The causes of this are widespread, are global in nature, and in aggregate are so widespread internationally and over many classes of debt instruments that the idea that quantitative easing, which ended a long time ago, could be the cause of this strikes me as far-fetched.  While I am not a deflationist, I argued in January 2009 that the U.S. was going Japanese financially.  Here’s the link to the relevant post, which to save you the click-through, is titled Land of the Setting Sun and begins unequivocally:  “We are Japan”.

The U.S. has managed both to sustain ZIRP and have a downtrend in longer-term interest rates despite a positive rate of price inflation.  Quite something to behold… To be discussed another time in more detail.

Next, the S&P 500 continues to show a loss of upward momentum.  It has been in the process of “rolling over” even since the 2009 rally faltered in the spring of 2010, leading to the failure of the Obama admin’s “Recovery summer” initiative.  LINK

A recovery back to the 50 day simple moving average is the usual response to this sort of setback, given that the 150 day and 200 day moving averages are moving up.  That, for example, was the pattern in 2007-8, 2010 and 2011.

Next, China and Europe multi-year charts.  Europe is in aggregate China’s largest customer, and given its accelerating economic contraction, China as a supplier gets hit harder than Europe.  This comes on top of China’s property bust.  Here are links to a major Chinese stock market index, then Hong Kong, then Europe.  LINK, LINK, LINK.  These will show as 6M charts.  Click on 5 year or your desired time frames.  I like 5 year looks here to capture the pre-financial crisis period.  You can see that they all look like the S&P chart (“SPY”) but worse.  Does this “worseness” reflect that the businesses listed on these exchanges are inferior?  Do they instead reflect a lesser degree of new money creation uncollaterized by other assets (as the European “LTRO” has been)?  Dunno.

Gold is of course up against all stock markets I know of in that time frame, as are silver and oil.

However, gold is now priced well above platinum, an anomaly that suggests to me that platinum is probably the better buy– and my trader’s guess (highly inexpert) is that platinum is unattractive in the short run.  My interpretation is that traders and investors are pricing in continued global industrial difficulties with more money-printing pending, and so they are bidding up gold but not platinum.  Thus gold may already be pricing a lot of intervention in, and perhaps if actual price deflation sets in as in 2009, gold could tumble from here.  A decline in the price of gold from top to bottom that comes close to 2008′s 30% peak-trough drop in gold would not surprise me (meaning to below $1400/ounce), nor would much higher all-time highs in later years than last year’s highs.  So all I’ve really said here is that I have no idea about gold.  LOL, sometimes one simply lacks an opinion.

Now that record low interest rates in longer and longer maturities have spread to Germany, the U.K and the U.S. along with Japan (and Brazil LOL), a form of the financial ”Ice Age” that various economic theorists have foreseen has started to occur.  It is here.

Why has this occurred, and what comes next?

The first response to the first question that occurs to me is that too much capital went to unproductive pursuits.  When real savings are well used, they generate so much new economic opportunity that there is great competition for said savings, leading to high interest rates and a high rate of economic growth:  the famous win-win scenario.  Investors win, businesspeople win, and society wins big.  Now, capital owners just don’t see good investment opportunities, so in the aggregate they put it in a form of suspended animation, or a deep freeze, to wait for better times.  Thus these owners of capital accept a low bid from governments and banks for their capital, which is the same as saying that they accept low interest rates.  (This of course pleases the borrowers.)

The response to the second question is that when governments are “forced” to intervene to “save” banks, that brings the governments away from their core competencies.  No doubt they mean well, but how great are they at doing the jobs that the “free market” should have done well on its own?

We all can answer that question as we see it.  My general sense is that with the Congressional Budget Office now opining that the 2013 scheduled tax increases will lead to a recession if implemented, the odds are that one way or another many of them will not be implemented.  One would think that if that’s the case, interest rates should rise to attract more lenders.

The way it’s been working for a while is just the opposite.  Thus it wouldn’t surprise me one bit to see even lower, and potentially much lower, U.S. interest rates as this year moves along, as the financial markets accommodate Uncle Sam’s borrowing.

Just as happened in… Japan.

Gold has always been money, as are dollars, euros and yen. It is not a currency or media of exchange presently because no one directly exchanges it for goods, services or assets and it has not formally collateralized other currencies since 1971. However, were gold to once again back today’s baseless currencies, then it would be astonishingly cheap at today’s exchange rates with them (i.e. gold prices), and by extension cheap to most operating businesses denominated in today’s currencies. Gold today is a speculation that someday it will again have recognized monetary status.

Gold is a store of purchasing power bought at certain exchange rates to other currencies – as we write this, about $1,600 an ounce to the dollar, €1,232 an ounce to the Euro, £988 an ounce to sterling, and ¥127,790 an ounce to yen. In the current monetary system in which all global currencies are uncollateralized, the perception of gold’s exchange rate (price) ultimately derives from its status as potential monetary collateral that might someday back government-sanctioned (fiat) money.

Thus, when gold is money or formally backs currencies, people save gold. Given its un-sanctioned monetary status today, gold may be considered an investment. Given its intrinsic cheapness vis-à-vis paper currencies today and economic conditions that make it highly likely it will become even cheaper to them, very civilized people across the world have been replacing a portion of their fiat cash and financial asset portfolios with gold not held in their investment portfolios. (The only way to hold physical bullion in a financial asset portfolio would be to own shares in mining companies, which provide direct ownership of physical bullion inventories held below ground.)

Despite the incessant negative chatter about gold by people in positions of influence, (or more likely because of it), there has been only a trifling allocation to it among financial asset investors. The vast majority of dedicated financial asset and derivative investors, including pension funds, mutual funds, individuals, and even futures speculators, remain either: a) unable to invest in it by charter, b) unconvinced that gold’s price will appreciate over a time horizon that matches their mandates, c) convinced that gold is a poor investment at today’s pricing because authorities will let bank system credit fail, or d) oblivious to what gold is and the economic forces behind it.

Precious metals allocations account for only about 0.15% of global pension fund assets. Within the gold futures market, only 0.50% of front month contracts typically take delivery of bullion, implying gold futures remain a source of financial return among speculators, not a means of amassing a physical position. Meanwhile, all gold and silver ETFs combined held only 90 million gold-equivalent ounces as of the end of April, which at about $1,650 an ounce equaled only about $150 billion. (Compare that to Apple’s market cap.) And perhaps the most telling indicator of indifference to gold among financial asset investors: the total market capitalization of all publicly traded precious metal miners (representing trillions in below-ground physical reserves) is only about $360 billion.

We think there are four main questions to be asked and answered: 1) how does one handicap what would be a multi-sigma event – whether or not gold will again gain formal monetary status; 2) over what time horizon might the perception of a significant change in the global monetary system occur (and would it include gold); 3) what would be a range of investment outcomes should such an event occur; and 4) how would such pro forma returns compare with the range of returns of other investments? We have devoted much of our research since 2007 to these questions and have written extensively about them. This paper, however, will only seek to place gold in proper perspective for Mr. Munger (and perhaps Mr. Dimon too).

What’s it all About, Charlie?

The difference between saving and investing is that savers seek to maintain their purchasing power and investors seek to increase theirs. In the current environment it is impossible to save at a positive real rate of return given that interest rates are near zero and central banks are diluting purchasing power through monetary inflation. Everyone is forced to speculate – even cash and (especially) bondholders.

Currently, cash, bank deposits and bond holdings denominated in baseless currencies are being diluted by global central banks and losing significant purchasing power, which means “savers” in these instruments are actually speculating this established trend will stop. Their real (inflation-adjusted) returns are already negative (against CPI), and so, by implication, they believe the return of the majority (but not all) of their purchasing power is better than “speculating” in productive businesses to try to generate a positive return on their current purchasing power.

In this, we agree with Charlie Munger’s partner, Warren Buffett: productive assets are better than cash and bonds denominated in baseless currencies. We agree with any implication that saving in fiat cash or fiat-denominated fixed-income instruments is a loser’s game at current pricing. But we would disagree with any implication that it is not the right time to exchange baseless currencies or most productive businesses denominated in them for gold.

A Bit of Theory

Consider that price is the quantity of money assigned to a good, service or asset, yet changing prices may not necessarily have anything to do with the changing value of goods, services and assets. For example, the value to society of a good, service or asset in relation to its quantity can remain constant or even fall; yet its price can rise substantially if the quantity of money increases more than the increase in demand relative to supply. The more monetary units available to chase the same supply/demand equilibrium, the higher the general price level for goods, services and assets must be.

This means that expectations of increasing or decreasing demand in an economy can only partially rationalize future price changes. The more moving parts (e.g. immigration, innovation, government spending, the whims of independent money issuers, etc.) that affect the supply and demand for goods, services, assets, AND MONEY; the less visibility there will be for prices — even if expected value is reasonably knowable. So, in the current monetary system, currencies are indeterminate claims on wealth and purchasing power kept in currency is an imperfect marker of wealth. (Of course, we know currency, per se, is not wealth because if it were then wealth could be created simply by creating more currency.)

