Inflation revisited, Bailouts, and Base Cases

In late 2020, I wrote about my views on inflation and why I thought inflation as measured by PCE and CPI had been so consistently low for so many years, while noting that asset price inflation had been simultaneously much higher due to monetary policy. Looking back, I am quite happy with what I published then in most regards, with the exception that I only briefly touched on how asset price inflation affected the rapidly disappearing middle classes of developed economies:

“Viewed in this way, it makes sense why the central banks who ‘tamed inflation’ cannot seem to hit their own two percent target rates, unfazed by even unprecedentedly aggressive and sustained interventions. They never were the predominant driver of inflation in the first place (unless they turned so extreme that they fell into hyperinflation like Venezuela, Zimbabwe, Turkey et al). The low interest rates drive little marginal capital formation and instead only serve to balloon financial assets and real estate – the former of which is not a part of PCE and the latter of CPI measures, respectively. Instead, cheap credit has warped security pricing of public and private markets, driven leveraging in risky and fragile areas and slowly hollowed out real incomes of middle classes and substituted them with growth-constraining dependence on consumer credit in the form of student loans, mortgages and other lifestyle related borrowing.”

What I failed to make fully explicit is just how destructive this hollowing out of the middle classes has been and will be, and quite how the ‘preferred’ inflation measures’ exclusion of asset prices allowed for several decades of artificially cheap credit post 1987 (with savage acceleration after 2008 and during the pandemic).

Put simply, CPI and PCE by design exclude capital goods as they are meant to capture changes in the cost of consumer goods and services.

[Yes, both CPI and PCE encompass components meant to proxy the cost of shelter. However, Owner’s Equivalent Rent does not reflect changes in real estate prices accurately for many reasons. For one, the peak correlation coefficient of 0.75 between US house price growth and OER is reached at a time lag of a full 16 months, according to this Dallas Fed analysis. Similarly, rents and measures thereof do not always move with increases in house prices, especially when falling rates cause increased homeownership demand. Neither CPI nor PCE contain even remote proxies for financial asset prices or deposit yields.]

However, societal expectations for members of the middle class have long entailed meaningful ownership of capital — in the form of ownership of a house (tellingly, U.S. homeownership rates definitionally include mortgaged homes, with only 37% of households being mortgage-free), retirement savings invested in stocks and bonds, and plain old cash which, in theory, should be yielding a steady risk-free return in an FDIC-insured bank account.

As the off-shoring of manufacturing and supply chains has kept consumer goods inflation low and even periodically negative, overall CPI looked deceptively low for many years. Meanwhile, interest rates plummeted, private and public equity skyrocketed, real estate soared higher than the boldest of bald eagles (importantly also as compared to median income), and savings accounts became cash incinerators in real terms. All of them remained unaccounted for by the conventionally accepted definitions of inflation which remained unchallenged by the economic orthodoxy. After all, why bother when ‘inflation’ was so low and the ivy league technocrat elite derived supreme legitimacy and unrestrained power from their ‘victory’ over the 08 crisis and inflation! To those young and less fortunate pursuing the dream of a ‘middle class’ life, the graduality and obscuring complexity of these enormous wealth transfers, excessively cheap consumer credit, and the propaganda suggesting that their lack of progress was due simply to lack of grit and hustle eventually became like water to the starving. The essential backbone of democratic stability and compromise, now afflicted with a Kwashiorkor promoted but simultaneously denied by a progressively narrower and intellectually homogenous political elite, became cheap to buy with premises of change of any kind, no matter from which end of the political spectrum. Alas, populism, once again, has revealed itself to be not the promise of genuine partnership, but the tenuous bond between client and supposed patron. The implicit social contract that has been supporting societal trust in what one might term liberal democracies is now viewed by large groups of people as fundamentally broken, with predictable consequences. I doubt that the decline in birth rates is solely attributable to the secularization of ‘richer’ countries, rather than growing pessimism about coming generations’ future prospects, for one.  

Nevertheless, supposedly low inflation statistics and the manifold temptations of Keynesian stimulus masked the slow transition of emancipated citizens to neo-feudal serfs well enough to continue with unsustainable monetary (and, through deficit monetization, fiscal) policy. Indeed, perversely, the disenfranchisement of the economically most vulnerable has made them all the more prone to suggestions that negative real rates and QE were part of the solution to their problems, rather than their very cause. Amazing really, that with such high energy prices and economic fragility the likes of the ECB’s Lagarde, the BoE’s Bailey, and the BoJ’s Kuroda get such massive budgets for gaslighting.

But I digress.

Even with such low inflation indicators unrepresentative of what they were supposedly measuring — namely, the decline in spending power as experienced by regular people due to aggregate price rises — such crude measures as the Taylor rule (itself relying on these deceptively understated definitions of inflation!) have shown massive divergence between policy and theoretically appropriate rates of interest for many years at both regional and global levels. Of course, once the absurdity of 0% and even negative rates became too difficult to ignore, some regimes, such as that of the United States, chose to use QE, a tool pioneered in modern times (2001) by the BoJ (after they themselves had introduced negative rates in 1999) to push more credit into the system than ordinary mechanisms would allow.

Note the Shadow Policy Rate translating the effect of QE into percentage changes in the FFR
Source: https://www.hoover.org/sites/default/files/14110_-bordo–exiting_from_low_interest_rates_to_normality-_an_historical_perspective.pdf

Fast forward to 2023, and we can see what massive costs it would/will entail to normalize rates and central bank balance sheets. The (in relative terms small, but highly unusual) contraction in aggregate money supply in 2022 as a result of a very minor reduction in the Fed balance sheet, has led to deposit outflows across basically all banks, the consequent failure of Silvergate and Silicon Valley Bank, and the ensuing loss of faith that ultimately felled the G-SIB that was Credit Suisse. For reasons that should be obvious, I will not comment on the regulatory actions taken in the context of these bank failures. In an abstract hypothetical scenario that by complete coincidence happened to resemble current goings-on but de facto bore no relations imagined or otherwise whatsoever, someone resembling my person but most definitively not me, might be tempted to suggest that these were bailouts of less-than-optimal structure that will exacerbate the longstanding buildup of moral hazard and dumbing down of financial market participants drastically. That person who is distinctly separate from mine, as I really cannot emphasize enough, would not be alone in that assessment.

Where to go from here?

In my estimation there are three different paths the developed economies could take in this context.

The first is to tighten monetary policy harshly (including some QT) and hence cause a recession with the corresponding increase in unemployment which would be politically unpopular but normalize asset valuations. I believe this is not likely take place for political and academic orthodoxy reasons (as evidenced by ECB and Fed officials implying neutral rates that are far too low, real interest rates continuing to be negative in US and Europe/UK, de Guindos calling for tools to limit core-peripheral EU government debt yield dispersion – I was in the audience that day and he seemed rather serious about the idea).

The second is to pursue long-term financial repression and keep real interest rates negative. To make this work, the European economies, the UK, and the US would need to introduce strict capital controls, as global capital flows would inevitably destabilize and make moot the attempted financial repression. I do not believe this to be particularly likely, but it certainly looks much more likely than it has in 30 or so years.

The third is to attempt financial repression/the tightening of monetary policy to levels insufficient to quell inflation without the introduction of effective capital controls. This would lead us into a stagflationary environment similar to the one pre-Volcker. This is my current base case. Naturally, there will likely be important differences to the late 60s and 70s of the previous century on the way there. I am not entirely certain what they will be. In fact, I am certain of perhaps only two things.

1. The real area of concern in the financial sector are not banks (and that is not to say banks will be completely unaffected), but shadow banks (that is, non-bank lenders). We will see the failure of many fintechs, Buy-Now-Pay-Laters, private equity funds, public funds, real estate firms, financial exchanges, hedge funds, venture capital outfits, family offices, factoring businesses, and whatever other vehicles have a business model that one way or the other relies on leverage.

2. We are now genuinely past the point of no return, and even the wisest policy must now focus on damage mitigation rather than avoidance. That is a pretty scary thought, even for me.

Let us hope we come out the other side renewed and primed for a better future, rather than ever more divided.

