Leithner & Co Pty Ltd
The Leithner Letter
Issues 71 spacer26 November 2005
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"" Central Bankers Past,
   Present and Future

""  Remember Paul Volker

""  Central Bankers’ Fatal
   Conceit

""  Central Banks and the
   Welfare State of Credit

""  Three Conclusions for
   Value Investors

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spacer  The Intelligent Australian Investor–Chris Leithner




 

Under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks – call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.... At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s – a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

The clear lesson I draw is that there is a high premium on doing what we can to minimise the risks and to ensure that there is time for orderly adjustment. I’m not suggesting anything unorthodox or arcane.... What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline.

Paul Volcker
“An Economy On Thin Ice”
The Washington Post (10 April 2005)

Perhaps the most surprising finding in this paper is that there has been no change in monetary policy after 1990 compared to the policies pursued before 1979.... Policy was different only in the 1979-90 [sic] Volcker interval, when fighting inflation was paramount and no weight was given to stabilising output. Our results overturn other research that finds a strong emphasis on inflation fighting not just between 1979 and 1990, but after 1990 as well. We show that ... the post-1990 “Greenspan” policy turns out to look much the same as the pre-1979 “Burns” policy; both are equally different from the 1979-90 inflation-fighting “Volcker” policy.

Robert Gordon
What Caused the Decline in U.S. Business Cycle Volatility?
(RBA Annual Conference 2005)

Central Bankers Past, Present and Future

During the last week of October, three chiefs of the U.S. Federal Reserve – one retired, one soon-to-retire and the other shortly to take the helm – generated prominent headlines. On the 27th, Paul Volcker, the Fed’s Chairman from 1979 until 1987, submitted the Report on the Manipulation of the United Nations Oil-for-Food Programme to the UN’s Secretary-General. Mr Volcker’s successor, Alan Greenspan (who retires at the end of January), once again received applause from politicians, economists, financial media and market participants. And his successor, Benjamin Bernanke (whose appointment was announced on the 24th), collected their congratulations and best wishes.

Many of the reflections about Dr Greenspan’s tenure were glowing, and some were rapturous. Lyle Gramley, a former Fed Governor (1980-85), concluded “he was exactly the right man for the job at the right time. It’s hard to give him a grade of less than A-plus. He’s been a phenomenal Chairman.” President Bush enthused that Dr Greenspan is “a legend.” For nearly two decades, he “has shepherded [the] economy through its highs and its lows. Under a steady chairmanship, [it] has come through a stock market crash, financial crises from Mexico to Asia, two recessions, corporate scandals, and shocks ranging from devastating national disasters to a terrorist attack in the heart of America’s financial centre. Through all these challenges, Chairman Greenspan’s prudent judgment and wise policies have kept inflation low. He’s played a major role in America’s strong economic growth. He has dominated his age like no central banker in history.”

For Dr Bernanke, too, there were hosannas aplenty. President Bush stated, “over the course of a career marked by great accomplishment, Ben has done path-breaking work in the field of monetary policy, taught advanced economics at some of our top universities, and served with distinction on the Fed’s Board of Governors. He’s earned a reputation for intellectual rigour and integrity. He commands deep respect in the global financial community. And he’ll be an outstanding Chairman of the Federal Reserve.” According to Alan Greenspan, “the President has made a distinguished appointment in Ben Bernanke. Ben comes with superb academic credentials and important insights into the ways our economy functions. I have no doubt that he will be a credit to the nation as Chairman of the Federal Reserve Board.” But not everybody cheered. Alan Abelson (Barron’s 31 October) wrote “the selection of Ben Bernanke has prompted a lot of mostly inane chatter by economists and press pundits. What a waste of words!.... What can be said is that the new guy in charge at the Fed is inheriting quite a financial mess the much-admired Mr Greenspan has been complicit in creating. Mr Bernanke’s challenge is to clean up the mess without incurring blame for it or the consequences of remedying what his predecessor wrought. We wish him luck. He’ll need it.”

During the last week of October, then, and whatever their views, financial journalists and market participants fixated upon two men. They mostly celebrated Greenspan’s accomplishments and praised Bernanke’s qualifications. And taking their cues from these men, most people expressed guarded optimism about America’s present condition and future prosperity.

