Sunday, December 21, 2008

If You Can't Tell Who The Sucker Is....

Thumbing through the sell-side research from their multitudes of Strategists, I notice some recurring phrases, small and innocuous as they may be, that trouble me. Time and again, they repeat, in various contexts, the mantras: "when things return to normal", "when markets return to normal", and "when x, y or z normalizes" with "normal" implied to be that which has been common over the past decade-or-so in respect of liquidity, leverage, asset prices, equity risk premiums, speculative activity, growth. Mulling this over, I wonder to myself: "is this not just the perfect "recency bias" example, defined by wikipedia as "a cognitive bias that results from disproportionate salience of recent stimuli or observations"? For as I consider what precisely is meant by "normal", it seems to me that there is a reasonable good chance insofar as this IS "The Big One" (as Bridgewater Associates precsiently termed it nearly a year ago) that all these things - debt, leverage, consumption vs. income, relative asset prices - are ALREADY returning to normal, and the strategists, demonstrating the old poker joke about "if you look around the table and you don't know who the sucker is, its you....", simply haven't yet fathomed the appropriate interval frame of the normality to which things are returning towards.

In Japan, "normal" meant that in 2004 residential real estate prices were roughly 30% of late 1980s or early 1990s prices. In Germany , though nominal prices might be similar in many places to those prevailing two decades ago, the real price destruction would be probably be similar to Japan's. But what is "normal" for economic growth? Or what is "normal" for aggregate US consumption? Or the amount of debt a typical household can sustain? What is the "normal" leverage for a bank, or the normal return on equity o a listed company? What is a normal share of GDP for corporate profits in an economy experiencing deep recession? What is "normal" for sustainable government budget deficits? What is the normal income multiple of a banker or CEO to a policeman, a professional baseball player to a school-teacher or a doctor to a nurse? What is the normal amount of due diligence a bank should do before extending a loan and what is normal for the amount Honeywell Industries will earn per-share in the coming years?

These may seem disparate and unrelated, but I fear they are not. I fear that the final acceleration towards the denoument of Peak Credit, rooted as it was in poor fiscal policies and lack of regulation & oversight, greased with monetary ease and official foreign mercantile enablement, and driven by parochial and herd-like animal spirits, has distorted what is normal, what should be expected, and of course, what is, and will prove to be reasonably sustainable in the future. But the Strategists, the ones who've offended my sense of the normal, seem, in their sanguineness, to be implying that is was normal to extend credit as it was during the last eight years; that gains in asset prices (be they a a portrait of Dr GachetNYC apartments, Chelsea or Notting Hill pied-a-terres ?) are normal at somewhere nearer to the top of their seemingly almost-exponential three-decade rise; that it is normal that US households continue to live with negative rates of savings or consume en masse beyond their means; or cavalierly burn hydrocarbons at the elevated relative per-capita rates that they do presently; that past income-inequality, now rolled-up into massive eddies of wealth discrepancy that approach those which evoke those prevailing during the enclosures in England are normal, and that their sense of normalcy will swiftly return despite the continued pressure to the contrary upon the financial sector, and households to return to a normalcy of a much different mean than those of the recent past, which in their turn directly the impact the corporate sector with body blows from BOTH the cost and availability of their gearing and the ultimate demand for their products.

I do not believe (yet) that we are about to beat each with bones back to the stone-age. But I believe that what we've seen in leverage and credit growth during the past 15 years is NOT normal, nor is it sustainable - neither relative to history or in absolute terms. And this return to what is sustainable, and service-able has profound economy-wide, implications, and they are indisputably contractionary: deleveraging, higher savings rates, matching household consumption to income, and government revenues to expenditure. Add to this the impending pull of demographics, the emerging trend towards greater environmental consciousness and sustainability, and "normal" begins to resemble a mean-that is something of a much different magnitude, something still to the south of where we are that - in the big time series - we will continue to revert towards from our presently divergent location rather than - as the Strategists imply - a normal that is something we've already overshot.


Gen Kanai said...

The US "norm" is now near the Japanese norm, at least as far as the interest rate is concerned.

Krugman talks at length at the recent National Press Club Luncheon about ZIRP in Japan vs. near ZIRP in the US.

I'm in the camp that says that there's more to learn from Japan's ZIRP experience than some think.

Unknown said...

So, I take it you short stock in the restorative powers of billions of dollars slapped into the crevices like putty at a higher, faster rate than ever in history?

Anonymous said...

Well, if the SEC hadn't banned shorting stocks... More seriously, stock markets have dropped so far I think the bottom is fairly close. But I don't think stocks will appreciate much after the bottom is found so not much of a point in dabbling in them. However, stocks are not the only thing you can short, and I'm sure more than a few overlooked rotten bonds can still be found if you want to make a killing.

Cassandra, bravo though a nitpick about German housing values. Reunification saw a huge property boom in the former DDR due to extremely generous tax incentives. When the incentives disappeared the hangover set in. And the hangover also affected prices in the west. So adjusted for inflation prices are lower than 10 years ago, but still higher than 20 years ago.

Unknown said...

Good to see this is the drift the discussion is taking. But there are a couple of bits with which I beg to differ.