Tom

Ps: It sure looks to me as though regulators are aggressively backstopping banks because they know there will be many more illiquid but potentially solvent entities knocking about in the near future (as they are less willing to cut rates than market participants seem to think). Setting a precedent of successful orderly resolution of bank runs and financial institution failures without depositors being adversely affected would be a shrewd move… if state capacity were sufficient in the West to credibly handle these subsequent restructurings. Unfortunately I do not believe that to be the case and we will instead see more of a worst of both worlds outcome when inevitably the powers of the Fed are used too inefficiently and unwisely to keep the monetary pressure cooker going.

Just want to keep on rollin

Huh. So it was not different this time after all. Who could have possibly seen this coming?

…

Let us take stock of some of the things that are going on right now. Simultaneous bear market in equities and fixed income. Elevated inflationary pressure, both headline and core, in every country. Rising nominal interest rates in most major economies (notable exceptions Turkey, China). Recessions across Europe, the United States, and China. War in Ukraine. Energy shortages. China still in political lockdown, its real estate sector melting down, marginal rural banks collapsing. Heavy sanctions regimes on semiconductors, military tech, commodities, capital flows. Disregard for property rights and legal formality. Historically large fiscal deficits in the major economies, massive central bank balance sheets, some very unhealthy government debt markets and debt levels. A significant contraction of corporate earnings looming. Overt Minsky moments in the UK and elsewhere. The list could easily go on for several more paragraphs.

And yet. Investors by and large have not panicked, the VIX has remained at benign levels considering the implications of the end of this 40-year credit cycle. This is simply delusional.

Quick tangential anecdote here. Not too long ago I had lunch at a rather nice and well reputed Hotel in Zürich, listening to a number of asset managers pitch their fixed income funds. They shall remain unnamed, but suffice to say that they were very large and well-known firms. One of the presenters, who shall remain especially anonymous, without any hint of sarcasm or sentience announced that with the previous day’s ECB hike to 1.25% we were now at the neutral rate (the previous month’s Euro Area core inflation rate stood at 4.3% by the by). I nearly succumbed to a piece of potato’s ambition to explore the far reaches of my lungs.

Yes, there are occasional bear rallies – the result of positioning. In the short term the positioning of market participants dominates price moves (e.g. simultaneous covering of significant short positions), but we know that ultimately market trends must end up reflecting fundamental trends. The nonlinearity of the path there does nothing to alter the outcome. It is a bit like observing a riverbend, noting that it seems to be turning away from the ocean and to confidently conclude it therefore must never meet the sea. The aggregate global economy is not like Gamestop, Tesla or AMC, which may indeed have altered their ultimate fate with having had the opportunity to raise irrationally cheap equity capital (though I think folks underestimate just how easy it is to burn through that money without changing the economics of the business to a sustainable trajectory and simply failing a few years later). Whom is the global economic system going to be raising cheap capital from? E.T.’s well-to-do aunt?  

To even have a chance to understand what is happening, it is absolutely utterly completely totally (!) crucial to acknowledge the singular driver of this mess: multi-decade inappropriate monetary policy across developed markets. The Neo-Keynesian interventionist conceit of being able to smooth the business cycle without paying for it in long-term real growth, even to claim an augmentation of the growth and productivity trajectory in the aggregate, is, and always will be, an ideological perpetuum mobile. That is to say, completely impossible. A fabrication. A falsehood. A lie.

The constant bailing out and rewarding of leverage and misallocation of resources across all segments of society has led to the metastasizing of moral hazard into the very bones of public and private institutions, worsening state capture and decline in public service merit. Markets, economies, and even entire societies cannot be driven largely by sensible decision making when shocks and recessions are not allowed to cull the unfit and truly foolhardy. This intense dependency on unnaturally easy capital and general learned helplessness in the face of even the most minor of volatility will only become more painful the longer we fight not to reverse it. Will we have the stomach and the clarity of purpose for the chemotherapy of positive real interest rates for a decade, the surgical excisions of QT, and the radiotherapy of reduced monetization of unproductive deficit spending? How I wish I could lay claim to belief in our collective lucidity but cannot but confess the lack of faith betrayed by my first name.

Instead of turning the page, we appear to be well and truly following the path to Japanification (were they not recently busy using their ‘unlimited resources’ to stabilize the yen to be able to continue their completely appropriate yield curve control or was that just a flight of mine excitable fancy?). Unless we accept meaningful net immigration and invest in effective integration, we will soon have the demographics to match to boot.

Ah but the most important take away for my personal investing is simply this: whether we reach for the bitter leaf of positive real rates or drink from the sweet cup of financial repression, neither is good for financial asset price performance in real terms. The groundwork for the value of future years is beginning to be laid today.

To the sufficiently patient and careful observer, genuinely attractive valuations will appear in time.

Tom

Bill Hwang, give me back my Billions!

One of the many things I find gratifying about the world of finance is the eternal flow of case studies illustrating just how inseparably brilliance and utter folly coinhabit the human condition. As you may have heard, this month a family office – Archegos Capital Management – made quite the headlines.

Archegos (Greek; aptly, ‘one who leads the way’) under Tiger Cub Bill Hwang, had made a series of highly concentrated bets in a handful of stocks of rather debatable merit using total return swaps with half a dozen bulge bracket banks, levered those in total something like 5 – 8x and kept reinvesting any and all gains straight into the very same positions, to the point where it began driving the prices of those stocks up by virtue of its enormous size and leverage alone. We are talking about actual money here, with Archegos holding a 100 billion USD portfolio at its peak and Hwang’s share adding up to roughly 20 of those billions. It appears that this was the overwhelming majority of his net worth because yes, naturally, makes sense, of course, why would it not be.

Now, this little dance with no strategic flaws whatsoever began in 2013 with a reported 200 million USD from a previous closed-down hedge fund and stepped to the jig quite merrily, making ludicrous returns right until it was margin called by some of its prime brokers when one core position in ViacomCBS faltered in price after an underperforming equity offering. Instead of taking the haircut but saving most of his many, many billions, Hwang doubled down and refused to exit his positions.

Finally, on March 26, Morgan Stanley and peers began liquidating the portfolio, triggering rumors on the Streets and extraordinary further declines in the price of the respective stocks. Led by Credit Suisse, Morgan Stanley, Goldman Sachs, Nomura et al ‘touched base’ over the weekend to try and coordinate the unwinding of these massive positions and cooling the incipient fire sale. Naturally, it did not work and the banks with lower exposures and sharper trading operations (namely Goldman Sachs, Wells Fargo, Morgan Stanley, UBS and good ol’ Deutsche Bank) stampeded over the bodies of Credit Suisse and Nomura on the way to the exits. While it looks like the former names got away with sub 1 billion USD in nominal losses each, CS ate 5.5+ billion and Nomura 2.9+ billion of what looks like a cool 10+ billion USD systemwide thus far. If we were so unkind to include the prospective losses from tarnished reputations, inevitable fines, restructurings, golden parachutes for the exiting bankfolk and sign-ons for their replacement and half a decade of upcoming litigation, there is no question the bill will add many -ions more.

There is a lot to this story worth discussing and generally speaking, I would say there are two angles people are likely to focus on and one they are not:

Angle 1: Bill Hwang

Everyone loves a good villain as much as or even more than a good hero, particularly with younger Millennials and Gen Z being conditioned into greater externalization of the locus of control (see Thunberg shouting at politicians, generational wealth and income inequality, the hyper passive nature of the internet meme format). It should, hence, not be surprising when people wish to learn more about the ‘protagonist’ of this debacle. Who is this Bill Hwang character? Where did he come from, why have I only heard of him now? What is up with that whole Christianity thing?

And in all fairness, Hwang is interesting. Did you know for instance that he paid a 44 million USD insider trading settlement in 2012 and was banned from trading in Hong Kong for four years in 2014? That he founded a ‘charitable’ organization with 500 million USD in assets that may or may not be an obvious shell company designed for bribery and/or as a plan B for exactly the scenario that is currently unfolding, guaranteeing a multi-millionaire lifestyle retirement somewhere lush and sunny no matter what. While we are on that subject, he is also major donor to ‘Focus on the Family’, so much so that they gave him his own little bio. Just in case it was not sufficiently clear from his portfolio what kind of man Hwang is, here is a brief excerpt from the Wikipedia page on that particular organization:

“Focus on the Family promotes creationism, abstinence-only sex education, adoption only by heterosexuals, school prayer, and traditional gender roles. It opposes pre-marital sex, pornography, drugs, gambling, divorce, and abortion. It lobbies against LGBT rights, including LGBT adoption, LGBT parenting, and same-sex marriage. Focus on the Family has been criticized by psychiatrists, psychologists, and social scientists for misrepresenting their research in order to bolster its religious ideology and political agenda.”