Perhaps because he was otherwise engaged at the UN, or because nobody wanted to hear what he might say – or simply because they forgot he ever existed – during the week’s frenzy of glad tidings nobody sought Paul Volcker’s opinion about economic and financial matters (see, however, Volcker Warns Inflation May Become Problem, AP 1 November). Is this a coincidence? Maybe not: judging from his recent utterances and writings, Mr Volcker is more downcast than upbeat. Further, reactions to Dr Bernanke’s appointment included many laudatory things about central bankers but next to nothing disparaging about central banking. Present policy settings and Bernanke’s promise to continue them were widely praised; but few wondered whether this policy – that is, anticipatory and aggressively inflationary monetary policy – actually does much more harm than good (see in particular What Does Inflation Targeting Mean? by Roger Garrison). The reaction to Greenspan’s retirement and Bernanke’s appointment, in short, was unbalanced. As a result, to my knowledge nobody uttered three unmentionables:

  1. Unlike Mr Volcker, neither the present nor the incoming Fed chairman is in any position to offer a dispassionate view about contemporary financial and economic conditions.

  2. Central bankers, however formidably intelligent and diligent they doubtless are, nonetheless profess to believe (and promise to do) things that common sense and everyday experience – and the laws of economics!–tell us are flatly impossible.

  3. The Federal Reserve, like any central bank, is not just an historical oddity: it is a logical absurdity. Central banks are price-fixers that, uniquely among the many such institutions established during the first half of the 20th century, have retained and enhanced their prestige. But they swim again the tide of more recent history. Over the past twenty years in Australia, many of these bodies have been emasculated and then abolished. The Australian Industrial Relations Commission seems to be the most recent example. Why shouldn’t the RBA be the next?

These thoughts are completely taboo. Yet the investment returns of tomorrow reside where today’s investors fear to tread. Accordingly, it is appropriate that investors ponder these thoughts, weigh their implications, draw their own conclusions and incorporate them into their plans.

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Remember Paul Volcker?

Perhaps because they are neither burdened by incumbency nor hobbled by the desire once again to recline upon ministerial leather, some former holders of powerful offices are prepared to speak candidly. In Our Precarious Financial Situation (San Diego Union-Tribune 23 August 2004), Georgie Anne Geyer noted “Paul Volcker, former chairman of the Federal Reserve Board and a Republican, says we face a 75% chance of a financial crisis within five years.” Others, too, are concerned. Robert Rubin, whom Bill Clinton appointed Secretary of the Treasury, says that Americans are confronting “a day of serious reckoning.... the traditional immunity of advanced countries like America to a Third World-style crisis isn’t a birthright.” Peter Peterson, formerly the Secretary of Commerce and the head of the Federal Reserve Bank of New York, and presently the chairman of The Blackstone Group (and another Republican), reckons that “we [Americans] are not paying our own way. As a nation, we are running on empty. If the ultimate test of a moral society is the heritage it leaves to its grandchildren, I would say we are failing that test.” Geyer concluded “these men – our best and brightest – are telling us that, while the nation is fixated on delusions of empire in the Near East and illusions of omnipotence, we are simply going broke” (see also Peterson’s Running On Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It, Farrar, Straus and Giroux, 2004; and Joe Scarborough, Rome Wasn’t Burnt in a Day: The Real Deal on How Politicians, Bureaucrats and Other Washington Barbarians are Bankrupting America, Harper Collins, 2004).

Alas, although they might be blessed with candour, they are also plagued with impotence. Precisely because they no longer crack the whip of power, the views of retired officeholders are often discounted or overlooked. Thankfully, Mr Volcker refuses to be ignored. He reiterated his concerns in An Economy On Thin Ice (The Washington Post 10 April). At first glance – which is as far as many people want to look – the size of America’s economic pie is growing. Ditto (albeit much more slowly) the European and Japanese economies. And growth in China and India, which comprise almost 40% of the world’s population, is proceeding at rates “that not so long ago would have seemed, if not impossible, highly improbable.”

