THE REALITY OF FUNDAMENTAL ECONOMICS

Why is economics—that is, the understanding of the real fundamentals
that drive and motivate markets—such a challenge? It is
because people make up both economies and companies.

“Ah, but economics is about rules, such as the law of diminishing
returns, efficient market theory, and portfolio theory,”
you may say. Well, yes and no. Such so-called laws are merely
attempts to generalize about patterns of economic activity that
have arisen in the past. But people are emotional, and they also
learn and evolve. Therefore, patterns of behavior alter and
evolve in an organic fashion. It would require a perfect understanding
of the motivation and thinking of people in today’s
society to make a fully accurate assessment and forecast of an
economy. Rather a daunting task, I would suggest. Hence, the
natural inclination to oversimplify—which is all very well as long
as we recognize this process for what it is so that we can see the
opportunity from a trading perspective that is then created.

Reductionist Theory and the Reality of Fundamental Economics
Today’s markets are complex, to say the least. Some of the people
who make up an economy are also directly involved in markets
(all are indirectly involved), and the level of participation in
markets is at a historical high. All participants in a market affect
that market’s price action, and as participation is higher than
ever and patterns of behavior continue to evolve, new patterns
of economic behavior and market price action are also continually
emerging.

Hence, the study of one aspect of this complexity—economic
activity data—is simply not enough. Economic data are historical
and therefore backward looking by definition. While such
data undoubtedly give clues to the likely forward path, they do
not represent the future at all. As such, any analysis locked too

tightly into such a perspective cannot succeed. This is why the
practitioners of pure economic theory applied to the latest run
of data typically have a modest forecasting record. Yet this is precisely the form
of analysis that tends to dominate all media reporting on fundamental developments
and drive the consensus view.

Most economic models are useful in polite conversation, but they cannot compete
with the cut and thrust of market realities. Indeed, this is not just a theoretical
affliction facing the economic world. Quantum physics has demonstrated that
reductionist philosophy—that is, the idea of reducing any subject
of study to its smallest constituent components—is flawed.

For instance, Einstein’s theory of relativity works most of the
time but not all of the time, and at some levels not at all. Such
attempts will ultimately lead to a severe disconnect between
expectations and actual events, as the reasoning deduced from
the model conflicts with the reality of that future.

Let me explain. As discussed, it is people who make up the
economy, not numbers. The confusion among contemporary
economists on almost any aspect of any economy is due to the
arguably flawed nature of current economic theory. All contemporary
economists are schooled in an approach to the subject
that is essentially derived from scientific method. This theory is
reductionist philosophy. Essentially, this is a means of understanding
whereby, when looking at competing theories or explanations
for a phenomenon, it is the simplest theory that should
be selected. The predominant approach to a subject is then to
break it down, reduce the subject to the smallest possible components,
and so derive a greater understanding of the subject
and a concrete mathematical model to explain it—all in the

belief that there is a model that explains what is going on. The
reality of markets is that no such model exists. Scary perhaps,
but true nonetheless. The warrior trader’s willing acceptance of
this point allows him or her to respond to fresh developments in
a market away from the consensus view more rapidly than other
participants, and even to prepare an attack strategy in advance.

The reductionist method is commonly used for predictions
and forecasting, based on the explanations derived from prior
happenings. Its emphasis is basically on a microscopic approach
to understanding, looking to derive a general understanding
from the features of a particular.

As the advantages of reductionist philosophy, which certainly
greatly accelerated scientific advances in the initial phases,
dawned on people, its use quickly spread to the humanities.
However, perhaps it is now being too widely applied.

The introduction of this philosophy and methodology of
explaining reality (or the micro) in terms of a reasoning derived
from specific and largely isolated theories diverted attention
away from some home truths that quantum physicists, in whose
field reductionist philosophy has been used most successfully,
are increasingly recognizing. In our complex market reality, all
things are connected and cannot be successfully approached in
isolation. This is exactly what almost all economic theories that
have been taught for decades do. They focus on one particular
aspect of economic or fundamental behavior in isolation. They
then perceive and prove a degree of correlation with another
aspect. This is not the full picture of what is going on, however,
and a strict adherence to a particular economic principle will
only end in market trading losses.

Further, once a subject is exposed to thought and discussion,
its behavior is altered by that very analysis. Any group of human
beings who begin to question themselves, in particular, why they
respond in a certain way to a particular set of events is unlikely to

respond in the same way in the future once the self-examination
has occurred.

Such is also the case in the field of economics, and particularly
so when looking at financial markets. Economic theorists striving
to understand, in greater and greater detail, the various
machinations of modern economies have accomplished only one
thing: the sleight-of-hand skill that seemingly enables historically
constructed models to follow an economy or market with
such rapidity that they seem to be keeping pace with real-world
developments—or even to be forward looking. This is not actually
the case, however, despite the mass false impression that is
achieved through the use of modern communication technology
to quickly analyze and explain real-time events. Rarely does such
analysis lead the real-time event, however—a subtle yet awakening
distinction that few market participants seem to recognize.

Almost all economic analysis and market analysis of an event
that is distributed to the clients of all the banks and brokerage
houses the world over is actually in hindsight. It therefore can
only come across to the reader as being particularly accurate
and insightful in nature. These qualities impress the reader and
give the individual confidence in dealing with that bank or broker
when trading in these markets. In fact, it is often the case
that the research produced is so perfectly formatted, presented,
in-depth, and generally impressive that many clients believe it
gives them an advantage over other traders and will do almost
anything to get that research. Such research has its place in
providing the warrior with a broad knowledge of what has
occurred recently and historically, but the warrior does not make
the mistake of interpreting such analysis as in any way an accurate
forecast of the future. There are three main types of human
creatures in banks and brokerage dealing rooms: economists/
researchers, traders, and salespeople. There is one distinction
the managers of such organizations never forget, unless to their

peril. That is to keep researchers away from trading, and traders
away from research. They are different activities. One is backward
looking; one is forward looking. It is important not to
confuse the two perspectives. Market view and trading are two
distinct activities.
Read More: THE REALITY OF FUNDAMENTAL ECONOMICS

Supply And Demand

We often talk of buyers and sellers of stocks in metaphorical terms. For
example, “buyers stayed away in droves” rationalizes a down market. Such
expressions are used, including by us in this book, as if there can be an
uneven number of buyers and sellers and it is this factor that drives stock
prices up or down. In reality, the number of buyers and sellers of a stock
is always exactly equal, as there can be no sale or purchase without both
a buyer and a seller. What is actually at work is a balancing of supply and
demand through the mechanism of price. In a smoothly functioning market
economy the prices of everything bought and sold are governed by supply
and demand. So it is too with the stock market. Companies issue a limited
number of shares, so when this finite number is then subsequently traded
on a stock exchange, the level of supply in that particular stock on any
particular day is constant and unchanging. It is the level of demand for the
stock that fluctuates, however, and the dynamic by which the fixed supply
and the shifting demand are kept constantly in a state of equilibrium is
through the mechanism of price.