An easy way to envision how to quantify purchasing power is to imagine two buckets: the first contains all of the world’s money and the second contains all things not-money. We may debate about the proper relative value of the various items in the money bucket (e.g. dollars, euros, yen, gold, etc.), and debate even more vociferously (and do) about the proper relative values of the items in the all-things-not-money bucket (e.g. toothpaste, labor, accounting fees, stocks, bonds, commodities, iPods, etc); however, it would be illogical to think that the aggregate value of the money bucket should not equal the aggregate value of the all-things-not-money bucket at all times. Conceptually, all the stuff in the world that can be purchased must have a means to be purchased, and so the aggregate value of each bucket must always equal the aggregate value of the other.

So then: if wealth is current and future sustainable purchasing power, and judging the future value of goods, services and assets relies on also judging the quantity of money, and the quantity of money and all the stuff it can buy must always be at equilibrium, then one of the first-order economic considerations among all members of society should be to judge the money in which he or she a) is compensated in, and b) chooses to invest or save in.

Practicalities

Very few people today think about the sustainable value of their money, including, it seems, Messrs. Munger and Buffett. If stocks are cheap to baseless cash, as they rightly argue, and stocks are cheap to gold, as they seemingly imply, then nothing has been determined (or even implied) regarding the relative value of gold to fiat cash within the money bucket. Somewhat strangely, their argument reduces to the contention that money in whatever form it may take – dollars or gold — has no economic function of value. They argue one should hold stocks as a residual claim on productive assets instead. We would vehemently disagree. We see the value in productive businesses; however, one must also consider the possibility that, even if they are intrinsically undervalued in fiat cash terms, productive business may be intrinsically overvalued in gold terms. (Judging by subsequent performance, it certainly seems BRK/A shares were quite overvalued vis-à-vis gold in 2000.)

When objectively defined and properly priced by the marketplace, the presence of money as a savings vehicle enhances the well-being of society. When subjectively rendered and manipulated by goal-oriented policy objectives, the value of money becomes distorted vis-à-vis goods, services, assets and labor. The difference today between investing in baseless currency-denominated productive businesses and exchanging baseless currencies for gold defines the difference between solving for nominal vs. real returns. Investors in most financial assets denominated in over-leveraged currencies today will receive nominal relative returns while gold holders store absolute real purchasing power (save in real terms).

Which is the better bet? The global gold stock increases about 1%-2% a year as compared to the global fiat money stock which increases many multiples of that. This should be the fundamental consideration when it comes to choosing a money form in which to speculate or in which to price one’s investments: which will have its purchasing power diluted less? If Berkshire Hathaway shares rise 25% in the coming years but the US dollars these shares are denominated in fall 35% versus consumer goods and services, then Munger and Buffet will have invested in productive businesses that made profits yet they would have lost purchasing power in the aggregate for shareholders. This dynamic illustrates precisely what has occurred since 2000.

(Safe) Harborous Relic

What exactly are the economics of shiny rocks as they relate to our very civilized contemporary society? The working figure for the amount of all the above-ground gold ever mined is about 170,000 metric tons, which converts to almost 5.5 billion troy ounces (5,465,619,000). At $1,600 an ounce this implies the recognized total value of all the mined gold in the world is a bit over $8.7 trillion today ($8,744,990,400).

Should we believe the 170,000 metric ton figure? Well, annual worldwide production of gold is about 50 million troy ounces. If we were to assume 50 million ounces mined over the last 200 years, (perhaps generous but this assumption would also be sufficient to include ancient mining since the time of the Aztecs), then there would be about 10 billion ounces mined since antiquity. Unlike other metals with industrial uses, gold is not consumed. Every ounce ever mined still exists. At $1,600 an ounce, the total amount of above-ground gold would equal about $16 trillion. So let’s say gold is currently valued somewhere between $8 trillion and $16 trillion.

Governments and their designated central bank currency issuers do not own most of the above-ground gold in the world. The World Gold Council reports that total official gold holdings throughout the world totals almost 31 thousand metric tons (30,878.2 tonnes), which, at today’s pricing, equals about $1.6 trillion ($1,588,357,750,464). Depending on how much gold has actually been mined, 5.5 or 10 billion ounces, the world’s treasury ministries and central banks only have somewhere between 10% and 18% of it.

This presents a problem for governments that would like to control the perceived value of money. There are no currencies today (since 1971) formally linked to gold or any other relatively finite collateral. This implies that virtually all global governments prefer to have direct control over their budgets, rather than allowing the collective will of their societies determine the scale of government spending. Authoritarian and representative governments alike prefer a global monetary system in which money is effectively issued by fiat and directed by appointed monetary policy makers (usually central banks).

The great challenge for elected and appointed monetary policy makers is to try to manage the quantity and pricing of their fiat currencies consistent with the multi-faceted and unpredictable dynamics of the global economy. Fiat currencies must be widely perceived to be priced more or less equitably, not only by the factors of production and wealth holders within each society but also by the various global governments overseeing economies with greatly different resources, social values and natural economic growth rates.

If global money, formally comprised today of all various baseless fiat currencies, were to begin to be perceived in the commercial marketplace as an insufficient marker of the future value for goods, services and assets, (domestically or internationally); then the global monetary system would be in jeopardy. In short, confidence is lost if and when currency is no longer perceived as a sufficient store of value. In such a scenario currency holders would discard it for goods, services and assets at an accelerating pace. Importantly, they would not necessarily exchange their baseless currency for labor or production, which would be an economic stimulant (or for shares of BRK/A). Prices would rise as economic factors of production, private wealth holders, and participating governments further accelerate their consumption of goods or assets they feel would store value better. Baseless currencies would ultimately lose credibility and the the global monetary system would fail.

When systems fail it does not mean that the values of goods, services and assets change, only that the numeraire of money is reset. (The numeraire is the value reference used to base a unit of account.) Global monetary systems periodically need resetting, most frequently in 1933, 1945 and 1971. Changing the numeraire requires the support of global economic agents, including the private marketplace and international government authorities. This, in turn, requires widespread confidence that the value and nature of the re-setting would not lead to an imminent need for further re-settings. This is precisely why gold remains relevant today.

The more “sophisticated” unreserved credit and its uses become, the more unknowable future purchasing power becomes. The more remote baseless currencies that comprise our global monetary system stray from being sustainable stores of value, the likelier it becomes they will be called into question. (Enter JP Morgan’s public recognition that it has an unwieldy balance sheet.)

Perhaps this is why governments and central banks have continued to own gold? You may recall not too long ago Ben Bernanke was asked if he considered gold to be money and he said “no”. When asked why the Fed still owned it, he shrugged and murmured something about “tradition”. You may also recall that more recently he was asked if the Fed owned gold, and he seemed to do his best to appear perplexed. He looked back and forth over his shoulder until finally an aide confirmed that indeed the Fed does hold gold certificates (which give the Fed rights to Treasury’s bullion).

It shouldn’t be shocking that the manufacturer of the world’s reserve currency expresses public bewilderment with the fascination over anachronistic, inert rocks by a few gentlemen with southern accents. What else could he say: pay no attention to gold’s long history of resetting societies’ wealth valuation mechanism against failed currencies? Or pay no attention to other central banks buying gold hand over fist currently? (Perhaps they are doing so because they want to be more traditional?)

All the Right People, Darling

The absolute amount of gold held in official hands – 10%, 18% or even 25% — is meaningless. The important concept to keep in mind is that the stock of official gold holdings throughout all economies is quite small relative to privately held bullion. Somewhere in the world there is between $7 and $15 trillion of gold wealth (at current spot pricing) held in private hands (vs. $1.6 trillion in official accounts). Private wealth holders across the world have been saving gold bullion for generations; in Europe, the Middle East, China, India, Japan, Russia, South America and the United States (even in private pockets on Wall Street, believe it not, where there’s an old saying: “Make it on Wall Street, bury it on Main Street”).

It should not be surprising that global central banks have begun buying gold bullion in ever increasing amounts. It was just reported this month that Hong Kong shipped almost 63 metric tons of gold to China in March, a 59% increase over February and a 587% increase year over year. Russia has been a consistent buyer of about 5,000 tonnes each month and has recently accelerated its purchases. Other high growth economies including India cannot seem to get sufficient supplies of bullion. Clearly the governments of these countries want to exchange their baseless and diluting reserves for a scarcer money form. And just this week the IMF – yes, the same IMF that had been selling its bullion to central banks of emerging economies with surplus reserves – announced it was buying $2 billion of gold. The reason: “there is a need to increase the Fund’s reserves in order to help mitigate …elevated credit risks”.

Meanwhile, central banks of developed debtor economies are being pressured by their contracting debt-based economies to manufacture more fiat currencies through the process of debt monetization – issuing even more debt and paying for it with newly-created base money (currency and/or bank reserves held at central banks). They are devaluing their currencies for savers and investors and destroying the future purchasing power of surplus reserves held abroad.

If past is prologue, the baseless currencies of developed economies will eventually be subjected to asset monetization. Greece could solve its debt problems tomorrow if it sold Mykonos for $400 billion and the US could halve its Treasury debt if it sold Alaska for $8 trillion. However, such asset sales seem far more unlikely (and in Alaska’s case, impossible – who could buy it?) than simply revaluing an asset already held in official hands — the asset monetary issuers have always used; the only monetary asset on their balance sheets that can be re-valued higher against the currency they manufacture (one might say the “traditional” one): gold.