Under the placid surface, however, Volcker detects dangerous currents. Some are doing most of the saving and producing, and others are doing most of the consuming. Residential real estate provides a stark example: once a source of financial security, it recent years it has become a foundation of ever more fevered speculation. The people who should be saving much more are often saving least. And those who are saving least are consuming their financial nest eggs. Politicians rank very prominently on America’s long dishonour roll of squanderers. Incredibly, however, the very pollies who preach “conservatism” are most likely to practice extremism at home and abroad.

“What holds it all together,” Volcker observed, “is a massive and growing flow of capital from abroad, running to more than $2 billion [actually, it’s now closer to $3 billion] every working day, and growing. There is no sense of strain. As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.” The result, thus far and at least on the surface, has been attractive. Americans fill their warehouses and shops (and then their houses, garages and pantries) with an astonishing array of imported goods; and stiffer competition among suppliers, particularly suppliers from overseas, has restrained domestic prices. Further, the tsunami of foreign capital has – never mind Americans’ vanishing savings – placed downward pressure upon interest rates. This pressure, in turn, has enabled Americans more easily to service their existing debts, and has tempted them vastly to increase their indebtedness.

“The difficulty,” Volcker continued, “is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6% more than it produces for long. The United States is absorbing about 80% of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of $US.... It’s not that it is so difficult intellectually to set out a scenario for a ‘soft landing’ and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture.... But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all? The answer is no. So I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States could fade.”

I am not surprised that Mr Volcker is gloomy and somewhat grumpy. He inherited a ramshackle fiat money system (remember the dissolution of Bretton Woods arrangements in 1971?) and placed it upon a path that – this does startle me – has extended its life another quarter-century. During the early 1980s, Volcker prescribed a shock course of painful medicine and withstood a noisy mob whose expectations about future rises of the CPI were progressively squeezed. Then, in the late 1980s, he was deftly upstaged. Volcker administered the enemas and the hefty doses of cod liver oil, and bequeathed to his successor a less rickety child than the one he inherited. Greenspan halted the nasty medicine and returned to tradition – that is, a seemingly endless diet of lollies, chocolates and puddings. Volcker did the heavy lifting and endured the brickbats; Greenspan has inherited the benefits and harvested the bouquets.

It seems to be a constant from one epoch to the next: people push prevailing notions to their limits. Greenspan’s contribution is to stretch to new extremes the pure fiat currency system he inherited from Volcker. He has steadily shrunk capital reserve requirements and induced ever more artificial (judging from the extent of resultant “carry trades”) interest rates. During the last decade or so, he has fooled – or, more likely, lulled into a complacent torpor – many people who really should know better.

But he has not pleased everybody. According to Kurt Richebacher (All Signs Point to Bubble 4 February), “...in the past few years, the Greenspan Fed has systematically and deliberately fostered parabolic credit and financial excess with the explicit purpose of inflating asset prices. What manifestly is duping most people is the fact that the bulk of the credit excess poured into asset prices and the soaring trade deficit, rather than into the CPI, as had been usual.” Nor is Hans Sennholz (The Debt Timebomb 29 March) favourably impressed: “the popular notion that an increase in the stock of money is socially and economically beneficial and desirable is one of the great fallacies of our time. It has lived on throughout the centuries, embraced by kings and presidents, politicians and businessmen. It has shattered numerous currencies, inflicted incalculable harm, and caused social and political upheavals. It springs forth again and again, no matter how often economists may refute it. American statisticians and economists want to make us believe that America is a new-paradigm exception in this respect, being miraculously able to generate unprecedented productivity growth with zero savings and record low fixed business investment. The consensus readily believes it. For us, this is macroeconomic rubbish.”

From now until January, it is likely that many people will write great quantities of effusive prose and utter torrents of fulsome words about Alan Greenspan, the Greenspan Fed and their legacy. Ignore these testimonials. Instead, as The Maestro’s retirement and Bernanke’s ascension approach, cock your ears and listen for Paul Volcker’s grouchy voice and dour words.

