Problems masquerading as solutions

“You cannot hope to build a better world without improving the individuals.”

• Marie Curie.

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One by one, the old political certainties are getting taken out and shot. Across Europe, established parties are taking a beating at the polls by disgusted electorates. We trace the origins of this generalised dissatisfaction back to a certain British plebiscite on 23^rd June 2016.

It took over four decades, but the UK, in a referendum eight years ago that was confirmed in reality on 31^st January 2020, finally managed to extricate herself from a failed political project. The Establishment did not see it coming, and was completely blindsided. The two publications that best represent the financial Establishment – ‘The Financial Times’ and ‘The Economist’ – did not see it coming, either. The whole Establishment remains in denial to this day.

The philosopher John Gray captured the post-June 2016 mood of the Establishment perfectly:

“..those who think the vote can be overturned or ignored are telling us more about their own state of mind than developments in the real world. Like bedraggled courtiers fleeing Versailles after the French Revolution, they are unable to process the reversal that has occurred. Locked in a psychology of despair, anger and denial, they cannot help believing there will be a restoration of an order they believed was unshakeable.”

There can be no going back. Yet as Gray correctly observed, the Establishment is trapped in Kubler-Ross’ first two stages of grief: denial, and anger. At this rate it will be quite some time before they can progress towards the latter three: bargaining, depression, acceptance.

“The vote for Brexit demonstrates that the rules of politics have changed irreversibly. The stabilisation that seemed to have been achieved following the financial crisis was a sham. The lopsided type of capitalism that exists today is inherently unstable and cannot be democratically legitimated. The error of progressive thinkers in all the main parties was to imagine that the discontent of large sections of the population could be appeased by offering them what was at bottom a continuation of the status quo.”

See also Alasdair Macleod’s post-Brexit synopsis here.

Establishment grief knew no bounds. The columnist Lucy Kellaway for ‘The Financial Times’ described Brexit as “the biggest domestic political crisis of my life.. The only other time I can remember when everything ceased was after 9/11..” The FT’s economics correspondent, Martin Wolf described the vote as “probably the most disastrous single event in British history since the second world war.”

We will see. If Brexit was really so disastrous, how to describe the economic legacy of Covid lockdowns (with which it has been lazily conflated by continuity Remainers) ?

More recently, the FT’s senior investment commentator, John Authers, published a piece entitled ‘Central banks are not the enemy’. It contains the following observations:

“Central banks are supposed to make themselves unpopular; as one chairman of the US Federal Reserve famously put it, they have to take away the punchbowl of cheap money just as the party is starting. But, since 2008, when they have left the punchbowl out for all to gorge on cheap money and rising asset prices in an attempt to jump-start growth, they have become the objects of passionate hatred and rampant conspiracy theories. Rational disagreement (which I share) has pickled into irrational anger..

“..Yet every day, reader comments under FT markets columns declare a grand conspiracy. Central banks have engaged in a “power grab”; they are deliberately debasing the currency. They must be reined in. Language in stockbrokers’ notes grows angrier. In the US, the Fed is politicised. Rick Perry, when governor of Texas, once described Bernanke’s policies as “treasonous” and warned, “We would treat him pretty ugly down in Texas.” All of this is hopelessly misdirected. Central bankers are viscerally uncomfortable about easy money. Twice in the past decade the European Central Bank has raised rates only to be forced to cut them again. The Fed announced in early 2009 that it would raise again by the end of 2009. The moment did not come until 2015. Monetary policy has stayed too loose for too long but that is not primarily a failure of central banks. Instead, it is a failure of politicians, who have avoided the spending commitments and deeper economic reforms, very painful at first, that would wean us off cheap money. And it is a failure of markets themselves, which freak out if denied their dose of easy money. Rather than ambitious power-grabbers, central bankers strike me as awkward technocrats, deeply uncomfortable with the role that the abdication of responsibility by others has forced on them.”

We have a little sympathy for some of John Authers’ arguments. He concedes that central banks are run by flawed human beings who often make mistakes. But as a confirmed member of the financial Establishment (he is now a columnist for Bloomberg), he cannot bring himself to link the various threads of his argument to a conclusion that, to us, has been clear for years: central banks are not the answer; they are, in fact, the problem.

The best economist you may never have heard of is an Austrian gentleman by the name of Ludwig von Mises. The IEA and the Cobden Centre provide an excellent, free summary of his thinking here. There is also an excellent resource in the US which continues in the Austrian tradition here.

Mises is one of the giants of economics, who was tragically overshadowed by the rise of Keynes. Mises is also one of “the” names behind the so-called Austrian school for which we have the most profound respect.

