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Evenlode Investment View - March 2011

The Paradox of Debt

John Maynard Keynes identified something in economics that he called ‘the paradox of thrift’. If you or I save money and pay down our debts, then that is a good thing. However, if the whole of society saves money and pays down its debts all at the same time, then that is not a good thing at all. At the end of 2008, as the world’s financial system hung by a thread, this paradox was enacted in real life on a global scale.

The subsequent bailouts of the financial system and massive fiscal stimulus programmes (most notably in the US and China) are straight from the Keynesian playbook. Barack Obama, in fact, is a self-confessed card-carrying Keynsian. These policies have been a direct attempt to prop up the financial system and encourage society to spend, rather than save, its way out of the economic malaise. In many commentators’ eyes - though mistakes may have been made in their execution - the world could not have done without these measures. As Charlie Munger said recently, ‘the bail-outs were absolutely required to save civilisation. You should thank god they did it. If you understand the system and the dangers it was in, you’d understand it. It is not completely crazy. You shouldn’t be bitching about a little bail-out.’ Munger, 87 years old, was born in 1924 and remembers living through the Great Depression of the 1930s. There is something in the tone of the above quote that suggests how indelibly that memory is etched in his mind.

The current low interest rates and quantitative easing (QE) programmes employed by western central banks, though different to stimulus programmes in form, also have the same basic goal in mind – to get society spending. These policies originate from the monetarist Milton Friedman – a great friend of Reagan and Thatcher - rather than from Keynes. Ben Bernanke made a now famous speech back in 2002 where, borrowing from Friedman, he suggested that deflationary conditions could always be fought by dropping money out of a helicopter. Since then he has become known as ‘Helicopter Ben’. Helicopter Ben and the central bankers of the western world hope that the immediate effect of low interest rates and QE – to make cash a ‘hot potato’ for savers and push up the value of all other financial assets – will give people and corporations the means and the confidence to spend. The recent price rises in stocks, commodities and corporate bonds are at least in part the consequence of these efforts.

There is logic to the Keynsian and monetarist world view, and the paradox of thrift makes intuitive sense. However, there is another kind of paradox, ‘the paradox of debt'. It goes something like this - if the rapid creation of credit got the world economy into difficulties in the first place, can the answer really be the creation of more credit? This is an idea that presents a direct challenge to the world view of current policymakers. It originated from the Austrian school of economists, who came to prominence in the 1930s. Effectively, they argued, there was a rampant credit boom in the 1920s and the Great Depression was the result. The original, crucial policy mistake was letting this credit boom go on too long – by 1929 it was too late to stop the inevitable downturn. Of particular relevance to today’s policy-making climate, the Austrians also argued that once the credit boom reverses, the excesses should be purged from the system. Trying to get the economy on its feet again too quickly won’t be a sustainable solution – bailouts will only kick the problem a little further down the road.

Well known value investor Seth Klarman, in a recent letter to shareholders, put an Austrian slant on the policy-making of today:

“Most of us learned about the Great Depression from our parents or grandparents who developed a "Depressionmentality," by which for decades people shunned leverage and embraced thrift. By bailing out the economy rather than allowing the pain of the economic and market collapses to be felt, the government has endowed our generation with a "really-bad-couple-of-weeks-mentality": no lasting lessons are learned; the government endlessly intervenes in the economy, and, ironically, the first thing to strongly rebound from the 2008 collapse isn't jobs or economic activity but speculation.”

Today’s sixty-four thousand dollar question, of course, is the extent to which the current Keynsian and monetarist policies will work. Is more public sector debt the answer to the world’s original problem – too much private sector debt? And when these policies are withdrawn – which in the case of US quantitative easing could be as early as the end of June – what will the ramifications be for the global economy and financial asset valuations?

Trying to forecast economics is not, I believe, a particularly fruitful enterprise for the thoughtful investor - buying good companies when they’re cheap tends to be a more successful strategy long-term. However, I do think that the essence of what the Austrian school suggests (that as night follows day, credit contractions will follow periods of rapid credit creation) is an important consideration in respect of risk avoidance for individual investments.

As I discussed last November (In Dr Bernanke We Trust) the two most significant parts of the world economy undergoing rapid credit creation are the Chinese banking system and the balance sheets of central banks in the western world (thanks to QE). We find it hard to see how either of these trends is sustainable. The former leads us to approach industrial metals and infrastructure/engineering companies with a high degree of caution. They have benefited from China’s construction boom for so long now. They are often referred to, without a trace of irony, as structural growth stocks, but we believe they remain cyclicals.

The latter– QE - does not lead so clearly to a specific group of stocks that should be avoided. But it is worth holding the following thought: very low interest rates and QE are having a distorting effect on financial assets. Shares look attractive relative to cash and bonds - particularly given the longer-term inflationary pressures that easy monetary policy may create. They are, you might say, the ‘least worst’ asset class. But I am also conscious that the ‘least worst’ is not quite the same as ‘the best’. Selectivity, focus and a thoughtful approach to stock valuation will be, we think, important protection from that fact.

Hugh Yarrow
March 2011

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 8th March and does not constitute investment advice.

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