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Central Bankers’ Fatal Conceit

And whilst you are doing so, consider an amazing conundrum (to use a word Dr Greenspan has popularised). Central planning in its broadest sense has been utterly discredited, such that few people seriously believe that governments should own factories, roads, schools and hospitals, or fix the prices of Vegemite, train fares, surgical procedures and insurance premiums. Yet most people – particularly the influential people within governments, universities and major financial institutions – fervently support central planning by central banks. Consider another paradox: virtually everybody, including these same prominent people, routinely allege that central banks “set interest rates.” But the simple fact is that they do not set rates; instead, they can only dictate a single rate (in Australia, the overnight cash rate at which commercial banks lend excess reserves to one another in order to remain within legal requirements set by the central bank).

Now consider the claim that emerges from these paradoxes. Encouraged by their vast and vocal cheer squad, central bankers insist that they can maintain the economic room temperature at a figurative 18-26c – not too cool and not too warm – simply by manipulating this single rate! This “Goldilocks Standard” is the implicit claim to fame of Alan Greenspan and Ian Macfarlane – and, come 1 February, of Ben Bernanke. If things become a bit chilly, then a timely clockwise twist of the monetary policy dial will put things right; conversely, if it is too warm, or if warmer temperatures are expected, then a deft anticlockwise adjustment will do the trick. In either case, trust them: they know when, in which direction and how far to turn the knob. The assumptions, in other words, are that central bankers can accurately measure the current economic temperature; they can anticipate the direction and magnitude of any changes of temperature; and they possess tools that can reliably equilibrate desired and actual economic conditions within some desired band.

A simple thought experiment, described by James Grant (Future Shock at the Fed, The New York Times 26 October), demonstrates the absurdity of this claim and its underlying assumptions. Let us imagine that a certain central banker’s (call him X to maintain his anonymity and therefore his dignity) field of expertise is not just the price of overnight loans of reserves among major banks: it is also the price of petrol. Let’s also say that X becomes Chairman of the Petrol Board. If X then offered a long-term – or even a short-term – forecast, would anybody act upon it? Would anybody even pay particular attention to it? Most importantly, would anybody have enough confidence in X’s forecast to allow him to fix the price of petrol and then adjust it whenever he chose?

Anybody who answers “yes” to these questions, if he is honest, would have to admit that he advocates price-fixing. And if he understands the implications of this position, he must be willing and able to justify his advocacy. In particular, he must explain how one man, X (assisted by one institution, the Petrol Board), can from one minute to the next know better than many buyers and sellers the market-clearing price of fuel. Further, he must not only divine present prices: because buyers and sellers routinely exchange contracts for future delivery, he must also accurately anticipate the future level and direction of prices. This proponent of price control would thereby be obliged to explain why this episode, directed by X and the Petrol Board, would end less comically or tragically than the countless others (beginning in Antiquity) that have preceded it. Expressed in these terms, and in Grant’s words, “the world would laugh. Yet we seem to accept, and even desire, such ludicrous claims of foresight from a Fed chairman. It follows that anyone who is willing to take the job as Fed chief is, by that reason, unqualified to hold it.”

What is a rate of interest if it is not a signal of the time-value people place upon money? Accordingly, on what possible basis can central bankers possess knowledge about these subjective valuations that is superior to that of borrowers and lenders in capital markets? Interestingly, central bankers explicitly and repeatedly disclaim any particular or superior knowledge about the market-clearing price of petrol – or, indeed, of other producer or consumer goods. Conveniently, given the asset bubbles they have repeatedly inflated, they also disavow any ability to detect asset price bubbles in advance – or even after the fact! “Moreover,” says Dr Bernanke, “if a bubble does exist, there is no guarantee that an attempt to ‘pop’ it won’t lead to violent and undesired adjustments in both markets and the economy.” So targeting the price level of financial assets is a no-no because the central bank has no special aptitude for it, and because these targets may lead to various upsets. But targeting the price level of producer and consumer goods is core business: “the central bank should focus the use of its single macroeconomic instrument, the short-term interest rate, on price and output stability.”

Central bankers tell us with a straight face that their targets with respect to the price level of producer and consumer goods do not inflate the prices of financial assets. Astonishingly, however, nobody (and certainly none among their cheer squad) laughs at this contention. And nobody, it seems, states the blindingly obvious: no matter how intelligent and diligent the central banker, and no matter how good his administrative support, no single person or Board of Governors, etc., can know better than the many actors in markets the present and future prices of assets, goods and services – including the appropriate price, tonight, tomorrow and every day thereafter, of overnight loans among major banks. To acknowledge this limitation and simultaneously to plead on central banks’ behalf is thus implicitly to admit that they will routinely fix a rate of interest that does not tell the truth about time.