Cassandra says:

"And this return to what is sustainable, and service-able has profound economy-wide, implications, and they are indisputably contractionary: deleveraging, higher savings rates, matching household consumption to income, and government revenues to expenditure."

The intent is all nice and agreeable.

But when and where in history has there ever been a sustainable monetary system? When in history have we ever openly thought or even considered the notion of designing sustainable monetary policies?

Apart from failed and/or marginal attempts, considering only mainstream jurisdictions, the answer is "never!". Monetary policies have always been giant Ponzi schemes, alternating long periods of irrational exhuberance with credit crises.

I also like the use of the word "service-able" in this context. But I would like to add "solvent" to it. A debt based monetary system is service-able in "normal" times in that interests can be paid at the condition liquidity is continuously injected. But "normalcy" is a meta-stable state because even then there is no solvency. The system is never solvent in aggregate as there is never sufficient money in the system to repay all existing debt and debt is not systematically restructured to follow collateral depreciation or appreciation. It's precisely a solvency crisis what triggers the final crisis and compromises service-ability no matter how much liquidity one is willing to inject.

I agree with Cassandra when she says that what can seriously come out of this crisis is a realization we do need sustainability and a balanced system. Achieving it is certainly not a question of adding a few more volumens of regulations to the already existing ones. One has to go at the very root of the problem and look into the process of money creation and distruction, resource allocation and consumption.

Mankind has been fooled many many times into piramid schemes. Let this be the last.

Unknown said...

Excellent blog - I just discovered it. Great comments as well.

"consume en masse beyond their means"

I've been thinking an enormous amount about exactly what this phrase might mean. For example, if we can produce stuff, why can we not afford it?

For example, we just produced a few million extra homes and upgraded millions of other homes. If the work is already done, how can it not be "net affordable" to our society?

We are then talking about a mismatch between our monetary system and the system of production...

Anonymous said...

>> how can it not be "net affordable" to our society

because the developer borrowed money to build it and in order for him to pay off his loan and make a profit someone must be willing to take on an even bigger loan.

Its true that the houses that were built are an asset but unlike a factory or farm they are not productive assets. So to have value they have to be in the right place and at the right price - something that most of the excess inventory is probably missing.

Anonymous said...

Structural Normality.

I can borrow pension fund money to buy a SUV.

Jet Fuel is reasonable and that guy with the Lincoln Town car has clean white gloves.

My dog Buster's credit is restored and I can use his card to speculate on wine futures.

My ordained place in the universe is rightfully restored.

I never buy "bulk" again.

donna said...

I think we need to go back to the meaning of what an "affordance" really is. ;^)

Psychologist James J. Gibson originally introduced the term in his 1977 article The Theory of Affordances[1] and explored it more fully in his book The Ecological Approach to Visual Perception[2] in 1979. He defined affordances as all "action possibilities" latent in the environment, objectively measurable and independent of the individual's ability to recognize them, but always in relation to the actor and therefore dependent on their capabilities. For instance, a set of steps which rises four feet high does not afford the act of climbing if the actor is a crawling infant. Gibson's is the prevalent definition in cognitive psychology.

It's always possible to build or produce something that you might not be able to actually sell at the price you would like, or are able to make a profit on. The questions now are indeed what individuals can afford, and not society as a whole. The problem, the real problem, has been that the distribution of wealth is inequitable, and those inequalities have finally caused the piles of stinking wealth to tumble over and rain down as shit on everyone else.

Those who did not have wealth were simply not able to afford the huge amounts they were loaned, anymore than infants can climb four foot walls. Pretending this was not the case got us all into big trouble.

Anonymous said...

The problem of affordability, rises from the fact that a large portion of society does not produce anything that is desired or needed by those that produce the goods that modern life requires.

The houses are not affordable, because those that want to live in them, do not produce enough to trade for them, and as such it makes no sense to build them.

Anonymous said...

The "All-Devouring Rent" is IMO important to understanding boom/bust cycles.

Titled land ownership in good times is a license to print money so attracts wide speculative interest. Due to the limited, fixed supply of land this results in land prices being bid up past the point of affordability on the upstroke.

Then the downstroke comes.

People think the US consumer is over-extended or going broke, but that is only because we have such high ground rents & land values. Knock ground rents and land values back to 1990 levels and the non-rentiers among us would be perfectly well-off.

When times get tough, land prices go down. This is no mystery, once you understand the mechanics of the "All-Devouring Rent".

Anonymous said...

Gen -- I lived in Tokyo 1992-2000 so, yeah, I think I've seen this movie before.

Anonymous said...

Quick reply to Mike Sankowski-the purchasing power of wages fell and did not return from their 1979 levels until 2001, while productivity has increased in every single year of that period. Purchasing power has dropped again.

Now you know why we can't afford what we produce. We keep producing more per person, yet each person does not get comparable increases in wages, remaining equal to what we could buy 29 years ago.

Unknown said...

If you're looking for the sucker, you're at the wrong table...

Anonymous said...

Why does the peak credit link show me a picture of a tibetan monk?

And what does that say about the sustainability of our scientific research programs?

Cassandra really is forcing me to think sideways ...

Anonymous said...

thanks...failed "cut and paste". The French Monk was from my MACs cache. Will fix. Happy hols...


Jesse said...