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Thread: Fisher, Keynes, Minsky, and Keen on "Bubbles in Everything" and Debt Deflation

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    Default Fisher, Keynes, Minsky, and Keen on "Bubbles in Everything" and Debt Deflation

    File Under: Nothing New Under the Sun

    Our previous News with AntiSpin was issued under the title "Sell Everything," as our interpretation of Grantham's recent observation that every asset on the planet is a bubble. Dozens replied to our interpretation with, "Everything? Even gold?"

    From here on out we will experience the long, strange journey of a modern debt deflation. Not as in the global debt deflation of the 1930s, or the Japanese debt deflation that started in 1990 and is with us to this day, or the Mexican or Argentine debt deflations of the 1990s.

    The US debt deflation will coincide with debt deflations from China to Spain to Australia. The process will likely go on for decades. At times it will appear to be over, and at others a runaway train. While its trajectory is knowable–down–its path is not knowable, as it meanders through the intersection of economics, politics, and finance. One might as well try to predict the trajectory of a marble rolling down the back of a cow.

    The beginning of the end is the decline in the global housing bubble following the "bubble in everything" as described by Jeremy Grantham.

    We take credit for a fair number of accurate predictions, but beat ourselves up for not predicting the housing bubble. We warn you now: we will not predict a lot of other events to come, either. We will, however, approach the problems with the highest level of independence and intellectual honesty we can muster.

    The good news is that, as usual, everything we need to know already exists, for in the worlds of economics, politics, and finance, there is nothing new under the sun. We need only to find the appropriate lesson of the past and understand its relevance during each stage of the process–no mean feat.

    Keynes, not always loved but usually respected, had some interesting things to say in the 1930s about "bubbles in everything."

    We are grateful to long time iTulip reader and esteemed economist Steven Keen of the University of Western Sydney for providing relevant quotes from Keynes in a lecture, re-published here with his permission.

    Keynes in his General Theory explains how expectations formation can lead to excessive valuations being placed upon financial assets.
    • In the midst of incalculable uncertainty, investors form fragile expectations about the future
    • These are crystallized in the prices they place upon capital assets
    • These prices are therefore subject to sudden and violent change with equally sudden and violent consequences for the propensity to invest
    • Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)
    • Three aspects to expectations formation under true uncertainty
    • Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto”
    • Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects”
    • Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214)
    • Fragile basis for expectations formation thus affects prices of financial assets
    • Conventional theory says prices on finance markets reflect net present value capitalization of expected yields of assets
    • But, says Keynes, far from being dominated by rational calculation, valuations of finance markets reflect fundamental uncertainty and are driven by whim:
    • “all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield” (1936: 152)
      • ignorance
      • day to day instability
      • waves of optimism and pessimism
      • “the third degree”
    • Ignorance due to dispersion of share ownership:
    • “As a result of the gradual increase in the proportion of equity ... owned by persons who ... have no special knowledge ... of the business... the element of real knowledge in the valuation of investments ... has seriously declined” (1936: 153)
    • Impact of day to day fluctuations
    • “fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market” (1936: 153-54)
    • Waves of optimism and pessimism
    • “In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual ... the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.” (1836: 154)
    • “The Third Degree”
    • Professional investors further destabilize the market by attempting to anticipate its short term movements and react more quickly
    Quotations from Keynes (thanks again to Keen) below refer to the behavior of investment professionals in a market. This is relevant today as the market is at this stage primarily driven by professionals. If, as the DOW approaches 14,000 and the private equity deals (LBOs) get larger week by week, and the following seem too familiar, you can skip to the Debt Deflation section below.
    “It might have been supposed that competition between expert professionals ... would correct the vagaries of the ignorant individual... However,... these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.” (1936: 154-55)

    “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of most skilled investment today is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” (1936: 155)

    “professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; ... It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (1936: 156)

    “If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investment on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets.”

    “Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and ignorance than to beat the gun.”

    “Moreover, life is not long enough;--human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is tolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

    “Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money...”

    “Finally it is the long-term investor ... who will in practice come in for most criticism, wherever investment funds are managed by committees or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes 1936: 156-58)
    Debt Deflation

    Professor Irving Fisher famously said on October 15, 1929, “Stock prices have reached what looks like a permanently high plateau." After that, he did not disappear from the scene. Instead, he went back to the drawing board and came up with a theory of debt deflation which was later more completely developed by Minsky. Relevant quotations by Fisher again from Steve Keen (See Keen's excellent lecture Modelling Debt Deflation (PowerPoint file)):
    1. Debt liquidation leads to distress selling and to
    2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
    3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
    4. A still greater fall in the net worths of business, precipitating bankruptcies and
    5. A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
    6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to
    7. Pessimism and loss of confidence, which in turn lead to
    8. Hoarding and slowing down still more the velocity of circulation. The above eight changes cause
    9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (1933: 342)
    With deflation on top of excessive debt, “the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344).
    Since The Great Depression, Fisher's is the generally accepted explanation for self-reinforcing deflationary depressions. The Keynesian solution is monetary policy aimed at halting a precipitous contraction in money and a severe slowing of the velocity of money after a crash, to prevent the cascade of negative results that follow. In 1990, Japan's economy was a ship with greater mass above the fulcrum than below. When it tipped after the 1990 crash, the Bank of Japan policy response was to fill the hull with ballast–to generate more credit–which at least prevented a full scale deflationary depression there. Owing largely to the greater soundness of the US banking system and credit markets, the Fed response to the US stock market crash in 2000 was more effective than the Bank of Japan's in 1990 at creating a fresh round of asset inflation.

    In theory, after the Keynesian cure of loose credit, low taxes, and fiscal deficits works its magic and the economy gets going again, these are to be withdrawn. What Keynes did not anticipate when he developed his model was the interaction of the economic cycle with the political process, at least in the US. The US congressional and presidential election cycles virtually guarantee that post-crash stimuli will remain in place forever, as neither political party wants to be held responsible for the negative impact of rolling them back. In the real world, the Keynesian approach to managing the aftermath of an asset bubble is a conundrum, not a solution.

    The result of the last disinflation-reflation (Ka-Poom) cycle is a US economic ship with a massively unbalanced mass of debt above the waterline. Today it is kept upright by sufficient forward movement, which is why a recession–a stopping of the ship–is feared by policymakers. Much will be done to prevent one, but the Fed must wait for a crisis before acting, otherwise in the high inflation environment that dominates globally the bond market will sell off.

    A debt deflation is a slow burning, under-the-covers financial crisis punctuated by occasional more visible crises, such as we are seeing in the mortgage market. The political response throughout the debt deflation process in the US will be reflexive: print more money, pay off the indebted voter, the campaign contributor, the foreign central bank that funds the fiscal deficit and pays for the war, etc., etc., etc., as in the case of the sub-prime market bail-out.

    But there are indeed limits, as the Japanese learned over the past 17 years. These are unique to each over-indebted nation's starting point fiscal, economic, and financial circumstances, and to the political and financial institutions of each. We watch these developments together.

    As promised, the Grantham letter is analyzed for iTulip Select subscribers here.

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    Last edited by BDAdmin; 03-28-08 at 02:38 PM.



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