But virtually nobody draws this conclusion. As a result, most market participants allow central bankers to bamboozle them – indeed, the former seem to demand that the latter pull the wool over their eyes. These days, most people are readily susceptible to the fallacy that the employees of certain organisations possess vastly more or better information, or systematically clearer crystal balls, than everybody else. Central bankers also succumb to this fallacy. Because they tend to be straight-A students and Ivy League or Oxbridge graduates, these “insiders” are vulnerable not just to the applause of market participants but also to their own hubris. Behind closed doors, some of the best and the brightest believe that the world is theirs to command. And therein lies a great danger.

Central bankers seem sincerely to think that they can comprehend the economic world and its complexities. In particular, they believe they can master it because their training tells them that they can model and measure it. This, given the subjective nature of economic calculation and the sometimes-arbitrary nature of statistical sampling and compilation, is (to put it mildly) a very ambitious belief. I do not dispute that Ivy League and Oxbridge graduates can (and often do) deploy outstanding brainpower in certain fields. I don’t doubt that their brains are better than mine. Nor do I criticise them because they regularly fix what in retrospect is clearly a wrong rate. I bag them because – and despite all the logic and evidence to the contrary – they continuously presume to know what the “appropriate” (they usually call it the “neutral”) rate is.

Although they might cross central bankers’ minds, the central precepts of Austrian School economics never ever pass their lips. They never concede that under specific but widely feasible circumstances, buyers and sellers in markets for goods and services act remarkably intelligently; and central bankers never admit that the transactions market participants undertake, as reflected by prices in unfettered markets, are almost invariably more sensible than those of the most intelligent individuals – including central bankers. Mark this point and mark it well: even if no market participants have formidable SAT scores, outstanding university credentials, etc.–indeed, no matter how “dumb” or “naïve” individual buyers and sellers might allegedly be – under a wide variety of conditions market participants as a whole will make better decisions than price-fixers and economic dictators (see in particular Israel Kirzner, Competition and Entrepreneurship, University of Chicago Press, 1973; The Meaning of Market Process, Routledge, 1996; How Markets Work: Disequilibrium, Entrepreneurship and Discovery, Institute of Economic Affairs, 1997; The Driving Force of the Market, Routledge, 2000 and The Role of the Entrepreneur in the Economic System).

What are these conditions? One is diversity of opinion: each buyer and seller in the marketplace possesses some tacit or private information (for example, a personal preference, opinion or perception). It is essential that each market participant use his information. Only if he does so will diversity of opinion prevail. Another condition is independence of opinion – that is, A must not just use his own information; he must also ignore B’s and C’s, etc. Sensible market participants do not work together, and ideally they do not even talk to one another. Where individuals hold diverse and independent opinions, decentralised (“bottom-up”) responses to problems of cognition, coordination and cooperation tend to prevail, and rational aggregating mechanisms (such as unfettered prices) hold sway.

Diversity and independence of opinion are vital because sound decisions emerge from disagreement and dissent – and not consensus or compromise. The more influence individuals exert upon each other (the more, in other words, they conform to some norm), the more likely it is that they will believe the same things, submit to the same biases and thereby commit the same errors. Assume for simplicity that an opinion comprises two elements: (i) “noise” and (ii) a kernel, perhaps a very small one, of genuine information. As long as market participants’ nonsense is not biased systematically in a particular direction, A’s bulldust will tend to cancel B’s, etc., and thereby help to bring the information into clearer focus. The best way for intelligent decisions to emerge in economic settings, in short, is for each market participant to ignore “leaders” and think and act for himself.

This notion is heretical – particularly within business schools. They babble incessantly about “leadership” and CEOs’ “visions” and “strategies” and “the war for talent.” (More generally, have you ever noticed that the more “diverse” business school faculties and student bodies become with respect to sociological attributes such as sex, ethnicity, etc., and the more they brag about it, the more they enforce a dreary uniformity of opinions and attitudes? B-School students are trained to suppress their own and deny others’ tacit information, glorify “teamwork” and otherwise ape their instructors – who very rarely have so much as a day’s experience running a business. In consequence, neither diversity nor independence of thought prevails, and “top down” approaches prevail. Add the love of big government and scorn of markets B-Schools instill into their students, and it is no wonder their graduates are often so poorly prepared for vocations in business.) But to absolutely no constructive purpose: the value of expertise – that is, the allegedly superior knowledge of a given individual or small group – is in many economic contexts vastly exaggerated.