We argue the final outcome must be to devalue current baseless currencies against gold and that governments of high-growth economies are buying official gold in increasing amounts so they have a representative share when gold becomes the basis for a new global monetary system.

Have global private gold savers/investors that comprise the great majority of its holders been buying in advance of a more formal currency reset (devaluation) of baseless paper against gold? Who are central banks buying their physical gold from currently? (Certainly they are not buying it from global commodities exchanges.) The only answer is that they must be buying all they can from the 80% to 90% of private gold holders in the world. And we should ask ourselves this: who has been buying gold consistently since 2000, when it traded around $250 an ounce, 11 years before central banks became net buyers? Could the buyers have been private holders around the world that understand wealth doesn’t begin and end with leveraged Western financial assets and baseless fiat currencies? This would make sense.

Still, the volume of physical gold traded relative to its stock remains tiny, implying that relatively few physical holders are willing to part with most of their gold. If central banks want to stock their shelves prior to devaluation then they would have to employ a bit of finesse. If we were a sovereign in search of gold we would short gold futures and take physical bullion off the market at synthetically low prices (the same way other sovereigns might manipulate, say, interest rates).

And finally, who are the private bullion-owning wealth holders that are leaking gold out to hungry governments and central banks? By definition they are collectively The Powers That Be. Whether they are disaggregated or conspiratorially linked, private gold holders are the true unencumbered savers among us. They are the ones that have a chunk of their wealth in a money form that stores purchasing power no matter what. And unlike fiduciaries overseeing the encumbered wealth of financial asset investors, there is no one and no system between them and their purchasing power.

We suspect most of these quiet savers are quite sophisticated, know exactly what they are doing, and view the preponderance of levered financial assets with suspicion regardless of whatever value they may have relative to one another. (Would it be that much of a stretch to believe these individuals holding trillions in inert rocks might also have great influence over global resources, monetary systems, banking systems and governments?)

Sophisticated Sophism

While Mr. Munger’s comments represent those of a power structure nominally larger and far more organized than private gold holders, it is a power structure that is unsustainable. Financial assets denominated in baseless paper currencies are marked-to-market many times higher than gold presently; however this pricing is only supported by the full faith and credit of a temporary authority, not by sustainable power. Functionally insolvent banking systems are supporting rotating politicians and policy makers, who, in turn, are furiously trying to reverse declining real output stemming from organic pressures for systemic de-leveraging. (During the leveraging process productive capital was greatly misallocated. During the de-leveraging process, it is logical that real productivity is declining.)

It would seem sustainable power no longer resides with the fellows, the institutions or the policies that promote a system in which higher numbers equal the false perception of sustainable wealth. It must reside in the commercial marketplace and among capital holders (those who own sustainable resources or sustainable savings that can buy resources no matter what the inflation-adjusted price is).

The list of well-known baseless money promoters is long. We can start with virtually all central bankers, current, retired or passed-on, throw in virtually all economic and political leaders of the modern era, add icons like Messrs. Munger and Buffett sitting atop a pile of numbers, and, for good measure, leaven the whole meringue with journalists calling upon financiers posing as capitalists for instruction and guidance. It is obvious that the preponderance of people that have ascended to positions of authority has directly benefitted from the financial system and has no incentive to question its merits today.

Is it any wonder Bob Rubin, who gamed the capital markets so well at Goldman Sachs and the FX markets so well at Treasury, chose the academic Larry Summers to follow in his footsteps? Summers, the child of two highly regarded Keynesian economists and the nephew of Paul Samuelson, (the man who literally wrote the book for all budding economists on how to manage economies), leant an air of intellectual rigor to Rubin’s market manipulations. True to form Summers recoiled and shrieked “gold is the creationism of economics!” this past winter in response to a question of whether he thought a gold standard might provide more discipline to runaway fiscal spending. The particular economic canon he and the vast majority of contemporary economists worship is a theory called “political economics“, which assumes sustainable and growing economies are best ensured by actively synthesizing constant demand growth through fiscal, monetary and trade policies, not by overseeing human commercial incentives and the private marketplace. We ask you: which requires more faith?

Nor should we be surprised that Paul O’Neill and John Snow, actual businessmen, were run out of Washington after a couple of years and replaced by a money man, Hank Paulson. The Republican Paulson and the Democrat, New York Fed President, Tim Geithner, (who would replace Paulson after the peaceful transition of power in 2008), bought “illiquid” (i.e. mismarked) bank assets with newly created base money. Demand was temporarily synthesized by bringing future purchasing power forward and effectively transferring it from taxpayers to commercial banks. Though the pain would have been felt only in the financial sector had nothing been done, “independent” policy makers were able to avoid a counter-factual called “deep depression”, and both parties were able to take credit. While politics may stop at the water’s edge, it clearly begins on the corner of Wall and Broad.

Calvin Coolidge said in January 1925 that “the chief business of the American people is business”. He did not say (although 85 years later he certainly might have); “the business of America is having banks create unreserved credit so that the broader economy would then have to focus on repaying its debts to banks.” The difference between the two principles is that the former suggests human industry sorts resources best while the latter institutionalizes producers and consumers into an encumbered mass to be managed by a few. (Again, please forget politics here. We are not advocating how much to tax, who to tax or what to spend it on, only pointing out a corrupt and failing monetary system.)

Whether they know it or not, our authority figures today are working on behalf of banking systems. Banks borrow capital from the factors of production and create bookkeeping assets many multiples of that capital for themselves in the form of unreserved credit. Meanwhile, the credit they extend becomes debt for their borrowers, fully-collateralized for banks by the borrowers’ assets and future labor. Fractionally reserved banking systems effectively permit banks to conjure future claims on currency where no currency exists today; creating “when-issued money” from thin air that must eventually be settled by their central banks. This ensures inflation.

Political economics not only accommodates fractional reserve lending — it relies on it. Its aim is to perpetuate nominal demand growth at all times to achieve full employment. This is a noble goal but it has a dark side too. Consistent demand growth requires consistent credit growth, which requires consistent debt growth and, in turn, public servitude to bank lenders. Policy makers ultimately find that inflation becomes an economic imperative in their effort to ease the nominal burden of repaying debts. (The business of America, the next President might say, is finance. This would seem entirely reasonable given that the next president will either be a proven budget buster or a professional leverager – a dismal tie in economic terms, a win in gold terms.)

Piffle & Baffle

Against this backdrop, Munger, Buffett, Bernanke, Geithner, Draghi, Lagarde, Rumpuy, Obama, Romney, McConnell, Boehner, Reid, Pelosi, Kudlow, Krugman, Roubini, Wolf, Hilsenrath, Kernen, etc. etc., seek to instill confidence among the factors of production and investors they influence. They are good and kind, highly intelligent and well-intentioned. But so what? Collectively they are wrong-headed. The fractional reserve banking system and debt money system they help sustain is directly responsible for the wealth and income inequality currently being experienced. (When they yell at the mention of this assertion ask them to disprove it.)

Promoting finance for the sake of financial return when it no longer produces capital cannot work. Arguing about taxes or austerity or budgets or infrastructure spending or political platforms is simply noise as more debt accrues and employment participation rates decline. What exactly is there to be confident about?

And why should perpetuating confidence be the foundation for all centrist economic policies? People at all income levels and of all political persuasions can no longer save their wages in the same currency it is paid. Are we to be confident that the real economy can expand when real wealth declines? Or that investing our excess baseless currency back into shares of productive businesses (denominated in the very same wasting currency) will provide investors with lasting purchasing power? Are we to be confident investing in a system where government, mortgage, corporate and municipal debts are priced at negative real rates because central banks, who will always have more money at their disposal than all bonds outstanding, threaten to continue buying them if need be?

We have met such authority figures and yes, they are usually charming, smart and dynamic. But almost without exception it seems they confuse their theories, (rationalized with econometric models filled with unrepeatable observations), for physical science.

Confidence in productive assets may be more warranted than confidence in bonds and baseless cash, but this does not mean one should have confidence about future real production, wealth creation, economic growth or the post-Bretton Woods monetary system. When the global monetary regime reduces to the solvency of one global banking system with interconnected, uncollateralized receivables, as it does today, then its sustainability relies on: a) the ability and/or willingness of depositors to keep savings in the banking system, (love those debit cards!), and, b) the willingness of the factors of production to continue accepting unreserved currency as compensation and the willingness of capital holders to save and invest in it. As workers, savers, investors, consumers, taxpayers, policy makers and politicians, why should we count on such unwarranted confidence to continue?

It is within this context that Mr. Munger and others urge those curious about gold to start walking upright, to stop dragging their knuckles on the pavement. They counsel civilized people to reinvest their baseless wages into baseless shares of productive businesses selling goods and services in return for baseless revenues and earnings. Do not save in a relatively scarce form of money, they say or imply, (because saving starves creditors and leads to nominal output contraction)! Again, it’s not about nominal anything; it’s about the purchasing power of wages, savings and investment.

