Investing for Sustainable Gains

For every debtor, there is a creditor…

I have read a lot of concern about the debt burdens of various nations, including not just government debt but also corporate, private, etc.  Mortgages, car loans, credit cards…  But, for every debtor, there must be a creditor.  Who are all the creditors?  And, with so much unsustainable debt, why is there so much credit?  Why have so many lent so much?

Did we try to sell the “New American Dream” of retirement to too many people?  Is there too much “retirement savings” chasing too few potential borrowers?  Can the economy support so many millions of non-working retiree creditors, as we will soon have?

Or is the distribution of wealth too skewed, with too many owing too much to too few?  Is the debt burden just another tax on the young and productive, transferring wealth to the aged and/or unproductive?

As for the creditors:  Why are they still trying to lend?  What happens when they stop trying?  Which borrowers will be able to pay off their debts, and which will default?

(1) Verb:  To review something and edit it so it “looks better”… but is no longer factual.

(2) Verb:  When a company’s auditor permits false and fraudulent accounting or reporting.

I saw some comments over on CalculatedRisk which compel me to explain how the Federal Reserve actually works in reality. It is different from the Fed’s self-generated mythology - and also from the skeptics’ mythology.

The Fed will have you believe that they “set interest rates”.  The skeptics will say no, the market sets rates, and the Fed merely follows and claims victory.

Neither is true, and yet both are true.  As usual, look not at what they say, watch what they do, and follow the money!  What does the Federal Reserve actually do?  They buy and sell debt, and they talk a lot.  But it is by means of the first activity that the Federal Reserve is able to manipulate the total amount of credit (what we now use as “money”) that is available in the economy. It does this by expanding or contracting its “balance sheet”.  For every security stored inside the Fed’s balance sheet … and paying interest to the Treasury … after the Fed takes its cut … someone else has a large amount of credit to spend on something.  The Fed creates credit “ex nihilo” - out of nothing.  A mighty power, which is why the Fed Chairman is frequently described as the most powerful man in the nation.

Those claiming that the Fed is a fictitious organization often point out that short term interest rates lead the Federal Reserve’s policy target rate. The market leads and then the Fed follows, right?  Well, the Fed does have to react when short term rates pressure the bounds of the policy target, because otherwise rates would go where the Fed doesn’t want them to go. But ask yourselves — how many folks spend thousands of hours each year trying to figure out where the Fed wants rates to go, and get there first? The market is doing the Fed’s bidding because that’s where the money is. What actually happens is that the Fed telegraphs to the market which way the rate is about to go — or the market has figured out where the Fed will be telegraphing, and has front-run them, which amounts to the same thing but yields more profit for the banksters.

Now, if the Fed can convince the market where it wants the market to go, and the market goes there, it’s a lot less work for the Fed.  And thus a lot less expensive. But there are times when the Fed has to take the market by the horns and implement massive adjustments.  This is part of what happened in 2008-2009. Sometimes the Fed dances with the market, and sometimes the Fed picks the market up bodily and shoves it into place…

But back to the standard operating procedure: the main tool is the policy press release issued at each Fed meeting, which typically reveals (in a few words) the Fed’s outlook for short-term rates. Secondary tools are the minutes released between the meetings, the “Beige Book” economic analysis, and also the public speeches which are frequently given by the various Fed members.  Each of these helps to set the market’s expectations of future policy.  Conversely, the market also communicates with the Fed, by way of current interest rate pressures (relative to the current Fed target rate) and prices in the rate futures markets.

Now, which is more powerful?  The market would always go where the Fed leads it, unless it believed the Fed were fully able to implement its targets.  On the one side, the Fed’s ability to drain credit from the market (by selling assets on its balance sheet and siphoning cash out of the system) is a potent, but not omnipotent, lever for raising interest rates.  By shrinking the supply of short-term credit, the Fed can fully offset private-sector increases in credit, and force short-term rates upwards.  This generally moves the long-term rates up as well — who wants to lend long when short rates are paying more, and less risky?  But sometimes the market is in full fraudulent bubble mode, in which case the Fed can force up short-term rates, but long-term lending supply doesn’t respond immediately, and rates fail to respond — as Greenspan’s “conundrum” showed in the 2004-2007 tightening cycle.