This raises the question of what it is exactly that causes the price of
any given stock to fluctuate fairly strongly, as most do each and every day.
The theoretical cause of the changes in demand for a stock during the trading
day is that demand is raised by increased expectations regarding the
prospects for the stock and decreased by dampened expectations. However,
if this were all that were going on, one would expect to see very little
change in most stocks’ prices from day to day or during the course of any
trading day, except for those for which quarterly numbers are reported or
other specific company news is released. But most stock prices actually do
move around quite vigorously, moving up and down and bouncing around
each and every trading day. Clearly something else is going on here. The
demand for individual stocks as well as the demand for stocks as a group
forming the overall market are both driven by a constant struggle among
all investors, both professional and amateur, involving the two major emotions
that affect people’s investing and trading habits—greed and fear. The
combined effects of the interplay between greed and fear in investors’ and
traders’ emotions drive the demand for and thereby the pricing of each individual
stock up and down, constantly throughout the day. Interestingly

as stock prices are affected by the prevailing currents of optimism and
gloom that wash constantly over the market, as a result the vast majority
of stocks exhibit price movements that are remarkably similar to each
other’s. The overall market too, as measured by market indices, exhibits
exactly the same movements up and down that characterize the majority
of individual stocks, and this is as would be expected as the overall
market is nothing more than a grouping of those stocks. However, we feel
that it is too simplistic to conclude that the direct connection of individual
stock prices to overall market movements is a one-way street. The truth is
more nuanced. In fact, as traders and investors watch the overall market
as much if not more than they do the prices of any individual stocks, it is
their perception of what is happening to the Dow that affects dramatically
their view as to whether they should be buying or selling individual stock
positions. It can be the subject of some debate here which is the chicken,
which the egg in this subtle cause and effect conundrum. Regardless, we
believe that it is the constant change of sentiment in the investment community,
lurching from positive to negative and back again regarding the
outlook for stocks, reinforced with data read from the Dow Jones Industrial
Average Index that actually spurs the majority of individual stock buys
and sells. It is this that drives the market even more than individual stock
price fluctuations caused by stock-specific news. Related to this point, it is
interesting how the market often has difficulty passing through important
psychological milestones such as the round number 1,000 markers—Dow
10,000, 11,000, 12,000, and so on. It is clear that investors become more
excited and nervous around these levels and trading is affected accordingly.

Clearly this has nothing to do with company fundamentals, news,
interest rate trends, economic and political developments, and the like. It
is an indication that the market index value—and essentially that of the
Dow Jones Industrial Average—is one of the prime influencing factors on
whether investors/traders are in the mood to jump in and buy or seek to
sell individual stocks.

Although the laws of supply and demand cause an ebb and flow in
stock market prices in the same way as they affect pricing in any other
kind of human economic activity, it is interesting to note that the stock
market is the only place where people are actually happier buying when
prices go up and are reluctant to buy when prices go down. It is really a
strange phenomenon. Can you imagine hordes of people arriving at a shopping
mall the day after Thanksgiving when many retailers lure shoppers by
marking down their prices, and being disappointed at the bargains? Would
it not surprise you to see all these would-be customers returning to the
parking lot upset and empty-handed and with the intention of coming back
when prices have risen again? Sounds crazy, doesn’t it? In the stock market,
down days represent those days on which stocks go on sale. By definition,

they are also days on which there is a greater reluctance to buy stocks.

Up days in the market, on the other hand, are naturally days in which
most individual stock prices are also up, and ironically, they are the days
that buyers start to salivate and open their wallets. Investors and traders
are buying up a storm, and the pricing power is back in the hands of the
seller. It is a classic case of crowd mentality at work—people are buying
because others are buying. But this is clearly illogical because it means that
investors/traders are as a rule happier paying higher prices. As Warren Buffett
once cannily put it, “You pay a very high price in the stock market for a
cheery consensus.”

As has been mentioned earlier in this book, it is interesting that many
writers on investment topics happily use the general upward rise over
the years of the Dow Jones Industrial Average to prove to their readers
the wisdom of buying and holding individual stocks over time. Yet, when
these same experts turn to individual stocks, they tend to proffer advice
on the buying and selling of these as if all that moves stocks are their own
internal dynamics as a stock and as a company. As noted, we strongly
believe that it is the direction of market movements on any given day or
even longer term, that actually provides the most fundamental driver of
individual stock price movements, whether their direction is up or down.
It is no coincidence that the short-term fluctuations we perceive and take
advantage of in individual stock prices mirror so closely those in the
overall market—they are to all intents and purposes the same fluctuations.

Just to emphasize the important point that we make here, the main
driver of any individual stock’s price movement is the movement of the
overall market. As the overall market fluctuates constantly, with a day or
two of a rising market followed by a day or two of a falling market being
the norm, so too do the prices of individual stocks fluctuate in very similar
patterns. It follows from this that a buyer of a stock has a choice. He can
either buy at a relatively cheaper level on a day and at a time that both the
overall market, as well as the stock he is purchasing, are down in price,
or he can do the opposite, buying at a relatively more expensive level on
a day and at a time that both the market and the stock are relatively more
expensive than they were just hours or days before. We prefer to aim for
the former course of action.



Read More : Supply And Demand

Economic cycles

At the heart of analysing market trends is the business cycle. It has long been appreciated that economies do not grow in a steady, linear direction; instead there are periods of expansion and contraction which tend to occur at regular intervals. Even in Genesis, the fi rst book of the Bible, there is reference to seven lean years and seven years of plenty.

In pre-industrial times the phenomenon of economic fluctuations was tied to the agricultural cycle with crop failure causing severe hardship in agrarian-based economies. But as society became more industrialised, these cycles still persisted. John Bates Clark, an American economist writing at the end of the 18th century, said of them: “The modern world regards business cycles much as the ancient Egyptians regarded the overfl owing of the Nile. The phenomenon recurs at intervals, it is of great importance to everyone and natural causes of it are not in sight.” Society remained mystifi ed by economic ebbs and fl ows until in the second half of the 19th century economists analysing statistical data noticed there was a periodic rhythm to these ups and downs.

Historical analysis of the business cycle
One of the earliest investigations into patterns of economic activity was carried out in the 1880s by William Stanley Jevons, an economist, best known for his book The Theory of Political Economy. In a paper “The Periodicity of Commercial Crises and its Physical Explanation” published posthumously by H.S. Foxwell, Jevons noted that going back to the beginning of the 18th century, what he described as “commercial crises” occurred approximately every 9–12 years, with the average interval being 10.44 years. Although Jevons did not “believe that any of our economists have yet untied this Gordian knot of economic science”, he thought the cause of these crises was linked to the cycle of sunspot activity on harvests.

At around the same time a French economist, Clement Juglar, discovered from his analysis of movements in interest rates and prices in the 1860s that alternating periods of prosperity and liquidation recurred on average every 9–10 years. However, it was a German economist, Werner Sombart, who fi rst put forward the idea that these economic fl uctuations should not be seen as a series of periodic crises but rather as a continuous wave that followed a set pattern of boom and bust. In the United States, the approximately ten-year economic rhythm has continued almost unbroken throughout the 20th century. The year in which the downturn starts varies a little, but for the past half century it has always been in the first three years of the decade. Recessions can occur at other times in a decade, but there is no regular pattern – they may be the result of excessive policy adjustments or external economic shocks. So the approximately ten-year economic pulse which Jevons and Juglar identifi ed in the 19th century still appears to be beating regularly.