Yup.

Angle 2: The Banks

Banks. We love to hate them. And it is easy to see why: In most people’s conception, banks are at best amoral and greedy and complicit in the 2007/8 crisis and at worst outright evil and single-handedly responsible for the real estate crash. So even though it is in some sense astonishing that all these sophisticated financial institutions decided to lend dozens of billions to a single client who at the time was a known inside trader all the while not knowing (not really wishing to know?) the true stupidity in quality and scope, of Archegos’ strategy, it also is not. And it is easy to take that perspective, run with it and pick out all the many poor decisions that were made at every one of those venerable institutions; e.g. how under Tidjane Thiam and his successor Thomas Gottstein, CS merged compliance and risk management departments, promoted Lara Warner (who had little background in risk management or compliance) to head of this chimera and pushed for the ‘commercialization’ of the risk management function.

And there are more than a few grains of truth to this narrative, too.

The problem with both of these popular takes on this type of story is that they leave all blame for these failures at the feet of the entities that are most obviously and directly involved in these breakdowns which A, does not help us figure out how to prevent these kinds of situations from happening in the future and B, neglects the culpability and indeed tacit complicity of supervising/delegating entities such as regulators, private interests, social norms, and, ultimately, us as individuals!

It is awfully convenient to a whole lot of us to go with narratives that abdicate our own responsibility whenever a crisis becomes too acute to ignore but this kind of behavior is in itself a key driver of what ails and holds us back as a collective.

Back at university I once had an argument with a classmate about this and it was stunning to me how seemingly everyone else in earshot took his position without questioning. These are genuinely bright people, too!

If you look at the 07/08 crisis for instance, who is to blame? My colleagues were ardent it was the almost exclusive failure of the greedy banks since they underwrote mortgages and loans to people of low & no creditworthiness. Banks evil, duh.

But if you reserve judgement for just a femtosecond, ask: What were the reasons the banks were giving out these mortgages in the first place when it was so obvious people could not afford them? Should banks not be trying to minimize losses on their loan book to maximize profit?

The superficial answer is that because banks could now securitize mortgages (CDO, MBS) and sell them off soon after origination, they did not bear the longer-term credit risk and hence did not have much incentive to be careful. And this is true. But why did this modus become so prevalent only in the 2000s in the first place, when MBS had existed since 1970?

• Retail banking had become less profitable because interest rates were artificially low as the Fed under Greenspan had sought to accelerate financial market recovery after the dot-com bubble burst (arguably the bubble had been inflated by the Fed’s overly easy monetary policy to begin with) and so banks were expanding into non-core lines of business

• Regulators determined (still do) capital reserve requirements of banks and financial intermediaries by assigning different risk weightings to different types of assets, including MBS, which meant that banks had incentives to favor certain assets, such as MBS, to attain lower reserve requirements and squeeze more profit out of their balance sheets

• The Big Three credit rating agencies (S&P, Moody’s, Fitch) had been allowed by regulators to gain oligopolistic market share and not been regulated in a fashion that recognized the adverse selection dynamics at play in the space even with competition and therefore helped facilitate a systemic misclassification of the true risk underlying securitized credit

• The Bush & subsequent governments pushed (particularly via Fannie Mae and Freddie Mac – which themselves had been created by the US gov in 1938 and 1970, respectively) for and subsidized aggressively the giving out of mortgages particularly to low income households for the purpose of ‘affordable housing’ and to be able to make politically expedient claims about how well the status quo worked for the poor and hollowing middle class

Further, artificially low interest rates (again, determined by the government entity that is the Federal Reserve) itself directly spurred on lending, financialization and speculation in numerous ways, such as by making loans of all kinds cheaper which meant more people were able and incentivized to take on higher leverage via mortgages, loans, and margin on their portfolios. Many of the people who had taken big losses on their speculative-at-best bets when the Internet bubble burst and felt that the stock markets were ‘rigged’ against them, enthusiastically reindulged in their minimally disguised gambling addiction and sought to outdo each other and get rich quick by repeatedly remortgaging or otherwise borrowing and speculating on real estate (e.g. ‘flipping’ houses). Yet others, who must have known that they could not afford the houses they were buying (because you do not go for a NINJA loan unless you have been rejected for more conventional arrangements and/or you already KNOW you will not be given one) did not hold back either.

As you can see, the Tango does not dance itself. It takes participants at all levels of society to make these massive dislocations happen. Of course, some actors are more significant than others; some weak points in the system more easy or difficult to address; some rules violated harder in one sector than another – but one cannot produce such concentrated systemic failure without willing and even knowing partakers.

In 9 AD, Publius Quinctilius Varus may have failed as a general solely in his own capacity… but why were there 3 legions trekking through Germania at all?

Rome – and its people – sent them.

This is – I believe – not a problem set that can be definitively solved. Humans will always feel the urge to cheat, to gamble, to transgress. Systems, rules and laws, too, will never be perfect and without gaps or captured-by-special-interests enforcement. Many a time the attempt at solving a past problem leads to the emergence of entirely new ones. Consider for instance the taxpayer-backed bailouts that are now commonplace. Are they entirely new? Of course not, financial institutions have been getting into trouble for as long as they have existed. The very notion of what a bank is has changed profoundly over the centuries: from goldsmiths, safekeepers, insurers, bureaux de change, lenders to aristocrats, merchant and trade financiers, loan sharks, real estate developers, investment firms to securities dealers, auctioneers, and deposit takers. The Fed itself (and federal deposit insurance schemes) was created to help stabilize the extremely fragmented banking system of the U.S., create confidence among savers and investors and prevent bank runs. Without the FDIC, the world of banking would look vastly different today.

What ought to be done? Should the state categorically cease to bail out financial intermediaries, indeed, abolish deposit insurance entirely so as to avoid creating moral hazard?

…

That to me appears a cure potentially worse than the disease, much like returning to the gold standard or bimetallism to offset some of the downsides of fiat. Society is a perpetually unfinished project, and we cannot but iteratively stumble forward, fall, rise again, collapse and get up once more only to keep flailing onward. But if we want to make our short lives, the few moves that fall into our generations’ hands count for not just us but our children and their progeny, we must not ignore that the ultimate and final backstop of institutions in a democracy is us. The voting majority. The original sovereign whose consent legitimizes the state and organs governing our society. If we as individuals choose to totally abdicate responsibility for corrupt and ineffective politics or imperfectly designed and imbalanced branches of government, then there is nothing else to right them. We fail by not even showing up.

It was disheartening for me to see that so many of my peers seemingly failed to acknowledge that reality. With such an outlook on life, it should not surprise us that there are many more Bill Hwangs yet to emerge.

It maddens and frustrates me nonetheless.

Tom

Ps: If you wish to read more in-depth about Bill Hwang, here is a good Bloomberg article – it even has pictures.

OK Boomer – but what am I supposed to do?

Disclaimer: None of this is investing advice. Do your own research and think critically before making any financial decisions.

This post was inspired by a recent conversation with friends and my desire to update the classic 60/40 portfolio strategy to our present conditions. I hope you find it of interest.

My recent posts have been quite negative on the medium-term future and present conditions. I think such an attitude is very much merited considering the level of moral hazard, arbitrariness, speculation, and misallocation that have built up since I started investing back in 2015. What an innocent time that was, where the S&P 500 lived in the 2000-2100 range and its P/E ratio of 20-24x-ish was cause for mild concern if one looked at it on a purely historical basis (over the past 140 or so years, median is 14.84x and mean 15.88x).

Fast forward to today, February 14, 2021, and the S&P 500 has since stridden to the 3900s and boasts a P/E of 40 times. It is very important to stress: We are here because of politics, not because of any fundamental paradigm shift. Or perhaps more accurately, the only true paradigm shift that has occurred, is to be found in central banking.

