Saturday, May 24, 2008

Gold Bars and a Shotgun

One occupational hazard of being an economist is getting asked for investment advice. I sometimes respond to such queries with a recommendation of "gold bars and a shotgun." I'm joking, of course (and trying to dodge the question), but the idea appears in a more serious form in Steve Waldmann's argument that the rise in commodity prices reflects a broader loss of confidence in financial assets:
It is common to invest in commodities as an "inflation hedge". If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-Macguyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be alright, when you've got some Spanish mortgages to pawn.

Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates....

But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl...

His sentiments are seconded and amplified by Yves Smith, who writes:

In times of crisis, people look to leaders for guidance. But in our prevailing doctrine of free markets, there are no leaders, just agents interacting in ways purported to produce virtuous outcomes. And the parties who ought to step into the breach fail to understand the need for that role right now. That is why an old fashioned (and very tall) banker like Volcker is so reassuring. He handled a crisis; he's not afraid to take the reins or say things are bad and changes are needed.

We are at the end of a paradigm: large scale OTC markets, lightly regulated players and instruments, dollar as reserve currency, US as the most important global economic actors...
Hmmm... It is useful to remember the economic purpose of the financial system - to channel savings by households into investment by firms. Deep, liquid markets with lots of people trading lots of different types of assets can facilitate that function. However it does sometimes seem like the growth of resources devoted to finance - and the rewards of its practicioners - has outrun its economic purpose. Recent events (and the corporate financial scandals of 2000-01) have reminded people of the instability and market failures inherent in the financial system. So, yes, it is perhaps time for soul-searching, even angst, in the world of finance....

But that does not mean the gloom extends to the real economy... there are plenty of non-trivial problems, to be sure, but nothing (yet) compared to the early 1980's. The financial sector may be nostalgic for the Volcker era, which arguably marked the beginning of a long boom for finance, but the real economy suffered severely from the high real interest rates and strong dollar and the ill-fated dalliance with monetarism hardly seemed like commanding leadership at the time.

So where should you put your savings in times like these? I have no idea.

NB: OTC: over the counter.


Benoit said...

hum... but aren't stocks also an hedge against inflation? Basically any investment not fixed income or cash will protect you to some extent. I think that the particular thing about the commodities is that some of them are essential to consumers. People will continue to buy food and use energy in a recession. Therefore these investments hedge against inflation AND recession a the same time. A lot of value has been lost in the economy recently and this loss of value has to be reflected somewhere. The feds won't be able to prevent loss but they do control the levers that direct the loss towards cash or towards Wall street. There is a lot of uncertainty as to which side they are going to pull the levers and how far. I guess as an investor right now the safer bet might be to diversify on both sides.

Bill C said...

Thanks for the comment. That is a good point about stocks and it generally is true that the stock market responds positively to signs that the Fed is easing - so an "aggressive" Fed is good for stocks, bad for holders of assets with fixed nominal payments. But I think Waldmann and Smith's broader argument might extend to stocks to the extent that there is reason not to trust companies' balance sheets/strategies these days.

Anonymous said...

isn't the "new" economic purpose of the financial system to channel savings from governments in Asia and the gulf to cash-starved US households?

firms self-financed a lot recently ... or at least did until they got pressured by the PE world to gear their cash flows up. the big deficits in the US are on the household and government sides


Bill C said...

Yes, indeed: the overall inflow of foreign saving - much of it governmental (as your blog does an excellent job documenting) - is financing US dis-saving... In this case the problem arises not solely from an excessive faith in "free markets" but the asymmetry between a country in the grips of market fundamentalism (until recently at least) and others, especially China, that are very heavily intervening in markets.

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