Read of the Day: Viewing the Market Through Beer Goggles

James Montier’s latest touches on the age of financial repression and investing in an uncertain environment.  I loved these comments from him regarding current Fed policy, but as always, the whole thing is a must read:

“Put another way, QE sets the short-term rate to zero, and then tries to persuade everyone to spend rather than save by driving down the rates of return on all other assets (by direct purchase and indirect effects) towards zero, until there is nothing left to hold savings in. Essentially, Bernanke’s first commandment to investors goes something like this: Go forth and speculate. I don’t care what you do as long as you do something irresponsible.

Not all of Bernanke’s predecessors would have necessarily shared his enthusiasm for recklessness. William McChesney Martin was the longest-serving Federal Reserve Governor of all time. He seriously considered training as a Presbyterian minister before deciding that his vocation lay elsewhere, a trait that earned him the beautifully oxymoronic moniker of “the happy puritan.” He is probably most famous for his observation that the central bank’s role was to “take away the punch bowl just when the party is getting started.” In contrast, Bernanke’s Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.

So why is the Fed pursuing this policy? The answer, I think, is that the Fed is worried about the “initial condition” or starting point (if you prefer) of the economy, a position of over-indebtedness. When one starts from this position there are really only four ways out:
i. Growth is obviously the most “popular” but hardest route.
ii. Austerity is pretty much doomed to failure as it tends to lead to falling tax revenues, wider deficits, and public unrest.
iii. Abrogation runs the spectrum from default (entirely at the borrower’s discretion) to restructuring (a combination of borrower and lender) right out to the oft-forgotten forgiveness (entirely at the lender’s discretion).
iv. Inflation erodes the real value of the debt and transfers wealth from savers to borrowers. Inflating away debt can be delivered by two different routes: (a) sudden bursts of inflation, which catch participants off guard, or (b) financial repression.

Financial repression can be defined (somewhat loosely, admittedly) as a policy that results in consistent negative real interest rates. Keynes poetically called this the “euthanasia of the rentier.”  The tools available to engineer this outcome are many and varied, ranging from explicit (or implicit) caps on interest rates to directed lending to the government by captive domestic audiences (think the postal saving system in Japan over the last two decades) to capital controls (favoured by emerging markets in days gone by).”

Source: GMO


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Very good comments indeed. The question is – where we are in these festivities? Are the close to an end?
    Achuthan drew a hard deadline today, one month from now, for his recession call. So in the first week of January, with unemployment and other critical economic numbers out, we finally should be able to judge his prediction. Cullen, what’s your current thought on recession?

  2. The financial repression talk is often used by the austrian school to be that higher rates means more savings which means more loans and investments which means more economic growth. If I understand MR, this type of thinking is not entirely correct because banks are not reserve (or savings) constrained when it comes to low.

    Also, the FT had a good article today on how lower rates (and real rates) means more hoarding and speculation in real assets (gold, commodities etc) because it becomes cost effective to “store” them at these low rates.

  3. It’s hard to quantify the effect of rates because you’re measuring the degree to which low rates attract new investment, spending and ease in debt burdren versus the lost income. Remember, interest rates are also a huge source of income for people so higher rates are essentially deficit spending in a roundabout way because the interest is a govt expense. The Fed essentially does fiscal in that sense. That’s why it’s hypocritical for some people to complain about low rates hurting savers and Fed policy distorting markets at the same time. You can’t have it both ways. Lower rates are either good or bad. I say they’re good right now because we need to ease the pressure on debtors. But that’s assuming the govt isn’t too austere because of the lost interest income….

    Got that FT link? I’d like to read if you have it handy. Thanks.

  4. Cullen, is there a typo in the title of this post? Did you mean to say: “through BEAR goggles” ? Seems like Montier leans bearish in contrast to David Kostin on Goldman who has done a flip-flop. Maybe you were hankering for an ice-cold beer when you typed this post? What is your favorite brand of beer?

  5. Boston,

    If you read the whole thing which I did, he explains his recommended equity allocation as a function of the length of the “financial repression” period. Essentially it is kind of like a supply and demand curve for equity allocation vs cash/bonds which depends upon both the expected rate of return of equities and their “fair value” expectations for the market.

    It is quite a quantitative argument and somewhat complex but overall easy in concept to understand if you spend the time reading it. For me, not a very happy read but extremely informative.

    Although he does not “like” equities per se, he is recommending a fairly significant allocation to them to avoid the negative effects of financial repression from negative real interest rates. He is not making an inflation argument for holding equities, actually quite the opposite.

  6. CW, thank you for summarizing and explaining as I did not take the time to read the whole thing. I dislike the idea of making a significant allocation to equities now, but they may be the “least bad” of all the choices out there. Which ETF out there would most correspond to GMO’s category of “high quality” US equities? One article I read mentioned VIG, the Vanguard Dividend Income Growth ETF. Would it make sense to gradually accumulate this?

  7. It’s Beer Goggles, he’s referring to this passage: “In contrast, Bernanke’s Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.”

    How many different Beers have you tried before settling on your favorite? ;)

  8. “Lower rates are either good or bad. I say they’re good right now because we need to ease the pressure on debtors.”

    The skeptic in me says that the Fed is doing it to ease pressure on creditors (to take losses) rather than the debtors. The debtors have no lobby and its not a given that foreclosure would be bad for them. Better a quick fix than an uncertain, drawn out fix.

  9. Financial Repression? Why were rates so low in late 1890’s and 1940 when there was no quantitative easing? Lack of credit demand- just like today. Similar outcome in Japan BEFORE they started doing QE. Rates would be exactly where they are without QE. And how about the fact that the equity market is extremely cheap. I would expect him to focus on the all the bad news that could go wrong and conclude that being contrarian is the appropriate thing to do as it is likely priced into risk assets.

  10. IK’s series of articles the last several months has been nothing short of incredible. Maybe I’ve just turned into a sucker fanboy, but my dream Econ theory right now is a marriage of MR (including all it’s influences such as Minsky, Godley, etc.) and the sort of radical Keynesian stuff Izzy’s been going on about. She recently opened a new blog called the Leisure Society. She has a post there that nicely sums up everything she’s been going on about that I think is a must read to those who haven’t been following her posts at FT Alphaville:

  11. Yes nominal rates were down for low credit demand. But real rates negative? I doubt.