For what, you might ask?   For the mess the current financial system is in, and the wealth destruction that has ensued.

Well, in fact, we all are to blame in some interconnected way, but it is clear to me that actions taken by the Fed a decade ago have been the prime determinant for the path we are on.  They never should have cut rates to such low levels and allowed them to stay there for so long.  They never should have indicated stability in rates and “measured” changes.  They never should have reached for quantitive easing.

Low rates have led to misallocation of capital on a scale never before seen.  This has “forced” savers to reach for yield and make poor investments.  This has allowed people and peoples to borrow money hand-over-fist and spend it unwisely.  There is a fantastic quote from Michael Lewis’ article in Vanity Fair:

When you borrow a lot of money to create a false prosperity, you import the future into the present. It isn’t the actual future so much as some grotesque silicon version of it. Leverage buys you a glimpse of a prosperity you haven’t really earned.

Leverage buys you a glimpse of a prosperity you haven’t really earned.  This encapsulates the problem we have.  A decade of easy money not only allowed people to become over-leveraged but also gave politicians the tools to go out and make promises that can’t be met; whether they are in Greece, California, or my local town school system.  A bailout will only kick the can down the road for someone else to face.  Borrowing more to solve a debt problem is not a solution that can work for the long term, as the debt is not borrowed to supercharge growth.  We are now entering the Decade of Defaults as it becomes clear that there is no other solution.

Why are the authorities so wary of defaults?  Because it will wreck the banks, pension funds, insurance companies that own this debt and want to treat it as money good.  I suspect it would have been better to take the losses and re-cap the banks and start to explain to people that their pensions and other “entitlements” are not entitlements rather than continue the charade.  Politicians do not have the stomach for this – they, like investors, are increasingly myopic.

I am in a small minority, and it is increasingly clear that banks, politicians and regulators have interests that are mis-aligned to what is best for the rest of society – they will continue on with their make-believe asset valuations and hold onto power beyond any reasonable expectation.

Ultimately, there will be a reconciliation and such a reconciliation will be political as much (or more so) than economic.  Political reconciliation can sometime be peaceful and through the system, but often than not it is neither.  Don’t blame me when it happens, blame the Fed.

Postscript: The ECB is just as bad, given their capitulation this weekend.

On Change: Everything is in flux.  Everything is a “fad”.  Nothing is constant.  Change comes, so accept it and embrace it.

On Capitalism: Capitalism is about efficient allocation of capital.  Regulations that get in the way distort capitalism and lead to inefficient allocations, often to the financial supporters of government.

On Social Democracy: You cannot borrow and tax your way into growth.  Pushing public debts onto Sovereign balance sheets for good reasons, ends up staying there for bad reasons.  Sovereign defaults is the expected outcome as politicians avoid hard solutions.

On Bureaucracy: The Fed has 20,000 employees.  20,000!

On American Democracy: Taxpayers want small government, as they pay for it.  Non-taxpayers want large government programs.  Only time will tell who will win out in the “grand experiment” of American democracy.

On Contrarian Investing: To make money you want to be where others are not or fear to be.  Be illiquid when others are not, own loss making ventures when others want dividends, be contrarian.

On China: China’s growth is amazing.  If only their government was driven to generate economic growth.  It is not, it is driven to stay in power and growth gets them there, for the time being.

On The Next Big Thing: China’s growth saved the world economy post the dot-com bubble.  Who/what will save us when the China ceases to?

On Investing Long-Term: There are two ways to invest; one involves constantly picking the right asset, and moving to the next one as soon as the money has been made in the first.  It is frenetic and involves thousand of investment decisions in a short period of time.  Another one is boring and patient and simply requires investments that fit a longer time-frame.

On Investment Horizon: In the investing game, time is your friend.  Invest so that your wealth can compound at the highest rates over the cycle, and remember that the gains in the out years are where the money is really made.

I came across the following charts and had to share them. They are the work of Barry Eichengreen and Kevin O’Rourke, and was published at voxEU.org on June 4th.

I suggest that you read their post and view their graphs in a quiet room and give yourself time to take them in.  They set the current discussion of “green shoots” in perspective and show that how bad things might seem today they can get worse. It is also worth noting that the first 50% correction of world stock markets took 27 months from the peak in 1929, whereas we achieved that in 10 months.  We are on the same path, but we are “smarter” now.  I hope.

There is a debate raging amongst economists and market participants about whether the US is about to suffer inflation or deflation.  It is an area of great discussion and there is no clear consensus.  I think that, as with most areas of this dismal science, people are too short term focused here to see clearly what is going on.  We will get both.

