Big Ben & The Shit-Cloud by Josh

Josh

Dandelion Salad
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Josh’s Blog Post

Aug. 16, 2007

Everybody and his mother these days is fixated on the wild fluctuations of the financial markets. The stock market, while proving itself to be very vulnerable to sudden gut-wrenching drops, still stands near an all-time high. Oil, precious metals, and other commodities have appreciated alarmingly over the past couple years. The well-to-do seem to have more money than ever before, and the displays of conspicuous consumption grow ever more extreme, yet the majority of Americans are struggling just to stay afloat. The powers-that-be assert that the economy is robust & healthy (except for a few “isolated” problems, like the sub-prime mortgage meltdown), while many financial professionals foresee doom and gloom of epic proportions ahead. So, what gives? How are we to make sense of this confusion?

Well, the first answer is that nobody really knows. Although the authorities would like us to believe that they’ve got everything under control and that maintaining a healthy economy is simply a matter of finding very smart people and letting them make the right decisions, the fact is that many of the best thinkers in history have recognized that economic processes are so complex that no human (or group of humans) can ever hope to achieve a comprehensive understanding of them. Rather, if someone like Ben Bernanke (Chairman of the Federal Reserve) was to momentarily abandon the false certainty required of top officials and speak candidly, I suspect that he would admit that, while he has spent his life trying to understand the markets, he still has a very imperfect understanding, and his opinions represent, at best, educated guesses.

So, what is the average American citizen to make of all of this? If Ben Bernanke doesn’t even understand it, how can we hope to make any sense of it all? Well, the obvious answer is that we can’t. But the fact remains that most of us still have to make important decisions (buying a house, planning for retirement, making career choices, etc.), the outcomes of which will be heavily influenced by complex processes that we will never fully understand. In a sense, financial decision-making is comparable to the game of poker. Poker is a game where one never has all of the relevant information and where big decisions must be made on the basis of incomplete information. And, in poker at least, it is a demonstrable fact that those who are skilled at analysis of incomplete information can consistently outperform the competition.

To extend the analogy, we can then ask, since Ben Bernanke is presumably one of the most highly-skilled players in the financial field, can we expect him to achieve good results, despite the fact that he can never attain a complete understanding of his domain? Unfortunately, my opinion is that at the current juncture it is highly unlikely that he will be able to navigate the increasingly treacherous terrain while avoiding a major economic crisis of one form or another. This is no judgment on Mr. Bernanke’s abilities, since the situation he has to deal with is not of his own making. He is in the extremely unenviable position of having to try to hold together a situation that is the product of years of irresponsible decision making on the parts of government, financial institutions, and individuals.

So, now that I’ve just finished explaining that nobody can really make complete sense of the complex financial picture, I am going to try to share my understanding of some its important aspects.

One thing that is a virtual certainty is that if you borrow money, you eventually have to pay it back. (Of course, it is possible to default on a debt, but this normally entails severe consequences including a greatly diminished ability to borrow money in the future.) We appear, at the present time, to be going through a painful process of coming to terms with this basic economic reality, which for several years has been unheeded by market participants large and small, public and private. Our government has pursued the obviously unsustainable course of reducing revenue (via tax cuts) while simultaneously increasing expenditures (most notably, through the economic sinkhole that is the war in Iraq). Simultaneously, more and more of the American public has been treating real estate as if it were a magically inexhaustible source of wealth. American families have spent more and more money (on homes, cars, consumer electronics, travel, etc.) without a corresponding increase in earning capacity. This unsustainable trend was made possible by the extraordinary increases in real-estate values which enabled families to borrow more and more money against the value of their homes. Such a situation works just fine as long as real estate continues to climb, but as soon as it levels off (or declines), the artificial fuel that drove consumer spending dries up, and the chickens come home to roost (witness the alarming increases in mortgage delinquencies).

So, where does this all leave poor Mr. Bernanke? I would argue that job of the Federal Reserve is basically to prevent the proverbial shit from hitting the fan. The typical balancing act that the Fed must attempt is to keep both unemployment and inflation under control simultaneously. Under normal circumstances, these two directives work in opposite directions. If the Fed is too tight in its monetary policy (i.e. sets interest-rates too high), businesses will have a hard time raising capital and will therefore have a diminished ability to create jobs, thus unemployment. On the other hand, if monetary policy is too loose (i.e. interest-rates are too low), business owners will have no problem raising capital, but the currency will begin to lose value (i.e. inflation), which, if it gets out of control, can be every bit as harmful as widespread unemployment.

To illustrate the challenge faced by the Fed, let’s imagine that there is a giant fan, and Ben Bernanke’s job is to stand in front of the fan and prevent a cloud of shit from reaching the fan. The shit-cloud corresponds to the ever-present possibility of financial collapse. Let’s further imagine that if Bernanke moves too far to the right side (which corresponds to tight monetary policy), the shit will hit the fan from the left side, while if he moves too far to the left, the cloud will reach the fan on the right side. (This is a highly simplified analogy, since it is possible to have both high inflation and high unemployment at the same time – this is the highly problematic condition called “stagflation”, which we experienced in the 1970s.) Now, if the financial system is healthy, the shit-cloud is relatively small and manageable. A little shit may slide past Bernanke on one side or the other, but he is able to skillfully keep his balance and prevent the bulk of the shit-cloud from reaching the fan. However, if, due to a lengthy period of unusually irresponsible behavior, the shit-cloud has grown in size, the task of interposing his body between the cloud and the fan becomes increasingly difficult. If this situation is allowed to proceed unchecked, the cloud will grow so large that, regardless of the skill of the Fed, a large amount of shit will hit the fan from one side or the other (or both, i.e. the aforementioned stagflation).