The long-term Kondratieff cycle
Working in the early years of the communist revolution, Nikolai Kondratieff, a Russian economist, was given the job of analysing the major capitalist economies – Germany, France, Britain and the United States – with a view to confi rming the Marxist theory that capitalism contains the seeds of its own destruction. (Much of Kondratieff’s work is based on Britain and France because before the mid-19th century these countries have “the most systematic statistical material”.) After analysing statistics on commodity prices, interest rates, wages, foreign trade and production of coal, pig iron and lead going back to the late 18th century, he came to the conclusion that long-term fluctuations were an inherent feature of the capitalist system. So although downturns would occur, they would eventually always be followed by periods of economic recovery, and these waves would last for approximately 50–60 years from trough to trough (a duration of 54 years is usually quoted but this is simply the average of the fi rst two long waves). Kondratieff anticipated that the length of each cycle would vary considerably. The fi rst wave he identifi ed was from 1789 to 1849, the second was from 1849 to 1896 and the third he dated from 1896 and predicted would end in the 1930s. He therefore accurately anticipated the 1930s slump and the subsequent recovery.

Kondratieff also made some empirical observations associated with these waves. The fi rst was that before the upward phase of each wave a signifi cant number of technical innovations and discoveries occurred. He also noted that what he described as big “social upheavals and radical changes in the life of society (revolutions, wars)” were more likely to occur during the upward phase of the long cycle. The French Revolution, the Franco-Prussian war and the fi rst world war all occurred during the rising phase of the cycle. His third observation was that the downward phase of the cycle coincided with periods of depression in agriculture. Lastly, intermediate cycles of between seven and eleven years occurred within the long wave. Kondratieff did not suggest a causal connection between these observations or that they could in any way explain the existence of the long wave. He admitted that he could not give a satisfactory explanation as to what triggered economic upturns, but postulated that they might be related to the period of time that it took for capital equipment to wear out and be replaced.

Kondratieff’s theory about long economic waves was published in a series of papers between 1922 and 1928. The idea that capitalism contained an economic “self-righting” mechanism ran counter to the views of the recently formed communist government and Kondratieff was put on trial. (Alexander Solzhenitsyn records in his book The Gulag Archipelago that Kondratieff was sentenced to solitary confi nement, became mentally ill and died in prison.) His work was, however, smuggled out of Russia and published in Germany in 1926. An abridged English translation appeared in The Quarterly Journal of Economics in 1935.
Read More : Economic cycles

The economic consequences of ageing populations

The combination of falling fertility and mortality rates will give rise to a dramatic shift in the ratio of elderly people to those of working age. For the world as a whole, the ratio of people aged 65 or over to that of people aged 15–64 is forecast to rise from 11:100 in 2000 to 25:100 in 2050. In more developed regions the ratio will rise from 21:100 to 44:100, and in less developed regions from 7:100 to 22:100.

The rise in elderly dependency ratios is likely to have an adverse impact on economic growth, particularly in countries where the demographic transition is already fairly well entrenched. The imf has estimated that in the developed world, falls in the working-age population could be responsible for reducing annual real gdp per head by an average of half a percentage point by 2050 (although, as the imf points out, this does not mean that real growth will fall by this amount because other factors infl uencing growth will also change over this period and these may more than compensate for the negative demographic effect.)

In parts of the world where the elderly dependency ratio is rising, a larger share of government budgets will have to be allocated to services for older people, such as pension provision and health care. The difficulty encountered by governments seeking to raise the pension age is a sign of the problems that lie ahead. Introducing policies to try to limit the fi scal consequences of ageing populations raises other interesting political questions. The combination of a growing number of older voters and the fact that people over 50 are more likely to exercise their right to vote than younger people will give older people considerable political clout, making it difficult to introduce reforms that will limit their financial benefits. (For a detailed discussion of the growing political clout of the elderly see S.H. Preston’s article “Children and the elderly: Divergent paths for America’s dependents” in Demography.)

An ageing population is likely to have signifi cant financial implications, quite apart from the fiscal consequences of higher pension and health-care costs. The life cycle theory of savings and investment postulates that to try to smooth out consumption over their lifetime, people tend to borrow when they are young, save when they are at the height of their earning capacity in middle age and then run down their savings in old age. In a society with a large proportion of middle-aged people, therefore, the level of savings will be high, driving down interest rates. But in a society with a high elderly dependency ratio the supply of savings will fall, pushing up interest rates.

The rise in the dependency ratio could have a similar effect on stock markets as an ageing population will sell its holding of stocks. Studies of the US stock market, for example, have shown a positive correlation between its performance and the proportion of the population that is at the peak savings period (40–64 years). Although a positive correlation does not necessarily imply causality, there is an intuitive logic behind this relationship.

Some analysts have questioned the assumptions underlying this life cycle of investment and savings, in particular the extent to which old people divest their savings. Uncertainty about life expectancy together with a desire to pass on wealth to future generations is likely, it is argued, to mean that older people will want to retain a proportion of their savings.

But the argument centres on the rate at which savings are used up, not the direction of the trend. Once people retire from paid employment, they are unlikely to be able to continue to build up savings and most will have to dip into them. Therefore in countries with a large and rising elderly population savings will decline.
Read More : The economic consequences of ageing populations

The great car economy

What Lady Thatcher once described as the “great car economy” brings enormous benefi ts to individuals, but for economies as a whole there are signifi cant negative externalities. There are already too many cars in the western world; from the Los Angeles freeway to London’s M25 motorway to the centre of Rome the roads are clogged. Many families run two or even three cars. Growing wealth in countries such as India and China will lead to a dramatic surge in demand for cars. The un Environmental Programme estimates that there could be 200m new cars – twice the number currently on the road in the United States – if car ownership in India, Indonesia and China reaches the global average. Nowhere is this trend more evident than on the gridlocked roads of Beijing, where car fumes add to the permanent thick smog that hangs over the city. The switch from bicycles to cars as the main means of transport has been so rapid that it has forced one of the country’s largest cycle manufacturers, China Bicycle, into bankruptcy.

Aware of the detrimental environmental impact of moving to a carbased economy, the Chinese authorities are planning to limit the damage by introducing a range of quality standards for car engines that will even- tually be more exacting than those prevailing in the United States. But with car ownership set to double by 2020, this will do little to improve the underlying problem. Cars account for about one-third of China’s annual energy consumption, and as the number of cars doubles, so will the demand for energy to fuel them.

One technological innovation that has already reached the market is the hybrid car, which runs mainly on petrol but has an electric battery that is charged up while driving along and can then be used to drive an electric motor to power the vehicle in slow-moving traffic. Although much cleaner and more efficient than the traditional internal combustion engine, these cars still produce carbon emissions. Car manufacturers are being encouraged to start producing these hybrid cars for the Chinese market. However, in the long run, a more radical solution is needed if China and other catch-up economies are to become car-based economies. The answer is another technological innovation: the fuel cell.

The fuel cell is a battery powered by hydrogen which, when mixed with oxygen from the air, produces electricity. The only by-product is hot water, so from an environmental perspective it is the perfect fuel source. Fuel cells could also be used to heat houses and water. Eventually, every home may have its own energy station that will provide all a household’s energy needs, but most of the development work is focused on using the technology to power cars.

The most diffi cult problem with the fuel cell is how to store the hydrogen that powers the car. Storage in a high-pressure cylinder – the only proven method – means the “fuel tank” is so heavy and bulky that it can only be used in a bus. Several other lighter and cheaper approaches are being explored, but none has yet reached the market. Even when it does, the initial cost of a fuel-cell car is likely to be high, perhaps as high as the existing fuel-cell buses (around $1m each). However, Toyota, a Japanese car producer, estimates that by 2015 the price will have dropped to $50,000. General Motors is much more aggressive in its pricing target; it is aiming to cut the cost to $5,000 in just fi ve years, although it does not envisage starting mass production as early as this.