Where Mises fundamentally differs from mainstream economists is in his belief that economics is not a science, but rather an encapsulation of human nature. His magnum opus (published in 1949) has the title ‘Human Action’.

Steve Baker MP – one of the handful of Austrian school sympathisers in government today – wrote the following in his introduction to Eamonn Butler’s primer on Mises listed above:

“..intervention in the mutual cooperation of free individuals [is] not reasonable or just. Price fixing in money, as in other commodities, is unwise and counterproductive, yet the control of interest rates is just that: price fixing. Its fruit is our present crisis..

“This is why Mises matters today: we appear to be living through his ‘Crisis of Interventionism’. While we pile intervention upon intervention, it is increasingly apparent that our reserve of private wealth is becoming exhausted. Restrictive measures can only restrict output. Intervention in the market is demonstrably counterproductive: witness bonuses to staff at bailed-out banks which still fail to lend. Wealth is generated, not given, and present policies must eventually extinguish prosperity, security and freedom.”

It took the Global Financial Crisis, and the good fortune to know a handful of Austrian school investors, for us to discover Mises, and others in the Austrian tradition, including the American economist, Murray Rothbard. In an exchange of emails we had with Martin Wolf back in 2012, Wolf made the following observation:

“I didn’t realise we had Austrians in the UK, too. I thought that was a purely American disease.”

Ouch.

When you look at the world through the prism of Austrian thinking, however, you start to appreciate why we’re now in the mess we’re in.

Expecting central banks to fix anything is delusional because, notwithstanding what John Authers suggests, they are themselves the guilty parties. This article from the Mises website points out the absurdity of believing that the markets are in control of interest rates, when they are plainly reflecting the overarching influence of monetary price-setters. The very idea of negative interest rates in a market economy is an absurdity – except to believers in central planning and the supremacy of the State over the individual.

And that is really at the heart of the problem. To members of the Establishment like Bloomberg’s columnists, the State knows best. Quite how the concept of central planning has managed to survive at the heart of the financial Establishment given the baleful histories of Nazi Germany, Soviet Russia and Communist China is staggering. As the American economist Thomas Sowell puts it,

“Socialism in general has a record of failure so blatant that only an intellectual could ignore or evade it.”

Let’s consider what central banks have brought us since the collapse of the Bretton Woods economic system in 1971 – when Nixon took the US dollar off gold.

We have had a succession of financial bubbles.

In the early 1980s the major US banks went on a lending spree in Latin America, determined to test the observation of Walter Wriston, a former head of Citibank, that “countries don’t go out of business”. But fairly soon afterwards, 27 of them did. In the summer of 1982, large American banks lost close to all their cumulative past earnings. The loss was equivalent to everything they had ever made up to that point in the entire history of American banking.

Then, in the 1980s and 1990s, US Savings and Loan companies – the equivalent of Britain’s building societies, designed to take deposits from retail savers and convert them into mortgages and personal loans – under pressure from rising interest rates and after a period of lax regulatory oversight, indulged in an array of highly speculative ventures. The outcome was that one in three savings and loan associations failed – 1043 businesses out of a total of just over 3200. The estimated cost of the crisis came to $160 billion. In what would become a model for future crises, most of that cost was borne by the US taxpayer.

The 1990s brought us the dotcom boom. That, as we know, burst in 2000, whereupon the Federal Reserve in time-honoured fashion slashed interest rates. Those lower interest rates brought us the US property boom, which burst in 2007, and led in large part to the Global Financial Crisis. The GFC led, in turn, to the lowest interest rates in world history, and to the greatest monetary stimulus in world history, too.

Which brings us to today.

Valuations are now so stretched across multiple asset classes, notably debt, property and ‘growth’ equities, that future returns for buyers today are almost certain to disappoint, perhaps catastrophically so if inflation and interest rates remain higher than the consensus currently expects.

Mises had a word for investments undertaken in an environment in which assets were badly mispriced. He called them “malinvestments”. Making “malinvestments” leads to unintended consequences – in the case of Japan, which was the first developed economy to enter an environment of profound deflation, it led to two lost decades.

And since the central banks have historically been so determined to avoid the pain of “malinvestments” from being properly felt by the banking sector, we have had QE, ZIRP (zero interest rate policy) and more recently NIRP (negative interest rate policy), all on a mind-blowing scale. Are you enjoying the recovery ?

Thought not. Because there hasn’t been one.

