The Hong Kong based financial commentator Mark Faber, as reported by the Economist, believes that high commodity prices cause wars; by funding unattractive rent-seeking governments and starving more productive economies of resources. Since it’s clear that low interest rates have in the present cycle been a major cause of high commodity prices, it’s worth adding this to the lengthy catalogue of costs caused to the world economy by excessively cheap money.
Cheap money is popularly supposed be an unalloyed good thing, allowing people to borrow money for home mortgages more easily, encouraging business expansion and giving Third World countries access to capital they would otherwise be denied. Like many popular superstitions, this one is largely the opposite of the truth.
In moderation, liquidity is essential to the functioning of an economy. Without it, companies very quickly get into difficulties, as trade credit dries up, while investment projects are unable to be financed. Nevertheless, in a modern economy a little liquidity goes a long way. An economy in which real interest rates are high is perfectly well able to grow, as was demonstrated by Japan in the 1960s and the United States in the 1980s. In such an environment asset values remain low, and savings rates remain high. Since Professor James Tobin’s Q ratio of market value to replacement cost is well below 1 for most companies, investments are undertaken only after great study, and must justify themselves from the income they operationally generate, as newly built assets can only be sold at a loss. Typically, companies are built through acquisition by operating companies, as managers seek other operations whose market value is far below replacement cost, and whose operations fit with those of the acquiring company. Thus new assets are built only sparingly and existing assets are used intensively, being redeployed when their economic usefulness has declined.
Those under 35 will barely recognize the possibility of such a world, but it is the one we all lived in until about 1985, or maybe a little earlier in Japan, with the exception of short periods in the late 1920s and the late 1960s when stock markets got ahead of themselves. Periods of speculation were short-lived and all investors were predominantly “value” investors. Aficionados of the last-decade’s hyper-valued markets will scoff, but productivity growth during this period was as high as today, indeed somewhat higher.
This has all changed. From 1996-2000 it appeared that we had simply entered another speculative stock market bubble, similar to those of the late 1920s or the late 1960s, albeit one that was of enormous size and reached valuations unthought-of in the earlier periods.
However, when the stock market bubble burst in 2000 it didn’t wholly deflate. Instead, interest rates remained far below normal historical levels and, we know now, were driven down still further by a Federal Reserve that was operating off false inflation data. After 2000, the bubble that had before that date been largely concentrated in the United States, the stock market and the tech sector became through the magic of globalization spread throughout the world, with borrowing rates for even the dodgier emerging markets falling to unprecedentedly low levels and real estate prices soaring worldwide.
The period of cheap money instituted by the Fed’s monetary slackness from 1995 and intensified by its misguided policy after 2001, has been longer and more developed than any previous such period, far more so than the credit booms of the late 1920s and the late 1960s. Consequently, it has produced a number of new pathologies, many of which have disturbing ethical or even moral implications.
- Increase in money management costs. New forms of pooled investment have arisen in hedge funds and private equity funds. These are particularly noted for the munificent scale of their management fees. When the figures are properly corrected for survivor bias, there is no evidence that these forms of investment produce higher returns than conventional equity funds, and they very often assume much higher levels of risk through leverage (hedge funds) or illiquidity (private equity funds). Hedge funds’ claim to provide a hedge against stock market downturns was partly valid in their early years, but has become less so as their volume has come to exceed readily available investment opportunities. Private equity funds never reasonably had such a claim – they depend crucially on take-out of their investments through Initial Public Offerings, and so are highly vulnerable to stock market downturns.
Just as the investment trusts of the late 1920s turned out to be often scams and almost universally poor investments, so too these funds, managed for the short term rewards they can earn their top executives, are almost certain to prove inferior in the long run to conventional funds. Countless studies have shown that it is very rare to earn returns consistently higher than the broad stock market, and that investors should concentrate first on reducing the fees they pay to those managing their investments. These funds violate both those tenets and are thus grossly inappropriate investments for third-party-managed investment pools such as pension funds and 401(k) plans. Pension fund trustees putting money into these “alternative investment classes” can expect to get their asses sued in the next downturn and quite right too.
Rewarding risk-takers and crooks. Cheap money does not only reward entrepreneurs, it also rewards risk takers and crooks. Because money is readily available, investors are continually seeking new investment opportunities, hence are less careful than they should be about matters of stewardship and corporate governance. Accounting standards are driven steadily downwards, as the worst accounting chicanery suffers little or no market penalty. Inevitably, lowlifes prosper in such an environment.
Excessive leverage and inadequate saving. Because money’s cheap, people borrow too much of it, maxing out their credit cards and buying houses with interest-only mortgages and no down payment. Naturally, a high proportion of these people get into trouble. The credit card industry, worried about personal bankruptcies, pushed through a tougher bankruptcy law in 2005. Nothing however seems to prevent the industry from forcing more and more people into the rigors of the new bankruptcy law by an ever-increasing flood of card offers. Savings meanwhile have dropped to an all-time low, but why should you save when your assets are going up in value and your returns on saving are often negative after inflation and tax are taken into account? This generation is in for a penurious old age, and low interest rates will have been the cause.
Short termism and inflated expectations. In a period of loose money, everybody knows people who’ve made a fortune through stock speculation, options manipulation or real estate juggling. The human mind being what it is, observers assume that if the neighbor, not obviously smarter than they, can make a fast fortune, so can they. Consequently get-rich-quick schemes proliferate, with consequent damage to long term investment and hard work. Haloid Corporation took over a decade to perfect xerography in the 1950s; these days everyone assumes that the natural path is that of Google or YouTube, from college student to billionaire in less time than it takes for a PhD.
Rewards to profligately run countries. Such countries, regardless of their mismanagement, are able to borrow from the plentiful supplies of international finance and don’t have to rein in spending. The most startling example of this was Argentina, which was able to borrow 20 year money throughout the late 1990s when it was already in deep trouble, then defaulted on its debt and resumed borrowing from international investors within 6 months of its default being finalized. The ready return of Argentina to international debt markets is a moral hazard creator we haven’t seen before; previously at least half a decade had to elapse between repudiation and forgiveness. It makes bond investment in Third World countries even riskier than it used to be. Such countries not only can default, contrary to 1970s Citibank Chairman Walter Wriston’s dictum, but without market sanctions in place most of them almost certainly will.
Epidemic of rent seeking. Internationally, in countries benefiting from high commodity prices, and in business and finance, on trading desks and among corporate management, cheap money produces rent-seeking, the devising of methods to achieve financial gain through one’s position, without providing commensurate goods and services in return. Almost the whole of the derivatives market is an example of this, although every now and then derivatives rent seeking goes wrong and losses result, enjoyably to outsiders.
Whether it’s Venezuela’s Hugo Chavez using oil revenues to destabilize Latin America or Goldman Sachs using Chinese bank Initial Public Offerings to make unjustified investment gains and pay its partners inordinate Christmas bonuses, rent seekers are able to use periods of cheap money and accompanying sloppy standards to extract wealth from the less fortunate. Yet again, the productive are disadvantaged in favor of the lucky.
- War. Finally, as the Economist pointed out, since cheap money by increasing commodity prices rewards bad governments and makes assets and resources more valuable, it inevitably leads to a greater likelihood of crime domestically and armed conflict internationally.
Truly Fed Chairmen Alan Greenspan and Ben Bernanke have a lot to answer for. You may not think you’re longing for the return of tight money, but trust me, taking cheap money’s effects overall, you should be.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)