In particular, there is precious little evidence that one can master something as amorphous as policy and strategy. Most importantly, there is little to suggest the existence of individuals who can accurately predict the specific future consequences of today’s fiscal or monetary actions. Similarly, evidence that a given individual or small group can accurately predict sales and profit margins of particular goods and services is very thin on the ground. Auto repair, prospecting for oil and minerals, skiing, building bridges and playing bridge – these things yield to individual talent, study and practice. But clarifying an opaque present, forecasting an uncertain future and deciding the optimal course of action are much less likely to do so. So thank heavens for free markets: a large group of diverse and independent individuals and the price mechanism will devise better and more intelligent decisions and forecasts than even the most skilled central banker – if only the latter is truly intelligent enough to restrain his hubris and leave the buyers and sellers in peace.

Alas, it is not just white bread politicians, degree factory academics and cookie cutter MBAs who believe that valuable knowledge is mostly formal and seldom tacit, that it congregates within a very few heads, and that these heads invariably studied at renowned universities and now reside in the upper echelons of powerful government departments and prestigious private sector organisations. These days, virtually everybody believes that the key to solving problems of cognition, coordination and cooperation is to find the “right” person who will supply the “correct” answer. Conversely, few recognise that knowledge is widely dispersed, that each individual tends to possess fragments of it and that participation in unfettered markets tends to reveal and aggregate it.

Hence the wisdom (compared to that of politicians, bureaucrats, CEOs, academics, etc.), as astonishing as it is unappreciated, that large numbers of buyers and sellers in unfettered markets repeatedly demonstrate. Hence too the “seer sucker theory”: no matter how much evidence disconfirms seers’ existence, suckers routinely pay big money for their services. People are pulled irresistibly to disown private knowledge and to chase and revere the “expert.” Ironically, what is predictable is that this chase generates suboptimal decisions – and unintended consequences of varying degrees of severity (see, for example, Leon Hadar, Beltway Intellectuals Are Useless; William Sherden, The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1997; James Surowiecki, The Wisdom of Crowds: Why the Many Are Smarter Than the Few, Abacus, 2004; and Is “Smart Money” Intelligent?).

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Central Banks and the Welfare State of Credit

People ranging from the most powerful politician to the humblest homeowner crave the soothing vagaries spoken by Alan Greenspan and Ian Macfarlane. Beginning on 1 February, they will probably fixate upon the clearer but no less comforting English spoken by Ben Bernanke (and later in 2006, when Mr Macfarlane retires, Australians will happily parse the kindly and reassuring words of his successor). But neither now nor then will anybody recall the bracing words of the Weimar central banker Hjalmar Schacht. In 1927, with the clouds of bust already forming, Schacht proclaimed: “don’t give me a low rate. Give me a true rate; and then I shall know how to put my house in order.”

Schacht’s severe words from then speak volumes about today’s indiscipline. The adulation heaped upon central bankers expresses the wide and deep confidence that they will deliver an “appropriate” – that is, aggressively low – overnight cash rate. Such a rate enables all and sundry to maintain their houses, literally as well as figuratively, in a blissful state of speculative disorder – free from any undue worry that inclement weather might damage the foundations or destroy the superstructure. This adulation is disguised – or perhaps uncomprehending – enthusiasm for the welfare state of credit.