Finance may be doomed but commerce is not. Total global bank assets are about $95 trillion and total bank reserves are not quite $10 trillion. This fractionally-reserved global banking system does not necessarily imply immediate economic contraction because there is no obvious catalyst that would force the leverage gap to suddenly close (though the JPM news just hit …). However, substantial bank leverage in combination with already highly-leveraged depositors, capital holders and consumers, are significantly retarding demand and real economic activity. There simply is no natural incentive for lenders or borrowers to leverage their balance sheets further, which in turn means that output growth and asset prices must continue to decline in real terms.

And so we think it would be fair to caution against heeding the advice of a self-interested financial establishment trying to fit a flawed, unsustainable and quickly deteriorating set of theories into what they would like us to believe is a noble and patriotic goal. The common good is not necessarily expressed accurately by past financial asset winners and the ambitious policy makers they support. Their barking is becoming more frequent — a clear sign that their baseless protestations and accusations are failing to turn the tide (not against squeaky pipsqueaks like us, but against fundamental logic, human incentives and the mathematical power of compounding nominal debts).

Don’t Worry, Be Happy

There is no reason to expect the demise of Western hegemony and no need to promote gold. Gold will be priced significantly higher in fiat terms over time, (or next week, who knows), either by the markets or by an administered fiat devaluation. There can be no fiscal solution over any amount of time; growth, austerity or some optimal combination of the two can no longer work. The only way out is massive currency dilution and we expect leaders across the political spectrum in all debtor nations to ensure this occurs.

We have no doubt the same misguided establishment will reverse course to save the day. They will ultimately choose to destroy the burden of repaying domestic debt through monetary inflation, a process that would reward the great majority of voters. They will choose this route because the alternative will be to keep exporting Western capital to developing economies and continued domestic unemployment. (Krugman wins.) By doing so, the West will have successfully shorted its currencies to export economies and will have received cheap imported goods and resources in exchange.

The developed economies of the West will become more vibrant afterwards because the prices of goods, services, labor, assets and liabilities will again reflect market clearing real (de-levered) values. Nominal prices may be unrecognizable but affordability across all income levels will improve. Debtor nations will wipe the slate clean and their factors of production will again be globally competitive.

The key to a successful transition is a credible monetary reset. Gold is the default collateral for money because it has a long and established precedent in this role. All that would be needed would be a fairly equitable distribution of gold among global monetary authorities (taking place now?), and an agreed-upon exchange rate vis-à-vis baseless paper. It would have to be an exchange rate at which central banks could successfully monetize assets by tendering for physical gold with newly manufactured paper money, an exchange rate high enough to attract enough gold to cover unreserved credit held in the banking system. It’s a high figure. The relative cost of holding physical gold today is minimal, (above-ground bullion or in-ground bullion through mining shares), against the negative real returns offered by the preponderance of financial assets in float.

We suggest one keep identities straight; invest with central banks, not against them; and consider the hollow rhetoric of the establishment that may temporarily suppress its paper price “a gift”. They are working for physical gold holders, not against them.

Copyright © 2012 · Lee Quaintance and Paul Brodsky of QB Asset Management Company, LLC, NY.
Published by kind permission of the authors.
No part of this document may be reproduced in any way without the written consent of QB Asset Management Company, LLC.

Before the financial crisis metastasized in 2008, Fekete wrote a paper that I think is underappreciated and under-discussed. “Can We Have Inflation and Deflation at the Same Time?” In his paper, he discussed the “tectonic rift” between paper Federal Reserve Notes (i.e. dollar bills) and electronic deposits. By statute the Federal Reserve cannot print dollar bills without collateral (e.g. Treasury bonds). Also, they have limited printing press capacity that is insufficient to keep up with a catastrophic crisis.

He discussed the inverted pyramid of John Exter. Gold is the triangle at the bottom, and then above is silver, dollar bills, and then the various kinds of electronic deposits, stocks, real estate, etc. In a crisis, people want to move from top to bottom of the pyramid, but of course there isn’t enough of the stuff at the bottom.

In a scenario in which desperate, panicky people are trying to cope with the enormity of a collapse that they don’t and can’t understand, I think this split between “physical” dollars and “electronic” dollars is very plausible.

Just as there is nothing to be accomplished by selling an underlying security as it becomes worthless, only to buy a derivative of it, selling Treasury bonds and buying dollars is equally nonsensical. The dollar is the Federal Reserve’s liability, backed by the Treasury bond as the asset. If you believe the Treasury bond is worthless, then you ascribe no value to the dollar either. This is why gold will go into permanent backwardation. Holders of dollars will provide an unlimited bid for gold that will not be reciprocated by holders of gold. The latter own the only safe asset, and the only monetary asset that is not ultimately backed by the Treasury bond or the dollar, and they will have no desire to give it up.

The concept of backwardation is simple. It is when people accept a future promise to deliver only at a discount to physical stuff handed over right now. This could be when there is a shortage, such as wheat before the harvest. Or in the case of gold, backwardation signifies a collapse in trust. But isn’t this the same phenomenon of a tectonic rift between paper dollars and electronic deposits?

In a certain sense, the “money you can fold” behaves like a physical commodity, a present good (I realize I am stretching the concept here more than a bit). The electronic deposit credit is most definitely a future promise. In my gold backwardation thesis, the action begins with the offer on the futures contract falling below the bid on spot gold. The bid-ask spread on spot gold widens, as the offer is relentlessly advancing, pulling the bid behind it. The bid-ask spread on the futures contract also widens, as the offer remains stubbornly high, but the bid withdraws and retreats as gold buyers don’t trust futures and buy physical gold instead. Eventually, there are no more sellers of physical gold and that is that (except for the dollar-commodities-gold arbitrage, a backdoor way for dollar holders to get a little gold before the end of the game).

If this split occurs in the dollar, I think it will play out the same way. At first, sellers of real goods may accept electronic credit money, but demand a higher price. The spread on the electronic dollar widens, with the bid from real goods falling. At the same time, virtually unlimited demand for the “real” paper you can fold causes the bid on the paper dollar to rise.

Who knows how long it could last? People could go on accepting paper dollars out of long habit. Obviously, this is an unstable situation that must necessarily collapse. Unlike gold, the paper dollar has no value other than the broken promises that back it.

I dub this “dollar backwardation”.

Keith Weiner is the founder DiamondWare, a VoIP software company, and is a PhD student at Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities. He is also president of the Gold Standard Institute USA.

© 2012 by Keith Weiner

I cannot underestimate the importance of this paper. The reason I started the Daily Capitalist was to show how well Austrian theory explains economic events and to demonstrate its usefulness to investors and financiers. What Mark does is to clearly explain the concepts of Austrian economic theory and why it is one of the bases of his firm’s investment strategy.

Mark points out that the majority of investors see events such as the Crash of 2008 and the ensuing bust as black swans because they didn’t understand Austrian theory. Mark explains that this provides “tremendous opportunity” for investors. As he poignantly puts it, “To the relentless willingness by most investors (as witnessed through my career, and indeed for at least the past century) to repeatedly price in the almost certain success of inflationary credit expansion, I owe my past and future success in betting against them; that is, betting on their assumptions about what are rare events.”

— JH

What is a black swan event, or tail event, in the stock market?

✓ It depends on who’s asking.

✓ To those familiar with Austrian capital theory, the impending U.S. stock market plunge (of even well over 40%)—like pretty much all that came before in the past century—will certainly not be a Black Swan, nor even a tail event.

✓ Nonetheless, the black swan notion is paramount—in perception: Market participants’ failure to expect a perfectly expected event—that is, they price in only Anglo swans despite the Viennese bird lurking conspicuously in the weeds—much like what is happening today, brings tremendous opportunity.

I. On Induction: If it looks like a swan, swims like a swan, …

By now, everyone knows what a tail is. The concept has become rather ubiquitous, even to many for whom tails were considered inconsequential just over a few years ago. But do we really know one when we see one?

To review, a tail event—or, as it has come to be known, a black swan event—is an extreme event that happens with extreme infrequency (or, better yet, has never yet happened at all). The word “tail” refers to the outermost and relatively thin tail-like appendage of a frequency distribution (or probability density function). Stock market returns offer perhaps the best example:

Over the past century-plus there have clearly been sizeable annual losses (of let’s say 20% or more) in the aggregate U.S. stock market, and they have occurred with exceedingly low frequency (in fact only a couple of times). So, by definition, we should be able to call such extreme stock market losses “tail events.”

But can we say this, just because of their visible depiction in an unconditional historical return distribution? Here is a twist on the induction problem (a.k.a. the black swan problem): one of vantage point, which Bertrand Russell famously described exactly one-hundred years ago with his wonderful parable (of yet another bird) [1]:

The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken … The mere fact that something has happened a certain number of times causes animals and men to expect that it will happen again.

Bertrand Russell, The Problems of Philosophy (1912)

My friend and colleague Nassim Taleb incorporates Russell’s chicken parable as the “turkey problem” very nicely in his important book The Black Swan [2]. The other side of the coin, which Nassim also significantly points out, is that we tend to explain away black swans a posteriori,¹ and our task in this paper is to avoid both sides of that coin.

The common epistemological problem is failing to account for a tail until we see it. But the problem at hand is something of the reverse: We account for visible tails unconditionally, and thus fail to account for when such a tail is not even a tail at all. Sometimes, like from the chicken’s less “refined views as to the uniformity of nature,” what is unexpected to us was, in fact, to be expected.