Even when the problems associated with storing and filling up cars with hydrogen are resolved, a hydrogen distribution system will need to be set up before cars powered purely by fuel cells can be sold commercially. A number of US states are beginning to develop hydrogen-filling networks. As with so many new ideas, California is leading the way.

Arnold Schwarzenegger, the state’s governor, promised in 2004 to have a “hydrogen highway” in operation by 2010. However, until the best means of storing the hydrogen on board has been identified, such initiatives may be premature. Read More : The great car economy

Total Risk And The Real Economy

Under the Modigliani–Miller (MM) paradigm, the economy is completely transparent and frictionless. A transparent economy implies that all economic agents share the same information and that there does not exist informational asymmetries between various stakeholders, such as current shareholders, debtholders, future shareholders, managers, suppliers, employees and customers among others. A frictionless economy means that the economy adjusts instantaneously and costlessly (no transaction or default costs) and that its workings are not hampered by various material, financial, managerial or organizational constraints. Consequently, financing an investment project through debt or equity is irrelevant in a MM economy.

This explains why a project’s value is the same irrespective of the firm that undertakes it or of its contribution to the firm’s total risk. All valuable investment projects can be financed whatever the firm’s financial position. A similar type of reasoning is adopted under the CAPM efficient market hypothesis as shareholders are assumed to be investing directly into a project providing a required rate of return satisfying the one-period efficient market equilibrium conditions. Again, the economy is transparent and frictionless.

Such a rule has been proposed and adopted by academics for over 40 years even though Eugene Fama’s article (1970) demonstrates that the CAPM formula cannot generally be used for discounting cash flows in a multi-period framework. The CAPM decision rule states that any investment project with a positive expected NPV should be accepted, irrespective of its own volatility or of its contribution to the firm’s total risk, for only systematic risk is relevant. We may qualify such a point estimate or certainty equivalent approach as normative to the extent that market conditions under which the investment process is taking place as well as the required rate of return both represent idealised conditions and are not at all descriptive of the actual workings of the real economy. Obviously, the proposed CAPM certainty equivalent evaluation and decision rule aim at determining the market value of an investment project. However, the market to which it is referring is the one of a one-period transparent and frictionless economy abiding by the Modigliani–Miller paradigm. In the very same sense, the CAPM efficient market completely ignores the fact that the real economy is neither transparent nor frictionless.

Indeed, the legal system establishes a clear distinction as to the roles, the rights and obligations of debtholders, shareholders and managers. Such legal constraints imply informational asymmetries which explain why the financing of risky investment projects, even those profitable, is not easily obtained. The difficulty to finance risky investment projects is even exacerbated under conditions of financial distress as the total risk of the firm rapidly becomes the fundamental and dividing issue between the main stakeholders.

For instance, when the probability of financial distress or bankruptcy of a firm is not trivial, and, consequently, when its equity value is low, then funds provided by shareholders serve essentially to make safer the debtholders’ risky outstanding debt, in addition to providing at their own expense the rate of return that the new shareholders will be seeking (Myers, 1977). We may also add that when a firm’s probability of bankruptcy is significant, it becomes quite rational for shareholders to increase the total risk of the firm by accepting very risky investment projects that might very well rescue the value of their equity even if this implies increased risks at the expense of debtholders. The shareholders risk to lose little and to gain much for in the worst case scenario shares would become worthless anyway. The shareholders would be actually transferring part of their total risk to the debtholders and thus maximizing the wealth of shareholders instead of the value of the firm (Jensen and Meckling, 1976).

Also, as a firm’s probability of financial distress increases, investors might find it evermore difficult, due to asymmetrical information, to distinguish sound projects that might increase the shareholders’ value from pet projects that aim essentially at increasing the size of the firm and consequently the powerbase, perquisites consumption, salaries and stock options of top managers. As a consequence of informational asymmetries, valuable projects might be foregone in the process of capital budgeting given the cash shortage experienced by a firm under financial distress (Stulz, 1999).

The proposition according to which managers should be risk neutral and should be using theCAPMcertainty equivalent decision rule is therefore not applicable when a firm experiences financial distress. That such a certainty equivalent decision rule has been proposed and used by academics for the last 40 years is understandable given that under the Modigliani–Miller perfect market paradigm it is always feasible to finance any profitable project even when a firm is close to financial distress. It should surprise nobody to learn that the CAPM equilibrium share price equation exposes itself to large values of probability of loss (Laughhunn and Sprecher, 1977). Now, considering that the CAPM assumes no default risk, it is quite logical that such an efficient market would set security prices without regard to the risk of bankruptcy caused by any failure to meet legal debt claims. Under the MM assumption of perfect and costless contracting: the problems that crop up when a firm becomes close to financial distress disappear because the firm can always costlessly recapitalize itself so that it is no longer close to financial distress. In the real world, such costless recapitalization is a dream. As a result, total risk matters and has to be taken into account when a firm evaluates a project. (Stulz, 1999: 9)

When a risky investment project imposes an additional cost on a financially strained firm through an increase of its total risk, the decision makers must quantify the marginal increase in total risk. To take this cost into account, managers have to quantify their total risk and have to understand how a new project might impact the firm’s total risk. Being close to action, managers have both ex ante and ex post information advantage over shareholders and debtholders. They might therefore try to maximize their own welfare (as any typically rational person might do) at the expense of shareholders or debtholders. However, given appropriate incentives (this is what stock options aim at), managers will take decisions to the shareholders’ advantage.

However, when projects go astray, shareholders will hold project managers responsible for the failed project and will certainly not think about blaming the economy’s systematic risk for its failure, the more so when the firm is in financial distress. The probability of loss then becomes important information, not as a criterion but as a constraint, in the selection and management of investment projects. Contrary to the concept of systematic risk which is drawn from a normative paradigm, the concept of total risk is derived from a positive probabilistic paradigm and aims at assessing the effective probability of loss. Therefore, it is just comes as a logical consequence that the hurdle rate that should be used to assess investment projects in a positive probabilistic paradigm should not be the CAPM prescribed cost of capital but the effective weighted marginal cost of capital of the firm.

The cost of total risk depends, among other things (a) on how the project is incorporated or organized, and (b) on how the firm is financed. The conventional capital budgeting practice is to include the project within the firm. Such a practice may not always be efficient considering that the credit risk supported by creditors is related to the firm’s total risk, rather than just the project’s risk. Given that creditors have claims against the entire firm, this implies the obligation to assess the firm’s total portfolio of projects’ and operations’ risks, a costlier operation than assessing the risk of a single project (Shaw and Thakor, 1987). Furthermore, incorporating the project within the firm creates an asset substitution moral hazard whereby cash flows can be diverted from safe projects to riskier ones at the creditors’ expense. Unless covenants prevent such substitution, creditors would recognize such a moral hazard and adjust the marginal cost of capital accordingly thereby impacting the total risk of the firm. On the other hand, organizing the project as

a distinctive legal entity prevents such a substitution but generates its own types of risk. To the increased overhead costs and underinvestment moral hazard problem, one must consider the increased financial cost generated by the increased financial risk that must be supported by the incorporated project (Flannery, Houston and Venkataraman, 1993).

