The greatest book that I have read so far is Economics in One Lesson
by Henry Hazlitt (published 1946). It was written to expose the popular fallacies in economics and the lessons are as applicable today as they were over 60 years ago.
I received a direct message on Twitter asking if I could explain what causes bubbles. Taking cue from Hazlitt, I said that I could do that in less than a dozen Tweets.
In this post I have reproduced the same (with a few edits to increase readability).
- Bubble Tip: There is no boom-bust theory in Micro Economics - ergo free markets are stable. The destabilization factor must come from... outside.
- Bubble Tip: Look for the fuel for speculation... check if real inflation adjusted interest rates are negative!
- Bubble Tip: The fuel for speculation comes when the Central Bank prints "mickey mouse" money out of thin air. [Hint: Printing = Quantitative Easing].
- Bubble Tip: "Mickey mouse" money has to go somewhere... and it fuels a speculative bubble where it does. First movers have an advantage.
- Bubble Tip: With the aid of leverages asset prices can be inflated beyond the wildest imagination. [Hint: Japan in the 80's].
- Bubble Tip: Monetary injections are like a steroid. It turbo-charges activity in interest rate sensitive sectors. [Hint: Nasdaq & Housing].
- Bubble Tip: Look if externally created incentives provide support for the bubble i.e. government policy. [Hint: Freddie & Fannie, The Community Reinvestment Act, Tax beaks on Capital Gains].
- Bubble Tip: Finally look for other tell tale signs - poor economic data, inflation, health of banks, inflation, mania, valuations...
- Bubble Tip: The music has to stop. It will when interest rates start to rise to pre-boom levels. Once it does the bubbles pop.
Believe I managed to explain the anatomy of bubbles in less than a dozen tweets. Credits go to Austrian School Economics – notably the work of Ludwig von Mises, Friedrich Hayek, and Murray Rothbard.
Yesterday I was out at a party when I caught with a friend who is a Wealth Manager at a leading multinational bank. At first the conversation meandered around how things were shaping up work and at home, India's prospects in the Olympics, and the general state of the weather... before finally moving to the topic that more often than not shows up when grown-ups have conversations i.e. investments.
I remarked that I was bullish on gold and bearish on just about everything else - including stocks, bonds, debt and real-estate and am looking to systematically accumulating gold with a longer term horizon (of roughly 5 to 10 years) in mind.
However, my friend tended to disagree with this investment strategy. "Gold might be ok for the short term... but might not give you much of an up-move next year", said my friend. Upon asking him why, he said "It is just a matter of time before the things in the US would pick-up ushering in a boom - and gold fares badly when stocks markets are going up". Unfortunately I don't share his optimism about the state of the US economy. For one US public debt is above $15,000,000,000,000 (a trillion has 12 zeroes) and rapidly heading further north towards $16,000,000,000,000 (yup... that is a lot of zeroes). And this is just public debt. The indebtedness position of the US economy is much worse if you were to consider both public and private debt - and in fact it is in the vicinity of $50,000,000,000,000. To me this looks like disaster waiting to happen!
"Don't worry so much", said my friend. "The US Government and the Fed will fix the problem by printing more money."
Don't know if it was his economic reasoning at work here or the mojito's that he was knocking back (he was on his sixth).... but this is where the problem starts. People thing that printing money is the method for resolving all economic ills. This was the rationale behind the Quantitative Easing (or QE) programs that the Federal Reserve embarked on. An increase in the US GDP and a reduction in employment were cited as the proof points of the fact that printing money can deliver prosperity. However, this is illusionary. Increasing the money supply by printing money out of thin-air cannot magically increase the quantity of land, labour, natural resources, capital goods or consumer goods within the economy. Then pray tell... how can it ever bring about real prosperity?
Printing money out of thin air only achieves one thing. It results in increased inflation. Ever time a new $100 bill is printed, it reduces the value of all the existing $100 bills floating in the economy thereby reducing the value of money. This is translated into higher prices of everything - including goods, services, real estate and equities. As the Central Bank prints more and more money it drives the interest rates lower… and most people see this as a positive sign. Financial experts like the news of printing. By reducing the purchasing power of the money encourages people to invest their money elsewhere in the economy so as to earn higher returns. This drives the stock and real estate markets higher.
Businessmen get happy because it means that they can get loans at lower rates of interest and hence embark upon expansion plans. Also, if money is printed and injected into the economy it invariably finds its way into the banking system and into the stock markets... driving bourses higher. This makes just about everyone happy.
However, there is a catch. Such prosperity is illusionary. Don't get fooled.
For starters low interest rates also discourage savings. I am yet to see anyone who gets excited at the prospect of saving more when interest rates are low. Instead people take this as an opportunity to take consumer and home loans. Moreover, the reduced purchasing power of money also encourages more spending since people prefer to spend their money instead of holding cash balances. Hence this drives consumption higher. This is also interpreted as a positive sign given that retail sales go up and businesses start making more money. This manifests as a period of prosperity.
Ultimately printing money out of thin air did not generate more resources. All it resulted in was in increased investment and increased consumption. This manifests as an artificial boom. Ultimately in economics you have what is called the Law of Scarcity - which means that resources are ultimately limited. Without an increase in real resources within the economy an increase in investments and consumption can never be sustained. Eventually the duelling forces of increased investment and increased consumption will result in an eventual collapse once people realize that there weren't as many resources needed to support the increased investment and consumption binge. This is in fact what always causes financial bubbles and recessions.
Printing is just a temporary Band-Aid that is applied to disguise the current economic problems. This is in fact the reason why bubbles and recessions are becoming more and more frequent. This is in fact the explanation of the fact why the US debt position stands at a position such as $50,000,000,000,000 because governments over the last few decades have attempted to cure a hangover with more whiskey. If the problem has been caused by printing money out of thin-air, then it is certain that more printing will not solve the problem.
The bottom-line is that printing cannot bring about prosperity... unless maybe if you manufacture printer toner. Ultimately incessant printing is a recipe for disaster that eventually would result in a collapse of the economy, the banking system, and finally a collapse of the currency. If you don't believe me then go and ask the Zimbabweans. If you still don't believe me then wait a few years see the same pattern unfold across most of the economies of the world.