II. Not Just Bad Luck: The Austrian Case

Perhaps more refined views would be useful to us, as well.

This notion of a “uniform nature” is reminiscent of the neoclassical general equilibrium concept of economics, a static conception of the world devoid of capital and entrepreneurial competition. As also with theories of market efficiency, there is a definite cachet and envy of science and mathematics within economics and finance. The profound failure of this approach—of neoclassical economics in general and Keynesianism in particular—should need no argument here. But perhaps this methodology is also the very source of perceiving stock market tails as just “bad luck.”

Despite the tremendous uncertainty in stock returns, they are most certainly not randomly-generated numbers. Tails would be tricky matters even if they were, as we know from the small sample bias, made worse by the very non- Gaussian distributions which replicate historical return distributions so well.² But stock markets are so much richer, grittier, and more complex than that.

The Austrian School of economics gave and still gives us the chief counterpoint to this naïve view. This is the school of economic thought so-named for the Austrians who first created its principles³, starting with Carl Menger in the late 19th century and most fully developed by Ludwig von Mises⁴ in the early 20^th century, whose students Friedrich von Hayek and Murray Rothbard continued to make great strides for the school.

To Mises, “What distinguishes the Austrian School and will lend it immortal fame is precisely the fact that it created a theory of economic action and not of economic equilibrium or non-action.” [5] The Austrian approach to the market process is just that: “The market is a process.” [4] Moreover, the epistemological and methodological foundations of the Austrians are based on a priori, logic-based postulates about this process.⁵ Economics loses its position as a positivist, experimental science, as “economic statistics is a method of economic history, and not a method from which theoretical insight can be won.” Economic is distinct from noneconomic action—“here there are no constant relationships between quantities.”⁶ [5]

This approach of course cannot necessarily provide for precise predictions, but rather gives us a universal logical structure with which to understand the market process. Inductive knowledge takes a back seat to deductive knowledge, where general principles lead to specific conclusions (as opposed to specific instances leading to general principles), which are logically ensured by the validity of the principles. What matters most is distinguishing systematic propensities in the entrepreneurial-competitive market process, a structure which would be difficult to impossible to discern by a statistician or historian.

To the Austrians, the process is decidedly non-random, but operates (though in a non-deterministic way, of course⁷) under the incentives of entrepreneurial⁸ “error-correction” in the economy.⁹ In a never ending series of steps, entrepreneurs homeostatically correct natural market “maladjustments” (as well as distinctly unnatural ones) back to what the Austrians call the evenly rotating economy (henceforth the ERE). This is the same idea as equilibrium, but, importantly, it is never considered reality, but rather merely an imaginary gedanken experiment through which we can understand the market process; it is actually a static point within the process itself, a state that we will never really see. Entrepreneurs continuously move the markets back to the ERE—though it never gets (or at least stays) there. Rothbard called the ERE “a static situation, outside of time,” and “the goal toward which the market moves. But the point at issue is that it is not observable, or real, as are actual market prices.”¹⁰ [7]

Moreover, “a firm earns entrepreneurial profits when its return is more than interest, suffers entrepreneurial losses when its return is less … there are no entrepreneurial profits or losses in the ERE.” So “there is always competitive pressure, then, driving toward a uniform rate of interest in the economy.” [7] Rents, as they are called, are driven by output prices¹¹ and are capitalized in the price of capital—enforcing a tendency toward a mere interest return on invested capital. We must keep in mind that capitalists purchase capital goods in exchange for expected future goods, “the capital goods for which he pays are way stations on the route to the final product—the consumers’ good.” [7] From initial investment to completion, production (including of higher order factors) requires time.

By about one hundred years ago, the Austrians gave us an a priori script for the process of boom and bust that would repeatedly follow from repeated inflationary credit expansions. Without this artificial credit, entrepreneurial profit and loss (“errors”) would remain a natural part of the process, except that, for the most part, they would naturally happen quite independently of one-another.

Central to the process is the “price of time” [7]: the interest rate market. This market conveys tremendous information to entrepreneurs due to the aggregate time preference (or the degree to which people prefer present versus future satisfaction) which determines it and is reflected in it.¹² Interest rates are indeed the coordinating mechanism for capital investment in factors of production.

Non-Austrian economists typically depict capital as homogeneous, as opposed to the Austrians’ temporally heterogeneous and complex view of the capital structure. We see this in the impact of interest rate changes. Low rates entice entrepreneurs to engage in otherwise insufficiently profitable longer production periods, as consumers’ lower time preference means they prefer to wait for later consumption in the future, and thus their additional savings are what move rates lower; high rates tell entrepreneurs that consumers want to consume more now, and the dearth of savings and accompanying higher rates make longer-term production projects unattractive and should be ignored in order to attend to the consumers’ current wants. The present value of marginal higher order (longer production) goods is disproportionately impacted by changes in their discount rates, as more of their present value is due to their value further in the future.

Variability in time preferences changes interest and capital formation. If lower time preference and higher savings and lower interest rates created higher valuations in earlier-stage capital (factors of production) which initiates a capital investment boom, this newfound excess profitability would be neutralized by lower demand for present consumption goods and lower valuations in that later-stage capital. (John Maynard Keynes’ favored paradox of thrift is completely wrong, as it ignores the effect on capital investment of increased savings, and resulting productivity—and ignores the destructiveness of inflation, as well.)

But there is an enormous difference between changes in aggregate time preference and central bank interest rate manipulation. Where this is all heading: The Austrian theory of capital and interest leads to the logical explication of the boom and bust cycle. To the logic of the Austrians, extreme stock market loss, or busts—correlated entrepreneurial errors, as we say—are not a feature of natural free markets. Rather, it is entirely a result of central bank intervention. When a central bank lowers interest rates, what essentially happens is a dislocation in the market’s ability to coordinate production. The lower rates make otherwise marginal capital (having marginal return on capital) suddenly profitable, resulting in net capital investment in higher-order capital goods, and persistent market maladjustments.

Despite the signals given off by the lower interest rates, the balance between consumption and savings hasn’t changed, and the result is an across-the-board expansion—rather than just capital goods at the expense of consumption goods. What the new owners of capital will find is that savings are unavailable later in the production process. These economic cross currents—more hunger for investment by entrepreneurs seizing perceived capital investment opportunities, and consumers not feeding that hunger with savings, but rather actually consuming more— creates a situation of extreme unsustainable malinvestment that ultimately must be liquidated.

The only way out of the misallocated, malinvestment of capital, is a buildup of actual resources (wealth) in the economy in order to support it. This could result from lower time preferences (but as we know compressed interest rates actually inhibit savings)—or of course by accumulated reinvested profits over time (but of course time will not be on the side of marginal malinvested capital earning economic losses).

Credit expansion raises capital investment in the short run, only to see the broad inevitable collapse of the capital structure. Eventually the economic profit from capital investment and the lengthening of the production structure are disrupted, as the low interest rates that made such otherwise unprofitable, longer term investment attractive disappear. As reality sets in, and as time preferences dominate the interest rates again (even central banks cannot keep asset valuations rising forever), projects become untenable and must be abandoned. Despite the illusory signs from the interest rate market, the economy cannot support all of the central bank-distorted capital structure, and the boom becomes visibly unsustainable.

“In short,” wrote Rothbard, “and this is a highly important point to grasp, the depression is the ‘recovery’ process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a ‘bust.’”[8]

Aggregate, correlated economic loss—the correlated entrepreneurial errors in the eyes of the Austrians—is not a random event, not bad luck, and not a tail. Rather, it is the result of distortions and imbalances in the aggregate capital structure which are untenable. When it comes to an end, by necessity, it does so ferociously due to the surprise by entrepreneurs across the economy as they discover that they have all committed investment errors. Rather than serving their homeostatic function of correcting market maladjustments back to the ERE, the market adjusts itself abruptly when they all liquidate.

What follows—to those who see only the “uniformity of nature”—is a dreaded tail event.

 III. The Stock Market as “Title to Capital”: Austrian Investing

In order for the Austrian School’s logical market process to help reframe an otherwise surprising negative event in the stock market, we need to somehow understand and track where we are in that process. Our limitations are underscored by a very important tenet of the Austrians themselves: controlled experiments simply aren’t possible in economics, and empirically isolating cause-and-effect is impossible. But perhaps, staying close to the principle of parsimony, the systemic distortions that we are seeking can still be rigorously and robustly recognized.

So if we want to distinguish periods of vulnerability to correlated entrepreneurial errors—the busts of the Austrian boom-bust cycle and the losses of the stock market, and thus recognize ex ante when such loss is no longer a tail event—we just need to recognize the periods of monetary credit expansion and resulting malinvestment. This isn’t necessarily all that easy, which the Austrians know well.

The natural approach should be to use the earlier gedanken tool of the fictional ERE and identify clear deviations from it. Recall the homeostatic entrepreneurial mechanism always at work which “smooths fluctuations and facilitates movement toward equilibrium,” [8] the aggregate entrepreneurial “goal” [7] of a mere interest return on invested capital. But we cannot observe an ERE, since it doesn’t even exist. Instead, we can observe what I’ll call the “aggregate ERE”—where “there are no entrepreneurial profits or losses” [7] in aggregate. In aggregate, it will look the same, and what it will tell us is functionally the same: What entrepreneurs (on aggregate) are doing and where they are heading.

