What rich people are worrying about

April 11, 2012  |  Uncategorized

Spend any time around finance people, and you start to worry about things. Unsustainable trends, ruinous policies, global economic collapse. I think it’s always like this— it’s a career that attracts and rewards worriers. But something’s different in 2012 finance: there’s a growing whiff of sheer, unadulterated panic in peoples’ honest evaluations. Very smart, very serious people are talking frankly of scenarios with real-world consequences that years earlier would have been unthinkable. There’s even a subgenre of blogs which can only be called “economic dispair porn” – and it’s hard to say exactly why they’re more unreasonable than those preaching calm and a slow-but-steady recovery.

Everybody who’s paying attention knows things need to change– that we’re at the wrong end of multiple unsustainable trends. Are we looking at a recession slowly leading into a recovery? A long-term recession characterized by stagflation as the new normal? A worldwide economic disaster? It’s hard to say. Nobody knows. All are real possibilities, though I think the Krugmans of the world are ignoring our structural problems and the magnitude of the pain required to solve them. What’s clear is we’re in a tight place, economically speaking, with a lot of risk and few good options.

Why do bad things happen to good economies? (Of Austrians, Keynesians, and the path of least resistance)

How’d we get into this mess? A lot of people blame greedy bankers, crony capitalism, partisan politics. There’s some truth in each of these, but one of the biggest factors is how we approach economic cycles. Keynesian economics suggests the healthiest way to handle cycles is to put money aside during the ‘up’ parts of the cycle, and spend these savings during the ‘down’ parts to smooth things out. It seems intuitive. Austrian economics, on the other hand, suggests that any attempt to subvert natural economic cycles is ultimately unhealthy, and we need to just tough out the recessions— moreover, the ‘down’ part of the cycle is actually the most healthy, since economic pain is the only way to cleanse an economy of bad investment and structural problems.

Economists have spent a lot of air and ink debating the relative merits of each (note: link is to an econ rap battle). But, ironically, since 1987 we’ve done neither: we’ve injected liquidity — banker talk for “thrown money at the problem” — whenever things slow down, as the Keynesians suggest, but we haven’t been setting aside money in the good times. So for 25 years we’ve taken the path of least resistance and financed our way out of short-term recessions by taking on more long-term debt, enjoying the fruits of economic growth while kicking the can down the road. This can go on… until it can’t. The music may be stopping, the party winding down, and the hangover is starting to pound.[1]

The domino effect (and, “at least we’re not Greece”)

The larger issue here is that most nations are in roughly the same fiscal position as the US, or worse. Greece went pseudo-bankrupt and is essentially sliding into ‘failed nation’ status; Spain is likely close behind. Ireland, Italy, Portugal, and really most of the Eurozone is in pretty sad shape, burdened with inflexible, unworkable policy and mountains of debt. Japan is stable but almost completely underwater, India is staggering, and though China seems to have different economic problems than those in the West, it may be in no better shape. Most countries export to the US, so a slowdown here means slowdowns elsewhere. The specific watchword here is “contagion”, which means since everyones’ economies are linked to everyone else’s, a default (bankruptcy) of one country or major bank could interrupt cashflow to its trading partners enough to cause a chain reaction of defaults. The more defaults there are, the more likely this is to cause even more defaults. Here’s a simple video on the topic.

Contagion is a serious concern, the cause of the government’s oft-maligned emergency TARP loans and of the EU’s special dealings with Greece. This situation is further complicated by the existence of hundreds of trillions of dollars of CDOs and CDSes (JPMorgan alone has a $70 trillion derivative exposure, a figure higher than world GDP, though nobody–JPMorgan included–knows quite what this means). These are essentially hugely leveraged bets that countries won’t default on their sovereign debt, bets that will explode in the world’s face in a fiery ball of leveraged pain and contagious uncertainty if a country like Greece does technically default on its debt.

Caveats (and their caveats…)

Not everything is certain gloom and doom, and there are some particular bright spots– American technology and startups, singularity trends, and the small-but-growing China export market could all help gloss over a lot of structural dysfunction. Reasonable people can be hopeful. But these bright spots have caveats— Thiel makes a solid case for pessimism about technological progress, there are strong bear arguments on Chinese growth and stability, and the Chinese consumer market is turning out a lot smaller than expected anyway. We’re probably going to need to fix our problems the old-fashioned way– which translated, means we should expect to experience pain sufficient to compel us to fix the structural problems that got us into this mess, before things turn good again. And given how entrenched the problems are and how long we’ve deferred said reckoning, it’s going to be significant.