On the other side, by expanding the supply of short term credit, the Fed can fully offset just about any private-sector decrease in credit, and force rates downwards. And again, drops in short rates tend to result in drops in long rates, as yield-seeking borrowers are forced to make longer commitments (and thus take on more inflation risk).  This again can fail (or at least take a long time) when the market is in full panic mode, in which case the Fed can also force down long-term rates by purchasing long-term securities.  (But as Bernanke is now experiencing, even after buying up over $1 trillion in fraudulent mortgage securities and flooding the banks with enough cash to give nearly $3,000 to every man-woman-and-child legally in the country, the Fed can force short term rates to zero, and it can pull 30-year rates under 5%, but it still can’t make  creditworthy borrowers out of overindebted individuals and institutions, nor can it make others lend for 30 years in a climate bordering on hysteria over long-term fiscal/policy stability questions…)

So which is more powerful?  From 2004-2008 we saw the market bubble with low long-term rates, despite (belated) Fed efforts to raise rates.  In 2008-2009 we saw the market panic with a total credit freeze (infinite rates - no credit at any price!) in many parts of the market. But we also saw the Fed go thermonuclear and force short rates to zero and long rates to record lows.  So in the short term, the Fed is more powerful.

But in the long term, the actions of the Fed have economic and political consequences. Buying up Treasuries is seen as printing money and enabling Congressional waste.  Buying up mortgage securities is not only probably illegal (based on a tight reading of the Federal Reserve act and the legal technicality that Fannie & Freddie debt is not “full faith and credit” debt of the U.S.), but also has political consequences as people begin to realize that fraudulent lending is “crime that pays”.  Some of those political consequences lead to “Audit the Fed” movements and other political pressures, and those in turn remind us that in the end, the Federal Reserve is only as powerful as Congress allows it to be.

But remember to watch what the Fed actually does!  It’s the Temporary and Permanent Open Market Operations that matter!  And the alphabet soup of lending programs.

And finally:  A more transparent Fed would go a long way toward cleaning up the Augean Stables of American Finance, and while that would be painful for us all in the short term, in the long term, accurate and transparent national accounting is vital to restore investor confidence in security of prinicipal and reasonable rates of return, on investments one can be proud of.

I’ve had this unscratchable itch after reading CR’s post about the labor force participation rate decline.  I wanted to know how labor force was defined (in the U.S., it’s everyone 16 and up minus students and a bunch of other exceptions), and whether the declining participation was related to the boomers hitting retirement age (or at least, early-retirement age), as opposed to their kids maybe not being so numerous to make up the difference.  At first glance, not so…  I went over to Wikipedia and found the population pyramid from the 2000 census data, which showed that the generational cohort currently entering the workforce is larger in number than the boomers.  Also, only the leading edge of the boomer population is in the 55-64 age group now, where early retirement might make sense for large numbers.

So I went looking for more information.  The BLS has a very nice economist named Mitra Toossi, who publishes reports every couple of years analyzing the labor force.

The most recent report (PDF alert) came out in November 2009.  Not too far back!  It says, on the first page, “the aging of the labor force will dramatically lower the overall labor force participation rate and the growth of the labor force”.  

I can see this.  The population aged 65+ is getting larger compared to the population aged 16+.  And those over 64 are less likely to be labor force participants.  Similarly, the population aged 55-64 is “booming” right now, and they are also less likely to be labor force participants (e.g. kids thru college and house paid off, so a lot of folks have more choices about whether or not to work…)

But then I ask myself, how much of this is “prediction” and how much is rear-view-mirror economythics?

So I open up the same report but from November 2007 (the previous version).  It says “BLS projects that the labor force participation rate will be 65.5% in 2016.”  That’s a no-growth prediction from the rate prevailing in 2007.  The all-time high was 67.1% in 1997 (or 67.3% in 1999-2000 if you look at their data (possibly revised since 2007)… The participation rate dropped to about 65.5% in 2004 after the dot-com recession.

More from the article:  “projected continuation of the decrease in the labor force participation rate of youths…”

“once the baby boomers exit the last years of the prime age group and enter the 55-and-over group, with participation rates roughly half that of the prime age group, the overall labor force participation rate will decline significantly…”

So it seems that some of this “labor force participation decline” was anticipated prior to the recession, and it’s just demographics.  If the marginal benefit from working is reduced (lower pay, less pleasant work environment), some folks who don’t HAVE to work right now, will wait for a better chance later.