We need a robust indication of when aggregate capital productivity, or aggregate return on invested capital—as capitalized in the price of capital—suddenly and persistently and inordinately exceeds or is below the cost of that capital: interest rates. As we know from the previous section, this is unique to a monetary credit expansion. Changing time preference won’t widen or narrow this spread from the noise of the ERE (recall that, in the case of higher savings, lower demand for consumption goods would ultimately offset higher demand and valuations in capital goods); innovations or productivity gains shouldn’t either (at least not very much, as “the sovereign consumer” [9] will ultimately steal those gains). Only central bank interventionism will accomplish this. All maladjustments, however, require an eventual return.

So a robust indicator of this spread will offer us information on where we stand in any central bank-induced boom- bust market process, or more specifically where entrepreneurs are most vulnerable to sudden and inevitable correlated errors.

Conveniently, as Rothbard noted, “the stock market is the market in the prices of titles to capital,”¹³ [8] and “at any point in time the capital value of a firm’s assets will be the appraised value of all the productive assets, including cash, land, capital goods, and finished products.” [7] As the expected productivity of capital is immediately capitalized in those title prices, and as the net tangible capital in place is part of a complex temporal capital structure with drawn- out production processes that adjust very slowly, how those aggregate prices of title to capital compare to the aggregate current net tangible replacement value of that capital in place must tell us something about the anticipation of aggregate profit. When the ratio is high, titles to the factors of production are being bid up by entrepreneurs as capital investments in higher-order goods grow and malinvestment accumulates; when the ratio is low, of course, the reverse is happening.

Conveniently, this ratio exists in the equity Q ratio¹⁴:

I have covered this measure in some detail (from a corporate finance as well as empirical standpoint) in a previous paper titled The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes (see link here) [10], so I’ll spare you the gory details. But it should be obvious that Q indicates in a very robust way the implied spread between aggregate return on invested capital and the aggregate cost of that capital.¹⁵

As discussed in the previous section, to the Austrians, stock prices are not just random fluctuations, and their losses are not random losses. In the above history of the Q ratio, there is visibly both an attractor at work in the ERE and a source of large perturbations in monetary policy. In each cycle, “businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption/investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful”[8] (i.e., the aggregate market for title to capital—much of which capital have returns which are suddenly below their costs—plummets.) High Q periods are periods of “wasteful malinvestment,” and “the adjustment process consists in rapid liquidation of the wasteful investments.” [8]

So what becomes of the tails when we condition on Q? Despite the Austrians’ warning that the path back to the ERE is inherently unpredictable, we should nonetheless expect to see regularities which reflect the extreme entrepreneurial vulnerabilities with higher Q:

Without a doubt (or at least with over 99% confidence¹⁶), bad things happen with increasing expectation when conditioning on higher Q ratios ex ante. That is, when Q is high, large stock market losses are no longer a tail event, but become an expected event.¹⁷

Basic corporate finance principles are enough to explain the entrepreneurial forces at work to drive the convergence (and empirical mean reversion) of the Q.¹⁸ But it is very difficult to rationalize the intermittent divergence without monetary arguments and the temporal complexities of the capital structure.

Clearly, time is required before “the end of inflation could reveal the widespread malinvestments in the economy, before the capital goods industries showed themselves to be overextended, etc.” [8] Again, the path back to the ERE—including the time it will take—will always involve uncertainties. But, again, there are regularities in this “stopping time” to liquidation:

Again I use the non-parametric bootstrap methodology of [13].

The question is not if, but when.¹⁹ And, in fact, though not surprisingly, the majority of the losses tend to happen in a rather concentrated plunge at the tail end of the path down to minus 20%; for instance, in just the last two months before the market passes through our 20% drawdown trigger, it typically (on average) has experienced a loss of nearly the entire 20%.

I see in these studies—in the deviations from the ERE, and in the violent shifting of capital back and forth into higher and lower stages of production with assumed changes in time preference, and with the surprising empirical regularities thereof—a tremendous century-long out-of-sample test²⁰ of the deductive a priori Austrian capital and interest theory; and we must certainly fail to reject the theory’s validity.

What would the assumption of the validity of these ideas and the reframing of tails have done for someone starting in 1913 (at the birth of the Federal Reserve) in the U.S.?²¹ There would have been moments of time when, with an understanding of the recovery process and the purging of distortions, aggressive investing would have been much easier to stomach.²² At other times, as the ticking time bomb is anticipated,²³ stepping aside during the entrepreneurial scramble for capital investment (though hopefully avoiding shorting that investment, a most hazardous act indeed²⁴) would have been perhaps somewhat easier—despite the frequent extreme opportunity cost (though longer term advantage) of doing so.

Austrian economics, with a little bit of data sprinkled in, makes the case clear: There haven’t been black swan events of significance in the aggregate U.S. stock market over the past century; more alarmingly—due to the evident monetary credit expansion today—we would be hard pressed to be surprised by severe stock market losses now.

Fortunately, most people (at least in the equity derivatives markets) disagree.

IV. Blackbirds Baked in the Pie

To me, this apparent intellectual nitpicking over the distinction between what is a tail and what isn’t a tail is rather important. In fact the black swan notion is paramount—in perception. If the market perceives (or rather prices) a large loss in the stock market as a tail event even when such perception (and pricing) is unwarranted, obviously tremendous opportunity exists—even if only to protect a portfolio against such deleterious losses.

One would think that the ubiquity of black swan consciousness (among the press and pundits, but presumably also among investors) would bring with it a heightened cost of “tail insurance.” Furthermore, aren’t Austrian economists overrunning the derivatives markets in a panic over their anticipation of sudden and rampant liquidations?

The answer is clear from the below chart of the S&P 500 variance swap market (a pretty good proxy for the price of tail hedging,²⁵ by duration of the tail hedge), both current and an arguably similar if not more benign environment five years ago:

Clearly, though inexplicably, there is little fear in the pricing of 1 to 3 month options,²⁶ which are cheaper than five years ago and even beyond.²⁷ (There is, however, great fear in the typically suboptimal long-dated protection space.²⁸)

But if the derivatives markets were showing much fear, wouldn’t this be perfectly inconsistent with the illusion of lowered aggregate time preference and thus greater attractiveness of longer-term capital investment in the first place? Monetary credit expansion is ultimately based on this fundamental illusion, and for the illusion to end—which would include an acceptance of most of the content of this paper by the marketplace—it would mean the recognition of accumulated malinvestment and its necessary liquidation. For the potential failure of the illusion to be perceived — including in the equity derivatives markets—as anything other than a black swan event would mean the collapse of the very illusion in the first place.²⁹

An extreme loss in the stock market is indeed priced in much (though not necessarily all) of the equity derivatives markets as an extreme tail. I cannot explain why this is—why a tail is still a tail—just as I cannot explain why the Austrian School remains (despite a century of evidence) the “somewhat reluctantly tolerated outsider.” [3] But, as the two are in fact one in the same, here too we should not be surprised.

V. The Eagle Has Landed

The epistemological problems of black swans and tails are significant; from the face of it, it is impossible to come close to predicting or even understanding the properties of the most severe and rare events by extrapolating what we have already seen. There is a fundamental illusion at the heart of this problem, a distributional illusion which can be shattered in an instant.

To me, “tail hedging” mainly addresses a very different (and even more severe) epistemological problem: the economic illusion created by monetary policy, which often takes long periods of time to wear off but, when it does, suddenly reveals the extreme entrepreneurial errors of malinvestment which lead to sudden rampant liquidation of capital.

This monetary illusion addresses the tail illusion, as disregarding the former in fact causes the latter.

Some may find this paradoxical coming from me: From my view, empirically and from an a priori Austrian interpretation, black swan events have been largely insignificant in at least the last century of capital investment in the U.S., including the current crisis.³⁰ Investors have indeed encountered surprising and pernicious events, but the fact is those who were surprised have essentially been those (in the extreme majority) with a brazen disregard for the central concepts of Austrian capital theory and monetary credit expansions; that is, capital goods and the time structure of production.

To the relentless willingness by most investors (as witnessed through my career, and indeed for at least the past century) to repeatedly price in the almost certain success of inflationary credit expansion, I owe my past and future success in betting against them; that is, betting on their assumptions about what are rare events.

Mises’ great insight was that the foundation of material civilization is the entrepreneurs’ patience in refraining from consuming a portion of their produced goods and returning it to the drawn-out production process. Only savings—that is, foregone consumption—creates capital goods and wealth. “Those saving—that is consuming less than their share of the goods produced—inaugurate progress toward general prosperity. The seed they have sown enriches not only themselves but also all other strata of society.” [14]

Don’t let Bernanke tell you otherwise. The Fed has in fact made this process much harder and much more treacherous, as we have seen, as capital structure profitability becomes highly illusory.

The great Austrian tradition and the market forces it elucidates in its a priori methodology for economic understanding provides an equally important, though unappreciated, methodology for investing.