Had Bernanke normalized monetary policy around 2012, as I believe he should have, or Janet Yellen when she succeeded him in 2014, we would not be here now. And make no mistake, this complacency does not flow from ignorance or accident but was a calculated decision made for political ends, likely around 2008 and 2009. This decision will prove not to have been in the interest of the American people at large, or indeed in the interest of anyone who is not a member of the Ivy elite and/or who does not have a majority of their meaningful wealth (aka measured in millions USD rather than the low 100’000s) in non-monetary assets (particularly stocks but also real estate, commodities, private equity etc.). Further, I personally believe it will not even prove to be in the absolute interest of those privileged groups either, making them relatively better off in a worse world. Yet, as much as I resent it, this is the world we are most likely to live in and there is very little that the median investor can change about that.

Now, there is nothing wrong with negative sentiment when it is warranted by the circumstances. Sometimes life can be cruel, and you find yourself dealt a bad hand. It is ok to be angry about this, to be frustrated and depressed. However, this on its own does nothing to solve your problems.

So, if you as an individual cannot do much about the bad hand as such, what can you do?

You can do your darndest to play the hand as well as humanly possible.

In terms of personal finance that means:

Avoid speculation at all cost. Leave the crypto, the crazy SPACs, the ARK ETFs to the others. Ignore options & futures contracts for every purpose other than insurance. Do not overdo it on that particular type of insurance either, ideally avoid owning the kind of portfolio that requires significant hedging at all. No short selling, no margin, no recourse leverage of any kind; either implicit or explicit. Have a sufficient nest egg in cash (not money market funds, not bonds) to pay for at least 6 months of living costs of you and all your dependents but aim for 12. If, like me, you are young (under 50) and in good health, be grateful (!) and continuously cost average a fixed percentage (no more than you can afford to lose on your very worst day) of your disposable income into 3-4 low-cost index funds such that your portfolio roughly reflects global market caps with direct US exposure making up no more than 60%. Do not bother with bonds, gold, commodities, or REITs. Try to match up your liabilities and assets/income streams (e.g. if you live abroad but your income is in a different currency). Avoid debt if at all possible, especially credit cards but also student loans for any non-vocational schools or below global top 50 universities (if you are from a high-tuition country, attend a more sensibly priced university abroad if you can). And most important of all: LOWER YOUR RETURN EXPECTATIONS. This strategy is not going to make you rich but hopefully it will protect you from becoming even poorer.

Now, it is easy to make up a basic approach, but I would like to give you a handful of simplified reasons to help understand what the above strategy is meant to accomplish.

The reason for having a nest egg in cash is simple: Life is unpredictable and unexpected costs, or loss of income will occur. Most likely they will come up when you are at your most vulnerable fiscally, physically, and mentally. The nest egg will give you space to breathe when shi* hits the fan and allow you to think about important life decisions rather than panicking and self-sabotaging. Liquidity management is absolutely essential no matter how rich or poor you are.

If you live in a first world economy, you can keep up to 2 months’ worth of the nest egg in cash somewhere safe (not under your mattress) if you want to be super prepared against extreme tail risk situations. However, for convenience and safety and most other purposes, keeping your nest egg in a deposit insured bank account should be good enough. If you live in a lower stability/development economy, you likely know better than I do how to handle cash efficiently within your context. If your nest egg is in renminbi, ideally try to convert it into one of the other major currencies at a sensible rate (major sums will likely be rather difficult). Always watch out for fraud and avoid drawing attention to owning significant amounts of cash/assets, even from members of your family & friends that you do not trust unconditionally.

The continuous cost averaging of a predetermined fixed percentage of your disposable income into equity is a compromise between the two most plausible outcomes that we face. Holding more than you need (i.e. significantly more than the nest egg) in cash is a guaranteed loss in real terms, as any positive inflation diminishes your real purchasing power. If – as I think is likely – monetary policy and politics continue down the present path, having most of your net worth in monetary assets will expose you to the full brunt of the ongoing net regressive redistribution of wealth. Stocks will mechanistically benefit from such an outcome. Owning stocks in other words, is your insurance against a scenario where asset inflation continues at the expense of everything else and wherein you do not own any of the asset classes that thusly rise. While for this purpose you could conceivably own certain other financial asset classes, I think stocks are the best choice by far on most dimensions.

The other reasonably plausible future outcome is in some sense the opposite extreme: a really harsh financial crisis (worse than 07/08) hitting all major financial asset classes (including house prices). That is why the nest-egg is non-optional. It is quite feasible that even such a globally diversified stock portfolio could decline by 60% or more in a matter of a few weeks or faster and in order for you to be able to hold and not sell anything, you must not think of your portfolio as a source of income or emergency buffer. This too, is crucial.

The cost averaging guarantees that you pay the average price over time. While at present valuations that may seem silly, you cannot know how long the present politics continue and only by owning financial assets can you prevent the first of the two undesirable outcomes I have laid out. Had you decided not to cost average/enter the market in say, 2015, because of elevated multiples, you would have done terribly compared to almost any metric so far. This strategy is not optimal for any one trajectory but instead works reasonably ok under most conditions and even more importantly, is possible to execute consistently and without undue emotional turmoil by most. If a crisis happens, the cost averaging will give you a slice of the recovery, too, so long as you stick with it under all conditions.

Anyone having read this far will understand the reasoning for the geographic diversification and the choice of low-cost index funds. In principle and on a historic basis, one could own much more US exposure, but I really would not recommend it.

That is most of the important stuff pertaining to the financial side of things. However, life is not only about money (anyone who knows me will be shocked at seeing this platitude coming from me, but it is true). One ought to think about life holistically.

In terms of lifestyle choices that means:

Stay healthy. Do not smoke (it is genuinely the worst thing you are legally allowed to do to yourself globally). Maintain a healthy weight. No crash or fad diets. Drink in moderation. Be sensible in your consumption of stimulants and recreational drug use. Avoid strongly habit-forming drugs/behaviors altogether.

Do not gamble with any non-trivial sums, ideally at all. Exercise, exercise, exercise – it is very good for physical and mental health and will help you lead a happier, more contented existence. Sin a little every now and then but never a lot.

Work on yourself. Get a hobby or two. Develop a new skillset. Take walks/hikes. Do not stay inside for more than three days at a time. Read books for fun. Take an hour or two every week to just sit/walk and think.

Invest in your relationships, romantic and otherwise. It does not matter how rich you get, you will be miserable if you do not create meaningful bonds with others.

Though much of the above may seem like moralistic advice, it is not. Investing is at least as much about self-exploration and behavioral management as everything else combined. To maximize your risk-adjusted returns, leading a sustainable lifestyle is of the essence.

I hope this proves useful to someone. Also, again, not investment advice.

Tom

Ps: If you live under a rock and do not know about xkcd.com, I highly recommend you check it out.

When does the Game Stop?

To those who are calling dot-com 2.0, remember that no two crises are exactly the same. Despite the shift in sentiment among talking heads, this could go on longer than most anticipate. It could still be months or even years, depending on how things like CPI inflation, monetary policy and retail trading sentiment/funding go. Even if things crash soon, it is possible central banks will start an extended period of ping-pong with market levels; propping fast and harsh crashes up repeatedly until moral hazard is sufficient to drive markets to truly unstable levels or central banks miss a step.

Be prepared

Tom

Central *anking, or the Underpass to Serfdom

Fair warning: The following is a highly political and somewhat pessimistic rant on a ‘dry’ subject. You may not enjoy it. In fact, you are a weirdo if you do.

I first became interested in central banking in a serious manner during my time as an undergrad at uni (and yes, I was fun at parties, why do you ask?). Naturally, I had been dimly aware of the existence of central banks since at least 08 and in a very superficial sense, grasped that interest rates were kind of important and had even heard of quantitative easing. Nevertheless, there was this lingering sensation that there was more to that particular story that I did not appreciate, something I just did not get about these systems that had such a powerful influence on financial markets, economies and the polis. Being a curious fellow, I went from furrowing my brow at Buffett talking about low interest rates pushing up equity valuations to reading Princes of the Yen (good book by the almost as crazy as he is sharp Richard Werner) and brooding over the Wikipedia entries of Gosbank, Gosplan and Gossnab to devouring Lords of Finance by Liaquat Ahamed (a fantastic book if you manage to ignore the unbecoming and, in my opinion, ahistorical level of idolization of Keynes). After not too long, it became pretty apparent to me that my ignorance of central banks had been a major blind spot and I all of a sudden felt many of the pieces that connected my knowledge of history with my growing literacy of economics fall into place in an almost uncanny fashion. Perhaps most impressive to me was just how political it all turned out to be. Perhaps that makes me naïve, but when Bernanke and Yellen, the very epitome of technocrats, talked about their rigorously data-driven approach and how well they managed 2008, I previously had not mustered the necessary context and critical thought to go, you know, ‘hang on how can something that drives level of employment, housing costs, FX, borrowing costs, bank capitalization regulations and asset prices simultaneously on national and global levels with minimal accountability to the electorate not be political?’. I am a little slow that way, I suppose.  

