A Letter to Bulls Part Two: Extending the Olive Branch
I'm unsatisfied with my last post: "A Letter to Bulls: Please Stop Cheer Leading Our Destruction." I feel I could have explained myself better, increased understanding, and avoided much of the confusion that followed. This follow up will hopefully add clarity, enlarge the issue I am driving at, and help add to the debate (fingers crossed.) And I have a totally canned and cheeky way to do it.
I'm here with David in Qatar: anarchist, champion bodybuilder, Shakespeare aficionado, and world-class lover, to find out where he comes up with his ridiculous ideas.
DQ: Thanks. Only one of those things is true, sadly.
I was being kind. In your last post you stated that the general price level of the stock market can not rise for decades on end without a rise in the money supply. Where does this crazy theory come from?
DQ: Believe it or not, I don't make stuff up off the top of my head. The theory belongs to Fritz Malchup, Austrian-born economist, and it appeared originally in his 1931 first edition of "The Stock Market, Credit, and Capital Formation." I have been reading the 1940 translation over the past couple of weeks. As you can tell from the book's timing, it was written shortly after the American stock market crash of 1929. The book is actually a defense of the stock market from a classical/Austrian School framework. I didn't do a very good job of explaining Malchup's theory, but it is quite simple.
Ok here's your chance to do it again.
DQ: Let's say you have an economy in Year 1 with a money supply of $1T and a total market cap of all stocks at $10M, and that this relationship is typical allocation of discretionary income for the stock market. In Year 50, if the money supply has remained at $1T, the total market cap of all stocks will be right around $1M, give or take the small fluctuations that happen from day-to-day. It is simply not possibly for the total capitalization of the market to continue to increase over that time unless new money is added to the money supply. It doesn't matter how successful individual companies have been during that time frame. Without an increase in the money supply, the market would remain flat. But that doesn't mean the economy's wealth would remain the same. Wealth is not determined by price level. It's determined by purchasing power.
So where did you go wrong?
DQ: Where didn't I go wrong? The worst thing you can do is haphazardly mix terms. I kept using the words static and stable, sometimes interchangeably, and sometimes with different meanings. The word stable can mean different things in monetary terms. You can have stable money, meaning unchanged supply. Or you can have a stable money, meaning that its supply rises predictably and steadily. Static can refer to the price level, but not the money supply. I could go on but I'll stop.
Inflation means two different things, sometimes more than that. Inflation to me is an excess issue of money (I'm an old-school kind of guy.) Inflation to others is rising prices. To some its currency devaluation.
Even the term money is tricky. Money can mean money in your wallet, bank credit, stocks, gold, IOU's. It all depends who you ask. I determine that all money currently in our economy is a money substitute and not real money, but that is an extremely controversial stance in mainstream quarters and not likely to be accepted.
So you screwed the pooch.
DQ: Yep, I found out I'm not perfect. Which sucks, because my favorite wrestler growing up was Mr. Perfect, and I know he'd be disappointed in me.
You're as close to perfect as I am to winning American Idol. So what was all this nonsense about dollar devaluation? Why not just say total market cap can only rise indefinitely if the total money supply increases?
DQ: That was another mistake. I was trying to integrate understanding of Malchup's theory with the Austrian Business Cycle Theory. I was trying to warn investors that cheap credit can push the market up, but it just sows the seeds for more destruction. But I would have been better off sticking to one topic.
An increase in the money supply is not, by definition, currency devaluation. I think I implied that, and that is a huge fail. Currency is devalued by an over-issue. This is nothing new. Understanding of currency devaluation goes back at least to Nicole Oresme's Treatise on the Alteration of Money. Long before Oresme, people understood what happened when the King altered the coinage.
Oresme sounds like a hoot at parties. So what's the connection then?
DQ: In the modern economy, our money originates from the Federal Reserve, not from the market. If the market determined the money supply, the amount of savings available would be represented by the interest rate. But with the Fed in charge, interest rates are a false signal. The Fed artificially lowers interest rates. If the interest rate is lower than the market interest rate would be, more money is being added to the money supply than the market demands. This is over-issue currency. It has to go somewhere. Nobody puts baby in a corner. The new money pushes the stock market higher, giving investors the feeling that they are getting wealthier. But it's not real. Only the person that cashes out before the bust gains real wealth.
You read Malchup for kicks and make Dirty Dancing references. You redefine sexy. So who says there has to be a bust? We can just print more money.