Contrary to what theMMparadigm asserts, the cost of total risk depends also on how the firm is financed. Debt financing improves the profitability of the firm by confering tax benefits and thus lowering its cost of capital, but makes the probability of financial distress and bankruptcy more likely. A highly levered firm must therefore assess the impact on the firm’s total risk. Debt financing has a cost, so has equity financing. Otherwise, as Stulz (1999) remarks, all firms would be all-equity financed with no probability of financial distress. Agency costs and asymmetrical information explains why equity financing is costly since there are few all-equity firms. The cost of equity financing is, at the margin, equal to the cost of total risk (Stulz, 1999). When total risk matters, the appropriate measure of risk is obviously not an equity return volatility index. A firm can increase at no additional cost its total risk when the probability of financial distress is unaffected by a risky project:

However, any increase in risk that increases the probability of distress is costly and should be accounted for when evaluating the costs and benefits of a project. Because the risk that is costly is the risk associated with large losses, the appropriate measures of risk are lower-tail measures of risk such as Value-at-Risk or Cash-flow-at-Risk rather than measures such as volatility of stock returns or volatility of cash-flows. (Stulz, 1999: 9) In other words, one needs to know the probability distribution of risky investment projects.
Read More: Total Risk And The Real Economy

FINANCIAL MARKETS AND THE ECONOMY

We stated earlier that real assets determine the wealth of an economy, while financial assets merely represent claims on real assets. Nevertheless, financial assets and the markets in which they are traded play several crucial roles in developed economies. Financial assets allow us to make the most of the economy’s real assets.

Consumption Timing
Some individuals in an economy are earning more than they currently wish to spend. Others, for example, retirees, spend more than they currently earn. How can you shift your purchasing power from high-earnings periods to low-earnings periods of life? One way is to “store” your wealth in financial assets. In high-earnings periods, you can invest your savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these assets to provide funds for your consumption needs. By so doing, you can “shift” your consumption over the course of your lifetime, thereby allocating your consumption to periods that provide
the greatest satisfaction. Thus, financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.

Allocation of Risk
Virtually all real assets involve some risk. When GM builds its auto plants, for example, it cannot know for sure what cash flows those plants will generate. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines. For example, if GM raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can buy shares of stock in GM, while the more conservative ones can buy GM bonds. Because the bonds promise to
provide a fixed payment, the stockholders bear most of the business risk. Thus, capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear that risk.

This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economy’s stock of real assets.

Separation of Ownership and Management
Many businesses are owned and managed by the same individual. This simple organization is well-suited to small businesses and, in fact, was the most common form of business organization before the Industrial Revolution. Today, however, with global markets and large-scale production, the size and capital requirements of firms have skyrocketed. For example, General Electric has property, plant, and equipment worth over $40 billion, and total assets in excess of $400 billion. Corporations of such size simply cannot exist as owner-operated firms. GE actually has over one-half million stockholders with an ownership stake in the firm proportional to their holdings of shares.

Such a large group of individuals obviously cannot actively participate in the day-to-day management of the firm. Instead, they elect a board of directors which in turn hires and supervises the management of the firm. This structure means that the owners and managers of the firm are different parties. This gives the firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders decide they no longer wish to hold shares in the firm, they can sell their shares to another investor, with no impact on the management of the firm. Thus, financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management.

How can all of the disparate owners of the firm, ranging from large pension funds holding hundreds of thousands of shares to small investors who may hold only a single share, agree on the objectives of the firm? Again, the financial markets provide some guidance. All may agree that the firm’s management should pursue strategies that enhance the value of their shares. Such policies will make all shareholders wealthier and allow them all to better pursue their personal goals, whatever those goals might be.

Do managers really attempt to maximize firm value? It is easy to see how they might be tempted to engage in activities not in the best interest of shareholders. For example, they might engage in empire building or avoid risky projects to protect their own jobs or overconsume luxuries such as corporate jets, reasoning that the cost of such perquisites is largely borne by the shareholders. These potential conflicts of interest are called agency problems because managers, who are hired as agents of the shareholders, may pursue their own interests instead.

Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans tie the income of managers to the success of the firm. Amajor part of the total compensation of top executives is typically in the form of stock options, which means that the managers will not do well unless the stock price increases, benefiting shareholders. (Of course, we’ve learned more recently that overuse of options can create its own agency problem.

Options can create an incentive for managers to manipulate information to prop up a stock price temporarily, giving them a chance to cash out before the price returns to a level reflective of the firm’s true prospects.) Second, while boards of directors are sometimes portrayed as defenders of top management, they can, and in recent years increasingly do, force out management teams that are underperforming. Third, outsiders such as security analysts and large institutional investors such as pension funds monitor the firm closely and make the life of poor performers at the least uncomfortable.

Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in monitoring management, unhappy shareholders in principle can elect a different board. They can do this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to vote the shares of other shareholders) to take control of the firm and vote in another board. However, this threat is usually minimal. Shareholders who attempt such a fight have to use their own funds, while management can defend itself using corporate coffers.

Most proxy fights fail. The real takeover threat is from other firms. If one firm observes another underperforming, it can acquire the underperforming business and replace management with its own team.
Read More: FINANCIAL MARKETS AND THE ECONOMY

Economic Forecasting

Almost every financial services firm has an extensive economic forecasting
effort. It is usually part of a so-called top-down investment process that
starts with an outlook for the economy and monetary conditions, continues to
the strongest industries, follows with detailed company study for stock selection,
and may include an overlay of technical analysis to provide a timing dimension.
Some would add analysis of social and political conditions even before economic
studies.

Economic forecasts derive from models—usually of the aggregate national
or global economy, but sometimes of parts of those economies: particular industrial
sectors, regions of the world, or even single products or firms. Basic approaches
to forecasting simply extrapolate the past; more sophisticated models
attempt to understand the sources of past changes and build them into their
forecasts. The latter requires knowledge of economic history and economic principles,
though, even then, forecasting is by no means an exact science. But while
the accuracy of economists’ predictions is frequently a target of jokes, forecasting
remains a popular pursuit.

Forecasts for the macroeconomy are published regularly by academic
institutions, thinktanks, governments, central banks and international organizations
like the OECD [Organization for Economic Cooperation and Development]
and the IMF [International Monetary Fund]. In these places, modeling
can, to a certain extent, be conducted free of the constraint of producing quick

and usable data on a daily basis. But in the investment world, forecasts are required
to be done early and often. A relatively short-term outlook is normally the
limit of investors’ aspirations—what will happen to interest rates within the next
month?—with decision makers demanding rapid output that they hope will be
directly relevant to their immediate problems.

Much of the output of financial market models is naturally closely guarded
in the hope that it may bring advantage to its owners and their clients. But, at
the same time, investment economists like to maintain a public profile for marketing
purposes and are often called on by the media to give their opinion on the
latest macroeconomic developments. Their interpretations of economic data
may give some clues as to how the financial markets will react, though more
often than not, they are explaining why the markets have already reacted as they
did. Invariably, too, there are disagreements about what various indicators mean,
depending on different beliefs about the economy and whether the firm is taking
an optimistic or pessimistic view of the markets.