Be that as it may, by the time I graduated I had been stewing long enough in the Keynes-Hayek-Friedman Goulash for matters of central banking to have by far eclipsed climate change in my short list of greatest concerns. In fact, the consequences of the present brand of central banking are one of the few things that manage to make me anxious, the others being neurodegenerative disease, stroke, fatal cancers and death. You can imagine that I have been observing global response to the pandemic with immense dismay.

Why? Because it really emphasized just how much consensus there is behind the path we are going down as a global society. Sure, people may be intensely divided all over on the Brexits, the Trumps & Bidens, the BoJos – but if you look at the field of monetary policy, the differences between factions are not qualitative but at best whether the next stimulus package should be measured in the single digit percentages of 2019 GDP or double digits. To be clear, I do not mean to suggest that there are no contexts in which these transfers will have merit, particularly in the United States, where helicopter money is a way to expand welfare without experiencing immediate political deadlock and public infrastructure is crumbling, or in selectively alleviating some of the pain of quarantines. But all this is not free, despite what the MMT people (it amazes me they can breathe independently) would have you believe.

There was almost zero opposition to taking the toolset quasi-pioneered in late 90s/early 00s Japan and escalated in the West in 2008 as an exceptional emergency response and making it the de facto new modus operandi at ever greater scale. What was supposed to be a last resort has become undeniably chronic. Interest rates have in some countries been negative for years and globally suppressed for decades (making traditional saving impossible), quantitative easing, which was meant to be long reversed by now, commonplace, and massive monetization of government debt accepted as though it were war time. Speculation is rampant and prices of every asset class distorted. But do not worry guys, we will totally raise taxes on the rich. Definitely not net regressive. Pinky promise.

This state of affairs is already absolutely toxic but I fear that the worst lies still ahead. As systemic fragility increases thanks to bloated valuations, dumb leverage and even dumber pricing (aka excessive momentum), the stakes grow higher and higher, guaranteeing a brutal recession if any major central bank should tilt even slightly hawkish. I am afraid that we have already passed the point of no return and I do not see any Volcker-like figure on the horizon, not without CPI inflation and certainly not among the peers of Powell and Yellen. They will continue to be more and ever more ‘accommodative’ and when the crashes become more frequent and more violent, they will turn more aggressively interventionist yet. The rhetoric that markets have become unhinged and need stronger government guidance will accelerate. And most people will believe it. It is twisted that arsonists should masquerade as firefighters, but it is sickening that most will give them credence.

Maybe it is just that I frequent the wrong public fora, but I think that present discourse is for the most part utterly imbecilic. People who cannot read the simplest of financial statements are drowning in FOMO, while lecturing on crypto and Tesla. Hundreds of thousands are gleefully gambling with their life savings and college funds (incidentally tuition inflation is also just another side effect of the status quo) on margin and derivatives they overtly do not understand. How does any of this make for a desirable society? Social mobility is beneficial when it is merit based, not when it rewards those who have excess capital merely for having it and the odd speculator for taking boneheaded risks they can ill-afford. Stocks only go up is a daft maxim, but it is orders of magnitude dafter that it will hold broadly true for as long as excess credit is pushed into the system. What a mess.

The funny thing is that I am not anti-government. Hell, I would wager that I consider the SEC far more important than Jay Clayton (admittedly not a high bar) does. But it is not a question of more or less government or regulation. The regulatory framework would have been sufficient, were it effectively and intelligently enforced! While I believe 100% that government plays an important role in the economy and society, I equally believe government should not be the economy and society. Some circles of intelligentsia may deride the cliché and people are free to think me a trite libertarian capitalist, but centrally planned economies and financial systems eventually collapse for good reason.

Further, I even notionally benefit from these developments, with over 95% of my net worth in equity. On the face of it I should embrace all this. But what point is there in being rich in a beggared global community? Were growth rates not low enough in the West to begin with, so that we now need to suppress productivity for political ends? The socioeconomic shifts that these policies constitute will only reinforce the demographics that are causing this polarization of politics the world over. I cannot see how drifting towards a China-style system (but even less efficient) is in the interest of anyone, least of all European and American middle-classes’.

Should real estate be appreciating significantly in real terms? 🤔
Source: http://www.econ.yale.edu/~shiller/data.htm

…

As you can see, I am ever so slightly frustrated. Just a tiny bit. At this point, significant consumer inflation would probably be the best turn of events, if it forced central banks to change course. But it might be too little too late. My best guess is that we will experience further asset price inflation, particularly in stocks but also in crypto, maybe even in some precious metals (though I do not advise buying or shorting either) and real estate (personally loathe the real estate people) for at least a few more years. Governments and particularly central banks will acquire a more authoritarian bend than they already have. Direct taxes will likely go up some but not offset the massive regressive redistribution. There will be many more nominal millionaires and billionaires. Classism and political segmentation will strengthen. Yet more trade conflicts. Lower real growth for the foreseeable future. Just peachy.

Hope that you do not feel too crestfallen after reading my perspective

Tom

Cyberpunk – 2077 in a Cyberfunk?

Disclosure: I have been holding shares in CDR since Q4 of 2015.

Oh dear. Alright, let me take some time here to reflect on the launch of Cyberpunk 2077 and the future of CD Projekt SA.

First of all, no, this is not the launch I expected. Yet I also cannot say I am entirely surprised. Especially in hindsight, it is not out of character for CDR to make blunders – particularly when it comes to bringing their games to consoles. You may recall that in my first post on CDR I mentioned how they almost went under when they failed to port their first title to Xbox 360 and PlayStation 3. That time, they had outsourced a lot of that work, having been too small a studio to work on The Witcher 2 and the port simultaneously. Perhaps somewhat ironically, the current scenario demonstrates an almost parallel situation in the sense that though this time they chose not to outsource the work on the console version of CP2077, due to the increase of scale and ambition of the title, even the now much larger studio failed to deliver a console version that lived up to the expectations. Of course, in most other ways the present developments are rather different from those 2009 days. This time, though buggy and poorly optimized, there are working and playable console ports available of the game on launch and they were developed in-house. The company has a strong balance sheet, secondary sources of income and is not pushed to the brink by having failed to fulfill contracts with external publishers and console manufacturers (mostly because CDR have grown to take control of almost all publishing activity directly where feasible). Of course, the context of this greater financial freedom is not particularly flattering on the decisions that were made to publish the title too early. That was clearly a significant miscalculation by the very top of management. But more on that later.

Similarly to the third Witcher title (The Wild Hunt), the launch of the PC version of CP2077 was plagued by optimization issues, glitches and a UI that needs a rework. But importantly and unlike the old-gen console versions, the PC and Stadia experiences are fine. Certainly, they are not perfect and will benefit a lot from at least several months of updates and polishing but they are perfectly enjoyable. Had the launch only involved PC and Stadia, there would have been very little blowback and it would have been a roughly average AAA title launch in terms of technical problems and very successful in terms of sales. I think both of those things hold true, looking at the PC version alone. The real problems stem from the console launch and the resultant reputational damage for the firm.

The truth is that no game publisher/developer can grow indefinitely without turning from plucky underdog into uncaring corporation in the eyes of consumers. Until this release, CDR had managed to cultivate an immensely valuable asset – consumer goodwill that reached almost fanatical proportions. And despite the significant damage sustained, particularly among old-gen console users, CDR still retains an above average reputation. Yet they will have to work diligently and without significant faux-pas for a solid number of years to recover and will never quite regain that pristine halo of being unable to do any wrong whatsoever.

To a significant extent the damage that has occurred is proportionate to the success of CDR’s marketing efforts and the exceedingly high expectations that have built up over the 8 years since the announcement of CP2077. Naturally, CP2077 has not actually been in full development for that long because resources were repeatedly diverted for The Wild Hunt. Which brings me to what I think is the crux of the cookie. CDR’s management systematically overextended. Though they have exploded in size and means, no organization can grow forever without experiencing at least some diminishing returns. That is because in the real world, some problems cannot be solved by mustering more money and manpower alone. In development work, too, there are bottlenecks that occur which need to be completed before deeper inroads can be made. And those bottlenecks are at times like baking a cake or carrying out a pregnancy. Impossible to rush significantly without serious consequences.