In his book The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation (Random House, 1996), James Grant uses this phrase to describe today’s hierarchical financial structure of vague law, malleable precedent, lax regulators and enthusiastic borrowers and lenders. Like its cousins, the welfare states of income and labour, its objective is to featherbed a privileged few and leave all others to their own devices. It overrules individuals’ diverse, fickle and supposedly irrational (“chaotic”) preferences and thereby – it is alleged – fosters stability. Towards the structure’s apex sit the ideas, laws and institutions that governments deem too important to fail. The first class cabins house fiat money, fractional reserve banking and the central bank, the bank’s key policies (i.e., manipulation of the overnight funds rate and, less directly, longer term rates and the currency’s exchange rate, and above all the accommodation of deficit spending) and amorphous corporate law and lenient bankruptcy law. Below them in the middle class berths are other financial and insurance regulators; and still further below are the commercial banks and insurers whose collective survival is a necessary condition of the ship’s stability. Lastly, the bulk of private borrowers and lenders (whose financial condition is expendable) sit on hard and cramped benches in steerage compartments.

This welfare state, although it was established in different ways during different intervals in different Anglo-American countries, has a single objective. In Grant’s words, it is “to avoid runs, panics, depressions, financial turmoil and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labour. The welfare state of credit is built to resist a repeat of the events of 1907 and 1931, just as the welfare state of labour ... is built to forestall another Great Depression.”

Alas, good intentions typically generate unintended and perverse consequences. True to form, the welfare states of credit, income and labour have nurtured the very diseases they supposedly try to cure. In the short run, they have attempted to forestall certain events (say, unemployment) by imposing certain ceilings or floors (such as minimum wages, standards and conditions). These controls, in turn, subsidise certain kinds of risky behaviour (for example, the willingness to depend upon the public purse until a desired job, as opposed to just any job, materialises). These welfare states, in short, breed moral hazards. The welfare state of labour, for example, encourages under-employment and unemployment (see in particular Charles Murray, Losing Ground: American Social Policy, 1950-1980, Basic Books, 1995 and Eric Schansberg, Poor Policy: How Government Harms the Poor, Westview Press, 1996).

In a similar way, the welfare state of credit feeds speculative frenzies and promotes excessive risk taking in financial and investment markets – all whilst attempting to prevent the losses associated with excessive risk taking. According to Grant, “it creates the boom that causes the bust, but it attempts to abolish the bust. The long-run consequence is to subsidise instability and economic stagnation in difficult-to-predict ways. The boom-bust can appear in specific sectors and at other times in whole industries. But it doesn’t often appear in extreme ways at the macroeconomic level. The system is designed to prevent that from happening, and it usually does.”

Usually, but not always. No thanks to the central bank and the artificially low cash rate it usually delivers, individuals’ calculations of risk and reward become distorted. As a result, vast numbers of people are induced to take risks they would not normally (that is, absent the boom’s euphoria) take. During good times, the conviction prevails among the public that central bankers will not allow unwanted things to happen. People come to believe, in effect, that central bankers can foresee icebergs and that they can steer the ship between and around them. Suitably emboldened, people then buy stocks and residential real estate – regardless, it seems, of their prices. The fact that in recent years people have paid (relative to historical averages) very high prices seems to trouble them not at all. They sleep soundly because they think that the downside has been conquered; and they believe this because politicians and central bankers implicitly and incessantly tell them so.

Yes, central bankers often and routinely warn about cycles and excesses. That is an integral part of their standard patter. But their warnings are never profound. Perhaps most notably, Alan Greenspan has never acknowledged the crucial insight – as a serious student of Austrian Economics during the 1960s, he is surely well aware of it – that artificial booms ignited by central banks eventually cause genuine busts. Instead, he has repeatedly regarded the ups-and-downs of the business cycle as things that – trust him – he can control. Not since the 1970s and early 1980s have stock markets in Anglo-American countries experienced extended and bracing bear markets. Grant’s insight is that this is not evidence of central banks’ track records of success. Quite the contrary: it exemplifies the artificial arrangements they have wrought. Milder downward legs of the business cycle have coincided with weaker upward thrusts. Setting aside their numerous conceptual shortcomings, this is the key to the torpor of national income statistics in most Western countries. “Stability,” concludes Grant, “is a false ideal. Instability is a vital and necessary part of the capitalist drama. The purpose of the downside of the business cycle is to make the economy clean and honest again. To reduce the downside is to dampen the upside.”