It seems to me that “tail hedging”, as I’ve been practicing it for about 15 years now (and I dare not speak for any others who are so new to the game), could be called “central bank hedging”—or, better yet, “Austrian investing.”³¹

Indeed, this activity over my career likely would have been much less interesting without the insights of Dr. Mises and the actions of Drs. Greenspan and Bernanke.

Danke schön, meine Herren. Wir sind jetzt alle Österreicher.*
[*"... We are all Austrians now." — JH]

_________________________________________
Notes:

¹ Nassim’s healthy skepticism of data—both forward looking (extrapolation) as well as backward looking (hindsight bias)—is, to this author’s thinking, his greatest contribution.

² Measured tail magnitude and thickness tend to grow with sample size under many power law distributions, for instance.

³ Ironically, the country of its namesake is decidedly non-Austrian. According to Mises, “Those whom the world called ‘Austrian economists’ were, in the Austrian universities, somewhat reluctantly tolerated outsiders.” [3]

⁴ Most notably in his monumental tome Human Action [4]

⁵ Mises named this praxeology, or the deductive science of human action striving to meet its ends. [4]

⁶ Interestingly, despite this skepticism of inductivist methods, observation does play a role in praxeology; as Mises said, “Only experience makes it possible for us to know the particular conditions of action. Only experience can teach us that there are lions and microbes. And if we pursue definite plans, only experience can teach us how we must act vis-à-vis the external world in concrete situations”. [6]

⁷ Mises spends much time on probability, bifurcating the subject into what he calls “class probability” and “case probability” (similar to Frank Knight’s “risk” and “uncertainty” distinctions, respectively), assigning insurance or pooling risks to the former (“We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.”) and economic action to the latter (unrepeatable and lacking quantifiability). [4]

⁸ Mises calls entrepreneurs (and suggests the more specific term promoters) “those who are especially eager to profit from adjusting production to the expected changes in conditions, …, the pushing and promoting pioneers of economic improvement.” [4] I combine this function with that of capitalists (whom Mises defines as those who own and risk capital) in my use.

⁹ What Mises called catallactic competition [4]

¹⁰ But our analysis “cannot describe the path by which the economy approaches the final equilibrium position.” [7] (Later we’ll take a peek nonetheless.)

¹¹ As per Carl Menger’s theory of imputation.

¹² Time preferences are “psychologically determined by each person and must therefore be taken, in the final analysis, as data by economists.”

¹³ And of course “real estate is the other large market in titles to capital.” [8]

¹⁴ This is related to Tobin’s Q ratio of James Tobin [11], which is the ratio of aggregate enterprise value (equity plus debt) to the aggregate corporate assets or invested capital; I am using the equity Q ratio in this paper, which is just total equity over the net worth of the firm—where total assets are netted against total debt, so with no debt the net worth is the invested capital.

¹⁵ See [12].

¹⁶ This is the same study I showed in [10], and for more detail on the data and methodology—the distribution-free, non-parametric bootstrap methodology used in [13]—I refer the reader there.

¹⁷ In options speak, if a 20% down strike is a “50 delta” (that is, it has a 50% likelihood of expiring in-the-money), it is the at-the-money strike—certainly not a tail. (In fact what is happening is the whole distribution of returns is shifted downward, as well as increasingly skewed.)

¹⁸ Tobin’s presumption that Q would drive capital investment was backwards, as title to that capital drives the Q; Q levels have only a mild pull on the slow process of production goods accumulation, but Tobin’s understanding of the error correcting nature of the entrepreneur was correct.

¹⁹ The current age of upper quartile valuation for the U.S. stock market is just above the median of 30.

²⁰ Truly free of hindsight bias.

²¹ In Vienna in mid-1929, for instance, we know that Mises decline a position with Kreditanstalt, declaring, “A great crash is coming, and I don’t want my name in any way connected with it.”

²² Let us remember, this is not simply a doom and gloom approach. It is just as likely to be a tremendously opportunistic optimistic approach—specifically when malinvestment is being liquidated and the Q becomes lower. Capital is not destroyed, but rather title just changes hands at more advantageous prices to the buyer.

²³ And there is much noise around these median stopping time estimates

²⁴ The beauty of options

²⁵ In terms of put premiums, think of this as tracking the implied volatility of very roughly a 25 delta put.

²⁶ Where heightened valuations would be expected, for reasons of the ticking time bomb of Figure 4, among others

²⁷ Clearly, one needn’t agree with the Austrians in order for tail insurance to make sense. This is especially the case at this pricing. As the previous section makes clear, the prices of titles to capital tend to climb with monetary credit expansions, until they don’t. Many see tail hedging as a way to remain long, perhaps even in a levered way, despite otherwise unacceptable uncertainties.

²⁸ If there is a blatant trade idea in this paper, it might just be to sell five year variance (or better yet a five year butterfly).

²⁹ This consistency in pricing explains the tendency for premiums in the options markets to generally diminish with rising Q ratios. The Austrian case simply does not get “baked in the cake,” at least not before it is imminently obvious and too late. The Krugman/neo-classical case (for monetary credit expansion), despite a perfect record of failure, apparently does.

³⁰ Of course this does not mean that catastrophic, free market capitalism-destroying events—either manmade or not—couldn’t have happened (and the manmade variety has historically been entirely related to the interventionism explored in this paper). We are dealing with the realm of entrepreneurial action within a competitive economic system and the monetary distortions which affect it. But note that during the one-hundred-plus years of this study there was much devastating unprecedented world conflict, which managed to still be subsumed by Austrian praxeological principles.

³¹ I have yet to have read about aggregate equity valuations vis-à-vis aggregate corporate net worth as the telltale sign of the Austrian business cycle at work, as well as an indication of location in that process, and I hope it becomes an investing offshoot of this great tradition.

______________________________________
Appendix: References

[1] Russell, Bertrand, The Problems of Philosophy (1912). [2] Taleb, Nassim, The Black Swan (2007).

[3] Greaves, Bettina Bien, Austrian Economics: An Anthology (1996).

[4] Mises, Ludwig von, Human Action (1949).

[5] Mises, Ludwig von, Notes and Recollections / Memoirs (1978).

[6] Mises, Ludwig von, Epistemological Problems of Economics (1933).

[7] Rothbard, Murray, Man, Economy, and State (1962).

[8] Rothbard, Murray, America’s Great Depression (1963).

[9] Mises, Ludwig von, The Anti-Capitalistic Mentality, Freeman (1956).

[10] Spitznagel, Mark, “The Dao of Corporate Finance, Q Ratios, and Stock Market Crashes” (2011).

[11] Tobin, J., “A General Equilibrium Approach to Monetary Theory”, Journal of Money Credit and Banking, 1, 15–29, (1969).

[12] Koller, T., M. Goedhart, D. Wessels, and McKinsey & Company, Valuation: Measuring and Managing the Value of Companies, 5th ed. (2010).

[13] Pandey, M.D., P.H.A.J.M. Van Gelder, and J.K. Vrijling, “Bootstrap simulations for evaluating the uncertainty associated with peaks-over-threshold estimates of extreme wind velocity”, Environmetrics, 27-43 (2003).

[14] Mises, Ludwig von, The Freeman (1963).

This document is not intended to be investment advice, and does not offer to provide investment advice or sell or solicit any offer to buy securities. Universa does not give any advice or make any representations through this document as to whether any security or investment is suitable to you or will be profitable. The discussion contained herein reflects Universa’s opinion only. Universa believes that the information on which this document is based is reliable, but Universa does not guarantee its accuracy. Universa is under no obligation to correct or update this document.

Neither Universa nor any of its partners, officers, employees or agents will be liable or responsible for any loss or damage that you may incur from any cause relating to your use of these materials, whether or not the circumstances giving rise to such cause may have been within Universa’s or any other such person’s control. In no event will Universa or any other person be liable to you for any direct, special, indirect, consequential, incidental damages or any other damages of any kind even if such person understands that these damages might occur.

© 2012 Universa Investments L.P. (all rights reserved)

With all the fiat money pumped into the U.S. economy (plus “liquidity” made available to the European Central Bank) by the Fed, one would think that we would be having high price inflation. Instead we are seeing declining prices. I suspect that one could debate the issue of whether or not the various official indices are low-balling the numbers, but that’s just another way to avoid explaining and understanding the issue.

The price data that came out of the Bureau of Labor Statistics last week certainly seemed to show that “inflation” is at best subdued. If you don’t trust those numbers look at MIT’s Billion Price Project for corroborating results. 

Here is the official BLS CPI calculation:

There was no increase from month-to-month, and the year-over-year was +2.3%. One would think this is a good thing, and in many respects the fact that prices are declining sounds good to me as a consumer. But … is it? Before I answer that question, look at the producer price index for all types of goods were negative, but the most significant tell-tale was the index for crude goods (commodities) was -4.4% MoM (-7.3% YoY):

The prices of goods are declining because the materials they are made of are declining. That usually means that worldwide demand for crude goods has declined which usually means that either recessions or economic flattening is occurring worldwide. And that is the case.

Also real earnings continue to decline or flatten (in April):

All-in-all I think most economists and analysts expected to see low price inflation, so it is not a surprise. And they think in one sense that’s a good thing because they believe that the Fed will print money, revive the economy, and then everything will be fine again. They know that the inflation hawks on the Fed Board will try to block more money printing if price inflation is heating up. But with the economy flattening-to-declining, and with low price inflation, they hope this will encourage the Fed to turn loose the money spigots again.  