The strategic overextension on part of CDR is everything but unusual in the games industry. I would in fact call it the norm rather than the exception in the AAA segment. I remember well the release of Total War: Rome II and what a mess that was for Creative Assembly, a studio that had just previously made one of the (in my estimation) greatest games of all time, Total War: Shogun 2. There it was the very same story of having cultivated an incredible team, only to divide it too early and chase two hares at once for the sake of strategic expansion. Those are without fail, by nature, top-down business decisions because only by having some separation from the hands-on process is it possible to misjudge the under allocation of resources to a project quite so drastically. There was no unbearable external pressure or financial imperative for CDR to release this year. The decision was squarely management’s.

This is both good and bad. It is good because it means that nothing is wrong with the core engine and most important asset of CDR: the employees. Having played CP2077, that was obvious to me very quickly.

On the obverse, if this decision-making is indicative of serious lack of judgement of management and thus of the handling of future releases, that bodes ill. 

Personally, I do not feel that way presently. Nevertheless, it ought to be crystal clear to Marcin Iwiński that they need to work on internal leadership and communication structures and then listen to them. Most importantly – and I am confident management have understood this for months or even years – they are spread too thin. This release is a wake-up call that the pace is too high, the timeline too ambitious as of yet. Some internal consolidation and rest are sorely needed. Everything else time and good work will fix (though they need to be smarter on the GOG side).

In the long run such a forced regrouping may turn out to be a blessing in disguise, as it does not existentially threaten the firm but punish intellectual complacency and shake up the leadership a little, causing them to think more realistically about the still very long road ahead.

As to how I think this will shake out, I will once again reference Rome II. Despite being literally unplayable on many PCs, Rome II went on to become Creative Assembly’s up until then most commercially successful title already on launch day. Months of patches turned the game from buggy mess to stable and enjoyable game. The management learned a little but not a lot, repeating (or perhaps more accurately, continuing to follow through on) the mistakes several times with Thrones of Britannia and Troy, as well as other, smaller projects. The reputation suffered, thousands were incensed. But ultimately, sales continued their record-breaking streak more or less unperturbed. Commercially, the apparent miscalculation may not necessarily have turned out to be one, seeing the success of the Warhammer series that would have been impossible (or occurred many years later) otherwise. Artistically and technically, of course, there were sacrifices. I still believe that CA have yet to make another game quite as good as Shogun 2. Nevertheless, seeing The Three Kingdoms and the Warhammer titles which I consider to be of high merit be released at such tempo, it cannot be said that the studio’s expansion has been a failure. Perhaps these trade-offs are closer to a structural inevitability of the AAA segment than I previously thought, disillusioning and cynical as that may be to ponder.

Speaking of cynical, let me for completeness’ sake do a very rough attempt at guesstimating around the sales numbers and whether or not the share price decline is likely to be rational quantitatively (again, provided one agrees with my conclusion that this launch is not evidence of new and fatal flaws in the company).

Let us pretend that there are no console sales (with Sony’s decision to pull CP2077 – very serious loss of face for CDR by the by – a much more realistic heuristic than anyone would have projected) and that PC and Stadia is all we will see for the period one to two months after launch. Very conservatively, what kind of revenues and earnings might one expect? Well, SteamSpy puts CP2077 ownership on Steam to between 10’000’000 and 20’000’000 users and as of this writing, 10 days after release, CP2077 remains at the very top of the global best sellers list on Steam at full price (50£, 60USD). So, let us say there are 13M on Steam and 2M on Stadia (both of those are guesses but probably on the low end all considered). That makes 15M copies sold at 60USD, making $900M, ca. 80% of which actually goes to CDR, thus resulting in revenues of $720M (I am ignoring currency conversion etc. as sales are geographically reasonably diversified and the US is a large market; plus, this is an incredibly rough guesstimate, not a projection).

With $720M in revenues, a roughly 40% net profit margin (historically that is about right) gives $288M in net profit. In other words, if CP2077 cost somewhere between $300-350M to develop (CDR always aggregate development cost, so the true figure is not publicly known), this pretty conservative guess pegs revenues at already twice that and net profit in the ballpark of 1x. Not too shabby.

For size, 2019 earnings were PLN175M (roughly $48M). 288/48 = 6. So, if that is all the earnings CDR made all year (which, you know, is not the case) that would be 6 times previous year earnings. If current P/E is about 100x, 100x/6 = ~16.7x. Unless I have made some egregious error somewhere, that seems like a darn ok deal to me.

[Funnily enough I did end up making an error that is significant by forgetting the P/E I was referencing is TTM. There was a significant difference in earnings TTM vs 2019 – PLN279M/$76M vs the supposed $48M. So the actual is 288/76 = ~3.79 and 100x/3.79 = ~26.4x which is obviously less desirable than a 16.7x. Mea culpa.]

In any case, read the disclaimer, this is not investment advice. I am heavily biased. Also probably insane, delusional and a velociraptor foaming at the mouth.

I hope that despite this, you have found this post worthwhile

Tom

On Inflation

Inflation! What a word, what a concept! Even in circles free from the burden of practical or theoretical knowledge of finance and economics, it is possible to receive a lecture on hyperinflation, printing money, and, if one is particularly… lucky…, how blockchain technology experiences none of it. Unfortunately, it seems to me that many professional economists and commentators themselves struggle to attain a firm grasp of the phenomenon significantly superior to the above mentioned. And, to my dismay, this includes my not quite so humble self! Hence it is high time for a first step on the path to remedy and redemption. While in this post I will not make the popular error of attempting to forecast short-term inflation or deflation, I will disaggregate some of the aspects of the concept and perhaps even demystify some of them.

The very first thing to note, is that of course the rate of inflation is not caused by just one convenient factor but many messy interrelations and, much like body temperature, can be symptomatic of many different conditions but is sufficient to definitively diagnose at best only those situations where it has turned so extreme as to become a problem unto itself (i.e. hyperinflation, sustained deflation) and at worst none at all. And why should it? It is an incredibly broad measure, defined as the fall in purchasing power of currency or, equivalently, the rise of general price levels over time. As such, there are many different measures of inflation available over which to argue. What goods and services should be included in the basket of comparison, how should they be substituted as goods and services evolve over time, how ought they be weighted, how and where should real economic data be collected and accounted for, over what period should inflation be studied and so on and on. It is what one might diplomatically call an active area of discussion.

While these particulars are important and interesting, I am at present much more concerned with the question of the nature and origin of inflation, rather than its precise magnitude – much as one might ask why an organism’s body temperature is rising or falling over time rather than what its precise quantity is at any given instance. But enough tattle, onto the subject at hand.

Inflation, as it is measured and defined in units of currency, is naturally a monetary phenomenon. But – and I believe this is one of the reasons for the broad fascination it elicits – it equally relates to real productive output. In other words, it is the interface between the otherwise quite disparate worlds of money, and stuff, respectively. It is inflation that exposes the excessive issuance of currency to enable greater consumption as alchemy. Obviously, if there are three sandwiches in the global economy each costing a doubloon, producing more doubloons by itself will not allow you to eat four until someone makes another one of those baked prisons for charcuterie. Inflation therefore, is simply an aggregated measure of how much less one gets of a selection of goods and services, as a result of the relative rates of growth of the quantity available of that selection of goods versus the quantity of currency in circulation (that is, available to induce that transaction). If that mix of goods grew at the same rate as the relevant money supply, inflationary pressure would be zero. If money supply growth exceeded output growth you would get inflationary pressure equivalent to the gap and deflationary pressure in the converse scenario. Human-made stuff is finite, and the laws of physics cannot be swayed to allow otherwise, not even in exchange for some crisp bank notes still warm from the press (yes, I know, most money supply is digital,  but that simply is not as evocative an image).

From this simple set of rules emerge more complicated expressions when looking at systems in motion and more representative of our world. Since the industrial revolution, all nations have experienced dramatic and continual increases to their productive capacity. The most successful of them have further seen another important transition away from manufacturing and turned into economies predominantly reliant on service and information-based activities. Since these changes materially concern the key inputs determining inflationary pressure (money supply and output) and the balance between them, it should not come as a surprise that they have also an important role in explaining inflation and the various proxies we choose to heed or ignore.