My first problem is that when people address the subject they are generally talking about price levels reflected in changes to the Consumer Price Index (CPI).  The CPI is flawed, however, as a measure of price levels.  It does not measure inflation that real people suffer in part because it is an average of an average and in part because it is manipulated down (by reasonable adjustments) so that government payments that are indexed to it are lower than they would be else wise.   CPI will, therefore, tend to underestimate inflation and overestimate deflation.

To get a better understanding of the inflationary and deflationary pressures we are facing I think that we have to look at the drivers of price levels and see what thematic forces are at work here.  Deflation and inflation are the results of larger thematic forces at work.  As a long-term investor in private equity I have to be thematically driven, but I think that it also gives you a good framework for understanding shorter term phenomena.

The themes that I think are most relevant here are Moore’s Law, democracy/capitalism, and globalization:

• Moore’s Law for processors (and its sister Nielsen’s Law of Internet Bandwidth) point to us being able to do more for less resources, be it processing or communicating.  This is pushing communication costs to/near zero and allowing new disruptive business models to be built at ever lower costs.  If I have a business that sells or services widgets for $10, and someone comes along with a new service at $5, it it at its core deflationary.  Moore’s Law is a massive deflation driver, especially for businesses that involve end-to-end communication and can be disrupted by moving from analogue to digital foundations; think newspapers, music, finance, education, etc.
• Democracy and capitalism go hand in hand in many places in the world today.  It is possible to have capitalism without democracy (such as in China or Saudi Arabia), but I cannot think of an example where we have democracy without capitalism.  They are powerful interlinked forces and they are forces where the driver for change is decentralized to the people and not centrally controlled and conceived.  The result is that the best ideas can percolate to the top and they facilitate the adoption of new idea, disruptive ways of doing things and, like Moore’s Law, are inherently a deflationary enabler.
• Globalization is both deflationary and inflationary.  Simply put the Indian outsource model is a huge arbitrage of wages in the West vs. wages in India.  It keeps a lid on wage inflation as there is someone the other side of the world able and willing to do the same job for less.  Today I can hire a programmer in the US for $5,000 -$10,000 a month here or $1,000 a month in India.  Moore’s law has reduced the cost and technology barriers, democracy and capitalism has facilitated the formation of such industries in India and the reduced political and tariff barriers from globalization makes this all possible.  Thus for the West globalization is deflationary – we make these goods in China because the end result is cheaper goods.  For China, India and the service centers and factories of the wold it is inflationary, especially for wages.  I would say that this is a good thing; rising wages in developing nations has a trickle down effect for their economy, raising living standards, raising availability of health care and lifting people out of abject poverty.

There is another theme here that combines all three (and other) themes; rising expectations in the developing economies.  Though America receives a bad press around the world, everyone wants to live like an American.  Everyone would love to consume as an American; drive a car, live in a big house, be rich.  Now I know that is not how many live here, but the American Dream is the World’s Dream.  The problem is that it is not possible, not in the short term, and even if we approach it it will seem to be more of a nightmare than a dream.  The world is resource constrained.

The speed of the growth of expectations and realization of those expectations in the developing economy is unprecedented in world history.  Never before have so many people been lifted from utter poverty to mild poverty, mild poverty to working class, working class to middle class.  This is amazing, it is magnificent and it has significant repercussions.  Some of these are good and some are not.  I remember reading in 2006 that the number of obese people in the world now exceed the number malnourished.  Forbes in 2007 published a table with 88 countries that have over 50% of their population with a BMI over 25.   There is not enough basis materials and resources available to meet the expectations of the newly enabled people from the developing world.  Advances in technology will ultimately bring us new and novel solutions, but in the short term these demands will lead to shortages that are resolved through price.  Commodity prices are going higher, agricultural product prices are going higher.  This demand driven inflation is required to lower demand.  It is basic economics.

Thus my expectation is that we see commodity based inflation combined with services and manufacturing based deflation.  I expect both.  We can expect a relative wealth transfer from the West to emerging economies, especially those that have an abundance of resources or cheap labor.  The recent economic crisis has only exacerbated the deflation aspects here as the cheap money led to a build up of excess manufacturing capacity, and a desire to increase productivity in the downturn that will reduce the need for labor going forward.  It also has led to a fall in commodity prices that I expect will prove to be temporary.  The end game is that the globalization arbitrage will continue, that living standards will move closer between emerging and developed economies, but that they will meet more in the middle than either expects.

Shanghai Rising

I see this a a natural outcome of policies and processes that are in place, have momentum and are tough to dislodge.  This is not all bad for those in developed economies.  There will be an unprecedented increase in the ranks of the middle classes globally, and this will stimulate massive new markets that can be addressed with new products that will benefit all of mankind.  For example there will be more people willing to pay for drugs and therapies for diseases that today are too “rare” to have research funded.  This will not just be limited to healthcare but extend to investment in consumer products, entertainment, and all aspects of life.  There will be change and disruption, but overall we will all benefit from this brave new world.