Each month, the Economist polls a group of financial forecasters and calculates
the average of their predictions for real gross domestic product (GDP)
growth, consumer price inflation, and current account balances in a variety of
countries. More specialized services like Consensus Economics survey over three
hundred economists each month and offer details on average private sector
predictions.

Economic Forecasting Guru: Peter Bernstein
Despite the pressures for early and often forecasts, a number of Wall Street and
City economists do as good a job as any forecasters, among them Abby Joseph
Cohen, Stephen Roach, and Edward Hyman. Most such investment economists
are good students of market conditions—careful keepers of useful data—and on
occasion creative in extracting some kind of signal out of the noise. Ed Yardeni,
for example, the chief economist at Deutsche Bank, turns his website into a
cyber-chart room. If you want to access data and view charts, Yardeni’s site is an
essential stop. He also makes his commentary available in a section for clients
that is password protected, but a substantial amount of the content is openly
accessible.

One economic commentator stands amid the few that many of us would
class as the best: Peter Bernstein. He grew up heading his father’s investment firm,

Bernstein MacCauley, in New York. He was the first editor of the Journal of Portfolio
Management, founded by Gilbert Kaplan, and has received many awards,
among them the highest honor granted by the Association for Investment Management
& Research, the investment management industry’s professional body.

Bernstein is able to walk on both streets—with practitioners and academics.
He writes a newsletter, Economics and Portfolio Strategy, to test and disseminate
his analyses. And writing is one of his main strengths: His two books
on the history of risk and on how capital ideas came to Wall Street were regulars
on the business best-seller lists during the 1990s.

Like a good academic, Bernstein marshals all the arguments, especially
those that are counter to his own position. His mid-February 1998 letter, for example,
examined the case for exuberant stock prices in the United States, giving
particular emphasis to the market’s reliance upon an all-knowing Federal Reserve
for economic management. Bernstein concluded that “stocks are a risky investment
and should be managed accordingly.” Since that analysis was approximately
the same as his November 1997 conclusion, he was ahead of the wave
and for the right reasons. Bernstein is also faster than most to admit where he has
been wrong and to try to examine what led him astray—or, as he jokes, “what
led the market astray when it failed to act the way I thought it would.”
Read More : Economic Forecasting

EARLY SYMPTOMS OF ECONOMIC DECLINE

The standard explanation for our poor economic performance is that our
productivity has grown too slowly. GNP per capita is determined by average
productivity, the average value of goods and services produced by each person.
In the long term meager productivity growth will be matched by disappointing
GNP growth. Unfortunately, our productivity growth has been mediocre,
despite, and perhaps because of, our adoption of purer free market policies. From
an average of 3% from the end of the Civil War through the Kennedy
Administration, our productivity growth is now struggling at just over 1%.


There are economists who insist that our productivity growth is better
than the official numbers. But careful research has not borne out such hopeful
claims. Professor Robert Gordon, a consultant for the Federal Reserve, recently
completed a comprehensive study on productivity. His results show that over
the past five years there has been no productivity improvement in the
manufacture of non-durable goods. For durable goods (except computers), there
has actually been a decline in productivity. Our entire increase in manufacturing
productivity has come from the computer-manufacturing sector, which
accounts for just over 1% of GNP.

But if we have adopted the most enlightened economic policies and if
productivity is so important, why is our productivity growth so low?
Economists have told us productivity growth depends on net business and
infrastructure investment, which in turn depends on savings. So our GNP
growth has been lagging because our productivity growth has been lagging. And
our productivity growth has been lagging because our investment has been
lagging. And our investment has been lagging because our savings rate has been
lagging.

This still fails to explain our mediocre productivity growth; it just redirects
the question upstream. If savings and investment are so important, why are our
savings and investment rates so low? In particular, what have we done to
increase our savings, investment and productivity?

Since 1980 we have tried two different approaches. The former approach,
adopted by the Reagan Administration, was a return to the strict orthodoxy of
laissez faire. Reagan’s team lamented that we had been deceived by the liberals
to worship the idol of big government. It claimed we were suffering the
consequences of our idolatry in lower savings and productivity and in slower
economic growth. If we wished to reap the full-flowing benefits of our economic
system, we would have to return to a pure faith in the free market.

One of the tenets of this faith is that it is the wealthy who generate savings.
Our lower and middle classes must spend all their income on the necessities of
life and have little left over to save. Only the wealthy have the capacity to save
and invest. But our oversized government has placed undue burdens on the
wealthy. Government has redistributed wealth, taking from the rich and giving
to the poor, who cannot save. It has also taken from the rich and given to

government bureaucrats to spend on their pet projects, unencumbered by the
market.

The Reagan program was designed to remedy these evils. If we were to take
after-tax dollars from those who need them and so are likely to spend them, and
give them to those who do not need them and so are likely to save them, we
would redirect consumption into increased savings, a higher level of investment,
greater productivity, and a better economy for all.

In addition, if we were to take money from government bureaucrats and
return it to the wealthy, they would save it and invest it in accord with free
market principles. These investments would now be regulated by the invisible
hand of market prices and no longer by the perceptions of bureaucrats. Because
the invisible hand automatically maximizes total wealth, at least in theory, this
transfer of capital must have a positive effect on the economy as a whole. Giving
more money to the wealthy would trickle down to everyone’s benefit.

In keeping with this picture painted by his economic advisors, the Reagan
tax cuts were geared entirely toward the rich. According to the Congressional
Budget Office, Reagan’s tax policies reduced the total federal tax rate (including
Social Security) for the top 1% while increasing it for the bottom 90%. A 1992
study by H & R Block showed that from 1977 to 1990 the total federal tax bill for
a person earning $50,000 a year increased 8%, while the tax bill for someone
earning $200,000 a year decreased 28%.

Many of those supporting the Reagan tax cuts pointed to the Kennedy tax
cut that reduced the top marginal rate from 91% to 70%. They claimed that this
was responsible for the halcyon economy of the 1960s. Wrong! Kennedy was
unable to get his proposals through Congress. The passage of his program had to
wait for Lyndon Johnson, and the tax reductions did not take effect until 1964
and 1965. So what happened?

These tax cuts did mark a major watershed. But — contrary to the claims of
apologists for laissez faire — it was a negative one. Real GNP growth declined
from over 5% in the first half of the 1960s to 3.3% in the second half of the 1960s
and 2.6% in the first half of the 1970s. The decades after these tax cuts have been
marked by slower growth, higher inflation, higher unemployment, higher
interest rates, and greater debt than the previous decades. After the tax cuts our
productivity growth, the most important determinant of long-term economic
growth, began to plummet. Long-term productivity growth declined 60% from
its levels prior to the Kennedy tax cut. (The other major pre-Reagan tax cut,

which reduced capital gains taxes by 30% in 1978, also marked a steep economic
decline.)

Despite this history, Reagan’s economic advisors, blandly confident,
assured us the Reagan tax cut would stimulate the economy and bolster savings.
They also assured us — at least until tax receipts plummeted — that the
economic growth produced by this tax rate cut would increase federal tax
receipts.

Contrary to these assurances, the Reagan tax cuts did not increase
economic growth, savings, investment or tax receipts. In light of the failure of
the Kennedy-Johnson tax cut, it should not be surprising that the effect of the
Reagan tax cuts was just the opposite of what his economic advisors had
forecast. Our savings rate, guaranteed to rise, did not even hold steady.