In an industrializing economy, one of the chief constraints of the growth of productive output is financial capital. In other words, the financing of the laying of railroad track, the construction of massive factories and machines and the turning to stone and steel of some seriously sexy bridges pulled from the late-night wet dreams of starchitects sucks up capital, making it scarce and expensive. Yet on balance these investments pay off immensely and the (autocatalytic) formation of more capital in the guise of machines, steel, concrete, labor and access to credit manifests in astonishing growth numbers and societal shifts. Each such investment also impacts inflation in a cyclical fashion over its lifetime. At the beginning, during the planning and funding phase, the investment absorbs scarce physical resources (in effect occupying some of the present capacity for output) and, being typically financed with credit, expands money supply. Aside from crowding out other possible investments, this causes inflationary pressure also and it is quite evident why: It widens the gap between available output and the supply of money chasing said output.

This pressure remains the same or levels off throughout construction and the phases of turning the investment productive (say bringing a factory online and reaching its cruising working capacity) based on the timing of financing and resource consumption. Yet, once the investment is starting to bear fruit, the initial phase reverses! Suddenly the factory/bridge/bank ceases to be a net consumer of the capital needed for further investments and turns net producer. It also starts repaying the credit once extended for the purpose of its creation, causing a contraction of money supply actively in circulation until the repaid money is once more extended to a new investment. Clearly, this is the opposite of our initial phase, reversing the inflationary pressure of the start and causing a deflationary force instead. So, over its lifetime, is the investment inflationary or deflationary? It depends. If the investment exactly pays for itself, it causes neither net inflation nor deflation over its lifetime. N.b. it still causes inflationary pressure in the beginning and deflationary pressure in its senescence, yet these offset in aggregate over its lifetime!

If, however, the investment is terrible and does not end up paying for itself, it then becomes clear that it is a net inflationary force. What though if it is a great investment? Then it simply causes net deflation in the long run. Should we therefore expect that economies in the process of successfully industrializing also are wracked by terrible bouts of deflation? Well.

Not necessarily.

You see, this is where it is important to once again look at the creature in motion. There is a reason why so far, I have carefully emphasized de/inflationary pressure rather than de/inflation, period. Because the deflationary pressure may be offset by the inflationary pressure of subsequent new investments (or simple consumption) and their phases overlap! If the economy keeps continuously reinvesting aggressively the returns of its prior investments and/or consuming them, the deflation may never self-evidently manifest as such and there may well be a sustained and positive rate of inflation, depending on the balance between successful mature investments’ return and the costs of new investments over time. A little bit like adding vectors of opposing forces in the Newtonian sense; the motion is an aggregate and determined by the net of the forces. The individual magnitudes of the forces are not readily apparent and only the resultant acceleration visible.

This explains, in my estimation, why inflation over the 20^th century has been markedly positive. In any economy exhibiting positive real growth, aggregate investment has been productive by definition and caused significant deflationary pressures over time. Yet, victims of their own success, earlier investments’ high returns fund more and more subsequent investments and drive down the cost of capital by virtue of increasing its supply on steady or declining demand, while the returns of each subsequent generation of investment slowly diminish, as the obvious opportunities are made use of and the opportunity set becomes gradually less attractive. In this manner, deflationary pressure eases off at a faster pace than resource allocators choose to reduce growth in investment and consumption. With chronically low interest rates and a societal imperative for more growth without concern as to its longevity or substance, inflationary pressure ends up chronically dominating the deflation caused by productive stewardship of resources.

This framework also helps contextualize what common sense already dictates: the waves of growing household consumerism and appetite for radio, microwave, fridge, car, computer and so on are not coincidental but play an important part in absorbing the newly available productive capacity.

US PCE Index, Source: Federal Reserve Bank of St. Louis

Further, it also now helps us make sense of the recent past and present. With investments becoming less productive in aggregate in post-industrialized economies, net lifetime deflationary pressure slows almost simultaneously as inflationary pressures from new big projects, now less attractive due to lower expectations of returns, decline. The balance looks remarkably stable, as the magnitudes of the inputs experience lower variance. I think this is a crucial realization.

Viewed in this way, it makes sense why the central banks who ‘tamed inflation’ cannot seem to hit their own two percent target rates, unfazed by even unprecedentedly aggressive and sustained interventions. They never were the predominant driver of inflation in the first place (unless they turned so extreme that they fell into hyperinflation like Venezuela, Zimbabwe, Turkey et al). The low interest rates drive little marginal capital formation and instead only serve to balloon financial assets and real estate – the former of which is not a part of PCE and the latter of CPI measures, respectively. Instead, cheap credit has warped security pricing of public and private markets, driven leveraging in risky and fragile areas and slowly hollowed out real incomes of middle classes and substituted them with growth-constraining dependence on consumer credit in the form of student loans, mortgages and other lifestyle related borrowing.

Clearly, I am not a fan of the path central banking has been taking us down since the latter half of the 20^th century. But more on that in a future post.

I hope the above has been of interest to you

Tom

Once a Match is struck

I recently finished reading The Match King, a biography of Ivar Kreuger, by Frank Partnoy. The book itself is good, the unexciting prose is more than compensated for by the comprehensive sourcing and research and of course the immutable allure of a story almost stranger than fiction. For those unfamiliar, I will refrain from saying too much other than that Kreuger was a Swedish man of exceptional ambition who, dealing in construction and safety match monopolies, rose to become one of the most infamous financiers of the early 20th century, competing directly with Jack Morgan of J.P. Morgan fame for business in a world recovering from the first world war, before dying under somewhat opaque circumstances in Paris, leaving behind a collapsing business empire, findings of numerous accounting improprieties and outright fraud – together with genuine innovations in securitization and new financial instruments, various companies (e.g. Swedish Match) and works of architectural significance such as Stockholm city hall (yes, the site of the Nobel Prize banquet) and the Matchstick Palace (also located in Stockholm).

Biographies like this provide a virtually unlimited supply of possible takeaways about the human condition but being the dullard I am, I was most impressed by the following initial observation:

Blest excrement, financial disclosures and publicly available data have come a long way since the early 20th century! According to Partnoy: “In 1926, only 242 of 957 companies listed on the New York Stock Exchange published quarterly reports. Nearly a third of listed companies did not issue reports at all, primarily because they had been members of the Exchange for many years and had nondisclosure agreements that were grandfathered from when they first joined. Newly listed companies filed quarterly reports, but they lacked detail. Listing requirements varied by company and were open to negotiation.” [emphasis added] (p. 94, Partnoy, 2009, The Match King, PublicAffairs)

Hey now. Typical, you might opine, the SEC once again slacking on the job! Nope, the SEC did not even exist yet, being established only in 1934! If you are a financial historian these things might not be new to you yet I for one cannot help but marvel at the eldritch abyss of these revelations. Double-entry bookkeeping has been around since 1494, but its fruits were denied to the investing public a measly century ago! This, too, powerfully illustrates just how profound the shift of financial sovereignty away from the Banks and to the retail investor and how blind their speculation must have been. It seems hardly coincidence that a Great Depression and massive regulatory reform were to follow.

Further, the realization that Graham’s Security Analysis (1934) not only was devilishly timely but indeed could not have been a meaningful contribution a decade or two earlier because, quite simply, the disclosures were too lackluster to support extensive financial statement analysis and the quasi-manic US-investor almost entirely uninterested in fundamental data anyway. A structuralist, I am nevertheless still frequently surprised at just how essential the evolution of these collective social edifices is in governing human agency, thought and behavior and how those individuals like Kreuger, with a mix of insight and luck, manage to leverage them to heroic (in the classical sense) ends. So easily distracted by these proverbial gods, we often neglect our agency – and responsibility – in the design of the machine that births them! After all, the public are not just victim of the likes of Kreuger but bear the liability of their creation. Perhaps worth contemplation also, is that the very same cosmos brings forth both Grahams and Kreugers by identical mechanism. How different are these men? Perhaps(,) in an important sense, not at all.

If this is the first time you have heard of Ivar Kreuger, I warmly suggest you at the very least give his Wikipedia a brief once-over

Tom

Ps: On a more personal note, relationships are far more vulnerable to creeping complacency than a buy-and-hold portfolio; treasure them while you can.

