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Policy Reflexivity (a/k/a WWF presents Davos v. Rickets)
This thread was inspired by an exchange of ideas in The March 16 Daily Digest, primarily between Davos and Rickets. I thought the discussion was outstanding, but I've also noticed that Daily Digest threads die out as soon as the next day's digest is posted. I think that the conversation that started there was worthy of continuing, so I've taken the liberty of creating this thread to continue the discussion.
First, my hat is off to both Davos and Rickets. They personify what I really love about this site: civil, adult discourse between members with strongly opposing views. I had just finished reading a few posts at Zero Hedge and was, as usual, disgusted by the name calling and ad hominum attacks against people trying to express their views that are so pervasive in the forums there. I'm so glad we have the CM.com forums for polite, grown-up discourse!
Second, I would like to re-frame the discussion a bit. Although the conversation in the Digest was framed primarily around inflation vs. deflation, I think the core issue that needs to be discussed (and was explored there) is actually what I call policy reflexivity. In other words, we frequently make the mistake focusing our analysis on what is supposed to be. For example, we think a lot about the $100T+ in unfunded entitlement obligations of the federal government, then we get too hung up (in my opinion) on what it would take to service those obligations, how much taxes would have to rise, etc. But that's missing the point! These things are already past the point of being servicable. For everyone to receive all their entitlements in real terms (meaningful cost of living increases included) is simply not possible. So it's not going to happen, period. Something else is going to happen, and that something will be determined more by social/political developments than economic ones.
Put another way, we have to figure out which alternative to what is being promised is most likely to really happen. Everybody getting their entitlement benefits with inflation adjustments isn't going to happen. It's impossible. Everyone getting their entitlement benefits as presently promised in nominal terms but watered down in real value by inflation is a distinct possibility, but before assuming it will happen we should consider how realistic it will be for the populace to accept their benefits being inflated away. They won't notice at first, perhaps, but eventually they will. Another possibility is for everyone to come to terms with the fact that these entitlement obligations are unsustainable, and phase them out. Everyone under the age of 55 is told that they are not going to get a penny from social security or Medicare, and they should start planning and saving accordingly. Some of us might think that's actually one of the most responsible solutions available, but its political viability is almost certainly next to zero.
If we accept that giving everyone their entitlements in real terms is impossible and that things have come to a head already (social security is now running a deficit rather than a surplus), we can start to postulate what might happen next in terms of public policy changing in reaction to the harsh realities of the economic situation that has already ensued. This phenomenon of the rules of the game itself changing as a result of how the last few moves have been played is what George Soros called Reflexivity in his 1987 work The Alchemy of Finance, a book that I frequently refer to when I want to predict what might happen next in financial markets, and which Davos frequently refers to when he needs to start a fire in his wood stove! (Davos and I politely disagree on the merits of Mr. Soros' work).
To kick things off, I'll offer a few thoughts that I think are most relevant to predicting how this might go down:
- In general, the more difficult a person's own circumstances become, the more they focus on getting what they need for themself and their family, and the less likely they are to see "the big picture" of how society on whole needs to advance. Witness Greece: you can bet that none of those people in the riot videos are thinking "Hey, our government spent beyond its means and our excessive union wages are crippling the long-term viability of our economy. .. We really need to adopt austerity and learn to live within our means!")
- As financial conditions worsen, the masses tend to move their views more toward socialism, focusing more on getting what they need and less on the systemic implications of the policies involved. To wit: consider the popularity of Hilary Clinton's words about the subprime calamity to the effect "We need to focus on keeping Americans in their homes". Most people, even those not in default themselves, resonated with this message. Very few had the reaction "Wait a minute, those people were irresponsible and the only way to keep them in those homes they cannot afford is for the rest of us to subsidize their living beyond their means". In other words, I posit that financial crises induce tunnel vision. People think about what they personally get right now without a lot of thought about systemic implications.
- Politicians have historically focused on giving people what they want, regardless of how realistic the policies in question become. This is perfectly exemplified by the fact that the current crisis is all about too much debt and unservicable government obligations, yet the most popular view among voters is that this is a good time to add another huge entitlement program (healthcare). When people can't afford to pay escalating healthcare costs out of their own pockets, they want and expect someone else to pay. Very few are willing to recognize that the money has to come from somewhere, and government isn't known for maximum efficiency. I am reminded of FSN's John Loeffler and his frequent airplane analogy: The only way to survive a crash is if it's a controlled crash intentionally executed by the flight crew. But politicians always insist on going full steam ahead until an uncontrolled crash results.
- From the previous point, I conclude that the most likely outcome will come in three parts:
- Politicians will continue on the "pretend and extend" plan for as long as it keeps working, borrowing and printing as much money as they need, with little concern for the servicability of the debts or the long-term consequences on the economy or even national security.