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Three Conclusions for Value Investors

1. Central Bankers Are Bureaucrats

Look past their academic credentials, awards and adulation, and recognise that central bankers are glorified bureaucrats. Some bureaucrats are indeed formidably intelligent and admirably diligent; but many others, submitting to institutional imperatives, decline to display these characteristics. Great or small, bureaucrats’ major source of income is a government paycheque; and in that respect they are no different from struggling pensioners. To remember that central bankers are government workers is to realise that they have particular incentives and disincentives, that they make (sometimes grievous) mistakes – and like all people, will devise extraordinarily clever strategies to draw attention to their “successes” and distract attention from their failures. Remind yourself regularly: what on earth can government workers, who suffer no financial penalty when they miscalculate, know about the future course of producer prices, consumer prices and credit? Your answer should curb your enthusiasm for their soothing words and the low rates (and therefore high asset prices) they strive to deliver.

2. Bureaucrats’ Reputations Will Fluctuate

Today, Alan Greenspan is revered. The Fed is trading, figuratively, at a lofty multiple of its “earnings.” It also commands a sharp premium to its book value and it pays no dividend. Market participants trust it so emphatically that it need not bother to pay a stream of tangible income: unrealised capital gains will do. But a quarter of a century ago a diametrically different situation prevailed. Paul Volcker, who had just commenced a long campaign to restrain the CPI, enjoyed no such lofty reputation. Nor did the institution he headed. In those days, the Fed “traded” at a single-digit multiple, below its metaphorical book value and at an allegorical double-digit dividend yield (which matched Treasury yields at the time). Many people doubted Mr Volcker, others reviled him, and the Fed was widely regarded as either impotent or incompetent (and probably both).

But many shall be restored that were once fallen. Interestingly, in recent years the stock of the Volcker Fed has risen. According to Abby Joseph Cohen (The Australian Financial Review 26 October), “‘when history is written about the Fed, I think Paul Volcker will get much more credit than he gets now. He was facing a horrible situation with rampant inflation, and that’s not taking anything away from Mr Greenspan, but Mr Volcker was a true hero.” What does this resurrection imply for Dr Greenspan’s reputation? The omens are not positive: many shall fall that are now in honour. According to James Grant (The New York Times 31 October), “home with his wife watching CNBC, the retired chairman may see strange and troubling occurrences: rising interest rates, a falling dollar, a bear market in residential real estate, a rising gold price. And though tempted to interpret these disturbances as the markets’ expression of loss at his exit (he is, of course, only human), Greenspan on reflection may finally see the truth. He was, in fact, no oracle, after all.”

3. Investors Reap What Bureaucrats Sow

The principal risk that inheres in financial markets is not a crisis-induced loss of confidence. Instead, it is miscalculation borne of earlier overconfidence. The boldness and even recklessness among market participants that today’s crop of central bankers has encouraged, and the artificiality of what these bureaucrats have created, is their unwholesome legacy to their successors. Part of this legacy is thus the possibility of speculative upset, of disgust with financial assets and a – long overdue – loss of faith in central bankers’ stewardship of financial markets. Value investors should look forward to that day.

As they buttress their fortifications, investors might hope that Dr Bernanke and his colleagues really are as intelligent as advertised. In an interview with the Minneapolis Fed in 2004, Bernanke reflected “economics is a very difficult subject. I’ve compared it to trying to learn how to repair a car when the engine is running. The economy is always changing, our knowledge of it is very incomplete, and our ability to predict it is not impressive.” These are surely among the wisest words he has ever spoken. If he adheres to them, then investors can rejoice because he will have to abandon any pretence of anticipatory and aggressively inflationary monetary policy.

Alas, his next two sentences dispel any such illusion. They tell us all we need to know about the incoming Fed chairman – and about contemporary central bankers and their cheer squad more generally – and thus provide ample cause for concern. “Nevertheless, I think that having good data, good statistics – and the United States generally has better macroeconomic statistics than most countries – and having good economists to interpret those data and present the policy alternatives, has a substantially beneficial effect on policymaking in the United States, not only in monetary policy but in other areas as well. I think in the end good economic policy research makes a very big difference to the welfare of the average person.” So be on your guard: they’re from the central bank and – like social workers – they’re allegedly here to help us. In self-defence, let us pray that events – specifically, the long-delayed consequences of his predecessor’s policies – control Bernanke. Let us also hope that these events render him more “Volcker” than “Greenspan.

Chris Leithner    

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