When less is more

There are several criteria that according to broad consensus a currency must fulfill in order to be considered a ‘good’ medium of transaction. These are qualities such as non-perishability, ease of transport/exchange, stability of value and general acceptance. In this short write-up, I will briefly detail why, in fact, a currency that is too stable and retains its value too well – characteristics that would be considered economically desirable by the orthodoxy – makes for poor, depending on degree even entirely unsuitable, money.

The key principle to be grasped here, is that there really only are two things one can do with currency: One can either spend it or save it (in order to spend it at a later date). Naturally, as one precludes the other, this decision involves an economic trade-off wherein presently realizable utility (buy pistachio ice-cream now) is weighed against future expected realizable utility (buy pistachio ice-cream later).

There are many factors that (rationally should) influence this weighing process, such as planning horizon of the agent, level of blood sugar (I find it very difficult to plan for the future when I am hungry) and, of course, the expected rate of return (of utility) on postponing consumption.

To complicate the matter, not all spending relates to the direct satisfaction of human needs but instead leads to increased projected realizable utility through a return on the decision to spend. This is also known as investment. (Note, that though I here differentiate between investment as a form of spending/consumption and saving (a choice to consume later), from the modern macro-economic point of vantage, saving must be investment. One of the core functions of the financial system is to spend (invest) savings.) It is the intimate entanglement of saving (deferred consumption) with investment (spending with an expectation of positive return) via currency that enables the continuous functioning of the economic system.

To understand this, one needs to think through a couple of different scenarios.

Suppose that you are in possession of money and that there is a good or service that you could acquire if you were to spend it which would (partially) meet some basic biological need (say hunger, for instance) and thus provide utility. Further, there is an alternate good or service, which, if bought, would generate a return over a period of time – an investment.

Your options regarding the use of your money are the following:

A) You choose to spend the money on the consumer good, realizing some utility now but foregoing the ability to spend in the future.

B) You buy the second good or service – the investment – realize its return over the investment horizon and later face the same three choices as now.

C) You do not buy anything, that is, you choose to save.

We can see that our decision-making, if rationally maximizing our realized utility, will depend on a series of factors and how they relate to one another quantitively. For instance, if the return of B is zero in real terms – the equivalent of there not being an investment – choices B and C are functionally equivalent. If B, however, provides a positive real return, then C is a strictly sub-optimal choice and should never be made.

Whether you will choose A or B will depend on the urgency of your desire to realize utility (sooner rather than later) and how much expected real return the investment provides.

Interestingly, these options available to you can also be viewed as a decision about how much of your purchasing power you want to hold in which type of medium – monetary or non-monetary. It presents a trade-off between the two types and in some sense is strangely existential, seeing as it is the aggregate decision-making of economic participants that determines which assets are regarded as monetary or non-monetary. An odd thought, is it not – just imagine a sudden reevaluation from one to the other. Of course, this need not be purely theoretical – whenever a new currency becomes accepted or an old one loses its support, a thing transitions from the state of being valued solely as a (physical) good to a monetary state and back, respectively. Seeing as humans have monetarized a great number of disparate commodities/assets/privileges over the past millennia, it is more than just idle rumination to think about the mechanisms that make or break money.

To examine said mechanisms we need to expand the dynamics of our three-choice-model. While price-fluctuation of investments and consumer goods is obvious, this variability also implies price-variability of money itself. If all/most purchasables systematically shift up or down in nominal price, this is indistinguishable from inflation or deflation of the monetary asset in which the exchange is denominated. How might this affect your spending choices?

Clearly, if you anticipate that the good you desire will decline in price for the foreseeable future, this decreases your desire to spend in the immediate present and makes it more desirable to save or even invest. This can feed on itself and cause a deflationary spiral where consumer demand slows, driving down prices, incentivizing further delay of purchases, triggering further price collapse causing yet more delay and so forth. After all, why buy a new couch today if in another two weeks you expect it to cost half? What may appear like a great deal for the individual can, over time and in aggregate, turn out to actually be catastrophic since if the employees at the couch manufacturer get laid off because of flagging revenues, they lose out on income and draw on savings & investments which they cannot spend as readily, causing further weakening of demand, prices, profits, employment, investment and overall economic activity. Not great. This is one way money may fail – sustained deflation and deferred spending slowing circulation to a crawl, clotting crucial commercial arteries and giving the economy a heart-attack.

Naturally, the opposite of sustained deflation, run-away inflation and eventually hyperinflation may also occur. If prices keep rising, you may become tempted to begin stockpiling, shifting forward demand and putting further inflationary pressure on prices. As the buying power per unit of currency nosedives, your need to consume more and more quickly skyrockets. Investment becomes discouraged (as does saving, since real returns on deposits are directly tied to the currency and the profitability of investments), especially where there is great up-front capital investment and a very long tail of monetization of said investment (because the same amount of revenue down the road is worth so much less than the initial outlay in real terms). With decreased investment comes decreased supply, further exacerbating the rise of prices. The adjusting of prices in the economy inevitably fails to keep pace, friction costs of transactions become prohibitive and economic activity, once frantic and spasmatic, seizes up just as surly as under sustained deflation. Not too pleasant either.

It is true that non-monetary assets may exhibit a certain level of resistance to the ill-effects of monetary volatility relative to monetary ones. This, however, is often overemphasized and misleading. Clearly money must exhibit 100% of the aggregate in-/deflationary trend, since it is the medium through which the phenomenon manifests and is measured in the first place. For an asset to ‘shelter’ you from monetary volatility better than currency it really does not need to be particularly extraordinary, it just needs to be less sensitive than 100%. Equity is the most likely to behave in this manner in aggregate. The more pricing power possessed by, less costly the friction of price readjustments, closer to continuous repricing and the more control over & the less need for capital-heavy (re)investment of a venture, the less adversely will it be affected by such monetary tectonics. But obviously, no business has perfectly frictionless and continuous pricing and therefore no asset will exhibit a non-positive sensitivity to monetary developments and thus every asset class suffers mechanistically from general monetary instability – no matter what anyone may claim to the contrary.

Now it is one thing to know what could conceivably happen to currency over time and an entirely different matter to observe it in vivo. Indeed, there seems to be a bias towards inflation in modern monetary history. The US-dollar for instance, has retained just 5 cents of purchasing power in real terms from 1802 to 2002. This example in particular is extraordinarily interesting since 200 years is a decently long period of time and includes intervals of both less and more active monetary intervention by central bodies (including the gold standard). Whichever way one turns the data, it is difficult not to note just how poor an investment currency makes in the long run. Despite this seemingly significant downside, the popularity and use of the US-dollar is undiminished. How come? Should a good currency not retain (or even grow) its value over time to make for a good medium of exchange?

Source: https://www.gurufocus.com/news/791807/jeremy-siegel-stocks-for-the-long-run

Our three-choice-framework now enables us to make a significant observation: monetary assets’ price dynamics drive aggregate decision-making and balance between consumption, direct investment and saving. If a monetary asset has a deflationary long-term trajectory, it will displace direct investment, strangle consumption and the economy and eventually self-destruct without intervention. If the monetary asset loses purchasing power too quickly, it will naturally fall out of favor just the same, as discussed above. In theory, a currency that remains relatively constant in value ought to work reasonably well, except if you believe that its natural tendency is significantly inflationary, in which case its stability requires significant intervention by central bodies which would adversely affect capital allocation in other ways, such as the arbitrary restriction on credit growth relative to economic development of the gold standard. This, too, appears counterproductive and unsustainable in the long term. A steadily declining but not plummeting currency on the other hand, has several advantages. It remains stable enough to remain in use and still be a decent proxy for short- and medium-term real price changes. It also steadily hollows non-inflation-indexed obligations over time, reducing the burden of debtors in real terms at the expense of lenders. This constitutes wealth redistribution from passive capital allocators to entrepreneurial elements and may be a very important long-term factor facilitating economic development. It may even reduce the cost and risk of entrepreneurship through the aforementioned erosion of obligations, though the implications are highly complex and far-reaching and there likely are few savers or pensioners with completely unambivalent feelings on this particular issue.

Nevertheless, even if the effect on economic growth rates is very small, if it is persistent it will compound its way into enormous significance, given time.

Though of course there is much, much more left to be said about money, I hope that this small attempt at analysis has provided you with some positive real value

Tom