- This pretend and extend policy will be interrupted only by a cataclysmic shock event, such as a revolution, foreign attack or terrorist act on a 9/11 or larger scale, or (probably most likely) a drying up of foreign capital followed by unbridled monetization resulting in a currency collapse. Politicians won't give in to being responsible until forced by a large exogenous event. The Von Mises quote comes immediately to mind...
- A new system will replace the old, either through an outright revolution or civil war, or a complete monetary collapse where all dollar denominated assets become worthless and individual wealth must be re-created from scratch. This would likely involve confiscation of gold and other valuable assets held by "the wealthy", as a national mood of socialism would almost certainly prevail.
- As evidenced by current events in Greece, whatever happens is unlikely to occur through civilized, reasoned discussion and evaluation of options. Those citizens most adversely affected by the economic crisis will likely foster enormous anger against which ever individuals they perceive to have been responsible for their misfortune, and will likely perpetrate violent revenge. That could come in the form of focused attacks on Wall Street executives and bank employees, or as attacks against anyone still appearing to have wealth, or in the form of general unrest, i.e. riots, vandalism, burning of buildings, etc. as "protest against the system" rather than revenge against specific individuals thought to be to blame. A big difference between Greece and the United States is the number of Americans who own firearms. During this period, decisions are more likely to be based on emotion than logic are accurate attribution of blame.
So my hope for this thread is that we can continue the Davos v. Rickets dialogue from the Digest, but also expand it to this theme: We know that growing out of this recession and everyone getting their entitlement in real terms is impossible, so something else has to happen instead. What will that something else likely be, and what will it mean to those of us trying to plan to protect ourselves, our families, and our savings?
Erik
Print
Good read, thanks!
I've tried to keep it simple with my core beliefs: G*d, Gold, Guns, Grub (Got grub from MachineHead) & Government will jack it up trying to make it better.
Everything I read is plotting a course towards debasement or default. Anyone thinking the government will right size should ask themselves: If this were the case then why on earth would they be taking on more social benefits?
Account deactivated per user's request.
Erik,
Great post! I just finished reading "The Collapse of the Dollar" by James Turk and John Rubino, and they had some interesting info on the last gold confiscation. After the confiscation announcement, only 21.9% of the gold coins in circulation, or 3.9 million ounces were actually turned in. The bulk of the coins remained illegally in private hands. I seriously doubt they will go house to house taking people's gold, but gold in IRA accounts are a different story. It is comforting to know that most people just gave the Gov't the finger, and I think they will again.
Also, just to give everyone a real world scenario on how people react to austerity. My wife who is a teacher receives a newsletter from the union once a month. The big buzz is the pension situation that is of course underfunded. It is so obviously unsustainable, but they don't really care. They want what was promised regardless of the impact on the school system or tax payers, and they will get it for as long as possible until the whole system implodes. People are all the same, they are for austerity as long as it does not affect their standard of living. My Dad told me a joke yesterday. It is a recession when your neighbor loses his job, but it's a depression when you do.
Where will it go? My guess is somewhere between the Soviet Union of 1996 and Mad Max. I fear we are too late to incorporate new monetary policy and political reform, like term limits on politicians.
How do we protect our descendant's future? By educating as many as we can now as to what is not woking now, but did work in the past and what new/old technologies may work in the future.
Starting with our family unit and branching out to our neighbors and community and town, we must also educate each other on how to build a community from the ground up, while surviving the loss of some, if not most, of the infrastructure we currently enjoy.
After we have restarted thriving communities, we can take the prior education on what worked and did not and apply it to rebuilding our Republic.
Thanks from the Beautiful Blue Ridge Mountains, Tycer
If what we face is a modern deflationary bear market, then I think Japan's Nikkei is an excellent illustration of how the markets respond to QE policy. From Sitka Pacific Capital Management's March 2010 letter:
The chart of the Nikkei on the previous page is an example of a “modern” deflationary bear market; i.e., a
deflationary bear market which is influenced on the way down by episodes of central bank monetary
printing. The Nikkei did not go straight down like the US market did during the great depression, but the
end result was the same. The main difference is that it took 20 years to do it, instead of just 4 years.
In order to achieve positive gains in Japan’s market during that long deflationary bear market, it was
necessary to trade into the market when the odds were favorable for gains, and then trade out of the market
when the odds were unfavorable. It took discipline to not try and wring every point out of an advance,
because often the market took back late gains much quicker than they were made, as it did in Japan in 1993,
1996 and in 2000.
This trade-focused approach has also been the winning approach here in the US over the past 10 years, and it will
likely continue to be the winning approach until the end of this long-term valuation contraction.