The Fed looks at it similarly except they have one more big concern. Declining prices. In their eyes this equals deflation and they think that is bad. Which, again, is also incorrect. I mean if your wages are dropping, but the prices of goods are dropping, that should be OK. It maybe bad for debtors because it takes more dollars to pay back debt. It depends on whose debt we are talking about. The Fed confuses inflation and deflation with supply-demand phenomenon which increase or decreases prices of goods and services. What inflation and deflation actually is, is an increase or decrease in money supply.

Most consumer debt is the detritus of the boom-bust cycle that we are still in. Consumers are shedding debt, but the debt levels are still high relative to historical trends. They engaged in “malinvestment” by leveraging up debt on their homes to support their lifestyles during the boom years. Those overvalued homes are still sinking in value, so with declining prices (“deflation”), mortgage debt and home equity loans will be more difficult to pay, which will lead to more bankruptcies. It is something that cannot be avoided.

We all know who the biggest debtor in the world is. The Fed is very concerned about the impact of deflation on our sovereign debt.  Declining prices and declining incomes means less revenue for the US government, which make the debt burden on U.S. sovereign debt (about $15.7 trillion) more expensive (interest cost is about $500 billion currently). So, in their logic, if we print more money today and create inflation, not only will it revive the economy, but it will make the world’s biggest debtor happy because it can pay debt costs in cheap(er) dollars.

They will ignore the fact that two rounds of money printing (quantitative easing), zero interest rate policy (ZIRP), and various Twists and turns, haven’t worked yet. But it’s the only thing they know how to do. 

Eventually the Fed could get it “right.” That is, according to their flawed economic theories, at some point they could print enough money to create high (>4%) YoY price inflation. Of course, in reality that is entirely wrong. Whether that will happen with the next round of QE is difficult to judge. What they fail to appreciate is that there is significant weakness in “real savings.” It is real savings that create growth, not fiat paper. That is, real wealth saved from the profits of organic growth rather than just so-called profits in the form of new fiat dollars. 

That lack of real savings is what is dragging the economy down, a phenomenon very reminiscent of Japan’s experience over the past 20 years or so. Each round of QE will be weaker than the last one because QE actually destroys real capital required for growth. When that next round of money printing fails, what will happen next as the economy stagnates and shrinks? 

My bet will be in favor of more money printing. It’s the thing that central banks and governments know how to do best.

Hat tip to Carl (UPDATE: and to Zero Hedge since they appear to already have this up).

“Working at my desk today was somewhat surreal. Global risk markets were closing out a dreadful week. Newswires were full of disconcerting articles – J.P. Morgan, Greece, Spain, Italy, China, etc. Meanwhile, CNBC was in the midst of blanket coverage of the Facebook initial public offering. Mark Zuckerberg rang the bell to open NASDAQ trading, while helicopters provided live video of the employee gathering at Facebook’s Menlo Park headquarters. Insiders are now worth billions, the “average” employee millions. Even U2’s Bono pocketed $1.2bn (with a “B”). I noted above how I see J.P. Morgan’s predicament as a microcosm of global financial woes. Well, it is difficult for me today not to see Facebook as emblematic of the incredible transfer of wealth associated with Credit Bubbles. It’s almost as if this historic Bubble has been waiting to end with just such an exclamation point.”

— From “The Jig is Up‟, by Doug Noland.

Like us, you may have missed Robert Wilmers’ blistering assault on Wall Street when it was first published. Happily, the Internet occasionally offers up a diamond amongst the garbage. The full letter to shareholders of M&T Bank can be read here. It is a must-read. (The really good stuff starts on page xi.) Nor is Mr. Wilmers some swivel-eyed Occupy Wall Street beatnik. He is the chairman and chief executive officer of the US commercial bank in question. His shareholders’ letter may be just one straw spinning within the eddies of a tempest, but it encapsulates a morsel of hope amidst a morass of inanity, greed and vile corporate behaviour. Credit to Business Insider for bringing it to a wider audience.

At the risk of driving a coach and horses through “fair use‟ limitations in Anglo-Saxon law, here are some of the choicer nuggets contained within Mr. Wilmers’ polemic:

As relatively good a year 2011 was for M&T itself, it was far from an easy one. Indeed, it is difficult, for one who has spent more than a generation in the field, to recall a time when banking as a profession has been publicly held in such persistently low esteem. A 2011 Gallup survey found that only a quarter of the American public expressed confidence in the integrity of bankers. We have reached a point at which not only do public demonstrations specifically target the financial industry but when a leading national newspaper would opine that regulation which might lower bank profits would be “a boon to the broader economy.” What’s worse is that such a view is far from entirely illogical, even if it fails to distinguish between Wall Street banks who, in my view, were central to the financial crisis and continue to distort our economy, and Main Street banks who were often victims of the crisis and are eager, under the right conditions, to extend credit to businesses that need it.

It is no consolation, moreover, to observe that banks and the financial services industry generally were far from alone in sparking the crisis. Nonetheless, it is true, and very much worth keeping in mind, that major institutions in other sectors of the American system – public and private – must be considered complicit, some in ways we are only beginning to learn fully about. As understandable as a search for particular causes, or villains, might be, the truth is that the economic crisis that began in the fall of 2007 implicated a wide range of institutions – not only bankers but their regulators, not only investors but those paid to advise them, not only private finance but its government-sponsored kin. The wide spectrum of the culpable has left the U.S. and the world with a problem which, although related to the financial crisis, transcends it and must be confronted: the decimation of public trust in once-respected institutions and their leaders. This has created a fear among those responsible for forming the rules and standards that shape the American financial services industry. And the outcome of this fear-driven rulemaking is likely to burden the efficiency of the American financial system for years to come and will potentially have broader implications for the overall economy.

… So it is that the crisis was orchestrated by so many who should have, instead, been sounding the alarm – not only bankers but also regulators, rating firms, government agencies, private enterprises and investors. That a former U.S. Senator, Governor and CEO of a big six financial institution was at the helm of MF Global on the eve of its demise due to trading losses, or that the largest-ever Ponzi scheme was run by the former chairman of a major stock exchange will long be remembered by the public. The repercussions have stretched beyond banking, creating an atmosphere of fear affecting and inhibiting those who should be leading us toward a better post- crisis economy.

Bravo, Mr. Wilmers. Bravo.

Wading into The Financial Times on an almost daily basis increasingly feels like working for a bomb disposal unit. One dreads to think of what unexploded “intellectual‟ ordinance one will discover. The weekend edition does not disappoint in this grim respect. With a strange mixture of horror and fascination we stumbled upon the “thoughts‟ of one Ed Miliband who, nicely displaying the infantilized tenor of our times, was granted a forum to share his “thinking‟ on economics …

The divide in politics now,

writes Mr. Ed,

is between those who think the lesson of the past two years is to offer more of the same and those of us who know now is the time for a different course. It is a divide between those who face the global economic storm having run out of ideas and those with a plan for putting right what has gone so disastrously wrong.

With what one can only describe as the intellectual equivalent of a million pots calling a million kettles black, Mr. Ed suggests that

[Prime Minister] David Cameron’s response to every downturn is to lecture the euro zone and to argue that nothing is his fault.

Mr. Ed calls for firm, coordinated action. Action, he repeats, is long overdue. Germany, for example, must support demand. Mr. Ed demands that Germany supports demand. He demands demand, and he supports it, too. And yes, uncertainty around the world’s banks should be resolved. Action! Demand! Support! Certainty!

It is very easy to call for grand, magical, all-resolving action when one is in opposition. That is almost what being in opposition is all about – windily opining about things about which one has very little understanding, and almost no power to influence. A bit like being an economics commentator at The Financial Times. I recall a definition of fascism I encountered whilst at school (in a history book, as opposed to the more general experience of being at the school in question, albeit it was an independent school):

“Fascism, n. A supreme belief in the superiority of action over thought.”

If I were even remotely associated with the Labour party, an entity which whilst in office oversaw government spending rising from 37% to 52% of gross national product, and which left the incoming coalition to deal with the largest level of peacetime indebtedness in our country’s history, I would not dare raise my head above the economic parapet for fear of having it shot off, by any number of forcibly embezzled taxpayers, pensioners, investors or savers.

Our mid-year resolution is to try and find, each week, a glimmer of positivity amid the slow- motion train crash that is the modern western economy. Speaking at Money Week’s second annual seminar on Friday, we focused on the investment opportunity and portfolio diversifier that is the systematic trend-following fund. Asked by the audience for a recommendation to navigate through the next 12 months (admittedly something of an artificial construct given the constrained time horizon) we plumped for Blue Crest’s recently listed BlueTrend fund. So we were intrigued to note the coincidence of the FT’s David Stevenson (Adventurous Investor), who in the weekend edition admitted to having recently bought precisely the same fund. Well, he actually mentions a fund called BlueLine, which doesn’t appear to exist. But as the likes of Mr. Ed and his blithering cabal of incompetents prove in spades on a daily basis, nobody’s perfect.

Tim Price is Director of Investment, PFP Wealth Management, London.