All this adds up to a rather scary prediction. I hope I’m wrong, and I wish there was more I could do to help.

What rich people are worrying about (the smart ones, at least…)

This brings us back to the point about worrying: let’s assume there’s a non-trivial chance that multiple unsustainable trends are going to come due in the next few years, that a lot of wealth is going to be destroyed, that the ‘economic pie’ is going to shrink drastically. The problem people with money face, then, is to find the pieces of the pie that will shrink the least. To make sure the wealth that’s destroyed is other peoples’. It’s not pretty, but economic contractions never are.

Pessimism doesn’t make hay; what to do?

There are so many rich economic pessimists so desperate for insulation against systemic risk that reasonably-priced hedges are few and far between. Gold, the standard hedge against fiscal uncertainty, has quadrupled in price since 2000. Farmland in the Midwest jumped ~25% in the past year after strong gains the past decade. The ol’ “hide your cash in your mattress” strategy isn’t very good when governments can simply inflate away its value. In other words, if you’re worried about finding a relatively disaster-proof way to store your wealth, you’re going to have to either pay a huge premium for being late to the party, or get a little creative and off-the-beaten-path.

A key problem here is the economic worth of most everything is linked to the level of economic activity. A hotel’s value, for instance, depends on how many people can afford to stay there. Copper’s value depends on lots of people wanting to make stuff with it. A vacation beach house’s value depends on there being people with enough disposable income for luxuries. So the ideal hedge would be something with inelastic or countercyclical demand, yet something that wouldn’t lose value if the financial apocalypse failed to materialize, or if singularity trends kept apace. Even better if it was a company or property that generated income under all such scenarios. And of course, you wouldn’t want to put all your eggs in one basket. It’s possible that something like the Vice Fund could be viable, but I have to say I think there are much better investments out there. We just have to find them. Or make them.



[1] Furthermore, the US’s dirty little secret is that we’ve slowly, imperceptibly drifted away from a market-driven economy and toward a government-driven economy, which further distorts natural economic cycles. Government spending accounts for ~40% of GDP, and government influence in the economy, in forms ranging from egalitarian employment mandates, security administration at airports, to interest rate manipulation, is everywhere. (On the Fed’s role, my dad has noted the irony “that we are probably in the mess we’re in because a follower of Ayn Rand [Greenspan] decided that central planning was better than the markets – as long has HE was doing the planning”.) Capitalism is never pure, and in modern societies there’s always some element of central planning. But our government bureaucracy’s influence on what happens inside our borders is more pervasive and less accountable than strictly necessary, and its sheer size is burdensome… especially during downturns, when the private sector sheds its least efficient jobs but the government doesn’t. (Or would be, if we weren’t just borrowing the money to pay for it.)



- One pernicious issue is how many elements of society have outsourced the funding of their financial obligations onto continued growth. See, e.g., CalSTRS, or the pension fund for the California State Teachers’ Retirement System. At 10% growth, it fully funds all its pensions. At 7.5% growth, it’s underfunded by $64.5 billion. At 1-2% growth… things look pretty grim for retired teachers.

We can’t just not shrink, we can’t just grow a little; we need to grow a LOT just to keep our financial obligations from blowing up. It didn’t have to be this way, but it is.

- David Brooks has a reasonable op-ed on structural problems, and how the same playbook that got us into this mess won’t get us out.

- The elephant in the room in these economic debates is whether the growth of the middle class in the last 60 years is a ‘new normal’ or just a temporary aberration. As Taibbi worries,

I think people are going to realize what a blip on the radar American-style democracy in the 20th century was. A big middle class that had a huge powerbase, financial interests, bosses giving benefits… all those things. It’s just a little blip in history. For the most part, concentrated wealth will make all the decisions and everybody else is dictated to.

Edit, 2-3-13: I highly recommend this fantastic bearish writeup on Zerohedge. Entertaining and enlightening. (Warning: it is long.)

1 Comment

  1. Perhaps there is no better indication of the seriousness of the problems than the current behavior of central bankers. For decades I’ve borrowed substantial amounts of money to operate my business. I’ve sat across the desk from an older and very experienced banker and had many conversations about money and politics. Now, I’m not talking about the bankers who are out in front dealing with the customers. I’m talking about the banker who sits in the back office, and who makes the final decisions about who will and who is not likely to pay back money loaned out. If there is one thing I’m sure about, it is that these guys *hate* the idea of printing money. I think we can assume that today, there is no alternative to printing money other than going through another depression. We should think about this – that they are willing to print huge sums of new money, thereby devaluing any money currently held by them or owed to them. It would be funny if it wasn’t so serious.

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