So QE policy does nothing to counteract a bear market, it only serves to stretch it out. I hope the inflationists are prepared to be wed to their views for the long haul. In ten years or so, I'll will be joining the inflationist party. I hope there is some beer left by then.
Captain Sheeple
If what we face is a modern deflationary bear market, then I think Japan's Nikkei is an excellent illustration of how the markets respond to QE policy. From Sitka Pacific Capital Management's March 2010 letter:
In order to achieve positive gains in Japan’s market during that long deflationary bear market, it was
necessary to trade into the market when the odds were favorable for gains, and then trade out of the market
when the odds were unfavorable. It took discipline to not try and wring every point out of an advance,
because often the market took back late gains much quicker than they were made, as it did in Japan in 1993,
1996 and in 2000.
This trade-focused approach has also been the winning approach here in the US over the past 10 years, and it will
likely continue to be the winning approach until the end of this long-term valuation contraction.
So QE policy does nothing to counteract a bear market, it only serves to stretch it out. I hope the inflationists are prepared to be wed to their views for the long haul. In ten years or so, I'll will be joining the inflationist party. I hope there is some beer left by then.
JAG -
Every one of the green boxes had a preceeding and/or following drop where you could also have enjoyed returns of 300% or better.
Except that the financial industry has biased most people to a green market mentality.
Market neutrality is the only way to go. Learn how to trade in a down market and the other half opens up for you. This is what is happening in the US markets right now. Take what the market gives you and break out of the green market mind set. Most people lack the discipline and foresight to move their positions to cash when a downturn is coming so it's easy for the author to say that one should "trade out of the market when the odds are unfavorable".
A little self-education, practice, discipline and effort and you can make the odds favorable for every move in the market - up or down.
Peace - DIAP "Handle every stressful situation like a dog. If you can't eat it or play with it, just pee on it and walk away."
Dogs,
I totally thought the same thing when I first saw that chart: "What about all those shorting opportunities in the red?!"
To me personally, in a bear market your first priority is to play the shorts. But this is Sitka's chart and though they make money in bear markets, they are never net short at anytime. They approach market neutrality by playing the spread on a long-short portfolio.
I'm content to let them manage the majority of my capital, but you can be sure that I'm following your approach with my personal capital.
Captain Sheeple
Erick - fantastic post. Thanks for taking the time to post your very well thought out and intellegent comments. I also think the title is hysterical. Davos, I have been working on my Pile Driver (I figure this falls into the training for self defense for the mad max scenario anyway).....see you in the ring, or, if the mad max scenario pans out - see you in the streets!
I agree with Erik in that we should look for how things might move and change in a dynamic and fluid situation - and not dwell on impossiblilities (full debt repayment without massive inflation or default for example).
As the internet caught fire, and globalization accelerated, the theory of international wage arbitrage took hold. This pheomena has taken hold in reality, and is accelerating. There is no reason an accountant in the US should make more than an accountant in India doing the same thing....or thats the general theory (all other things like language barriers being equal). Step two in this arbitrage is naturally international standard of living arbitrage. Given wage arbitrage is accelerating, and cant be stopped, it follows (imo) that the standard of living arbitrage will follow. This can mean the US moves down while others stay the same, while others move up, or while others move down more slowly - the point is that in some way we get closer to the same.
To me, this means the masses dont have a choice. They can fight austerity all they want, but the teckonic plates are moving, and there is nothing anyone in the US can do to stop them. For this reason alone, the US will drift or crash to a much more in line standard of living.
What will our governments do? In a post a few months ago, I said my decision on whether to defend myself from deflation or hyperinflation (after securing as much self sufficiency as I can) would be dependent on how the individual US States handle the money crunch, and if the union contracts and pension obligations are supported or rejected by judges. I stand by this today. As California/NJ/NY/Nevada go so goes the country.
At this point, the federal government has rejected the idea of bailing our states, and quite firmly. This could change....but has not. The legistlative arms of these states have been pathetic, as Erik suggested they would be when reducing spending. However, as states dont have the legal option of running up deficits, Govenors are now taking dramatic steps and cutting services because there is no choice and no money. In other words, the legislative branch of the governments - locally, are getting overruled by reality. Their time is up - the end of the road has been seen and defined (imo).
Further, there are stories of unions being rejected across the country. Finally, they are being told reality trumps their arrogance. They are being treated like the legistators - they are being told no. Now, this isnt happening in every case, but precedence has shifted, and their time is ending. Pensions - this is still an evolving story. There are both stories of renegotiation/reduction and of refunding via debt. This story needs more time.
Now, given wage and std of living arb, given unions are losing, given states are actually coming to grips with reality, whats the downside? Its not nearly as big as we all think - its 10 - 30%. Now, economically thats huge, and as we go through life, it will feel like nothing any of us have experience if we have lived in the US for our whole lives. We will bleed slowly but surely for years and years. But, life will go on. There will likely be credit shocks over and over just like we had in the last 2 years. But, we are not talking a 50% reduction in everything - at least not in a years time. This will be slow, because we have started....started to take our medicine like adults already.