To return from the world of fans & shit-clouds, let’s look at how this all might play out in the actual realm of the financial markets. One obvious fact is that the United States government has built up an enormous debt that requires hundreds of billions of dollars per year in additional borrowing just to pay the interest on the outstanding debt. The on-going ability to fund this ever-increasing liability has been largely due to the unique position of the US dollar in the global economy.

Holders of wealth around the world are always in search of ways to safeguard their assets. The form in which you hold wealth can have huge implications for how well that wealth holds up over time. For example, if you and I each have $100 at the beginning of the year, and I use my hundred dollars to buy gold, while you use your hundred dollars to buy milk, and then we both store our respective assets in a warehouse and come back at the end of the year, our initially equivalent positions will have changed dramatically. I will still have the same amount of gold that I had at the beginning of the year. You, on the other hand, will be the proud owner of a stinking pile of sludge with zero economic value (and possibly the additional burden of having to pay to clean up your mess). In a similar manner, any participant in the global economy who generates wealth will want to find a suitable way to store the portion of this wealth that is not intended for immediate consumption. And, since most tangible assets deteriorate over time, it is extremely important for anyone who wishes to store wealth to find a form of value that will not diminish with time.

For much of human history, people have chosen precious metals, most commonly gold, to fulfill this vital economic function. Gold, unlike almost any other form of matter, is both rare and never deteriorates. It is therefore considered a very sound store of value. During the first stages of a paper-money economy, the value of money was secured by the fact that it was convertible into a fixed amount of gold. Over time though, various factors pressured governments to suspend the convertibility of currency into gold, and nowadays, money has zero “intrinsic value”. This creates a problem for anyone wishing to store wealth.

The result was that market participants around the world chose the US dollar as the pre-eminent store of value. The reason for this was that the US economy was the largest and most robust in the world, and the US financial authorities were considered to be the most knowledgeable and trustworthy. So, for example, if you were an Argentinian businessman and you generated wealth in excess of your current consumption needs, and you furthermore feared that the local financial authorities were not trustworthy, you would have chosen to convert your wealth into US dollars, which you considered a better long-term store of value. Such has been the case globally for most of the last century. As a result, there was always a steady demand for US currency (and securities, since it is even better to hold a US Treasury Bill than plain currency, since the T-bill has the additional benefit of providing an interest payment). So, this has been the engine that has allowed the US government to borrow a seemingly inexhaustible amount of money to fund its perpetually imbalanced finances. If the general consensus that the US dollar is the safest store of value was to ever change, however, the on-going ability of the government to borrow as much as it needs could be jeopardized.

This is one of the elements of the increasingly difficult challenges faced by Big Ben. Following the dot-com bust in the early part of this decade, the Federal Reserve (under Alan Greenspan) pursued a very loose monetary policy in order to prevent the losses from spreading to the economy at large. The problem though (keep in mind the image of the fan and the shit-cloud) is that by overcompensating in one direction, an even larger problem was created. The loose-money of the last several years fueled an increase in real estate values that was completely out of line with the underlying economic fundamentals. This should be familiar to most Americans who saw almost everyone they knew suddenly becoming real-estate speculators over the past few years. It seemed like the easiest thing in the world – borrow money at a very low interest-rate, buy property, wait for the property to appreciate (due to the fact that everyone else had the same brilliant idea), and then sell the property for a profit and pay off the debt. Unfortunately, like anything that seems too good to be true, it was indeed too good to be true.

Now that real estate has stalled, the magic money machine doesn’t work anymore, and all of the borrowing that fueled it must be reckoned with. And this leaves Big Ben with a truly daunting dilemma. If he raises interest-rates, more and more homeowners (and real estate speculators) will be unable to pay their increasingly burdensome debts. As homeowners are forced to sell their homes, the supply/demand situation in the real estate market will deteriorate, causing yet more people to be forced to sell, thereby creating a vicious cycle. If, on the other hand, Bernanke keeps interest rates low, market participants world-wide will start to question whether the US dollar is still the rock-solid store of value it once was. (In fact, this process has already begun, with many foreign financial institutions choosing to hold a diversified portfolio of world currencies, instead of dollars exclusively.) If this were ever to happen to a large degree, the US government would be faced with the very real possibility of not being able to borrow ad infinitum. The US would then be faced with no choice but to raise interest-rates (since global investors would demand a larger return to compensate them for the increased risk of holding dollars). An increase in interest-rates would, as described above, have a disastrous impact on heavily indebted Americans. Thus, the dilemma of the shit-cloud. The cloud has reached such an alarming size that, even if Big Ben was the most skillful Fed Chief in history, he might still be incapable of preventing a calamitous meeting of shit & fan.

Whether the scenario ends up being one in which rising interest-rates cause a worsening of the real estate market (which would eventually impact the larger economy and cause a recession or depression) or one in which the Fed attempts to stop the slide in real estate by cutting interest rates (which would then lead to inflation), I doubt that Big Ben is capable of averting a major economic crisis. In fact, just today we learned that the Fed pumped $38 billion into the economy in just the past few days in order to support the sagging stock market (with little success). Just as the analogy of the shit-cloud would predict, once the cloud gets too big, it doesn’t matter what you do, you’re guaranteed to wind up with an ugly and painful mess.

3 thoughts on “Big Ben & The Shit-Cloud by Josh

  1. Pingback: Stagflation: The Two-Headed Monster by Josh Sidman « Dandelion Salad

  2. Pingback: Financial Wisdom From Wong’s Palace by Josh « Dandelion Salad

  3. There is no ‘decent money’ to be made with the federal reserve (an illegal operation, like the IRS) printing it.
    They will pillage US dry and follow haliburton to Dubois….
    Economic war is like any other, just mind over matter; The wealthy elite don’t mind, because we don’t matter.

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