While our net savings had only rarely and briefly dropped below 6% of
GNP from 1950 to 1980, it has been declining steadily since the early 1980s,
decisively penetrating the 6% level. It has gone negative for the first time in 70
years. Even corporate investment, consistently our most positive investment
sector, has failed to improve. Despite heavy borrowing and large reductions in
corporate tax rates in the 1980s, corporate investment is little changed from its
levels of 50 years ago when the highest corporate income tax rate exceeded 50%.

In short, the bill of goods we were sold is worthless. The Reagan
Administration proclaimed that if our tax policies were tilted to favor the rich
then savings and investment would rise and everyone would prosper. But
contrary to the glowing promises of progress and prosperity for all, our
economic growth slowed, our savings rate declined, our debt rose sharply, and
all but the richest lagged.

Had we considered the effect of the Kennedy-Johnson tax cut, we might
have hesitated to swallow whole hog the laissez faire revivalist message of
Reagan’s economic advisors. Had we looked at Western Europe, where the ratio
of tax revenues to GNP is 30% higher than ours, but where savings exceed ours
and productivity and standards of living are rising faster, we might have
reconsidered. Had we even examined our own historical correlation between
reducing marginal tax rates on the highest incomes and slower economic
growth, we might have had second thoughts about sharply cutting the top
marginal tax rates.

Why did we not look at the historical evidence and decide — at the very
least — on a more gradual approach? Why did the attraction of free market
ideology overwhelm the lessons of history? For an administration that described

itself as conservative, this is astonishing, for central (if not defining) themes of
conservative thought have been the precedence of history over ideology and a
worry about what could go wrong with radically new policies.

From a truly conservative perspective, considering the previous failure of
similar policies, the failure of Reagan’s policies was no surprise. Surprising or
not, that failure left us with declining savings, stagnant investment, mediocre
productivity improvement, and slowing economic growth.

Our more recent attempt to deal with low productivity growth stems from
the Clinton Administration of the 1990s. It reflected a different philosophy: if
you can’t hit the target, move the target. In the spirit of this philosophy, we
introduced a new variable to the measurement of productivity and economic
growth. This is the hedonic deflator, which is applied to the computer industry
and adjusts the price of an item for improvements in quality.

No other major economy uses the hedonic deflator, which has been
challenged as inappropriate by European economists. Our use of this measure for
the past several years renders meaningless comparisons of our economic growth,
productivity growth and inflation with those of other countries or our own past.
Yet the hedonic deflator is a superficially plausible measure. If the quality
of an item improves, then a commensurate price increase provides the same
value. What appears to be inflation — a higher price — really is not. Why, then,
do other countries reject this measure?

They can make a powerful case. Suppose the hedonic deflator had been
introduced in 1980. Since then, three years after the Apple II was marketed as the
first personal computer, the amount of memory in personal computers has
increased several million-fold. The power of microprocessors has grown ten
thousand-fold. Software that comes with the computer makes it far more user
friendly. Modems and the Internet dramatically widen the range of tasks
computers can perform.

Today’s computer is at least 500 times more valuable than the 1980
computer. The 1980 computer sold for $2,000. So our modern computer has a
real value of $1 million ($2,000*500). Presently, 15 million computers are sold
annually. The real value of those computers is $15 trillion ($1 million * 15
million).

Thanks to this contribution, our annual real GNP growth since 1980 would
approach 10% even if the rest of the economy had not grown at all. How
remarkable, when no developed country has ever managed to sustain real GNP

growth of more than 5% per year and when our Federal Reserve warns that
prolonged growth above 3% would stimulate inflation.

Even better, we have had 20 years of deflation. Our real GNP, including $15
trillion just from computer sales, exceeds $15 trillion. Our nominal GNP is only
$10 trillion. If real GNP grows faster than nominal GNP, that must be because of
deflation.
Note how misleading a picture this is of our, or any, economy. That is why
other countries reasonably reject such a measure. We adopted it primarily
because it makes us look better without having to take action to improve our
savings rate, investment or productivity. While this may make us feel better in
the short term, sub-par productivity growth in the long term has always been
debilitating.

Productivity growth, investment and savings are not merely academic
issues. While our economy did grow in the 1980s and 1990s, much of this growth
— meager as it was — was financed by trillions of dollars obtained from
borrowing and from the sale of assets. By recycling capital from our trade
deficits, foreign interests have come to own an enormous amount of not only our
debt (a record 44% of liquid Treasuries plus 20% of corporate debt), but also our
corporate assets (10% of our total corporate stock) and our commercial real
estate (one half of the commercial real estate in downtown Los Angeles, onethird
in Houston and Minneapolis).

Because our trade deficits have been financed by the purchase of our bonds,
real estate and capital stock, they have had little adverse short-term impact. It is
the long term that is worrisome. Throughout history, and not only in the West,
persistent trade deficits have been destructive. “Even when the situation was not
so dramatic, if deficit became a permanent feature it spelled structural
deterioration of the economy sooner or later. And this is precisely what
happened in India after 1760 and in China after about 1820-1840.” (Braudel, The
Wheels of Commerce, p. 219.)

Our policies derived from our free market theology, though painless in the
short run, have compromised our long-term health. As Warren Buffet put it:
“We are much like a wealthy family that annually sells acreage so that it can
sustain a lifestyle unwarranted by its current output. Until the plantation is
gone, it’s all pleasure and no pain. In the end, however, the family will have
traded the life of an owner for the life of a tenant farmer.” (Fortune, May 1988) In
the same spirit, “In Trading Places, former Commerce Department official Clyde

Prestowitz referred to the U.S. as ‘a colony in the making.’” (Philip Mattera,
Prosperity Lost, p. 170.)

The irony is the extent to which we have positioned ourselves to be the
principal agent in our downfall. In the immortal paraphrase of John Paul Jones
by Walt Kelly (Pogo): “We have met the enemy and he is us.”
Read More : EARLY SYMPTOMS OF ECONOMIC DECLINE

HISTORY: THE EFFECTS OF ECONOMIC INEQUALITY

The previous sections show that pure free markets have underperformed
well-focused mixed economies, that they must underperform, and that what
they offer is not what we want. It is worse yet. Laissez faire is leading us down a
well-trodden path to decline and even disaster.

Decline
Western history has witnessed a sequence of transitions of economic (and
most of the time, military and political) hegemony: in the ancient
Mediterranean, from Assyria to Egypt to Persia to Greece to Rome; centuries
later, from Italy to Spain to Holland and France to England to the U.S. In most of
these cases, at least in the last millennium, the dominant country was
supplanted not by a mortal enemy but by a country that had previously been
allied or neutral, or even by a former colony. The transfer of power occurred, not
as a result of an invasion or series of battles, but as a result of economic
exhaustion.

Even the greatest empire, Rome, did not escape the consequences of
economic exhaustion.

But the Empire, alas, was ruined. Its exhausted finances no longer enabled
it to maintain on its frontiers the compact armies which might have contained
at any point the thrust of the Germans driven back by Attila, whose hordes

were still triumphantly advancing towards the West, overthrowing, as they
came, people after people. Stilicho saved Italy only by leaving undefended all
the Transalpine provinces. The result could not be long delayed. (Pirenne, A
History of Europe, p. 27.)


In light of this history (and in light of the fact that hegemonic powers have
always had the arrogance to believe their hegemony would last forever) we may
wonder who will supplant us and what will be the cause of our decline to a
second- or third-rate power? Historical precedent suggests that the cause of our
decline is more likely to be our economic lassitude than the aggression of other
countries. So what is it that determines whether a country’s economy will be
vibrant or stagnant, whether the country will thrive or falter? What are the early
warning signs of secular economic decline?

