a central bank continues to expand its balance sheet, the law of diminishing returns kicks in. Japan has been at it for years to the point where total central bank assets are now ¼ the size of the overall economy (see chart 3), but the results have been less than impressive. There are several reasons for this, but the most important lesson learned from Japan is that you cannot stop de-leveraging with lower interest rates.

QE2 around the corner? Inside the vaults of the Federal Reserve Bank, this fact does not seem to have sunk in yet with Bernanke seemingly prepared to initiate another round of QE shortly. He has even stated publicly that equity and bond markets are far more sensitive to monetary policy than is the real economy; hence the most effective way to stimulate the economy is through boosting financial markets. One problem with such a policy, though, as pointed out by Edward Chancellor in the FT earlier this week, is that it requires for consumers to draw on their savings to be successful. America needs higher savings and investments, not a continuation of recent years’ reckless spending.

Another problem is that it distorts currencies, but the Fed clearly doesn’t care. Not that they have said so in so many words, but their actions speak their own very clear language. I also find it remarkable that the Fed suddenly seems to be applying inflation targets. In the past, the Fed has always stayed clear of such policy. Now they are stating publicly that QE is necessary as current inflation is too low. Maybe it is, but relative to what? Officially, the Fed does not have an inflation target. The only conclusion I can draw is that they want the dollar to go lower, and equity prices to go higher, in order to fix the economic mess they have created themselves in the first place.

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Related article: Capt Bernanke on course for icebergs – By Edward Chancellor

Jim Grant Says Fed Seeking to Generate `Debased' Dollar

Found via The Big Picture.