Central bank QE has bought up interest-bearing securities from the economy, parked them on central bank balance sheets, and substituted them for cash. QE and then NIRP forced holders of cash out onto the risk spectrum in search of yield or return, converting savers and investors forcibly into speculators. Many markets are now horribly mispriced and commercial banks, especially in the US, are paying the price. But that has nothing to do with the central banks, says the Establishment – it’s all to do with a glut of savings.

Nonsense.

The Establishment, meanwhile, directs its usual tin ear to any criticism, claiming, outrageously, that there’s no fundamental problem with QE – we just haven’t done enough of it yet.

But there’s the world as it is, and there’s the world as we would like it to be. The world as we’d like it to be is a world free of the inflationist scourge of central banking. But we have to operate, as investors, in the world as it currently is.

Our erstwhile writing colleague Dan Denning once published a note received from a subscriber:

“Hi Dan

I’ve been following with interest your, Bill Bonner’s and Jim Rickards’ exposure of fake money. First let me say that I totally agree with everything you have all written. I thought you might be interested in a concrete example.

In 1971, as Nixon was embarking on his great economic experiment, my wife and I were in the process of buying our first house, a newly built three bedroom semi. As Warren Buffett remarked, ‘Price is what you pay, value is what you get.’ Everything that can be reasonably described as capital has an intrinsic value. The intrinsic value of that house was that it provided a comfortable home for a young family. It was large enough to not feel claustrophobic. It had some private outside space, a drive on which you could park two cars and there was enough room to build a garage, although we couldn’t afford to do that. It was in a pleasant and safe environment with all amenities you would need, e.g. schools, doctors, a pub, an off-licence etc. That house is still there today. Its intrinsic value is pretty much the same today as it was 45 years ago. Perhaps a little less if its state of repair has deteriorated over the years or possibly a little more if the owners have added to it but no significant change.

Money has no intrinsic value only extrinsic value. The value of money is simply what you can buy with it. In 1971 the house we bought cost £4,000. Today the same house would sell for about £200,000. That is an increase of a factor 50 in 45 years or about 9 % per annum. We tend to call this ‘inflation but in reality it is ‘debasement of the currency’. How can we distinguish between the two? If I had bought the house in 1971 using gold I would have had to pay about 140 oz. If I wished to buy it today in gold it would cost me 190 oz. Given that the exchange rate between gold and fiat currencies has been manipulated to a low value over quite a long time span the price of the house in gold has hardly changed. If gold reaches £1,428 per ounce in the not too distant future, which is a conservative estimate if you listen to Jim Rickards, the price will be identical in gold terms. Gold is a currency that can’t really be debased.

You wouldn’t need to go far back in UK history to find a time when the punishment for debasing the currency was hanging and drawing. I believe it didn’t include quartering although I might be wrong. Perhaps reintroducing this punishment might concentrate the minds of those that dictate economic policy.”

We genuinely believe that central banking in its current form cannot survive this crisis. The question is whether central banks get forcibly reformed before they blow up the financial system.

Investing in the world as it is should be precisely that, investing, and not speculation.

The great ‘value’ investor Ben Graham defined those two words as follows:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

By Ben Graham’s definition, most forms of investment today are actually speculations instead. The ones that aren’t are predicated on possessing a combination of characteristics:

1. Objectively high credit quality (if bonds);
2. Objectively high management quality (if stocks or actively managed funds);
3. Attractive valuations;
4. Relative scarcity;
5. A ‘margin of safety’ – or other attributes consistent with broadly defensive capital-preservation qualities.

Now is not the time to achieve abstract diversity, it’s the time to be highly selective. Think of each of your investments as an exit visa out of this current madness – and if an investment doesn’t give you that degree of comfort, replace it with one that will.

The irony of investment publishing is that there are legions of books out there offering advice about how to make money. There are few, or none, that give advice about how to keep it, once you’ve made it. We sincerely hope that these commentaries can help in this somewhat rarefied cause.

There is ultimately one question that we all seek answers to, and it is a question that cannot be answered: when ? Just how long is this monetary insanity going to last ? With the US ‘official’ national debt standing at $34 trillion and growing at the rate of $1 trillion every 100 days (the off-balance sheet, unfunded liability version probably stands at over $100 trillion), the US administration faces the painful reckoning that accompanies decades of choosing the soft option when it comes to fiscal discipline. The only plausible outcomes seem restricted to the Hobson’s choice of default or hyperinflation.

In fact there is an answer, of sorts, and that answer, of course, is gold. If you have yet to take the plunge, it is still not too late to start to build a position in the finest form of money that money can buy – during the most dangerous financial environment that any of us are ever likely to see.

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As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:

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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks.