Growth and Natural Cycles

Why does the economy grow?

When we look at the natural world we see cycles of growth and decline. Gardens sprout in the spring, bear fruit in the summer, and die back in the fall. Populations of rabbits and deer grow until they’re everywhere and then collapse. Rivers go into flood, then slow to a trickle. Only with economies do we see steady, long-term growth. A generation ago cars only went 100 thousand miles or so, and you had to wait for weeks to get parts to repair them. Several generations ago people were just getting indoor plumbing. We’re a lot better off now. Why is this?

It’s been said that the economy is more productive now because we’re smarter than we used to be. That’s not exactly true–human nature hasn’t changed. Conflict and war is still common; leaders are still felled by hubris and overreach; education and study are still hard work. But living standards have been rising steadily for 200 to 300 years. Why?

Two centuries of economic research have shown that economies grow because they accumulate capital– human, physical, or financial–and the more flexible that capital is, the more steady that growth will be. That is, if you can shift a railroad from shipping coal to shipping oil, the line won’t go unused (and jobs lost) when the price of oil declines dramatically. Dolphins don’t build factories, and chipmunks don’t trade with field mice.

That’s why the natural world is an imperfect model for understanding the economy. And the faster the economy grows, the better-off everyone is.

Douglas R. Tengdin, CFA

Chief Investment Officer

Storm Warning?

It’s been a mild hurricane season so far. Will it stay that way?

At this time of year people watch a storm center in the Caribbean to see how tropical storms develop. In the same way, observers can watch storm centers in the global economy to see if financial problems might be headed our way. For the past several years we’ve kept an eye on Southern Europe, but recently South and Southeast Asia has become a new global storm center.

The Indian Rupee is down 12%; the Indonesian Rupiah 10%; and the Malaysian currency 8%, and their stock markets have fallen 10-20%. Capital is leaving the region and financing costs are increasing. For many, this is reminiscent of the "Asian Contagion" of some 15 years ago. Are we headed there again?

Probably not. Back then, a major issue was the fixed exchange rates that many countries maintained against the dollar. When capital fled, they had to use up their hard-currency reserves to support the fixed rate. Now their currencies float. Also, the most vulnerable countries–Indonesia and India–are much less levered than Thailand and Singapore were in the late ’90s. And the region is more diversified and flexible than it was before 1997.

This means that while foreign lenders to these countries will likely feel some pain, there aren’t that many, and their currency exposure is probably hedged in some way. The hurricane season isn’t over, and economic issues in Asia could still organize themselves into a major gale. For now, however, it just looks like a hard blow.

Douglas R. Tengdin, CFA

Chief Investment Officer

Cause and Effect (Part 3)

So what caused the financial crisis?

Now that we understand the four types of causation, we can apply them to what happened in 2008. Because if we understand how it all happened, we can apply these lessons to today. The efficient cause of the crisis was the sub-prime mortgage market. That’s what blew up in 2007 and wiped out trillions in capital.

The material cause was what made up that capital–the monetary system that underlies our financial system. It’s why some people want to reestablish the gold standard. Change the material of the financial system and you change how the system works.

The formal cause is the structure of the financial system itself. This structure creates vulnerabilities. Change the structure, and you may become less vulnerable. It’s why there have been such changes in financial regulation and ongoing monitoring recently.

The final cause–or goal–of any economic setback is to rebalance the underlying economic system. In 2002 through 2006–for many reasons–we built way too many homes. During the recession, homebuilding went down to levels not seen since the ’50s. That allowed the economy to work off the excess inventory. Because economic needs change, we’ll always have recessions. It’s the only way that a system can adjust to new circumstances.

By looking at the crisis through the lens of classical causation, we can see how and why some changes in the system might help us become less vulnerable during the next crisis. Because be assured, another crisis will come. As someone once said, we are born to trouble as the sparks fly upward.

Douglas R. Tengdin, CFA

Chief Investment Officer

Cause and Effect (Part 2)

In order to understand what caused the Financial Crisis, we need first to understand what it means to cause something.

Classically, causation can be classified four ways. We looked at material and efficient causes yesterday. Today we will examine formal and final causes. The formal cause of a table is the plan for a table–a horizontal plane supported by several legs. Think of it as the blueprint, or ideal structure. The formal cause of a chemical reaction would be periodic table and electro-chemical potential of various molecules.

The final cause is the purpose it serves. The final cause of a table is to lift stuff up so someone can get at it. The final cause of a car is transportation. It’s what we

So when we ask what caused the Financial Crisis, we should look at it classically, using the four causes. The efficient cause of the crisis was the subprime mortgage market; the material cause was monetary and financial flows; the formal cause was the structure of the financial system; and the final cause was to correct the imbalances and distortions that had developed in the economy.

We need to look at the crisis as fully as possible in order to understand it. Because if we don’t understand history we’ll just go through it again. We sure don’t need that.

Douglas R. Tengdin, CFA

Chief Investment Officer

Cause and Effect (Part 1)

What caused the Financial Crisis of 2008?

On the face of it, that’s a simple question. But it really depends what you mean by "cause." This isn’t a word game. Classically, we can look at causation in one of four ways: material cause, efficient cause, formal cause, and final cause. We’ve largely forgotten Aristotle’s notion of the four types of causation, but that doesn’t make them any less practical. If we don’t want something to repeat itself, we’d better understand what brought it about in the first place.

To understand Aristotle’s delineation of causation, it helps to think about a table, and what caused a table to be sitting in your kitchen. The material cause of a table’s presence is the wood or metal that the table is made of. It’s a pretty simple notion–material causes are created by the material something is made of. In the same way, the material cause of genetic trait would be the DNA-sequence in the cell-nucleus.

The efficient cause for a table’s presence would be the carpenter who build’s it. Efficient causes are the action or process that created something. We don’t want to fall into the "post hoc" fallacy–after this therefore because of this–but in order to cause something, it has to come before it. In order for a red billiard ball to cause a blue ball to move, the red one has to be moving first. The post hoc fallacy just mistakes sequence for causation.

These two types of causes are what people usually think of when they think of causation, but the other two are helpful as well. We’ll look at them tomorrow.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Cult of College

Is college worth it?

That’s a reasonable question, and it’s what’s behind the Administration’s recent effort to reign in college costs. The value of getting a college education has been an article of faith for so long (buttressed by study-after-study about lifetime earnings and unemployment) that questioning the value of a college education is like questioning the value of happiness. But it’s important: college costs have eclipsed home prices for many as the single biggest expense of their adult lives.

And it’s unclear what we’re paying for: education or the degree. Students in college can acquire valuable skills–advanced math, lab science, critical reading and writing–but they also receive a sheepskin. If it were just the skills that were important, cheating wouldn’t happen. And we wouldn’t bother to punish it.

Between 1992 and 2008, the number of BAs awarded annually rose from 1.1 to 1.6 million. Around 60% of those additional graduates end up in jobs that don’t really need a degree: electricians, waiters, mail carriers. So now we’re seen an explosion in graduate degrees. Where will it end?

Right now we’re on a cost merry-go-round, where high prices lead to more federal aid which requires increased administration which pushes up costs and prices–lather, rinse, repeat. Maybe the President’s proposal of online scorecards and regulatory waivers–combined with massive online courses–will help. For now, though, we’re using subsidized debt to purchase an asset of questionable economic value that everyone claims will only go up in price. Have we seen this movie before? And how did it end?

Douglas R. Tengdin, CFA

Chief Investment Officer

Elections Uber Alles?

What if they held an election and nobody noticed?

That’s the situation in Germany right now. Their federal elections will be held in a month, but German voters don’t seem to care. In spite of scandals involving defense procurement or plagiarism by her ministers, Angela Merkel remains well-liked. It is widely seen that this election will have a significant impact on the future of the Euro, but the German public just isn’t that engaged.

Recent polls indicate that less than a third of voters are following the election and fewer than half could even tell you when it is going to take place. When the ruling party has a popular leader and the opposition party doesn’t put a credible alternative forward, this kind of apathy is the result. In a head-to-head contest, Merkel leads her opponent 63 to 29 percent–among those who bothered to respond.

So it looks like the upcoming contest will be a snoozer: a wide majority for the Chancellor, but low-turnout and no broad mandate. Which is a shame: because if no one votes, nothing is really decided.

Douglas R. Tengdin, CFA

Chief Investment Officer

Many Assurances?

Is bond insurance coming back?

One of the more prominent casualties of the financial crisis the bond insurance industry. Before 2007–for a modest fee–issuers could have a third party evaluate their credit and underwrite their bonds. By virtue of low default and high recovery rates among the insured, insurers’ capital could transform otherwise marginal credits into AAA bonds.

70% of munis are held by individuals, so it seemed like a perfect business. Investors would buy the bonds; the insurers would do the analysis. But the insurers tried to expand, and the model that worked so well with munis blew up with mortgages. They were all downgraded, and then no one cared about bond insurance. Some insured bonds actually traded at higher yields than uninsured counterparts–for the same credit!

But it looks like people are beginning to care again. Detroit’s 18 billion-dollar bankruptcy has gotten investors’ attention. While the city and other bond issuers–Yankee Stadium parking lot bonds come to mind–may suspend payment of principal and interest, insured bonds keep right on paying. The insurer is on the hook, and unless there’s a haircut, they’ll eventually get paid back.

It’s one more way the financial markets are showing signs of healing. It’s just ironic that for the marketplace to get better, a big borrower has to get sick.

Douglas R. Tengdin, CFA

Chief Investment Officer

Past And Future

Why is economic growth so hard to predict?

When you look at an economics textbook, it looks so clear: supply and demand each have their functions, and the two lines meet somewhere on a price/quantity graph. Economists call this the equilibrium condition. It’s like physics–an object at rest tends to remain at rest, right?

Only it doesn’t. Prices and quantities are always changing, and nothing seems to be at rest. In classical physics, cause and effect are clear: you have a past, a present, and a future that proceeds in one direction. But in economics, you’re modeling decisions made by thinking producers and consumers. Their expectation about the future can combine with their memories of the past to create a different set of behaviors in the present. The past, present, and future don’t run in a straight line–it’s more like a set of interlocking rings and feedback loops

For example, expectations of higher interest rates today are leading many to lock in mortgage refinancing rates. Thus, while refinancing is significantly less financially attractive than it was three months ago, many banks are seeing their refi activity hold up. That can’t continue.

Finance and economics are complicated because people act on their best judgment. When all those expectations line up in one direction, watch out: something’s gonna change.

Douglas R. Tengdin, CFA

Chief Investment Officer

Chaos and Chance

Are markets just random?

It’s easy to think so. One day they’re up 100 points, then they’re down 200, then up 400. What comes next? The market appears to move to its own inaudible beat, uncertain as to time, place, and level. When the economy is good is often a bad time to invest, and when the economy is bad appears to be a good time to invest. What to do?

All living systems–biological, sociological, economic–are immersed in a sea of randomness. The most basic biochemical processes depend on the random thermal motion of the proteins, enzymes, and DNA. The mechanism of evolution depends on random mutations. Life progresses because of the balance between rigid, formal structures and flexible, adaptive processes.

Economies and markets do the same thing: they balance the stability of what’s familiar with the innovation of something new. But they aren’t perfectly random; they have a decidedly upward bias over the long run. That’s because knowledge (and capital) accumulate over time. We’re more significantly more productive now than we were 50 years ago because we work smarter than we did then.

Still, short-term wiggles and jiggles can upset even the most patient investor. We just have to be sure that we don’t get fooled by randomness into doing something stupid.