Why do I say 10 - 30%? Because that is a common range for underfunded pensions. A 20% reduction in our personal debt or deficits would buy a heck of a lot of time. A 20% reduction in Social Security fixes much of the problem...etc. In other words, we dont need to shrink by 50 or 80%, only 10 - 20% and if we dont revert to 1998 - 2008 debt increase levels after that we will be just fine. To put this in perspective, the US has 2 - 3x the amount of retail sq ft as any other country in the world. We live in GIANT homes...I would bet 95% of those on this site could live with one less tv, one less restaurant meal a month...etc. 20% is bad, and it will look bad, but after a couple years we will all be used to it, and we will still live in comfort and ease. We have so much excess, lets not fret over a 20% reduction like it creates mad max and kills the US.
Now, the federal level: Since the stimulous in early 08, Congress has been in gridlock as the people have had it with bailouts and spending. Further, its clear there are many states who are saying no more to the federal govt. The fed reserve knows it has become powerless - as they flood the banks with money, its not going anywhere. The velocity of money is dying, and credit is contracting far faster than they print the money. While the fed might seem like morons, its stacked with the brightest financial minds in the world. They know full well that what they are doing is not producing the result they want. Further, they dont want hyperinflation - its a Fed killer. Inflation...fine, deflation, fine, but killing the currency kills the Fed. Now, as state and private debt is forced under control, the system stabilizes. The federal govt/fed has bought some time, and they are at levels now that are not much different than Japan. At this point, we will survive, and at the local level the right decisions are being made. The masses education in public finance is going viral, and the anger toward fed gov spending is at generational highs. I like our chances of taking our medicine more than the odds of neverending spending increases. Further, its real easy to come up with massive debt reduction plans (leave the wars, move social security out 5 years in a phase out plan...etc) that virtually kill the hyperinflation argument (imo...Davos, attack this statement....ATTACK!)
Now, while I believe our currency will be fine, and our government will survive just fine, I do think there are massive financial shock waves ahead. I think with shrinking government and massive reductions in M-3, we are in for a deflationary wave that will be terrifying. But, like the last one, we will recover. Perhaps this next wave will see the government protect only deposits, and force full loss to bond and equity holders. The cost of these bailouts would be minimal, and send the message that free market forces are again in play. Thats my guess on the govt reaction in the next leg down.
I also understand the scarcity issues. These are huge, but they are 10 years off (at least)....and it seems the focus of this conversation is on the shorter term? As CM has mentioned several times - we need to weight severity of a crisis, its probability, and its timeframe. Right now, I am focused on the next couple years....with and eye and intent on the longer term.
I also think the title is hysterical. Davos, I have been working on my Pile Driver (I figure this falls into the training for self defense for the mad max scenario anyway).....see you in the ring, or, if the mad max scenario pans out - see you in the streets!
The thing is, Rickets, we still haven't seen your photo, and we don't even know your first name.
I perceive Davos as the Andy Kauffman-like character in this story. Brilliantly intelligent, witty, but admittedly a bit weird. But you, Rickets, are a complete and total mystery... I want to think you're a Jerry Lawler lookalike, but I have no idea. Enquiring minds want to know... 
Erik :-)
What a great thread! Being as how I'm only two IQ points above a crash test dummy I don't have anything valuable to contribute, but I am smart enough to appreciate the fact that I got a front row seat to a great event.
Although it's billed as Davos vs. Rickets, with Erik, Dogs, JAG and others in the mix it looks like we got a tag team event here. Let's draft Morpheus, Farmer Brown and Machinehead and we'll have a real brawl!!
(Notice that I stand back in a "Let's you and him fight" posture. A man must know his limitations.)
Here's an excellent article from ZeroHedge that provides some interesting charts and further discusses the inflation vs. deflation aspects of this discussion.
Going back to my policy reflexivity theme, I think the prediction of this article about more and more nations choosing to default on sovereign debt will have a serious effect on unerwater mortgages. Right now a whole lot of Americans who are underwater on their mortgages are not walking away, because they are accepting the bankers' rhetoric that it would be shameful, immoral, and irresponsible not to make good on the debt you got yourself into. But if more and more governments (perhaps including our own) behave as rational economic actors and choose default if it makes economic sense, I predict that everyone will stop feeling morally obliged to the bankers, and that everyone who is significantly underwater will walk away, resulting in another big down-leg in the housing market. Of couse the gov't won't allow that to continue, and non-recourse mortgages will be legislatively modified to become recourse mortgages.
Erik