Beyond The Headlines

Nostalgia isn’t what it used to be

The title of this paper is stolen from an autobiography by renowned French actress Simone Signoret. It has only marginal relevance to my subject here, but I have long dreamed of using this catchy phrase.

In any case, I was reorganizing my library this week and came across many books that I had not opened in years. Among them was a little booklet published by The Free Press under the aegis of New York University, entitled “The Rediscovery of the Business Cycle.” It was in fact the text of a lecture given by Paul Volcker in 1978, when he was still President of the New York Fed and one year before he became Chairman of the whole U.S. Federal Reserve system.

The lecture is interesting on many fronts.

First, it clearly shows Volcker’s overwhelming concern with inflation, which was raising its menacing head at the time, and which he would courageously vanquish later at the cost of a painful recession (1980-1982). But in addition he describes the complacency of most economists of the period, who essentially thought that postwar economic management and countercyclical policies had definitively conquered the traditional business cycle. Famous last words!

Particularly interesting is the distinction Volcker made between the traditional business cycle of about 3 years, and a longer cycle of maybe 17 years or more that would be hard to measure or anticipate precisely.

The traditional business cycle could be largely traced to the fluctuations of inventories in an economy that was essentially physical (as opposed to today’s increasingly digital one). The longer cycle was more elusive and, without going into the specifics of modern behavioral economics, it was clearly associated in Volcker’s mind with the vagaries of human nature and the psychological biases of the crowd.

In fact, though I am not sure of the chronological relationship between the two, his remarks reminded me very much of Hyman Minsky’s hypothesis, which I have mentioned in previous papers, that long periods of economic and financial stability automatically lead to instability (and crises) by inducing people to assume more risk. Since Minsky saw no need for specific shocks to prompt such crises, they were difficult to anticipate precisely, but you could become aware of their eventual likelihood as excesses built up.

Of course, it also reminded me of the “black swan” analogy enunciated by Nassim Taleb in the book of that title. For Taleb, a “black swan” is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.

Someone once joked that economists call a black swan any event that they failed to foresee. But it is telling that Taleb’s first book, which introduced the theory, was entitled Fooled by Randomness, implying that the world is full of unpredictable events if you only anticipate what you are familiar with (white swans).

As I was rehashing these thoughts, John Mauldin, of Mauldineconomics.com, re-issued a paper he had authored in 2006 (just before the 2007 financial crisis and the ensuing Great Recession). It is entitled Ubiquity, Complexity and Sandpiles.

One of the interesting examples in this paper is the parallel with a sandpile where one would add sand grains one at a time. Most of the time, nothing would happen (stability) and then, suddenly one grain would cause an avalanche that would partly or entirely destroy the pile.

The timing and the severity of the avalanches are unpredictable. But mathematicians have identified some areas in the sandpile (“fingers of instability”) where a network of vulnerabilities develops and could work in domino effects to cause an avalanche. We, as investors, should be able to discern some vulnerabilities in markets or economies as excesses develop. But we are still far from being able to predict the exact trigger and timing of the next crisis or recession.

All this also reminds me of an acronym that became popular in the 1990s: VUCA (volatility, uncertainty, complexity, ambiguity). The acronym was coined at the United States Army War College to describe the less-predictable world that emerged after the end of the Cold War. Ours is also an era of increasing volatility, uncertainty, complexity and ambiguity. But as French mathematician and philosopher Blaise Pascal said in his Pensées: “It is not certain that everything is uncertain.” One thing I feel pretty certain about, though, is that when we misbehave – either through bad deeds or through laxness – a time comes when we must pay the piper, i.e., accept the consequences of our thoughtless or rash actions.

Over the past decade, in the aftermath of the Great Recession (2007-2009) and particularly during the COVID-19 pandemic, governments have given their populations ample reasons to become complacent, if not irrationally exuberant. In a K-shaped economy, where different sectors recover on sometimes diverging paths, segments of the population have been affected differently.

After a decade of gains, regardless of the many problems facing the world today, the relatively small percentage of the population that owns most of the nation’s savings invested in the stock market is very comfortable, feels entitled to more gains and is willing to accept more risk to achieve them.

In addition, many investors have come to believe that, no matter what happens to the market, the Fed will “have their back”. Many members of this segment of the US population also have access to credit at record-low interest rates to finance housing and other heavy purchases. As a leading stock market strategist said last week, “There are very few bears left”, implying that there is no reason to expect significant corrections as long as there are no sellers.

Much of the rest of the population often owns little in the way of liquid savings and investments and therefore must depend mostly on wages and salaries to sustain its standard of living. But in the last couple of years, this group has received significant support from the government in the form of unemployment assistance and other income-maintenance programs.

For many individuals who had lost jobs, these programs have sustained a minimum level of income. As a result, the United States now seems to experience a worker shortage, even though the economic recovery is not complete, as businesses have difficulty bringing back the workers they furloughed or laid off.

All in all, the COVID episode has capped a decade of irregular recovery with what cynics might call a relatively “comfortable” crisis. But the Federal Reserve’s monetary profligacy and the record size of the government’s fiscal support cannot be sustained indefinitely. When they diminish or reverse, the moment to pay the piper will have arrived.

Many observers have concluded that all these budget deficits, increased debt and money-printing can only lead to higher inflation. Based on decades of history, they also argue that there are only two ways to erase unsustainable government debt: through default or by reducing the value of a country’s currency (and obligations) through inflation. Unlike Volcker’s example in the 1980s, I doubt that many of today’s politicians would have the courage to risk a national default. So, inflation seems a logical outcome of our current conundrum.

On the other hand, my partner Bogumil Baranowski, upon learning the subject of this paper, pointed out that my tentative prediction (inflation) was more in line with the recent consensus than it was contrarian, and he suggested investigating the possibility of an opposite (deflationary) outcome.

Indeed, a minority of economists (such as Dr. Lacy Hunt of Hoisington Management) argues that when you finance a debt-laden economy with more debt, each new layer of additional debt becomes less effective at stimulating demand, until recession and perhaps deflation ensue. The investors who follow these economists’ logic are those buying bonds even at today’s record-low interest rates.

Celebrated Italian theoretical physicist Carlo Rovelli once wrote: “The very foundation of science is to keep the door open to doubt.” (Seven Brief Lessons on Physics, Penguin Books, 2016) This precept is valuable for investors as well. But either way, the complacency and fear of missing out that have driven investors to increasing recklessness in recent years should not remain costless forever.

In the stock market, except for brief interludes, there are only two directions: up or down. Fortunately, even though both scenarios facing us (inflation or deflation) are unlikely to end painlessly, for those who have prepared and possess liquid reserves for the aftermath, outsized buying opportunities should emerge in time — as they have in previous crises.

François Sicart – September 1, 2021

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