It is characteristic of European history that the prosperity and even
dominance of a country can be linked to a large middle class, reflecting a broad
dispersion of wealth. One can point to seventeenth century Holland or
nineteenth century England or the U.S. in the middle of the twentieth century.
During the golden age of Amsterdam, it was “‘commonly said that this city
is very much like Venice. For my part I believe Amsterdam to be very much
superior in riches.’ At the upper levels of society, this observation of a
seventeenth-century English traveller could not be verified: patricians of
Amsterdam, at the end of the century, had, on average, little more than half the
assets of their Venetian counterparts. The Englishman, however, was more
impressed by the diffused prosperity which put peasants with £10,000 in his
way.” (Fernandez-Armesto, Millennium, p. 309.)

As a burgher complained: “‘Our peasants are obliged to pay such high
wages to their workers and farmhands that [the latter] carry off a large share of
the profits and live more comfortably than their masters.’” (Braudel, The
Perspective of the World, p. 179-80.)

Two hundred years later, the second half of the nineteenth century was
characterized by the economic, political and military hegemony of England,
which enjoyed a broad dissemination of wealth. “[A]s a French correspondent
writes, for ‘the poor man’s fortune [in the mass] in England is greater than the
rich man’s fortune in more than one kingdom.’” (Ibid., p. 607.) In addition to —
and perhaps because of — its broad dispersion of wealth, England had the
highest GNP per capita in the world, and by a wide margin.


Inversely, “By the end of the (twentieth) century Britain was probably the
least egalitarian of the core states — the bottom half of the population owned
less than 7 per cent of all the wealth.” (Ponting, The Twentieth Century, p. 151.)
Corresponding to this, by 1994 the U.K. had a lower GNP per capita than
Austria, Belgium, Denmark, France, Germany, Holland, Italy, Norway, Sweden,
or Switzerland. (Maddison, Monitoring the World’s Economy 1820-1992, p. 195, 197.)

A large and prosperous middle class has characterized our own era of
world economic dominance. Even in the nineteenth century our robust
economic growth was accompanied by a chronic shortage of labor. That led to a
wage scale higher than Europe’s and insured an increase in real wages every
decade. High wages moderated our wealth disparity and contributed to the
development of a middle class. (They also increased the incentive for industry to
invest in productivity-improving capital equipment.)

But our middle class is now under increasing pressure. Gains in the 1980s
and 1990s were limited to the wealthiest. To the extent that our middle class has
been able to maintain itself, it is because of a large increase in the number of twoincome
households. This is unlikely to continue, as 60% of married women are
employed.

Some of the pressure on our middle class is due to a development that
characterized European powers in early stages of their declines: the Italian citystates
of the late Renaissance, late sixteenth century Spain, eighteenth century
Holland, and late nineteenth century England. These all witnessed the growth of
multi-national banking and investment as a service sector producing enormous
profits for those with ready access to capital. Funding foreign enterprises that
would successfully compete with domestic industry resulted in an increasing
concentration of wealth in the hands of a few rich investors at the expense of the
working middle class.

“If one seeks the causes or the motives for Amsterdam’s decline, in the last
analysis one is likely to fall back on those general truths which hold for Genoa at
the beginning of the seventeenth century as much as for Amsterdam in the
eighteenth, and perhaps for the United States today, which is also handling
paper money and credit to a dangerous degree.” (Braudel, The Perspective of the
World, p. 267) A similar, contemporary, moral is drawn by Arrighi and Silver in
Chaos and Governance in the Modern World.

Carried in the wrong direction by our prevailing economic theory, we
appear to be sailing the same course. Could it be that our misguided insistence
that laissez faire is the only acceptable economic theory will contribute to our

secular decline? George Santayana (The Life of Reason) observed: “Those who
cannot remember the past are condemned to repeat it.”
As a culture, we seem to better reflect the wisdom of Henry Ford: “History
is bunk.”
Read More : HISTORY: THE EFFECTS OF ECONOMIC INEQUALITY

The Failings of Fundamental Economics

An approach to markets based on contemporary economic principles
and the predictions or writings of those who follow such
arguments is, therefore, unlikely to lead to any great financial
success, for two main reasons:
1. The analysis provided may well be based on flawed economic
principles in the first place.
2. The analysis provided is subject to, and influenced by,
market movement itself. Warrior traders recognize that it
is often the recent direction of the price movement that
drives the tone of the fundamental research provided by
the major houses, rather than the other way around, as
they would have us believe.

Ultimately, objectivity is lost.
This is not to say that all market commentaries should be
ignored—there are some excellent examples of winning research
writers out there. You have to do some mining to find these diamonds,
however. One cannot assume that just because the bank
or house name is impressive and distinguished the research will
be right more often than it is wrong, and good research needs to
do just that and in a manner that encourages profitable trading
activity. These winning research writers tend not to be mainstream,
preferring instead to utilize additional principles in
deriving their market view. The mainstream commentaries have

value in providing a guide as to how most of the market is thinking
(or will be thinking). They remain a force to be reckoned
with, and, indeed, no trend will be sustained without this contributing
activity—albeit, usually in the middle or toward the
end of a trend, as the crowd catches up and the arguments begin
to be justified and revised.

Further, there is a significant time delay between an event on
the ground, such as a shift in consumer purchasing or an overrun
in production, and that event becoming apparent in the
released data stream. In most cases, the data can lag by three or
more months. This time lag is so significant that, although surprises
in economic data may already have corrected themselves
at ground level, the discussions of what was happening months
ago—an aberration—may still be in progress. Broad consensus
views can therefore be far behind reality.

Some would argue that the current data stream is the best we
have to work with and, therefore, that is how we should proceed.
The problem is that the market generally has no true
comprehension of this data-reality gap, and therefore makes
assumptions based on data that have a far greater variability
than is initially recognized. This means that if you rely on economic
data for a view on an economy, or a market, you are working
with dated tools.

Admittedly, this is an overly simplistic description of the enormous
and deservedly respected art of economics, but it is done
to make a point. There are quite capable economists out there
who lift their eyes from the textbooks and data in an effort to
get an understanding of what is happening in real time, but
they are in the minority. It can be difficult for them to be heard.

They are often shouted down by the economist masses who
think of their university textbook as a bible and tend to sing in
unison, thus drowning some of the more talented independent
voices.

To my mind, the majority of economists are like meteorologists

who don’t look out the window. If they are heavily absorbed in
the stream of data and charts on their desks, using proven techniques
of reasonable success rates in deriving future weather
patterns that enable a forecast, but they fail to look out the window
as they put pen to paper, then they risk getting it very
wrong indeed. If the meteorologist says, “It is going to be raining
heavily for most of the day,” and then you, yourself, look out
to see that the skies are clear, do you grab your umbrella if you
are only going for a short walk? No. Why then do so many
traders staunchly follow the market forecasts of economists who
are operating in an environment that is essentially art rather
than science? Because most traders just read the research presented
to them on a daily basis without bothering to look out the
window for themselves. Warrior traders sit on the roof and get a
feel for the real-world environment for themselves, as well as
absorbing the commentaries of proven market artisans.
Read More: The Failings of Fundamental Economics