On the other hand, given that the decline in participation was forecast years in advance, shouldn’t policymakers have anticipated a deeper recession that normal just from the workforce demographics?  And perhaps more importantly going forward, since we know the boomers are going to be retiring en masse over the next few years (many with their belts fully tightened by the recession) doesn’t this imply a very weak recovery?  If workforce participation is going to be declining even in good times, the number of willing workers will be suppressed, and might even decline outright, even if total population remains stable to slightly increasing.  (It doesn’t help that the 2000s were a weak decade for population growth, with no sign of improvement, either.)  After all, it’s a mathematical identity that GDP is the product of the size of the workforce, the hours per worker, and the productivity per worker…  Size has some headroom due to layoffs, but not as much as it would if population were booming.  Hours are stagnant and honest-work productivity may be plateauing due to computer technology reaching the saturation point…  All of which points to weak growth in the U.S. for a while, which is not bullish for optimistic P/E multiples in the stock market.  Nor for bond default and/or rollover risks, with a lot of bond issuance predicated on perpetual-growth thinking…

Ruh-Roh!  The economy may have had “enough!”

W.S.

“Wisdom Speaker” is a working physical scientist living on the east side of the San Francisco Bay Area.  Wisdom Speaker is between 30 and 50 years old and has a top-tier Ph.D. in his field.  W.S. also has a spouse, 2 children in school, a house with a mortgage, and occasionally a sharp tongue. Like many his age, W.S. manages a portfolio that is “big enough to worry about, but too small to retire on”.

For years, W.S.’s spouse led the family to develop strong saving habits, and over the years they invested using conventional buy-and-hold, dollar-cost-averaging, asset-allocation methods. But in 2005 realized that conventional financial wisdom was no longer adequate to the times. Unfortunately this occurred after buying a new home near the peak of the 2000-2006 housing bubble. Although the home equity could not be saved (for some years, anyway), the housing experience “woke them up” to the speculative/Ponzi financial environment. Time was invested in a more detailed financial education. Abandoning “buy-and-hold” and taking detailed control of the household finances, W.S. went to cash and avoided the 2008 financial panic.

The family finances came out well ahead of their 75/25 allocation benchmark, but now the question arises as to how, exactly, one should invest for sustainable gains going forward.  The classic definition of an “investment operation” is one which, “upon thorough analysis, promises security of principal and a reasonable rate of return” (Benjamin Graham). In short, a sustainable gain!  Now, some of what is often considered speculation is in fact investment (e.g. trading with a high probability of success, but a short time horizon).  On the other hand, the lesson America failed to learn from Enron and the dot-coms is that too often, what is sold as “investment”, is actually speculation - or worse, fraud!  Clearly we cannot trust others to do our “thorough analysis”, guarantee “security of principal”, or deliver a “reasonable rate of return” for us.  How now to invest?  W.S. hopes to share what he has learned about investing for “Sustainable Gains”, and to learn from others with similar interests.

W.S. also believes that Graham missed a critical element of what constitutes an “investment”.  There is an ethical or moral dimension to investing:  one must put one’s time and treasure to good use, and be able to sleep well knowing what the “investees” are doing with one’s treasure.  An “Investment Operation” must be one which “upon thorough analysis, promises security of principal and a reasonable rate of return while putting capital to a use one can agree with.  Wave upon wave of financial scandal shows that this issue is far wider than “socially responsible” index fund sellers would have one believe.  Even the simple act of buying a CD, or a T-bill, has an ethical component. So ”Ethical Investing” will be another theme covered here.

Another issue that comes up almost immediately is that the fiat money we use today isn’t wealth, or capital, or anything really.  It’s a bunch of carefully arranged electrons (or paper, or metal disks, but always of minimal intrinsic value) which record the exchange of debts.  But debt is not capital!  Capital is the surplus of production over consumption.  Debt is an agreement to deliver future production in exchange for current production.  True wealth might be better defined as accumulated resources to meet human needs.  W.S. has only dabbled in this area so far, but understanding the “Nature of Wealth” is vital to having “Sustainable Gains” in this area, and will be another theme here.

Finally, there is the eternal issue of time. One can often earn more money, or save it, but one’s time is far more strictly limited. Time spends itself whether one likes it or not, one never knows how much one has left, and it’s darned hard to get more!  But perhaps careful “Time Investing” (not just time management), particularly in conjunction with financial investing, can lead to sustainable gains (measured in terms of any personal goal) as well?  At any rate, between work, family, and personal needs, W.S. feels time-poor, and struggles to fit all the joys and sorrows of life into the 24-hour day, so “Time Investing” will be another theme here.

Hope you enjoy the site!  I look forward to seeing where this goes…