DQ: The longer the Fed suppresses interest rates, the worse it gets. Entrepreneurs engaging in higher order stages of production need accurate interest rates. Their projects take longer to complete than lower order stages (finished goods). They use the interest rate as a signal that savings is available to make their projects worthwhile in the long run. Low interest = high savings. High interest rate = low savings. More and more time consuming projects are taken on because of the low rates. But the savings isn't really there. And as time goes by, just a slight rise in interest rates can cause these projects to go bankrupt, leading to a tidal wave of bank defaults. The rest, as they say, is history.
So right now the Fed is trying to re-inflate, crank up the bank credit, lower the rates, and get these entrepreneurs to start taking on new projects. But the same problem persists. The interest rate does not reflect reality, and the when the Fed can no longer keep the rate near zero, we will get hit with another wave of bankruptcies, defaults, and finger-pointing.
And the finger should be pointed at the Fed
DQ: Absolutely. The Federal Reserve has moved beyond the point of "maintaining the value of the dollar" - if they ever did that - and is now attempting to manipulate the economy. This is central planning, not capitalism (at least, not the kind of capitalism I like.)
The rising stock market comes directly from the Fed's monetary manipulations. The more it goes up, the more trouble awaits us.
What if the Fed is right? And interest rates accurately reflect economic reality?
What are the chances of the that? Not even the Fed has the gall to say this is really what interest rates should be. They say "we need to keep rates low so we can get the economy going." But remember what I just said. The low rates send a signal to entrepreneurs that savings is higher than it really is. It's like deja-vu.
Can't entrepreneurs adjust? You always make them out to be supermen?
DQ: Certainly they can, and they are. As of right now, they're not taking the bait, which is frustrating the heck out of the Fed. And what's the Fed's response? "How about negative interest rates?" I'm sorry, but you wave enough crack cocaine in front of a reformed user and he's going to give in. The fact that he knows better becomes irrelevant.
So are stock market bulls really cheerleading our destruction, or is something else going on?
DQ: I admit, that's a little harsh. They're good people trying to make a buck, enjoying one of the games of life. I wanted to be controversial, hoping that it would reach a wider audience. But that's a total backfire. I don't wish any harm on DragonLZ, MegaEurope, rofgile, or any other CAPS members that are excited to see the market rise. So again, my bad.
But I hope they understand what is going on here. Maybe they do, maybe they don't.
Do you think the market is going up? What do you base your analysis on?
DQ: Yes and nothing. It's a gut feeling. This doesn't feel right. People tell me that the market priced in QE2. I don't think so. For starters, I'm not sure that's possible, and even if it was nobody knows exactly how big we're talking. This market is getting a nudge up, and when QE2 hits it is going to start taking off. It's not like there's less leverage available today than in 2006. When this rally gets going, we're going to see a lot of the same mistakes made. That's my gut feeling. But this isn't scientific or anything.
So why should anyone listen to you?
DQ: They shouldn't. I think an understanding of Austrian Business Cycle Theory provides tremendous explanatory power, more than any economic theory I have come across, but it's a Theory not a Law. As far as stock picking go, I've studied it for over a decade, but I've only had real money to invest for three years. That makes me a novice because only those three years mean anything. Studying investing makes you see your mistakes faster, but you still make them.
I always stress that people need to decide for themselves what is right. We may never agree, but I have no desire to force you to agree. I would prefer it if you understand my point of view, but that's all I can ask.
Finally I notice you often have harsh words for mainstream economics. Why is that?
DQ: Simply put, mainstream economic theory is a fraud. It's not theory at all. In econ class, I was taught the mechanics of modern day economics and told it was theory, as if modern economies evolved from the learned study of economic scholars.
In fact, the exact opposite is true. Economies evolved through the mostly-backroom deals of bankers and bureaucrats, with almost no input from economic theory at all. Take the Bretton Woods agreement as a prime example. From what economic theory did Bretton Woods take its cue? Stumped? You should be. It was a compromise of two economic plans, neither of which originated from the centuries of economic writing that formed the discipline. In practice, Bretton Woods operated as you'd expect: a shell game doomed from the start.
Yet, these concoctions and compromises, as nice as they are when they help avert total war, are presented to economic students as the result of intense economic study, only implemented after being sanctified by the deans of the field. Ha! Try rubber-stamped ex post facto.
So yeah, I tend to be hard on the establishment's economics, but they bring it upon themselves.
I hope this post helped your understanding. And again, I apologize for the weakness of my original post.
David in Qatar